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Branch Profits Tax
The branch profits tax is a branch-level tax on the repatriation of earnings, in the form of dividends, from a foreign corporation's branch in the United States to the home office in the foreign country. The tax is also applied to excess interest on US effectively connected income. It is a tax imposed only on foreign corporations who have effectively connected earnings and profits in a trade or business branch in the US. The foreign corporation does not need a physical presence in the US for the tax to apply, and the tax is imposed in addition to any income tax paid by a foreign corporation. The creation of the provision is Congress's attempt to eliminate disparity between the tax treatment of a US subsidiary and a US branch for foreign corporations with US investment.
Tax on Dividend Equivalent Amount
A foreign corporation must view effectively connected earnings and profits as variable to changing US equity. Effectively connected earnings and profits are decreased for a US reinvestment, creating an increase in US equity from previous to current year. In effect, the dividend equivalent amount is calculated as the effectively connected earnings and profits, less the increase in US equity. In addition, effectively connected earnings and profits are increased for a US disinvestment creating a decrease in US equity from previous to current year. Effectively, the dividend equivalent amount is the effectively connected earnings and profits plus the decrease in US equity. It is upon the dividend equivalent amount which the 30% branch tax rate is applied, unless lowered by a treaty provision. The following is an example from Regulation §1.884-1:
Example Reinvestment of all ECEP. Foreign corporation A, a calendar year taxpayer, had $1,000 U.S. net equity as of the close of 2010 and $100 of ECEP for 2011. A acquires $100 of additional U.S. assets during 2011 and its U.S. net equity as of the close of 2011 is $1,100. In computing A's dividend equivalent amount for 2011, A's ECEP of $100 is reduced by the $100 increase in U.S. net equity between the close of 2010 and the close of 2011. A has no dividend equivalent amount for 2011.
Ultimately, it is advisable from a tax standpoint to continue US reinvestment in order to avoid this second layer of taxation.
Tax on Excess Interest
A foreign corporation with US effectively connected income and US assets is subject to a 30% tax on excess interest paid or accrued on US-booked liabilities. The following types of interest are exempt from the branch profits tax:
- Interbranch interest
- Exempt interest in bank deposits
The foreign corporation may be able to reduce the 30% rate under applicable treaty provisions.
Income Tax Treaty Benefits
The Income Tax Treaties were created by Congress to help alleviate double taxation faced by the foreign corporation in the US and in the foreign country. The amount of branch profits tax under a treaty is determined by either the branch profits tax amount specified in the treaty or the dividend rate specified in the treaty. Typically these treaty provisions reduce the branch profits rate from 30% to 5% or 15% rates.
The 1989 US-Germany Income Tax Treaty defines the amount for a dividend tax rate under Article 10. If the beneficial owner is a company that owns at least 10% of the voting shares of the corporation paying the dividends, then the rate is 5%. In all other cases it is 15%.
There are limitations under the US-Canada tax treaty which benefit Canadian corporations investing in US interests. If a Canadian corporation with a US branch has a deficit in accumulated effectively connected earnings and profits in preceding years and a positive amount in the current year. There will be no dividend equivalent amount in the current year if positive earnings and profits do not exceed the aggregate deficit. In addition, there is a $500,000 one-time exemption allowing Canadian corporations to accrue $500,000 of dividend equivalent, before any excess faces the branch profits tax.
However, it is important to be mindful that “treaty shopping,” or incorporating in such a way as to achieve treaty benefits, is on the Internal Revenue Service’s radar. The IRS is looking to make sure that a foreign corporation’s country of incorporation has significant business purpose.
Qualified Resident Test
The foreign corporation must also be a qualified resident of the foreign country to benefit from treaty provisions. A foreign corporation can be a qualified resident by meeting either an ownership or active business test. A qualified resident, for ownership purposes, is defined as a foreign corporation who is also a resident of the foreign country unless more than 50% of the company is owned by shareholders who are not residents of the same foreign corporation or US citizens or resident aliens, or 50% or more of its income does not go to support liabilities of such residents. A publicly traded corporation can be treated as a qualified resident if its stock is primarily traded in the country of its foreign residence. A foreign corporation may also qualify as a qualified resident if engaged actively in a US trade or business that is integral to its business and has a substantial presence in its home country.
Avoiding Branch Profits Tax through Liquidation and Reorganization
There are certain rules to follow when liquidating or restructuring in order to avoid the branch profits tax. Discussed below are planning techniques for consideration.
A corporation is not subject to branch profits tax in the year in which it terminates all of its US branches and operations and effectively connected earnings and profits are eliminated. Four conditions must be met for the termination to be validated:
- The corporation must have no US assets, or all shareholders must agree to a complete liquidation.
- Neither the corporation nor any related corporation may use the terminated US assets within 3 years of liquidation.
- The corporation must not have any US effectively connected income 3 years from the date of liquidation.
- A waiver of the statute of limitations must be signed and filed by the corporation in the year of termination and not less than 6 years after that year.
The corporation may also be deemed to have a complete termination if the acquiring corporation elects §338 in an acquisition. As long as a related corporation does not carry on business from the proceeds of the stock sale, the acquired corporation's effectively connected earnings and profits are extinguished and the corporation will not be subject to branch profits tax in the year of termination.
Incorporations and Reorganizations
Typically, branch profits are triggered when a foreign corporation transfers assets to a domestic trade or business. When choosing to incorporate, a foreign company can partially escape the branch profits tax if it elects to incorporate under IRC §351, transfer to a corporation controlled by transferor. Section 351 dictates that the foreign corporation has control, owning at least 80% percent of the US corporation's stock immediately after the exchange. In the year in which the §351 transaction occurs, the repatriated effectively connected earnings and profits are subject to the branch profits tax. However, reinvested earnings in the US transferee corporation are not. The transferee corporation must agree to elect to increase its earnings and profits by the transferor’s effectively connected earnings and profits. As an effect of the transfer and election, the effectively connected earnings and profits of the transferor corporation are reduced in the year following the §351 transaction, by the amount transferred to the US corporation. Finally, the transferor must agree to pay any branch profits tax that may arise on the disposition of the US corporate stock.
A foreign corporation looking to make investments in the US can also just choose not to operate with a US branch. Creating a US subsidiary or purchasing stock in a domestic corporation are viable options for avoiding the branch profits tax. A US subsidiary helps shield the parent corporation from having to file a US tax return. The subsidiary is still liable for US taxes but will not be faced with the branch profits tax on repatriation of earnings.