Forms of overseas operations: this two-part article explores the major characteristics, advantages and disadvantages of the different types of entities for conducting business overseas.
A branch generally operates as an independent unit and maintains separate books and records. Since 1997, a U.S. taxpayer can elect an entity's tax classification under the "check-the-box" regulations in Regs. Sec. 301.7701-2 and -3. If a U.S. taxpayer wholly owns a foreign entity that is not a corporation per se, the foreign entity can be effectively disregarded as a separate entity by default or election under Regs. Sec. 301.7701-3(a) and (b). Such a disregarded foreign entity is, in effect, treated as a branch for U.S. income tax purposes. A foreign entity taxed as a corporation under foreign law, but as a branch (or flow-through entity) for U.S. tax purposes, is referred to as a "hybrid entity."
A branch's income is immediately taxable to the U.S. taxpayer. This may not be a serious concern if the effective tax rates of the foreign country and the U.S. are approximately equal. Also, the U.S. income tax might be fully sheltered by FTCs. Conceptually, the FTC a taxpayer can use in any year is the lesser of the actual foreign income taxes paid on the foreign-source income or the U.S. income tax allocable to such income (the FTC limit). (1)
Prior to the American Jobs Creation Act of 2004 (AJCA), Sec. 904(d) listed the following nine separate FTC categories (FTC baskets):
* Passive income (e.g., dividends and interest). (2)
* High-withholding-tax interest (i.e., 5% withholding tax or greater). (3)
* Shipping income (including income from operating an aircraft or a vessel on the high seas and in space).
* Financial services income (i.e., banking, finance or a similar business and certain insurance investment income).
* Dividends from noncontrolled Sec. 902 corporations (4) (at least 10%, but not more than 50%, ownership).
* Dividends from a domestic international sales corporation (DISC) or former DISC.
* Dividends from a foreign sales corporation (FSC) or former FSC.
* Taxable income attributable to foreign trade earned by an FSC.
* Other income (general income). (5) In addition, Sec. 907(a) separately limits the FTC for foreign oil and gas extraction income. Typically, the most common FTC baskets encountered were passive income, general income, high-withholding-tax interest and dividends from noncontrolled Sec. 902 corporations.
AJCA Section 403(a) retroactively amended the treatment of dividends from noncontrolled Sec. 902 corporations. For tax years beginning after 2002, dividends from noncontrolled Sec. 902 corporations are subject to Sec. 904(d)(4)'s lookthrough rule, under which dividends are treated as income in separate FTC baskets in the same proportion as the foreign corporation's earnings and profits (E&P) in each basket bears to its total E&P.
For tax years beginning after 2006, AJCA Section 404 consolidates the nine FTC baskets into passive income and general income baskets. (6)
C corporations: Solely from an FTC standpoint, a domestic C corporation generally prefers directly owning a foreign corporation, due to the former's ability to claim a "deemed-paid" (or indirect) tax credit. A domestic C corporation can receive an indirect tax credit for foreign taxes paid by its foreign subsidiaries when the subsidiaries' earnings are actually (or deemed) distributed. Under Secs. 902 and 960, the indirect tax credit is generally available to a U.S. corporate shareholder with a 10%-or-more ownership interest (voting power) in the foreign subsidiary.
A C corporation generally prefers income deferral from a foreign corporation, unless it has unused FTCs and a branch can greatly improve the FTC limit in comparison to a foreign corporation. The FTC limit generally increases as foreign-source taxable income increases.
Under current law, a branch and a foreign corporation do not normally generate equal amounts of foreign-source taxable income, due to different interest apportionment rules. The FTC limit is based on foreign-source taxable income, which is the amount after allocating and apportioning deductions. Expenses directly related to a class of gross income are allocated directly to that class. If the class includes both domestic- and foreign-source income, the expenses are then apportioned between them. (7) Specific apportionment rules apply to interest, which can vary depending on the type of foreign entity. Generally, under Temp. Regs. Sec. 1.861-9T(g)-(i), interest expense is apportioned based on either the adjusted tax basis or fair market value (FMV) of the U.S. taxpayer's assets. If the foreign operation is a branch, the branch's interest expense is included as part of the U.S. taxpayer's interest and apportioned based on the taxpayer's total assets, including the branch's assets, under Temp Regs. Sec. 1.861-9T(f)(2). In contrast, a foreign corporation's interest expense is not included as an expense of the U.S. taxpayer, while the foreign corporation is treated as a foreign asset of the taxpayer. (8)
For tax years beginning after 2008, AJCA Section 401(a) amends Sec. 864(f) to provide a one-time election for a U.S. corporation to account for its foreign subsidiaries' interest expense in computing the FTC limit. This expense applies solely in determining how the U.S. taxpayer's interest expense is to be apportioned between U.S.-source and foreign-source income; it is not deductible by the U.S. taxpayer.
S corporations: For an S corporation (or flowthrough entity), a branch is generally the preferred choice for FTC purposes, unless the operation is in a low-tax jurisdiction. A branch allows S corporation shareholders to claim an FTC on foreign income tax the branch paid. An S corporation does not qualify for the indirect tax credit that can be claimed by C corporations. Under Secs. 702(a)(6) and 1373(a), only foreign taxes directly paid or accrued by an S corporation (or taxes that flow through to it) are available to shareholders.
The 15% tax on dividends received by individuals affects an S corporation's choice of entity. Based on Notice 2003-69, (9) dividends from foreign corporations incorporated in a country that has a treaty with the U.S. can generally qualify for the reduced rate. (10) Income from a branch, however, is taxed in most cases at ordinary income rates. Thus, a foreign corporation might be preferred if the foreign country has a low tax rate.
A branch is also desirable for an S corporation's foreign operations that would generate subpart F income if operated as a foreign corporation. Under Sec. 951(a)(1)(A), subpart F income is income immediately taxable to the S shareholders, even though it is not repatriated. As will be discussed in Part II of this article, under "foreign corporations," subpart F income is generally passive income or income earned by a controlled foreign corporation (CFC) outside its country of incorporation from certain related-party transactions.
Foreign Branch Losses
A common tax reason for setting up a foreign branch is to allow losses to flow through to the U.S. corporation. A branch loss, however, may generate no tax benefit if there is an offsetting reduction in FTCs. When foreign losses offset foreign-source income that would have been sheltered by FTCs, such losses provide no tax benefit. Under Sec. 904(c), unused FTCs expire after five years. For unused FTCs incurred in (or carried forward to) tax years beginning after Oct. 22, 2004, the carryover period is extended to 10 years by AJCA Section 417(a), amending Sec. 904(c). In addition, branch losses are subject to the dual consolidated loss (DCL) rules and certain recapture rules.
The DCL rules generally apply to corporate taxpayers. While subject to interpretation, they should not affect S corporations. (11) They are intended to prevent losses from being deducted both in the U.S. and another country. Basically, a DCL is a foreign loss that may generate a current or future foreign tax benefit for a person other than the one that generated the loss. A branch loss is automatically a DCL; it can only be used to offset income earned from the branch. (12) Any unused branch loss is carried forward to subsequent years to offset future branch income. Conceptually, the DCL rules are similar to the separate return limitation year rules for consolidated returns.
A U.S. corporation generally can deduct a branch loss if it files an election under Regs. Sec. 1.1503-2(g) (2) with the return for the tax year in which the loss was incurred. It must certify that the loss has not been--and will not be--used to offset the income of any other person under the foreign country's income tax law. (13) Annual certifications are required under Regs. Sec. 1.1503-2(g)(2)(vi)(C) for each of the following 15 tax years if the branch is a hybrid entity (i.e., a legal entity treated as a corporation under foreign tax law, but as a branch for U.S. tax purposes).
The U.S. corporation must report the previously deducted branch loss as taxable income on a DCL triggering event, under Regs. Sec. 1.1503-2(g)(2)(iii). Triggering events include (1) the use of the loss within a 15-year period to offset the income of any other person under foreign law; (2) a transfer of branch assets that results in a carryover of the losses to another entity under foreign law; and (3) a deconsolidation of the U.S. corporation with the foreign branch from the U.S. consolidated group.
Foreign Loss Recapture
Foreign losses are also subject to income recapture rules that can reduce the allowable FTC. (14)
Resourcing: The tax benefits of previously deducted foreign losses can be recaptured by resourcing future foreign income either as U.S.-or foreign-source income to another FTC basket. (15)
Foreign losses are grouped into separate baskets. The foreign losses and income in a basket are first netted in that basket; any remaining loss is then proportionately allocated among the other baskets. Under Sec. 904(f)(5)(B), any remaining foreign loss in a basket not offset by foreign-source income in other baskets reduces U.S.-source income.
Under Sec. 904(f)(5)(C), foreign-source income in one basket is resourced to another basket until losses that previously offset income in the latter basket have been completely resourced. If, for example, foreign general limitation losses offset foreign passive income, future foreign general limitation income would be resourced as foreign passive income. Income resourcing can reduce the use of FTCs, because the foreign tax is not resourced.
The resourcing of foreign-source income to U.S.-source income also occurs if foreign losses previously offset U.S.-source income. Foreign-source income in the same basket as the previous losses that offset U.S.-source income is resourced to U.S.-source income. Under Sec. 904(f)(1) and (2), resourcing in a tax year is limited to the lesser of (1) the income in the basket that generated the previous losses; (2) 50% of the total foreign-source income from all baskets (or a higher percentage elected by the taxpayer); or (3) the foreign losses that had offset U.S.-source income, but had not been resourced. By resourcing foreign-source income to U.S.-source income, the allowable FTC is reduced.
Transfers: In addition to resourcing rules, recapture in the form of gain or income recognition can be required when foreign assets are transferred, even if the transfer would have otherwise been tax free. Under Secs. 904(f)(3) and (5)(F), gain is generally recognized when assets used predominately outside the U.S. for the prior three years are disposed of and the taxpayer has foreign losses that offset U.S.-source or foreign-source income in another basket, but have not been recaptured. Under Sec. 367(a)(3)(C), income can also be recognized when a foreign branch is incorporated.
Subpart F and Foreign Tax Planning
Under the "check-the-box" regulations, a foreign business entity, except for a corporation per se, can be taxed as a hybrid entity. For U.S. income tax purposes, a wholly owned hybrid is a disregarded entity and taxed as a foreign branch. A hybrid can be used in a structure involving multiple tiers of foreign entities.
For example, if a U.S. corporation owns a CFC, which in turn owns a lower-tier CFC, dividends from the lower-tier to the upper-tier CFC constitute subpart F income taxable to the U.S. taxpayer. Although the dividends were earnings from the lower-tier CFC's business that are not subpart F income, the dividends are taxed as such. (16) If the lower-tier CFC elected to be treated as a branch, the dividends would be disregarded. Instead, the upper-tier CFC would be treated as directly conducting the lower-tier's operation. Thus, the dividends from the lower-tier CFC would no longer be treated as subpart F income subject to immediate U.S. income taxation.
The check-the-box election can also prevent U.S. tax issues that would otherwise result from techniques used to minimize foreign income taxes. It is generally desirable to shift income from a high-tax to a low-tax country. For example, a U.S. C corporation could own a CFC holding company, which in turn could own two direct subsidiaries (one in a high-tax jurisdiction, F1, and one in a low-or-no-tax jurisdiction, F2).To minimize foreign taxes, F1 and F2 would enter into intercompany transactions designed to move income to the lower-tax jurisdiction. Thus, F2 might hold the intellectual property used in F1's business and license it to F1. This intercompany transaction generates a royalty deduction for F1 and royalty income for F2, effectively shifting income to a lower-tax jurisdiction. However, such royalty income is generally taxable to the U.S. taxpayer immediately as subpart F income.
This can be eliminated if both F1 and F2 are treated as disregarded entities. When F1 and F2 are effectively treated as branches of the CFC holding company, the licensing transaction between them is disregarded and there is no subpart F income for U.S. tax purposes.
Presently, this (and other similar) strategies to minimize foreign taxes are still possible. However, the IRS issued Prop. Regs. Sec. 1.954-9, (17) which would prevent the use of such techniques, by providing that a hybrid branch payment that reduces foreign tax would generally be treated as subpart F income. The proposed regulations will generally become effective five years after they are finalized (18); thus, these planning strategies remain viable.
Foreign Currency Gains/Losses
A branch is a qualified business unit (QBU), defined under Sec. 989(a) as any separate and clearly identified unit of a trade or business of a taxpayer that maintains separate books and records. In 1991, the IRS issued Prop. Regs. Sec. 1.987-2 for determining taxable income and exchange gain or loss of a QBU with a functional currency different from the taxpayer's currency. In Notice 2000-20, (19) however, the IRS announced that the proposed regulations are being reviewed "to determine if such regulations are administrable and provide rules that call for the appropriate recognition of foreign currency gain or loss...." The current proposed regulations do not cover some key issues and can be administratively burdensome. New proposed regulations are supposed to be issued soon, which might materially change the current proposed method of determining exchange gain or loss.
Under current Prop. Regs. Sec. 1.987-1(b), the operating taxable income or loss of a branch (or any other QBU) is first calculated in its functional currency, then translated into the taxpayer's currency using a simple average of daily exchange rates for the year. The taxpayer recognizes currency exchange gain or loss on receiving a remittance from a branch or other QBUs. Under Prop. Regs. Sec. 1.987-2(a), all unrealized exchange gain or loss is recognized on branch termination.
Under the current proposed regulations, the exchange gain or loss on a branch remittance is basically the difference between the remittance value at the exchange rate on the remittance day and its value at a moving average exchange rate over the branch's existence. To compute the exchange gain or loss, a taxpayer is required to maintain two pools--the equity pool and the basis pool determined under Prop. Regs. Sec. 1.987-2(c). The equity pool is increased by transfers to the branch (contributions) and income. It is decreased by losses and transfers from the branch (remittances). The equity pool is maintained in the branch's functional currency. The basis pool records the same items in the taxpayer's currency. When the branch makes a remittance, the amount is translated into the taxpayer's currency, then compared to the amount from the basis pool allocated to the remittance. Under Prop. Regs. Sec. 1.987-2(d), the difference is the amount of exchange gain or loss. Under the proposed regulations, every branch remittance most likely results in exchange gain or loss, unless one currency "piggy backs" the other.
Part II of this article, in the April 2005 issue, will focus on foreign partnerships and corporations as alternatives for conducting foreign business operations.
(1) Under Sec. 904(a), the FTC limit is: U.S. income tax X (foreign-source taxable income/total taxable income). In effect, the FTC limit equals the taxpayer's U.S. effective tax rate multiplied by its foreign-source taxable income.
(2) Passive income generally includes dividends, interest, rents, royalties, annuities, net gains from the sale of assets that produce passive (or no) income, and net gains from certain commodity and currency transactions; see Sec. 904(d)(2)(A)(i) and Regs. Secs. 1.904-4(b)(1) and 1.954-2(a)(1). Passive income also includes income reported under the foreign personal holding company (FPHC) and passive foreign investment company (PFIC) rules; see Sec. 904(d)(2)(A)(ii). It does not include high-taxed income, export financing interest and income included in another basket (e.g., high-withholding-tax interest). High-taxed income is passive income subject to an aggregate foreign income tax (including deemed-paid taxes) greater than the highest applicable U.S. tax rate. The high-taxed income test is applied to net passive income (i.e., after the allocation of expense of the U.S. taxpayer to such income); such high-taxed income is excluded from the passive income basket and included in the general limitation basket. Passive income items are segregated into groups in determining whether they are high-taxed income; see Sec. 904(d)(2)(A)(iii) and Regs. Sec. 1.904-4(c).
(3) High-withholding-tax interest is any interest income subject to 5% foreign withholding tax or more. Under Regs. Sec. 1.904-4(d), all such interest is included in the high-withholding-tax-interest basket, except for export financing interest.
(4) A noncontrolled Sec. 902 corporation is any foreign corporation in which a U.S. taxpayer owns at least 10%, but no more than 50%, of the voting stock. Prior to 2003, a separate limitation basket was required for dividends from each noncontrolled Sec. 902 corporation. For tax years beginning after 2002, AJCA Section 403 amends Sec. 904(d)(4), and retroactively provides that dividends from noncontrolled Sec. 902 corporations are subject to look-through rules.
(5) This basket includes income items not included in another basket. Most active trade or business income should fall within this basket. Export financing interest and high-taxed passive income are also included. This basket can have both high- and low-taxed income; see Regs. Sec. 1.904-4(h).
(6) For details, see Zink, Tax Clinic, "FTC Baskets Reduced to Two," 36 The Tax Adviser 76 (February 2005).
(7) See Regs. Sec. 1.861-8(b) and Temp. Regs. Sec. 1.861-8T(c).
(8) See Sec. 864(e) and Temp. Regs. Sec. 1.861-9T(a) and (f)(1).
(9) Notice 2003-69, IRB 2003-42, 851.
(10) For tax years of foreign corporations beginning before 2005, dividends from FPHCs, foreign investment companies (FICs) and PFICs do not qualify" for the 15% rate. For tax years beginning after 2004, it appears that only dividends from PFICs will not qualify, because both the FPHC and FIC rules were repealed by AJCA Section 413(a).
(11) Under Regs. Sec. 1.1503-2(c)(2), an S corporation is not a dual-resident corporation. Further, any "separate unit" of a domestic corporation is treated as a dual-resident corporation. A separate unit includes a foreign branch under Regs. Sec. 1.1503-2(c)(3). Thus, the proper interpretation is that an S corporation should not be subject to the DCL rules.
(12) See Regs. Sec. 1.1503-2(b) and (c).
(13) If a foreign country (e.g., the U.K.) has a law that mirrors the DCL rules and disallows the foreign branch loss from offsetting another person's income, Regs. Sec. 1.1503-2(c)(15)(iv) treats the loss as if it had actually offset that income. Thus. the election to deduct a branch loss cannot be made for losses generated in foreign countries with legislation that mirrors the DCL rules.
(14) Before amendment by AJCA Section 402(a), a U.S.-source loss offsetting foreign-source income would not be subject to recapture by recharacterizing subsequent U.S.-source income as foreign income. Effective for losses in tax years beginning after 2006, U.S.-source loss will be subject to recharacterization under Sec. 904(g).
(15) See Sec. 904(f)(1) and (5)(C). If a taxpayer has a loss in a separate limitation basket that offsets U.S.-source income or income in another limitation basket, the taxpayer must establish and maintain an account for that loss. If the loss offsets U.S.-source income, the taxpayer must establish an "overall loss account" for the separate limitation basket that incurred the loss. If the loss offsets income in another limitation basket, the taxpayer must establish a "separate limitation loss account" for the separate limitation basket that generated the loss (Regs. Sec. 1.904(f)-1(b)). Additions and subtractions are made to the account each year. The balance in the account represents the amount to be recharacterized or resourced.
(16) The dividends are not subpart F income if both CFCs are incorporated in the same country and the lower-tier CFC uses a substantial part of its assets in a trade or business in the country of incorporation (Regs. Sec. 1.954-2(b)(4)). Also, the dividends can be excluded as subpart F income if the foreign country taxes them at an effective tax rate greater than 90% of the maximum U.S. income tax rate; see Sec. 954(b)(4).
(17) REG-113909-98 (7/13/99).
(18) Pre-June 19, 1998, arrangements are grandfathered; see Prop. Regs. Sec. 1.954 9(c).
(19) Notice 2000-20, 2000-1 CB 851.
* The opportunity to use FTCs and foreign losses is a major factor in choosing a foreign business form and a branch in particular.
* From an FTC standpoint, a C corporation would generally prefer direct ownership of a foreign corporation, but an S corporation would most likely favor a branch operation.
* A wholly owned hybrid entity is one form of branch operation used in a multiple-tier structure of foreign business entities.
For more information about this article, contact Mr. Lau at Plau@blackmankallick.com.
Editor's note: Mr. Lau is a member of the AICPA Tax Division's International Tax Technical Resource Panel.
Paul C. Lau, ABV, CMA, CPA
Blackman Kallick Bartelstein, LLP
Michael G. Shum
University of California, Berkeley
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|Title Annotation:||part 1|
|Author:||Shum, Michael G.|
|Publication:||The Tax Adviser|
|Date:||Mar 1, 2005|
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