As we discussed in Series 203: International Tax System for Businesses, the United States taxation of a foreign-based company is generally limited to those items of income derived from the united states. However, how the income is taxed, and which rate it is taxed at, depends on the foreign business operates in the US. If the foreign business merely has passive investments in the US, then its income is subject to the “Fixed, Determinable, Annual, Periodical” (FDAP) income regime. In opposite, if the foreign business operates a full trade or business in the US, then its income will fall under the “Effectively Connected Income” (ECI) regime of taxation.
In addition, there are special nuances when a foreign business operates a branch in the US, which then becomes subject to a punitive regime of taxation, known as the “Branch Profits Tax”. Furthermore, a foreign business’s investment into US real property is subject to the rules promulgated under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA).
We will discuss each one of these scenarios in turn.
FDAP, Investment Income, and Capital Gains
So, what constitutes FDAP income? Generally, FDAP income consists of income associated with passive investment assets, including interest, dividends, rents, royalties, annuities, and other fixed or determinable annual or periodic gains, profits, and income. In addition, non-resident aliens are considered to have FDAP income on certain capital gains and social security benefits. What is important to note is that there is no parallel rule for gains from the sale of capital assets or social security benefits derived in the US which constitute FDAP income specifically for foreign corporations. That means foreign corporations, with passive holdings of capital assets in the US, can escape FDAP treatment of capital gains on the disposition of such capital assets. This is an important differentiation, as it provides planning opportunities for foreign persons and businesses to avoid the imposition of US taxation on certain capital assets held in the US.
Why is it important to determine what qualifies as FDAP income? This is due to the flat 30% tax that is automatically withheld from such income. That’s right—all FDAP income is subject to a flat 30% tax that is automatically withheld from the payor of such proceeds. The IRS imposes the obligation to collect and remit such tax on the payor of such income rather than by collecting the tax directly from the income’s recipient. What is important to note is that this flat 30% withholding tax on FDAP income can be altered by applicable bi-lateral income tax treaties the US enters with other countries. The changes treaties bring about to the general US system of taxation are discussed further in Series 206: US Tax Treaties.
In addition to the flat 30%, the FDAP regime disallows the use of tax deductions against investment income derived and subject to the FDAP regime. For example, let’s assume a foreign corporation, FC, earns $100 of dividends each year. Assume that in earning such dividends, it pays a portfolio manager $20 to manage its investment in the US. Under the FDAP regime, all $100 of dividend income derived is subject to a flat 30% tax—no deduction is allowed for the $20 paid to FC’s portfolio manager.
There are, however, exceptions to the types of income that qualify under the FDAP regime.
Effectively Connected Income (ECI)
Income that is “effectively connected to a US trade or business” is not FDAP income. This concept is explained later in this article.
Income from Intangible Property and Patents
Generally, income from intangible property, such as royalties, is considered FDAP income. However, there is a nuance when income is generated from the sale of a patent. If income, from the sale of a patent, is contingent on the use or productivity of such intangible, then it is still considered FDAP income. However, if income from the sale of a patent is not-contingent on its productivity or use, then the income from the sale of such patent is treated as if it were a capital gain, and thus not subject to FDAP income specifically for corporations. A non-contingent gain from the sale of a patent can still be considered FDAP income for foreign individuals depending on their period of residency in the US for a certain tax year.
- Interest Payments—The Portfolio Interest Exception: Generally, interest received by a foreign person or business will not be considered to be FDAP income so long as it is not received by a person who owns 10% or more of the stock of the payor, measured by voting power. In addition, the obligation giving rise to the interest must be in registered form and the payor receives a statement showing that the beneficial owner of the obligation is not a US person.
- Certain Dividends: Dividends, paid by foreign corporations, which are US source dividends are not considered FDAP income. Essentially, to receive this treatment, the dividends paid by the foreign corporation must essentially be “effectively connected income to a US trade or business”.
- Income from Real Property: While rents are generally considered passive income, and thus FDAP income, foreign persons are allowed to make an election to treat such income as if it were “effectively connected income with a US trade or business. In addition, the FIRPT regime applies to gains and losses from the sales of US real property, thus treating it as “effectively connected income from a US trade or business”
The last item we will touch upon this section is that of the withholding requirement on FDAP income. Generally, the payor of FDAP income must withhold from any such payment a flat 30% tax and remit it to the IRS. Under the rules set out by the IRS, the payor required to withhold tax from FDAP income are themselves liable for the tax. The person responsible for withholding is better known as the “withholding agent”.
In addition to being required to withhold the flat 30% tax, the payor must determine the residency status of persons to who they will make the payments. Generally, this is determined upon a certificate the payee provides the payor. A foreign person will provide this certificate on Form 8233 (for compensation income) or Form W-8BEN-E (for all other FDAP income). If the payee does not furnish the certificate, payments may be subject to the withholding tax if payable to a foreign address.
For partnerships with a foreign partner, the partnership itself is responsible for withholding the flat 30% tax. It must occur when the partnership furnishes Form K-1 to its partners, or if early, upon distribution of FDAP income to a foreign partner.
Finally, a withholding agent must provide Form 1042-S to each recipient reporting the amount of tax withheld, and all of the Form 1042-S must be attached to a separate information return (i.e. Form 1042) field by the withholding agent to the IRS.
Effectively Connected Income
“Effectively Connected Income” – this is a separate and distinct category of income that is earned by a foreign business conducting activities, with the motive of profit, in the US so much so that their actions are viewed as a trade or business, and not merely an investment. As noted above, if income is determined to be “effectively connected to a US trade or business”, then it is not FDAP income.
The important distinction between these two categories of income is the way taxable income is calculated and taxed for purposes of US tax. Unlike FDAP income, “Effectively connected income with a US trade or business” is taxed on a “net” basis, and subject to the US’s normal graduated tax rated. Thus, expenses incurred in generating such income will be deducted when arriving at a foreign business’s net, taxable income. Furthermore, this income is not subject to the flat 30% withholding tax that FDAP income is otherwise subject to. Finally, the recipient of this income, not the payor, is responsible for filing a return to report their net earnings and paying their own taxes on such income earned.
So, what constitutes “effectively connected income with a US trade or business”? To effectively explain this concept, we will have to break this analysis into two parts—first, what activities rise to the level of a “US trade or business”, and second, what income is “effectively connected” to such US trade or business.
Establishing a US Trade or Business
The determination of whether someone is engaged in a US trade or business depends upon all the facts and circumstances—there are no hard and fast rules defining what level of activities constitute this. Rather, a myriad of court cases helps provides guidance on what is versus what is not a US trade or business. Generally, the court cases focus on the following factors: (1) activities pursued by the foreign person in the US, and (2) physical presence in the US. The degree and significance of the foreign business’s US activities are often the focus of this analysis. Generally, cases and precedents suggest that a US trade or business is generally characterized by progressive, continuous, or sustained activity that occurs during some substantial portion of the taxable year. In addition to this, to be considered as being placed in the US, the business’s essential activities that are essential to deriving profit, must be conducted int eh US.
As a rule of thumb, a US trade or business likely exists if a foreign person maintains a stock of inventory in the US and they additionally pursue sales or engage in significant marketing activities in the US. However, if a foreign person or business’s presence in the US is limited to maintain an office for merely administrative functions, it is not likely a US trade or business.
What business owners need to be aware of is the potential attribution of activities to them through dependent v. independent agents, and the activities of entities they own. When reviewing the acts of the former, a dependent agent’s (i.e. an employee) actions will be attributed to their principal when analyzing the issue of a US trade or business and is likely to result in the establishment of such if their activities are significant enough. However, independent agents (i.e. an independent contractors), while still attributable, are far less likely to result in the establishment of a US trade or business. While still considered for purposes of this analysis, the activities of an independent agent hold far less weight than that of a dependent agent.
What must also be considered are the actions of an entity a foreign person or entity owns. The attribution of an entity’s actions to its foreign owner depends on the entity’s tax status in the US. If treated as a corporation, its activities will not be attributed to tits owners merely because the owners controlled the corporation. However, where the entity is a partnership, it is codified in US tax law that any foreigner who is a partner in the partnership shall be considered engaged in a US trade or business if the partnership is so engaged. Finally, for those entities wholly owned and disregarded for US tax purposes, the actions of the entity will be considered taken by the owner directly. Thus, the owner will be deemed to be engaged in a US trade or business if the disregarded entity is deemed as such.
What also needs to be discussed is the type of activity performed in the US—
- Performance of Services: It is codified in US tax law that services, performed by a foreign person or business in the US, constitutes a US trade or business, with exception to a narrow de minimis rule.
- Real Property Activities: Unlike services, ownership of US real property does not automatically give rise to a US trade or business. Rather, the totality of the facts must be taken into consideration to make this determination. However, there are two rules that permit income to be treated as ECI with respect to a foreign person or business activity in the US. First is an election that allows income derived from real property by a foreign person to be treated as ECI, even if no US trade or business exists. Second, gains or losses from the disposition of US real property are automatically treated as ECI.
- Purchasing Activity: Whether purchasing activity from or within the US constituted a US trade or business depends on the totality of the facts. However, a high volume of purchases, with service components and sales activity can lead to the establishment of a US trade or business.
Determining What Income is “Effectively Connected” to Such US Trade or Business
Without the establishment of a “US trade or business”, there can be no income “effectively connected” to it. Once established, there is a formal process to separate a foreign person or business’s “effectively connected income” (ECI).
- First, gross ECI derived from a US trade or business is segregated from other foreign and domestic source income that is not effectively connected.
- Second, expenses related to the domestic trade or business are segregated
- Third, these expenses are allocated among categories of gross income
- Fourth, the expenses can be further apportioned among foreign and domestic source income within a class of income
Once the above four steps have been run through, the net ECI derived is taxed at the US normal graduated rates applicable to the person or business
Branch Profits Tax
The Branch Profits Taxes (BPT) rules apply to foreign corporations engaged in a US trade or business. The BPT rules are designed to conform to the US tax treatment of foreign corporations operating through a branch in the US to the tax of a foreign corporation doing business through a US corporate subsidiary. Thus, the idea is to have the branch, or what is now deemed as a US corporate subsidiary, taxable on its worldwide income plus a tax on dividends repatriated back to its foreign owners. There are other regimes applicable to this situation, such as the Base Erosion Anti-Abuse Tax (the BEAT) as discussed in Series 204: US Based Companies with Foreign Operations – Part 1: Anti-Deferral and US Tax Base Shifting Provisions. Without this provision, the foreign branch would only be subjected to tax on ECI without any tax on the repatriation of income to its owners. The BPT imposes on foreign corporations doing business I the US in an unincorporated form an additional tax of 20% that is designed to replicate the tax imposed on earnings repatriated by a US subsidiary via dividends or interest payments to a foreign, corporate parent. The BPT is imposed in addition to the regular corporate income tax on ECI.
The application of the BPT can be broken down into 3 rules—
Tax on the “Dividend Equivalent Amount”
The first BPT is 30% of a foreign corporation’s “dividend equivalent amount” (DEA). The DEA equals the foreign corporation’s current earnings and profits from its US trade or business, plus or minus decreases in its “US net equity”. The DEA is representative of earnings repatriated—if equity is lowered, then a dividend is assumed to have been paid. If opposite, ten it is assumed that additional capital was contributed to the foreign corporate branch.
The Branch Interest Tax
The second arm of the BPT imposes a 30% tax on interest paid by the foreign corporation’s US trade or business to a foreign person who is not engaged in a US trade or business. The purpose is to treat interest amounts paid as if they were FDAP income.
Branch Excess Interest Tax
This final arm of the BPT applies at the foreign corporate level, imposing a 30% tax on a foreign corporation on the amount by which an interest deduction allowed to the foreign corporation against its ECI exceeds the interest paid by the corporation’s US trade or business. Essentially, the excess interest is treated as paid to that foreign corporation by a wholly owned US subsidiary.
Each part of this rule has several nuances and exceptions laid within its operations. In addition, the rates imposed by each arm of the BPT is subject to change via an applicable bi-lateral tax treaty.
These nuances are beyond the scope of this article. What you should know is that the BPT is viewed as a punitive regime imposed by the US and is generally planned around. To avoid its application, it is generally recommended the foreign corporation form a US corporate subsidiary to conduct its affairs through instead of dealing with the application of the BPT to its operations here in the US.
Investments in US Real Property
Pursuant to the Foreign Investment in Real Property Tax Act of 1980 (i.e. FIRPTA), the ownership and subsequent disposition of US real property by a foreign person or business is treated as ECI of a US trade or business. The gain from the sale will be subjected to the normal graduated rates of US taxation and can be offset by relevant deductions.
Prior to the enactment of this provision foreign individuals and businesses could invest in US real property and avoid the taxation of capital gains on the disposition of such property. As we discussed earlier in this article, foreign individuals and businesses are subjected to tax on either FDAP income or ECI. FDAP income generally does not include capital gains from sources within the US, with narrow exceptions for individuals and corporations alike. In addition, since the ownership and rental of a parcel of real property is not generally deemed as a US trade or business, the subsequent capital gain was generally not deemed ECI subject to US taxation.
The provisions of FIRPTA apply to both direct investments in US real property and indirect investments, such as through the ownership of a foreign or domestic corporation or partnership. In both scenarios, FIRPTA will apply if (1) a “US real property interest” is involved, and (2) there is a “disposition” of that interest.
US Real Property Interest
A “US real property interest” generally includes any interest in real property included in the US or the Virgin Islands. In addition, it not only includes land, but also fixtures to the land, improvements, and personal property associated with the use of the land. It can additionally include leaseholds of land and improvements and options to acquire such land or leaseholds.
In addition to tangible property, “US real property interests” include intangible property. If not, creative planning could be used to sell real property on an installment note, and thereafter sell the installment note to a third party, thereby skirting the application of FIRPTA. Interests held solely as a creditor are not subject to FIRPTA, however, there are several exceptions to this. As such, a mortgage can be considered a “US real property interest” to the extent it allows for participation in appreciation of the real property.
The final item to note for “US real property interests” is the look-through rule applicable to the ownership held through a partnership, trust, and/or an estate. Essentially, the disposition of an interest in a pass-through entity, to the extent the consideration is attributable to a “US real property interest’ held by the entity, is directly received by the taxpayer.
So, what then qualifies as an indirect holding of a “US real property” interest? Generally, this applies when there is an indirect investment into US real property through a domestic corporation. FIRPTA arises in the situation where the foreign person owning the US corporation sells the stock of the corporation before the US corporation engages in the sale of the parcel of US property. If FIRPTA did not apply, the capital gain arising from the sale of the US corporation would otherwise escape US taxation as either FDAP income or ECI to a US trade or business.
Specifically, FIRPTA will apply to a gain from the sale of shares of a US corporation by a foreign person if that corporation has at any time in the past five years been a “US real property holding corporation.” This rule applies regardless of the foreign person’s or business’s ownership percentage of the US corporation.
Thus, an “US real property holding corporation” must be established for FIRPTA to apply to indirect investments. Generally, a “US real property holding corporation” is any corporation whose fair market value of its US real property interests equals or exceeds 50% of the value of all of its combined foreign and domestic real property interests and business assets. For purposes of calculating this percentage, holdings by the domestic corporation in other business entities are considered. Thus, if a corporation owns an interest in a partnership, trust, or estate, it is treated as holding directly its proportionate share of that entity’s assets.
Furthermore, the ownership of another corporation will affect this overall calculation. If a US corporation owns 50% or more of another corporation, the US corporation is deemed to directly own a pro-rata share of the subsidiary’s assets. However, if the US corporation owns less than 50%, this attribution rule does not apply, and the sole issue is to determine whether the subsidiary itself consists of a US real property interest. If so, then the entire value of its interest is a real property interest.
There is an exception for holding corporations that are publicly traded, so long as the shareholder owns 5% or less of the publicly traded holding corporation. These corporations will not be “US real property holding corporations” with respect to that shareholder.
Planning Note: It is important to note while both foreign and domestic corporations can be US real property holding corporations, only the disposition of an interest in a domestic US real property holding corporation will be subject to FIRPTA. However, the evaluation of a foreign corporation as a “US real property holding corporation” is relevant for determining whether a domestic corporation, whose assets include stock of the same foreign corporation, is itself a “US real property holding corporation”. Please note that the buyer will still be subject to tax under the FIRPTA regime in this case.
A disposition for purposes of FIRPTA includes any transfer that constitutes a disposition by the transferor for purposes of US tax law. This includes items such as outright sales, the recognition of gains in certain non-recognition transfers such as like-kind exchanges, and even gifts where the relief of liability is more than the taxpayer’s basis resulting in a gain. Generally, non-recognition transfers are respected so long as US real property interest are exchanged for interests which carry the similar FIRPTA taint upon its later disposition. An example of this would include a non-taxable contribution of property to either a corporation or a partnership.
Contact an Experienced International Tax Attorney
The US tax laws applicable to foreign business with operations in the US are complex, full of nuances but also full of plenty of panning opportunities. If you have questions regarding the application of the rules or would like to engage in a planning session to get your affairs in a tax efficient manner to avoid the punitive rules of the US tax system, please contact our team to assist you with your needs.