Now that we’ve covered the basics of tax for businesses in Series 201: Tax Deadlines to Know for Businesses and Series 202: Types of Entities and How They Are Taxed, were ready to jump into an overview of how the US international tax system applies to businesses.
The first question to ask is whether your entity is a US-based entity or a foreign-based entity with a limited presence in the US. The answer to this question is the crux of the starting point as to how a business that operates internationally will be taxed in the US.
As a general statement of US tax law, entities that are considered to be domestic are taxed or required to report their worldwide income. Those that are considered to be foreign or non-US entities are only required to report and pay tax on income that is “effectively connected” to a US trade or business, or if a tax treaty applies, income which is connected to a “permanent establishment” in the US. These definitions and more are covered later in this article.
It is prudent to first cover the crux of these different systems of taxation—is the entity a US, domestic entity, or are they a non-US, foreign entity?
Domestic v. Foreign Entities—How to Determine the Difference
It is relatively straightforward to determine whether an entity is domestic or foreign since this question depends on the country in which the entity was formed. For example, the Internal Revenue Code (IRC) provides that a domestic, US corporation is one that is organized under the laws of the US or any of its states. In opposite, the IRC defines a foreign corporation as a corporation that is not domestic. Simple, right?
Well, this becomes more complicated depending on the type of entity at play on top of the myriad of exceptions the IRC provides for such as those provisions which permit a foreign corporation to elect domestic status, while other provisions require that some corporations are treated as domestic whether or not formed under foreign law. An example of this is in the case of a corporate “inversion”, whereby a corporation, that meets certain requirements, changes its corporate headquarters to a foreign country in hopes of avoiding or minimizing its US tax burden.
Beyond the entities that are clearly corporations, the hardest part of this analysis comes down to the initial determination of how an entity should be treated for US tax purposes as a corporation, partnership, or a disregarded entity with the consideration of any entity classification election available or taken. It is this, the classification of an entity for US tax purposes as a corporation or as a non-corporate entity, that determines the applicable method of US taxation, as described in Series 2020: Types of Entities and How They Are Taxed. However, once again determining if an entity, irrespective of its classification, is domestic or foreign depends on what country’s laws the entity is formed—if formed under US law, then it is domestic. If formed under foreign law, then it is foreign.
Specifically speaking to foreign entities, if a foreign entity falls under the IRC’s “per se” corporation regime, then it is, by default, a foreign corporation and is not eligible to change its classification from a corporation to a partnership or disregarded entity. There are more than 85 foreign entities that are treated as “per se” corporations under the regulations to the IRC.
However, if a foreign entity is not treated as a corporation due to its inclusion in the per se entity list, then it is an entity who has the ability to elect its status as a corporation, partnership, or disregarded entity depending on the total owners and the limited liability afforded each of its owners under foreign law. These election rules are informally known as “check-the-box” rules.
First, a foreign entity with a single owner that is not afforded limited liability protection is, by default, treated as a disregarded entity. This entity can make an election to be treated as a corporation.
Second, if a foreign entity has one or more owners, all of whom are afforded limited liability protection, it is, by default, treated as a corporation. This entity can make an election to be treated as a disregarded entity if there is only one owner, or as a partnership if there are two or more owners.
Finally, a foreign entity that has two or more owners, and at least one of which is not afforded limited liability protection, it is, by default, treated as a partnership. This entity can make an election to be treated as a corporation.
All of the elections described above can be made by preparing and filing IRS Form 8832, Entity Classification Election. The election made on Form 8832 can be made at the time the entity is formed or at a later date when the entity is already in existence. There are various requirements that must be followed if an election is made during the life of an entity, and potentially significant tax ramifications from making such an election. Please do not make any such election during the life of an entity without first consulting a tax advisor or our team to help you understand such ramifications.
US International Taxation of Domestic Entities
As mentioned earlier, a domestic entity is required to report and pay tax (if applicable) on its worldwide income, regardless of where it is earned. For example, Corporation A is a US corporation engaged in the business of manufacturing and selling widgets. Corporation A earns $100 of taxable income form sources within the US and $100 of taxable income from Country X. Corporation A will be required to report and pay tax on all $200 of income it earned as part of its US tax filings.
As you could imagine, this broad scope of taxation imposed by the US can lead to double taxation of the same income earned in a foreign country. If we continue with the same example of Corporation A, let’s assume that Corporation A was required to pay a 10% tax on the taxable income it earned in Country X to Country X. Thereafter, assuming no relief provisions apply, let’s assume that Corporation A is subject to a 21% tax on all of its income earned in the given year, for a total of $42. Without any relief provisions for the incidence of double taxation, Corporation A would be required to pay $10 of tax on the $100 earned in Country X to Country X, and then again pay $21 of tax to the US for income earned in Country X. This in turn leads to a total of $31 of tax on the $100 of income earned in Country X. Seems punitive, right?
Well, luckily the US government agrees with you and has measures in place via the IRC and tax treaties that lower or mitigate the incidence of dual taxation. The biggest of these dual tax relief provisions is better known as the foreign tax credit (FTC). The relief provided follows the provisions name—essentially, domestic entities are provided a credit for foreign taxes paid on foreign income that is subject to taxation in the US. This is a very nuanced and technical area of the law and is subject to a myriad of restrictions depending on the type of income earned. This provision and its limitations are discussed in detail in Series 204: US Based Companies with US Operations.
A simple example will be sued to demonstrate the effectiveness of this provision. Continuing with the example of Corporation A, Corporation A’s gross tax liability due to the US on its worldwide income remains $42. However, since Corporation A paid $10 of foreign tax on income it earned in Country X, it will be able to lower its gross tax due to the US by $10. Thus, Corporation A will only owe the US $32 of tax after taking into consideration its FTC.
However, how does the US tax income earn by a foreign subsidiary? Generally, this depends on the foreign subsidiary’s entity type. If the foreign subsidiary is a foreign partnership or disregarded entity (i.e. such as a branch), the income earned by such entity is accounted for on its domestic parent’s tax return. Please consult Series 202: Types of Entities and How They Are Taxed for an overview of how these items of income are accounted for on their owner’s returns. But what about in the case of a foreign subsidiary corporation? As you may know, a corporation is an entity that is treated as separate and distinct from its owner and is liable to report and pay tax on its income earned each year. Thus, a domestic entity’s foreign subsidiary is subject to limited taxation in the US. This is because (as describe in greater detail below) foreign entities are only required to report and pay tax on income that is either effectively connected to a US trade or business or a permanent establishment if a tax treaty applies.
As you could image, the US’s limited ability to tax income earned by a foreign corporate subsidiary encouraged many to move their operations offshore into low tax jurisdictions to avoid the imposition of US tax. Essentially, the mechanisms used are deferral mechanisms that allow foreign corporate subsidiaries to earn income, exempt from US tax unless and until some of those earnings are repatriated back to the US. Many companies took advantage of this “loophole” and moved the majority of their operations to low tax jurisdictions. In response to this, the US has implemented a number of measures to curb this behavior, better known as “anti-deferral” measures. These anti-deferral measures are described in greater detail in Series 204: US Based Companies with Foreign Operations, but essentially allow the US to tax certain types of income earned by foreign corporate subsidiaries.
The world of US international tax as it applies to domestic entities is extremely complex and should not be traversed alone without consulting a tax advisor. We would encourage you to read the rest of this series to understand, generally, some of the nuances at play and to contact our team to help structure and implement a tax efficient structure that best meets your business needs and goals.
US International Taxation of Foreign Entities
If a business does not operate through a domestic, US entity, and has been formed under a foreign country’s laws, the US ability to tax its income becomes much more limited. Specifically, a foreign entity’s income is generally subjected to tax in the US on (1) fixed, determinable, annual or periodic income (better known as FDAP); (2) income that is effectively connected with a US trade or business; or (3) if a tax treaty applies, income that is attributable to an permanent establishment in the US. There are many nuances to these general rules which are discussed further in Series 204: US Based Companies with Foreign Operations and Series 205: Foreign Based Companies with US Operations. However, we will take turn explaining each one of these concepts below.
Fixed, Determinable, Annual or Periodic (FDAP) Income
While this topic was fully covered in Series 103: US International Tax System for Individuals, US Residents v. Non-US Residents, it is prudent to cover it again in this series as it applies to businesses and not just individuals. Non-US residents and foreign entities are subject to tax on a very defined set of categories of income in the IRC. A major category of which covers income associated with passive investments into the US, such as dividends, interest, rents, and royalties. This is income is better known as FDAP income.
FDAP income is a special category of income that specifically arises when the types of income previously mentioned are derived from investment activity into the US, and not an activity that rises to the level of an actual US trade or business. In the case the activity is deemed purely an investment, FDAP income is not allowed to be offset by any corresponding deductions or expenses and is subject to a flat 30% withholding tax. Generally, this 30% tax is otherwise characterized as a withholding tax as the payor of the FDAP income is required to withhold the amount on the amount paid out instead of the recipient being required to file a tax return.
There are various exception to these general rules, the most notable of which applies to interest. For interest, it is exempt from the FDAP regime if the interest is not effectively connected with the payee’s US trade or business and it is not received by a person who owns 10% or more of the stock of the payor. This exception is better known as the “portfolio interest” exception. In addition to the exception listed above, interest paid to a controlled foreign corporation from a related person is not subject to the FDAP regime. The details of a “controlled foreign corporation” are further described in Series 204: US Based Companies with Foreign Operations.
While these are the general FDAP rules, you need to know that they can be adjusted or modified by an applicable tax treaty the US entered with another country. While these are more fully covered in Series 206: US Tax Treaties, what you need to know is that tax treaties have the ability to modify general tax rules set out by the IRC. What you will normally see with respect to FDAP income is the changing of the flat 30% withholding rate. Depending on the treaty, this 30% withholding rate can be reduced to 15%, 105, 5%, or even in some cases, 0%. What you will additionally see is that the lower reduced rates (5% or 0%) are allowed if the foreign payee owns at least a 10% or more ownership interest in the payor of the FDAP income. Please make sure to consult our team or a tax advisor if you would like to understand the implications of FDAP income intermixed with the application of a tax treaty.
Income that Effectively Connected with a US Trade or Business
The second category of income to discuss here is income that is effectively connected with a US trade or business. This is a phrase that has been defined by years and years of case law and requires a thorough breaking down to better understand. However, what you must understand is that if income is deemed to be effectively connected with a US trade or business, then it is not FDAP income. In that case, the income derived can be offset by corresponding deductions and expenses and is subject to the normal system of taxation in the US. That means there is no flat 30% withholding tax and the payee will be required to file and pay tax on its effectively connected US trade or business income.
As part of this analysis, it must first be determined that the foreign person or entity is engaged in a “trade or business” as defined under US tax law. This “trade or business” definition is based upon a review of all the facts and circumstances applicable to the taxpayer. Traditionally, this analysis depends upon the case law definition a trade or business in IRC Section 162. For a general rule of thumb, if a person is engaged in an activity, for profit, and their activity is continuous and substantial, it is likely a “trade or business” is established. A “trade or business” under IRC 162 must be contrasted with an investment activity as defined under IRC Section 212, which is also a facts and circumstances test defined by a myriad of case law.
Once it is determined that the foreign person or entity’s activity is a “trade or business”, then it must be ascertained whether the taxpayer’s activities in the US give rise to an “United States trade or business”. Once again, IRS guidance and case law provide the most amount of guidance in making this determination. However, the guidance focuses on two factors: (1) activities pursued by the foreign person in the US, and (2) physical presence in the US (such as an office or other fixed place of business). As you may be able to tell, the degree and significance of the foreigner’s US activities are the focus of this determination.
In many situations a foreign person will conduct a US trade or business through an entity they own. So, does the owner of the entity become engaged in a US trade or business because the entity they own is so engaged? This highly depends on if the entity used is a corporation. If the entity is a corporation, the owner is not deemed to be engaged in a US trade or business merely because of its ownership of a corporation that is so engaged. However, if the entity used is a partnership, the IRC specifies that the partners in the partnership will be considered engaged in a US trade or business if the partnership is so engaged. Furthermore, if the entity is a disregarded entity, then the actions of the entity are disregarded and are considered that of its owner. Thus, if the disregarded entity’s activities give rise to an US trade or business, its owner will be considered so be so engaged.
If the foreign person or entity’s activities in the US are substantial enough in the US to give rise to a “United States trade or business”, they become taxable on income that is “effectively connected” to such trade or business under the normal principles of US tax law. So, what kind of income is “effectively connected’ with a US trade or business? This determination is made in three steps—
- First, the gross effectively connected income derived int eh foreign person’s US trade or business is separated from other foreign and domestic source income which is not effectively connected;
- Second, expenses related to the domestic trade or business are separated; and
- Third, these expenses are allocated among categories of gross income.
In determining what is “effectively connected income”, IRC Section 864(c) lays out three categories—(1) US source capital gains or loss, and FDAP income; (2) all other US source income, and (3) certain foreign source income. Additionally, some items relating to real property also constitute “effectively connected income”. Each of these categories has its own complex set of rules to determine what is ECI within each category and are beyond the scope of this article. But as a rule of thumb for you, if income derived directly results from a foreign person or entity’s US trade or business, then it is “effectively connected” to such US trade or business and is subjected to the normal principles of US taxation.
Please keep in mind that these are the general rules laid out by the IRC. If a treaty applies, and its protection is elected on a return, you will normally find that income earned from a US trade or business is rather analyzed in terms of “income attributable to a permanent establishment”.
Income Attributable to a Permanent Establishment
As previously mentioned, foreign persons and entities are subject to US tax on all income on income effectively connected with a US trade or business. However, this general principal is changed if a tax treaty applies. IN such case, most treaties change default US tax law such that foreign persons and entities are subject to US tax on “business profits” that are “attributable to” a “permanent establishment” maintained in the US.
While the concepts of “trade or business” and “effectively connected’ discussed above are similar to the concepts of “permanent establishment” and “attributable to”, the treaty itself requires a greater connection to the host country than do the general norms of the IRC. However, what remains the same is that income deemed as “business profits attributable to a permanent establishment” are subjected to the normal principals of US tax, such that income derived can be offset by allocable deductions and expenses. Additionally, the net taxable income is subjected to the normal rate of US tax applicable to individuals and other business entities.
Similar to the analysis above, determining how a treaty impact the US taxation of business income involves a number of steps before determining the ultimate tax consequences. First, it must be determined that a foreign person or entity is carrying on a US trade or business in the US for treaty purposes. If so, it must be determined whether the business is conducted through a “permanent establishment”. If not, the income is not taxed as business profits. Alternatively, if the business is carried on through a permanent establishment, income and expense must be allocated to the permanent establishment. The net income or expense attributable to such permanent establishment is then subject to the normal graduated rates of tax in the US.
As we covered above, the determination of whether a foreign person or entity is carrying on a business in the US for tax treaty purposes is likely the same standard used for analyzing “effectively connected income”. Thus, the activity of the foreign person or entity must be continuous, regular and substantial to rise to this level. However, if it is determined that the foreign person or entity does not conduct a trade or business, they are exempt from US tax on their active business profits without the need of a treaty exemption.
Next, we must determine that there is a “permanent establishment”. A “permanent establishment” has a different standard than an activity that constitutes a trade or business and is harder to establish allowing those without activities constituting a “permanent establishment” to avoid US tax on their business profits.
So, what is a permanent establishment? Most US tax treaties define a permanent establishment as a fixed place of business through which the business of an entries is carried on. More specifically, a business possesses a permanent establishment in the US if (1) it maintains a fixed place of business in the US, or (2) the activities of another person (i.e. such as an agent) who maintains a fixed place of business in the US is imputed to the business. While this is a good general rule to follow, please note that there is a myriad of exceptions, and that different treaties contain different standards. Additionally, there are exceptions such that even certain business activities, performed at a fixed place of business directly by the business or an agent do not by themselves create a permanent establishment.
Treaties provide guidance on what constitutes a permanent establishment. Generally, can include a place of management, a branch, an office, a factory a workshop, a warehouse, or a place of extraction of natural resources. As you can surmise, permanent establishment requires some sort of physical presence. In addition to this, most treaties provide guidance on what does not constitute a permanent establishment. For instance, arrangements for the storage, stock, or display of goods do not qualify, nor do maintenance of fixed places of business solely for the purpose of purchasing goods, collecting information, or carrying on preparatory activities. Each tax treaty the US is entered into has its own definition, so please make sure to read through what qualifies and what does not to understand the concept of permanent establishment. In addition, there are many nuances to the concept of the permeant establishment so please contact our team to have your activities reviewed to help make a determination if permanent establishment arises.
Once permanent establishment is determined, the next step is to calculate the amount of “business profits” “attributable to” the permanent establishment. Generally, these profits are subject to tax in the US in the same manner as business profits earned by domestic individuals and entities. Generally, a formulaic approach is used to determine the amount subject to tax in the US—(1) gross income derived by the foreign person or entity must be segregated from other foreign or domestic source income which is not attributable to the permanent establishment; (2) the foreign person or entity’s expense related to the permanent establishment must be segregated; and (3) the expenses must be allocated between income attributable to the permanent establishment and other income.
The first item to determine in this analysis is the concept of “business profits”. “Business profits” generally includes income derived from any trade or business. Thus, this includes income derived from the conduct of an active trade or business. What should also be noted is that the business profits article of a treaty will override any other article dealing with specific types of income. For example, assume a treaty exempts certain types of interest income from tax. As part of the taxpayer’s business in the US, the taxpayer derives interest income in connection with its permanent establishment. In this case, the interest income will be characterized as business profits and will become subject to normal US tax principles and not exempt from US tax.
The final concept to cover in this analysis is the “attributable to” concept. Generally, business profits are “attributable to” a permanent establishment if the assets or activities of the permanent establishment play a meaningful role in generating profits. If this link can be proven, the income earned by the foreign person or entity becomes subject to US taxation.
As you can see, the application of a treaty to determine taxable business profits in the US is complex and should not be undertaken alone. What is of importance is to note that the application of a treaty does give rise to a higher threshold that must be met for the US to tax a foreign person or entity’s income. Thus, for those looking to minimize their tax in the US, they should consider the application of a treaty. Our team is well versed in this analysis and can help make a determination if you stand to gain a benefit from the application of a relevant US tax treaty.