Docstoc

week4

Document Sample
week4 Powered By Docstoc
					WEEK 4

Taxing Rules for U.S. Activities of Foreign Taxpayers

There are generally two distinct sets of rules for taxing the income earned by
nonresidents in the United States. Under I.R.C. § 871(b) (individuals) and I.R.C. § 882
(corporations) nonresident individuals or corporations who are “engaged in a trade or
business” in the U.S. whose net income is “effectively connected” with those trade or
business activities are taxed in the same way as a U.S. resident would be on net income
earned. Under I.R.C. § 871(a) (individuals) and I.R.C. § 881 (corporations) a
nonresident with fixed or determinable annual income or investment income such as
periodic profits or gains that are derived from U.S. sources, will be taxed on these gains
on a gross basis at a flat 30% rate, unless there is an existing treaty to lower this rate.

In relation to partnerships, under I.R.C. § 875(1), partners are considered to be engaged
in a trade or business in the U.S. if the partnership conducts trade or business in the
U.S., and the partner is acting as an representative of the partnership. The question,
however, is „what constitutes a U.S. trade or business‟? The various international tax
provisions are not particularly helpful in defining the term. Although we can ascertain
that certain income from rental property or gross interest and dividend income may be
taxable at the 30% rate, this passive income would not constitute trade or business.
Even more difficult to define are the activities of nonresident aliens or foreign
corporations in the U.S. that are directed by agents, whether they be partners or agents
that manage transactions via power of attorney.

In relation to the trade of stocks, securities, or commodities, specific rules do exist. If a
foreign taxpayer is involved in the previously mentioned trades and their activity is
handled through a resident independent broker whose office is within the U.S., then
under I.R.C. § 864(b)(2)(C), the trades can be considered a “trade or business”.
Without the U.S. office, stocks, securities, or commodities can be traded by nonresidents
and dealers through resident brokers or other agents without being classified as “trade
or business”. The U.S. covers a broad scope in terms of what constitutes a U.S. trade or
business. The I.R.S. has in the past successfully argued that a foreign taxpayer who
sells products or takes orders in the U.S. does not necessarily have to have an office in
the U.S. to be considered engaged in trade or business.

Personal services provided by a nonresident U.S. taxpayer are considered a trade or
business, even if it is only a one-time event. However, if the level of service is rendered
as de minimis it may not be considered trade or business if the following applies:

1.     the service(s) is performed while the taxpayer is only in the U.S. temporarily

2.     the taxpayer is present in the U.S. for 90 days or less during a taxable year

3.     the payment for the service is $3,000 or less

4.     the employer is not engaged in trade or business in the U.S. or a foreign office of
       a U.S. person.

Treaties will often play a role in the scope of the de minimis rule.


                                              1
Another issue relates not to whether the taxpayer is engaged in trade or business, but
where the trade or business is actually located. A foreign taxpayer from country XYZ
could be in the U.S., purchasing equipment from U.S. manufacturers for sale to country
ABC. ABC would then wire payment for the goods to the taxpayer in the U.S.
subsequent to shipping – all of this business done from a temporary site. In this case
the taxpayer would be assessed taxes on any income that arose from the sale to ABC
because of the taxpayer‟s level of activity (solicitation of sales, purchase and sale of
goods, etc.)

Effectively Connected Income – U.S. Source

The nonresident alien or foreign corporation engaged in trade or business in the U.S. as
stated earlier is taxed at the same rates as U.S. residents and citizens on “effectively
connected income” – income that is connected to managing the U.S. trade or business.
Under I.R.C. § 864(c), effectively connected is defined as all income from sales,
services, or manufacturing that is generated in connection with trade or business
engaged in by the taxpayer in the U.S. Example: If a foreign corporation sells grommets
in the U.S. through its U.S. branch, any income produced by that branch would be
considered effectively connected income. Any income generated from the sale of
grommets or inventory in the U.S. by the home office would also be considered
effectively connected if title to the inventory or grommets passes with the U.S. – with or
without the involvement of the branch!

U.S. source investment income is effectively connected if one of the following applies:

1.     the income is derived for assets used conducting U.S. trade or business;

2.     the activities of the trade or business are a consequential element in the
       generation of the income.

One test applied to determine if the income is effectively connected is called the “asset-
use” test. If the taxpayer earns interest from an account receivable originating with the
trade or business. Another test is the “business-activities” test that ascertains whether
dividends obtained by dealers in securities or royalties obtained form a servicing venture
are decided to be effectively connected income.

Effectively Connected Income – Foreign Source

Although foreign source income is usually not regarded as effectively connected income,
there are occasions when foreign source income may be regarded as effectively
connected in relation to U.S. trade or business and thus taxed accordingly in the United
States. Occasions that would cause foreign source income to be considered in this light
include income that can be connected to a fixed place of business or office. Under Reg.
§ 1.864-7 the U.S. defines an “office or fixed place of business” as a store, plant, or
office where the foreign taxpayer is engaged in business. In regards to an agent, under
I.R.C. § 864(c)(5)(A), an office or fixed place of business will not satisfy the requirement
unless the agent meets the following:

1.     the agent possesses and regularly exercises the authority to negotiate and
       conclude contracts for the principal or maintains an inventory of merchandise that
       is used to fill order on the principal‟s behalf; and

                                             2
2.     the agent is not an independent agent


Under I.R.C. § 864 (c)(4)(B)(i), any rent or royalties that are attributable to property
situated outside of U.S. jurisdiction that are obtained while conducting U.S. trade or
business are considered effectively conneced income. This would include income
generated by foreign patents or trademarks that are licensed through a U.S. office.
Additionally, income can be considered effectively connected if it is generated by banks
or other financial institutions that earn dividends or interest from securities or stocks that
are attributable to a U.S. trade or business, or if earned by an institution who trades
stock or securities as their principal business – even if the source is foreign. As an
example, if a U.S. branch of an Australian financial institution makes loans that earn
interest from borrowers in the Netherlands, that income (or interest earned) will be
considered effectively connected income as it is attributable to the U.S. branch. (I.R.C. §
864 (c)(4)(B)(ii))

Furthermore, under I.R.C. § 864 (c)(4)(B)(iii) any foreign source income gain from the
sale of inventory with title passing outside of the U.S., whether the inventory is proposed
for use in the U.S. or not, will be considered effectively connected if the nonresident is
pursuing trade or business in the U.S. through a U.S. branch. This would not be true if
the foreign office of the taxpayer participates significantly in the sale transaction and is
not used in the U.S. In this case a gain would not be viewed as effectively connected
income. Unfortunately for most foreign taxpayers the second illustration is not typical and
the income or gain will be treated as effectively connected. Under I.R.C. § 864 (c)(5)(B)
foreign source income in the above scenario is attributable to a U.S. office under the
following circumstances:

1.     the office is a significant factor in the production of income; and

2.     the income is realized in the ordinary course of the trade or business of the
       office.

The term significant in production of income would include solicitation of orders, contract
negotiation, or other services that result in a sale.

Income Effectively Connected to Pre-existing Trade or Business

Should a foreign taxpayer conclude business or trade in the U.S. and begin to sell off
inventory or perform services over a period of years, would that income be considered
effectively connected? The answer according to I.R.C. § 864 (c)(6) is, yes. Although the
payments are being received subsequent to the taxpayer discontinuing trade or business
in the U.S., the installments or payments are still considered effectively connected
income, just as they would have had the income been received prior to the conclusion of
business or trade in the U.S. In a slightly different scenario, if the foreign taxpayer
ceases to do business in the U.S. and then sells off property or equipment that was used
to conduct that business, the property retains its characterization as business property
for 10 years; after that time the income from the sale would not be effectively connected.
I.R.C. § 864 (c)(7). Thus, under I.R.C. § 871(a) (individuals) or I.R.C. § 881
(corporations), income from a sale of property after the conclusion of trade or business
would result in no income or gross base taxes for the business.

                                              3
Foreign Investment on Real Property in the U.S.

If a foreign investor owns real property in the United States that produces rental income,
and the foreign investor is engaged in U.S. trade or business, then the net rental income
is effectively connected income and taxable in the same fashion as other U.S. taxpayer
business income. Under I.R.C. §§ 871(a) or 881, if not engaged in U.S. trade or
business, the foreign taxpayer would be taxed on the gross rental income at a 30% rate.

On certain occasions a foreign taxpayer may choose to have income considered
effectively connected even though it is not. Although this may sound strange there is a
very good reason for this choice. Certain circumstances will allow the foreign taxpayer
to do this. Under I.R.C. § 871(d) and 882(d), should a nonresident alien individual or
foreign corporation own U.S. real property they can choose to treat the rental income as
effectively connected. The reason for the foreign property owner to elect this treatment
has to do with “net basis”, which allows the owner the benefit of business deductions
such as depreciation as opposed to being taxed at a 30% flat rate on gross rental
income. Sometimes the higher nominal tax rate that is applied to net income is
preferable to a lower rate applied to gross income as it may significantly reduce tax
liability. Once the “net basis” choice is made, it is irrevocable. Regardless of the
nonresident‟s choice of effectively connected or net basis, loss or gains on the sale of
U.S. real property will be taxed as if the taxpayer, even though a passive investor, were
engaged in U.S. trade or business and as though said loss or gain were effectively
connected with a trade or business.

Another interesting situation would be one in which a foreign corporation with U.S. real
property receives no gross income from the property, but does incur expenses in
connection with that property. In response to nonresident taxpayers who hoped to take
advantage of the net basis election in order to offset taxes for other activities that were
effectively connected, the IRS concluded that nonresidents may not elect the net basis
filing alternative for U.S. real property for a taxable year in which the taxpayer has not
received income from that property. The IRS did rule that any excess deductions over
income received on the real property could be used to offset effectively connected
income, and, when applicable, the excess deductions could be carried back or forward
to other years. The ruling, Revenue Ruling 92-74, 1992-2 C.B. 156, applies only to
foreign corporations but may be offered to non-resident aliens too.

Gain from the sale of U.S. real property by a nonresident involved in U.S. trade or
business of selling and buying property is considered effectively connected income and
taxable. But historically, the foreign investor who is not usually engaged in the sale of
property would not be subject to tax. Because the IRS was becoming concerned over
the increase of foreign ownership of U.S. real property, Congress in 1980, enacted
I.R.C. § 897 to address gains from the sale of U.S. real property. Under this code the
foreign investor can be considered to be engaged in a trade or business in the U.S. and
the gain can be considered effectively connected income. Real property interests could
include leasehold property, timeshares, options, and natural resources. Should the
nonresident hold property through a trust or partnership, the sale by the entity of U.S.
property or by nonresident of the interest in the entity could result in effectively
connected income. The code I.R.C. §§875 and 897(g) the Code has a “look through”
rule and reviews the attributes of the sale by the entity to participants in the sale or


                                            4
considers the sale of the entity interest partially as a sale of U.S. real property held by
the entity.

This principle does not apply to corporate entities that are treated as separate entities for
tax purposes. In these cases the sale of U.S. property by a corporation, the foreign
corporation is taxed on any gain as effectively connected income and the gain is not
attributed to the shareholders. Under I.R.C. § 897 the foreign corporation is taxed on the
sale, but shareholders who enjoy appreciated stock are not taxed on the gain.
Obviously if a U.S. corporation sells U.S. real property (I.R.C. § 11), the corporation is
taxed on the gain. And if a foreign shareholder of stock in a U.S. corporation sells
appreciated stock in that corporation, the shareholder may be taxed on the gain as it will
most likely be treated as effectively connected income.

An equity interest in a U.S. corporation is known as a U.S. real property interest or
USRPI and is subject to I.R.C. § 897 if the corporation is a U.S. real property holding
company or USRPHC. The corporation is classified as a USRPHC if at any time over the
previous five year period the fair market value of the USRPI constituted a minimum of
50% of the total fair market value of the corporation‟s total worldwide real property
interests and business assets. If a domestic corporation is a USRPHC during any
determination date in the five-year period, it is then considered a USRPHC. A
determination date would be 1) the last day of the corporation‟s tax year, or 2) the date
of each transaction that may cause a corporation to be considered a USRPHC. The
transactions considered could be disposition of a foreign real property or assets used in
trade or business or the acquisition of a USRPI.

To determine if a U.S. corporation is a U.S. real property holding corporation the look
through rule is used. Should the U.S. corporation own interest in an entity such as a
partnership or own no less than 50% of stock in a U.S. or foreign corporation, a pro rata
portion of the assets are considered to be owned by the parent corporation. No look
through is done if less than 50% is owned by the second corporation. In this case, the
second corporation is a USRPHC, if it is a U.S. corporation and the full amount of the
stock interest is then treated as a USRPI in the calculations to determine if it is a
USRPHC. Should the U.S. corporation be a USRPHC, distribution resulting in a gain by
a nonresident other than a creditor, would be subject to taxation in the U.S. This covers
stock interests and hybrid securities as well. Other than sales any disposition can result
in U.S. taxation. Under I.R.C. § 351, nonresidents could exchange U.S. real property for
stock of a foreign corporation in what is referred to as a non-recognition exchange. This
would allow the taxpayer to sell the stock in a foreign corporation free without any tax
liability. I.R.C. § 897(e) disallows statutory non-recognition provisions except if the
property received in the transaction is taxable in the U.S. should it be sold.

Income from U.S. Sources – Non-business

Nonresident aliens and foreign corporations may be subject to a 30% tax on various
non-business income as defined under I.R.C. §§ 871(a) and 881(a). (Keep in mind that
the tax will vary depending on existing treaties.) This flat 30% fee is usually collected
through withholding and does not allow for any deductions or allowances for costs
incurred in generating the income. The tax applies to dividends, interest, royalties, rents
or other “fixed or determinable annual or periodic income” (FDAP income). The income
must be determined to:


                                             5
1.     be includible in gross income

2.     be from U.S. sources

3.     not be effectively connected with the conduct of a U.S. trade or business

Interest Income

This includes original issue discount and unstated interest such as deferred payment
under a contract of sale. The majority of interest received by nonresidents falls in the
area of portfolio interest, which is not subject to the 30% tax.

Original issue discount obligation is one in which the face value exceeds the issue price.
This means that a loan may be made by a nonresident for a particular amount. Instead
of collecting interest, repayment of the loan after a determined amount of time will
include the original amount of the loan plus an additional predetermined amount. Under
I.R.C. § 1273, the difference between the original loan amount (issue price) and the
repayment amount redemption or face value) must be accrued for tax reporting
purposes by both the lender and borrower. Though this difference is treated in the same
manner as though it was interest paid throughout the period of the loan, it will not be
taxed at the 30% rate until the loan is sold, exchanged, or retired.

Portfolio interest is U.S. source interest received by a nonresident not taxable at the 30%
rate under I.R.C. §§ 871(h) and 881(c). This exemption allows for competition between
U.S. borrowers and borrowers in other countries that may not tax interest payments
made to foreign lenders. Prior to the implementation of this exemption, U.S. borrowers
might establish offshore international finance subsidiaries in jurisdictions that offer
favorable treaties, using borrowed funds as a loan to finance the subsidiary‟s U.S.
parent. The interest payments from the U.S. parent to the subsidiary and then from the
finance subsidiary to the lenders in Europe were not taxable in the U.S. due to
applicable tax treaties. The offshore jurisdiction would more than likely assess little or
no tax. With the portfolio exemption, there is no need for the complicated transactions
described above.

Congress aimed to restrict benefits of the exemption to U.S. borrowers and unrelated
foreign lenders. In order to fulfill this aim, I.R.C. §871(h)(3) implicitly states that the
exemption does not apply to interest payments made to a foreign lender who owns 10%
or more of the voting power of the stock of the borrower. U.S. lenders are deterred from
using the exemption, interest paid on bearer debt such as unrecorded debt instrument
entitling the holder to interest and principal payments, can only be considered portfolio
interest if the debt falls under the following:

1.     The debt is sold under procedures designed to prevent sale of the debt to U.S.
       persons

2.     The debt bears interest payable outside the U.S.

3.     The debt indicates that U.S. holders are subject to tax penalties.

Also, interest paid on registered obligations qualifies for the exemption if there is a
statement on file that the beneficial owner is not a U.S. individual.

                                            6
Occasionally foreign investors seek to camouflage dividend payments as portfolio
interest since dividends are subject to a 30% gross base withholding tax and portfolio
interest often eludes U.S. withholding altogether. In theory, dividends paid by a
corporation fluctuate more than interest payments. In other words, equity investments
are more unstable than loans. To avoid misuse the portfolio interest exemption for other
streams of income, I.R.C. § 871(h)(4) allows for contingent interest which disallows any
portfolio interest exemption for interest determined through the reference of income,
receipts, sales, or asset appreciation of the debtor. Also the portfolio interest exemption
is denied if the interest rate is tied to the dividend rate.

In response to “creative financing” by U.S. corporations Congress authorized the
Treasury to publish multiparty financing regulations under I.R.C. § 7701(l). This code
dissuades U.S. corporations from lending to unrelated foreign borrowers or
intermediates who then in turn lend the money to a U.S. subsidiary to allow qualification
for the portfolio interest exemption. The regulation prevents foreign taxpayers from
misusing intermediate entities to acquire reduced withholding benefits. Also the IRS can
disregard any intermediate entities in a financing arrangement if they feel the entity is
merely functioning as a conduit in the financing arrangement. Financing arrangement in
this sense is defined as a series of two or more financing transactions such as lending,
borrowing, purchasing stock – a loan of money to one party by another through one or
more parties to another party. The intermediate is considered a conduit under the
following conditions:

1.     By participating in the financial arrange the conduit reduces imposed taxes.

2.     The participation is pursuant to a tax avoidance scheme.

3.     There is a relation between the intermediate such as related to the financing
       entity or the financed entity, or they intermediate would not have participated in
       the arrangement if the financing entity had not engaged in the transaction with
       the intermediate entity.

If such an arrangement is found the payments form the financed entity to the
intermediate entity would be recategorized to disallow the portfolio interest exemption.

Interest received by nonresidents from State and Municipal obligations, as well as FDAP
income from foreign sources, are not usually taxable. Of course as discussed earlier,
income received by nonresidents from sources within the U.S. that is effectively
connected would be taxable. In some circumstances tax may be assessed on income
that is not actually received or paid, but only reallocated. Again, comparisons should be
made between FDAP tax rates and that of tax rates for income that is effectively connect
to determine which course results in the least liability, if policy allows.

Although bank deposit interest that is effectively connected to the conduct of trade or
business in the U.S. is taxable as business income, interest earned from bank deposits
in U.S. bank by nonresident investors is not subject to the 30% tax even though it U.S.
sourced.

If a foreign corporation makes a loan to a U.S. subsidiary, under I.R.C. § 881, any
interest payments on that loan would be subject to a 30% withholding tax. Although it is

                                            7
possible to make a loan from another source, such as a tax-exempt pension fund any
substitute payments that might be made in the amount of an interest payment would still
have the same features as the underlying interest payment and thus would be subject to
tax under I.R.C. § 882. This is true whether the borrower is a U.S. or foreign borrower.
This treatment also applies if the foreign corporation sells the debt instrument under a
contract that allows for repurchase of the debt instrument. Only if the foreign company
qualifies for the portfolio interest exemption and has the interest paid directly to it would
the substitute payment qualify for the portfolio interest exemption too.

Dividend Income

Although dividends are usually subject to the 30% withholding tax, like almost every
other rule, there are exceptions to this one too.

1.     If 80% of a dividend-paying domestic corporation‟s gross income for three
       preceding years is obtained from business income that is foreign sourced, the
       dividend paid is not subject to the 30% withholding tax as the dividend is
       connected to foreign income. I.R.C. § 871(i). In essence, because the dividend
       income was earned abroad the U.S. does not have territorial jurisdiction.

2.     When dividends paid by a foreign corporation with substantial U.S. earnings,
       even though the earnings may be U.S. sourced they may not be subject to the
       30% tax rule. This has to do with the operation of branch profits. This works
       similarly to the substitute interest payment concept. A foreign stockowner can
       lend the stock to an individual and receive a substitute payment equal to a
       dividend distribution on the loaned stock.

Capital Gains

If a nonresident receives capital gains from the sale of property they are rarely subject to
the 30% withholding tax. If a nonresident sells stock from a U.S. corporation that results
in a gain, the gain cannot be taxed. Gains from the sale of property that is effectively
connected, on the other hand, are taxable as business income. The current residency
rule is clear in that any individual who is present in the U.S. for 183 days or more during
a taxable year is considered a U.S. resident for tax purposes and can be taxed on
worldwide income that includes capital gains.

Rent Income

If a nonresident or agent receives rental income that is not effectively connected to a
trade or business, that income will be subject to the 30% withholding tax. If the rent is
effectively connected, the income will be taxable as business income.

Service Income

Salaries and wages are rarely subject to the 30% withholding although they are listed as
FDAP income. The income is taxable as effectively connected income since it is usually
relates to service performed in the conduct of trade or business. Additionally, pensions
or other retirement distributions may be subject to the 30% withholding tax. An
exclusion should be noted for those nonresident aliens who do not have gross income


                                             8
for annuity payments received under a qualified retirement plan. The exclusion would
only apply under one of the following conditions.

1.     the service was performed outside the U.S. while the taxpayer was a
       nonresident; or

2.     the service was performed inside the U.S. while the taxpayer was temporarily
       present (90 days or less)

In addition, if less than 90% of the retirement plan participants are residents or citizens
of the U.S. at the onset of the nonresident‟s annuity, no exclusion will apply unless:

1.     The nonresident‟s country of resident grants a substantially equal exclusion to
       the U.S. residents and citizens

2.     The nonresident‟s country is a beneficiary developing country under the Trade
       Act of 1974.

Treaty rules may also alter rules related to pensions as we will see when we discuss
treaties later in the course. The U.S. is barred from taxing the majority of pensions
received from U.S. sources by residents of the other contracting state in accordance with
Article 18 of the 1996 U.S. Model treaty.

Under I.R.C. § 871(a)(3), 85% of social security benefit amounts, including disability
benefits, railroad retirement, and survivor benefits are subject to a 30% tax.

Royalty payments not effectively connected to trade or business in the U.S. are also
subject to the 30% withholding tax, as well as gains from the sale of royalty-producing
property, alimony, commissions, prize winnings, and gambling profits.

Branch Profit Tax on Earnings

Before 1987, foreign corporations that were owned by foreign investors and conducting
business in the U.S. were taxed at the corporate level under graduated corporate rates
on any income effectively connected to a U.S. trade or business. This also applied if the
foreign investors operated in the U.S. through a domestic corporation. Distinctions
occurred if the corporation distributed the corporate earnings to the foreign owners.

In the case of domestic corporations, under I.R.C. § 881 dividends were subject to a
30% tax rate (depending on existing treaties) and collected through withholding. At one
time it was not likely that dividends paid to foreign investors would be subject to U.S. tax
due to favorable tax treaties or because the dividend was from foreign source income
and as such, not subject to the 30% tax under either I.R.C. §§ 871(a) or 881 as a result
of the distributing corporation‟s mix of U.S. and foreign income.

This all changed with the Tax Reform Act of 1986 that included I.R.C. § 884 relating to
Branch Profits Tax. The reason for this tax is to liable the income earned by foreign
corporations that operate in the U.S. to the same two levels of taxation that income
earned and distributed by U.S. corporations operating in the U.S. are subject to. For the
U.S. corporations operating in the U.S. income is taxed at a maximum marginal rate of
30% tax when they make a dividend payment. Under the new rules, the income of

                                             9
foreign corporations is taxed at a maximum marginal rate of 35% when it is earned and
an additional 30% branch profits tax is imposed upon repatriation from the U.S. branch
to the foreign home office. Essentially the new branch profits tax regards the U.S.
branch like a U.S. subsidiary of the foreign corporation.

Under I.R.C. § 884(e)(3), instead of a secondary withholding tax being assessed on the
dividends paid by a foreign corporation, the 30% branch tax is assessed on the dividend
equivalent amount. This amount is equal to the foreign corporation‟s earnings and
profits that can be effectively connected with the performance of trade or business in the
U.S. Depending on how the effectively connected earnings and profits are invested in
the U.S. the dividend equivalent amount may be decreased, resulting in a reduction in
the base to which the branch profit tax is applied. The earnings in effect have not be
repatriated to the home country. Of course, the opposite is also true – as the foreign
corporation‟s investment in qualifying U.S. assets decreases due to repatriation or
conversion of previously invested assets, the dividend qualifying amount increases.
Qualifying U.S. assets would be money or property used by the foreign corporation to
conduct trade or business in the U.S.

The Code additionally imposes a 30% tax on interest paid by a branch of a foreign
corporation engaged in U.S. trade or business. I.R.C. §884(f) imposes a branch level tax
on interest, making it less possible for a foreign corporation to decrease or avoid the
branch profits tax through payment of interest to its foreign investors (interest payments
are deductible) thereby decreasing taxable income, effectively connected earnings, and
profits. U.S. source interest payments would be subject to the 30% tax under I.R.C. §§
871(a) or 881 whereas without I.R.C. §884(f) interest payments by a foreign corporation
would be considered foreign source income and not subject to the 30% tax.

The new code includes two rules for taxing interest that is paid by a U.S. branch of a
foreign corporation:

1.     For a foreign corporation engaged in a U.S. trade or business, interest paid by
       the U.S. trade or business is handled in the same manner as if paid by a
       domestic corporation. I.R.C. §884(f)(1)(a). The interest is taxed as U.S. source
       income at a flat 30% rate, unless it is portfolio interest in which case there is no
       U.S. tax.

2.     To the extent that the amount of interest allowable is deductible exceeds the
       interest actually paid by the branch (under I.R.C. § 882) in computing the taxable
       income of the U.S. Branch, the excess will be treated as interest paid by a
       fictional U.S. subsidiary or branch to the parent, thus subjecting it to a 30% tax
       under I.R.C. § 881.

The income that is subject to U.S. corporate income tax for income effectively connected
under I.R.C. § 882 is also subject to branch profits tax it the income is not reinvested in
qualifying U.S. assets. If the foreign corporation makes a dividend distribution to its
foreign investors, there is usually no additional tax assessed. The branch profit tax
serves the same purpose as the dividend tax on distributions form domestic corporations
to foreign investors of 30%.

Congress has retained the right to apply the 30% tax on dividend distributions from
foreign corporations when the branch profits tax cannot be applied due to treaties

                                            10
issues. The withholding tax on dividends is an effective alternative for the branch profits
tax.


Transportation Income

Nonresident U.S. source income related to air or water transportation activities or from
the lease of a vessel or aircraft is subject to U.S. taxation unless there is a reciprocal
exemption rule in effect. Such income would be treated as effectively connected income
if the taxpayer is engaged in trade or business in the U.S. through a fixed place of
business and the material portion of the U.S. taxpayer‟s transportation income is
generated through regularly scheduled transportation. If the income is not effectively
connected a 4% gross income tax on the transportation income will apply.

The income of a nonresident operating ships or aircraft in the U.S. will be exempted from
U.S. taxation if an equivalent exemption exists for U.S. citizens within the taxpayers
home country. In an effort to avoid “flag shopping” the exemption does not apply to
foreign corporations in which the majority of stock is own by nonresidents. Income tax
treaties play an important role in this area.

Foreign Government Taxation

In general, specific U.S. source interest income acquired by foreign governments is not
subject to U.S. Federal income tax, unless the income is gained through commercial
activities. The requirements that must be met by the foreign government to avoid
taxation are: status requirement and income requirement.

The foreign government must qualify as “a foreign government” under I.R.C. § 892. The
Code defines foreign government as a controlled entity of a foreign sovereign; controlled
entity meaning a corporation that is wholly-owned by a single foreign sovereign, the
earnings of which do not strengthen the benefit of any one individual and whose assets
would return to a foreign government upon dissolution. A controlled entity could include
a pension benefit for foreign government employees.

The foreign entity or government is exempt from U.S. tax on stocks, bonds, securities,
and interest on bank deposits. However, the exemption does not cover all rental income
from U.S. real property. Any income earned from the conduct of commercial activity by
the government or entity will be subject to U.S. taxation. A controlled commercial entity,
is one that is engaged in commercial activities anywhere in the world should the
government holds more than 50% of the total interests or less if it holds effective control.
Income received from or by this entity would be subject to U.S. taxation under I.R.C. §
892(a)(2) The corporation may could be taxable under I.R.C. § 881 if it receives
dividends or interest for a U.S. payer. If the foreign government is not tax exempt U.S.
domestic tax rules apply and it will be treated in the same manner as a foreign
corporation, including the tax benefits accorded corporate residents.




                                            11

				
DOCUMENT INFO
Shared By:
Categories:
Stats:
views:3
posted:6/1/2011
language:English
pages:11