Are You A Foreign Business Expanding to the US? Consider These US Federal Income Tax Rules
The first step when forming a US or foreign business is to decide what type of entity is the best form for the business. This depends on structure, liability, management and tax considerations. Non-tax factors usually are the primary considerations because in many instances a business can choose how it is treated for US tax purposes. However, tax considerations should not be disregarded altogether.
While this article will generally explain the US federal income tax classification rules that apply to foreign businesses, including how different types of entities are taxed, which entities are eligible to “check the box” and special US tax regimes that apply to certain foreign corporations, there may be special tax rules applicable to trusts or specialized industries (e.g., tax-exempt organizations, banks, insurance companies, or other regulated businesses).
Overview of US Tax Classification of Foreign Businesses
In many cases, a foreign business can choose how it is classified for US federal income tax purposes. For US tax purposes, a foreign business is treated as one of the following:
A foreign business cannot elect to be treated as an S-corporation (only US Businesses can be S-Corporations). The foreign law classification of a foreign business is not always the same as the US tax classification of that business (for example, a foreign law partnership that is a partnership for foreign tax purposes can often elect C-corporation status for US tax purposes). An eligible US business generally can avoid double taxation by electing on formation to be treated as an S-corporation if it meets the IRC requirements for an S-corporation election (such as the requirements regarding the number, type and residency of stockholders) (IRC § 1361 and 1362). An S-corporation is a pass-through entity for US tax purposes, which means it generally does not pay an entity level tax. Instead, the S-corporation’s profits and losses generally pass-through to its stockholders who include their respective share of those items on their income tax returns (whether or not distributed). However, as mentioned above, only an eligible US business can make an S-corporation election.
The US tax classification of a foreign business is important because the US tax rules that apply to a disregarded entity, C-corporation and partnership are quite different.
Certain foreign entities are automatically classified as C-corporations for US tax purposes. These types of entities cannot choose another US tax classification (please refer to per-se corporations further below).
C-corporations are generally subject to double taxation (i.e., two levels of tax on their income):
At the entity level when earned.
At the stockholder level when distributed.
The relative inefficiency of two levels of taxation is somewhat reduced by the 21% corporate income tax rate that applies beginning in 2018.
A foreign C-corporation that is engaged in a US trade or business generally is subject to US tax on a net income basis at the same rate as US C-corporations (currently 21%) on income and gains that are effectively connected with the conduct of a US trade or business (ECI) (IRC 882). If an income tax treaty applies, a foreign C-corporation carrying on a US business through a permanent establishment is taxed on income attributable to that permanent establishment rather than on ECI.
A foreign C-corporation is also subject to a 30% US withholding tax on certain non-business income from US sources (IRC §§ 861 and 881). In addition, a foreign C-corporation that is engaged in a US trade or business through a US branch is subject to an additional branch profits tax (BPT) (IRC § 884).
A US corporation is taxable on its worldwide income, including foreign source income and gains (subject to any available foreign tax credits). Foreign source income includes dividends from any foreign subsidiaries classified as C-corporations for US tax purposes. A US corporation is generally not subject to US tax on the profits of a foreign subsidiary classified as a C-corporation for US tax purposes until the foreign subsidiary pays a dividend. However, special US tax regimes override this general rule if the foreign subsidiary is a CFC or, in certain cases, a PFIC (see further below).
The IRC does not provide a definition of “effectively connected” or of what it means to be engaged in the conduct of a US trade or business. In practice, a foreign business has ECI if it derives certain categories of US source income (and in some cases, foreign source income) from ongoing business activities it conducts in the US. However, investing in a US corporation is insufficient by itself to count as conducting a US trade or business.
A foreign C-corporation determines its ECI in the same manner that a US C-corporation determines its gross income and deductions. In addition, certain gains on US real property transactions are automatically treated as ECI (see FIRPTA below).
Gains from the disposition (for example, by sale) of a US real property interest are automatically treated as ECI under the Foreign Investment in Real Property Tax Act (FIRPTA) rules (IRC § 897). A US real property interest includes any interest (other than solely as a creditor) in:
• US real property.
• A US corporation that is classified as a US real property holding corporation (generally, if 50% or more of the US corporation’s assets by value are US real property-related assets).
In practice this means that a foreign business can be liable for US tax on gains from the sale of stock in a US real property holding corporation (unless reduced by an applicable income tax treaty). The FIRPTA rules do not apply to sales of shares in a foreign C-corporation.
In addition, the FIRPTA rules apply to dispositions by foreign businesses of other US real property interests (for example, a direct interest in US real estate).
In addition to tax on ECI, a foreign C-corporation is subject to BPT if it is directly engaged in a US trade or business (IRC § 884). The purpose of BPT is to place a foreign C-corporation operating in the US through a branch in the same position as a foreign business operating through a US subsidiary. For BPT purposes, a branch is any business operations of the foreign C-corporation that occur in the US and that are not conducted by a US corporation.
A foreign business operating through a US subsidiary pays US tax at both the corporate and the stockholder level (that is, a US tax on profits in the US subsidiary and US tax on dividends paid to US and foreign stockholders). Under the BPT, a US branch is treated in certain circumstances as if it paid a dividend to the foreign C-corporation.
Foreign C-corporations operating through a US branch pay an additional US tax of 30% on their “dividend equivalent amount” for the taxable year, unless the BPT rate is reduced by an applicable income tax treaty. Usually, the dividend equivalent amount is the foreign C-corporation’s earnings and profit that are ECI. This is adjusted up or down according to the increases or decreases in US net equity (usually the foreign corporation’s net US trade or business assets). Gain realized on the disposition of an interest in a current or former US real property holding corporation (but not other US real property interests) is excluded from effectively connected earnings and profits and is not subject to BPT.
A business entity taxed as a partnership is a pass-through entity for US tax purposes, which means it does not pay an entity level tax. Instead, the partnership’s profits and losses are computed and allocated among the partners annually and pass-through to the partners who include their respective share of those items on their income tax returns (whether or not distributed).
The US taxation of the income and gains of a foreign business that is treated as a partnership for US tax purposes depends on the tax residency and US tax classification of its partners. A US or foreign partner is taxed on the income and gains of a foreign partnership as if it earned the income directly. A US partner is subject to US tax on its entire allocable share of the partnership’s profits and losses but it may be entitled to foreign tax credits for any foreign taxes paid by the partnership. A foreign partner is subject to US tax on its ECI and on non-business income from US sources (see ECI above). Generally, a foreign partner is deemed to be engaged in a US trade or business if the foreign partnership is engaged in a US trade or business (IRC § 875). If the foreign partner is a C-corporation, it may also be subject to the BPT (see BPT above).
However, certain US and foreign partnerships are treated as a publicly traded partnership (PTP) for US tax purposes (IRC § 7704). A PTP is a US or foreign partnership (or other business entity that is treated as a partnership for US tax purposes) whose interests are traded on an established securities market or readily tradable on a secondary market. A PTP is taxed as a C-corporation unless 90% or more of a PTP’s gross income consists of certain types of passive investment income. Except in certain industries, partnerships are not typically publicly traded.
Choice of US Tax Classification by Foreign Businesses
The foreign law classification of a foreign business is not always the same as its US tax classification (for example, a foreign law partnership that is a partnership for foreign tax purposes can often elect C-corporation status for US tax purposes). Under the check the box treasury regulations, a foreign business is classified either as a “per se” C-corporation or as an entity eligible to choose its US tax classification (referred to as an eligible entity) (Treas. Reg. §§ 201.7701-2 and 301.770103).
Per Se Corporations
Under the check the box treasury regulations, certain businesses are automatically classified as per se C-corporations and cannot elect to be treated as a disregarded entity or partnership for US tax purposes (Treas. Regs. §§ 301.7701-2 and 301.7701-3(a)). For example, the following foreign businesses are classified as per se C-corporations:
Brazil: Sociedade Anonima (S.A.).
People’s Republic of China: Gufen Youxian Gongsi.
France: Societe Anonyme (SA).
Germany: Aktiengesellschaft (AG).
Hong Kong: Public Limited Company (PLC).
India: Public Limited Company (PLC).
Ireland: Public Limited Company (PLC).
Kingdom of Saudi Arabia: Sharikat Al-Mossahamah (SC)
Netherlands: Naamloze Vennootschap (NV).
United Kingdom: Public Limited Company (PLC).
An eligible entity (meaning, a business that is not a per se C-corporation) generally chooses its US tax classification (Treas. Reg. § 3301.7701-3).
The check the box treasury regulations include default rules for eligible entities (Treas. Reg. § 301.7701-3(b)) but these rules are different for US and foreign businesses. Under the default rules for a foreign business, the US tax classification of an eligible entity is:
A partnership if it has two or more members and at least one member does not have limited liability.
A C-corporation if all members have limited liability.
A disregarded entity if it has a single owner that does not have limited liability.
An eligible entity only needs to make a formal check the box election on IRS Form 8832 if it desires a different US tax classification than its default US tax classification (Treas. Reg. § 301.7701-3(a)). For example, an eligible foreign entity that defaults to partnership tax status can elect to be treated as a C-corporation for US tax purposes, so that the US owners of the foreign C-corporation can defer US taxation of a foreign C-corporation’s profits, subject to the controlled foreign corporation (CFC) and passive foreign investment company (PFIC) rules. Alternatively, an eligible foreign entity that defaults to C-corporation tax status can elect to be treated as a disregarded entity or partnership for US tax purposes, so that income and gains (as well as any associated foreign tax credits or losses) pass-through to the owner or owners for US tax purposes.
To avoid potential adverse tax consequences, an eligible entity should file a check the box election within 75 days of its formation so that it is effective on the date of formation (Treas. Regs. §§ 301.7701-3(c)(1)(iii) and 301.7701-3(g)). If an eligible entity elects to change its US tax classification after formation, it generally cannot make another election to change its US tax classification for five years unless there is a significant ownership change (more than 50%) and the Internal Revenue Service (IRS) permits the change (Treas. Reg. § 301.7701-3(c)(1)(iv)). This limitation on changing elective US tax classification does not apply to an election made by a newly formed eligible entity that is effective on the date of formation.
About Privatus Counsel
Privatus Counsel is a US based law firm with offices in the United States and abroad.
Our attorneys take an active approach in maintaining a close relationship with our clients; we listen, we understand, and then, we work closely to provide tailored solutions to their issues. Our aim is to reinvent the traditional lawyer-client relationship by assuming a more internal role with our clients. Our generalist approach, based on our broad experiences, places our boutique firm shoulder-to-shoulder with our clients around the world, helping them through every step of their journey. Our lawyers in all offices draw upon the knowledge of our global network.
We pride ourselves on having the capacity and expertise to guide our clients on legal matters that span a wide variety of industries, and we are invested in seeing our clients succeed.
For more information about Privatus Counsel’s attorneys, please visit our People Page.
For more information about Privatus Counsel’s offices, please visit our Offices Page.
Contact Privatus Counsel today to learn more about how our global teams can assist you to provide bespoke services tailored to your unique personal and business needs.