Tag Archives: avoiding the branch tax. branch tax planning

Branch Profits Tax The Foreign Corporation Double Taxation

The branch profits tax  is a complex tax law.  It is composed of two very complex math equations.  Here is a summary.  

This is one of the trickier American tax laws.  It applies when foreign corporation has a business in the U.S.  This includes a business owned by a partnership or a limited liability company (LLC). 

When money or other assets are removed from the business, the tax applies.  “Removed” means that the money or asset is distributed to the shareholder or is transferred out of the U.S. business. 

The branch profits is similar to an old  tax law that applies to domestic corporations that have accumulated earnings.  Under this tax law (Section 531), a domestic corporation is  subject to dividend tax if it accumulated assets more than its working capital needs.  This same rule applies to the branch profits tax.   

Imagine that during a tax audit, the IRS decides that you had more working capital than the IRS believed is necessary (with the advantage of hindsight). The corporation owes tax of 30 percent of the asset value, penalties, and interest.

For example, a BVI company opens an office in Texas to expand into the U.S. market. The BVI company net income,  after U.S. income taxes, is $1,500,000.  $500,000 is transferred to the Company’s  U.K. office in London.   

The removal of $500,000 of net equity is taxed at 30%.  The tax is $150,000.  

If the company has been a United KIngdom company instead of a BVI company, the tax rate would be be 30%.  The tax rate would be the lower tax rate found in the U.S-U.K. Income Tax Treaty.

I have a technical summary of branch profits tax at this hyperlink

This link has ideas on winning a branch profits tax audit.

Branch Profits Tax Causes a Double Taxation of U.S. Business Income (Including Real Estate).

 A fatal approach of the foreign business operating in the United States is the use of a foreign corporation to own the American business. The branch profit tax law classifies the American operation as a branch office of the foreign corporation.

This branch office classification occurs regardless of the existence of a foreign headquarters or home office. The branch office is an income tax concept found in Section 884.

Many times, the foreign corporation will form a domestic limited liability company (LLC), which is just as fatal. A single member LLC (SMLLC) does not exist as a separate entity for income taxes. The result is that the foreign corporation is seen as if it directly opened a branch office.

Often a foreign corporation will own a portion or all of a domestic limited liability company (LLC). This structure has the same flaw unless the LLC elects to be taxed as a corporation. Without the election, the LLC is a partnership. The foreign corporation has a branch in the U.S. as to its portion of the LLC.

The branch profits tax is in Section 884; It consists of three main parts:
1. Tax on the removal of earning from the U.S. business or the keeping of assets to avoid the tax,
2. Branch-level interest tax on and
3. An anti-treaty shopping rule.

(1) The branch profits tax – Regulation 1.884-1 has the rules for computing the tax.

The branch profits tax is 30 percent tax on the after-tax earnings of a foreign corporation’s U.S. trade or business that are not reinvested in a U.S. trade or business by the end of the taxable year.

The amount subject to the branch profits tax is the “equivalent dividend amount” which is defined as the reduction in the net worth of the U.S. business.

 One may feel that by merely keeping all of the net profits in the U.S. branch that you can avoid the tax.  However, that is not the case.  You must prove the business reasons for not distributing the money to the home office or the shareholder.  

 The IRS has years of experience in a similar law with corporations taxed under subchapter C.[1]   Like the branch profits tax; this law taxes a domestic corporation a second time if it retains money not needed for its business.   The accumulation of profits beyond the reasonable needs of the corporation is taxed as dividend.

Section 1.884-2T contains special rules regarding the termination or incorporation of a U.S. trade or business, or the liquidation or reorganization of a foreign corporation or its domestic subsidiary. In these cases, the tax does not apply.

 (2) The branch-level interest tax. This is a complex math equation.  The basics are below.

 Section 1.884-4 provides rules for computing the branch-level interest tax. In general, interest paid by a U.S. trade or business of a foreign corporation (“branch interest,” as defined in Section 1.884-4(b)) is treated as if it was paid by a domestic corporation and may be subject to tax under Section 871(a) or 881, and to withholding under Section 1441 or 1442.

Also, when the interest allocated to the U.S. business income exceeds branch interest, the excess is treated as interest paid to the foreign corporation by a wholly owned domestic corporation and is subject to tax under Section 881(a).  The tax rate for section 881(a) is thirty percent.

Footnote

[1] Section 531 a tax on accumulated earnings and profits.