A successful foreign corporation doing business in the U.S is taxed a second time. The tax is called the branch profits tax.
A U.S. business includes real estate, investments in a domestic (American) limited liability company or partnership, manufacturing, retail, distribution and providing services.
With a rate of up to thirty percent (less if the corporation is taxable in a tax treaty country), the successful business wants to minimize or eliminating the branch profits tax. The tax is reported on Form 1120F.
The Problem: The Hidden Branch Profits Tax Trap
This tax applies when the foreign corporation has accumulated profits beyond the needs of its active business. The theory of the branch profits tax is similar to the accumulated earnings and profits tax that applies to a domestic corporation. This domestic tax has applied to domestic C corporations for more than half a century. Thus, the tax planning, below, is based upon the tax court cases regarding the domestic tax.
For example, In 2000, a foreign corporation invests $2,000,0000 of cash into a partnership that owns commercial rental property in the U.S. The partnership is successful and has distributed profits each year of $100,000. The U.S. and state income tax are $40,000. The net cash after tax is $60,000. After 15 years the $ 60,000 annually plus the investment income has grown to $1,000,000.
The foreign corporation has kept the money in U.S. banks and the U.S. stock market. These assets are not used in the foreign corporation business, that of being a partner.
The IRS audit the foreign corporation and successfully assessed the branch profits tax. The foreign corporation owes $300,000 in tax and a $60,000 penalty for reporting the tax.
How to avoid the branch profits tax
Here are few tried and true methods that have been used by U.S. corporations to prevent a similar tax known as “the accumulated earnings tax.”
By the way, merely keeping the profits in U.S bank accounts or investments does not avoid the tax unless you can prove the funds are necessary for the business activities. Below are some business activities that have been accepted by the courts.
(1) Convert the business arrangement into a non-corporate structure. The most popular is a combination of a Nevada trust with a Nevada single member limited liability company. Since many corporations do not know what their earnings and profits are, the corporation’s earnings and profits should be calculated before deciding whether the conversion is a good idea.
(2) Increase salaries within the reasonable compensation rule limits. Avoid issuing bonuses since the tax court often sees a bonus as a non-deductible and taxable dividend.
(3) Provide more fringe benefits (e.g., a qualified pension plan).
(4) Have the corporation invest in securities generating capital gains. Since the accumulated earnings tax only falls on taxable income, the corporation should invest in securities, the sale of which generates capital gains.
(5) Redeem stock, using a deferred payment obligation as Consideration. Accumulating money to pay for a redemption is not considered a valid purpose for accumulating earnings but redeeming now and paying off the debt later is permissible.
(6) Establish a qualified pension plan. A resulting unfunded pension liability should reduce unreasonable accumulations.
(7) Recapitalize the corporation to shift dividends to selected shareholders.
(8) Buy business assets instead of leasing them.
(9) Most important! Keep corporate minutes. Do the minutes within a reasonable time after the meeting of the board of directors of the corporations. These minutes must prove the business reason for the corporation retaining its profits. The eight items above are examples of business reasons.
If you want to increase the quality of your tax planning, then email me, Brian Dooley, CPA, MBT, at firstname.lastname@example.org.
 Mountain State Steel Foundries, Inc. v. Commissioner, 284 F.2d 737 (4th Cir. 1960); C.E. Hooper, Inc. v. Commissioner, 539 F.2d 1276 (Ct. Cl. 1976).