Foreign Corporations & US Tax – The Basics
As providers of US tax advisory and compliance services, based outside of the US, we work daily with foreign corporations (non-US) who do have US tax filing requirements and often US taxes to pay. We frequently see this specifically with our Private Equity and Venture Fund clients. Below is a useful overview of how US taxes work with Foreign Corporations including an example using a non-US Private Equity Fund.
What are the primary differences between the US taxation of domestic corporations and foreign corporations?
A domestic corporation is taxed on its worldwide income and annually files Form 1120 to report net taxable income and pays tax at the federal corporate rate, currently 21%, plus any state and local taxes. A foreign corporation is taxed only on income that is considered to be US-sourced and may be required to file Form 1120F to report some types of US-sourced income in certain circumstances. It is also important to note that while the non-filing of a Form 1120 can result in penalties for late filing and late payment of tax, not filing a Form 1120F when required attracts these same penalties but also can result in the total loss of the ability to take any deductions against gross income. There may also be certain information reporting requirements for a foreign corporation (Form 5472) depending upon the structure and activity. The penalty for non-filing of Form 5472 timely, when required, is a minimum $25,000 per form per year.
What is a foreign corporation?
Any legal entity formed outside the United States that meets one of 3 specific criteria:
1) It is on the list of entity types that are always treated as a corporation for US tax purposes (a ‘per se corporation’);
2) the entity characteristics meet the definition of a corporate entity type, where all owners have limited liability; or
3) the entity is an eligible entity type that has made a valid and timely election on Form 8832 to be treated as a corporation for US tax purposes. It often requires an analysis to confirm the US tax treatment of a specific entity.
It is important to note that while it is the legal characteristics of the foreign entity that assist in defining its treatment for US tax purposes, the treatment under US tax law may differ from the tax treatment in the jurisdiction of formation and does not impact its legal organization or status in that jurisdiction. As one example, a foreign Private Equity or Venture Capital fund with investments in US assets (such as US-based funds) is typically organized as a flow-through entity in the jurisdiction of formation but often elects to be treated as a corporation for US tax purposes if there are no US investors.
When is a foreign corporation subject to US taxation?
The Form 1120F is not comparable to the 1120 and the difference goes far beyond the simple fact that the 1120 is filed for a domestic corporation on worldwide income while the 1120F is filed for a foreign corporation with US source income. The 1120F is a very complex form with multiple requirements for compliance, reporting, types of income taxed and withholding under US tax laws and regulations.
What types of US source income is taxable to a foreign corporation?
When a foreign corporation engages in business in the US, either directly, through a subsidiary or branch, or by investment, the resulting net income is US-sourced income known as ‘Effectively Connected Income’ (ECI) which is taxable by the US. Net ECI is taxed at the corporate tax rate, currently 21% at the federal level plus any additional state and local taxes.
Engaging in business in the US or holding assets that generate ECI create an additional layer of taxation known as the ‘Branch Profits Tax’ (BPT), which is essentially a tax on deemed dividends and is typically assessed at 30%; if the foreign corporation qualifies for treaty benefits, this rate can be lowered.
When a foreign corporation holds US situs assets, including but not limited to, investment in US company stock, domestic partnerships engaged in a US trade or business, investment in US real estate or US rental activities, or otherwise holds ownership in a US business, this can result in US source income that is either ECI, or income that is deemed ‘Fixed, Determinable and Periodic’ (FDAP).
FDAP income is passive income, the most common of which is dividends paid to the foreign corporation by a US corporation. The payment of FDAP income to a foreign corporation is subject to withholding of US tax by the payor at 30%; if the foreign corporation qualifies for treaty benefits under the Limitations of Benefits clause of the appropriate treaty this rate may be reduced.
Example of how a foreign entity could be subject to US taxation:
- Fund A (a non-US private fund in the UK or Europe) is a flow-through entity.
- Non-US investors.
- Fund A obtains a US tax identification number (EIN) and elects to be treated as a corporation for US purposes by timely filing Form 8832 within 75 days of formation.
- Fund A holds an interest in US partnerships and LLCs with US-sourced income including dividends and operating income (loss).
- Fund A has both FDAP and ECI which are taxable by both the US and applicable US states.
- Required to use Schedule K-1s from the US partnerships to file Form 1120-F (foreign corporate income tax return).
- Branch Tax profits may apply.
- Fund A will have FDAP withholding by the US and should apply treaty provisions certified on their Form W8-BEN-E as provided to each US LLC or US Partnership.
- Should receive a Form 1042-S showing FDAP withholding and paid. (note: ECI may or may not have withholding, depending on type, but withholding if applicable should be reported on Form 8805).
What factors must be considered when filing a US income tax return for a foreign corporation?
A foreign corporation that generates or receives income that is ECI must file an income tax return for each year ECI is present, even when the ECI is negative or there is a loss. The existence of a ‘permanent establishment’ in the US, as determined by the specific activities of a foreign corporation, generally is deemed to be a US trade or business, which creates ECI for the foreign corporation and a filing requirement along with a tax liability.
There are situations where a ‘protective return’ may be filed to preserve the ability to carry forward losses, make certain elections or preserve the ability to deduct expenses against future income. However, this type of return must be filed in a timely manner, or any benefit is lost.
The impact of the Branch Profits Tax (BPT) cannot be underestimated; this tax is generally based on a calculation of the decrease in net equity of US assets that generate profits that are ECI. This decrease is deemed to be a return of investment to the foreign corporation and is therefore available to its shareholders as a dividend; the deemed dividend is taxed at 30% (or the applicable treaty rate if qualified) and paid with the filing of Form 1120F.
Note that the ownership of a partnership interest in a US partnership that is doing business in the US will create either ECI or FDAP or both for the foreign corporation holding that interest.
A US Taxpayer Identification Number (EIN) is required to file a Form 1120F.
When is withholding required and who is responsible?
The payor of US source income (ECI or FDAP) is responsible for withholding the correct amount of US tax from US source income paid or attributed to a foreign corporation at the time it is paid or earned. If US tax is correctly withheld, reported and paid to the IRS, the foreign corporation is deemed to have met its US tax requirements and no return is required. If the withheld amount is incorrect or not properly reported, the foreign corporation must file a return to report the income and pay the correct amount of tax.
What does the foreign corporation need to do to ensure correct withholding?
When a foreign corporation engages in activity in the US that will generate US source income, the payor of that income will request Form W8-BEN-E, which provides the payor with the information needed to correctly determine the rate of withholding on any US source income that will be earned or paid. It is critically important that this form be prepared accurately and provided timely. A US Taxpayer Identification Number (EIN) is not required to complete this form.
Can a foreign corporation receive income from a US payor that is not US Source income?
Yes, sometimes. If the foreign corporation meets certain requirements, is doing business in a jurisdiction where a double tax treaty with the US is in place and meets the Limitation on Benefits clause of that treaty, does not have an office or place of business in the US and has not created by its activity or actions a permanent establishment, it is possible that income paid by a person or entity in the US may not be US-sourced income. This cannot be assumed and any activity of the foreign corporation that has a US connection should be carefully considered prior to engaging in that activity to assess the US tax implications.
Summary of a foreign corporation’s US filing compliance and filing (simplified and very broadly speaking)
Foreign Corporation: A foreign entity organized as a corporation, as defined by US tax laws, or a foreign entity that has made an appropriate and timely Check the Box election, that has US source income may be required to file Form 1120F
ECI: Effectively Connected Income (can be negative), taxed at 21% plus state and local taxes at the applicable rates
FDAP: Passive income (interest and dividends), taxed at 30% or the applicable treaty rate based on withholding certificate (Form W8 series), return only required if the amount withheld is incorrect or not reported on Form 1042-S.
BPT: Branch Profits Tax – tax on deemed dividend at 30% or the applicable treaty rate.
Active Trade or Business – operating income either directly or indirectly owned.
Contact us if you have a more specific query.