Editor: Kevin D. Anderson, CPA, J.D.
Foreign Income & Taxpayers
Foreign corporations investing in the United States through a partnership that generates effectively connected income (ECI) must file a branch return (Form 1120-F, U.S. Income Tax Return of a Foreign Corporation) and are subject to the U.S. branch profits tax (BPT). Unless reduced by an international income tax treaty, the U.S. BPT rate of 30% can become costly for a foreign investing corporation. The BPT rules under Sec. 884(a) generally apply to any foreign corporation that is investing in the United States through a U.S. branch, which includes an interest in a partnership earning ECI.
The following highlights some of the tax compliance challenges that often arise as a result of BPT exposure.
Background and General Overview of the BPT
The BPT is intended to achieve parity for investments in the United States through a U.S. branch or a U.S. subsidiary. While dividend payments by a U.S. subsidiary to its foreign parent corporation are generally subject to a 30% withholding tax under Sec. 881(a), remittances of a U.S. branch to its foreign home office could escape this source tax without the BPT. Sec. 884(a) imposes a 30% tax on a foreign corporation’s effectively connected earnings and profits (ECE&P) that are not reinvested in a U.S. trade or business by the close of the foreign corporation’s tax year, or that are disinvested in a later year (dividend equivalent amount).
The dividend equivalent amount is calculated by adjusting current-year ECE&P either upward or downward, depending on the foreign corporation’s movement in U.S. net equity during the tax year. If the U.S. net equity at the beginning of the tax year was higher than at the end of the tax year, the foreign corporation is deemed to have repatriated or disinvested earnings (Regs. Sec. 1.884-1(b)(1)). U.S. net equity is the aggregate amount of U.S. assets over U.S. liabilities, whereby U.S. liabilities are generally determined under Regs. Sec. 1.882-5, and U.S. assets are the U.S. adjusted basis modified for E&P purposes (see Regs. Secs. 1.884-1(c)(2) and (d)(1)). Basis adjustments for E&P purposes could, for example, consist of depreciation adjustments to a straight-line method where an accelerated depreciation method was used for income tax purposes.
The following illustrates the dividend equivalent amount computation:
Example 1: In year 1, foreign corporation has U.S. net equity at the beginning of the year (BOY) of $5,000, end of the year (EOY) U.S. net equity of $5,100, and ECE&P of $300. The foreign corporation’s dividend equivalent amount is $200, resulting in a $60 BPT ($200 × 30%—assuming no treaty benefits) and nonpreviously taxed ECE&P of $100. In year 2, foreign corporation has U.S. net equity BOY of $5,100, current-year ECE&P of $500, and U.S. net equity EOY of $3,800. Since the foreign corporation only had $100 nonpreviously taxed ECE&P from the prior tax year, the dividend equivalent amount is $600 (ECE&P of $500 + $100) and BPT is $180 ($600 × 30%).
Thus, it becomes clear that changes in U.S. net equity and ECE&P determine the calculation of the U.S. BPT liability.
U.S. Net Equity of a Foreign Corporate Partner in a U.S. Partnership
A foreign corporate partner generally determines its U.S. assets by taking into account its interest in the partnership and not its share of the underlying partnership’s assets (Regs. Sec. 1.884-1(d)(3)). (Notably, this approach is in contrast to the “aggregate approach” that is applied upon a foreign partner’s sale of a partnership interest as set forth in Rev. Rul. 91-32 and which is proposed to be codified in the Obama administration’s 2013 budget proposal.)
An investment partnership (e.g., a hedge fund) will often have a wide variety of U.S. or foreign, ECI, or passive/FDAP (fixed or determinable annual or periodical) types of investments. The regulations offer two alternative methods to determine the proportion of the partnership interest that should be deemed a U.S. asset: the income method or the asset method. Thus, a foreign corporate partner’s interest in a U.S. partnership is not in its entirety, per se, a U.S. asset for purposes of determining U.S. net equity.
Under the income method, which is set forth in Regs. Sec. 1.884-1(d)(3)(iii), the extent to which a partner’s interest in a U.S. partnership is a U.S. asset is determined in the same ratio as the corporate partner’s distributive share of ECI bears to its distributive share of all partnership income for that tax year.
Example 2: Total partnership income was $2 million during the tax year (including $1.95 million of FDAP income and $50,000 of ECI). If the foreign corporate partner’s investment in the U.S. partnership at BOY was $6 million and at EOY $4 million, then its U.S. assets for purposes of determining U.S. net equity at BOY were $150,000 and EOY $100,000. The decrease in U.S. net equity could lead to an upward adjustment in ECE&P of $50,000 in this example.
Alternatively, a foreign corporate partner may also elect the “asset method” to determine its U.S. assets for BPT purposes (Regs. Sec. 1.884-1(d)(3)(ii)). Under the asset method, the foreign corporation’s partnership interest is a U.S. asset in the same ratio as its proportionate share of the adjusted bases of the partnership assets that would be U.S. assets if the partnership were a foreign corporation, and the corporate partner’s distributive share of the adjusted bases of all partnership assets.
Example 3: Foreign corporation F owns a 20% interest (capital and profits) in partnership PS with a basis of $2 million. PS owns U.S. assets with an adjusted basis of $4 million and non-U.S. assets of $1 million. F’s interest in PS that is a U.S. asset is $1.6 million [$2 million × ($800,000 ÷ $1 million)]. If in the subsequent year, F would not have any ECE&P from PS, but PS reduced its U.S. assets by, for example, $1 million, then F’s interest in PS that is a U.S. asset would be reduced to $1.5 million. This could trigger an upward adjustment for F of ECE&P of $100,000 (possibly limited by nonpreviously tax-accumulated ECE&P).
Selecting the Right Method
By comparing the asset method and the income method for purposes of determining U.S. assets, a foreign corporate partner may find significantly different BPT results depending on the method it chooses. A foreign corporate partner should carefully select its method, bearing in mind the type of investment and business forecasts it may have. As a practical matter, the investment partnership may often be unwilling or unable to provide the partner with the necessary asset information; and the corporate partner will have no choice but to use the income method. But this method can be rather distortive in years when the partnership incurred an ECI loss. EOY U.S. net equity could plunge to zero (but presumably not below zero), which, in turn, could trigger BPT if there was accumulated ECE&P.
Making the Election
The foreign corporate partner can make the election only with a timely filed U.S. corporate tax return of a foreign corporation (Form 1120-F) for the first year in which the foreign corporate partner receives a distributive share of ECI from the partnership. The election cannot be made on an amended return. The chosen method also may be applied to determine the proportionate investment in a lower-tier partnership. Once the method has been timely elected, the partner must apply the chosen method for a five-year period. Changing the elected method before then requires IRS consent, which is granted only in “rare and unusual circumstances” (Regs. Sec. 1.884-1(d)(3)(iv)(A)). If the foreign corporate partner failed to make a timely election, the IRS may make the election on the foreign corporation’s behalf, and the election is binding (Regs. Sec. 1.884-1(d)(3)(v)).
Kevin Anderson is a partner, National Tax Services, with BDO USA LLP, in Bethesda, Md.
For additional information about these items, contact Mr. Anderson at 301-634-0222 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.