Foreign Income & Taxpayers
How to Avoid Triple Taxation Under the Branch Profits Tax and FIRPTA
Under certain realistic scenarios, shareholders of a U.S. company with a foreign subsidiary who do not correctly structure their situation with an exit plan in mind may find themselves paying three levels of U.S. tax on a foreign corporation’s profits due to the interplay between the branch profits tax and the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). Fortunately, with proper tax planning, there are ways to avoid this draconian tax treatment.
The threat of triple taxation looms when a parent U.S. company (USCo) conducts international activities through its wholly owned foreign corporation (FC). If the FC is based in a country with no U.S. income tax treaty and finds itself with excess cash, it must give careful consideration before lending any excess cash back to U.S. investors, even if they are unrelated. If such loans have U.S. real property or U.S. real property holding companies as collateral, a loan default may leave the FC, directly or indirectly, holding U.S. real property and subject to income taxes under FIRPTA.
FIRPTA rules characterize the disposition of U.S. real property by foreign persons as gain effectively connected with a U.S. trade or business (Sec. 897). With such characterization, the eventual income from the sale of U.S. real property would be subject to U.S. income tax. FIRPTA provisions indirectly cause a second layer of taxation on the gains because when those gains are treated as gains from a U.S. effectively connected trade or business, the FC will be deemed to have a branch in the United States and will therefore be subject to the branch profits tax (BPT).
Before the passage of the BPT provisions under Sec. 884 in 1986, foreign corporations were able to avoid the
dividend tax. However, to ensure that the United States could collect this tax, the BPT rules were enacted. The BPT is assessed at 30% of any non-U.S. treaty country FC’s U.S. effectively connected income (ECI), with adjustments for increases or decreases in U.S. net equity of the FC’s U.S. branch. Basically, unless the FC reinvests its U.S. effectively connected earnings back into U.S. assets, it will be subject to the BPT. This dividend-equivalent tax represents the second layer of taxation on a potential sale of the U.S. real property.
Example: X, an FC, is owned by C, a U.S. company, and owns U.S. real property, which it received when one of its loans defaulted. X has decided to sell the real property and transfer the funds as dividends to C. Upon doing so, X will have ECI under FIRPTA rules and will therefore be subject to corporate income tax. In addition, unless X reinvests the gain proceeds in U.S. assets, it will not have any change in its U.S. net equity on this sale, and the 30% BPT will be applied to the dividend equivalent amount, in this case the gain on the sale. Therefore, the gain is subject to standard income tax and BPT. Also, once the U.S. parent distributes the proceeds it received from X, the standard dividend tax will be applied to the shareholders who receive those dividends because currently no credit is allowed against U.S. taxes for BPT paid.
Planning Strategies
Tax planning can be done to avoid such disastrous tax consequences. The most evident planning strategy would be to avoid the traps of FIRPTA by actively avoiding any investments by an FC that could result in its holding U.S. real property. If avoiding this situation is impossible, careful planning can eliminate the BPT.
A simple solution that mitigates the BPT’s effect is to conduct transactions through a company based in a U.S. income tax treaty country that minimizes the BPT. Although most treaties do not completely eliminate the BPT, many provide for lower tax rates than the regular 30%.
In the example, X holds U.S. real property and cannot claim relief under an income tax treaty. Another method of avoiding the BPT could be achieved by structuring the sale of the U.S. real property and the subsequent dividends to C as part of a complete liquidation of X. The BPT rules provide that upon complete termination and liquidation of X’s U.S. trade or business, the BPT can be avoided if (1) X no longer has any U.S. assets, (2) it does not reinvest in U.S. activities for three years, and (3) it has no ECI for the three years after termination (Temp. Regs. Sec. 1.884-2T(a)(2)). The rule against reinvestment in U.S. activities includes reinvestment through a related company, so the dividends paid to C would at first seem an impediment against claiming the benefits of this provision. However, the regulations provide that upon a complete liquidation in a Sec. 381(a) transaction, C may effectively take on X’s attributes for BPT purposes (see Temp. Regs. Sec. 1.884-2T(c)). In other words, X’s effectively connected earnings and profits will not be subject to the BPT; they will be transferred to C and incorporated into C’s accumulated earnings and profits (AE&P).
Caution: Special attention should be given if C has foreign shareholders, because dividends paid to such shareholders from X’s AE&P may not be eligible for treaty benefits.
Conclusion
Even though the triple taxation result described above may have originally been unintended, Congress is now aware of the issue but has not acted to correct it. Until the issue is corrected (if it ever is), simple tax planning can make sure that these unintended results do not become a real and costly issue.
From Ashley Autrey, CPA, Rafael Carsalade, CPA, and Aidan Arney, CPA, PKF Texas, Houston, TX
Notice 2007-13: Loosening the Rules Surrounding Substantial Assistance
The global marketplace has undergone a dramatic transformation since the regulations governing foreign base company services income were issued in 1968. As this change continues, the IRS must give serious consideration to the relevance of existing statutes that originated when American commerce was far more domesticated than it is today.
Fortunately, Treasury is taking note of the need for reform. Notice 2007-13 was released in January 2007 in response to a growing segment of businesses with foreign subsidiaries that use certain domestically centralized support functions. The notice will provide welcome relief to those U.S. corporations that have been forced either to pay tax on foreign base company services income or to employ a suboptimal corporate structure to avoid the tax.
In general, under Sec. 367(b), the earnings of a controlled foreign corporation (CFC) are not taxed in the United States until they are repatriated to its U.S. parent company. As a result, before the enactment of subpart F (Secs. 951–965), a corporation could generate earnings through a CFC incorporated in a low-tax jurisdiction and avoid (or at least defer) U.S. taxation on those earnings. Subpart F was enacted in response, making certain types of income generated by CFCs subject to taxation in the United States in the tax year the income is earned, regardless of whether the income is repatriated. This item focuses on one such type of income: foreign base company services income (FBCSI).
Sec. 954(e)(i) defines FBCSI as in-come of a CFC generated from the performance of services that (1) are performed for, or on behalf of, a related person and (2) are performed outside the country in which the CFC is organized. Services are deemed to be performed for, or on behalf of, a related person if that person provides substantial assistance contributing to the performance of such services. The determination of substantial assistance is the primary focus of Notice 2007-13.
The notice announces several amendments that will be made to Regs. Sec. 1.954-4(b)(2). Under current law, taxpayers may use either a subjective test or an objective cost test to determine whether substantial assistance is provided in connection with services performed. The subjective test, which provides that assistance is substantial if it is a “principal element” of the services performed, will be eliminated under the updated regulations, and the objective test will be revised drastically to limit the level of assistance that is considered substantial.
Under the objective test, current regulations specify that income from services performed by a CFC outside its country of incorporation is considered FBCSI if the cost of services provided by a related person is at least 50% of the CFC’s total cost of performing the services. The new regulations will increase this amount to 80%, allowing U.S. parent corporations more freedom to centralize support functions and provide assistance to CFCs without incurring immediate inclusion of foreign earnings in the U.S. tax base. In addition, the 80% includes only services provided by related U.S.persons; services provided by related CFCs no longer contribute toward substantial assistance. While other minor changes are introduced by the notice, those mentioned here are the most important.
Planning Strategies
As in any case in which tax rules change in favor of the taxpayer, one of the primary considerations going forward is whether strategies used under the old regulations are still sound. Previous tax planning on substantial assistance dealt largely with how services were provided to CFCs. In order to avoid generating FBCSI, certain support functions had to be decentralized, and often duplicated, to reduce the percentage of services provided by related parties. For example, to avoid providing substantial assistance, a multinational corporation engaged in construction might have previously decided to train personnel to supervise operations in the country of incorporation of one of its foreign subsidiaries, rather than centralize all supervisory services in the U.S. parent, even though centralization may have increased operational efficiency and reduced overall costs. The new regulations will allow a substantially greater portion of services to be provided by the U.S. parent, enabling the corporation to use the optimal operational structure without fear of generating subpart F income.
Perhaps the greatest opportunity for new planning stems from the exclusion of services provided by related CFCs from the definition of substantial assistance. Foreign subsidiaries will now be able to receive an unlimited amount of assistance from related foreign corporations in the performance of the services without generating subpart F income. Practically speaking, a multinational corporation can centralize support functions in whatever foreign jurisdiction is most advantageous, providing services above the 80% threshold, if necessary, without violating substantial assistance rules. This provides additional options for multinationals to locate regional service centers based on where the talent pool is located.
Caution: This exclusion does not apply to services performed indirectly by a U.S. corporation seeking to provide substantial assistance to a CFC through a related foreign corporation.
Conclusion
Notice 2007-13 itself is rather brief and defers to the final regulations a number of interpretive issues that remain unaddressed. Even so, it is a welcome change and serves as an encouraging signal that Treasury will continue to respond to the changing needs of a growing number of internationally focused businesses. Taxpayers may rely on the notice until the regulations are issued (when issued, they will apply to tax years of CFCs beginning on or after January 1, 2007).
From Joe Ben Combs, CPA, and Frank Landreneau, CPA, PKF Texas, Houston, TX
U.S. Individual’s Investment in Overseas Rental Property
The regulations under Sec. 904, issued in July 2004, make clear that the subpart F provisions continue to apply to overseas investment in real property by individuals. Those regulations expand the definition of what are considered active rents for the purposes of determining the passive activity foreign tax credit limitation. However, in passing, the preamble to those regulations reaffirms the long-standing but often overlooked and misunderstood rules about what constitutes active rents for subpart F inclusion purposes (TD 9141). This item addresses the tax ramifications of a typical scenario in today’s hot Costa Rican real estate market, which likely is applicable to many practitioners.
Example: X and Y, a U.S. couple, in 2005 formed two Costa Rican SAs (sociedades anónimas, or corporations), A and B, which purchased two condominium units (each costing approximately $120,000), partly through cash contributions from X and Y and partly through mortgage financing obtained by A and B. X and Y intend to rent out the condo units and have little interest in visiting Costa Rica. The purchase is an investment, which will be managed by a local management company in Costa Rica. Costa Rica will impose tax on the income derived from the rental operation.
Individuals generally are taxable on the cash basis. Corporations that do not repatriate earnings to individuals generally do not trigger a second layer of tax at the individual level. However, these rules are potentially superseded in certain cases, such as foreign corporations that are predominantly U.S. owned (controlled foreign corporations, or CFCs).
In the example, X and Y are significant U.S. shareholders and hold 100% of both A and B. Thus, it is clear under Sec. 957 that A and B are CFCs. X and Y are therefore subject to the CFC rules for A and B.
The CFC rules create for the CFC’s owners a deemed inclusion of income for certain types of income, all called subpart F income. The issue here is to determine whether the Costa Rican CFCs (A and B) have subpart F in-come. Under the CFC rules in the context of foreign rental operations, rents are generally subpart F income, with certain exceptions. Thus, unless an exception applies, X and Y would need to report A and B’s rental activity on a current basis.
Exceptions
The only possibly relevant exceptions in a typical individual ownership scenario are either (1) rents in an active trade or (2) rents earned in a “high tax” foreign country. Rents are considered derived from an active trade when they are derived from real property for which the CFC regularly performs active and substantial management and operational functions during the lease period (Regs. Sec. 1.954-2(c)). Typically, taxpayers and many practitioners seem to believe that this includes a situation in which a taxpayer hires a management company to manage the property, as opposed to just letting it be or calling from overseas to check on things. However, this is not the case. The example of inactive, and hence subpart F, rents is set forth in the regulations and includes instances in which the CFC engages an unrelated real estate management firm to lease the real property, manage the buildings, and pay over the net rents (Regs. Sec. 1.954-2(c)(3), Example (3)). This is what X and Y plan; accordingly, they will have a subpart F income inclusion if no other exception is met.
The regulations also include an example of active rents (Regs. Sec. 1.954-2(c)(3), Example (4)). The CFC hires its own employees to manage the operation. Typically, these employees would need to occupy a rented office space for their management operation.
There are obviously other scenarios between these extremes of not handling anything and handling everything about the properties; however, from a careful review of the few relevant rulings on point, a certain conclusion begins to emerge. To achieve active rents status, it appears that the CFC must retain some employees to handle at least some aspects of the rental activity’s management and operations (e.g., maintenance, marketing, etc.). For the purposes of this example, X and Y fail to qualify under this exception, because a management company will manage their Costa Rican rentals for them, so the only alternative is the high-taxed-income exception.
The rationale for the high-taxed-income exception is simply that a taxpayer would not attempt to defer income from U.S. tax by subjecting it to a higher tax in another country. The high-taxed-income exception applies when the income is subject to at least 90% of the highest U.S. corporate rate (Sec. 954(b)(4)). In numerical terms today, the income would need to be subject to at least a 31.5% effective tax rate (90% × 35%). Costa Rican tax rates graduate to a top rate of 30%, depending on the level and location of the income. Since 30%, though high, is less than the needed threshold of 31.5%, this exception does not apply to X and Y’s Costa Rican rentals. Since no exceptions apply, the U.S. owners will have a deemed inclusion of income on their U.S. tax returns to the extent of the net rental income of A and B.
Note: This deemed income inclusion is limited to a CFC’s earnings and profits (E&P) (Sec. 952(c)(1)(A)). E&P are computed according to U.S. ac-counting and tax principles and may therefore not be identical to the amount on the books kept locally for Costa Rican accounting purposes. It is also important to note that if there are deficits from the operation, they are not included on X and Y’s return; however, they may offset a future year’s current-year E&P, with the result that the income inclusion could be limited in such a year (Sec. 952(c)(1)(B)).
Treatment of Costa Rican Tax
From a U.S. tax point of view, the income tax imposed by Costa Rica on A’s and B’s rental earnings belongs to the corporations and does not automatically flow to the owners. Therefore, the tax would not be available as a foreign tax credit (but see “Elective Treatment,” below). This is akin to the U.S. treatment of U.S. corporations that pay tax on their income, on which the shareholders pay another tax when they receive their dividends. Given this, a taxpayer may wish to simply have the corporations remit the earnings that the taxpayer is being taxed on anyway. In such a case, the taxpayer needs to be aware of any withholding taxes that the foreign country might impose on the remittance.
Costa Rica imposes a dividend withholding at source of 15%. Although, generally speaking, foreign withholding tax at source (such as in the case of dividends) is available for a foreign tax credit in the U.S. (generally limited to the ratio of foreign source income to gross income multiplied by the U.S. tax due (Sec. 904)), this will not be true in the case of Costa Rica. Rather, under Regs. Sec. 1.903-1(b)(2), dividend distributions actually made, to the extent a tax at source would be imposed, would not be available in the case of Costa Rican withholding because the IRS has ruled (in Rev. Rul. 2003-8) that the Costa Rican tax at source is a “soak-up tax” (i.e., Costa Rica imposes it only if credit for it is given in the foreign country —in this case, the United States).
Practice tip: It is imperative when investing in soak-up countries that the investment corporation file an application with the foreign country’s tax authorities to request and obtain an exemption from the country’s withholding at source. Otherwise, foreign withholding on the distributions back to the United States will be subject to a noncreditable foreign withholding tax. This is an important planning point that practitioners should discuss with their clients.
Sec. 904(d) was amended by the American Jobs Creation Act of 2004, P.L. 108-357 (AJCA), to expand the definition of active rents for foreign tax credit limitation purposes. The amendment allows rents to be regarded as active (and thus not passive) if any related taxpayer (as defined) has active rents; assume this does not apply to X and Y. Finally, note that for 2007 onward (per the AJCA), the foreign tax credit limitation baskets in Sec. 904(d)(1) are reduced to only two: passive and general.
Elective Treatment
The use of corporations for real estate investment precludes the availability of a foreign tax credit for the foreign taxes imposed in the foreign country on the local rental activity of the corporations. However, Regs. Sec. 1.962-2 affords one avenue of relief to an individual taxpayer, allowing the individual to make an election to tax in the United States the subpart F inclusion at corporate tax rates and to receive a foreign tax credit for the underlying corporate tax that the CFC itself paid—in this case, the Costa Rican income tax paid by A and B. This could be beneficial for an individual, depending on his or her total U.S. tax picture, because U.S. corporate tax rates start at 15% (for the first $50,000 of income). This works only if the foreign country tax is regarded as an “income tax” in the U.S. tax-rules sense. Practitioners should get involved in making this determination.
Caution: Any amount actually distributed subsequent to this inclusion “pickup,” to the extent that the CFC’s E&P exceed the U.S. taxes paid on the previous inclusion pickup, must be included in income (Sec. 962(d)).The effect is to water down the benefit of the U.S. credit previously allowed to roughly equal the benefit of a deduction, the actual benefit of which would depend on the taxpayer’s marginal tax bracket and the length of time between the inclusion pickup and the actual distribution.
If the election is not made, the inclusion is treated under the regular CFC rules. It would be taxed at the individual rates, and a subsequent distribution of it would be wholly excluded from U.S. tax.
There are additional reporting re-quirements for U.S. owners of CFCs. Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, must be filed. Generally speaking, taxpayer investors like X and Y would fall into Category 4 (see the Form 5471 instructions), which basically requires the reporting of much additional information about the CFC. Each CFC failure to file is subject to a $10,000 penalty, plus a reduction of any relevant foreign tax credit.
Under the election noted above, the taxpayer would need to use Form 1118, Foreign Tax Credit—Corporations. The taxpayer may also have an interest in a foreign account, to be disclosed on Treasury form TD F 90-22.1, Report of Foreign Bank and Financial Accounts.
From Dan Wise, CPA, Gorfine, Schiller & Gardyn, P.A., Owings Mills, MD
