U.S. Income Taxation of Foreign Corporations (Portfolio 908)

Tax Management Portfolio, U.S. Income Taxation of Foreign Corporations, describes the Internal Revenue Code provisions applicable to foreign corporations.

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The United States asserts jurisdiction to tax foreign corporations only if they are engaged in business in the United States or receive income from sources within the United States. Foreign corporations that are engaged in a trade or business in the United States are subject to net-basis income tax under §882 on any of their income that is “effectively connected” with that business. Such corporations also may be subject to the branch taxation regime of §884, which is described in 6480 T.M., The Branch-Related Taxes of Section 884.

In addition, all foreign corporations, whether or not engaged in a business in the United States, are subject to gross-basis tax under §881 on certain types of U.S.-source income—primarily investment income, such as interest and dividends—that are not “effectively connected” with a U.S. business.

This Portfolio also addresses the impact of the U.S. income tax treaty network on U.S. taxation of foreign corporations. The provisions of a bilateral U.S. income tax treaty may modify the U.S. tax treatment of foreign corporations entitled to the benefits of the treaty. For example, foreign corporations entitled to treaty benefits are taxable under §882 only on income that is “attributable to” a “permanent establishment” in the United States. Treaty provisions may also reduce (or eliminate) the tax imposed on U.S.-source income under §881.

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U.S. Income Taxation of Foreign Corporations was authored by the following experts.
Jessica L. Katz, B.S. Princeton University (1988); J.D. Columbia University Law School (1992); Adjunct Professor, Georgetown University Law Center (2001-02); Former Of Counsel, Caplin & Drysdale.

Charles T. Plambeck, Managing Director, Citigroup, New York, NY. A.B. University of North Carolina (1983); J.D. University of North Carolina Law School (1986); Office of Associate Chief Counsel (Int'l), IRS (1988-90); Special Counsel to Chief Counsel, IRS (1990-92); Of Counsel and Partner, Caplin & Drysdale (1992-97); Managing Director and Tax Counsel, Bankers Trust Company and Deutsche Bank (1997-2001).

Diane M. Ring, Professor of Law, Boston College Law School, Boston, MA. A.B. Harvard (1986); J.D. Harvard Law School (1990); Caplin & Drysdale (1991-94); Assistant Professor, Harvard Law School (1994-2004); Associate Professor, University of Florida (2004-2005); U.S. National Reporter to IFA (2003-04, 2011-12).


Detailed Analysis

I. Overview

A. U.S. Taxation of Foreign Corporations: Summary

B. Historical Background

C. Taxation of Effectively Connected Income

1. Taxation of ECI: Section 882

2. Taxation of Gains from U.S. Real Property: Section 897

D. Second Level Branch Taxes

1. Branch Profits Tax

2. Branch Interest Withholding Tax

3. Branch-Level Interest Tax

E. Taxation of Non-ECI U.S. Source Income: Section 881

F. U.S. Taxation of Foreign Corporations: Special Industries

1. Taxation of Transportation Income: Section 887

2. Taxation of Foreign Insurance Companies

G. Anti-Deferral Provisions

1. Accumulated Earnings Tax: Sections 531-537

2. Personal Holding Company Tax: Sections 541-547

3. Taxation of U.S. Shareholders of Foreign Corporations

H. The Effect of Treaties on U.S. Taxation of Foreign Corporations

II. Foreign Corporations

Introductory Material

A. Classification of Entities for U.S. Tax Purposes

1. Classification of Entities: History

2. Classification of Entities Under the Check-the-Box Regime

a. "Per Se" Corporations

b. Electing Classification Under the Check-the-Box Rules

B. Classification of Entities for Foreign Tax Purposes: Hybrid Entities

C. Inversion Transactions

III. Taxation of Effectively Connected Income - Section 882

Introductory Material

A. Engaged in a U.S. Trade or Business

1. General Rule for U.S. Trade or Business: "Considerable, Continuous, and Regular" Activities

a. Type of Activity

b. Amount of Activity

2. Imputed Activity

a. Agents

b. Partnerships, Trusts, and Estates

3. Performance of Personal Services

4. Trading in Stocks, Securities, and Commodities

a. Safe Harbors for Trading in Stocks and Securities

(1) Trading Through a Broker or Other Independent Agent

(2) Trading for the Taxpayer's Own Account

(3) Meaning of "Trading in Stocks or Securities"

b. Safe Harbors for Trading in Commodities

(1) Commodities

(2) Commodities "of a Kind Customarily Dealt" on an Exchange

(3) Commodities Transactions "of a Kind Customarily Consummated" at Such Place

c. Application of Securities and Commodities Trading Safe Harbors to Derivatives Trading

5. Engaging in a U.S. Trade or Business by Deriving Real Property Gains

6. Engaging in a Banking or Similar Business

B. Effectively Connected Income

1. Gross ECI

a. U.S. Source Capital Gains and Income Described in § 881(a)

(1) Asset-Use Test

(2) Business-Activities Test

(3) Accounting Treatment

(4) "Active and Material Participation" Test for Investment Income from Banking, Financing, and Similar Businesses

(a) Attributable to

(b) Other Conditions

b. Other U.S. Source Income

c. Foreign Source Income

(1) Office or Other Fixed Place of Business

(a) General Rule: Fixed Facilities

(b) Management Activity

(c) Activities of an Agent

(2) Income "Attributable to" an OFPB

(a) "Material Factor"

(b) "Regularly Carries On" Activities

(c) Income "Properly Allocable" to the OFPB

(3) Categories of Foreign-Source ECI

(a) Section 864(c)(4)(B)(i): Certain Income from Intangible Property

(b) Section 864(c)(4)(B)(ii): Certain Income from a Banking or Securities Business

(i) Banking, Financing, or Similar Business

(ii) Trading in Stocks or Securities

(c) Section 864(c)(4)(B)(iii): Certain Income from Inventory Sales

(i) Background

(ii) "Attributable to"

(iii) Exception

(d) Section 864(c)(4)(C): Income from a U.S. Life Insurance Business

(4) Categories of Foreign-Source Income Excluded from ECI

d. Income from Financial Products: The Proposed Global Dealing Regulations

(1) Background

(2) The Proposed Global Dealing Regulations

(a) The "Separate Entity" Approach of the Proposed Regulations

(b) Elimination of "All or Nothing" ECI Rule

(c) "Recognition" of Interbranch Transactions

(d) Interest Expense and Capital

e. Other ECI

(1) Gain and Loss from Disposition of U.S. Real Property Interests (§ 897)

(2) Transportation Income (§ 887)

(3) Space and Ocean Activities (§ 863(d))

(4) Telecommunications Income (§ 863(e))

(5) Foreign Sales Corporation Income (§ § 921(d), 926(b))

(6) Election for Related Person Insurance Income (§ 953(c)(3)(C))

(7) "Deemed" ECI

(a) ECI of Foreign Corporations Formerly Engaged in a U.S. Trade or Business

(i) Deferred Payments

(ii) Ten-Year Rule for Business Property

(b) Other "Deemed" ECI

(i) Election for Real Estate Income

(ii) Interest Income of Possessions Banks

f. Exclusions from ECI

(1) Shipping, Aircraft, and Railroad Rolling Stock Income

(2) Earnings from Communications Satellite Systems

2. Deductions Other Than Interest Expense

a. General Rules

b. Research and Experimental Expenditures

c. Stewardship Expenses

d. Legal and Accounting Expenses

e. Taxes

(1) State Taxes

(2) Foreign Taxes

(3) Property Taxes

f. Losses

3. Allocation of Interest Expense

a. Background

b. ABL Method

(1) Step One: Determining Total Value of U.S. Assets

(a) Definition of "U.S. Assets"

(b) Valuing U.S. Assets

(i) Loans

(ii) Financial Instruments

(iii) Election to Use Fair Market Value

(iv) Total Value of U.S. Assets

(2) Step Two: Determining Total Amount of U.S.- Connected Liabilities

(a) Actual Ratio

(b) Fixed Ratio

(3) Step Three: Determining Interest Expense Deduction

(a) U.S.-Booked Liabilities

(b) U.S.-Booked Liabilities Exceed U.S.-Connected Liabilities

(c) U.S.-Booked Liabilities Less Than U.S.-Connected Liabilities

(d) U.S.-Booked Liabilities Equal to U.S.-Connected Liabilities

c. Separate Currency Pools Method

(1) Step One: U.S. Assets in Each Currency Pool

(2) Step Two: U.S.-Connected Liabilities in Each Currency Pool

(3) Step Three: Interest Expense Attributable to Each Currency Pool

d. Rules of Application

(1) Direct Tracing of Interest Expense

(2) Limitation on Interest Expense

(3) Translation of Foreign Currency

(4) Coordination with Other Sections

(5) Interbranch Transactions and Coordination with Tax Treaties

(6) Anti-Abuse Rules

(7) Elections

4. Credits

a. General

b. Foreign Tax Credit

5. Return Requirement

IV. Taxation of Income Not Effectively Connected with a U.S. Trade or Business: Section 881

A. Introduction

1. Income Subject to Tax Under § 881

2. Relation of § 881 Tax to Withholding Tax

B. FDAP Generally

C. Interest, Original Issue Discount, and Interest Equivalents

1. Bank Deposit Interest Exemption

a. Eligible Deposits

b. Eligible Depository Institutions

(1) "Persons Carrying on the Banking Business"

(2) Savings and Loans and "Similar Associations"

(3) Insurance Companies

2. Portfolio Interest Exemption

a. Portfolio Interest on Bearer Obligations

(1) "Reasonably Designed" Arrangements

(2) Interest Payable Outside United States

(3) Statement on Face of Obligation

b. Portfolio Interest from Obligations in Registered Form

(1) "Registered Form"

(2) Beneficial Owner Statement

(3) Registered Obligations Targeted to Foreign Markets

c. Exceptions to Portfolio Interest Treatment

(1) Interest on Bank Loans

(2) Interest Paid to 10% Shareholders

(3) Interest Paid to a Controlled Foreign Corporation

(4) Certain Contingent Interest

(5) Other Interest Specified by Treasury

3. Original Issue Discount

a. OID Obligation

b. Amount of OID Subject to Tax

4. Banker's Acceptances

5. Substitute Interest Payments

D. Dividends and Other Corporate Distributions

1. General Rule

2. "Dividends"

3. Exception for Certain Dividends from "80/20" Domestic Corporations

4. Substitute Dividend Payments

E. Royalties and Other Income from Intangible Property

1. General Rule for Royalties

2. Gains from Sales of Intangible Property

3. "Cascading" Royalties

F. Gains

1. General Rule

2. Gains from Timber, Coal, or Iron Ore

G. Other Types of Income

1. Income from Notional Principal Contracts

2. Rents

3. Insurance Premiums

4. Annuities

H. Conduit Financing Arrangements

V. Treaties

A. Background

1. Objectives of Tax Treaties

a. Preventing Double Taxation

b. Facilitating Trade and Investment

c. Advancing International Enforcement of Tax Laws

2. Relationship Between Tax Treaties and U.S. Domestic Law

a. "Later in Time" Rule

b. Choosing Treaty or Code

3. Interpreting Tax Treaties

a. Undefined Terms

b. Other Sources of Guidance

4. Model Income Tax Treaties

5. Scope of Treaties: Taxes Covered

B. Entitlement to Treaty Benefits

1. Residence

a. Residence for Treaty Purposes

b. Residence of Corporations

2. Beyond Residence: Preventing Treaty Abuse

a. The Requirement of Economic Ownership: Treaty Shopping, Beneficial Ownership, and the Conduit Regulations

(1) The Problem of Treaty Shopping: Background

(2) Beneficial Ownership Generally

(3) Section 7701(l) and the Conduit Regulations

(a) Financing Transaction

(b) Conduit Entities

(i) Reduction in Tax Imposed by § 881

(ii) Tax Avoidance Plan

(iii) Additional Requirements for Treating Unrelated Entities as Conduits

(c) Effect of Disregarding Conduit Entity

(d) Consistency with Treaties

(e) Recordkeeping Requirements

(4) Beneficial Ownership Rules for Hybrid Entities

b. The Requirement of Tax Ownership: Hybrid Entities, "Derived by," and § 894

(1) 2006 U.S. Model Treaty

(2) Former Temporary Regulations Under § 894

(a) General Rule of Former Regs. § 1.894-1T(d)

(b) Fiscally Transparent Entities

(c) Reciprocity Rule

(3) Section 894(c)

(4) The Current § 894 Regulations

(a) Domestic Reverse Hybrids

(b) U.S. Regular Hybrids

(c) Other Specific Provisions of the Final Regulations

c. The Requirement of Economic Nexus: Treaty Limitation on Benefits Provisions

(1) Publicly Traded Entities

(2) Ownership and Base Erosion Tests

(3) Active Trade or Business Income

(a) Active Trade or Business

(b) Income "Connected with" or "Incidental to" a Trade or Business

(i) Connected With

(ii) Incidental To

(c) "Substantial" Trade or Business

(4) Competent Authority Relief

C. Business Profits and Permanent Establishments

1. Permanent Establishment

a. Permanent Establishment Through Fixed Place of Business

(1) "Place" of Business

(2) "Fixed" Place of Business

(3) "Business Carried on Through" a Fixed Place

(a) "Business"

(b) Business "Carried on": Continuous and Regular Requirement

(c) "Through" a Fixed Place of Business

(4) Auxiliary and Preparatory Activities

(a) Specific Exempted Activities

(b) Other Auxiliary or Preparatory Activities

(c) Combinations of Activities

b. Permanent Establishment by Imputation

(1) Dependent vs. Independent Agents

(a) Control by Principal

(b) Business Risk

(c) Agent's Profits

(d) Exclusivity

(2) Independent Agent Acting "in the Ordinary Course" of Business

(3) Authority to Conclude Contracts

(4) Imputation from Partnerships

(5) Imputation from Trusts

(6) Imputation from Subsidiaries

c. The "At Any Time" Rule

d. Permanent Establishment vs. U.S. Trade or Business

2. "Business Profits"

3. Business Profits "Attributable to" a Permanent Establishment

a. Determining "Attributable" Business Profits

(1) Arm's-Length Principle

(2) The Article 7(2) and 7(3) Conflict: Interbranch Transactions

(3) Formulary Methods

(4) Assets and Activities Test

(5) Exception for Purchase of Goods

b. Allocating Expenses

(1) Formulary Approach

(2) Treatment of Interbranch Interest Expense

c. Profits "Attributable to" a Former Permanent Establishment

4. The Interaction of Treaty Business Profits Provisions and Taxes on Undistributed Earnings

D. Interest, Dividends, Rents, and Royalties

1. Interest Income

a. General Rule: Exemption from Source Country Taxation for Interest

b. "Interest"

c. "Arising in" a Treaty Country

(1) OECD Model Treaty

(a) Interest "Incurred in Connection with" a Permanent Establishment

(b) Interest "Borne by" Permanent Establishment

(2) U.S. Model Treaty

d. Certain Interest Subject to Source Country Taxation

(1) Contingent Interest and REMIC Inclusions

(2) Related Person Interest

e. Interest Attributable to a Permanent Establishment

2. Dividend Income

a. Dividends

b. Non-Portfolio Intercorporate Dividends

c. Dividends Paid by RICs and REITs

d. "Second Level" Taxes on Corporate Earnings and Distributions

(1) Introduction: Second Level Taxes in General

(2) Treaties and the Branch Profits Tax

(3) Treaties and the "Second Tax"

e. Dividends Attributable to a Permanent Establishment

3. Royalty Income

a. Royalties

(1) Consideration for the Right to Use Intangible Property

(2) Contingent Gains from the Sale of Intangible Property

b. Related Person Royalties

c. Royalties Attributable to a Permanent Establishment

4. Rental Income from Tangible Personal Property

E. Income and Gains from Real Property

1. Real Property

2. Income from Real Property

3. Election to Tax Real Estate Income on a Net Basis

4. Gains from the Disposition of Real Property

F. Other Gains

G. Compensation for Personal Services

1. Income from Employment

2. Special Rules for Certain Personal Services

a. Entertainers and Sportsmen

b. Other Categories of Personal Services

H. Other Income

I. Disclosure of Treaty-Based Return Positions

1. Specific Positions Requiring Disclosure

2. Positions Not Requiring Disclosure

3. Method of Disclosure

4. Penalties for Failure to Disclose

VI. Return Requirements for Foreign Corporations

A. Income Tax Returns of Foreign Corporations

1. Foreign Corporations Engaged in a U.S. Trade or Business

2. Other Foreign Corporations with Income Subject to Tax Under Subtitle A

3. Special Rules for Certain Foreign Insurance Companies

4. Time and Place of Filing

5. Consequences of Failure to File

B. Information Returns for Foreign Corporations


Working Papers

Table of Worksheets

Other Resources

Worksheet 1 Form 1120F - U.S. Income Tax Return of a Foreign Corporation

Worksheet 2 Form 8833, Treaty-Based Return Position Disclosure




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