Branch Profits Tax and FIRPTA
Where we are to date:
Now would be a good time to review the different concepts we covered and how they all fit together.
Question 1: Is the taxpayer a US person or a non-US person?
For any issue you are faced with in international tax, this is always the first issue you must resolve.
Question 2: What is the source of the income?
The source of income is also relevant to further analysis you will be conducting.
If you’ve determined that you are dealing with a non-US person, there are 2 important questions you must ask:
1- Is the non-US person a resident of a country that has a tax treaty with the US?
2- Does the non-US person have a US trade/business or a Permanent Establishment (if there is a Treaty in effect)?
I have created a decision tree that will help you get through the various questions that arise for non-US persons.
Branch Profits Tax
The Branch Profits Tax (BPT) was created to create parity between the situation when a non-US person has a US subsidiary and when a non-US person has a US branch.
Consider the following two scenarios:
Scenario 1:
A foreign corporation (ForCo) owns 100% of the shares of a US corporation (USSub)
USSub earns $1000 of income that is subject to corporate tax at the normal marginal rates (let’s assume the applicable rate is 35%), resulting in $350 of tax.
The remaining $650 is distributed to ForCo as a dividend. Since the $650 dividend is FDAP income (and no exception applies), it is subject to the 30% withholding tax.
After $195 is withheld, ForCo receives a payment of $455 from USSub.
Scenario 2:
A foreign corporation (ForCo) is engaged in a US trade/business. Since the US business is unincorporated it is a branch. The US branch earns $1000 of income which is ECI. The income is therefore subject to tax at normal marginal rates (let’s assume it’s taxed at 35%), resulting in $350 of tax.
When the remaining $650 is remitted to ForCo, the income is not characterized as FDAP income. In this case the $650 does not constitute a dividend payment (since it is not a distribution of earnings from a corporation to a shareholder); it is merely an inter-company payment that is only reflected on the company’s internal books.
After the inter-company is payment is made ForCo would have $650 from the US branch.
As you can see, by having a US branch instead of a US subsidiary ForCo was able to bypass the 30% withholding tax. The BPT steps in to remedy this difference. Essentially, the BPT treats a branch as if it was a subsidiary by imposing a 30% withholding tax on a branch’s earnings that are deemed to be distributed to the foreign corporation.
The difficulty is in determining the “deemed dividend amount.” A US subsidiary has the discrepancy of distributing any amount it chooses to its shareholders. So if USSub earned $650 after-corporate taxes, it could choose to pay a dividend anywhere from $0 to $650. It would therefore be too simple to assume that the “deemed dividend amount” of a branch was merely its after-tax ECI. We have to account for the potential that the branch may have re-invested some of its earnings into the US operations. As a result, the “deemed dividend amount” is reached by performing the following calculation:
Determine the US trade/business’ ECI ($1000 in our example)
Subject the ECI to the appropriate marginal tax rate (35% in our example)
Post-tax ECI is Effectively Connected Earnings & Profits ($650 in our example)
In order to account for reinvestments in the US operations, we need to adjust the Effectively Connected Earnings & Profits by changes in the branch’s Net Assets.
So we need to look at the branch’s balance sheet for the prior year and the current year and determine whether the Net Assets increased or decreased. Assume that at the end of the prior year, the branch’s Net Assets were at $450 and at the end of the current year the branch’s Net Assets were at $500. We can conclude that the Change in Net Assets was $50.
When there is an increase in Net Assets, we assume that there was a reinvestment into the branch’s operations. Hence, we assume that of the $650 of Effectively Connected E&P, $50 was reinvested into the branch, leaving only $600 to be distributed to the Foreign Corporation. In this example, a 30% withholding tax would be imposed on $600.
FIRPTA
We discovered in the last two weeks that non-US persons are generally not subject to US tax on their US source capital gains unless they are ECI with a US trade/business.
The major exception to this rule is in the case of Real Property. Capital gain realized by non-US persons from the sale of Real Property is subject to tax at normal tax rates (i.e. ordinary income rates for short-term capital gain and capital gains rates for long-term capital gain).
However, imagine that a non-US person created a US corporation (USCo) and the only asset that the USCo owned was US real property. At first, it would appear that if the non-US person sold shares in USCo, it would not be subject to any tax because shares of stock are personal property, not real property.
In order to curtail this abuse, the tax code will treat a US corporation as a US Real Property Holding Company (USRPHC) if 50% or more of its assets are a US Real Property Interest (USRPI). The sale of shares of a USRPHC is treated the same as the sale of Real Estate.
A USRPI includes most forms of Real Estate (e.g. buildings, land, etc…) as well as other USRPHCs. So if a US corporation’s (USCo1) only asset is stock in another US corporation (USCo2), and USCo2’s only asset is a building, then both USCo1 and USCo2 are USRPHCs.
To determine if you reached the 50% threshold for a USRPHC perform the following formula:
USRPI (including other USRPHCs) / USRPI (including other USRPHCs) + Foreign Real Property + All other assets used in a trade/business
Note that passive assets are not included in the formula. So if a US corporation owned $100 worth of US Real Property and $300 of bonds and $50 of trade/business assets, it would be a USRPHC because the USRPI would be more than 50% of the RELEVANT assets:
USRPI ($100) / USRPI ($100) + trade/business assets ($50) = $100/$150 = 67%
The investment assets of $300 are NOT included in the denominator of the formula.