Foreign corporations taxed on their U.S. source income

Regulation § 1.6012-2(g)(1) requires foreign corporations that are viewed under the IRC to be engaged in ongoing U.S. trade or business activity to file Form 1120-F on an annual basis. Applicable foreign corporations are required to file even where it has no Effectively Connected Income (ECI), U.S.-source income and even where its income is entirely exempt from tax under the IRC or via a treaty provision. However, under regulation § 1.6012-2(g)(1)(i), where the corporation has no taxable income for U.S. purposes it need only provide the identifying information on the return and attach a statement indicating the nature and amount of any exclusions claimed under the code or via treaty to the return as well as Form 8833 disclosing the treaty-based return position as required by Regs. § 301.6114-1(a)(1)(ii).             

Note – watch for foreign corporations claiming to not be required to file a return under the rules of Regs.  § 1.6012-2(g)(1) because it has no U.S. permanent establishment as defined under an applicable treaty.  At a minimum, such a corporation may still be required to file a U.S. return under the rules of § 6114 in order to disclose any applicable treaty-based return positions.

FOREIGN CORPORATIONS SUBJECT TO TAX UNDER SUBTITLE A OF THE IRC               

Even where not deemed to be engaged in a U.S. trade or business, Under Regs. § § 1.6012-2(g)(1)(i), -2(g)(2)(i)(a) foreign corporations are still required to file a U.S. return to report income taxable under subtitle A of the Code if the associated tax liability is not fully satisfied by withholding at source.  Look for U.S.-source income taxable under § 881, ECI taxable under § 882(d) or (e).   Even where a foreign corporations U.S. tax liability is fully satisfied by withholding, it will still be required to file a U.S. return if it is seeking a refund of U.S. tax or if it is subject to the accumulated earnings tax under Regs. § 1.6012-2(g)(2)(i)(b).

WHEN AND WHERE TO FILE

Where required to file, Regs. § 1.6072-2(b) require a foreign corporation to file its U.S. income tax return on or before the 15th day of the third month following the close of the taxable year (March 15^th for a calendar year corporation). Foreign corporations without a U.S. office or fixed place of business are granted an automatic three-month extension of time to file its U.S. income tax return (June 15^th for a calendar year corporation). To qualify the corporation must attach a statement to its return showing that it was eligible for the extension because it had no U.S. office of fixed place of business.  The automatic three-month extension also applies to the payment of any taxes due, consequently the automatic extension tolls for three months the imposition of late payment penalties but does not toll interest on any payment made after the original due date and during the extended time period.  Corporations that qualify for the three month automatic extension are still required to file within 6 months of the original due date of the return. All foreign corporation are entitled to a six-month extension of time to file its U.S. returns by filing Form 7004 and paying its estimated unpaid tax liability by the original due date of the return (or extended three month period if applicable).  The 7004 does not extend the time for payment of tax if the foreign corporation does not qualify for the automatic three month extension, thus, the corporation remains subject to interest and penalties for payments made after the initial due date of the return. Foreign corporations are required to file with the IRS Service Center in Ogden, Utah.

INFORMATION RETURNS REQUIRED OF FOREIGN CORPORATIONS

There are a variety of U.S. information reporting requirements potentially applicable to foreign corporations. For instance, a foreign corporation may be required to file Forms 1096 and 1099 were applicable just as domestic corporations are so required. A foreign corporations can be required to file form 1042 if it makes payments of U.S.-source income to foreign persons. There are various reporting requirements applicable to U.S. shareholders, officers, and directors of foreign corporations and foreign personal holding companies where more than 10% of the stock is owned by U.S. persons.  Foreign corporations engaged in a U.S. trade or business are required to file Form 5472 to report information about the corporation and transactions with  related parties during the tax year.

EFFECTIVELY CONNECTED INCOME (ECI)                                              

A foreign corporation is taxable on its net ECI at normal corporate rates under § 882. Generally, a foreign corporation only has ECI if it is engaged in a trade or business within the United States.  In calculating net ECI a foreign corporation may deduct from ECI expenses that are incurred in the process of earning the ECI. 

BRANCH PROFITS TAX

Foreign Corporations also face a potential branch profits tax:   See Q and A on that subject.

SECTION 881 TAXATION OF NON ECI BUT U.S. SOURCE INCOME        

Fixed or determinable annual or periodical (FDAP) income such as dividends, royalties, and compensation and other FDAP-like income derived by a foreign corporation from U.S. sources but not technically ECI are taxed under  § 881 on a gross basis at 30%.   

ANTI-DEFERRAL PROVISIONS APPLICABLE TO FOREIGN CORPORATIONS                                                          

The 20% accumulated earnings tax on accumulated taxable earnings imposed by section 531 on corporations that accumulate earnings beyond their reasonable business needs applies to foreign corporations with U.S.-source income, only where at least one of its shareholders would be subject to U.S. income tax upon receipt of a distribution from the corporation.

TAXATION OF U.S. SHAREHOLDERS OF FOREIGN CORPORATIONS.                      

The taxing nexus of the U.S. over foreign corporations is limited even where the foreign corporation is owned entirely by U.S. residents, however the ability to establish taxing nexus over its own citizens is unlimited. To this end, the U.S. has a variety of methods to tax U.S. persons based on their ownership interest in a foreign corporation or entity. U.S. persons can be taxed on their foreign holdings under the controlled foreign corporation (“CFC) regulations of Subpart F, and the passive foreign investment company (PFIC) regulations, and a plethora of other statutory provisions, such as § 367, which regulates transfers of property by a U.S. person to a foreign corporation.

THE AFFECT OF TAX TREATIES ON THE TAXING OF FOREIGN CORPORATIONS                 

Where a foreign corporation is entitled to the benefits of a treaty, the treaty provisions may alter the manner in which the U.S. statutory framework applies. For example the right of the United States to impose tax under  § 882 may be limited to situations in which the corporation maintains a “permanent establishment” in the United States and has business profits that are “attributable to” the permanent establishment. A treaty provision may reduce or even eliminate the 30% withholding tax that can be imposed on a gross basis under § 881 on U.S.-source interest, dividends, and other similar income.

The regulations under § 6114 come into play whenever a taxpayer takes a treaty-based return position. A taxpayer can be considered to have adopted a return position under the Regulations § 301.6114-1(a)(2)(i) when the taxpayer determines its tax liability even if no return is actually filed (especially where this result is arrive at based on reliance on a treaty). To determine whether a return position is treaty-based, the taxpayer must compare the tax liability that is reportable on a return including the effect of a treaty with the liability that would be required as if the relied upon treaty provision did not exist. The difference, if any, is a treaty-based return position and thus § 6114 reporting is required.

PENALTIES FOR FAILING TO DISCLOSE A TREATY BASED RETURN POSITION                        

Section 6712 hits corporations with a $10,000 penalty for each failure to report a treaty-based return position.  Under § 301.6712-1(a) the penalty is per transaction not per annual filing and thus will apply separately to each reportable payment or income item where the required disclosure is not made even if they involve the same payor. The regulations under § 301.6712-1(b) empower the IRS to waive all or a portion such penalties where it can be established that the omitted discloser was not due to “willful neglect.”

CLASSIFICATION OF FOREIGN ENTITIES FOR US TAX PURPOSES 

Before the issuance of the check the box regulations promulgated in 1996, the definition of a foreign entity as a corporation versus a partnership or trust for example was a source of continuing controversy. The code defines corporations as associations, joint-stock companies, and insurance companies. Under the check-the-box regulations elective entity classification is certain and unequivocal. An eligible entity can make an entity classification election on Form 8832 however a foreign multiple member entity will be classified as a corporation only if all members have limited liability, otherwise, the foreign entity will be classified as a partnership or a disregarded entity if only one member.  

Limited liability for foreign entity classification purposes exists solely where the member has no personal liability for the debts or claims against the entity because of being a member.  Personal liability exists if the entity’s creditors are able to seek satisfaction from the member of any portion of their debts or claims against the entity. The above determinations are exclusively based on interpretation of the foreign law under which the entity is organized.   Many U.S. tax services provide listings of common foreign entities by country and provide a determination of what the U.S. entity equivalent is.     

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