Fixed, determinable, annual or periodic investment income is taxed at 30% by means of withholding tax.
If a foreign corporation enters United States market, we have to see if its activities are subject to U.S taxation.
Determination of U.S Taxation?
If a foreign person’s income is effectively connected with the conduct of a trade or business with in the United States, it will be subject to U.S taxation.
Code does not have a comprehensive definition of the term “trade or business”.
Case law suggests that a U.S trade or business exists only if the activities of either the taxpayer or the taxpayer’s dependent agents with in the United States are considerable, continuous, and regular.
A U.S trade or business ordinarily includes the performance of personal services in the United States.
Nonresident aliens can make short business trips to the United States free of U.S taxes.
Income tax treaties often contain more generous exemptions which allow for longer stays and increase or eliminate the limitation on earnings for business travelers from treaty countries.
If an independent agent located in the United States trades for an account of a taxpayer, it does not constitute a U.S trade or business.
Trading by taxpayers for their own account does not constitute a U.S trade or business, regardless of whether the trades are made by the taxpayer, the taxpayer’s employee, or an independent agent.
Permanent Establishment:
A permanent establishment includes a fixed place of business.
A permanent establishment will exist if employees or other dependent agents habitually exercise in the United States an authority to conclude sales contracts in the foreign business’s name.
If a fixed place of business used solely for auxiliary functions like purchasing, storing, displaying or delivering inventory, it is not considered a permanent establishment.
Tax treaties usually provide various exemptions for personal services income. These provisions allow nonresident alien individuals to perform personal services within the United States and avoid U.S taxation as long as their U.S activities do not exceed a specified level of intensity. Income derived by nonresidents is usually exempt from the U.S taxation if following conditions are met:
The employee is present in the United States for 183 days or less.
The employee’s compensation is paid by an employer that is not a U.S resident.
The compensation is not borne by a permanent establishment that the employer maintains in the United States.
The activities of an independent salesperson typically do not result in either a U.S trade or business or a permanent establishment for the foreign company.
Effectively Connected Income:
Most U.S source income. An example of effectively connected income include income derived by a U.S branch from the sale of inventory or form providing services.
U.S source dividends, interest, rents and royalties are also included in effectively connected income if the item of income meets one of the following tests:
Asset Test: The income is derived from assets used in or held for use in the conduct of the U.S trade or business.
Business Activities Test: The activities of the U.S trade or business were a material factor in the realization of the income.
Certain type of foreign source income attributable to a U.S office is also considered effectively connected income if the foreign person maintains an office or other fixed base in the united States and the U.S office is a material factor in producing the income and regularly carries on activities of the type that produce such income.
This inclusion applies to following types of foreign source income:
1 – Rents or royalties for the use of any intangibles derived from the active conduct of a U.S trade or business.
2 – Dividend and interest income derived from the active conduct of a banking, financing or similar business within the United States or received by a corporation whose principal business is trading in stocks and securities for its own account.
3 – Gains from the sale or exchange of inventory sold through the U.S office or other fixed base of business, unless the inventory is sold for use, disposition, or consumption outside the United States and a foreign office materially participates in the sale.
Certain type of deferred income that is recognized in a year that the foreign person is not engaged in a U.S trade or business, but which would have been effectively connected income if the recognition of the income had not been postponed.
Income from an interest in U.S real property that a passive foreign investor has elected to treat as effectively connected income.
Allowable Deductions:
A foreign corporation or nonresident alien individual engaged in the conduct of a U.S trade or business can claim the following deductions against its effectively connected gross income:
1 – Expenses, losses and other deductions that are directly related to effectively-connected gross income as well as ratable portion of any deductions that are not definitely related to any specific item of gross income.
2 – Foreign income taxes imposed on either foreign-source effectively connected income or U.S source effectively connected income that is subject to foreign taxation by reason of the income’s source rather than the taxpayer’s citizenship, residence or domicile.
3 – Charitable contributions made to U.S charitable organizations.
4 – In the case of a nonresident alien individual, casualty and theft losses with respect to personal property located within the United States, and a personal exemption deduction.
Profits attributable to a permanent establishment:
A foreign corporation in a treaty country will pay U.S taxes. Some corporations follow effectively connected rules and other apply transfer pricing rules.
Applicable tax rates range from 15% to 35% for foreign corporations and 10% to 40% for nonresident alien individuals.
A foreign corporation or nonresident alien individual engaged in a U.S trade or business can claim a credit for any foreign income taxes imposed on foreign-source effectively connected income or U.S source effectively connected income that is subject to foreign taxation.
The credit is allowed only against U.S taxes on effectively connected income and cannot offset U.S withholding taxes or the branch profits tax.
The effectively connected income of a foreign person is subject to the alternative minimum tax if the foreign person’s tentative minimum tax exceeds the regular tax for the year.
The Branch Taxes
The Branch Profit Tax
The branch profits tax creates a shareholder-level U.S tax that is equivalent to the U.S withholding tax imposed on dividends.
The branch profits tax is payable in the same manner as a foreign corporation’s regular income tax. The branch profits tax does not require estimated tax payments.
The tax base for the branch profits tax is the dividend equivalent amount, which estimates the amount of U.S earnings and profits that a branch remits to its foreign home office during the year.
Some tax treaties provide a specific exemption or rate reduction for the branch profits tax. If the applicable treaty does not provide a specific exemption or rate reduction, the treaty rate for the branch profits tax is the rate that applies to dividends paid to the foreign corporation by a wholly owned domestic corporation.
Under the branch interest withholding tax, any interest paid by a foreign corporation’s U.S branch is treated as if it were paid by a domestic corporation.
The branch withholding tax is not imposed on interest that qualifies for one of the following withholding tax exemptions:
1 – The portfolio interest exemption
2 – The exemption for interest paid on a U.S bank deposit.
3 – The exemption for interest income that is effectively connected with the conduct of a U.S trade or business.
4 – The reduced withholding or exemption offered by an applicable treaty.
Returns and Payment of Tax
Corporations
Any foreign corporation that is engaged in a U.S trade or business at any time during a taxable year must file Form 1120-F, U.S Income Tax Return of a Foreign Corporation.
This requirement applies even if the corporation does not have any effectively connected income, has no U.S source income or all income of the corporation is exempt from U.S taxes by reason of a treaty provision.
If a corporation is subject to U.S withholding tax, it must also file Form 1120-F.
Any foreign corporation that is engaged in U.S trade or business must make quarterly estimated tax payments of its income tax liability.
Individuals
Any nonresident alien individual who is engaged in a U.S trade or business must file Form 1040NR, U.S Nonresident Alien Income Tax Return.
Nonresident alien must file 1040NR even if he does not have any effectively connected income, has no U.S source income or all of its income is exempt from U.S tax by reason of a treaty provision.
If a nonresident alien has income that is subject to U.S withholding taxes must also file Form 1040NR.
A nonresident alien must make estimated tax payments if his tax exceeds the amount of any withholding tax.
Partnerships
Any partnership engaged in a U.S trade or business or that has income from U.S sources is required to file Form 1065, U.S Partnership Return of Income. It is an information return.
Partnerships must also file Form 8804, Annual Return For Partnership Withholding Tax and Form 8805, Foreign Partner’s information Statement and Form 8813, Partnership withholding Tax Payments.
References:
Practical Guide to US Taxation of International transactions 9th Edition
Robert J. Misey Jr.
Michael S. Schadewald
Publishers: Wolter Kluwer, CCH Incorporated.