Most foreign corporations are not subject to U.S. taxes. Sovereign nations impose tax based on residence of the taxpayer in the nation or based on the source of the income being in the nation. A foreign corporation that is located outside the United States and does not earn any of its income from the United States is not subject to U.S. tax based on residence or source.
Foreign corporations may be subject to U.S. taxes if they do business in the United States. The test for whether a foreign corporation does business in the United States is based first on U.S. tax law. It is referred to as the ECI test, which refers to a determination of whether the foreign corporation is engaged in a business which is effectively connected with the United States. If a foreign corporation is considered to be doing business in the United States under the ECI test, then the foreign corporation is required to filed a U.S. federal income tax return and pay taxes on its net income earned from the U.S. trade or business on the same graduated income tax rates as apply to U.S. businesses in general. It entitled to claim deductions against its gross income in determining its U.S. net income.
Foreign corporations which qualify as residents of treaty countries may be exempt from U.S. tax on earnings from doing business in the United States, even though they would normally be subject to U.S. tax under the ECI test. For purpose of this paragraph a treaty country is a country with a income tax treaty with the U.S. Under the tax treaty the ECI test of U.S. domestic law is replaced with a generally more lenient test referred to as the Permanent Establishment test. The Permanent Establishment test varies with the tax treaty, although most follow the same basic pattern. In most cases the ECI test and the Permanent Establishment test will produce the same result. However, for the company that manages to accomplish its business objectives without being considered to be engaged in a U.S. trade or business through a permanent establishment, the tax savings can be substantial.
Foreign corporations may also be subject to U.S. tax because they have an investment which produces income and the investment is considered to be of a type that yields U.S. sourced income. Foreign corporations are taxed on their earnings of U.S. sourced income based on the gross amount of the earnings. The tax rate is generally 30% of the gross income earned. The tax on U.S. sourced earnings is collected through a withholding tax, sometimes called the Foreign Withholding Tax to distinguish it from the withholding tax imposed on wages earned by employees. Any U.S. person who makes a payment of U.S. sourced income to a foreign corporation or other foreign person is required to withhold the amount of the tax from the payment and pay the withheld portion over the U.S. Treasury.
Not all U.S. income is considered to be U.S. sourced income. The U.S. government has made exceptions to encourage foreign capital investment in the United States. One of the biggest exceptions is interest earned on U.S. bank deposits. There is no U.S. withholding tax on the interest earned from such accounts. There are numerous other exceptions.
U.S. tax treaties generally reduce the amount of U.S. withholding tax that applies on the more common U.S. investments made by foreign corporations. In many cases the tax rate is reduced to 10 or 15% rather than the standard 30% rate. In some cases, the withholding tax rate is eliminated entirely.
U.S. SHAREHOLDERS OF CONTROLLED FOREIGN CORPORATIONS
=A Controlled Foreign Corporation is a foreign corporation that is significantly owned by U.S. investors. Why is this important? U.S. tax authorities are concerned that foreign corporations offer U.S. investors an opportunity to delay recognizing income from one year to another and possibly much longer. Putting off income recognition means putting off the payment of tax on that income. The deferral of tax can result in significant savings over time.
If a foreign corporation is essentially controlled by U.S. investors, those investors may cooperate with each other to cause the foreign corporation to act in a way that promotes tax deferral for the investors and hurts the U.S. treasury. A major way that this can be done is by delaying the payment of dividends on profits earned by the foreign corporation. Under traditional U.S. tax rules the U.S. shareholders do not have to pay income tax on the foreign corporations earnings until the dividend is paid or accrued. If the foreign corporation simply does not declare a dividend and retains the earnings, the tax on the income of the U.S. shareholder is postponed. Perhaps indefinitely.
A Foreign Corporation is considered to be a CFC if:
(i) more than 50% of the combined voting power of all classes of stock of such foreign corporation entitled to vote; or
(ii) more than 50% of the total value of the stock of such corporation
is owned by United States shareholders on any day during the taxable year of such corporation.
For the purpose of this definition, a United States shareholder is a U.S taxpayer that owns 10% or more of the combined voting power of all classes of stock of such corporation that are entitled to vote.
U.S. tax authorities devised a plan to neutralize the deferral of dividends in a CFC. The plan requires certain U.S. shareholders of foreign corporations meeting the control definition, to pay tax on the income of the Controlled Foreign Corporation in the year it is earned by the foreign corporation without regard to whether the foreign corporation declares and pays a dividend out of those earnings. If the shareholder pays a tax on the deemed dividend, the shareholder gets a credit so that another tax does not have to be paid when the dividend is finally paid and received.
This story gets more complicated. Not all foreign income earned by a CFC is subject to the deemed dividend treatment. Congress decided that U.S. business should be able to use foreign corporations that are CFCs to compete globally against foreign business competition. The deemed dividend rule was considered to harsh to permit fair competition by U.S. business. Therefore, it was decided that certain active trade or business income earned by CFCs would not be subject to the deemed dividend rule. Only certain income, primarily from passive investments of the foreign corporation would be considered bad income which was given the name Subpart F income after the part of the Income Tax Code where these rules can be found. The test for whether the earnings of a CFC are or are not Subpart F income are laced with many special and peculiar rules. For this general coverage, a working rule can be used that passive income is likely to be Subpart F income and most active trade or business income earned by the CFC from its business activities is likely to escape Subpart F treatment.
There is a big trap for the unwary in the Subpart F rules. Income that has been deferred because it is legitimate active trade or business income may suddenly be considered to have been repatriated or paid and thus subject to tax, if it is reinvested in the United States. Such reinvestment can be deemed to have occurred if the U.S. shareholder of the CFC, particularly a U.S. corporation that has a CFC as a foreign subsidiary utilizes the subsidiarys retained earnings as part of the credit support for a financing of the U.S. shareholder. This can be the result of any number of ordinary business transactions whereby the U.S. parent is seeking financing. The result can be a significant and unplanned tax event.
United States shareholders of CFCs are required to file a U.S. tax form 5471 on which the earnings of the CFC are reported. The form is also used to track the previously taxed earnings of the CFC so that these are not subject to tax when distributed to the shareholders.
There are significant penalties for failure to properly and timely filed the form 5471, beginning with a $10,000 penalty. The penalty is imposed, even if no U.S. tax would otherwise be owed by the U.S. shareholder.
Tax planning for share ownership in a CFC is complicated and any person or company planning on setting up a foreign corporation to do business is advised to seek professional counsel from tax advisers familiar with Subpart F issues.
U.S. Shareholders of Passive Foreign Investment Corporations
U.S. shareholders of foreign corporations that are not CFCs still must consider whether the special tax rules relating to Passive Foreign Investment Corporations or PFICs as they are called, apply to them. Unlike the CFC rules, the PFIC rules apply to shareholders with small holdings in the foreign corporation stock – from a single share, up to 100% of the shares. The CFC provisions only apply to U.S. shareholders with at least 10% of the shares of the CFC.
Passive Foreign Investment Corporations are foreign corporations that primarily invest the capital of their shareholders in activities that generate passive income rather than active trade or business income. PFICs are defined as any foreign corporation if
(1) 75% or more of the gross income of such corporation for the taxable year is passive income, or
(2) 50% or more of the corporations assets are held for the production of passive income.
An unfortunate feature of this definition is that no threshold is given for a minimum amount of income or assets that would not trigger the definition. Therefore many tiny and new companies fall into the PFIC category for at least a period of time while the only asset the new corporation has is an interest bearing bank account holding some amount of start up capital. Research and development companies that have not brought a product to market yet, will also generally meet the test for PFIC status as their only income is generally passive income.
U.S. tax authorities have singled out U.S. shareholders of PFICs for special tax treatment, as they believe that investors seeking passive returns can move their investment overseas more easily than can investors in active trades or business. If PFICs offer U.S. shareholders the opportunity to defer U.S. tax, the tax authorities fear that too many taxpayers would find the opportunity appealing.
Preventing the deferral of tax for PFICs is a difficult tax problem. U.S. shareholders of a PFIC may be very minor investors in the company. They may not have the clout in the company to be able to ask the company to provide them sufficient details as to the earnings of the company to satisfy U.S. tax authorities as to the proper tax to impose. The tax authorities decided that in light of the shareholder problem of getting information they would offer the U.S. shareholders a set of choices on how to report the income from the PFIC. In general the shareholders that are lucky enough to be able to get the most cooperation from the foreign company and therefore the most information get to choose the least burdensome tax treatment. PFIC shareholders who have less information to work with may have to rely on much more complex and burdensome methods of reporting their income.
The different tax reporting methods available to U.S. shareholders of PFICS are:
1) inclusion in income of the earnings of the PFIC annually as ordinary income;
2) mark to market tax reporting; and
3) taxation of excess distributions from the PFIC based on an allocation of the excess to each day in the shareholders holding period with imputed tax and interest charges.
The third method based upon allocation to the holding period is a very intricate accounting problem that can create compliance costs greater than the income to be earned from smaller investments.
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