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Course Code: 732015
ITTF GS-0419-0A
Revised: May 2019
Chapter 1
Overview of U.S. Corporate International Taxation
Learning objectives
Recognize the comprehensive system of outbound (core) and inbound U.S. international taxation laws
Recognize the concepts of timing for income recognition.
Identify the international tax provisions of the Tax Cuts and Jobs Act (TCJA) signed in December 2017.
Recognize U.S. federal income tax benefits for U.S. exporters of U.S. property under the interest charge domestic international sales corporations (IC-DISC) regime.
Summary
This course will cover the fundamentals of U.S. corporate international taxation, with a primary focus on “outbound concepts” and technical tax issues. This course has been updated to cover the fundamental international tax provisions within the TCJA, including for international tax Treasury Regulations and Notices released through March 2019.
In general, the United States taxes U.S. persons on their worldwide income. The United States may grant the functional equivalent of an exclusion through a foreign tax credit or tax deduction. For example, under Section 936, a domestic corporation may offset hypothetical U.S. taxes on certain income connected with U.S. possessions against U.S. taxes that otherwise would be due.
Section 7701(b) contains methodical rules to define when an alien is a U.S. resident. Mere presence in the United States for 183 days in a taxable year may subject an alien to taxation on worldwide income for that year. In general, a domestic corporation, which is subject to U.S. taxation on worldwide income, is a corporation incorporated in the United States.In certain narrow cases, however, the Internal Revenue Code (IRC) may treat a foreign corporation as domesticor treat a branch of a domestic corporation as foreign.
In general, a U.S. person that incurs foreign losses may deduct those losses for U.S. tax purposes. However, the deduction of a dual consolidated loss may be limited. Further, recapture rules may trigger income in a taxable year after a foreign loss.
Because the United States generally taxes U.S. citizens and residents on worldwide income, the issue of double taxation may arise when such a person has income from foreign countries or U.S. possessions. To reduce the problem, the United States generally grants a foreign tax credit for income taxes paid to foreign countries and U.S. possessions. Section 904 contains complex rules regarding the foreign tax credit, and its limitations may severely limit the actual use of the credits.
The United States does not automatically tax a U.S. person on the income of a foreign corporation that is owned in whole or in part by that person. Therefore, U.S. persons may form a foreign corporation to conduct foreign activities without incurring U.S. taxes before receipt of distributions from the corporation or a sale of the corporation's stock. However, Congress and the U.S. Treasury have adopted rules, regulations, notices, and significant annual reporting requirements for controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs), in addition to foreign disregarded entities, foreign branches, or qualified branch units (QBUs), and foreign partnerships.
The United States has entered into tax treaties and conventions with many foreign countries. In general, those treaties affect the U.S. taxation of foreign persons, not U.S. persons. The “Saving Clause” in each treaty generally gives the United States the right to tax its corporations, citizens, and residents as if the treaty had never come into force. In certain cases, a tax treaty may limit the U.S. taxation of U.S. persons. Examples of such help for U.S. citizens and residents include (a) the allowance of U.S. foreign tax credits, with special source rules for purposes of Section 904; (b) tax treaty or protocol clauses that prevent discriminatory treatment of foreign persons that are U.S. residents and of domestic corporations owned by foreign persons; (c) exemptions for certain types of income; (d) the allowance of certain deductions; and (e) the use of competent authority procedures (for example, mutual agreement procedures or “MAP”) to resolve inconsistent treatment by the United States and the foreign treaty country.
U.S. Outbound Tax Concepts
Exporting U.S. products to foreign countries
Exporting or performing services to foreign persons outside the United States
Foreign branch of a U.S. business — Section 987
– Section 987 may apply when the U.S. taxpayer operates in a branch form (such as a check-thebox foreign disregarded entity or a foreign partnership) and such branch is a QBU with a functional currency different than that of its owner.
New benefits and tax provisions available only to C corporations under the TCJA
Subpart F income from CFCs
global intangible low-taxed income (GILTI) from CFCs
Dividends Received Deduction (DRD) or Participation Exemption applicable for C corps that own at least 10% of a foreign corporation — Section 245A
Investment in U.S. property by a CFC — Section 956
Section 863(b) sourcing rules modifications
Foreign tax credits (FTC)
– Direct foreign tax credit, Section 901
–
Indirect or deemed-paid credit, Section 902 (repealed by the TCJA)
– Allowable credit calculated on Forms 1118 (corporate) or 1116 (individual)
Limitation on FTC, Section 904
U.S. shareholders of PFICs
Limits on interest expense for U.S. businesses (that is, 30% of adjusted taxable income [ATI])
Knowledge check
1. Section 987 addresses which issue?
a. Currency translation values at the time of a transaction.
b. Character of gain or loss.
c. Foreign branches that are QBUs.
d. Transfer pricing.
U.S. Inbound Tax Concepts
Investment or passive types of income from U.S. sources (for example, fixed, determinable, annual, or periodical [FDAP]) — Sections 871 and 881
Effectively connected income (ECI) derived from a U.S. trade or business (ECI from a U.S. trade or business) — based on IRC, U.S. case law, and IRS rulings
Business profits attributable to a U.S. permanent establishment (PE) — based on U.S. tax treaties and conventions
Interest expense limitation or the thin capitalization and anti-earnings stripping rules, Section 163(j) Debt versus equity U.S. tax law
Foreign Investment in Real Property Tax Act (FIRPTA) — the disposition of a U.S. real property interest by a foreign person (the transferor) is subject to U.S. source withholding tax. FIRPTA authorized the United States to tax foreign persons on dispositions of U.S. real property interests. Sections 897 and 1445. PATH Act revisions
Base erosion and anti-abuse tax (BEAT) — Section 59A
Modified Section 1446(f) and new Section 864(c)(8) reverses the holding within the Grecian Magnesite Mining case, and reverts to the original holding in Rev. Rul. 91-32 for U.S. income tax treatment of foreign partners who sell their interest in an operating U.S. partnership (that is, a U.S. partnership that has ECI from engaging in a U.S. trade or business)
Other fundamental U.S. international tax concepts
Choice of entity classification, U.S. “check-the-box” rules
Section 7701, and Treasury Regulation 301 7701-1, -2
U.S. tax law governs the classification of a form of foreign business organization for U.S. tax purposes. The check-the-box regulations under Section 7701, generally effective January 1, 1997, provide that any “business entity” that is not required to be treated as a corporation is an “eligible entity” that may choose its classification. The regulations provide default classification rules. Eligible entities may elect out of the default rules. Entities that wish to change their previous classification must also do so by filing an election that qualifies for purposes of Section 7701.
– Form 8832 is known as the “check-the-box” election form, or the entity classification election form.
Sourcing of income and (allocation of) expenses
Tax treaties and conventions
– Tax treaties generally reduce withholding tax rates between Treaty partner jurisdictions and contain provisions that allow for procedures to avoid double taxation on one item of income by the same taxpayer by two different taxing jurisdictions and or States.
Transfer pricing rules — intercompany or related party transactions, Section 482
– Requires an arm’s length price or rate on an intercompany or related party transaction under Section 482, Treasury Regulations under Section 482, and Organization for Economic Cooperation and Development (OECD) rules. – OECD’s base erosion and profit shifting initiative
– Country by Country (CbC) reporting
U.S. statutory withholding tax rules for FDAP income under chapter 3 (regular) and chapter 4 (FATCA for financial services industry) of the IRC
International tax fundamental concepts
Definition of “U.S. person”
The term "United States person" means a citizen or resident of the United States; a partnership created or organized in the United States or under the law of the United States or of any State, or the District of Columbia; a corporation created or organized in the United States or under the law of the United States or of any State, or the District of Columbia; any estate or trust other than a foreign estate or foreign trust. (See IRC Section 7701(a)(31) for the definition of a foreign estate and a foreign trust); or any other person that is not a foreign person.
A foreign person includes a nonresident alien individual (NRA), foreign corporation, foreign partnership, foreign trust, a foreign estate, and any other person that is not a U.S. person. It also includes a foreign branch of a U.S. financial institution if the foreign branch is a qualified intermediary. Generally, the U.S. branch of a foreign corporation or partnership is treated as a foreign person. A nonresident alien is an individual who is not a U.S. citizen or a resident alien. A resident of a foreign country under the residence article of an income tax treaty is an NRA for purposes of U.S. withholding tax.
U.S. citizens, resident aliens, corporations, and fiduciaries are generally taxed on their export income in the same manner as on their domestic income from the United States.
U.S. businesses report income and deductions from export activities on the same tax returns used to report income from domestic sales. However, there are two significant differences:
1. Income may be considered earned by a U.S. business for purposes of U.S. taxation even though exchange or capital controls imposed by foreign governments restrict the ability of the business to use the proceeds of the export sale.
2. There are particular forms and schedules to be completed that reflect specific issues that arise only in international transactions.
Example 1-1
Sessions Corporation, a financial services company, incorporated and headquartered in the United States, opens a trading office in Sao Paulo, Brazil. Sessions office in Sao Paulo attracts investment from several large Brazilian investors. Sessions collects commissions for these sales but is not allowed to return its commissions to the United States due to a currency control recently imposed by the Central Bank of Brazil. Sessions must nevertheless report the Brazilian commissions on its U.S. federal income tax return, absent an election to file a separate U.S. Form 1120 for blocked income.
Knowledge check
2. When a U.S. business has commission sales in country X but cannot remit the sales commissions to the United States due to currency control regulations in X, the U.S. business must recognize income
a. When the sales commissions are remitted to the United States.
b. On its U.S. federal income tax return.
c. In an amount equal to 50% of the sales commissions.
d. In an amount equal to 75% of the sales commissions.
Recognition of income
In general, businesses are considered to recognize income and are required to report the income for tax purposes when the business receives the income, accrues the income under generally accepted accounting principles, or has the right to obtain the income.
Time of payment
Generally, income is recognized when received or accrued. Recognition of income may take place earlier than actual receipt; however, when funds are deposited in a bank account in the name of the business or otherwise made freely available to the business. Similarly, recognition of income may take place later than actual receipt if the funds are subject to future contingencies.
A business may recognize income even though payment is made to another company. The determination of whether the recipient is acting solely for the business depends on whether the recipient is a real entity engaged in a real transaction.
Example 1-2
Assume in example 1-1, that Sessions Corporation incurs a significant net operating loss in its Sao Paulo office and earns a substantial commission rendering services in the United States. Before collecting the commission, Sessions transfers the commission contract to its Brazilian subsidiary to shelter the commission income earned in the United States with the Brazilian loss. Upon examination of Sessions’ U.S. tax return, the IRS will include the U.S. commission in Sessions’ U.S. tax return.
U.S. businesses are on the cash method of accounting with respect to amounts owed to a related foreign person except where the related foreign person is a CFC, a passive foreign investment company or a foreign personal holding company, in which case the U.S. business can deduct accrued amounts as of the day on which a corresponding amount of income is recognized by the CFC, the passive foreign investment company or the foreign personal holding company.
Effective October 22, 2004, accrued but unpaid amounts due from a U.S. business to a related CFC or passive foreign investment company cannot be deducted by the U.S. business until a corresponding amount is included in the gross income of a U.S. person(s) who owns stock, directly or through a foreign entity, in the CFC or the passive foreign investment company.
Example 1-3
Assume in example 1-1, that Sessions Corporation takes a working capital advance from its Sao Paulo office. The working capital advance to the U.S office is documented in a promissory note and bears interest at a market rate. Sessions U.S. accrues a quarterly interest payment to its Sao Paulo office on December 31, the end of Sessions U.S. tax year and pays the amount accrued January 10 of the following tax year. Sessions U.S. cannot deduct the interest payment accrued but not paid December 31 until actually paid in the subsequent tax year.
Delivery of goods
In some situations, a U.S. business will recognize income when goods are delivered to a foreign person. If the purchaser makes advance deposits with the seller or the purchaser pays with an irrevocable letter of credit, delivery of the goods may trigger recognition of income to the U.S. business. However, if the U.S. business ships goods on consignment to a foreign dealer, the U.S. business will recognize income after the goods are sold by the dealer.
Introduction of International Tax Provisions enacted by the TCJA
Select general tax provisions of the TCJA
The TCJA provisions affect tax years beginning in 2018, with some exceptions.
A permanent 21% corporate income tax rate effective in 2018, representing a 40% decrease over the prior corporate income tax rate of 35%
Limitations on business and personal net operating losses and business interest deductions
Repeal of the corporate alternative minimum tax (AMT)
Repeal of the domestic production activities deduction (DPAD)
New broader interest expense limitation regulations under Section 163(j) that limit interest expense to 30% of Adjusted Taxable Income (ATI)
A 20% deduction for qualifying pass-through income from partnerships, LLCs, and S corporations; notable exceptions (SSTBs) that do not qualify are in consulting, accounting, law, healthcare and medicine, and related fields — The “pass-through deduction” for up to 20% of Qualified Business Income of U.S. pass-through business entities under Section 199A (generally requires W-2 employee expense) that require modeling between the effective tax rate of a pass-through entity versus a C corp entity.
Revisiting the technical rules surrounding the Accumulated Earnings Tax (Sections 531, 532) and Personal Holding Company Tax (Sections 541-543) for C corporations
Introduction and listing of U.S. international tax provisions
The TCJA imposes a one-time tax on a 10% or greater U.S. shareholder’s share of the accumulated and previously untaxed foreign earnings and profits of specified foreign corporations (SFCs). SFCs are defined as CFCs and other foreign corporations having a domestic corporate shareholder with at least 10% ownership. The post-1986 accumulated earnings of all SFCs will be treated as an increase to current-year Subpart F income and mandatorily deemed repatriated to their “U.S. shareholders.”
Repatriated earnings held in cash and cash equivalents will be taxed at a 15.5% rate, and the remaining amount of earnings held in illiquid assets will be taxed at an 8% rate. For 10% U.S. C corporation shareholders, a proportional, partial foreign tax credit is allowed.
The amount of accumulated foreign earnings and profits subject to mandatory repatriation will be determined as of November 2, 2017, or December 31, 2017, whichever is greater. The first installment (or the entire amount) is due by the original due date of the tax return filed for the last tax year beginning before January 1, 2018, without regard to extensions. For calendar-year filers, this would be the tax year beginning January 1, 2017, and ending December 31, 2017, which means that the first installment (or the entire amount) was due April 17, 2018.
For S corporations subject to the deemed repatriation tax, there is a special provision that defers the tax until the S corporation sells substantially all of its assets, ceases to conduct business, changes its tax status, or the electing shareholder transfers its stock.
U.S. base erosion provisions — “BEAT,” Section 59A (inbound tax provision)
The BEAT is an alternative minimum tax on corporations that have annual gross receipts for the three prior years of at least $500m and that make certain “base erosion” payments to foreign related parties in excess of a threshold amount.
Base erosion payments include amounts paid or accrued to a foreign related party that are deductible against U.S. taxes, such as interest, royalties, and service fees (but do not include costs of goods sold).
The BEAT tax rate is 5% for tax years beginning in 2018, 10% for tax years 2019 through 2025, and 12.5% for tax years beginning after 2025.
A further base erosion provision also applies to deny a deduction for certain payments of interest and royalties to related parties either pursuant to a hybrid transaction, whereby the characterization of the payment differs between U.S. and foreign tax law, or by or to a hybrid entity (a foreign disregarded entity) where the payment is not included in income by the related party.
Base erosion provisions are modified to clarify that dividends received by an individual from a surrogate foreign corporation as a result of an inversion transaction are not qualified dividends and, therefore, are not eligible for the lower qualified dividend rates
Global intangible low-taxed income, Sections 951A and 250
Summary: minimum (that is, generally 10.5% to 13.125%) U.S. income tax on CFC’s annual, computed income, determined after Subpart F income
The effect of the GILTI provision is to subject U.S. shareholders of CFCs to current taxation on the aggregate net income of the CFCs over a routine return.
The GILTI provision applies to the tax years of a CFC that begin after December 31, 2017, and to U.S. shareholders of such CFC in which or with which such tax years of the CFC end.
U.S. corporate shareholders of CFCs (but not individuals, partnerships, or S corporations) are allowed to deduct 50% of GILTI for tax years beginning after December 31, 2017, and before January 1, 2026, and 37.5% of GILTI after 2026.
U.S. corporate shareholders of CFCs can also claim a foreign tax credit with respect to included GILTI amounts, but such foreign tax credit is limited to 80% of the foreign tax paid, and any unused FTCs cannot be carried forward or carried back to other tax years.
U.S. individual shareholders of CFCs that implemented the Section 962 election pursuant to the Regulations released in 2019, (a) will also be allowed to deduct 50% of GILTI for tax years beginning after December 31, 2017, and before January 1, 2026, and (b) may claim a foreign tax credit with respect to included GILTI amounts, but such foreign tax credit is limited to 80% of the foreign tax paid, and any unused FTCs cannot be carried forward or carried back to other tax years.
The objective or hope was for the U.S. Treasury to impose an effective tax rate (ETR) of 10.5% to 13.125% on each CFC’s annual income (subject to complex regulatory computations), to the U.S. shareholders.
Foreign-derived intangible income, Section 250
As an incentive to keep intangible assets, functions, and activity inside and originating in the United States and also encourage U.S. export activity, a U.S. C corporation is allowed to deduct 37.5% of its foreign-derived intangible income (FDII) for taxable years beginning after December 31, 2017, and before January 1, 2026. For taxable years beginning after December 31, 2026, the FDII deduction is reduced to 21 875
FDII of a U.S. corporation is generally the excess of its gross income over deductions properly allocable to such income, to the extent such income is derived in connection with the sale of property to a non-U.S. person for a foreign use, or services provided to any person (or with respect to property located outside the United States) located outside the United States.
The objective or hope was for the U.S. Treasury to impose an ETR of 13.125% on qualified FDII of C corporations. However, tax rate modeling and detailed tax computations have shown that such an ETR will not always be the result. At times, it can be higher.
Compare the existing IC-DISC regime that benefits non C corps, such as individuals, S corps, partnerships, and LLCs that primarily export tangible property of at least 50% U.S. component or origin.
Quasi-territorial system of taxation of U.S. C corporations, Section 245A
Known as the DRD or Participation Exemption
Subpart F and Section 956 are still in effect and Regulations address the coordination of the rules –
Subpart F must be considered and included before Section 245A and 951A
– Section 956 may be eliminated or mitigated with 245A DRD
U.S. C corporations that own 10% or more of a foreign corporation (other than a passive foreign investment company that is not also a CFC) shall be entitled to a 100% DRD for the foreign-source portion of dividends received from such corporation.
Constructive dividends arising from a U.S. corporation’s sale or exchange of stock in a foreign subsidiary (held for more than one year) will be treated as a dividend for purposes of the 100% DRD.
Any foreign taxes attributable to the income that gives rise to the dividend will not be eligible for the foreign tax credit or deduction. There is a holding period requirement that must be met for the dividend to be eligible for the deduction, where the foreign corporation stock must be held for more than 365 days during the 731-day period beginning 365 days before the ex-dividend date.
All amounts that are eligible for the 100% DRD will reduce the U.S. corporation’s basis in the stock of the foreign corporation for purposes of determining loss on the eventual sale of such stock.
Foreign Tax Credit Regulations and other U.S. international tax provisions
On March 4, 2019, Proposed Regulations provided that individual U.S. shareholders of CFCs will be eligible to apply a 50% deduction on taxation of GILTI. Individual U.S. shareholders who make the Section 962 election will also be permitted to take the Section 250 deduction with respect to their GILTI inclusion amounts. This treatment should result in individual U.S. taxpayers who choose to make the Section 962 election seeing a decrease in U.S. taxation of their GILTI inclusion amounts from 37% down to (a potential) 10.5%, also subject to further reduction by applicable FTCs. Note that Smith v. Comm’r, 151 T.C. No. 5 (2018) (Tax Court case) found that a “Section 962(d) distribution” from a Hong Kong CFC was not qualified dividend income. Instead, it was subject to ordinary income tax rates.
The Section 902 deemed-paid foreign tax credit on dividends received from foreign subsidiaries has been repealed.
There are separate baskets for foreign branch income and GILTI for foreign tax credit purposes. The current law 50-50 sourcing rule, for income from the sale of inventory produced partly in and partly outside the United States, has been modified by allocating and apportioning such income solely on the basis of production of that inventory. Therefore, inventory produced entirely in the United States will be 100% U.S.-source income for foreign tax credit purposes, even if title to such inventory is outside the United States.
A new election is also available for foreign tax credit purposes. Generally, under current law, in situations in which a taxpayer incurs a loss and is limited in regard to claiming a foreign tax credit, U.S.-source income can be recharacterized as foreign-source income in subsequent years in an amount equal to the lesser of the entire amount of such loss that is not carried back or 50% of the taxpayer’s U.S.-source taxable income for the succeeding year. For taxable years beginning after December 31, 2017, and before January 1, 2018, taxpayers may elect to compute the percentagebased amount differently if it results in a higher amount.
Provisions requiring inclusion of foreign base company oil-related income as a category of foreign base company income have been repealed.
Provisions requiring inclusion of foreign base company shipping operations income when investments in CFCs decrease have been repealed.
A change has been made to the CFC attribution rules (that is, repeal of Section 958(b)(4)) such that, in certain situations, stock held in a foreign corporation by a foreign person can be attributed to a U.S. person for purposes of determining CFC status of a corporation (but see Notice 2018-13).
A change has been made to the definition of a U.S. shareholder to now include any U.S. person who owns 10% or more of the total value of shares of all classes of stock of a foreign corporation, in addition to the current 10% voting stock rule (which means it is easier to become a “U.S. shareholder” of a CFC).
A change has been made to eliminate the 30-day minimum holding period for determining whether a U.S. shareholder must include the CFC’s Subpart F income (which means it is easier to have or own a CFC). Notice 2019-01 and Proposed (Foreign Tax Credit) Regulations replace the former pooling system with intricate rules for calculating foreign taxes incurred by a CFC that are “deemed paid” by a U.S. shareholder, and the respective shareholder’s FTCs. Foreign taxes are eligible to be treated only as deemed paid, and the resulting FTCs are available only to a U.S. shareholder, in respect of Subpart F and GILTI inclusions and distributions of previously taxed earnings and profits (PTEP). With some exceptions, these rules approximate a “tracing” regime under which FTCs are available only to the extent the underlying foreign taxes are attributable to particular items of income giving rise to Subpart F or GILTI inclusions to the U.S. shareholder, or to foreign taxes imposed on distributions of PTEP.
For purposes of the Section 960(b) credit, the proposed regulations require the shareholder to maintain up to 10 annual accounts of previously taxed earnings and profits and related foreign income taxes (PTEP groups) for each CFC. Recall that, before Section 959(c)(1) and (c)(2), E&P was referred to as PTI; however, the proposed regulations favor the PTEP acronym. The 10 accounts relate to the different types of Section 959(c)(1) and (c)(2) PTI (or PTEP) attributable to different inclusions, such as under Subpart F, Section 965, GILTI and Section 956. PTI in one PTEP group may be reclassified as PTI in another PTEP group as a result of a Section 956 income inclusion (investment in U.S. property).
The proposed regulations require each PTEP group and related foreign income taxes be maintained in annual layers.
U.S. Export Tax Incentive through an IC-DISC
IC-DISC
With the repeal of the extra territorial income exclusion, the IRS noticed the resurgence of the domestic, international sales corporation (DISC) in the form of an interest charge DISC (IC-DISC). The relevant tax provisions for the IC-DISC are generally within IRC Sections 991 through 996, and corresponding regulations, and is commonly referred to as the last practical tax incentive for U.S. exporters. If certain requirements are met under the IRC and the regulations, the IC-DISC may provide U.S. exporters significant benefits including a qualified dividend tax rate versus an ordinary income tax rate, deferral of IC-DISC income from current taxation (up to $10m annual revenue limit), increased cash flow for exporter due to tax savings, a lower ETR, and elimination of double taxation in C corporations.
The IC-DISC is a tax incentive whereby U.S. exporters exporting U.S. products to foreign destinations are able to receive the qualified dividend tax rate currently at 20% plus the 3.8% net investment income tax imposed by Section 1411, for a total of 23.8% maximum federal income tax rate. This is a considerable reduction from the maximum federal income tax rate for individuals currently at 40.8% (maximum federal individual income tax rate 37% plus 3.8% net investment income tax).
The DISC generally determines its income on a transaction by transaction (T by T) basis or if it so elected it could determine income on groups of transactions. Whether it used the T by T method or grouped their transactions, the DISC’s income is based on one of the following three pricing methods:
1. Four percent of qualified gross export receipts plus 10% of the DISC’s export promotional expenses attributable to such receipts
2. Fifty percent of combined taxable income (CTI) plus 10% of the DISC’s export promotional expenses attributable to such income
3. Taxable income based upon the sale price actually charged but subject to the rules under Section 482 transfer pricing rules
Ownership and organizational structure
An IC-DISC is a separate (legal) C corporation that acts as a sales commission agent for a U.S. agricultural, food manufacturing, or distributing exporter (the exporting entity). The IC-DISC is by design and by operation of tax law within the IRC more form over substance. In the IRS audit guide, it is apparent that the form, including documentation and a completely thorough and accurate IC-DISC [formal] election, are crucial for the qualification and maintenance for the IC-DISC tax beneficial status.
An IC-DISC does not need employees or office space and does not have to perform any services or participate in any sales to earn a commission. The entity is required to maintain a separate set of books and records, including a separate bank account. It may have only one class of stock and must, at all times, have stock outstanding with a par or stated value of at least $2,500. Any type of entity or individual can own an IC-DISC. In most situations, ownership should be held by an individual or flow-through entity (an LLC, partnership, or S corporation) for the greatest tax benefit. If the exporting entity is one of these pass-through entities, the IC-DISC can even be formed as a subsidiary. However, if the exporting entity is a C corporation, the IC-DISC should be set up as a sibling to the exporting entity rather than a subsidiary, and it should generally be owned by the exporting entity's individual shareholders.
Note that the shareholders of the IC-DISC do not need to be the same as the shareholders of the exporting company. An IC-DISC can be used to provide a benefit to key employees or as a tool in estate and or succession planning.
An IC-DISC is also allowed to have foreign shareholders as long as the foreign shareholder agrees that any distribution (actual or deemed) is income effectively connected with a U.S. permanent establishment. The dividends paid from an IC-DISC to its shareholders are generally considered to be foreign-source income. This makes the use of an IC-DISC particularly valuable to U.S. shareholders with passive foreign tax credit carryovers.
Taxation of an IC-DISC
An IC-DISC is categorized as a domestic C corporation that is tax exempt for federal income tax purposes. However, to obtain this tax exempt status, the corporation must file Form 4876-A, Election to Be Treated as a DISC, within 90 days of its first taxable year. If the corporation elects to be treated as an IC-DISC moving forward, then the election must be made within 90 days before the beginning of the first taxable year of the DISC. The election must be signed by all shareholders as of the effective date of the election. Once made, the election is effective for all subsequent years until it is revoked by the corporation. Based on foreign sales of products manufactured, produced, grown, or extracted in the United States, the exporter pays a commission to the IC-DISC and then deducts the commission from its ordinary business income. This results in a deduction at ordinary tax rates. The IC-DISC receives the commission without having to pay federal tax on the income. In most cases, the IC-DISC then distributes this cash as a dividend to its shareholders. As long as the shareholders are individuals or pass-through entities such as S corporations or partnerships, the dividend is taxed at the favorable qualified dividend tax rates.
For example, say an S corporation hops grower has domestic gross receipts of $25m and foreign gross receipts of $15m for a total of $40m. The cost of growing, harvesting, drying, and bailing the hops —
which will be sold both domestically and overseas — leaves the gross margin at $8m. Take out general expenses, and the grower’s net taxable income is now $3.75m domestically and $2m internationally. To determine the permanent federal tax savings using an IC-DISC, start by calculating its commission, which in this case can be either: 50% of export net income or 4% of export gross receipts (limited to export net income).
In this example, the first method gives us a commission of $1m (50% of $2m, the grower’s net taxable international income), and the second gives us a commission of $600,000 (4% of $15m). Generally, the taxpayer will want to choose the larger of the two amounts for the greatest tax benefit. In this case, the first choice results in a $1m commission paid by the grower to the IC-DISC. As a result of this commission, the grower’s taxable income is reduced by $1m. Because the grower is an S corporation, its shareholders report this income (now reduced by $1m) on their individual income tax returns. Assuming the shareholders are in the top tax bracket (and taxed at 37%), the commission payout results in a federal tax reduction of $370,000 in total for the shareholders. The $1m paid to the IC-DISC is taxed to the ICDISC’s owners (when paid or deemed paid) as a qualified dividend at the 23.8% rate (factoring in the 3 8% NIIT tax), resulting in tax of $238,000. The difference between the ordinary income tax saved by the individual shareholders and the qualified dividend tax liability incurred by the IC-DISC results in a tax savings of $132,000. The IC-DISC may also choose not to pay a dividend to its shareholders. In this case, an interest charge would apply to the deferred tax (hence the entity's name). The interest charges are based on Treasury bill rates, so at this time the potential interest charges are small. There are also deemed distribution rules related to qualified export receipts that exceed $10m; these rules can result in shareholders being taxed on the DISC's earnings without there being an actual distribution.
Commissions
As summarized earlier, there are a few different methods that may be used to calculate (and optimize) the amount of commission the IC-DISC may receive.
Four percent of its qualified export receipts, subject to export profit limitations
Fifty percent of its CTI (its export profits)
The actual amount earned by a buy-sell IC-DISC that has employees and operations of its own
Annual maintenance of IC-DISC
Once an IC-DISC is formed, annual requirements must also be met. These requirements include:
At least 95% of the gross receipts must be qualified export receipts.
A reasonable estimate of the commission must be paid within 60 days of the exporter’s tax year-end.
An IC-DISC tax return, Form 1120-IC-DISC, must be filed annually by the 15th day of the ninth month following the close of the IC-DISC’s taxable year. (The IC-DISC’s taxable year must be the same as that of its principal shareholder.)
The IC-DISC must maintain its own separate set of books and records. International boycott (Israel) operations must be disclosed (in conjunction with Form 5713).
At least 95% of the IC-DISC’s assets must be qualified export assets that fall into several categories: export property, working capital (only the amount necessary for required working capital), commission receivable, stocks or securities of a related foreign export corporation, and producers’ loans.
Qualified export property must be manufactured, produced, grown, or extracted in the United States, and for use or consumption outside the United States.
Up to 50% of the fair market value of the export property can be attributable to foreign content.
Qualified export receipts include the following:
The sale, exchange, or other disposition of export property
The lease or rental of export property used outside the United States
Related and subsidiary services
Dividends from the related foreign export corporation
Interest on obligations that are qualified export assets
Engineering and architectural services for construction projects outside the United States
Sales made to U.S. distributors and sales made to foreign disregarded entities may qualify in some cases.
Chapter 2
Foreign Branches
Learning objectives
Recognize what the definition of a foreign branch is following the Tax Cuts and Jobs Act (TCJA), for U.S. income tax purposes.
Identify foreign branch income rules following the TCJA.
Identify the choice of entity classification rules — the “check-the-box” rules.
Recognize the concept of functional currency.
Recognize fundamental corresponding foreign currency tax issues.
Operating through a foreign branch — summary
After exporting goods from the United States, the next step for a U.S. business is conducting direct business operations overseas, either through foreign branch operations or through foreign subsidiary corporation(s). A foreign business operation may manufacture goods, provide services, or perform special functions (for example, advertising, financing, and sales). Frequently, a foreign business operation requires a significant number of full-time personnel, including people who are transferred from the United States to the foreign country.
U.S. taxpayers typically use the following approaches to establish a foreign branch.
1. Send personnel or employees or have an office in a foreign jurisdiction sufficient to be considered a branch but with no legal entity within the foreign jurisdiction (a true branch).
2. Establish a legal entity that is legally considered a branch within the foreign jurisdiction or country.
3. Form a legal entity/corporation within the foreign jurisdiction and make an entity classification election or check-the-box election to treat the entity as a foreign disregarded entity (FDE) for U.S. federal income tax purposes (a checked branch or an FDE).
Foreign Branch Income Taxation — Post-TCJA
For U.S. federal income tax purposes, a foreign branch is a division that operates a trade or business in a foreign country and maintains a separate set of books and records. The foreign branch generally is also subject to the income tax laws in the foreign country in which it operates.
The term branch describes a complete, distinct business operation of a U.S. corporation. Although a branch may be separate with respect to function, personnel, or location, it is part of the same U.S. corporation. As before the TCJA, income, deductions, losses, and credits of the foreign branch are considered in calculating the tax liability of the U.S. consolidated group (that is, flow-up). The income of a foreign branch is subject to the 21% corporate tax rate.
Losses of the branch flow into the U.S. consolidated group and reduce taxable income of the group. Dual consolidated loss (DCL) rules, however, provide that such losses cannot be used currently if the losses can also be used by a foreign subsidiary to reduce its income under foreign law.
Definition of a foreign branch for U.S. federal income tax purposes post-TCJA
The proposed rules define a foreign branch by reference to the Section 989 regulations, with modifications, such that a foreign branch must carry on a trade or business outside the United States and maintain a separate set of books and records Therefore, activities undertaken within the United States would be excluded when determining whether activities rise to the level of a trade or business outside the United States. Under Section 1.989(a)-1(c), for activities to constitute a trade or business, they “must ordinarily include the collection of income and payment of expenses.” This requirement
created the possibility that a branch that does not earn any regarded income is not a qualified business unit (QBU) under Section 989, regardless of the level of activity within the branch (for example, a maquiladora). In contrast, the proposed rules provide that, for purposes of determining whether this test is met in the context of Section 904, disregarded transactions are considered and may give rise to a trade or business for this purpose.
The decision to provide a rule considering disregarded transactions in determining whether the trade or business test is met for purposes of the foreign tax credit rules represents a departure from the Section 989 regulations. Accordingly, a branch that does not earn any regarded income (for example, because all of its transactions are with its owner) may constitute a foreign branch for purposes of the foreign tax credit limitation and Section 250, but might not be treated as a QBU for purposes of Section 987, which applies the definition in the Section 989 regulations. The foreign branch definition would not import the Section 989 regulations’ per se QBU rule for partnerships, but rather would provide that if a partnership’s activities constitute a trade or business conducted outside the United States, then those activities will constitute a foreign branch even if the partnership does not maintain books and records for the trade or business that are separate from the partnership’s books and records. Activities that constitute a permanent establishment in a foreign country under a bilateral U.S. income tax treaty would be presumed to constitute a trade or business conducted outside the United States.
Under new foreign branch regulations, post-TCJA, foreign branch category income is limited to the income of a U.S. person attributable to foreign branches held directly or indirectly (via disregarded entities, partnerships, or other pass-through entities) by such U.S. person. Foreign persons (including controlled foreign corporations or CFCs) cannot have foreign branch income. The proposed rules would define a U.S. person for this purpose to exclude pass-through entities (for example, partnerships). As such, foreign branch category income would be determined at the U.S. corporate or individual level, applying an aggregate theory for partnerships. Generally, the proposed rules would attribute gross income to a foreign branch to the extent such gross income is reflected on the foreign branch’s separate books and records, but would exclude the following.
1. Income attributable to activities carried out in the United States
2. Income relating to stock held by the foreign branch, such as dividends, CFC and PFIC inclusions (for example, Sections 951(a), 951A(a), and 1293(a)), and gain from the disposition of such stock (unless the stock is dealer property)
3. Income from the sale of interests in entities that are treated as pass-throughs or disregarded for U.S. federal tax purposes, except in the case of a disposition of a partnership interest that is in the ordinary course of the foreign branch owner’s trade or business — The ordinary course standard is deemed satisfied if there is at least 10% ownership of the entity and the owner and the entity are in the same or related businesses.
4. Income or payments reflected (or not reflected) on the books and records if “a principal purpose” of recording (or not recording) the item is tax avoidance and the books and records do not reflect the substance of the transaction — For this purpose, a foreign branch’s related party interest income (other than certain financial services income) is presumed to be excluded from foreign branch category income.
These exclusions from foreign branch category income, and in particular the presumption for related party interest, intend to prevent taxpayers that may otherwise try to artificially shift mobile, low-taxed income into an otherwise high-taxed foreign branch category, resulting in cross-crediting that would be contrary to the purpose underlying the establishment of the foreign branch category.
The TCJA imposes limits on the use of foreign tax credits for foreign branches and establishes a separate foreign branch limitation category, or “basket.” The new law holds that U.S. tax on branch business income can be reduced only by taxes paid by a foreign branch of the U.S. consolidated group, and any excess foreign income taxes of a group’s foreign branches cannot be used to reduce U.S. tax on other foreign-source income of the consolidated group. See the Foreign Tax Credit chapter.
Generally, distributions (that is, branch remittances) from a foreign branch to a U.S. home office are not subject to U.S. taxation. Such distributions include distributions of branch profits and “dividends” paid by disregarded entities, interest paid to the home office on loans from the home office, and repayments of loan principal to the U.S. shareholder or owner. If a foreign branch has a functional currency other than the U.S. dollar, however, such distributions can result in foreign currency gain or loss based on changes in the exchange rates between the time the branch income was included in the U.S. group’s income and the date such amounts are distributed to the home office. It is not clear whether such gain or loss is within the branch foreign tax credit limitation basket.
A foreign country may impose withholding tax on payments made by a foreign branch to its home office. Although such taxes may be claimed as a credit, the new law is not clear about whether such taxes are within the foreign tax credit category for branch income or whether they fall within the general limitation category. There appears to be an error in the revised Section 904 foreign tax credit limitation provisions that treats such foreign taxes as within the branch category as well as taxes on disregarded payments not involving a branch (the section cross-reference should be to the general basket).
Under the TCJA, all gain on the transfer of assets to a foreign subsidiary is taxable. The transfer of goodwill and going concern value, as well as identifiable intangible property, is treated as a contingent sale of the property with an amount reported annually that is commensurate with the income generated by the property transferred. Upon incorporation, the losses of a branch are recaptured (for example, branch loss recapture [BLR] rules) to the extent that the aggregate losses exceed prior income earned by the branch. Under the TCJA, the amount of such loss recapture is not limited to gain on the assets transferred (although the amount of recapture income reduces the gain on assets transferred that is otherwise subject to taxation). Other loss recapture rules may also apply where the branch has a DCL or the group has an overall foreign loss.
Foreign branch income limitations and repeal of ACTB exception
Under the TCJA, foreign branch income is not eligible for reduced tax rates otherwise available for foreign-derived income (for example, FDII under new Section 250 for foreign-derived intangible income), and the TCJA greatly limits the use of foreign income taxes paid on branch income as a credit.
With respect to FDII, the preferential tax rate on deemed intangible income attributable to export activities presumably is intended to encourage U.S. corporations to keep (or relocate) production functions, assets, and activities within the United States. Under the new law, income earned from an active business conducted offshore would generally be taxed at full (ordinary income tax) U.S. rates if undertaken in the form of a foreign branch, while if conducted through a CFC, the majority of the income may still be taxed in the United States under the global intangible low-taxed income (GILTI) regime but would be eligible for the reduced GILTI effective tax rate (for example, 10.5% to 13.125%). It is worthwhile to note the incongruous treatment for business activities conducted through a foreign branch as opposed to a CFC whose U.S. shareholders can benefit from the lower effective GILTI tax rates.
Prior to TCJA, Section 367(a)(3) provided an exclusion for transfer of assets (other than stock) if the assets are used in the active conduct of a trade or business conducted outside the United States. The TCJA repeals the active trade or business exception of Section 367(a)(3) for transfers made after December 31, 2017.
The TCJA requires domestic corporations to recapture foreign branch losses in certain foreign branch transfer transactions. If a domestic corporation transfers substantially all the assets of a foreign branch (within the meaning of IRC Section 367(a)(3)(C)) to a 10%-owned foreign corporation of which it is a United States shareholder after the transfer, the domestic corporation must include in gross income the “transferred loss amount” (TLA) with respect to such transfer.
The TLA is defined as the excess (if any) of the sum of losses incurred by the foreign branch and allowed as a deduction to the domestic corporation after December 31, 2017, and before the transfer, over the sum of – any taxable income of such branch for a tax year after the tax year in which the loss was incurred, through the tax year of the transfer, and – any amount recognized under the Section 904(f)(3) “overall foreign loss recapture” provisions on account of the transfer.
The amount of the domestic corporation’s income inclusion under this provision would be reduced by all gains recognized on the transfer, except gains attributable to BLR under Section 367(a)(3)(C).
Whether a foreign business operation is a branch or a corporation
Choosing to operate in a foreign country either as a branch or a corporation has significant tax consequences. For example, determining whether a foreign business operation constitutes a separate corporation for U.S. tax purposes will affect the amount and the timing of available foreign tax credits, the applicability of the pass-through rules of Subpart F, the applicability of other deferral rules of Subchapter C, and a number of other IRC provisions.
Example 2-1
Brubeck Boilerplate Corp., a U.S. corporation, manufactures electric heaters in its domestic plant. It manufactures 220-volt heaters for the central European market in its branch in the Grand Duchy of Aukum Aukum law requires every foreign-owned plant to adopt a fixed opening amount of capital investment and to compute its taxable income as if it were incorporated under Aukum law. Remittances from the branch to the home office are treated as if they were dividends and are subject to a withholding tax of 12%
Brubeck also manufactures heaters for the Middle Eastern market in the Emirate of Jamul. Local business custom has impelled Brubeck to place its Jamul branch into a legal entity called an enterprise. Under Jamul law, and by the terms of the formation documents, the enterprise creates an entity with separate legal personality, a separate balance sheet, and separate local tax liability. Ownership of the enterprise is evidenced by share certificates. The duration of any enterprise is limited by law to 10 years, the shareholders are fully liable for any debts of the enterprise, and the share certificates are not transferable without permission of the Jamul Foreign Investment Board.
The following discussion reviews the law as applied to the facts presented in example 1.
The 1996 “check-the-box” Treasury regulations permit an unincorporated business organization to elect to be treated as a corporation or as a partnership. Under prior law, the determination of whether the Aukum and Jamal entities constitute branch operations or affiliated corporations is an analysis of whether each entity possesses sufficient corporate characteristics.
Per se corporations
The 1996 regulations apply to any “business entity”—defined as an organization that is recognized as an entity for federal tax purposes and is not classified as a trust or other special entity for federal tax purposes. Per se corporations are generally defined and listed in Treasury Regulation 301.7701-2(b); but certain types of recently created foreign corporations inadvertently may not be listed. Several types of business entities are always treated as corporations for federal tax purposes, including the entities listed in the material that follows.
A business entity organized under a federal or state law that describes the entity as “incorporated as a corporation, body corporate, or body politic [or] as a joint-stock company or joint-stock association…”
A business entity organized under any one of several dozen foreign laws specifically identified in the 1996 regulations as analogous to state incorporation laws.
An entity subject to tax as an insurance company.
A business entity wholly owned by a foreign government.
A business entity that is required to be taxed as a corporation, for example, a publicly traded partnership.
Assume that neither Aukum nor Jamal statutes applicable to Brubeck Boilerplate’s plant operations in Aukum and Jamal are foreign statutes specifically identified in the 1996 regulations as analogous to
state incorporation laws. Therefore, neither of Brubeck Boilerplate’s plant operations constitutes a per se corporation.
Knowledge check
1. Determining whether a foreign business operation constitutes a separate corporation for U.S. tax purposes will not affect the
a. Amount and the timing of available foreign tax credits.
b. Applicability of the pass-through rules of Subpart F.
c. Applicability of other deferral rules of Subchapter C.
d. Deductibility of expenses attributable to domestic or foreign-sourced income.
2. Several types of business entities are “per se corporations” and are always treated as corporations for federal tax purposes. What does not fall into this category?
a. A business entity organized under any foreign laws specifically identified in the 1996 regulations as analogous to state incorporation laws.
b. An entity subject to tax as an insurance company.
c. A business entity wholly owned by a foreign government.
