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U.S. Income Taxation of Foreign Operating Entities

October 31, 2017
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Introduction

Today we live in a global economy. One of the key decisions a business must make in determining an optimal international expansion strategy is the structure of the foreign entities. Each foreign entity structure will lead to diverse tax implications and compliance issues and will have a significant impact on the following:

  • Deferral of U.S. taxation on foreign earnings and profits (E&P)
  • Availability of foreign losses to offset U.S. income
  • U.S. and foreign income tax rates, foreign withholding taxes, and foreign tax credits
  • State income taxation

Foreign Corporations

Generally, a foreign corporation is taxable in the U.S. only on the following types of income:

  • U.S. source fixed, determinable, annual or periodical income (FDAP) income, e.g., dividends, interest, rents and royalties
  • Income effectively connected with the conduct of a U.S. trade or business (ECI)

A U.S. shareholder of a foreign corporation is generally not taxable until income is repatriated or shares are sold.  However, under the anti-deferral regimes, a U.S. shareholder may be subject to U.S. taxation on certain income earned by the foreign corporation.

U.S. Anti-Deferral Regimes

A U.S. shareholder of a controlled foreign corporation (CFC) may be required to include in income amounts attributable to foreign operations before profits are repatriated to the U.S. A CFC is a foreign corporation of which more than 50 percent in vote or value is owned directly, indirectly or constructively by U.S. shareholders.  In general, a U.S. shareholder is a U.S. person who is a direct, indirect or constructive owner of at least 10 percent of the voting stock of the CFC.

Subpart F Income

A U.S. shareholder owning the stock of a CFC directly, or indirectly through a foreign entity, is currently taxed in the U.S. on certain types of income earned by the CFC to the extent of the CFC’s current E&P. Subpart F income includes the following categories of foreign base company income (FBCI):

1) Foreign Personal Holding Company Income (passive types of income)
2) Foreign Base Company Sales Income
3) Foreign Base Company Services Income 

Certain exceptions to Subpart F income may apply, which include:

1) De Minimis Rule
2) High Foreign Tax Exception
3) CFC Look-through Rule

Subpart F income inclusions are not eligible for qualified dividend treatment and are, therefore, subject to tax at ordinary income tax rates.  An indirect foreign tax credit is available for U.S. corporate shareholders who have a Subpart F income inclusion during the taxable year.

Section 956 Income – Investment of Earnings in U.S. Property

A U.S. shareholder of a CFC is subject to immediate U.S. taxation for any taxable year on its Section 956 income, which is generally equal to the lesser of:

(1) the U.S. shareholder’s pro rata share of the average amount of U.S. property held (directly or indirectly) by the CFC as of the close of each quarter of the taxable year, less that portion of the CFC's E&P attributable to prior years’ Section 956 income inclusions or Section 956 income that would have been included if it had not already been included as Subpart F income, or

(2) the U.S. shareholder’s pro rata share of the CFC’s applicable earnings. A CFC’s applicable earnings are generally defined as current and accumulated E&P, reduced by distributions during the taxable year and by E&P attributable to prior years’ Section 956 income inclusions or Section 956 income that would have been included if it had not already been included as Subpart F income.  If the CFC has an accumulated E&P deficit at the beginning of the taxable year, the deficit is disregarded and only current E&P is taken into account.

Section 956 is primarily concerned with U.S. shareholders attempting to repatriate earnings of a CFC through nontaxable transactions. Common examples of investment of earnings in U.S. property include a loan from the CFC to its U.S. parent (also the CFC’s guarantee of a loan of its U.S. parent) and an investment by the CFC in stock of a “related” U.S. corporation.

Similar to the treatment of Subpart F income, Section 956 income inclusions are subject to tax at ordinary income tax rates and an indirect foreign tax credit is available for U.S. corporate shareholders.

Foreign Partnerships

A partnership, whether domestic or foreign, is not subject to income tax. The partners in the partnership report their distributive share of the partnership’s income, gain, loss, deduction, or credit.  Therefore, if a foreign partnership has a foreign partner whose distributive share includes U.S. source income or ECI, the foreign partner is subject to U.S. taxation with respect to this income.

Foreign Disregarded Entities (FDE)

A FDE is a foreign corporation under the laws of its country of incorporation but disregarded as separate from its owner for U.S. income tax purposes.  The activities of a disregarded entity, whether domestic or foreign, are treated in the same manner as a sole proprietorship, branch, or division of the owner.  If the owner of the FDE is a U.S. person, the activities of the FDE must be reported on the tax return of the U.S. person and the income is subject to U.S. taxation.  Alternatively, if the FDE is owned by a foreign person, the foreign person will be subject to U.S. taxation only on income generated by the FDE that is characterized as U.S. source income or ECI. 

Jennifer Sklar-Romano is a director in Citrin Cooperman’s International Tax Services Practice.  She specializes in domestic and international tax planning, including researching, analyzing, and drafting memoranda on complex tax issues, and advising on and reviewing foreign information reporting, including Subpart F income calculations. She can be reached at 212-697-1000 or at jsklar-romano@citrincooperman.com.