The corporate tax rates in the USA flow from 15% to 39% of the corporation's taxable income for the year. Supplementary tax applies to personal holding and regulated investment companies. Also, an accumulated earnings tax of 20% applies to accumulated undistributed taxable income. The latter aims to stimulate the distribution of dividends to shareholders out of earnings and profits that are not appropriated for the needs and activities of the corporation.
The classification of an entity organized in the United States depends on statutory classification principles and the so-called "check-the-box" rules. Under the statutory classification rules, an unincorporated entity with a single owner will be classified as "disregarded entity" for tax purposes. An unincorporated entity with two or more owners is classified as a partnership for tax purposes. Public companies, banks, insurance companies and certain other entities that are treated as "per se" corporations are always classified and taxed as corporations.
However, the "check-the-box" regulations published in 1996 provide that an eligible unincorporated entity that is not a trust or estate may elect to be taxed as a corporation, partnership or disregarded entity. To make the "check-the-box" election a qualifying unincorporated entity must file Form 8832 "Entity Classification Election with the IRS. Certain grandfathered rules apply to entities that were in existence prior to 1996.
Foreign entities adopt a statutory tax classification that depends on the liability of the owners with an option to make a "check-the-box" election. The federal legislation stipulates that private companies organized outside the United States are classified for tax purposes as:
- A "disregarded entity" if the company has only one owner with unlimited liability;
- A corporation if the entity has one or more owners, all of whom with limited liability;
- A partnership if the company has two or more owners and, at least, one of them has unlimited liability;
Certain qualifying entities may make a "check-the-box" election to change the statutory classification. However, the statutory classification as a corporation is mandatory for Public Limited Companies, financial institutions, insurance companies, and certain other "per se" corporations.
A partnership, including a Limited Liability Company with two or more members, is fiscally transparent entity for tax purposes. The partnership is required to file an information return, on Form 1065, with the IRS to report results from operations. Subsequently, all items of income or loss flow into the hands of the partners, who are required to file a return and pay the taxes due. The above provisions do not apply to Publicly Traded Partnerships (PTP) and qualifying entities that have elected under the "check-the-box" rules to be treated as associations taxable as corporations.
The Internal Revenue Code does not contain a comprehensive definition of the term “trade or business within the United States.” Treas. Reg. 1.864-4(c)(5)(i) gives the definition of "US trade or business" applicable to a foreign corporation engaged in banking, financing or similar activities.
However, the courts have adopted a facts and circumstances test to evaluate whether the activities of a foreign person cause that person to be engaged in a trade or business within the United States. The IRS follows the guidance established by the courts. The courts and the IRS agreed that a foreign corporation would engage in a trade or business within the United States if the foreign corporation’s activities in the United States are considerable, continuous, and regular (Pinchot v. Commissioner of Internal Revenue, 113 F.2d 718, 2d Cir. 1940).
Consequently, a foreign corporation is deemed engaged in a US trade or business, only if for a considerable portion of the year, the corporation was continuously and regularly conducting a substantial part of its profit-oriented activities within the United States (Continental Trading, Inc. v. Commissioner, 265 F.2d 40, 9th Cir. 1959). Mere managerial attention to own investments in the United States (Higgins v. Commissioner, 312 U.S. 212) or sporadic and isolated activities (Linen Thread Co. v. Commissioner, 128 F.2d 166, 2d Cir. 1942) are usually insufficient to indicate a trade or business activity.
The Branch Profits Tax (BPT) was introduced as a substitute for dividend withholding tax on foreign corporations engaged in a trade or business in the USA through unincorporated entities. Before the implementation of the BPT, foreign corporations that had formed a U.S. branch or an LLC were better off compared to parent-subsidiary structures. In essence, the BPT targets a "dividend equivalent amount" when paid to a foreign parent out of an unincorporated entity. The tax is imposed at a 30 % or lower tax treaty rate on earnings and profits of the U.S. entity if withdrawn and repatriated to the parent. The BPT does not apply in certain reorganizations, in a complete liquidation of the U.S. business, or when there is no deemed dividend withdrawal.
The IRC 1441/1442 tax withholding requirements apply only to U.S. source FDAP income. Consequently, a determination is required for the source (domestic or foreign) and the type of income (FDAP or effectively connected with a trade or business), before the provisions of IRC 1441 and 1442 are applied.
IRS Form 5471 "Information Return with Respect to Certain Foreign Corporations" is required under the provisions of Sections 6038 and 6046 of the Internal Revenue Code. The form is filed by United States persons who fall into four different categories. A United States person includes a U.S. citizen or resident, U.S. corporation, partnership, estate, and trust. The classes of United States persons are:
- A U.S. citizen or resident who is a director or executive officer of a corporation organized outside the United States. The filing requirement applies when a U.S. person acquires 10% or more of the foreign corporation's outstanding stock or voting power.
- A U.S. person who acquires 10% or more of the outstanding stock or voting power of a foreign corporation. It also includes a U.S. person who disposes of sufficient stock to reduce ownership of stock or voting power below the 10% threshold. Thus, the filing requirement is transactional in nature and applies to acquisitions, dispositions, organizations, or reorganizations of a foreign corporation. Special rules apply to a foreign corporation that is a captive insurance company.
- A U.S. person who controls a foreign corporation. Control exists when a U.S. person owns more than 50% of the outstanding stock or voting power of the foreign corporation directly, for at least 30 days during the company's accounting year.
- A U.S. person who owns directly, indirectly, or by attribution 10% or more of the outstanding stock or voting power of a foreign corporation that is a Controlled Foreign Corporation (CFC). Special rules apply to a foreign captive insurance company.
A failure to file the information return on Form 5471 results in a penalty of $10,000.00 and reduction of any applicable foreign tax credit.
Maybe. U.S. Partnerships must withhold tax in accordance with Internal Revenue Code Section 1446 on income attributable to foreign partners. However, the IRC 1446 tax withholding requirement applies only to partnerships that have Effectively Connected Taxable Income (ECTI). Form 8805, Foreign Partner's Information Statement of Section 1446 Withholding Tax, is filed by the partnership to report the income and the U.S. tax withheld. The tax withholding rate is 35% for foreign corporate partners and 39.6% for non-corporate partners.
A Passive Foreign Investment Company (PFIC) is any foreign corporation, including a foreign-based mutual fund, pooled-equity fund, exchange-traded fund (ETF), real estate investment trust (REIT), or any other similar investment vehicle, that meets either the passive income or assets test, and has at least one U.S. shareholder.
Under the foreign income test, a foreign corporation is PFIC if at least 75% of its gross income for the taxable year is passive. Passive income includes interest, dividends, rents, royalties and the like. The asset test looks at the fair market value of the corporation’s assets. If 50% or more of the aggregate market value of all corporate assets are passive, then the company is presumed to be a PFIC. Passive assets are all assets that produce passive income.
Certain exceptions apply to non-publicly traded foreign corporations and to Controlled Foreign Corporations that are subject to tax under the Subpart F provisions. Once PFIC status is established, the U.S. shareholders are taxed on the undistributed income of the company. The taxation of undistributed earnings aims to preclude deferral of income. The U.S. taxpayers may choose to use three methods to compute taxes. These are the Qualifying Election Fund (QEF), excess distribution and mark-to-market method. The election is made by attaching Form 8621 to the taxpayer's income tax return.
A Controlled Foreign Corporation (CFC) is any corporation organized outside the United States, if more than 50% of the total value of the stock of the corporation or more than 50% of the voting power of the corporation, is owned directly, constructively, or by attribution by U.S. shareholders. However, only the U.S shareholders who own 10% or more of the voting power or classes of stock of the corporation are counted for the purposes of the 50%-ownership test.
Example 1: Tom and Francine are unrelated persons who formed a French corporation. Tom is a U.S. citizen and Francine is a citizen and resident of France. Tom owns 55% of all classes of stock and Francine owns the remaining 45%. The corporation is a CFC.
Example 2: Twenty unrelated U.S. citizens decided to pool their funds and organize a corporation in Panama. Each of the U.S. citizens owns 5% of the corporation’s voting power. In result, the Panama Corporation is 100% owned by U.S. shareholders. The business of the corporation is investments in luxury real estate around the world. The Panama Corporation is not a CFC because none of the shareholders owns 10% or more of the corporation. However, the corporation is a foreign-based REIT and it meets the definition of a Passive Foreign Investment Company (PFIC).
The precise definition of a CFC, including the more restrictive rule applicable to captive insurance companies, is given in Section 957(a) of the Internal Revenue Code.