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Foreign
Corporations
A foreign corporation, for US tax law purposes,
is any corporation not organized under the laws
of the United States, any state, or the District
of Columbia. A corporation organized in a US possession,
such as Guam, is considered a foreign corporation,
unless certain conditions detailed in IRC section
881(b) are met.
Income earned by a foreign corporation is subject
to US income tax under two circumstances: net
income effectively connected with a US trade or
business is taxed at normal corporate income tax
graduated rates (see company
tax); US source income not effectively connected
with a US trade or business is taxed at a 30%
rate.
However,
tax treaties often specify a lower rate on non-effectively
connected income or exempt income that is effectively
connected but not attributable to a permanent
establishment.
Only
a few types of foreign source effectively connected
income of foreign corporations are subject to
tax.
Tax Code 9IRC section 864(c) contains the rules
for determining if income is effectively connected
with a US trade or business. There are different
rules for US and foreign source income.
US source income is separated into two categories,
periodic income and other income.
Periodic income includes gains or losses on the
sale of capital assets. It also includes fixed
or determinable annual or periodic gains, profits,
and income. Examples of this type of income include
interest and dividends, rents and royalties, salaries,
wages, and fees.
Other
income is considered effectively connected if
the taxpayer has a trade or business.
The Code prescribes two tests to help determine
if periodic income is effectively connected: the
"Asset Use" and the "Business Activity"
tests. The "Asset Use" test looks to
see if the asset that generated the income is
used in the US trade or business. If it is, then
the income is effectively connected. The "Business
Activity" test tries to determine if the
US trade or business was a material factor in
the realization of the income. If it is, then
the income is effectively connected.
Foreign source income can only be effectively
connected if the foreign corporation has an office
or fixed place of business in the United States.
The US office must be a material factor in earning
the income. Only the following types of income
that are from foreign sources can be considered
effectively connected:
- Rents
or royalties;
-
Interest and dividends (banks, financial institutions,
and stock or security traders only);
-
Sale of inventory (except if property is for
use outside the United States and a foreign
office materially participated in the sale);
-
Insurance premium income (no requirement for
office in United States).
A
foreign corporation is considered to have a place
of business if it maintains an office, factory,
mine, store, or other fixed place of business
in the United States. In certain circumstances,
the office of a corporate agent can be considered
as an office or fixed place of business of the
foreign corporation.
Many tax treaties provide an exclusion for income
earned by a foreign corporation in the United
States. The treaty exclusion usually requires
that the foreign corporation not have a permanent
establishment in the United States. The term "permanent
establishment" is defined in the treaty.
To qualify for treaty benefits, the foreign corporation
must be a resident of a country which has a tax
treaty with the United States.
IRC section 882(c) allows only those deductions
and credits associated with effectively connected
income. A foreign corporation must file a timely,
true, and accurate return to claim deductions
and credits. If a foreign corporation has both
effectively and non-effectively connected income,
it must allocate its deductions between the two.
An interest expense deduction for foreign corporations
uses an allocation method based on the average
balance of assets during the year that generate
effectively connected income.
Foreign corporations are allowed a credit for
taxes paid on foreign source effectively connected
income. However, foreign income taxes imposed
on US source income are not allowed as a credit
if the foreign country would not tax the income
but for the fact that the foreign corporation
was created, organized, or domiciled in that country.
A foreign corporation which has US source income
that is not effectively connected is taxed at
30% on a gross basis. No deductions are allowed
in computing taxable income. This tax may be reduced
or eliminated under a tax treaty.
Interest on deposits in US banks and portfolio
interest are exempt from this tax. The exemption
is available only to foreign corporations and
nonresident aliens. If the interest income is
effectively connected, the exemption is not available.
IRC section 882(d) states that a foreign corporation
that receives certain types of non-effectively
connected income from US real property may elect
to treat that income as effectively connected.
This allows for a deduction of related expenses
and the use of the graduated tax rates. The election
can be made any time before the expiration of
the statute of limitations for filing a claim.
This period is usually three years after the due
date of the return. The election may be revoked
during the same period. The election can only
be made for years in which income from US real
property is received. Once made, the election
is effective for all subsequent years. All US
real property interests owned by the foreign corporation
are covered by the election. Once the statute
of limitations expires on the year the election
was first made, it may be revoked only with the
consent of the Internal Revenue Service.
The
types of real property income eligible for this
election are:
-
Gains from a sale or exchange
-
Rents
- Royalties
from natural resource deposits
-
Gains from disposal of timber, coal, or iron
ore with a retained interest.
IRC section 897 classifies all gains from the
sale of US real property interests by non-resident
aliens or foreign corporations as effectively
connected income. This applies even if no election
under IRC section 882(d) is made.
NB:
This is a highly simplified account of the taxation
of foreign coporations. Please consult a tax adviser
or the IRS for more detailed information.
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