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 ofany 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, andany 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.
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.