THE INROADS OF INBOUND CHALLENGES OF … THE INROADS OF INBOUND – CHALLENGES OF TAXING FOREIGN...

THE INROADS OF INBOUND –CHALLENGES OF TAXING FOREIGN COMPANIES IN THE UNITED STATES

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Overview of Inbound Taxation

• ECI

• FDAP

• Branch Profits Tax

• FIRPTA

• Treaties

• Filing Requirements

Overview of Inbound Taxation: ECI

• Business Income: Nonresident corporation engaged in a U.S. trade or business is taxed on net income “effectively connected” with the conduct of that trade or business in same manner as a U.S. resident. § 882.

• U.S. Trade or Business

– Trade or business within the US is not defined in the Code

– Generally exists if there are regular, continuous and considerable business activities in the US.

– On the other hand, isolated or sporadic transactions will not usually be construed as the conduct of a trade or business.

– Passive investment activity does not rise to the level of a trade or business.

• Effectively Connected Income (“ECI”)

– If a taxpayer is engaged in a trade or business in the United States, generally, all sales, services, or manufacturing income from U.S. sources is ECI.

– U.S. source investment income is ECI if either:

1) derived from assets used in the conduct of the U.S. trade or business; or

2) activities of the trade or business are a material factor in the realization of the income. § 864(c)(2).

– Foreign source income may also be treated as ECI. § 864(c)(4)(B) & (C).

Overview of Inbound Taxation: FDAP

• Investment Income: Fixed or determinable annual or periodical income (“FDAP”) is taxed on a gross basis at flat 30% rate or lower treaty rate. § 881.

• FDAP

– The flat 30% tax (or lower treaty rate) applies to interest, dividends, rents, royalties and other FDAP received by a foreign corporation if the income is:

1) includible in gross income;

2) from U.S. sources; and

3) not ECI.

– Sections 1441 and 1442 require withholding at the source.

Overview of Inbound Taxation: Branch Profits

• Branch Profits Tax - § 884(a)

– Purpose is to equalize taxation of foreign corporation’s U.S. business, whether done through U.S. subsidiary or U.S. branch

– Applies only to after-tax E&P that is effectively connected with a foreign corporation’s U.S. trade or business (ECEP) to the extent that such ECEP is not reinvested in a U.S. trade or business by the close of the year or is disinvested in a later taxable year.

– Tax is in addition to tax imposed by Section 882

– 30% of the “dividend equivalent amount”

– For the taxable year

Overview of Inbound Taxation: FIRPTA

• FIRPTA - § 897

– A foreign person owning real property in the United States may be subject to the provisions of the Foreign Investment in Real Property Tax Act (“FIRPTA”).

• Operates where investor is not engaged in a U.S. trade or business.

– FIRPTA treats gain from the sale of a “U.S. real property interest” (“USRPI”) as if the taxpayer is engaged in a trade or business in the United States, and as if the gain is ECI.

– Ownership can be direct or indirect through “U.S. real property holding corporation” (“USRPHC”). A USRPHC is a domestic corporation holding USRPIs having an aggregate FMV greater than or equal to 50% of the FMV of the corporation’s real property and business assets.

– Section 1445 generally requires 15 percent withholding by transferee on amount realized by foreign person on disposition of USRPI.

• Exceptions if transferor is not a foreign person or property is nota USRPI

Overview of Inbound Taxation: Treaties• Purpose

– Avoidance of double taxation and prevention of fiscal evasion

– Allocate taxing rights between the source state and the residence state

• Role/interpretation– Treaty and Code are given equal weight under the Constitution

– Later in time rule – if a treaty provision conflicts with a statutory provision, the one that was enacted/entered into force later in time controls

– But absent clear Congressional intent to override, courts will generally endeavor to construe statute and treaty provision harmoniously so as to give effect to both, if that can be done without violating the language of either

• Effect – In the inbound context, treaties alter our Code rules for taxing income earned by a

foreign corporation that’s a resident of a treaty country

– PE/business profits standard, instead of USTB/ECI

– Reduced rate of tax or exemption from tax for certain types of FDAP income, including interest, dividends, and royalties

– Some treaties reduce or eliminate the branch profits tax

Overview of Inbound Taxation: Treaties

• Residence

– In general, only residents of one of the Contracting States are eligible for benefits under a treaty. See Art. 1(1) of 2006 US Model Treaty (“This Convention shall apply only to persons who are residents of one or both of the Contracting States, except as otherwise provided in the Convention.”)

– Art 4(1): “A resident of a Contracting State means a person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature.”

• Limitation on benefits (LOB)/qualified resident

– Most treaties contain a limitation on benefits article which sets forth various “safe harbors” or “tests” that need to be met in order for a resident to be eligible for benefits under the treaty

Overview of Inbound Taxation: Treaties• A foreign person who is a resident of a treaty country is taxable in the United

States only on business profits that are attributable to a permanent establishment it has in the United States

• Permanent establishment (PE)

– A PE is a fixed place of business through which the business of an enterprise is wholly or partly carried on. See Art 5(1) of the 2006 U.S. Model Treaty.

– Exceptions: a foreign person may perform certain activities in the United States without being treated as having a PE. Such activities include:

• the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or of collecting information, for the enterprise;

• the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character;

– Agents – an enterprise is deemed to have a PE if it acts through persons who have, and habitually exercises, an authority to conclude contracts that are binding on the enterprise. See Art 5(5) of the 2006 U.S. Model Treaty. But activities of an independentagent who is acting in the ordinary course of business will not cause an enterprise to have a PE. See Art 5(6).

– Services PEs

Overview of Inbound Taxation: Treaties

• If a foreign corporation does have a PE in the United States, it is subject to tax only on business profits attributable to that PE.

• Allocation of business profits:– In calculating the profits of a PE, can deduct expenses incurred by the

PE and a reasonable allocation of expenses incurred by the owner/home office of the PE.

– AOA (authorized OECD approach) treaties– profits attributable to a PE determined using arm’s lengths principles (482 transfer pricing principles) by treating the PE as a hypothetical separate entity. See, e.g., Art 7(2) of US-UK treaty.

Overview of Inbound Taxation: Filing Requirements

• A foreign corporation that is engaged in a trade or business in the United States must file a Form 1120-F, even if it has no ECI or is exempt from U.S. tax under a treaty

– Foreign corporations claiming to be exempt from tax under the business profits article of a treaty must file an 1120-F with a Form 8833

• A foreign corporation not engaged in a U.S. trade or business and whose U.S. tax liability has been entirely satisfied through withholding at source does not need to file an 1120-F

• Denial of deductions– a foreign corporation that fails to file a 1120-F before the deadlines set forth in Treas. Reg. § 1.882-4(a)(3) cannot take deductions or credits under IRC §882(c)(2), i.e., subject to tax on gross basis

– Protective returns

– Waiver under Treas. Reg. § 1.882-4(a)(3)(ii)

Enforcement of Inbound Taxation

• LB&I Enforcement Campaigns

– What are Campaigns?

• The IRS Large Business and International division first announced on 1/31/2017 a move toward issue-based examinations and a compliance campaign process in which the organization decides which compliance issues that present risk require a response in the form of one or multiple treatment streams to achieve compliance objectives.

• Treatment streams could be examinations, soft letters, published guidance, externally published practice units, practitioner outreach.

• These campaigns were identified through LB&I extensive data analysis, suggestions from IRS compliance employees and feedback from the tax community. LB&I's goal is to improve return selection, identify issues representing a risk of non-compliance, and make the greatest use of limited resources.

• Second batch of campaigns released on 11/3/2017. 11 more added to the original 13.


• LB&I Enforcement Campaigns Related to Inbound Taxation

– Form 1120-F Non-Filer Campaign

• “Foreign companies doing business in the U.S. are often required to file Form 1120-F. LB&I has data suggesting that many of these companies are not meeting their filing obligations. In this campaign, LB&I will use various external data sources to identify these foreign companies and encourage them to file their required returns. The treatment stream for this campaign will involve soft letter outreach. If the companies do not take appropriate action, LB&I will conduct examinations to determine the correct tax liability. The goal is to increase voluntary compliance by foreign corporations with a U.S. business nexus.”



– Inbound Distributor Campaign

• “U.S. distributors of goods sourced from foreign-related parties have incurred losses or small profits on U.S. returns, which are not commensurate with the functions performed and risks assumed. In many cases, the U.S. taxpayer would be entitled to higher returns in arms-length transactions. LB&I has developed a comprehensive training strategy for this campaign that will aid revenue agents as they examine this IRC Section 482 issue. The treatment stream for this campaign will be issue-based examinations.”

• Only Transfer Pricing Campaign in initial release.



– Form 1120-F Chapter 3 and Chapter 4 Withholding Campaign• “This campaign is designed to verify withholding at source for 1120-Fs claiming refunds.

To make a claim for refund or credit to estimated tax with respect to any U.S. source income withheld under chapters 3 or 4, a foreign entity must file a Form 1120-F. Before a claim for credit (refund or credit elect) is paid, the IRS must verify that withholding agents have filed the required returns (Forms 1042, 1042-S, 8804, 8805, 8288 and 8288-A). This campaign focuses upon verification of the withholding credits before the claim for refund or credit is allowed. The campaign will address noncompliance through a variety of treatment streams including, but not limited to, examinations.”

– Verification of Form 1042-S Credit Claimed on Form 1040NR• “This campaign is intended to ensure the amount of withholding credits or refund/credit

elect claimed on Forms 1040NR, U.S. Nonresident Alien Tax Return, is verified and whether the taxpayer has properly reported the income reflected on Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding. Before a refund is issued or credit allowed, the Internal Revenue Service verifies the withholding credits reported on the Form 1042-S. The campaign will address noncompliance through a variety of treatment streams including, but not limited to, examinations.”


• Case Law Related to Inbound Taxation

– Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner• Tax Court decided not to follow Rev. Rul. 91-32 that a non-US partner is subject to

U.S. tax on gain from the sale of a partnership interest to the extent the partnership was engaged in a U.S. trade or business.

• Tax Court applied an entity not aggregate approach, where the partners generally are treated as owning a direct interest in the partnership and not in the partnership's underlying assets, unless the tax rules specifically provide otherwise (as they do in the case of a partnership owning USRPIs).

• Under the entity approach, the Tax Court ruled that the non-US partner's gain from the redemption of its partnership interest did not constitute ECI (except to the extent attributable to the partnership's USRPI assets) and, therefore, did not subject the non-U.S. partner to U.S. federal income tax.

• One factor in the determination was that neither the partnership's U.S. office nor any U.S. office of the taxpayer regularly engaged in a trade or business of buying and selling partnership interests.

• Any other takeaways aside from holding?

• ****BUT STAY TUNED TO THE END OF THE PRESENTATION

Tax Reform Implications for Inbound (other than BEAT)

• Reduced corporate rate

• Withholding rates

• 163(j) – interest limitation with teeth

• ETB/ECI – new applications

• Downward attribution – surprise!

• FDII

• Goodbye Grecian Magnesite

• WTO, Income Tax Treaties & BEPS considerations

Rate Reductions

• Corporate tax rate reduced to make US operations more attractive.

• US operations in partnership form may also benefit from reduced effective rates under new section 199A.

Withholding Rates

• Despite the headline rate drop to 21% on corporate income, the withholding rate in section 1442 was not adjusted below 30%.

– Oversight in the drafting process?

Interest Expense Deduction Limitation

New Law:

• A taxpayer’s ability to deduct net business interest expense limited to 30% of adjusted taxable income.

• Adjusted taxable income ≠ EBITDA/EBIT – only a rough proxy calculated using tax principles.

• “Adjusted taxable income” = Taxable income, excluding certain deductions:

– Income/gain/deduction/loss not properly allocable to a trade/business

– Business interest expense or business interest income

– NOL deductions

– Depreciation, amortization, depletion deductions (only until 2022)

– Any 199A deduction for qualifying business income

– Additional adjustments provided by future regulations

Interest Expense Deduction Limitation cont’d

Observations:

• Generally in line with OECD recommendations

• No grandfathering for existing debt

• Indefinite carryforwards

• The transition to EBIT in 2022 will likely mean a harsh result for many taxpayers.

• Exceptions for certain real estate businesses, regulated public utilities, car dealerships, and small businesses.

• Disincentivizes highly-leveraged transactions and increases the attractiveness of equity funding (including preferred equity).

ECI / ETB Concept - New Applications

• New section 59A (the Base Erosion and Anti-Abuse Tax, or “BEAT”) uses the “effectively connected” income of a US trade or business to calculate gross receipts of foreign persons in determining whether the overall $500 million threshold is met.

• New section 199A (providing a deduction for Qualified Business Income, or “QBI”) uses the “effectively connected” concept to define “qualified items of income, gain, deduction and loss.”

Downward Attribution

• The TCJA repealed the exception for downward attribution from foreign persons to U.S. persons for purposes of determining CFC and U.S. shareholder status.

– U.S. shareholders that directly or indirectly own at least 10% of a foreign corporation that was not treated as a CFC under pre-2018 law could become liable for tax on subpart F income and GILTI.

– In a foreign-parented group with wholly owned U.S. and foreign brother-sister subsidiaries, the U.S. subsidiary is now a U.S. shareholder with respect to its sister foreign sub, a CFC.

• Relief from 5471 filing obligations provided in Notice 2018-13 is available for certain taxpayers.

Foreign US

ForeignParent

Foreign US

90% 10%

Foreign-Derived Intangible Income (FDII)

• U.S. corporations are generally taxed at a 13.125% rate to the extent their income (above a fixed routine return on tangible property) is derived from foreign sales, royalties or services.

• Property does not need to be manufactured in the US to benefit from FDII.

Foreign-Derived Intangible Income (FDII) cont’d

Observations:

• If a foreign investor operates its U.S. operations in branch rather than corporate form, it is ineligible for the preferential FDII rate, notwithstanding its being subject to full US taxation.

• Non-US reactions? Germany may deny deduction for royalty payments to U.S. persons that qualify for FDII benefits. Other possible issues?

Grecian Magnesite Repeal

• New section 864(c)(8) reversed the result of the Tax Court’s 2017 Grecian Magnesite opinion (149 T.C. No. 3).

• Grecian Magnesite held that a foreign partner’s gain on redemption of its interest in a partnership with a U.S. trade or business was foreign-source and thus not subject to U.S. tax.

• The TCJA legislatively overrides the Grecian Magnesite holding and codifies the Service’s position in Rev. Rul. 91-32.

– Look-through rule for such gain, using the same mechanic as section 751 (a constructive sale of partnership assets) to determine source.

• The TCJA also imposes a new 10% withholding rule on sales of partnership interests, unless the seller can establish that it is a U.S. person.

– Notice 2018-08 suspends this rule with respect to publicly traded partnerships.

Income Tax Treaty & WTO Concerns

• Might FDII be viewed by the WTO as an export subsidy violative of the GATT?

– Any such determination by the WTO would likely take many years.

• Does BEAT violate non-discrimination clauses in treaties? Does BEAT result in double taxation?

– “Later in time” rule means a statute passed more recently than a treaty would apply in the event the statute and treaty conflict. Intent to override?

• Does FDII violate BEPS Action 5 minimum standard?

– Repercussions?

• Base Erosion and Anti-Abuse Tax– Subjects corporations with gross receipts of $500 million or more to a

type of alternative minimum tax computed by adding back in deductions for payments to foreign related parties

– Income with deductions added back is “modified taxable income”

– BEAT rate is 5% in 2018, 10% in 2019, and 12.5% in 2026

– Applies if “base erosion percentage” is 3% or higher

– Applies to amount paid or accrued to a foreign related person

• for which a deduction is allowable, or

• in connection with acquisition of depreciable property

– Also applies to COGS for payments to inverted companies

BEAT: Overview

BEAT: Example

US Corp

$250 Interest payment

F Sub 2F Sub 1

Purchase ofmachinery & equipment $50 admin. services

F Corp

US Corp is an Applicable Taxpayer:

• C corporation• At least $500 million average annual gross receipts • Base erosion percentage is at least 3%

BEAT: Example (cont.)

US Corp


Gross Sales 1,000Returns/Allowances 50Net Sales 950COGS (150)Gross Income 800

Admin. Services (50)Interest (250)Depreciation (200) Taxable Income 300Regular Tax Liability 63

F Sub 2F Sub 1


F Corp


US Corp




F Sub 2F Sub 1


F Corp

Modifications under BEAT:

Taxable Income 300

Admin. ServicesInterest 250Depreciation 200 Modified Taxable Income 750


US Corp




F Sub 2F Sub 1


F Corp

Modifications under BEAT:

Taxable Income 300

Admin. ServicesInterest 250Depreciation 200 Modified Taxable Income 750

Additional Tax under BEAT:

10%* x 750 75Regular Tax Liability –certain credits (10) (53)Base ErosionMinimum Tax 22

* 5% in 2018; 12.5% in 2026

• No exception for payments subject to high rates of foreign taxation

• Double taxation of payments to CFCs

– GILTI and also subject to BEAT

• Double taxation of payments to US branch of foreign related person

– ECI to branch and also subject to BEAT (and branch profits tax)

• Surprising tax credits disallowed by BEAT

• Taxpayer may receive full, or no, benefit from base eroding payments depending solely on the amount of residual regular tax liability in the US

• BEAT applies only if the percentage of the taxpayer’s deductions that are considered base erosion tax benefits is 3% or higher—a big cliff effect!

BEAT: Technical issues

Taxpayer 1

Gross Income

Total Deductions

Base Erosion Tax Benefits

Foreign Tax Credits

100 100 2 0

BEAT: Tax Liability with No Taxable Income

Income Tax BEAT Total Tax

0 0 0

BEAT does not apply• Base erosion percentage = 2%

Taxpayer 2

Gross Income

Total Deductions


ForeignTax Credits

100 100 3 0


0 0.3 0.3

BEAT applies• Base erosion percentage = 3%• 10% x Modified Taxable Income -

(Regular Tax Liability - Credits)• 10% x (0 + 3) - (0 x 21% - 0) = 0.3

• As a result, a small increase in deductions for payments to related parties can subject a taxpayer to a large increase in tax

– Yet the base erosion percentage computation language is unclear

• Foreign tax credits (FTCs) reduce income tax liability without increasing BEAT until they reduce a taxpayer’s income tax liability below 10% (5% for 2018) of modified taxable income

– Thereafter, each additional dollar of FTC still reduces income tax liability but also increases BEAT liability by a dollar

– FTCs provide no benefit above this level (recall that GILTI credits gone for good because no carryover)

BEAT: Technical Issues (Continued)

Taxpayer 1

Gross Income

Total Deductions


Foreign Tax Credits

200 100 2 11

BEAT: FTC Disallowance Threshold


10 0 10


Taxpayer 2

Gross Income

Total Deductions


ForeignTax Credits

200 100 3 11


10 0.3 10.3



Taxpayer 1

Gross Income

Total Deductions


Foreign Tax Credits

200 100 2 15

BEAT: Double Taxation


6 0 6


Taxpayer 2

Gross Income

Total Deductions


ForeignTax Credits

200 100 3 15


6 4.3 10.3



• BEAT does not cover payments for services that qualify for the “services cost method”

– Treas. Reg. § 1.482-9(b) was written for an entirely different purpose

– Must be a covered service (listed in Rev. Proc. 2007-13, or median mark-up of no more than 7%)

– Cliff effect: if median exceeds 7%, becomes BEAT payment

– Must be not an excluded activity (e.g., manufacturing, distribution, research, engineering)

– Business judgment rule does not apply

– Issues awaiting guidance, such as whether cost-plus contracts qualify to the extent of cost

BEAT: Services Cost Method

THE INROADS OF INBOUND CHALLENGES OF … THE INROADS OF INBOUND – CHALLENGES OF TAXING FOREIGN...

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