This document provides an overview of the taxation of foreign taxpayers in the United States. It discusses two types of income subject to tax: income effectively connected to a U.S. business, which is taxed at progressive rates, and fixed or determinable annual or periodic income from U.S. sources, which is generally taxed at a 30% rate. Exceptions include portfolio interest, interest on securities, and gains from the sale of property that are not effectively connected. The Foreign Investment in Real Property Tax Act treats gains from the sale of U.S. real property as effectively connected income. The branch profits tax and earnings stripping rules aim to prevent base erosion through interest payments between related parties.

1. Taxation of Foreign Taxpayers Presented by Edward Umling, CPA, LLM August 17 – 18, 2009

2. General Overview The United States asserts jurisdiction to tax income whenever it considers the income to be from sources within the United States; (i.e., to have some nexus or connection with the United States that justifies taxation), even if the income is earned by a foreign corporation not subject to U.S. residence-based taxing jurisdiction. See II-1

4. Income Not ECI (i.e. FADP)Income Earned Foreign Corporation  from U.S. Sources See II-1

5. Fixed and Determinable Annual Period Income  this term “is merely descriptive of the character or class of income,” whether or not paid in a lump sum, a statement inspired largely by the decision in CIR v. Wodehouse/ This is basically passive income (i.e. rents royalties, dividends and interest

6.  If the transaction constitutes a sale or exchange, gain will not be taxable provided it is not effectively connected with a U.S. business.

7. How are the two types of income taxed If its ECI its taxed at progressive rates If its is FADP its taxed at a flat 30% rate unless reduced by a treaty

8. Exceptions Interest on Bank deposits exempt Interest on securities Capital gains if they are not ECI Sale or exchanges of 471 property (trading with the U.S. v. Trading in the U.S.) See II-2

9. Sales of U.S. Real Property Nonresident alien individuals and foreign corporations are subject to tax on realized gain from the disposition of an interest in U.S. real property, held directly or indirectly. The gain is taxed as if it were effectively connected with the conduct of a U.S. trade or business, whether or not the foreign person is in fact engaged in a U.S. trade or business during the taxable year (§897)

10. The Foreign Investment in Real Property Tax Act (FIRPTA) The characterization of property as real property for purposes of this source rule generally depends on local law. FIRPTA provides an exception to this rule. For purposes of applying the source rule to property covered by FIRPTA, real property includes certain personal assets such as stock ownership, partnership interests, and other indirect interests in real property owned by foreign persons (§897(c)) See II-9

11. Foreign Investment in Real PropertyPolicy Overview Before 1980 foreign investors realized gains on the sale of real property tax free. Congress responded by enacting Foreign Investment in Real Property Act (“FIRPA”) This law basically treats gains realized on sales of real property located in the U.S. as ECI.

12. Example II-2 Foreign Company received Royalties Analysis Represents “FADP” subject to 30% unless reduced by treaty. Go to Article 12.

13. Example II-2 Foreign Company received Dividends Analysis Represents “FADP” subject to 30% unless reduced by treaty. Go to Article 10.

14. Example II-2 Foreign Company received Interest Analysis Represents “FADP” subject to 30% unless reduced by treaty. Go to Article 11.

15. Example II-2 Foreign Company received Royalties Analysis Represents “FADP” subject to 30% unless reduced by treaty. Go to Article 12.

16. “PE” Established The Company send a salesman in the U.S. for two months and takes orders for 200 cars and title passes in the U.S.

17. Analysis of Remaining Answer Trading with the U.S. v. Trading “In” the (U.S. Article 5 ¶ 5 Determines Taxability) Title Passage Rule under 863(B). Income sourcing rules 1) Books of accounting method 2) IFP method 3) 50/50 method.

18. Debrief Income derived from U.S. sources is taxed at progressive rates FADP is taxed at the lower of the treaty rate or 30% Portfolio interest – exempt Interest on securities exempt Sale of 471 property exempt Real Property – treated as ECI

20. Branch Profits Tax I.R.C. §884Policy Overview Prior to the Tax Reform Act of 1986 (TRA), foreign corporations could face significantly different tax consequences on the distribution of U.S. profits. See II-6

21. Policy Overview A domestic subsidiary was subject to a 30% (or lower treaty rate) withholding tax on the remittance of earnings to its parent. By Contrast, Profits from a branch office, however, could be repatriated to the foreign home office without being subject to the additional withholding tax.

22. Policy Overview To eliminate the disparity, the TRA created Sec. 884, imposing the so-called branch profits tax (BPT). Sec. 884 attempts to put a foreign branch operation on the same tax footing as a foreign subsidiary. This is accomplished by determining the amount of U.S. earnings theoretically "repatriated" to the foreign parent/shareholders by the branch. See II-6

23. Policy Overview To determine this amount, Sec. 884 looks to the "U.S. net equity" of the branch at the beginning and end of the tax year. If this amount has decreased (and is not attributable to an operating loss), there is deemed to have been a repatriation of funds. See II-6

24. Earnings Stripping Rules Policy Overview Sec. 163(j) Enacted by the Revenue Reconciliation Act of 1989, placed substantial restrictions on the amount of certain related-party interest expense deductions a foreign-owned U.S. corporation may take in computing its income tax (the so-called earnings stripping rules).

25. Earnings Stripping Rules Policy Overview Sec. 163(j) These rules were enacted in response to what was perceived as an erosion of the U.S. tax base through interest expense deductions. The earnings stripping rules generally apply to a corporation with a debt-to-equity ratio in excess of 1.5 to 1;

26. Earnings Stripping Rules Policy Overview Sec. 163(j) These rules were enacted in response to what was perceived as an erosion of the U.S. tax base through interest expense deductions. The earnings stripping rules generally apply to a corporation with a debt-to-equity ratio in excess of 1.5 to 1; See II-7

27. Example Overview Needs 5M to capitalize US Co Debt or Equity ?

28. Example Overview US Co Equity 50,000 Debt 4,950,000 Has the effect of reducing U.S. taxes for the interest expense deduction. Moreover the payment to the parent usually had nil withholding.

29. 163(j) Comes along and does two things Disallows the U.S. companies excess interest expense as a current deduction where the interest is paid to a related person Requires a minimum capital structure of debt to equity Excess interest – interest that exceeds 50% of taxable income

30. Example II-8 Interest to UK 100,000 Unrelated 60,000 160,000 Interest Income 70,000 Interest Expense 90,000 Taxable Income 50,000 Add Back 90,000 Adjusted Taxable Income 140,000

31. Example II-8 Interest Income 70,000 Interest Expense 90,000 Taxable Income 50,000 Add Back 90,000 Adjusted Taxable Income 140,000 70,000 90,000 50% 20,000