Taxation of Foreign Branches after Tax Reform
The US tax treatment of a foreign branch owned by a domestic corporation remains fundamentally the same following the 2017 tax reform legislation. However, the establishment of a new foreign tax credit basket for branch income, as well as other changes in the legislation, may make it worthwhile to reconsider whether to conduct various foreign operations in corporate or branch form.
A domestic corporation may operate in a foreign country through an actual foreign branch, or may own a foreign entity that is classified as a disregarded entity and treated as a foreign branch for US tax purposes. As a general rule, a foreign branch for US tax purposes is a division which operates a trade or business in a foreign country and maintains a separate set of books and records. The foreign branch generally is subject to the income tax laws in the foreign country in which it operates.
General. For US tax purposes, a foreign branch (or foreign disregarded entity) of a domestic corporation in a consolidated group is generally treated as part of the domestic corporation. The income, deductions, losses and credits of the foreign branch are taken into account in calculating the tax liability of the US consolidated group.
The income of a foreign branch is subject to the 21 percent corporate tax rate. While the new section 250 provides a 13.125 percent effective tax rate for certain foreign-derived income of a domestic corporation, income earned in a foreign branch is not eligible for that lower rate.
A material benefit of operating through a foreign branch is that losses of the branch flow into the US consolidated group and reduce taxable income of the group. Dual consolidated loss rules, however, provide that such losses cannot be used currently if the losses can also be used by a foreign subsidiary to reduce its income under foreign law. Branch losses limited by this rule can be carried forward indefinitely and reduce future income of the foreign branch.
Foreign Tax Credits. US taxes paid on foreign source branch income can be reduced with foreign tax credits. Under prior law, foreign income taxes paid or accrued by the branch or by any member of the US consolidated group could be used as a credit, and if a branch paid more foreign income taxes than necessary to eliminate US tax on its income, such foreign taxes generally could be used as a credit to reduce US tax on other foreign source income of the group. The 2017 Tax Act imposes limits on the application of the foreign tax credit rules to foreign branches. New rules establish a separate foreign branch limitation category (or “basket”), such that US tax on branch business income can only be reduced by taxes paid by a foreign branch of the US consolidated group, and any excess foreign income taxes of a group’s foreign branches cannot be used to reduce US tax on other foreign source income of the consolidated group. Excess credits can be carried back one year and forward 10 years.
This limitation on the use of foreign tax credits can present a problem for a taxpayer with losses in some foreign branches and income in other foreign branches. For example, if a US consolidated group has $1,000 of losses from Foreign Branch X and has $1,000 of income in Foreign Branch Y on which it pays foreign income taxes of $200, the taxes would not be currently usable as a foreign tax credit. While the excess taxes can be carried forward, they may ultimately expire unused.
This new limitation also can be problematic if a US consolidated group has a foreign branch subject to a tax rate in excess of the US corporate rate of 21 percent. For example, a branch in Mexico may be subject to a 30 percent effective tax rate. The Mexican taxes that cannot be used as a credit in the current year may never be usable. This problem is increased if a material amount of expenses (e.g., interest expense) of the US group is allocable to the foreign source income earned by the Mexican branch, which would further limit the amount of Mexican taxes that can be claimed as a credit.
The amount of income subject to the new foreign tax credit limitation (and to the associated carve-out from the reduced rate for certain foreign-derived income) also may be unclear in many common situations. The new limitation applies only to “foreign branch income,” which is defined as the business profits “attributable to” a foreign branch under regulations that the Treasury Department and the IRS will need to issue. In the meantime, it will be necessary for taxpayers to use their best judgment to develop reasonable methods to differentiate foreign branch income from other income in situations in which a taxpayer generates income from integrated branch and non-branch operations.
If a US group has an aggregate loss for all branches in a taxable year, such loss can reduce other foreign source income of the group for purposes of applying the foreign tax credit limitation rules. When the group has aggregate branch income in a subsequent year, such income is treated as income of other foreign source categories that were reduced by prior branch losses until all prior branch losses are recaptured (or, to the extent the prior branch losses reduced US source income, 50 percent of the branch income would be recharacterized as US source income). Foreign income taxes paid on recharacterized branch income remain in the branch basket and can only be used to reduce US tax on branch income that is not recharacterized.
Branch Remittances. Generally, distributions from a foreign branch to a US home office are not subject to US 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 home office. If a foreign branch has a functional currency other than the US 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 US 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. While such taxes can be claimed as a credit, the new law is not clear whether such taxes are within the foreign tax credit category for branch income or fall within the general limitation category. Under prior law—which did not include a separate category for foreign branches—it was generally viewed that foreign taxes paid on such disregarded payments were within the general limitation category. We note an apparent scrivener’s error in the revised section 904 foreign tax credit limitation provisions which 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).
Planning Ideas. A taxpayer with foreign branches that gives rise to losses will continue to benefit in using the foreign losses to reduce taxable income of the US consolidated group. As previously mentioned, however, branch losses can limit a company’s ability to claim foreign tax credits, particularly for taxes paid by foreign branches.
A consolidated group with ongoing excess foreign tax credits generated by foreign branches may consider restructuring its operations. The rules encourage modifying operating structures to reduce the amount of foreign income taxes.
One idea is to move all or a portion of the business out of the foreign branch and into the United States, resulting in a reduction of foreign income taxes. For US purposes, some or all of such income may qualify for the 13.125 percent tax rate on certain foreign-derived income, which applies to income from sales of property for foreign use and income for providing services to persons located outside the United States. Such restructuring, however, may be subject to foreign taxation, and also may result in foreign currency gain or loss for US tax purposes under the branch remittance rules.
An alternative is to operate the branch business in a foreign subsidiary. This could be implemented by transferring the branch to a new foreign corporation, or filing an election to classify a disregarded entity as a foreign corporation. The income earned in a controlled foreign corporation, less a routine return on depreciable tangible assets, would generally be subject to a 10.5 percent US effective tax rate under the new “global intangible low-taxed income regime,” although excess foreign income taxes paid on the income would be lost (as that regime applies on a strictly annual basis), and an additional 20 percent foreign tax credit haircut would apply. Alternatively, all or a portion of the CFC’s income may be Subpart F income, in which case it would be subject to a 21 percent US tax rate with deemed paid tax credits in the general limitation basket (and the income might be excluded from US taxable income by electing the high tax exception), with no 20 percent haircut, and with the ability to preserve excess foreign tax credits as carryovers.
The transfer of a foreign branch to a foreign subsidiary would give rise to US taxation. Under prior law, tangible assets used in a foreign trade or business could be transferred without US taxation, as could foreign goodwill and going concern value (subject to recently promulgated regulations). Under the 2017 Tax Act, all gain on the transfer of assets to a foreign subsidiary is taxable. In addition, 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 (which amounts might be eligible for the 13.125 percent rate for certain foreign-derived income). The foreign subsidiary receives a deduction for such annual inclusion that should reduce any Subpart F income and GILTI inclusions.
In addition, upon incorporation the losses of a branch are recaptured to the extent the aggregate losses exceed prior income earned by the branch. Under the 2017 Tax Act, the amount of such loss recapture is no longer 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 dual consolidated loss or the group has an overall foreign loss.
A third alternative is to elect to classify as disregarded entities one or more low-tax first-tier foreign subsidiaries. This would provide low-taxed branch income to absorb excess foreign tax credits in existing branches. While under prior law the earnings and profits of the CFC would be subject to US taxation upon liquidation into the United States, such liquidation can generally be achieved on a tax free basis under the 2017 Tax Act, because the earnings should be excluded from income as previously taxed income or via the 100 percent dividends received deduction of section 245A for un-taxed earnings and profits. Such election, however, will require the taxpayer to forgo the 10.5 percent tax rate on the CFC’s non-Subpart F income and subject the CFC’s routine return on depreciable tangible assets to US taxation because all of the income of the foreign branches would be subject to the full 21 percent corporate tax rate.
In conclusion, under the 2017 Tax Act income and losses of a foreign branch of a domestic corporation continue to be reported by the US consolidated group. This provides a benefit for branch losses which reduce US taxable income (but can limit the use of foreign tax credits). Foreign branch income, however, is not eligible for reduced tax rates otherwise available for foreign-derived income, and the Tax Act significantly limits the ability to use foreign income taxes paid on branch income as a credit. Under certain circumstances, the US group may consider restructuring foreign branch operations to reduce foreign taxes and qualify for lower US tax rates (but such restructuring will likely give rise to tax costs).