Foreign Investors: Know How to Navigate U.S. Tax Consequences2/11/2016 | Winter 2016 Newsletter
Foreign businesses seeking to invest in a U.S.-based business or to operate in the U.S. should carefully plan and manage the structure of their U.S. business to minimize its effective U.S. tax rate. The following is intended to summarize some of the options available to foreign investors.
U.S. TAXATION OF FOREIGN INVESTMENTS
A foreign person is generally subject to federal income tax on taxable income that is deemed to be “effectively connected” with a U.S. trade or business at the same tax rates applicable to U.S. persons. Non-U.S. persons are required to file a U.S. income tax return to report such income and are entitled to deduct their expenses in connection with the U.S. business. A foreign corporation earning effectively connected income is subject to an additional 30% U.S. branch profits tax on its after-tax net income. A foreign person is also subject to a 30% U.S. withholding tax on any U.S. source “fixed or determinable annual or periodic” income, which generally includes dividend income.
With proper planning, these two additional levies can be avoided.
DIRECT AND INDIRECT INVESTMENT OPTIONS IN U.S. BUSINESSES
If a foreign entity is providing services in the U.S. that are performed by its employees, the foreign entity will be considered to directly engage in a U.S. business. As a result, the non-U.S. entity would be required to file a U.S. tax return and report and pay tax on its effectively connected income generated by those services. Similarly, if the foreign entity invested in a U.S. business directly or through an entity treated as a partnership for U.S. tax purposes, the non-U.S. entity would be required to file a U.S. tax return and pay taxes on any effectively connected income generated by the business.
To avoid having to file a tax return in the U.S. in connection with income from a U.S. business and the payment of the branch profits tax, the foreign entity could form a U.S. corporation to employ the persons who will be performing services in the U.S. or to hold its investment in a U.S. business. The U.S. corporation would file a U.S. tax return and be subject to regular U.S. corporate income taxes on the income generated by the U.S. business, minus its business expenses. In the event the U.S. corporation proceeds to make any distributions to the foreign entity, such distributions would be subject to a U.S. dividend withholding tax at a rate of 30% or such lesser rate as provided in the applicable U.S. income tax treaty, if any, with the foreign country.
Should the U.S. corporation decide to sell its U.S. business or its investment in a U.S. business, the U.S. corporation would be subject to U.S. tax on any net gain realized on that sale. However, the U.S. corporation would have the option to liquidate and distribute the proceeds from its business or its investment to its non-U.S. parent company, and this type of distribution would not be subject to U.S. withholding taxes. Consequently, the non-U.S. entity can avoid a second level of U.S. tax, namely the branch profits tax or dividend withholding tax, on its U.S. business or its investment in a U.S. business if it makes its investment through a wholly-owned U.S. corporation, so long as the U.S. corporation does not make any distributions to the non-U.S. parent until its complete liquidation.