If your company operates outside the United States in branch form, it may be time to revisit your tax positions and consider planning opportunities due to new tax reform rules.
The treatment of foreign branches under US tax rules can be quite complicated. Guidance has been released intermittently over the past decades, and proposed regulations under Section 987 issued in 1991 and 2006 languished for years and were never finalized. However, with the passage of tax reform, commonly referred to as the Tax Cuts and Jobs Act (TCJA), an abundance of changes and new guidance related to foreign branches should cause taxpayers to evaluate the impact on their overall tax position.
Foreign Branch Definition
The term foreign branch refers to the business operations of a US company in a foreign country. If a US company conducts business through a foreign legal entity that’s disregarded for US tax purposes, that foreign disregarded entity is also considered a foreign branch.
In general terms, if a US company is subject to income tax in a foreign country, it’s likely that the operations are considered a foreign branch.
Foreign Derived Intangible Income (FDII)
As of 2018, US C corporations that export goods or services are eligible for a 37.5% deduction of their FDII. Despite including the word intangible in its name and the income from that being eligible, the FDII deduction is also an export incentive for C corporations on sales made or services provided to foreign persons.
The purpose of the deduction is to provide a preferential tax rate to US exporters, so foreign branch income, which is earned offshore, isn’t eligible for the deduction. When calculating FDII, taxpayers with foreign branches should revisit their foreign branch income calculations to determine how to most effectively increase their FDII.
Foreign Branch Impacts on Section 199A Deductions
The TCJA enacted Section 199A establishing a new deduction for taxpayers other than corporations that own pass-through entities such as partnerships and S corporations.
Beginning in 2018, if the taxable income of a pass-through entity is considered qualified business income, individual, trust, and estate taxpayers may take a 20% deduction. Qualified business income only includes income connected with a US trade or business, known as effectively connected income (ECI).
In general, income earned through a foreign branch isn’t considered ECI, and therefore taxpayers must exclude such income from qualified business income otherwise eligible for the Section 199A deduction. As with FDII, taxpayers should revisit their expense allocation methodologies to see if they can increase the Section 199A deduction by reducing the exclusions from qualified business income.
Section 987 Regulations
In the flurry of activity since the enactment of tax reform, taxpayers may have lost sight of the Section 987 regulations first issued in 2016, which are quite ambitious in scope. The Department of the Treasury has delayed the effective date of these regulations to January 1, 2020, although early adoption is still permitted.
These regulations require taxpayers to segregate the assets of their foreign branches into two categories: marked and historic. The regulations also provide new requirements for calculating foreign currency exchange gain or loss on certain foreign branch transactions. Special foreign currency exchange rates must be applied when translating income statement amounts related to historic assets.
Taxpayers should continue to prepare for implementation of these regulations in 2020 and consider evaluating these new regulations now in order to determine whether early adoption might be advantageous.
Tax Reporting Changes for Foreign Branches
Beginning in 2018, taxpayers are required to file Form 8858 to report activity of all foreign branches. Prior to 2018, this was only required for foreign disregarded entities. Also, transactions between a US person and a foreign branch, or transactions between foreign branches, are required to be made in accordance with the arm’s length standard of Section 482.
This area wasn’t of great issue prior to the enactment of TCJA, but new foreign tax credit reporting rules have increased its significance. It’s important to discuss all non-US activity with your tax professional in order to determine the correct filing obligations.
We’re Here to Help
These new rules for foreign branches, in conjunction with long-standing prior guidance, shouldn’t be viewed in isolation; rather, they should be considered as part of a taxpayer’s overall international tax planning strategy.
To learn more about evaluating the implications of US tax rules related to foreign branches, and how we can work with you to help evaluate your international tax position, contact your Moss Adams professional.