US taxation of income earned by non-US persons depends on whether the income has a nexus with the United States and the level and extent of the non-US person's presence in the United States.
Prior to the enactment of US tax reform legislation on December 22, 2017 (the Act), a non-US corporation engaged in a US trade or business was taxed at a 35% US corporate tax rate on income from US sources effectively connected with that business (ECI). However, the Act significantly revised the federal tax regime. The Act permanently reduced the 35% corporate income tax rate on ECI to a 21% flat rate for tax years beginning after December 31, 2017. Certain US-source income (e.g., interest, dividends, and royalties) not effectively connected with a non-US corporation’s business continues to be taxed on a gross basis at 30%.
AMT previously was imposed on corporations other than S corporations and small C corporations (generally those with three-year average annual gross receipts not exceeding $7.5 million). The tax was 20% of alternative minimum taxable income (AMTI) in excess of a $40,000 exemption amount (subject to a phase-out). AMTI is computed by adjusting the corporation's regular taxable income by specified adjustments and 'tax preference' items. Tax preference or adjustment items could arise, for example, if a corporation has substantial accelerated depreciation, percentage depletion, intangible drilling costs, or non-taxable income.
The Act repeals the corporate AMT effective for tax years beginning after December 31, 2017, and provides a mechanism for prior-year corporate AMT credits to be refunded by the end of 2021.
Foreign corporations and nonresident alien individuals are subject to a yearly 4% tax on their US-source gross transportation income, which has an exception for certain income treated as effectively connected with a US trade or business. Transportation income is any income derived from, or in connection with, either:
Nonresident alien individuals from, and foreign corporations organized in, countries with an equivalent exemption provided to US persons may be eligible for an exemption from this tax, provided certain detailed conditions are met.
US-flagged vessels engaged in US international trade also may be subject to a federal tonnage tax.
The ‘base erosion and anti-abuse tax’ (BEAT) was enacted by the Act as Section 59A. The Act targets US tax-base erosion by imposing an additional corporate tax liability on corporations (other than RICs, REITs, or S corporations) that, together with their affiliates, have average annual gross receipts for the three-year period ending with the preceding tax year of at least $500 million and that make certain base-eroding payments to related foreign persons during the tax year that constitute 3% (2% for certain banks and securities dealers) or more of all their deductible expenses apart from certain exceptions. The most notable of these exceptions are the net operating loss (NOL) deduction, the new dividends received deduction for foreign-source dividends, the new deduction for foreign-derived intangible income (FDII) and the deduction relating to the new category of global intangible low-taxed income (GILTI), qualified derivative payments defined in the provision, and certain payments for services.
The BEAT is imposed to the extent that 10% of the taxpayer’s ‘modified taxable income’ ─ generally, US taxable income determined without regard to any base erosion tax benefit or the base erosion percentage of the NOL deduction ─ exceeds the taxpayer’s regular tax liability net of most tax credits. (For certain banks and securities dealers, the percentage is 11%.)
A base erosion payment generally is any amount paid or accrued by the taxpayer to a related foreign person with respect to which a deduction is allowable or that is in connection with the acquisition of property subject to depreciation or amortization, or for reinsurance payments. The category also includes certain payments to certain entities treated as ‘surrogate foreign corporations’ or entities related to them under the anti-inversion rules of Section 7874.
Proposed regulations were issued on December 13, 2018. They address the mechanics of determining, among other things, the applicable taxpayer status, a taxpayer’s base erosion percentage, and a taxpayer’s modified taxable income. They also address the application of the BEAT rules to certain partnerships, banks, registered securities dealers, insurance companies, and consolidated groups, and provide an anti-abuse rule that generally disregards certain transactions undertaken with a principal purpose of avoiding the BEAT rules.
The provision is effective for base erosion payments paid or accrued in tax years beginning after December 31, 2017. For tax years beginning after December 31, 2025, the percentage of modified taxable income that is compared against the regular tax liability increases to 12.5% (13.5% for certain banks and securities dealers) and allows all credits to be applied in determining the US corporation’s regular tax liability. Special rules apply for banks and insurance companies.
Note that references here and elsewhere to proposed regulations are intended to provide information as of the time this publication went to press in May 2019; the content of proposed regulations may change substantially when they are finalized, and the discussion here with respect to proposed regulations will not reflect the final rules after the time of publication.
The Act uses the mechanics under subpart F to impose a one-time ‘toll charge’ on the undistributed, non-previously-taxed post-1986 foreign earnings and profits (E&P) of certain US-owned foreign corporations as part of the transition to a new territorial regime. The toll charge, found in revised Section 965, is reduced by a deduction computed in a manner that (in the case of US corporate shareholders) ensures a 15.5% effective tax rate on earnings represented by ‘cash’ and an 8% effective tax rate to the extent the earnings exceed the cash position.
The United States does not impose a federal sales tax, value-added tax (VAT), or federal goods and services tax (GST).
All goods imported into the United States are subject to customs entry requirements. US law requires the importer or its legal agent to file with US Customs and Border Protection (Customs) the declared value, quantity, classification, and origin of the merchandise, and provide information and documentation necessary for Customs to properly assess duties, collect accurate statistics and determine whether any other applicable requirements of law apply. Furthermore, Customs regulations mandate more specific reporting requirements, such as the importing carrier, port code, manufacturer identification code, country of origin, mode of transportation, and dates of import and export.
Goods imported into the United States are dutiable or duty-free in accordance with their classification under the applicable subheading of the Harmonized Tariff Schedule of the United States. The subheading also identifies eligibility for special programs and free-trade agreement preferential duty rates. When goods are dutiable on an ‘ordinary’ basis, ad valorem, specific, or compound duties may be assessed. An ad valorem rate – the type most often applied — is a percentage of the value of the merchandise, such as 7% ad valorem. A specific rate is a specified amount per unit of measure (weight or quantity), such as 6.8 cents per dozen. A compound rate is a combination of both a specific rate and an ad valorem rate, such as 0.8 cents per kilo plus 8% ad valorem. In addition to ordinary duties, select products also may be subject to punitive tariffs that are imposed in response to specific trading conditions and for specified time periods. In such cases, the punitive tariffs are assessed in addition to the ordinary duties.
In addition to ad valorem, specific, or compound duties, other fees may be assessed in connection with the imported merchandise. Two of the most common fees are the Merchandise Processing Fee (MPF) and the Harbor Maintenance Fee (HMF). MPF is an ad valorem fee assessed at 0.3464% of the dutiable value of the imported merchandise with a minimum fee of $25.67 and a maximum fee of $497.99 per entry (i.e., import transaction). HMF is a 0.125% ad valorem fee assessed on the dutiable value of imported merchandise shipments arriving via ocean cargo through identified ports. While exceptions apply to MPF assessments, including merchandise entered under the North American Free Trade Agreement, there are no exceptions from HMF for commercial import transactions.
Applicable duties and fees are assessed based on the value of the imported merchandise that is declared at the time of importation (i.e., customs value). Customs requires that the value of the goods be properly declared, regardless of the dutiable status of the merchandise. Customs value generally is based on the price paid by the importer when purchasing the foreign merchandise for export to the United States. When imports result from a transaction between related parties, the price paid to a related entity may serve as the basis of customs value, provided it can be demonstrated that the relationship did not affect the price.
Liability for the payment of duty and other customs fees becomes fixed at the time an entry is filed with US Customs and Border Protection (CBP), although the amount of duty owed may change subsequently if any of the information declared on entry is later determined to be erroneous. The obligation for payment is on the person or firm in whose name the entry is filed, the importer of record. The importer of record has a legal obligation to exercise reasonable care in all aspects of its importing activity.
The US government imposes excise taxes on a wide range of goods and activities, including air travel, gasoline and diesel fuel used for transportation, and manufacturing of specified goods. A fee on health plans under the Affordable Care Act (ACA), called the Patient-Centered Outcomes Research Institute (PCORI) fee, is reported and paid as an excise tax as well.
The excise tax rates are as varied as the goods and activities on which they are levied. For example, a federal excise tax of 7.5% is charged on commercial air transportation, and the excise tax imposed on motor fuel is 18.3 cents per gallon of gasoline and 24.3 cents per gallon of diesel fuel. Many states and cities also impose their own excise taxes on certain activities. For example, New York imposes an excise tax on telecommunications in the amount of 3.095% (state tax rate of 2.5% on telecommunications sourced to New York plus a surcharge of 0.595% for telecommunications services sourced to the Metropolitan Commuter Transportation District (i.e., MTA Surcharge). Further, New York City separately imposes an excise tax on telecommunications in the amount of 2.35% for telecommunications sourced to New York City.
There is no federal-level stamp tax; however, state and local governments frequently impose stamp taxes at the time of officially recording a real estate or other transaction. In many state and local jurisdictions, this is also referred to as a real property transfer tax. The state or local transfer tax on real estate generally is imposed on the recording of the transfer of the transferred deed. In some states, the transfer tax also is imposed on the transfer of a controlling interest in an entity that owns real property.
The corporate tax rate on long-term capital gains currently is the same as the tax rates applicable to a corporation’s ordinary income. (By contrast, individuals may be subject to a lower rate on long-term capital gain than on short-term capital gain.)
Corporations (other than S corporations, domestic and foreign personal holding companies, corporations exempt from tax under Subchapter F of the Internal Revenue Code, and passive foreign investment companies) accumulating earnings and profits for the purpose of avoiding shareholder personal income tax are subject to a penalty tax in addition to any other tax that may be applicable. The accumulated earnings tax equals 20% of 'accumulated taxable income.' Generally, accumulated taxable income is the excess of taxable income with certain adjustments, including a deduction for regular income taxes, over the dividends paid deduction and the accumulated earnings credit. Note that a corporation may be able to justify the accumulation of income, and avoid tax, based on its reasonable business needs.
US corporations and certain foreign corporations that receive substantial 'passive income' and are 'closely held' may be subject to personal holding company tax. The personal holding company tax, which is levied in addition to the regular tax, is 20% of undistributed personal holding company income.
Compensation paid to employees for services performed within the United States constitutes wages generally subject to (1) federal income tax withholding, (2) Federal Insurance Contributions Act (FICA) taxes (i.e., social security, Medicare, and Additional Medicare), and (3) the Federal Unemployment (FUTA) tax, unless an exception applies. For employees sent to the United States by their foreign employer, there is a de minimis federal income tax exception for amounts less than $3,000 and visits of less than 90 days. Also, certain treaty provisions may eliminate the need to withhold income taxes (but generally not the need to report) to the extent requisite documentation is gathered.
Similarly, foreign employers often rely on totalization agreements between the United States and other countries and gather a requisite certificate of coverage, to exempt wages for services performed in the United States from FICA taxes. If such relief is not available, and another exemption does not apply, the foreign employer must withhold social security taxes equal to 6.2% of wages for the employee and pay 6.2% for the employer, up to $132,900 of wages in 2019, and Medicare taxes equal to 1.45% for the employee and 1.45% for the employer. Note: There is no cap on wages subject to Medicare taxes. The employer also must withhold an additional employee-only 0.9% Additional Medicare tax on wages above $200,000. FUTA tax, imposed on the employer only, is between 0.6% and 6.0% (depending on credits for state unemployment taxes) on the first $7,000 of wages paid to an employee. See Appendix B for a list of current US social security totalization agreements.
A foreign employer generally must withhold, make timely deposits, and file quarterly and annual employment tax returns, including Forms 941 and 940, and annual wage statements, including Forms W-2 and W-3, in its name and employer identification number unless such statements are filed by a properly authorized third party.
Importers, manufacturers, and sellers of crude oil, petroleum products, ozone-depleting chemicals (ODCs), or imported products manufactured using ODCs, are subject to environmental taxes calculated per barrel or weight of the ODCs. These taxes are reported on Forms 6627 and 720. The ODC tax on imported taxable products is determined under an exact method by weight or via the table method based on the listed product (such table is provided in the instructions to Form 6627). If the weight cannot be determined, the tax is 1% of the entry value of the product.
Generally, a foreign corporation engaged in a US trade or business is taxed on a net basis at regular US corporate tax rates on income from US sources that is effectively connected with that business and also is subject to a 30% branch profits tax on the corporation’s effectively connected earnings and profits to the extent treated as repatriated to the home office; the branch tax can be reduced or eliminated under an applicable US tax treaty.
In addition, a foreign corporation is subject to a 30% tax on the gross amount of certain US-source income not effectively connected with that business (see section I.P.1, below, with respect to withholding on certain payments to non-US persons); such 30% tax potentially may be reduced or eliminated under an applicable US tax treaty. (These 30% rates were not changed by the Act.)
There is no definition in the tax statute of the term trade or business within the United States – instead, that concept has been developed mainly by the IRS and court decisions through a facts-and-circumstances analysis. A foreign corporation needs to consider the nature and extent of its economic activities in the United States, either directly or through its agents. The following have been considered to be important factors by the courts and/or the IRS:
An agent’s activities in the United States may result in a US trade
If a non-US person has a US trade or business, the question arises as to what income is ‘effectively connected’ to such US trade or business.
All US-source active income earned by a non-US person is treated as effectively connected. Passive-type income and gain from the sale of capital assets are treated as effectively connected to a non-US person’s US trade or business only if a connection with the US trade or business exists. Such a connection exists if the passive-type income or capital gain is derived from assets used in the US trade or business (the asset use test) or if the activities conducted in the US trade or business are a material factor in the production of the passive-type income or capital gain (the business activities test).
Certain types of foreign-source income generated through a US office can be effectively connected income. These include:
The Act modifies Section 863(b) with respect to income, profits, and gain from the sale of inventory produced by the taxpayer by sourcing such amounts entirely to the place of production rather than by reference to the location of production and sales, effective for tax years beginning after 2017.
US tax law imposes a 30% branch profits tax on a foreign corporation's US branch’s effectively connected earnings and profits (ECE&P) to the extent they are treated as distributed, based on any decrease in the branch’s US net equity for the year. The branch profits tax may be reduced or eliminated under an applicable US tax treaty. The tax does not apply in the year the foreign corporation terminates its US trade or business. The purpose of the branch profits tax is to treat US operations of foreign corporations in a manner similar to US corporations owned by foreign persons – that is, it is a proxy for the US tax on dividends paid by a US subsidiary to a foreign person.
With certain exceptions, a 30% (or lower treaty rate) branch-level interest tax is imposed on interest treated as paid by a US branch to foreign lenders. This applies both to interest paid by the branch and to a portion of the interest paid by the home office to the extent taken into account in determining the corporation’s tax on effectively connected income.
For US federal income tax purposes, the Internal Revenue Code and the Treasury regulations prescribe the classifications of business entities and organizations. Whether an organization is an entity separate from its owners for US federal income tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law.
Inbound insight: The LLC is a popular form of business entity organization in the United States because of the limited liability for owners, as determined under state law, as well as flexibility under the ‘check-the-box’ regulations. That is, a US LLC has the default classification of either a disregarded entity or partnership (depending on the number of owners), but is eligible to make an entity classification election to change from the default classification to the classification of corporation for US income tax purposes.
A business entity with two or more members is classified for US Federal income tax purposes as either a corporation or a partnership. A business entity with only one owner is classified as a corporation or is disregarded. If the entity is disregarded, its activities are treated in the same manner as a branch, division, or sole proprietorship.
The initial classification of a business entity depends on the prescribed default classification. The default classification is based on several factors, including whether the entity is domestic (organized or incorporated in the United States) or foreign (not organized or incorporated in the United States).
With respect to foreign entities, the regulations deem certain entities as ‘per se’ corporations. ‘Per se’ corporations must retain the default classification of corporation and may not elect classification as a partnership or disregarded entity. Any other foreign entity generally has the default classification of corporation if all owners have limited liability, or the default classification of partnership (or disregarded entity) if one or more owners has unlimited liability.
An eligible foreign entity that is not classified as a ‘per se’ corporation may elect a classification that departs from the default classification. The election is subject to specific procedural rules and is made by filing Form 8832, Entity Classification Election, with the IRS.
Multinational entities, such as corporations and partnerships, face a variety of tax systems in the countries where they operate. To reduce or eliminate double taxation between countries, promote cross-border trading, and alleviate the burden of administration and enforcement of tax laws, countries typically enter into income tax treaties outlining how parties to the treaty (contracting states) will be taxed on income earned in each contracting state.
Income tax treaties contain an article describing whether the activities of an enterprise rise to the level of a permanent establishment (PE) in a contracting state. The existence of a PE is important because it gives a contracting state the right to tax the enterprise’s income attributable to the PE. This includes income from conducting a business in the contracting state and passive income, such as interest, dividends, and royalties if such income is attributable to the PE.
A PE generally means:
Other rules and exceptions also apply. This is a very factual determination that requires a full understanding of a company’s particular facts and circumstances. Read more about US tax treaties.
An affiliated group of US 'includible' corporations, consisting of a US parent and its US subsidiaries directly or indirectly 80% owned, generally may offset the profits of one affiliate against the losses of another affiliate within the group by electing to file a consolidated federal income tax return.
A foreign incorporated subsidiary may not be consolidated into the US group. A partnership may not be included in a consolidated return, even if it is 100% owned by members of an affiliated group, since a partnership is not a corporation. However, a member's earnings that flow through from a partnership are included as part of the consolidated group's taxable income or loss.
Filing on a consolidated (combined) basis also is allowed (or may be required or prohibited) under the tax laws of certain states.
Sales, dividends, and other transactions between corporations that are members of the same consolidated-return group generally are deferred or eliminated until such time as a transaction occurs with a non-member of the group. Losses incurred on the sale of members of the group are disallowed under certain circumstances.
Transfer pricing regulations govern how related entities set internal prices for the transfers of goods, intangible assets, services, and loans in both domestic and international contexts. The regulations are designed to prevent tax avoidance among related entities and place a controlled taxpayer on par with an uncontrolled taxpayer by requiring inter-company prices to meet the arm's-length standard.
The arm's-length standard generally is met if the results of a controlled transaction are consistent with results that would have been realized if uncontrolled taxpayers had engaged in a similar transaction under similar circumstances. If a company is not in compliance with the arm's-length standard, the IRS may adjust taxable income and tax payable in the United States. After a transfer pricing adjustment, a multinational company may face potential double tax, paying tax on the same income in two countries. If the related party to the adjustment is in a country that has a tax treaty with the United States, multinational companies may request ‘competent authority’ relief from double taxation and there may be arbitration provisions.
In seeking to avoid potential transfer pricing penalties, US taxpayers may prepare contemporaneous transfer pricing documentation. A protective approach available to companies may be to seek an advance pricing agreement (APA) with the IRS, unilaterally, or with the IRS and another tax authority, bilaterally, covering inter-company pricing. Since 2015, when the IRS issued new APA revenue procedures in Rev. Proc. 2015-41, there has been a tendency for companies not to seek a unilateral APA unless there is a compelling reason for this option.
The prior-law earnings stripping rules were replaced under the Act by a set of rules under which the deduction of business interest expense is limited essentially to the taxpayer’s business interest income plus 30% of the taxpayer’s ‘adjusted taxable income.’ These rules are described in section I.M.18 below.
Under the subpart F regime of the Internal Revenue Code, a CFC is any foreign corporation with respect to which US shareholders own more than 50% of either the voting power of all classes of stock entitled to vote or the total value of the corporation’s stock on any day during the foreign corporation’s tax year. For these purposes, a US shareholder is any US person owning (directly, indirectly through foreign intermediaries, or constructively) 10% or more of the total value of shares of all classes of stock or of the total combined voting power of all classes of stock entitled to vote of a foreign corporation. (The Act added the value threshold to the definition.)
Corporations with 100 or fewer shareholders, none of whom may be corporations or partnerships, that meet certain other requirements may elect to be taxed under Subchapter S of the Internal Revenue Code and thus are known as S corporations. S corporations are taxed in a manner similar, but not identical, to partnerships. That is, all tax items, such as income and deductions, flow through to the owners of the entity. Thus, S corporations generally are not subject to US federal income tax at the corporate level.
Inventories generally are stated at the lower of cost or market on a first-in, first-out (FIFO) basis. Last-in, first-out (LIFO) may be elected for tax purposes on a cost basis only and, if elected, also must be used for financial statement purposes.
US tax law requires capitalization for tax purposes of several costs allocable to the manufacturing process that frequently are expensed as current operating costs for financial reporting (e.g., significant cost variances and the excess of tax depreciation over financial statement depreciation).
Gains or losses on the sale or exchange of capital assets held for more than 12 months are treated as long-term capital gains or losses. Gains or losses on the sale or exchange of capital assets held for 12 months or less are treated as short-term capital gains or losses.
For corporations, capital losses are allowed only as an offset to capital gains. An excess of capital losses over capital gains in a tax year may be carried back three years and carried forward five years to be used to offset capital gains.
For dispositions of personal property and certain nonresidential real property used in a trade or business, net gains are first taxable as ordinary income to the extent of the previously allowed or allowable depreciation or amortization deductions, with any remainder generally treated as capital gain. For other trade or business real property, net gains generally are taxed as ordinary income to the extent that the depreciation or cost recovery claimed exceeds the straight-line amount, with any remainder treated as capital gain.
An exception to capital gain treatment exists to the extent that losses on business assets were recognized in prior years. A net loss from the sale of business assets is treated as an ordinary loss. Future gains, however, will be treated as ordinary income to the extent of such losses recognized in the five immediately preceding tax years.
For capital loss deductions by individuals, see section VI.F.9.e. below
For tax years beginning before January 1, 2018, a US corporation generally may deduct 70% of dividends received from other US corporations in determining taxable income. The dividends-received deduction (DRD) is increased from 70% to 80% if the recipient of the dividend distribution owns at least 20% but less than 80% of the distributing corporation. Generally, dividend payments between US corporations that are members of a consolidated group are eliminated from gross income. With minor exceptions, a US corporation may not deduct any amount of dividends it receives from a foreign corporation. For tax years beginning after December 31, 2017, the Act reduces the 70% DRD to 50% and the 80% DRD to 65%.
A 100% DRD is provided for the foreign-source portion of dividends received by a US corporation from certain foreign corporations with respect to which it is a US corporate shareholder. The 100% DRD applies to distributions made after December 31, 2017.
A US corporation can distribute a tax-free dividend of common stock proportionately to all common stock shareholders. If the right to elect cash is given, then all distributions to all shareholders are taxable as dividend income whether cash or stock is taken. There are exceptions to these rules, and extreme caution must be observed before making such distributions.
Interest income generally is includible in the determination of taxable income. Note: Interest income affects the Section 163(j) interest deduction limitation discussed below.
Rental income generally is includible in the determination of taxable income.
Royalty income generally is includible in the determination of taxable income.
The income (loss) of a partnership passes through to its partners, so that the partnership itself is not subject to tax. Thus, each partner generally includes in taxable income its distributive share of the partnership's taxable income (or loss).
Generally, a US corporation is taxed on its worldwide income, including foreign branch income earned and foreign dividends when received. Double taxation is avoided by means of foreign tax credits; alternatively, a deduction may be claimed for actual foreign taxes that are paid.
A major element of the Act is the addition of a 100% deduction (DRD) for the foreign-source portion of dividends received by US corporate shareholders from certain foreign corporations, effective for distributions made after December 31, 2017. Foreign tax credits (and foreign tax deductions) are disallowed for foreign taxes paid on amounts eligible for the abovementioned 100% DRD.
In the case of CFCs, certain types of undistributed income are taxed currently to certain US shareholders (Subpart F income). More specifically, in situations in which a foreign corporation is a CFC, every US shareholder owning at year-end 10% or greater of the total value of shares of all classes of stock or the total combined voting power of all classes of stock entitled to vote of such a foreign corporation (US shareholder) must include in gross income its pro rata share of the Subpart F income earned by the CFC, regardless of whether the income is distributed to the US shareholders.
With certain exceptions, Subpart F income generally includes passive income and other income that is readily movable from one taxing jurisdiction to another (i.e., income that is separated from the activities that produced the value in the goods or services generating the income). In particular, Subpart F income includes insurance income, foreign base company income, and certain income relating to international boycotts and other violations of public policy.
There are several subcategories of foreign base company income, the most common of which are foreign personal holding company income (FPHCI), foreign base company sales income (FBCSI), and foreign base company services income (FBCSvI). FPHCI is passive income (e.g., dividends, interest, royalties, and capital gains). FBCSI and FBCSvI are sales and services income earned in cross-border related-person transactions. There are a number of common exceptions that may apply to exclude certain income from the definition of Subpart F income, including exceptions relating to highly taxed income, certain payments between related parties, and active business operations.
In situations in which the US shareholder is a domestic corporation, the domestic corporate shareholder may claim a foreign tax credit (discussed below) for such Subpart F inclusions. Furthermore, certain rules track the E&P of a CFC that have been included in the income of US shareholders as Subpart F income to ensure that such amounts (known as previously taxed income or PTI) are not taxed again when they are actually distributed to the US shareholders.
The Act requires a US shareholder to include in income the ‘global intangible low-taxed income’ (GILTI) of its CFCs, effective for tax years of foreign corporations beginning after 2017. Note: Despite the name, this provision is not limited to low-taxed income from intangible assets.
The full amount of GILTI is includible in the US shareholder’s income, and is then reduced through a 50% deduction in tax years beginning after December 31, 2017, and before January 1, 2026, and a 37.5% deduction in tax years beginning after December 31, 2025. A corporate taxpayer generally also can claim a credit for 80% of the foreign taxes associated with GILTI.
Income derived with respect to passive foreign investment companies (PFICs) also is subject to special rules designed to eliminate the benefits of deferral. A PFIC is defined as any foreign corporation if, for the tax year, 75% or more of its gross income is passive income (the ‘income test’) or at least 50% of its assets produce, or are held for the production of, passive income (the ‘asset test’). For purposes of these tests, ‘passive income’ includes dividends, interest, gains from the sale or exchange of investment property, and rents and royalties (other than rents and royalties that are received from unrelated parties in connection with the active conduct of a trade or business). By contrast, income derived from the performance of services does not constitute ‘passive income.’
PFIC status is determined on an annual basis. However, the PFIC ‘taint’ in some cases may continue throughout an investor’s holding period even after the foreign corporation ceases to qualify as a PFIC unless the investor makes a special election (as discussed below). Certain US shareholders of a CFC may be exempt from the PFIC rules with respect to that CFC.
There are three regimes under the PFIC rules: (i) the excess distribution regime, which is the default regime; (ii) the qualified electing fund (QEF) regime; and (iii) the mark-to-market regime. The latter two regimes are elective and cause the US investor in the PFIC to be either taxed currently on its proportionate share of the PFIC’s ordinary earnings and capital gains each year (i.e., the QEF regime) or taxed annually on the increase in value, if any, of the PFIC stock (i.e., the mark-to-market regime). US shareholders generally are subject to special reporting requirements with respect to an investment in a PFIC.
If the US investor does not make either a QEF or mark-to-market election with respect to its PFIC stock, the US investor is subject to taxation under the default, excess distribution regime. Under this regime, ‘excess distributions’ are subject to special tax and interest charge rules. If a PFIC makes an actual distribution, the distribution generally will be treated as an excess distribution to the extent it exceeds 125% of the average of the distributions made with respect to the stock over the three immediately preceding years (or the US person’s actual or deemed holding period, if shorter). Furthermore, gains on dispositions of PFIC stock generally are treated as excess distributions.
The excess distribution is allocated ratably to each day in the US investor’s actual or deemed holding period. Any amount allocated to a prior tax year in the holding period in which the foreign corporation qualified as a PFIC (a ‘prior PFIC year’) is subject to tax at the highest marginal tax rate in effect for that year. All other amounts are included in income currently as ordinary income.
The special tax amounts for prior PFIC years also are subject to an interest charge, which is designed to eliminate the benefit of the tax deferral that arises out of having an overseas investment for which no current US income taxes are paid. Finally, PFICs can be owned indirectly through other entities, including other PFICs, under ownership attribution rules.
Dividends from PFICs do not qualify for the 100% DRD when received by US corporate taxpayers or for the reduced rate of taxation on qualified dividend income when received by US individual taxpayers.
Once a foreign corporation qualifies as a PFIC at any time during a US person's holding period for stock in such foreign corporation, it remains a PFIC in such US person's hands unless a timely QEF election or mark-to-market election is made. Alternatively, the US investor could ‘purge’ the PFIC taint from the prior portion of its holding period (and pay any applicable tax and interest) or seek relief to file the relevant election retroactively as of the beginning of its holding period, if certain requirements are satisfied.
In general, under the FIRPTA rules — which derive their name from the legislation that outlined them, the Foreign Investment in Real Property Tax Act of 1980 — gain or loss from the disposition by a foreign person of a US real property interest (USRPI) is treated as if the gain or loss were effectively connected to the conduct of a US trade or business and, accordingly, is subject to US income tax under normal graduated tax rates. Withholding of tax generally is required on any disposition of a USRPI.
A USRPI includes any interest, other than an interest solely as creditor, in real property (including an interest in a mine, well, or other natural deposit) located in the United States or the US Virgin Islands. The term ‘real property’ includes: (1) land and unsevered natural products of the land; (2) improvements; and (3) personal property associated with the use of real property. In addition to a direct interest in US real property, a USRPI includes an interest in a domestic corporation if, at any time during the shorter of (1) the period after June 18, 1980, during which the taxpayer held the interest or (2) the five-year period ending on the date of the disposition of the interest in the corporation, the domestic corporation was a US real property holding company (USRPHC).
In general, a domestic corporation is a USRPHC if the fair market value of its USRPIs equals or exceeds 50% of the fair market value of the sum of (1) its USRPIs, (2) its interests in real property located outside the United States, plus (3) any other of its assets that are used or held for use in a trade or business.
Depreciation deductions are allowances that may be taken for capital outlays for tangible property. For property placed in service after 1986, capital costs must be recovered by using the modified accelerated cost recovery system (MACRS) method. Depending on the type of tangible property, the general cost recovery periods are 3, 5, 7, 10, 15, 20, 27.5, and 39 years (31.5 years for property placed in service before May 13, 1993). The cost recovery methods and periods are the same for both new and used property. Most tangible personal property falls in the three-, five-, or seven-year class.
Property placed in the three-, five-, seven-, or 10- year class is depreciated by first applying the 200% declining-balance method and then switching to the straight-line method when use of the straight-line method results in a larger depreciation deduction than the 200% declining-balance method. Property in the 15- or 20-year class generally is depreciated by using the 150% declining-balance method and later switching to the straight-line method. An election may be made to use the alternative depreciation system (basically, the straight-line method over generally longer prescribed lives).
Residential rental property generally is depreciated by using the straight-line method over 27.5 years. Nonresidential real property generally is depreciated by using the straight-line method over 39 years (31.5 years for property placed in service before May 13, 1993).
An election to use the straight-line method over the regular recovery period is also available. Alternatively, taxpayers may elect to use the 150% declining-balance method over the regular recovery period for all property other than real property. The 150% declining-balance method is required for AMT purposes. However, as noted above, corporate AMT is repealed for tax years beginning after December 31, 2017.
Special rules apply to automobiles and certain other 'listed' property. Accelerated depreciation deductions can be claimed only if the automobile is used 50% or more for qualified business use as defined in related regulations. Further, for automobiles placed in service after 1986, the allowable yearly depreciation deduction cannot exceed specific dollar limitations.
Separate methods and periods of cost recovery are specified by statute for certain tangible personal and real property used outside the United States (i.e., the alternative depreciation system).
Rapid amortization may be allowable for certain pollution control facilities.
Tax depreciation generally does not conform to book depreciation. Further, tax depreciation generally is subject to recapture on the sale or disposition of certain property, to the extent of gain, which is subject to tax as ordinary income.
The cost of most intangible assets is capitalized and amortized ratably over 15 years.
Corporations can elect to expense, up to a specified statutory amount per year, the cost of certain eligible property used in the active conduct of a trade or business, subject to a taxable income limitation and to a phase-out of the deduction based on total capital spend. This is commonly referred to as the Section 179 deduction. What constitutes property eligible for the Section 179 deduction is very broad. It generally means any tangible property or computer software that is ‘Section 1245 property’ (i.e., property that has been or could have been subject to depreciation or amortization) acquired by purchase for use in the active conduct of a trade or business.
Tax cuts enacted in 2003 temporarily increased the maximum aggregate dollar amount that may be deducted under Section 179 from $25,000 to $100,000 and also increased the phase-out amount from $200,000 to $400,000. These amounts have been further modified and extended several times on a temporary basis, increasing to $500,000 and $2 million, respectively, for tax years beginning in 2010 through 2014. For tax years beginning in 2015, the PATH Act made these amounts permanent. For tax years beginning after 2015, the $500,000 and $2 million amounts are indexed for inflation. For 2017, the inflation-adjusted amounts were $510,000 and $2,030,000, respectively.
For property placed in service in tax years beginning after December 31, 2017, the Act increased the dollar limitation to $1 million, while increasing the cost of property subject to the phase-out to $2.5 million. The new dollar limitations are indexed for inflation for tax years beginning after December 31, 2018.
A 50% special first-year depreciation allowance (i.e., ‘bonus’ depreciation) applies (unless an election out is made) for new (i.e., property with respect to which the original use begins with the taxpayer) MACRS property with a recovery period of 20 years or less, certain computer software, water utility property, and certain improvements to leased or owned real property acquired after December 31, 2007 (but before September 28, 2017), and placed in service before December 31, 2017 (December 31, 2018, for certain aircraft and longer production period property). For property acquired before September 28, 2017, and placed in service before December 31, 2018 (December 31, 2019, for certain aircraft and longer production period property), the bonus depreciation percentage is reduced to 40%. For property acquired before September 28, 2017, and placed in service before December 31, 2019 (December 31, 2020, for certain aircraft and longer production period property), the bonus depreciation percentage is reduced to 30%. Thereafter, bonus depreciation no longer will be available for property acquired before September 28, 2017.
The special allowance applies for regular income tax and AMT purposes. No AMT adjustment is made if the special allowance is used. The special allowance does not apply to property that must be depreciated using the alternative depreciation system or to 'listed property' not used predominantly for business. The special allowance reduces basis before regular depreciation is figured. Claiming bonus depreciation on automobiles also may affect the first-year depreciation limits on such automobiles.
The Act replaces 50% bonus depreciation with 100% bonus depreciation and expands the property eligible for such benefit by repealing the original use requirement. Thus, for certain new and used property acquired and placed in service after September 27, 2017, and before January 1, 2023 (with an additional year for certain aircraft and longer production period property), taxpayers may expense immediately the entire cost of such property. For qualified property placed in service in calendar years 2023, 2024, 2025, and 2026 (2024, 2025, 2026, and 2027 for certain aircraft and longer production period property), 100% is reduced to 80%, 60%, 40%, and 20%, respectively.
For natural resource properties other than timber and certain oil and gas properties, depletion may be computed on a cost or a percentage basis.
Cost depletion is a method of depletion applied to exhaustible natural resources, including timber, which is based on the adjusted basis of the property. Each year, the adjusted basis of the property is reduced, but not below zero, by the amount of depletion calculated for that year. The current-year cost depletion deduction is based on an estimate of the number of units that make up the deposit and the number of units extracted and sold during the year.
Percentage depletion is a method of depletion applied to most minerals and geothermal deposits, and, to a more limited extent, oil and gas. Percentage depletion is deductible at rates varying from 5% to 22% of gross income, depending on the mineral and certain other conditions. Percentage depletion may be deducted even after the total depletion deductions have exceeded the cost basis. However, percentage depletion is limited to 50% (100% for oil and gas properties) of taxable income from the property (computed without allowance for depletion). Generally, percentage depletion is not available for oil or gas wells; exceptions exist for natural gas from geopressurized brine and for independent producers of oil and gas.
The cost of goodwill generally is capitalized and amortized ratably over 15 years, beginning in the month the goodwill is acquired.
Generally, start-up expenditures must be amortized over a 15-year period beginning in the month in which the active trade or business begins; however, certain taxpayers may elect to deduct some expenses in the tax year in which the trade or business begins.
For tax years beginning before January 1, 2018, Section 199 generally provides taxpayers with a 9% deduction for qualified production activities (QPA) income (subject to a taxable income limitation). The deduction is available to all taxpayers actively engaged in QPA. For most corporate taxpayers, the deduction generally will mean a federal income tax rate of 31.85% on QPA income, although certain oil- and gas-related QPA receives a less generous reduction that equates to a federal income tax rate of 32.9% for tax years beginning before January 1, 2018. The deduction also applies in calculating the AMT.
There is a limit on the amount of the deduction equal to 50% of W-2 wages allocable to domestic production gross receipts (DPGR). The deduction generally is not allowed for taxpayers that incur a loss from their production activities or have an overall loss (including a carryover loss) from all activities.
A taxpayer's QPA income is calculated using the following formula: DPGR less the sum of cost of goods sold allocable to such receipts and other expenses, losses, or deductions that are properly allocable to such receipts.
The Act repeals Section 199 for tax years beginning after December 31, 2017.
Bad debt resulting from a trade or business may be deducted in the year the debt becomes wholly or partially worthless. Determining the date the debt becomes worthless may present difficulty.
Deductions for allowable charitable contributions may not exceed 10% of a corporation’s taxable income computed without regard to certain deductions, including charitable contributions themselves. Deductions for contributions so limited may be carried over to the five succeeding years, subject to the 10% limitation annually.
The Internal Revenue Code provides incentives for employers to provide retirement benefits to workers, including employee pension, profit-sharing, and stock bonus plans. The employer is allowed a current deduction up to certain limits for contributions made to fund the retirement benefits and pay plan expenses; an employee’s tax liability is deferred until the benefits are paid.
These programs are subject to the Employee Retirement Income Security Act of 1974 (ERISA), which governs eligibility, vesting, spousal rights, fiduciary duties, reporting and disclosure, and other related issues, as well as to the extensive requirements for tax qualification under the Internal Revenue Code. Qualified retirement plans must not discriminate in favor of highly compensated employees, and are subject to additional rules regarding eligibility, vesting, benefit accrual, funding, spousal rights, and fiduciary duties.
For-profit, non-government employers generally have two types of available plans. The first category is the defined benefit plan under which employees earn a right to a retirement benefit based on their years of service and compensation and/or other factors, payable beginning at their retirement and generally continuing for life. The employer contributes on an on-going basis to pre-fund the amount of retirement income that ultimately will be owed to employees under the plan. Any investment gains or losses will not affect the amount of benefits paid to participants but will affect the amount an employer must contribute to cover its obligation.
The second category is the defined contribution plan, including the commonly offered '401(k) plan' and profit-sharing plans, under which employees’ benefits are based on the value of their individual accounts. The employer's contributions (if any) are allocated among the separate accounts of participating employees. Investment gains or losses and the history of contributions will affect the value of a participant's account at retirement but will not affect an employer's contributions because the employer is not obligated to ensure any specified level of benefit in the plan. A 401(k) plan also provides employees a pre-tax means of saving for their own retirement, and permits the employer to match these contributions.
Non-profit employers, including charities and government entities, may offer similar retirement plans, although some different requirements apply. Small employers and self-employed individuals also have similar options available but may be subject to different requirements.
No deduction generally is allowed for fines or penalties paid to the government for violation of any law for amounts paid or incurred before the enactment date of the Act (i.e., before December 22, 2017).
For amounts paid on or after December 22, 2017, all payments to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law are nondeductible, unless such payments clearly reflect amounts paid for restitution or to come into compliance with the law and are identified as such in the underlying agreement.
An amount paid, directly or indirectly, to any person that is a bribe, kickback, or other illegal payment is not deductible.
State and municipal taxes imposed on businesses are deductible expenses for federal income tax purposes. Note: Individual taxpayers, unlike corporations, are subject to a limitation on the deduction for state and local taxes. See section VI.F.9.a. below.
For tax years beginning before January 1, 2022, corporations can continue to elect under Section 174 to expense all research and experimental (R&E) expenditures that are paid or incurred during the tax year or to defer the expenses for 60 months. Taxpayers also can make a special election under Section 59(e) to amortize their research expenditures over 120 months. A portion of the research expenditures may qualify for a research tax credit that is described in section N.5 below.
For tax years beginning after 2021, the Act repeals expensing of Section 174 R&E expenditures, including software development costs, and requires such expenditures to be capitalized and amortized over a five-year period (foreign R&E expenses over 15 years), beginning with the midpoint of the tax year in which the specified R&E expenditures were paid or incurred. R&E expenditures that are attributable to research that is conducted outside the United States would be capitalized and amortized over a period of 15 years.
The IRS in July 2014 finalized regulations under Section 174 that are considered taxpayer favorable. The final regulations address several issues related to whether the subsequent sale or use of tangible property created through research is deductible, clarify the depreciable property rule, clarify that integration testing could qualify as an R&E expense, provide a definition of ‘pilot model,’ and introduce the ‘shrink-back’ rule concept to the Section 174 context. The final regulations were not affected by the Act.
An NOL is generated when business deductions exceed gross income in a particular tax year. NOLs generated in tax years ending before January 1, 2018, may be carried back to offset past income and possibly obtain a refund or carried forward to offset future income. Generally, a loss generated in tax years ending before January 1, 2018, may be carried back two years and, if not fully used, carried forward 20 years.
Special rules regarding NOLs generated in tax years ending before January 1, 2018, may apply (1) to specified liability losses or (2) if a taxpayer is located in a qualified disaster area.
Under the Act, NOLs generated in tax years ending after December 31, 2017, generally may not be carried back and must instead be carried forward indefinitely. (For carrybacks and carryforwards of NOLs by individuals, see section VI.F.9.e. below.)
Furthermore, for NOLs generated in tax years beginning after December 31, 2017, the NOL deduction is limited to 80% of taxable income (determined without regard to the deduction).
Complex rules may limit the use of NOLs after a reorganization or other change in corporate ownership. Generally, if the ownership of more than 50% in value of the stock of a loss corporation changes, a limit is placed on the amount of future income that may be offset by losses carried forward.
Subject to certain limitations, a US corporation generally may claim a deduction for royalties, management service fees, interest charges, and other items paid to foreign affiliates, to the extent the amounts are actually paid and are not in excess of what it would pay an unrelated entity (i.e., they are at arm's length). US tax, collected through withholding, on these payments generally is required. Under certain circumstances, however, such payments may give rise to a BEAT liability for the US payor, as discussed above. See also discussion of new hybrid rules below.
A US corporation generally may claim a deduction for insurance premiums paid, even if the insurance is purchased from an affiliated insurance company (captive insurance company). To be treated as insurance for tax purposes, the insurance arrangement must involve the transfer of insurance risk, result in adequate risk distribution, and meet commonly accepted notions of insurance under US tax principles.
If the captive insurance company is domiciled outside the United States, the premium payments would be subject to an excise tax of 4% on direct premiums (other than for life insurance) and 1% on life insurance and reinsurance premiums. However, the excise tax may be exempt under a tax treaty. A 2016 IRS revenue ruling concluded that the 1% excise tax under Section 4371(3) no longer will apply to premiums paid for reinsurance policies issued by one foreign reinsurer to another foreign reinsurer even if the underlying risks are US risks. Insurance premiums are not subject to withholding taxes (other than under FATCA).
Note: Consider the impact of the Act on inbound companies with one or more captive insurance structures with respect to both direct as well as reinsurance business. In particular, the BEAT provisions discussed above may have specific implications for companies making payments to non-US captive insurance companies.
Under the Act, Section 163(j) limits US net business interest expense deductions to the sum of business interest income, 30% of ‘adjusted taxable income’ (ATI), and floor plan financing interest of the taxpayer for the tax year, effective for tax years beginning after 2017.
The Section 163(j) interest limitation broadly applies to the ‘business interest’ of any taxpayer (regardless of form) and regardless of whether the taxpayer is part of an ‘inbound’ group or an ‘outbound’ group. Section 163(j) applies regardless of whether the interest payment is to a foreign person or a US person, and regardless of whether such person is related or unrelated. ATI is roughly equivalent to EBITDA until January 1, 2022, when ATI roughly would be equivalent to EBIT. Disallowed business interest expense can be carried forward indefinitely.
On April 2, 2018, Treasury and the IRS released Notice 2018-28, which provided interim guidance with respect to Section 163(j). They then issued proposed regulations on November 23, 2018. The proposed regulations address the mechanics of determining the interest expense limitation and clarify the application of the limitation to consolidated groups, RICs, REITs, partnerships, controlled foreign corporations, and other foreign corporations. Notably, they expand upon (and depart from) the statutory text by introducing a broad new definition of ‘interest’ solely for the purposes of Section 163(j) that includes certain interest equivalents.
New Section 267A regarding hybrid entities and hybrid transactions denies a deduction for interest and royalty payments paid or accrued by a US corporation to a related foreign party pursuant to a ‘hybrid transaction’ or made by or to a ‘hybrid entity’ if (i) there is no income inclusion by the foreign related party for foreign purposes (based on country of residence), or (ii) the related party is allowed a deduction for foreign purposes. Section 267A applies with respect to tax years that begin after December 31, 2017.
Proposed regulations with respect to Section 267A were issued on December 20, 2018. They provide certain clarification with respect to the scope of Section 267A as applied to hybrid arrangements involving the payment of interest or royalties by certain branches, reverse hybrid entities, and other hybrid mismatch arrangements.
Under the Act, for tax years beginning after 2017 and before January 1, 2026, new Section 250 allows as a deduction an amount equal to 37.5% of a domestic corporation’s foreign-derived intangible income (FDII) plus 50% of the GILTI amount included in gross income of the domestic corporation under new Section 951A (discussed above). For tax years beginning after December 31, 2025, the deduction is reduced to 21.875% and 37.5%, respectively. If, in any tax year, the domestic corporation’s taxable income is less than the sum of its FDII and GILTI amounts, then the 37.5% FDII deduction and the 50% GILTI deduction are reduced proportionally by the amount of the difference.
The Protecting Americans from Tax Hikes (PATH) Act, signed into law on December 18, 2015 (PATH Act), included retroactive, permanent extension of the research credit and certain other business and individual tax provisions; more than 30 other expired provisions were renewed retroactively for either two or five years.
The general business incentives that were made permanent by the PATH Act include the following:
The general business incentives extended by the PATH Act to either 2016 or 2019 include:
Generally, in any year, a taxpayer can choose whether to take as a credit (subject to limitation) or as a deduction foreign income, war profits, and excess profit taxes paid or accrued during the tax year to any foreign country or US possession. An FTC reduces US income tax liability dollar for dollar, while a deduction reduces US income tax liability at the marginal rate of the taxpayer.
For taxpayers with an NOL for the year, the FTC is of no value in such year. However, a benefit might be received either in an earlier year (through a refund of previously paid taxes) or a later year (through a reduction of future taxes). Note also that a taxpayer has the ability to switch from deduction to credit at any time in a 10-year period commencing when the foreign taxes were paid or accrued. Generally, an FTC may be carried back one year and, if not fully used, carried forward 10 years.
The FTC goes beyond direct taxes to include foreign taxes paid 'in lieu of' a tax on income, war profits, or excess profits that otherwise generally would be imposed. It also includes deemed-paid (indirect) taxes paid for certain US corporate shareholders of non-portfolio foreign corporations. FTCs (and foreign tax deductions) are disallowed for foreign taxes paid on amounts that are eligible for the new 100% DRD. The FTC system has numerous other limitations to mitigate potential abuses of the credit by the taxpayer.
Various business credits are available to provide special incentives for the achievement of certain economic objectives. In general, these credits are combined into one 'general business credit' for purposes of determining each credit's allowance limitation for the tax year. The general business credit that may be used for a tax year is limited to a tax-based amount. In general, the current year's credit that cannot be used in a given year because of the credit's allowance limitation may be carried back to the tax year preceding the current year and carried forward to each of the 20 years following the current year.
In general, the current-year business credit is a combination of the following credits for 2019:
A 'work opportunity tax credit' is available for employment of certain targeted groups of individuals who are viewed as difficult to employ. 'Creditable' wages generally are the first $6,000 of wages paid to each qualified employee for the year. The credit is 25% of creditable wages for employees who worked for at least 120 hours but fewer than 400 hours and 40% of creditable wages for employees who worked for at least 400 hours, for a maximum credit of $2,400. The PATH Act extended this credit through 2019.
The research tax credit under Section 41 is available for companies that incur qualified research expenditures (QREs) to develop new or improved products, manufacturing processes, or software in the United States.
The PATH Act made the research credit a permanent provision of the Internal Revenue Code. The credit was first enacted in 1981 on a temporary basis to help increase research spending in the United States, and had been extended on a temporary basis numerous times since then.
The research credit generally is computed by calculating current-year QREs over a base. The base is calculated using either the regular research credit (RRC) method or the alternative simplified credit (ASC) method. Under the RRC method, the credit equals 20% of QREs for the tax year over a base amount established by the taxpayer in 1984–1988 or by another method for companies that began operations after that period.
The ASC equals 14% — for the 2009 tax year and thereafter — of QREs over 50% of the average annual QREs in the three immediately preceding tax years. If the taxpayer has no QREs in any of the three preceding tax years, the ASC will be 6% of the tax year’s QREs. Under final regulations issued in February 2015, the ASC may be claimed on an amended return for a tax year ending after February 27, 2015 — provided the taxpayer has not previously claimed research credits for such year — as well as on the taxpayer’s original return for such year. Taxpayers using the RRC also may take a 20% credit for incremental payments made to qualified organizations for basic research. For tax years ending after August 8, 2005, taxpayers also may take the Energy Research Consortium Credit, which provides a 20% credit for expenditures on qualified energy research undertaken by an energy research consortium.
The deduction for R&E expenditures (see section I.M.14 above) must be reduced by the entire amount of the credit unless an election is made to reduce the amount of the credit.
There generally are no specific incentives related to inbound investment at the federal level, other than certain portfolio debt, short-term debt (183 days or less), and bank deposit exceptions. The portfolio debt exception enables nonresidents and foreign corporations to invest in certain obligations (which must meet certain requirements to qualify as 'portfolio debt') in the United States without being subject to US income tax (or withholding) on the interest income.
Interest income received on certain qualified private activity bonds generally is exempt from federal income tax. This enables a business enterprise to issue the bonds at a lower interest rate. The Act preserves this exemption, but repeals the interest exemption for advance refunding bonds issued after 2017.
Most US inbound companies no doubt are aware of recent US developments regarding cross-border transactions characterized as ‘corporate inversions.’ Both the executive and legislative branches of the US government continue to express concern about these transactions; however, the focus shifted in 2017 from taking administrative actions to make it more difficult for US companies to invert and reduce the tax benefits of inversions to enacting tax reform legislation to make US companies more competitive and the United States a more attractive place to do business.
On the administrative front, final Section 385 regulations are under review by the Trump Administration. Treasury and the IRS on October 13, 2016, released final and temporary regulations under Section 385 that address whether certain instruments between related parties are treated as debt or equity. The government made significant changes to the proposed regulations in response to public comments, significantly narrowing the application of the final rules. In addition, in July 2017 the IRS announced a one-year delay in application of the Section 385 documentation requirements. However, controversy remains, and Treasury may take administrative steps to revoke or modify the regulations. On September 21, 2018, Treasury issued proposed regulations that would revoke the documentation rules under the Section 385 regulations. (For discussion of the Section 385 regulations, see Section VIII below.)
On April 21, 2017, President Trump signed an executive order instituting an immediate review of ‘all significant tax regulations’ since the beginning of 2016 and requiring Treasury to provide an interim report on its findings within 60 days. Treasury Secretary Steven Mnuchin confirmed that this review would include the Section 385 regulations, among others.
On the legislative front, certain changes made by the Act to the US international tax system take away some of the incentives to engage in inversion transactions, such as by significantly lowering the US corporate income tax rate and repealing the corporate AMT.
Moreover, the Act includes a number of provisions that may have the effect of making inversion transactions less attractive, including making dividends paid by inverted companies to US individual shareholders ineligible for the lower tax rate for qualified dividend income, tightening interest deductibility limitations for all companies (thus making it more difficult to erode the US tax base through interest payments), imposing the BEAT (which has especially strict provisions targeted specifically at inverted companies), and making it more difficult for non-US-parented companies to engage in transactions to de-control their CFCs.
Under US tax laws, a foreign person generally is subject to 30% tax on the gross amount of US-source income (other than capital gains) that is not effectively connected with a US trade or business. Persons making US-source payments ('withholding agents'), such as US-source interest, dividends, and royalties, to foreign persons generally must withhold 30% of the gross payment as tax withheld at source and deposit it with the US government. In other situations, withholding agents may apply a lower rate of withholding if the payee certifies it is eligible for a reduced rate under a tax treaty or by operation of US tax law (e.g., portfolio interest exemption). The withholding agent generally is liable for 100% of any tax that should have been collected through withholding but was not. Penalties and interest also may apply. See the latest edition of IRS Publication 515.
The United States has entered into income tax treaties with more than 60 countries in order to avoid double taxation of income and to prevent tax evasion. See Appendix A or the IRS web site for a summary of the benefits resulting from these treaties. Read more about US Tax treaties.
The ability to apply a reduced rate of withholding depends on whether the withholding agent receives timely and valid documentation certifying the foreign payee’s eligibility for a lower rate of tax that it can reliably associate with a payment. Valid documentation includes documentation provided using a withholding certificate (from the Form W-8 series). Since there are various types of Forms W-8 (e.g., W-8BEN, W-8BEN-E, W-8IMY, etc.), the payee must determine the correct form to be completed. The withholding agent must review the withholding certificate for completeness and for inconsistencies prior to reducing the rate of withholding.
Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals), is used to establish that an individual is not a US person and is the beneficial owner of the income related to which the form is being provided. Form W-8BEN also can be used to claim a reduced rate of withholding based upon an applicable income tax treaty. Treaty claims made by nonresident alien individuals who provide independent personal services in the United States are made on Form 8233, Exemption from Withholding on Compensation for Independent (and Certain Dependent) Personal Services of a Nonresident Alien Individual, instead of on Form W-8BEN.
Among other purposes (e.g., FATCA), Form W-8BEN-E, Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities) is used to establish that the payee entity is not a US person and is the beneficial owner of the income for which the Form W-8BEN-E is being provided. Form W-8BEN-E also can be used to claim a reduced rate of withholding based upon an applicable income tax treaty.
In addition to Form W-8BEN or Form W-8BEN-E, the following forms may be provided by a non-US payee to establish that it is eligible for a reduced withholding rate:
Forms W-8BEN, W-8BEN-E, W-8ECI, and W-8EXP generally are valid until the end of the third full calendar year from the date the form is signed (expiring December 31 of that year). New forms are required prior to the form expiring. Additionally, a new form is required if there is a change in circumstances that causes the information disclosed by the payee on the forms to become unreliable. For some purposes (not applicable if treaty benefits are claimed), the forms can remain valid indefinitely absent a change in circumstances. Forms W-8IMY are valid indefinitely unless there is a change in the information disclosed by the payee on the forms. Form 8233 is valid for only one year. The IRS updates the forms periodically; persons completing these forms for the first time or renewing an existing form must use the most current version.
All US and non-US entities are responsible for information reporting and backup withholding for payments made to US non-exempt recipients, including US individuals, partnerships, and limited liability companies (LLCs). Backup withholding at the current rate of 24% (for any payments made on or after January 1, 2018; the rate for prior payments was 28%) is required if the US non-exempt recipient fails to provide a taxpayer identification number (TIN) in the proper manner prior to payment or if the payor is instructed to backup withhold by the IRS. Payors that fail to impose backup withholding when required are liable for 100% of the withholding that should have been made but was not.
Payments made to US exempt recipients are not subject to information reporting or backup withholding, and such recipients are not required to provide a TIN. Depending on the payment, exempt recipients include governments (federal, state, and local), tax-exempt organizations under Section 501(a), individual retirement plans, international organizations, foreign central banks of issue, and most corporations and financial institutions.
Payments made to US non-exempt recipients for dividends, gross proceeds, interest, compensation for services, rents, royalties, prizes, awards, and litigation awards, among others, must be reported. A proper TIN should be obtained from all US payees to avoid backup withholding. A TIN is best obtained (and can be required) by receiving a valid Form W-9, Request for Taxpayer Identification Number and Certification, from US non-exempt payees, including exempt recipients. The IRS’s TIN Matching Program can be utilized to verify names or TINs with IRS records to ensure accuracy.
Under the Act, a foreign partner’s gain or loss from the sale or exchange of a partnership interest is treated as effectively connected with a US trade or business to the extent the foreign partner would have had effectively connected gain or loss if the partnership had sold all of its assets in a taxable sale at fair market value and allocated the gain or loss to the foreign partner in the same manner as non-separately-stated income and loss (i.e., generally the partner’s distributive share). The provision (Section 864(c)(8)) applies to a foreign partner that directly or indirectly owns an interest in a partnership that is engaged in a US trade or business.
A provision added to Section 1446 (which generally requires a partnership to withhold tax on effectively connected taxable income (ECTI) allocable to a foreign partner) requires the transferee of a partnership interest to withhold 10% of the amount realized on the acquisition of a partnership interest if any portion of the gain is treated as ECI under the new provision unless the transferor certifies that it is not a foreign person. At the request of the transferor or transferee, Treasury may prescribe a reduced amount of withholding tax if Treasury determines that the reduced amount will not jeopardize the collection of tax on the amount of gain treated as ECI under the provision. If the transferee fails to withhold the tax, the partnership is required to withhold tax from distributions to the transferee partner.
The provision treating gain or loss on the sale of a partnership interest as ECI is effective for sales, exchanges, and dispositions after November 27, 2017. The withholding tax provision, however, is effective for sales, exchanges, and other dispositions after December 31, 2017, although, as noted below, under Notice 2018-08, the withholding provision is suspended temporarily with respect to dispositions of publicly traded partnership interests.
Note: On December 29, 2017, the IRS issued Notice 2018-08, providing that withholding on dispositions of interests in publicly traded partnerships under Section 1446(f) is suspended until additional guidance is issued. Notice 2018-08 indicates that the forthcoming guidance will be prospective and will include transition rules that are intended ‘to allow sufficient time’ to prepare for implementation of the rules. In addition, Notice 2018-08 requests comments on how the rules should be applied to publicly traded partnerships, and whether a similar suspension or additional guidance is needed for dispositions of non-publicly-traded partnership interests.
On April 2, 2018, the IRS issued Notice 2018-29, providing interim guidance regarding the procedures for withholding under Section 1446(f). The Notice was meant to apply while regulations were being drafted by Treasury and the IRS. The Notice suspended the liability of partnerships for tax that should have been withheld by transferees but was not. Transferees are directed to use procedures under Section 1445 (relating to transfers of US real property interests by foreign persons), specifically Form 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests, and Form 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests, to report the disposition and withholding tax within 20 days of the transaction. The Notice also sets forth guidance for various types of certifications that can be provided by the transferor or the partnership to the transferee that could reduce or eliminate the amount required to be withheld.
Any taxes withheld on payments made to non-US payees must be reported to the IRS on Form 1042, Annual Withholding Tax Return for US Source Income of Foreign Persons. Form 1042 must be filed with the IRS on or before March 15 following the calendar year in which the income subject to reporting was paid, unless an extension of time to file is obtained. Form 1042 must be filed if a Form 1042-S is required to be filed (see below), even if there is no withholding on the payment (e.g., because of an applicable tax treaty).
A withholding agent must file with the IRS and furnish to each foreign payee Form 1042-S, Foreign Person’s US Source Income Subject to Withholding. Form 1042-S is the information return used by withholding agents to report US-source payments paid to specific non-US payees. Form 1042-S must be filed with the IRS and furnished to the non-US payee on or before March 15 following the calendar year in which the income subject to reporting was paid, unless an extension is obtained. Form 1042-S is required whether or not withholding applied to the payments. Form 1042-T is used to transmit Forms 1042-S to the IRS. Financial institutions must file Forms 1042-S electronically (even if less than 250 forms), as must any withholding agent that files 250 or more forms for a calendar year. While special rules apply to partnerships, in general partnerships with more than 100 partners must file Forms 1042-S electronically. Electronic filing is done by use of the Filing Information Returns Electronically (FIRE) system.
A US entity engaged in a trade or business that during the calendar year makes payments to a US non-exempt payee totaling $600 or more must report the amount of the payments on Form 1099-MISC, Miscellaneous Income. Payments subject to Form 1099-MISC reporting include compensation for services (other than wages paid to employees), rents, royalties (reporting required for amounts beginning at $10), commissions, gains, and certain types of interest. US payers are responsible for reporting the payment whether made by cash, check, or wire transfer. Amounts paid by payment card (including debt, credit, and procurement) or through third-party payment networks (i.e., internet payment service providers) are not subject to Form 1099-MISC reporting by the payor.
Form 1099-MISC must be furnished to payees no later than January 31 of the year subsequent to the year of payment and must be filed with the IRS by February 28 of the year following the payment if filed on paper or March 31 if filed electronically. Requests to extend these dates may be made, but extensions are not automatic.
If the payor is required to file 250 or more Forms 1099-MISC, it must file the forms electronically with the IRS by use of the FIRE system. If Forms 1099-MISC are filed electronically, the due date for filing with the IRS is by March 31, with the exception of Forms 1099-MISC that contain income reported in Box 7 as “Nonemployee Compensation.” Those forms must be filed with the IRS, either on paper or electronically, by January 31 of the year following payment.
The payor also must file Form 945, Annual Return of Withheld Federal Income Tax, to report any backup withholding. Form 945 must be filed with the IRS by January 31 of the year succeeding the year of payments.
FATCA, the Foreign Account Tax Compliance Act, was enacted in 2010 to prevent and detect offshore tax evasion by US persons. FATCA seeks to compel disclosure of US ownership of foreign accounts, interests, and assets. While the name may imply that FATCA is directed at financial institutions, many global companies outside the financial services industry may be affected if they have entities in their worldwide network falling under the purview of FATCA, hold financial accounts outside the United States, or have operational units that make or receive payments subject to FATCA.
FATCA added chapter 4 (Sections 1471-1474) to the Internal Revenue Code. FATCA requires many foreign financial institutions (FFIs) to enter into agreements with the IRS under which they undertake procedures to identify which of their accounts are held by certain US persons and annually report information regarding such accounts to the IRS. An FFI that has entered into such an agreement is known as a 'participating FFI.’ In addition, some nonfinancial foreign entities (NFFEs) must report information regarding certain direct or indirect US owners to withholding agents.
Non-compliance with FATCA triggers a 30% withholding tax on certain US-source fixed or determinable, annual, or periodical (FDAP) payments. However, IRS regulations provide for various exceptions, such as categories of FFIs or NFFEs that are eligible for lightened compliance obligations. As discussed below, the IRS issued proposed regulations in December 2018 providing that withholding on gross proceeds from the disposition of securities issued by US persons will not become subject to withholding under FATCA, contrary to prior guidance.
FATCA imposes registration, due diligence, information reporting, and tax withholding obligations on entities that qualify as FFIs. Legal entities with FFI characteristics must determine whether they are, in fact, FFIs and, if so, whether they are required to register with the IRS.
Multinational corporations (MNCs) should examine their treasury centers, retirement funds, and holding companies, to name a few examples, to determine whether they meet the definition of an FFI. Properly identifying the FATCA status of each entity in a large organization can take significant time and effort and must be repeated regularly, because the final FATCA regulations impose several different income and asset tests at both the entity and global organization levels. In addition, the IRS has entered into intergovernmental agreements (IGAs) with many nations that contain certain modifications or clarifications that apply to entities in the particular jurisdiction. See Section iv. The impact of IGAs, below.
Regardless of FATCA status, obligations are imposed on withholding agents with respect to US-source FDAP income, which include many MNCs. These companies must have processes and procedures in place to identify and categorize non-US payees for FATCA purposes, report, and potentially apply 30% withholding tax to avoid being liable for the withholding tax and potential interest and penalties. Even if a foreign entity is not an FFI, FATCA still requires the recipient of a US-source payment to establish its FATCA status with appropriate documentation including, for certain types of NFFEs, information regarding US persons that own (directly or indirectly) more than 10% of the NFFE.
There are several important exemptions from FATCA withholding on US-source FDAP payments. For example, FATCA withholding should not apply when the payee provides to the withholding agent appropriate documentation demonstrating that the payee is not subject to withholding (i.e., the entity documents its FATCA status and provides all required information to the withholding agent, and that status is not ‘nonparticipating FFI’). Even though FATCA withholding does not apply, reporting still is required. The withholding agent also must evaluate whether reporting and withholding apply under the information reporting rules discussed in the previous section.
Treasury regulations provide a number of categories of FFIs that may be treated as deemed-compliant with FATCA or as ‘exempt beneficial owners.’ These categories of FFIs have characteristics that are considered to present a lower risk of use for tax evasion by US persons. Accordingly, these entities do not have to enter into an FFI agreement with the IRS (though they may still have to register) and generally will not be required to perform the same due diligence and reporting that participating FFIs must perform.
NFFEs that either have no substantial US owners or that properly identify these owners to withholding agents should not be subject to withholding, nor should NFFEs that are deemed by the IRS to represent a low risk of US tax evasion, such as publicly traded companies and their affiliates, and those engaged in active trades or businesses. A withholdable payment made to a documented non-US entity is not subject to FATCA withholding, but reporting may apply.
MNCs need a FATCA compliance program to ensure that all necessary FATCA classifications, documentation, monitoring, and reporting are undertaken. This process should be documented in a series of policies and procedures ensuring that the process has controls that can be replicated and tested. Further, the program should highlight changes in business practices that may be necessary for FATCA compliance, and inform senior management that all areas of the organization have been reviewed according to requirements.
To mitigate certain foreign legal impediments to FATCA compliance, IGAs have been negotiated between the US Treasury and other governments. Under certain IGAs, known as Model 1 IGAs, information is exchanged directly between the IRS and the foreign taxing authority. This obligates entities in IGA jurisdictions to report information to their government that may not have been required or permitted in the past. Other IGAs, known as Model 2 IGAs, provide that local governments will direct FFIs resident in the jurisdiction to report directly to the IRS.
Assessing FATCA’s impact requires identifying whether an IGA applies to the entity at issue. Provisions in the final regulations or in any IGA that provide more favorable results may be utilized. Treasury has focused on negotiating consistent requirements in each IGA, but there are noticeable differences in the agreements signed to date. For an MNC, this will require an analysis of the applicable FATCA rules across all jurisdictions in which it operates.
FATCA imposes the most significant obligations on FFIs. Companies engaged in nonfinancial businesses may think that few or none of their foreign entities constitutes an FFI. However, the definition of an FFI is broad and includes more types of entities than one might expect.
Although the rules provide various exceptions, the following are types of entities that may be FFIs:
When an MNC determines that it has entities within its global structure that are FFIs, the MNC should determine if such entities may qualify for an exception from FFI status. One of the primary exceptions covers holding companies and treasury centers that are part of a group that is determined to be ‘nonfinancial.’ The status of ‘nonfinancial’ is based on the ratios of active vs. passive income and assets, as well as the income generated by FFIs within the group.
If an entity is an FFI, the MNC has to determine whether the FFI must become a participating FFI (or a reporting FFI under an IGA), or if it qualifies for deemed-compliant or exempt beneficial owner status. If the entity does not qualify for such status, it must properly register with the IRS. To avoid the 30% withholding tax on withholdable payments it receives, each FFI must use the IRS’s online FATCA portal to execute an FFI agreement, confirm its due diligence, and receive an identification number, the Global Intermediary Identification Number, or GIIN.
FATCA withholding and reporting generally apply when a multinational business makes a withholdable payment (i.e., a payment of certain US-source FDAP income). From a practical perspective, a large range of payors can be affected—just about any multinational business that makes payments falling within this definition will experience the impact of FATCA. As a result, global organizations should focus their efforts on payment details such as:
The term ‘withholdable payment’ generally refers to the gross amount of US-source interest, dividends, certain insurance premiums, and any financial payment etc., and can include other types of US-source income not otherwise subject to withholding under Chapter 3 of the Internal Revenue Code.
Treasury functions, accounts payable departments, and other areas of a global organization may make withholdable payments. The following are a few common examples of third-party or intercompany payments that may be included in the definition:
Note: Recently proposed regulations would eliminate the obligation to impose FATCA withholding on gross proceeds from the sale of assets that produce US-source interest or dividends. Treasury and the IRS cite complexity and the impact of FATCA intergovernmental agreements on compliance as reducing the need to impose withholding on gross proceeds. Withholding agents are permitted to rely on the proposed regulations immediately. (Reg-132881-17 published December 2018)
Certain nonfinancial payments are not treated as withholdable payments under FATCA. However, some of these payments (such as payments for services, rents, and royalties) remain subject to existing information reporting and withholding requirements. Certain obligations in existence on July 1, 2014, are considered ‘grandfathered’ and are not subject to FATCA withholding.
As a core concept of FATCA, payors of a withholdable payment must ask, ‘who is the payee?’ and ‘is the payee FATCA compliant?’ IRS forms, such as W-8BEN-E and W-8IMY, enable payees and intermediaries to certify both their FATCA status and information relevant to Chapter 3 of the Code. In addition, the regulations that harmonize the FATCA requirements with the existing Chapter 3 withholding requirements have altered the way in which documentation can be used and have also modified the way in which other types of information can be used to facilitate proper withholding and reporting.
Payors will need to ensure that their counterparties are FATCA compliant and exempt from withholding. For example, if the withholding agent receives sufficient documentation, such as a global intermediary identification number (GIIN) from an FFI and a valid Form W-8, withholding is not required (although reporting is required).
Those entities within a group receiving withholdable payments may be subject to 30% FATCA withholding if they cannot provide proper documentation. These may include an NFFE located outside of the United States, which may be treated as a ‘passive NFFE’ and subject to FATCA withholding if it fails to timely and properly identify itself to its withholding agent and provide information regarding its ownership.
Businesses that do not adhere to the obligations under FATCA may face a variety of consequences, with possible loss of 30% of the value of specific payments being of foremost concern. Consistent with other US information reporting regimes, a payor that fails to deduct and remit FATCA withholding when required will be liable for 100% of the amount not withheld as well as related interest and penalties.
US corporate taxpayers are taxed on an annual basis. Corporate taxpayers may choose a tax year that is different from the calendar year. New corporations may use a short tax year for their first tax period, and corporations changing tax years also may use a short tax year.
The US tax system is based on the principle of self-assessment. Legislation enacted in 2015 changed filing dates for corporate, partnership, and certain other returns filed for tax years beginning after December 31, 2015. As a result of the legislation, a calendar-year corporate taxpayer generally must file an annual tax return (generally Form 1120) by the 15th day of the fourth month following the close of its tax year (April 15). Such C corporations also receive a six-month automatic extension to file. Failure to timely file may result in penalties.
Wage and Tax Statement
Employers must provide employees with statements regarding total compensation
Must be sent to employees on or before January 31, with copies to the Social Security Administration.
Information returns to be provided to recipients of dividends and distributions, interest income, non-employee compensation, miscellaneous income, etc.
Must be sent to recipients on or before January 31.
1120 series, including 1120S (for S corporations) and 1120F (for foreign corporations)
US Corporation Income Tax Return
Income tax returns for domestic corporations or foreign corporations with US offices.
C corporations- April 15 for calendar-year returns (Form 7004 may be filed to obtain an automatic six-month filing extension for tax years beginning before January 1, 2026).
S corporations- March 15 for calendar-year returns, with six-month maximum extensions.
Partner's Share of Income, Deductions, Credits, etc.
Information returns to be provided to partners by partnerships.
US Return of Partnership Income
Information returns to be filed by partnerships.
March 15 for calendar-year returns (Form 7004 may be filed to obtain an automatic six-month extension)
1094/1095 series (ACA reporting)
Employer-provided health insurance offer and coverage and Transmittal of Information Returns
Statements to covered individuals and full-time employees of health coverage offered and provided by month during the year; transmittal of statements to IRS.
For 2017, Forms 1095 were to have been provided to employees and covered individuals by January 31, 2018, with copies and Forms 1094 sent to the IRS by February 28 (April 2 if filing electronically)
Employer's Annual Federal Unemployment (FUTA) Tax Return
Report of employee wages for FUTA purposes, FUTA taxes, and applicable state credit reductions.
State income tax returns
Income tax returns for states where corporation carries on trade/business.
A taxpayer's tax liability generally must be prepaid throughout the year in four equal estimated payments and fully paid by the date the tax return is initially due for that year. For calendar-year corporations, the four estimated payments are due by the 15th days of April, June, September, and December. For fiscal-year corporations, the four estimated payments are due by the 15th days of the fourth, sixth, ninth, and 12th month of the tax year. Generally, no extensions to pay are allowed. Failure to pay the tax by the due dates can result in estimated tax and late payment penalties and interest charges.
The installment payments must include estimates of regular corporate income tax, environmental tax, and, for foreign corporations, the tax on gross transportation income. To avoid a penalty, corporations must calculate the installment payments based on at least 25% of the lesser of (i) the tax shown on the current tax return, or (ii) the prior year's tax liability, provided that the tax liability was a positive amount in the prior year and that such year consisted of 12 months. However, corporations with taxable income of at least $1 million (before use of NOLs or capital loss carryforwards) in any of the three preceding years may not calculate the installment based payment on the prior year's tax liability, except in determining the first installment payment. Instead, such corporations must calculate the installment payments based on the tax shown on the current year’s tax return.
In 2017, corporations with $1 billion or more in assets were required to make estimated tax payments in the months of July, August, or September in varying amounts. That special rule was applicable for payments in 2017, but will not be applicable for payments in 2018 and 2019. However, in 2020, these same corporations will be required to make estimated tax payments in varying amounts.
The annualized income installment is the product of the tax on the corporation’s taxable income for the corresponding portion of the tax year on an annualized basis, and reduced by all prior required installments for the tax year. A corporation can choose between using the standard monthly periods or either of two optional monthly periods. An election to use either of the two optional monthly periods is effective only for the year of election. The election must be made on or before the date required for the first installment payment. Adjusted seasonal installments may be used only if the average of the corporation's taxable income for the same six-month period in the three preceding years was 70% or more of annual taxable income.
Traditionally, the IRS focus on large businesses consisted of examinations that would cover most items reported on an entity’s tax return. The IRS has moved away from this traditional examination structure to more streamlined and issue-focused examinations. Smaller businesses and individuals with lower incomes and less complicated tax returns generally have always been subject to similar issue-focused examinations.
The IRS Large Business and International Division (LB&I) has implemented procedures in its efforts to move away from continuous audits of large corporate taxpayers. These changes will allow LB&I to conduct issue-focused examinations, resulting in limited-scope examinations for this group of taxpayers. As part of these changes in examination processes, the IRS in January 2017 began announcing ‘compliance campaigns’ identifying areas of non-compliance. The IRS currently has announced 50 such compliance campaigns. The campaigns cover issues such as the Section 199 deduction, US distributors of imported goods with losses or minimal profits, structures used to repatriate funds tax-free into the United States, and the Section 965 transition tax, . The IRS intends to continue to announce more campaigns.
Currently, the IRS continues to focus on ‘abusive payments’ related to contribution to capital of a corporation, domestic manufacturing deduction, foreign earnings repatriation, foreign tax credit ‘generators,’ repairs vs. capitalization change in accounting method, research credit claims, transfer of intangibles/offshore cost sharing, withholding taxes, and worker classification as employee or independent contractor. The IRS also has announced it will add Section 965 (the new transition tax provision discussed above) issues to its enforcement focus as well as other new provisions introduced by the Act.
Inbound insight: Increased cross-border information sharing along with the OECD BEPS initiative (discussed in Section V below) are likely to affect audits of inbound companies, perhaps tempered by current IRS budget and resource issues.
Inbound insight: LB&I has released numerous International Practice Units (IPUs) since 2014. These IPUs provide guidance to IRS examiners in addressing a range of issues involving US federal income taxation of cross-border activities. The IRS has classified its IPUs according to a new organizational scheme, the ‘International Matrix,’ which reflects an updated LB&I approach to cross-border issues generally. Some of those issues include income shifting, inbound financing, and repatriation/withholding. This organizational scheme reflects growing IRS awareness of how taxpayers and their advisors may consider cross-border US federal income tax issues. For example, the previous IRS taxonomy did not distinguish between concerns of inbound and outbound taxpayers.
The IRS Compliance Assurance Program, or CAP, is a collaborative pre-filing program in which the taxpayer and the IRS examination team work together to resolve potential tax issues before the taxpayer files its next tax return.
Entering CAP can be a risk-mitigation strategy for taxpayers by gaining certainty regarding tax positions prior to filing a tax return. Due to the change in focus to more limited-scope examinations by LB&I as discussed above, LB&I recently reviewed the role of CAP, and in September 2018 announced modifications to CAP for tax years 2019 and beyond. LB&I has not added any new participants to the program since 2016, as the IRS was actively reviewing the program. Along with the CAP modification announcement, LB&I announced it expected to review new CAP applicants for the 2020 tax year, but only new applicants that are publicly traded corporations with assets of $10 million or more.
The IRS generally has three years after an original return is filed to assess income taxes. A return will be deemed to have been filed on its original due date, even if the return is actually filed on an earlier date. If a return is filed on extension, the limitations period generally is computed from the filing date. In most instances, the IRS will request a taxpayer extend, by formal agreement, the statute of limitations when a tax year is under examination.
It is important to note that certain provisions of the Internal Revenue Code may allow for an extended statute of limitations in certain circumstances. Most relevant to inbound entities is Section 6501(c)(8), which provides for an extended statute period when a taxpayer has failed to report certain information related to foreign entities and transfers. Some of this information is reported on Forms 5471, 5472, and 926. Under Section 6501(c)(8), the limitations period remains open until the taxpayer provides the required information and may be limited when there is reasonable cause for the failure to provide the information.
Treasury regulations require taxpayers to disclose transactions determined to be abusive or possibly abusive. Current information on these transactions, known as listed and reportable transactions, is available from the IRS website. Certain standards for penalty relief differ with respect to these transactions, and taxpayers should use diligence when reporting matters related to
For US federal tax purposes, the two most important characteristics of a tax method of accounting are timing and consistency. If the method does not affect the timing for including items of income or claiming deductions, it is not an accounting method and IRS approval generally is not needed to change the treatment of the item. In order to affect timing, the accounting method must determine the year in which an income or expense item is to be reported.
In general, in order to establish an accounting method, the method must be consistently applied. Once an accounting method has been adopted for federal tax purposes, any change must be requested by the taxpayer and approved by the IRS. Changes in accounting methods cannot be made through amending returns. The two most common methods of accounting are the accrual-basis and cash-basis methods.
Civil and criminal penalties may be imposed for failing to follow the Internal Revenue Code. The civil penalty provisions may be divided into four categories: delinquency penalties, accuracy-related penalties, information reporting penalties, and preparer or promoter penalties. Many, but not all, of these provisions include exceptions for reasonable cause in not complying. In addition, many include rules as to how a particular penalty interacts with the other penalties.
These four main civil penalty categories may further be divided. First, the delinquency penalties may be divided into failure to file, failure to pay, and failure to make timely deposits of tax. Failure to make timely deposits of tax applies to taxpayers required to make installment payments and withholding tax payments.
Second, the penalties relating to the accuracy of tax returns are divided into the negligence penalty, the substantial understatement penalty, substantial overstatement of pension liabilities, substantial estate or gift tax valuation underestimates, and the valuation penalties. These penalties also are coordinated with the fraud penalty to eliminate any stacking of the penalties. Again, like other provisions, the fraud penalty is not intended to be imposed as a stacked penalty.
The third category of penalties is the information reporting penalties. These penalties may be imposed on those who only have a duty to report information to the IRS.
The fourth category of civil penalties generally applies to tax return preparers or promoters of potentially abusive transactions. These penalties may apply for either negligent or willful behavior and have different standards of review.
The government also may seek penalties when a taxpayer takes a frivolous position in administrative or judicial proceedings.
In addition to these civil penalties, there are international tax-related penalties for failures other than timely and accurate filing — e.g., willful failure to report international boycott activity, failure of a US person to furnish information relating to CFCs and controlled foreign partnerships, and failure of a US person to report foreign bank accounts. Pension and employee benefit-related tax penalties are intended to protect the policy reasons for the tax incentives including, most notably, early withdrawal of pension funds and the requirement that funds in qualified plans be used solely for the benefit of the participants and not the employer. Another group of specialized penalties applies to tax-exempt organizations.
Criminal penalties exist for situations when the failures to comply with the Internal Revenue Code are more egregious and the actions are willful. Criminal penalties apply to both business and individual taxpayers.
In addition to the penalty provisions, interest at statutory rates generally applies to underpayments of tax and is asserted automatically. Interest is not subject to abatement, except in very limited circumstances.