For non-US corporations, it’s often difficult to determine to what extent contacts with the U.S. market triggers a U.S. tax liability.
In this blog, we outline the key U.S. tax concepts at play for foreign businesses and describe why clarity on the issue of U.S. taxability can be elusive.
We then explain the benefits of filing a so-called protective 1120-F with the IRS as a means to protect a foreign business from an onerous result if the business is ultimately caught by the U.S. tax net.
A Form 1120-F Background
In order to understand the Form 1120-F and its protective filing, it’s important to take a step back and understand the mechanics of U.S. tax reporting for non-US businesses.
In general, foreign persons (including entities) are taxed in the U.S. in two circumstances. First, foreign persons are generally subject to tax on U.S.-source “FDAP” (fixed, determinable, annual, or periodic) income, which is sometimes referred to as “passive income.” The types of income that are characterized as FDAP income include interest, rent, royalties, and dividends.
U.S.-source FDAP income is taxed on a “gross” basis (i.e., with no offsetting deductions) at the rate of 30% by way of withholding at source by the U.S. payer, who has primary responsibility as the “withholding agent” to collect, deposit, and report the tax to the IRS.
Second, and more relevant for the current discussion, foreign persons who are considered to earn income “effectively connected” with the conduct of a “trade or business within the United States” are subject to tax at graduated rates on a “net” basis (i.e., reduced by available deductions). Such effectively connected income (“ECI”) is sometimes referred to as “active income” (in contrast to passive-natured FDAP income).
In this regard, it is important to understand that a trade or business within the U.S. is a prerequisite for income to be considered ECI. Therefore, in the case of a foreign entity not engaged in a trade or business in the U.S., subject to certain exceptions (which are not relevant for the current discussion), no income, gain, or loss of such person is treated as ECI.
Form 1120-F for Foreign Corporations with a US Trade or Business
The “U.S. trade or business” concept is used in many different provisions of the Code and regulations, but it has no single comprehensive definition. In general, the determination as to whether a foreign person is engaged in a U.S. trade or business is left to U.S. common law and thus is governed by judicial (court) and administrative (IRS) determinations. Generally, whether a trade or business exists is a question of fact depending on the nature and extent of the foreign person’s economic activities in the United States.
Under case law precedent, a U.S. trade or business exists if the foreign taxpayer’s activities are “considerable, continuous, and regular.” Due to the highly factual nature of this issue, the IRS ordinarily will not even issue rulings on whether a foreign person is engaged in a U.S. trade or business.
The lack of definition clarity can make it difficult to determine to what extent contacts with the U.S. market triggers a U.S. tax liability.
This base line issue often comes up for our non-US clients who have entered the U.S. market, for instance, via:
- A third-party agent such as Amazon
- Digital sales to U.S. customers
- Real estate management activities via third-parties
- Occasional but irregular activities in the U.S.
- A U.S. subsidiary that is disregarded for tax purposes, such as a U.S. LLC
If it’s decided that a foreign corporation does in fact have a US trade or business that generates ECI, the corporation must file a Form 1120-F with the IRS to report the ECI and pay the resulting U.S. tax liability, if any.
The Form 1120-F and the Role of Treaty Law
Similar (although not identical) to the U.S. trade or business and ECI concepts under domestic law, U.S. tax treaties provide that the business profits of an enterprise (i.e., a business) of a contracting state (i.e., a country that is a party to the tax treaty) are taxable only in that state unless the enterprise carries on business in the other contracting state through a permanent establishment (“PE”) and such business profits are attributable to such PE.
So, for instance, if a U.K.-resident entity has a PE in the U.S., then the business profits of such U.K.-resident attributable to the PE in the U.S. would be subject to U.S. taxation. If the U.K.-resident company were to not have a PE in the U.S., then the business profits of such company, even those sourced in the United States, would not be subject to U.S. taxation.
Since the definition of a PE is considered narrower than a U.S. trade or business, foreign corporations located in a treaty country can claim that although it may be generating ECI, since it has no PE in the U.S., it is not subject to U.S. taxation. It should be noted in this regard that the definition of a PE, and the extent to which a treaty resident’s income is attributable to a PE, have been the subjects of decades of controversy, litigation, and interpretation – and not just in U.S. tax treaties, but in other bilateral tax treaties as well. Further, the definition of a PE and the parameters of PE attribution will vary somewhat from treaty to treaty, so each treaty must be analyzed on its own to determine the applicable rules.
If a foreign corporation wants to use a treaty to claim it is exempt from U.S. taxes, a Form 1120-F is required along with a Form 8833 explaining the treaty-based position.
The Benefits (and Risks) of a Protective Form 1120-F
For foreign corporations that are unsure whether their activities rise to the level of a U.S. trade or business, consideration should be given to filing what’s known as a protective Form 1120-F.
The main reason to do this is that the filing preserves the right of the non-US corporation to later claim any deductions against gross income to which it may have been entitled.
If an 1120-F is not filed, and it’s later determined by the IRS that U.S. tax was in fact owed, the foreign corporation will not be allowed to take any deductions from its gross revenue. Filing a protective Form 1120-F solves this potential problem by preserving the ability to deduct normal business expenses, without having to report any income or deductions on the protective return itself.
Some foreign businesses may be hesitant to file a protective 1120-F because it alerts the IRS that tax may be owed, so an audit may more likely be triggered. We believe each case is unique and needs to be reviewed on its own merits to determine whether the protection offered by the filing outweighs this risk.
Foreign companies are given some additional time to make a final decision – the due date of the protective 1120-F is eighteen months subsequent to the original due date of the return.