The branch profits tax - traps for the unwary.

• Author: Attkisson, James R.

Prior to the Tax Reform Act of 1986 (TRA), foreign corporations could face significantly different tax consequences on the distribution of U.S. profits. A domestic subsidiary was subject to a 30% (or lower treaty rate) withholding tax on the remittance of earnings to its parent. Profits from a branch office, however, could be repatriated to the foreign home office without being subject to the additional withholding tax. (A second-tier withholding applied to subsequent distributions by the foreign corporation if certain conditions were met, but the availability of exemptions, treaty reductions and general enforcement difficulties made the effectiveness of this withholding problematic.) To eliminate the disparity, the TRA created Sec. 884, imposing the so-called branch profits tax (BPT).

Sec. 884 attempts to put a foreign branch operation on the same tax footing as a foreign subsidiary. This is accomplished by determining the amount of U.S. earnings theoretically "repatriated" to the foreign parent/shareholders by the branch. To determine this amount, Sec. 884 looks to the "U.S. net equity" of the branch at the beginning and end of the tax year. If this amount has decreased (and is not attributable to an operating loss), there is deemed to have been a repatriation of funds. If post-1986 current or accumulated earnings and profits (E&P) exist, the BPT is imposed on this "dividend equivalent amount," theoretically equalizing tax treatment of the domestic branch and the domestic subsidiary.

There are problems with this approach both as to the underlying theory and the practical application of the provisions. The mechanical manner in which the tax is determined provides many traps for the unwary. Some, but certainly not all, are discussed below.

Definitions and determination of tax

To determine the BPT, one must define certain terms. Regs. Sec. 1.884-1(b) defines the following:

* Dividend equivalent amount (DEA): A foreign corporation's effectively connected earnings and profits (ECE&P), either:

1. reduced for increases in U.S. net equity (but not below zero), or

2. increased for decreases in U.S. net equity, with such increases limited to the foreign corporation's accumulated ECE&P (AECE&P) as of the beginning of the year.

* Effectively connected income (ECI): Income effectively connected with the conduct of a trade or business in the United States.

* Effectively connected earnings and profits: E&P as determined under Sec. 312, with certain...