CHAPTER 13 TAX CONSIDERATIONS: BRANCH VERSUS SUBSIDIARY
| Jurisdiction | United States |
(Feb 1991)
TAX CONSIDERATIONS: BRANCH VERSUS SUBSIDIARY
Davis, Graham & Stubbs
Denver, Colorado
This paper deals with the determination of whether to conduct a foreign mining operation as a branch or subsidiary. The paper focuses on a U.S. parent corporation which proposes to operate a mining venture in a foreign host country and concentrates principally on the U.S. tax issues. However, host country taxes also must be taken into account. Moreover, non-tax considerations oftentimes will dictate the choice. For example, some countries restrict ownership of mineral interests to locally created corporations.1
1. Introduction.
Prior to the mid-1970s, when practicing tax law was fun, foreign mineral operations generally were commenced as foreign branch operations of consolidated U.S. subsidiaries (in order to offset the deductible exploration and development expenses against other income of the U.S. parent company group) and converted to foreign subsidiaries once the foreign mineral operations became profitable (in order to defer U.S. income tax until the foreign profits were repatriated to the U.S.).2 The
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conversion from a foreign branch to a foreign subsidiary generally was tax-free, with no branch loss recapture or other toll charge on the transfer of the branch properties to a foreign subsidiary. As a consequence of numerous changes to the U.S. income tax law, however, commencing in the mid-1970s, including limitations on current deductions for foreign exploration and development expenses,3 slower depreciation rates for foreign properties,4 recharacterization of foreign source income as U.S. source income in calculating the foreign tax credit limitation,5 recapture of foreign branch losses,6 and reduction in U.S. tax rates to rates which are now lower than the tax rates in most other countries,7 the determination whether to structure a foreign mining operation as a branch or subsidiary is less clear and must be made with regard to each taxpayer's specific tax situation (including foreign tax credits and net operating loss carryovers).
2. Definition of Branch and Subsidiary.
From a host country's perspective, a subsidiary is a corporation established under the laws of the host country8 and a branch is a corporation established under the laws of a country other than the host country.9
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A branch may be incorporated under the laws of the foreign investor (in our example, under U.S. law10 ) or under the laws of any country other than those of the host country (e.g., a Bermuda subsidiary of a U.S. corporation conducting mining operations as a branch in Chile).
3. Forms of Foreign Branch Operations.
A U.S. parent corporation can operate a branch in a host country in at least three ways: (i) it can operate directly as a branch in the host country; (ii) it can create a wholly-owned U.S. subsidiary which operates as a branch in the host country; or (iii) it can create a foreign subsidiary under the laws of a country other than the host country which operates as a branch in the host country.11
From a U.S. tax perspective, forms (i) and (ii) are the same, because a U.S. subsidiary generally joins with its U.S. parent in filing a consolidated federal income tax return.12 Indeed, if a U.S. parent corporation files a consolidated federal income tax return, its U.S. subsidiaries must be included in its consolidated federal income tax return.13 Accordingly, a U.S. corporation normally will create a separate subsidiary (U.S. or foreign) to conduct mineral operations in a foreign country, in order to limit the non-tax risks to the subsidiary's assets.
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4. Deductibility of Foreign Losses.
Losses normally are generated during the early phases of a mining operation. If the U.S. parent corporation has taxable income subject to U.S. income tax, it typically desires to utilize the tax deductions generated by the initial mining operations to reduce its taxable income. Under U.S. tax law, allowable deductions generated by foreign activity can be included in a U.S. income tax return to offset other domestic or foreign source income of the U.S. corporate group.14 However, these deductions are available only if derived by the U.S. parent itself or by a U.S. subsidiary of the U.S. parent. A foreign corporation may not be included in a consolidated federal income tax return,15 unless it constitutes a contiguous country corporation (i.e., a Canadian or Mexican corporation) which meets certain tests.16
5. Deductions Limited for Foreign Exploration and Development Expenses.
Certain initial costs incurred in a mining venture, whether domestic or foreign, are not deductible currently. For
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example, geological and geophysical costs must be capitalized, and amortized over the life of the mineral property or written off when the property is abandoned.17 On the other hand, certain deductions incurred in foreign mineral ventures are subject to more restrictive rules than if they had been incurred domestically. Foreign exploration costs are, at the election of the taxpayer, capitalized and recovered through depletion or deductible ratably over 10 years.18 Similarly, foreign development costs are, at the election of the taxpayer, capitalized and recovered through depletion or deductible ratably over 10 years.19 In addition, depreciation of tangible property used predominantly outside the United States is subject to the alternative depreciation system, which mandates the straight line method and longer class lives.20 Percentage depletion is allowed for most foreign minerals, but the rates may be less than the rates prescribed for the same minerals in the U.S.21 Moreover,
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the use of foreign percentage depletion may cause a reduction in allowable foreign tax credits on foreign mineral income.22 Finally, foreign deductions may reduce foreign tax credits otherwise available to the U.S. parent corporation.23
Notwithstanding the foregoing limitations on foreign deductions, U.S. taxpayers should consider commencing foreign mineral projects through a U.S. subsidiary, because of the uncertainty of success of foreign mineral projects, as well as the elapsed time before successful mineral projects become profitable. U.S. individuals who wish to claim deductions for foreign mineral operations might utilize an S corporation, which will afford limited liability and at the same time permit a pass through of deductions.24 The Subchapter S rules were amended to permit S corporations to derive both foreign income and passive income, subject to certain limitations.25
6. Dual Consolidated Loss Limitations.
A U.S. corporation may not offset a "dual consolidated loss" against income of other members of its consolidated group.26 A dual consolidated loss means a net operating loss of a domestic corporation which is subject to an income tax in a foreign country on its worldwide income rather than on its income
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only from sources within such foreign country.27 Thus, a U.S. corporation whose central management and control is in Australia or the United Kingdom, which countries tax resident corporations on their worldwide income, may be subject to these rules.
Unfortunately, the Temporary Regulations expand the scope of these rules beyond the apparent intent of the statute.28 A branch or partnership interest of a U.S. corporation in a foreign country will constitute a "separate unit" of such U.S. corporation and the losses of separate units are subject to the dual consolidated loss limitations as though the branch or partnership interest were a wholly-owned domestic subsidiary of the U.S. corporation.29 Thus, U.S. corporations which have "separate units" in a foreign country (e.g., branches) may be subject to these rules even if they are not part of a consolidated group.30
It is possible for a U.S. corporation to defer or even avoid the dual consolidated loss limitations by filing a so-called recapture agreement with its tax return for the year of the dual consolidated loss and by filing annual certifications for the subsequent 15 years.31 Thereafter, and within such 15 year period, if a "triggering event" occurs, the dual resident corporation must recapture the dual consolidated loss and pay tax with interest so as to eliminate the present value benefits of having claimed the loss.32 The recapture agreement (and the associated triggering events) is more onerous for actual dual resident corporations and hybrid entities taxed as corporations under local law, than for branches or partnerships.33 A
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triggering event generally includes the sale or transfer of a separate unit. A recapture agreement can be filed, however, only if there is no present possibility that any other person under the laws of the foreign country can use the losses of the dual resident corporation.34
A contiguous country corporation (i.e., a Canadian or Mexican corporation that elects to be treated as a domestic corporation and included in a consolidated tax return) may be treated as a dual resident corporation, because Canadian and Mexican corporations are taxed on their worldwide income. Thus, it may be necessary for a contiguous country corporation to file a recapture agreement to avoid the dual consolidated loss limitations.
7. Conversion of Branch to Subsidiary.
A foreign corporation is not subject to U.S. income tax unless the foreign corporation is engaged in a U.S. trade or business or derives passive income from U.S. sources.35 Income derived from foreign mining operations, which should constitute foreign source income,36 normally would not be subject to U.S. income tax if derived by a foreign corporation. Accordingly, once the foreign mineral operations become profitable, consideration should be given to converting a foreign branch of a U.S. subsidiary to a foreign subsidiary.37...
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