Forms of overseas operations: this two-part article explores the major characteristics, advantages and disadvantages of the different types of entities for conducting business overseas.

• Author: Lau, Paul C.
• Position: Part 1

U.S. companies operating overseas can choose among different types of presence in a foreign country. They can (1) use a branch, (2) have an interest in a foreign entity taxable as a partnership for U.S. tax purposes or (3) create an entity taxable as a corporation for U.S. tax purposes. Selecting the right structure for an overseas operation can be a challenge. The major factors generally affecting the choice of foreign operation are foreign tax credits (FTCs) and start-up losses. Overall, the key tax goal is to minimize the present value of both U.S. and foreign taxes. Part I of this two-part article, below, focuses on branch operations. Part II, in the April 2005 issue, will examine foreign partnerships and corporations.

Branch Operations

A branch generally operates as an independent unit and maintains separate books and records. Since 1997, a U.S. taxpayer can elect an entity's tax classification under the "check-the-box" regulations in Regs. Sec. 301.7701-2 and -3. If a U.S. taxpayer wholly owns a foreign entity that is not a corporation per se, the foreign entity can be effectively disregarded as a separate entity by default or election under Regs. Sec. 301.7701-3(a) and (b). Such a disregarded foreign entity is, in effect, treated as a branch for U.S. income tax purposes. A foreign entity taxed as a corporation under foreign law, but as a branch (or flow-through entity) for U.S. tax purposes, is referred to as a "hybrid entity."

FTC

A branch's income is immediately taxable to the U.S. taxpayer. This may not be a serious concern if the effective tax rates of the foreign country and the U.S. are approximately equal. Also, the U.S. income tax might be fully sheltered by FTCs. Conceptually, the FTC a taxpayer can use in any year is the lesser of the actual foreign income taxes paid on the foreign-source income or the U.S. income tax allocable to such income (the FTC limit). (1)

Prior to the American Jobs Creation Act of 2004 (AJCA), Sec. 904(d) listed the following nine separate FTC categories (FTC baskets):

* Passive income (e.g., dividends and interest). (2)

* High-withholding-tax interest (i.e., 5% withholding tax or greater). (3)

* Shipping income (including income from operating an aircraft or a vessel on the high seas and in space).

* Financial services income (i.e., banking, finance or a similar business and certain insurance investment income).

* Dividends from noncontrolled Sec. 902 corporations (4) (at least 10%, but not more than 50%, ownership).

* Dividends from a domestic international sales corporation (DISC) or former DISC.

* Dividends from a foreign sales corporation (FSC) or former FSC.

* Taxable income attributable to foreign trade earned by an FSC.

* Other income (general income). (5) In addition, Sec. 907(a) separately limits the FTC for foreign oil and gas extraction income. Typically, the most common FTC baskets encountered were passive income, general income, high-withholding-tax interest and dividends from noncontrolled Sec. 902 corporations.

AJCA Section 403(a) retroactively amended the treatment of dividends from noncontrolled Sec. 902 corporations. For tax years beginning after 2002, dividends from noncontrolled Sec. 902 corporations are subject to Sec. 904(d)(4)'s lookthrough rule, under which dividends are treated as income in separate FTC baskets in the same proportion as the foreign corporation's earnings and profits (E&P) in each basket bears to its total E&P.

For tax years beginning after 2006, AJCA Section 404 consolidates the nine FTC baskets into passive income and general income baskets. (6)

C corporations: Solely from an FTC standpoint, a domestic C corporation generally prefers directly owning a foreign corporation, due to the former's ability to claim a "deemed-paid" (or indirect) tax credit. A domestic C corporation can receive an indirect tax credit for foreign taxes paid by its foreign subsidiaries when the subsidiaries' earnings are actually (or deemed) distributed. Under Secs. 902 and 960, the indirect tax credit is generally available to a U.S. corporate shareholder with a 10%-or-more ownership interest (voting power) in the foreign subsidiary.

A C corporation generally prefers income deferral from a foreign corporation, unless it has unused FTCs and a branch can greatly improve the FTC limit in comparison to a foreign corporation. The FTC limit generally increases as foreign-source taxable income increases.

Under current law, a branch and a foreign corporation do not normally generate equal amounts of foreign-source taxable income, due to different interest apportionment rules. The FTC limit is based on foreign-source taxable income, which is the amount after allocating and apportioning deductions. Expenses directly related to a class of gross income are allocated directly to that class. If the class includes both domestic- and foreign-source income, the expenses are then apportioned between them. (7) Specific apportionment rules apply to interest, which can vary depending on the type of foreign entity. Generally, under Temp. Regs. Sec. 1.861-9T(g)-(i), interest expense is apportioned based on either the...