In the USA, the four most common forms of business organisations are sole proprietorships, partnerships, limited liability companies (LLCs) and corporations. While the corporation remains the entity of choice for most large businesses, primarily due to liability protection, LLCs have become increasingly popular over the last several decades, and also offer increased liability protection. Each form has distinct tax and non-tax advantages and disadvantages, some of which are discussed below.
An entity’s treatment for tax purposes does not need to align with its treatment for non-tax purposes. For example, certain entities can make a “check-the-box” election, which can change the way in which the Internal Revenue Service (IRS) will treat the business for tax purposes. Thus, if an individual sets up their business as an LLC (which is generally taxed as a “pass-through” entity), they can nevertheless choose to have the business taxed as a corporation.
A sole proprietorship can be used where a single individual owns and operates a business. In such a case, the income and other tax attributes (such as deductions and credits) generated by the business are attributed to the sole proprietor and taxed at the tax rates applicable to individuals. In addition, the sole proprietor is personally liable for all of the obligations of the business (both tax and non-tax). For this reason, new business owners tend to gravitate towards one of the other entity forms that limit the business owner’s exposure to the liabilities of the business (eg, an LLC).
Where two or more individuals own a business together, the arrangement is – by default – treated as a general partnership. In a general partnership, each partner is liable for all of the partnership’s obligations, which means that each partner in a general partnership is at risk of losing more than the capital that they contribute to the partnership. In contrast, a limited partnership is an arrangement whereby the business owners enter into a “limited partnership agreement”, pursuant to which a single general partner is responsible for the management of the business, and one or more limited partners act as investors, with very limited or no managerial power.
Similar to a general partnership, the general partner in a limited partnership is liable for all obligations of the business. The limited partners, however, are only at risk for their own capital contribution. If a limited partner begins to exercise a level of managerial control indicative of a general partner, however, it could lose its limited liability protection and become exposed to all of the limited partnership’s obligations.
Limited Liability Companies
Like a limited partnership, an LLC is an arrangement whereby the business owners (“members”) enter into a contract that sets out the rights of each party. Each LLC member’s exposure to the LLC’s obligations is limited to the amount of that member’s individual capital contributions. Unlike a limited partnership, an LLC need not necessarily have a general partner with managerial responsibility and unlimited liability. Instead, the management of the LLC and allocation of liabilities is determined contractually and can involve any number of the LLC’s members.
For tax purposes, both partnerships (general and limited) and LLCs are referred to as “pass-through” entities, meaning that the entity’s income and other tax attributes (such as depreciation, basis and losses) are attributed to the individual partners or members based on their ownership interest in the entity rather than to the entity itself. Accordingly, the entity itself is not generally subject to taxation. As noted above, however, the members of an LLC may choose to “check the box” and have the LLC treated as a corporation for tax purposes.
Stakeholders generally have the flexibility to allocate the income, losses and tax attributes generated by the entity amongst each other in any way they see fit (subject to certain anti-abuse rules). In light of the flexibility offered by limited partnerships and LLCs, and the fact that they are not automatically subject to tax at the entity level, such entities are often used to form investment funds. In addition, LLCs and partnerships are especially beneficial in business ventures where it is desired that deductions and losses flow through to investors so as to reduce taxable income from other sources.
Unlike the pass-through entities described above, corporations themselves are subject to tax. Accordingly, profits earned by a corporation are taxed once at the corporate level and again after they are distributed to the corporation’s shareholders as dividends. This “double taxation” is the primary drawback of organising a business in the corporate form.
Despite double taxation, the corporate form remains popular for various reasons, three of which are described below.
See 1.1 Corporate Structures and Tax Treatment regarding partnerships and LLCs. A US partnership or LLC generally is treated as a transparent entity for US federal tax purposes unless a “check-the-box” election is made to treat such entity as a corporation. Subchapter S corporations (closely held corporations that elect to be treated as a pass through) and certain trusts also may be fiscally transparent.
The USA taxes residents on worldwide income; for example, all of the profits of a corporation organised in the USA are taxed in the USA, regardless of the country in which such profits are generated. The following summarises how tax residence is determined based on the type of entity.
A corporation formed under US federal or state laws is a domestic corporation. Other corporations are foreign corporations. See 5.2 Taxing Differences between Local Branches and Local Subsidiaries of Non-local Corporations for discussion of the different tax treatment of domestic and foreign corporations, including treaty considerations.
As discussed above, partnerships and LLCs are not themselves subject to income tax. Instead, partners and members are taxed based on the underlying investments and activities of the business. Accordingly, the tax residence of partnerships and LLCs (whether or not they are formed in the USA) is less important than where the assets of the business are located and where the business is conducted. For example, a non-US member of an LLC formed outside the USA will still be subject to US tax on its share of income effectively connected to a US trade or business of the LLC. Also, the USA generally imposes tax on any US person who earns income from a flow-through entity regardless of where the business operates. Again, the existence of a tax treaty may affect the analysis.
The tax rate on the earnings of a corporation is a flat 21%. Dividends paid to a US person are generally subject to a 20% tax, plus an additional 3.8% “net investment income tax”. Dividends paid by a US corporation to a non-US person generally are subject to a 30% withholding tax (subject to reduction by applicable income tax treaties). Accordingly, earnings of a US corporation are subject to two layers of tax that may exceed 40% once the earnings are distributed to its shareholders.
Income generated by pass-through entities is “passed through” to the owners and is therefore subject to taxation at the individual or corporate tax rates, as the case may be. The highest graduated individual tax rate on ordinary income is 37%. The highest graduated rate on net capital gains and qualified dividends is 20%. Individuals are also subject to an additional 3.8% “net investment income tax”, which generally applies to passive income (such as dividends, interest and capital gains). Some individuals may be eligible for a 20% pass-through deduction on some or all of their pass-through income.
A corporation’s taxable income is its gross income for the year minus allowable deductions. Gross income is similar but not identical to financial profits and can include receipts from sales, dividends received, interest collected, income from rents and royalty payments, and capital gains. Deductions include all “ordinary and necessary” expenses of the business, which typically include compensation (ie, payroll) and benefits expenses, repairs and maintenance expenses, taxes, licences, interest payments, depreciation and depletion, and advertising and marketing. Corporations generally must calculate gross income on an accrual basis, but certain smaller businesses can account for gross income using a cash or modified cash accounting method.
Corporations are generally taxed equally on all types of income, so there is no reduced rate applicable to corporations for capital gains. Capital losses of a corporation can generally only be used to offset the capital gains, not ordinary income, of the corporation. Generally there are no special exemptions for distributions from the “capital” of a corporation. A distribution is a taxable dividend to the extent the corporation has any current or accumulated earnings and profits (thus payments are deemed to be made out of earnings before they are treated as a return of capital), although a corporation that receives a dividend from another corporation is generally entitled to a “dividends received” deduction ranging from 50% to 100%.
The USA provides special incentives for certain industries and activities, the most important of which are aimed at encouraging corporations to develop new, and refine existing, technology. Corporations may claim a deduction or credit for certain research and experimental expenditures in the experimental or laboratory sense. In addition, a special research credit may be claimed by corporations in connection with incremental research expenses.
The USA also provides special incentives for a handful of other industries and businesses, including clean energy (eg, advanced energy credit, credit for electricity produced from renewable sources), railroads (eg, railroad track maintenance credit) and pharmaceuticals (eg, orphan drug credit). Businesses should generally consult with their tax counsel or tax preparer to determine their eligibility for special tax credits.
A 100% first-year deduction generally is allowed for certain qualified new and used property acquired and placed in service between 27 September 2017 and 2023.
Rules on Carry-Backs and Carry-Forwards for Corporations
When a corporation operates at a net loss for a given taxable year, it incurs a net operating loss (NOL), which can be used to offset taxable income in other tax years. In general, a corporation cannot use an NOL from a given tax year to offset taxable income from prior years (no “NOL carry-back”) but can use the NOL to offset income from future years with no expiry (an indefinite “NOL carry-forward”). The use of an NOL deduction is limited to 80% of income in the year the NOL carry-forward is used. These general rules were modified in March 2020 to permit a corporation to carry back NOLs generated in tax years beginning after 31 December 2017 and before 1 January 2021 for up to five years and to provide that use of NOLs generated in tax years prior to 1 January 2021 is not subject to the 80% income limitation.
Treatment of Capital Gains and Losses for Individuals
In contrast to corporate NOLs, the US tax rules limit an individual’s use of certain losses in situations where the individual does not have significant capital “at risk”, and where the individual does not materially participate in the business generating the loss. These limitations generally apply to individuals who incur these losses directly or through the ownership of pass-through entities or “closely held” corporations.
For individuals, capital gains and losses are first characterised as long term (underlying asset held for more than one year) or short term (underlying asset held for one year or less). For individuals, short-term capital losses are first applied to offset short-term capital gains. Long-term capital losses are then applied to offset long-term capital gains. If there is a net short-term capital loss, it would then be applied to offset the net long-term capital gain.
If a net capital gain results at the end of this netting process, tax rates lower than the normal tax rates applicable to ordinary income will apply (with some exceptions). If the end result is a net short-term capital gain, instead of a net capital gain computed as described above, that gain would be subject to the same graduated tax rates as ordinary income. If an individual ultimately realises a net capital loss instead, the net capital loss may be used to reduce a limited amount of other income and may be carried over to subsequent years.
Treatment of Capital Gains for Corporations
Corporations do not enjoy preferential tax treatment on their long-term capital gains and there is no deduction against income for capital losses that exceed capital gains. A corporation nets capital losses against capital gains. If the corporation has excess capital losses, the losses are carried back three years or forward five years and applied against capital gains. The losses must be used in the earliest year in which there are net capital gains. Capital losses cannot produce or increase NOLs in the year in which the capital loss is carried back.
Net business interest deductions are generally limited to 30% of the “adjusted taxable income” of the company (with some exceptions). Excess interest deductions may be carried forward to later years. Under the “AHYDO” rules, certain interest on high-yield obligations is deferred or disallowed. Also, US tax rules can treat instruments as equity (resulting in non-deductible dividends or other payments instead of interest), notwithstanding that the instruments are labelled as, or otherwise in the form of, debt instruments. In particular, Treasury regulations can apply to treat certain related-party debt instruments as equity. Other US tax rules can limit deductions connected to acquisitions whose principal purpose is to secure the benefit of a deduction.
Subject to certain income thresholds and elections, there is a limit on a corporation’s or pass-through’s ability to deduct “net business interest” (ie, business interest expenses minus business interest income). Any business interest deduction disallowed under this limitation generally can be carried forward to future taxable years.
In general, an “affiliated group” of corporations (a chain of corporations owned by a common parent in which 80% of the vote and value of each corporation is generally directly or indirectly owned by the parent corporation) may file a consolidated income tax return covering all group members. Foreign corporations generally may not file a consolidated return.
While there are administrative burdens, one of the most important advantages is the general ability to use losses generated by one corporation in the group to offset the taxable income of another corporation in the group (generally not possible for related corporations that do not file a consolidated return). Inter-corporate dividends for corporations filing a consolidated return are generally not taxed. Inter-corporate profits arising as a result of sales or services exchanged within the group also may be deferred.
Unlike individuals, corporations do not enjoy preferential tax treatment on their long-term capital gains. All capital gains, whether long term or short term, are subject to the corporate tax rate. See discussion in 2.4 Basic Rules on Loss Relief regarding carry-overs of capital losses.
In addition to the US federal income taxes imposed on incorporated businesses, such businesses may also be subject to numerous other taxes, including state, local and municipal income taxes, a range of withholding taxes, sales and other transfer taxes, employment and payroll taxes, and, for non-US businesses, taxes imposed under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA).
To prevent companies from stripping earnings out of the USA through deductible payments made to related foreign parties, the USA applies a base erosion minimum tax (BEAT). BEAT applies to corporations with average annual gross receipts of USD500 million or more that made deductible payments to foreign affiliates of at least 3% (2% for banks and securities dealers) of the corporation's total deductions for the year. The tax is structured similar to an “alternative minimum tax”.
Closely held businesses in the USA typically operate in non-corporate form, usually as sole proprietorships, partnerships or LLCs. See 1.1 Corporate Structures and Tax Treatment for discussion of these pass-through entities.
While partnerships and LLCs are generally the preferred form of entity to operate a closely held business, a Subchapter S corporation is sometimes used (albeit less frequently now that people have become more comfortable using LLCs). A Subchapter S Corporation is a hybrid between a partnership and a corporation where (i) tax is generally not imposed on the entity but instead the income and losses generally pass through to its owners (similar to a partnership for tax purposes) and (ii) it follows certain corporate rules for distributions, redemptions and reorganisations for corporations. Nonetheless, for non-tax purposes, an S corporation must still observe all corporate formalities applicable under state law, and does have the liability protections normally afforded corporations.
In order for a corporation to qualify as a Subchapter S corporation, it must meet numerous requirements, including:
A Subchapter S Corporation is often the preferred form of entity for a pre-existing corporation seeking to achieve pass-through taxation because the conversion itself does not generally result in tax, whereas a conversion from a corporation to a partnership or LLC would result in a taxable liquidation.
Some closely held US businesses choose to operate as corporations for a variety of reasons, including facilitating an initial public offering and to rely on the robust and settled case law governing corporations in certain states. Additionally, non-US persons generally favour conducting business in the USA through corporations rather than pass-through entities in order to avoid incurring a requirement to file a US tax return, thereby becoming subject to the investigatory authority of the IRS, and due to certain US tax laws that specifically eliminate some of the benefits of pass-through taxation for certain non-US persons.
While entity-level corporate tax rates may be lower than individual tax rates, various factors and rules exist that discourage individual professionals (eg, architects, engineers, consultants, accountants) from forming corporations taxed as corporations to earn income for their services. As discussed above, corporations and their shareholders are subject to two levels of taxation that, when combined, are greater than the generally applicable individual income rates. Nonetheless, if earnings are not distributed to shareholders, then the corporate form may offer tax savings.
Accordingly, there are rules governing personal service corporations that prevent individual service providers from utilising corporate entities to reduce their tax burden. A personal service corporation performs personal services as its principal business, and such services are substantially performed by the corporation’s employee-owners. If a corporation is a personal service corporation, the IRS may allocate the income, deductions, credits, exclusions and other allowances of the corporation between the corporation and its employee-owners in certain circumstances.
Passive activity loss rules limit the deductions and credits that closely held corporations and personal service corporations can claim with respect to passive activities. Under these rules, losses and credits derived from passive activities cannot be used to offset income from other non-passive activities. A passive activity is a trade or business activity in which the taxpayer does not materially participate; this generally means a regular, continuous and substantial involvement in the operations of the activity (sometimes interpreted as over 500 hours of participation). In addition, in certain circumstances, an “accumulated earnings tax” of up to 20% can apply to earnings of a corporation that are not distributed, to the extent that such accumulated earnings are beyond the reasonable needs of the business.
Individuals are generally taxed at the preferential long-term capital gains rate on the sale of shares in a closely held corporation that have been held for a period of more than one year. Short-term capital gains on the sale of shares held for one year or less are taxed at the same rate as ordinary income. “Qualified” dividends (dividends paid by US and certain non-US corporations with respect to stock held by the owner for a certain minimum holding period) are also taxed at the preferential capital gains rate. Capital gains from the sale of shares in a corporation may also be subject to an additional “net investment income tax”.
The taxation of dividends and gains applicable to individuals holding shares in a publicly traded corporation are the same as those applicable to those who hold shares in a closely held corporation. See discussion in 3.4 Sales of Shares by Individuals in Closely Held Corporations.
Non-US persons may be subject to either of two different US federal income tax regimes, or both. The first regime applies to items of income from US sources that are not “effectively connected” with the conduct of a US trade or business (“FDAP” income). The second regime applies to net income that is “effectively connected with the conduct of a US trade or business”.
Payments of US-source FDAP income made to non-US persons are generally subject to US withholding tax at a rate of 30%, subject to certain exemptions and reductions (described further below). FDAP income subject to this type of withholding generally includes all US-source income except gains from sales of real or personal property. Common types of FDAP income include interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations and emoluments. US tax rules provide specific sourcing rules to determine whether a particular type of income is “US source”. For example, dividend income is generally US-sourced if it is paid by a US corporation.
The 30% withholding tax may be reduced or eliminated pursuant to a provision of US tax law (such as the “portfolio interest” exemption), or a tax treaty between the USA and the country in which the recipient of the income is resident (and who qualifies for the treaty benefit).
An additional withholding may be imposed under the Foreign Account Tax Compliance Act (FATCA), enacted in 2010 in order to prevent US persons from evading US tax by holding income-producing assets through accounts at foreign financial institutions (FFIs) or through other non-US entities (non-financial foreign entities, or NFFEs). FATCA generally requires FFIs to identify US account holders and report them to the IRS (either directly or by reporting to the FFI’s home country, which will then share such information with the IRS pursuant to an applicable intergovernmental agreement). In addition, NFFEs are generally required to provide information regarding their ownership to withholding agents, including identifying any substantial US owners. FFIs and NFFEs that do not comply with the requirements of FATCA incur a 30% withholding tax on payments to them of certain categories of US-source passive investment income.
The primary tax treaty countries that foreign investors use to make investments in US corporate stock or debt are the Netherlands, Ireland and Luxembourg.
If an entity is a resident of a contracting state within the meaning of an income tax treaty (ie, the USA or the treaty partner), that entity is generally entitled to the benefits of that treaty. However, there are certain circumstances in which the US tax authorities will challenge the use of treaty country entities by non-treaty country residents.
Certain treaties contain limitations of benefit (LOB) clauses intended to prevent “treaty shopping”, premised on the idea that an entity that is a resident of a contracting state must have a sufficient nexus to that country to be eligible for the tax treaty benefits. While the LOB provisions differ in treaties, they commonly enumerate objective tests used to establish entitlement to treaty benefits. An entity that fails these tests may nonetheless apply to the competent authority for a (discretionary) determination that it did not engage in treaty shopping and is still entitled to treaty benefits.
In addition to applying LOB provisions, the USA may challenge the use of treaty country entities through various economic substance and substance over form doctrines. These doctrines are discussed in further detail in 7.1 Overarching Anti-avoidance Provisions.
The USA has one of the oldest and most mature transfer pricing regimes. In 2010, the IRS reorganised its international division to focus its resources on enforcement of transfer pricing rules and regulations and resolve transfer pricing disputes, among other things; the IRS’s focus on transfer pricing has not abated. The increasing complexity of transfer pricing disputes has led the IRS to require substantial evidentiary support from the taxpayer. At the outset, an inbound investor will have to be prepared to substantiate the transfer pricing methodology chosen, among other things. Treasury regulations provide penalty protection if a taxpayer prepares and maintains contemporaneous transfer pricing substantiation documents at the time they file the relevant tax return.
For inbound investors, knowledge of the adversarial nature of the complex US transfer pricing regime is important. IRS audits can be time consuming and costly.
Where a limited risk distributor purchases products for resale from a related party, the price at which the products are purchased (ie, the transfer price) must be arm’s length. This, in turn, is dependent upon the functions performed and risks assumed by the distributor. Thus, with respect to a limited risk distributor, the transfer price should be respected if the profits earned by the limited risk distributor are comparable to the profits earned by an unrelated distributor performing similar functions and, likewise, assuming limited risks.
Limited risk distributor arrangements are also subject to potential challenge under agency principles. If the distributor bears insufficient risks, it may be treated as the agent of the parent. This could subject the parent to taxation as it is treated as being engaged in a US trade or business through the agent distributor.
The USA has a comprehensive transfer pricing regime, which it currently believes sufficiently addresses the issues raised by BEPS Actions 8 through 10. The US transfer pricing regulations are generally viewed as being consistent with the OECD standards. A question remains, however, regarding how the OECD guidelines will be interpreted by other countries and, thus, there remains a possibility that the guidelines will be interpreted by other countries in a way that results in differences.
The IRS has long had an Advance Pricing and Mutual Agreement (APMA) Program. The APMA Program assists taxpayers both in resolving transfer pricing disputes through mutual agreement procedures (MAPs) and avoiding disputes through advance pricing agreements. The IRS’s requirements and procedures are set forth in Revenue Procedures 2015-40 and 2015-41.
A key challenge of the MAP process is that treaties ordinarily provide only that the tax authorities endeavour to avoid taxation in contravention of the treaty. Accordingly, relief is not guaranteed. While many current treaties do not contain an arbitration provision, a trend in more recent treaties is the inclusion of an arbitration option in an effort to provide relief even where the initial negotiations were unsuccessful. Nevertheless, MAP is largely successful. The APMA Program closes approximately 300 MAP cases per year. Approximately 85% of cases result in either unilateral relief being granted or an agreement fully eliminating double taxation or taxation otherwise not in accordance with the relevant treaty.
When the IRS and a taxpayer resolve a transfer pricing dispute, it is common for the IRS to impose a transfer pricing adjustment as well as collateral adjustments. A common collateral adjustment is one that conforms a taxpayer’s accounts to reflect the initial transfer pricing adjustment. For example, if a corporation paid above-arm’s length consideration to its parent company, the excess amount may be recharacterised as a dividend. There are also procedures that may apply to allow a taxpayer to make payments to conform its accounts and avoid conforming adjustments.
Where the related party is also a US taxpayer, the IRS will ordinarily make a correlative adjustment to the related party to avoid double taxation. If the related party is not a US taxpayer but is a resident of a country with which the USA has a tax treaty (and the parties are eligible for the benefits of the tax treaty), the IRS may work with the foreign government to achieve a result that avoids double taxation. See discussion in 4.7 International Transfer Pricing Disputes regarding the APMA Program.
Non-US entities operate in the USA either through a subsidiary structure or through a branch. In a subsidiary structure, the foreign parent incorporates a wholly owned corporate subsidiary in the USA. The US subsidiary is liable for US tax on all profits earned by the US subsidiary. Further, the repatriation of profits (a dividend distribution) by the US subsidiary to the foreign parent is generally subject to a withholding tax of 30%, subject to treaty relief.
Conversely, a non-US entity may operate in the USA through a branch (whether a pass-through entity or an office that is not a legal entity). The income from the US branch passes through to the non-US entity. The non-US entity would then be subject to US tax on the income that is “effectively connected” to the US business at normal US corporate tax rates. The non-US entity with effectively connected income operating through a branch may also be subject to a branch-level tax of 30% (which may be reduced pursuant to a tax treaty) imposed on the repatriation of earnings as well as on certain excess interest paid or accrued on liabilities booked in the USA. The intent behind the branch profit tax is to put the earnings and profits of a branch on equal footing with the earnings and profits of a US subsidiary.
In general, capital gain derived by non-US persons (including non-US corporations) from the disposition of stock issued by a US entity is not subject to US tax. If a non-US person sells the stock of a US entity that holds substantial US real property, however, such gain might be subject to US tax under FIRPTA.
Generally, there are no change of control provisions that could apply to trigger tax or duty charges upon the disposal of an indirect holding higher up in the overseas group. Judicially developed doctrines such as the sham transaction and economic substance doctrines may operate to pierce arrangements structured for tax avoidance purposes.
Mandatory formulas are not used to determine the income of foreign-owned local affiliates selling goods or providing services in the USA. Rather, pursuant to the US transfer pricing rules and regulations, a taxpayer must select an appropriate pricing method to test the arm’s-length nature of its transfer prices. While formulas are used in transfer pricing, the values in the formulas are derived from uncontrolled transactions and should not be seen as “mandatory formulas”.
For services, a transfer pricing method referred to as the services cost method (SCM) provides for reimbursement at cost-plus 0%. The SCM applies to “specified covered services”. While this may be viewed as a formulaic approach, the SCM is an elective method.
Where a non-US affiliate charges a related US entity for management and administrative expenses incurred by it, the costs charged will be determined against the “arm’s-length” standard. In certain cases, the SCM may apply (see 5.5 Formulas Used to Determine Income of Foreign-Owned Local Affiliates).
Related-party debt is subject to special scrutiny, including under (i) related-party debt rules for certain large group entities and (ii) general substance over form principles of the US tax rules. Related-party interest deductions are also subject to the limitation of 30% of adjusted taxable income that applies to all corporations.
Treasury regulations regarding debt between related entities set forth certain documentation requirements that must be complied with in order for a purported debt instrument issued and held by certain members of an “expanded group” to be treated as debt. These regulations only apply to a purported debt instrument issued by a US corporation and held by a member of such US corporation’s expanded group (which generally is a corporation directly or indirectly connected by at least 80% common ownership).
In addition, these regulations treat certain purported debt instruments as equity in certain other circumstances, notwithstanding that the documentation requirements are met. In order for an instrument to be treated as debt, the instrument must satisfy certain criteria that establish that the instrument, in substance, is a debt instrument.
US taxation of foreign income differs depending on whether the income is earned directly by a US corporation or indirectly through a foreign subsidiary of that US corporation.
US corporations are subject to tax on their worldwide direct income; the USA does not have a territorial system for direct income. Accordingly, the same tax rules generally apply to income earned by a US corporation inside and outside the USA. This worldwide taxability often results in income earned outside the US being taxed twice, by both the USA and the foreign jurisdiction. In order to address double taxation, the USA generally permits a US corporation to credit certain foreign taxes against its US taxes, subject to limitations.
US corporations with foreign subsidiaries are generally exempt from federal income tax through a participation exemption. See 6.3 Taxation on Dividends from Foreign Subsidiaries. Further, the USA has base erosion and minimum tax provisions that are imposed on multinational groups.
Deductions and limitations on deductions are governed by statute.
Dividends received by US corporations from their foreign subsidiaries are generally exempt from US taxation via a 100% dividends received deduction. In order to qualify for this exemption, the US corporation must own at least 10% of the vote or value of the foreign subsidiary. There are also holding period and foreign tax benefit restrictions.
Intangibles developed by US corporations may be used by non-US subsidiaries, subject to transfer pricing rules. Royalties earned by the US entity from the licensing arrangement are subject to US tax.
Pursuant to the US “controlled foreign corporation” (CFC) rules and the “GILTI” rules, a US corporation can be taxed on the income of its foreign subsidiaries before the foreign subsidiary distributes such amounts. A CFC is a foreign corporation where more than 50% of the stock by vote or value is owned by “US shareholders”. For this purpose, a US shareholder is a US person who owns 10% or more of the total combined voting power or value of all classes of stock in the foreign corporation.
Once a foreign corporation is classified as a CFC, its US shareholders must currently report and pay tax on a portion of certain types of income of the CFC (including certain related-party sales, services income and passive income), through what is effectively an annual deemed dividend. Further, gain on the sale of a CFC’s shares is generally treated as a dividend rather than capital gain to the extent the earnings and profits of the CFC were not previously subject to US taxation. US corporations with CFCs are also subject to a minimum tax provision that effectively works as a deemed dividend. This minimum tax, imposed on earnings above a set return, is at a reduced rate.
In addition to the tax imposed by the CFC rules, another tax is imposed on the US shareholders of a CFC based on “global intangible low-taxed income” (GILTI). In general, GILTI equals the CFC’s aggregate net income, reduced by 10% of adjusted tax basis in depreciable tangible personal property. The GILTI tax rate is generally 10.5%; foreign tax credits may apply.
In order for transactions involving non-local affiliates to be respected, the non-local affiliate must have substance. See 7.1 Overarching Anti-avoidance Provisions.
When US corporations sell shares of their foreign subsidiaries, any resulting capital gains are generally taxed at the ordinary corporate income tax rate of 21%, potentially reduced by credit for foreign taxes. See 6.5 Taxation of Income of Non-local Subsidiaries Under CFC-Type Rules for special rules if the foreign subsidiary is a CFC.
There are four primary judicial doctrines commonly invoked by the IRS to invalidate tax structures or transactions:
All four are utilised by the IRS to determine the substance of the transaction over its form (substance over form is also sometimes used as a separate doctrine). These doctrines sometimes overlap in their application.
Traditionally, courts have used either a one or two-pronged test to determine whether a transaction has economic substance. Under the one-pronged test, a transaction has economic substance if, viewed objectively, a non-tax business purpose exists for the transaction. Under the two-pronged test, the first prong is objective – does the transaction, viewed objectively, have economic substance? The second prong is subjective – does the taxpayer have a subjective business purpose for the transaction? Some courts that apply a two-pronged test apply the two prongs conjunctively (both elements must be satisfied) and some apply the test disjunctively (satisfying either prong will satisfy the test). The economic substance doctrine was codified in 2010, with limited substantive impact on when the doctrine is applied, but with additional penalty provisions.
The business purpose doctrine sets forth the requirement that a transaction be driven by some business consideration other than the reduction of tax. To determine the intent of the taxpayer, many factors have been considered by the courts.
The step transaction doctrine applies to multi-step transactions. Under this doctrine, certain formal steps of an integrated transaction can be ignored for US tax purposes in certain circumstances. Courts apply one (or more) of three tests to ascertain whether transactions are integrated for tax purposes:
The sham transaction doctrine also looks at the substance of a transaction. A sham transaction can either be a sham in fact or a sham in substance. A sham in fact is a transaction where the economic activity that generates the tax benefit at issue did not, in fact, occur. A sham in substance is a transaction that actually occurred, but the only economic effect is the creation of a tax benefit.
In the partnership context, certain “anti-abuse” Treasury regulations have been issued with the purpose of ensuring that the income tax treatment of each partnership transaction is consistent with the intent of the US partnership tax rules. In addition, a host of specific statutory and administrative provisions may invalidate specific transactions or subject them to adverse treatment, including with respect to disguised sales, related-party losses, mixing bowl transactions and issuances of profits interests.
Taxpayers are generally obliged to file tax returns with the IRS on an annual basis, but there is not a regular, routine audit cycle. In general, the IRS may audit a tax return for three years after the due date of the tax return or the date it was filed, whichever is later. If there has been a substantial omission of gross income on the return, the statute of limitations is extended to six years.
The taxpayer and IRS can agree to extend the statute of limitations. This often happens when a statute of limitations for a year under audit is due to expire and the IRS has not yet completed its audit. There is no statute of limitations where a required return has not been filed or where the IRS alleges that there has been fraud. This can be a trap for the unwary where, for example, a non-US person has a US income tax filing obligation but fails to file the required return.
Selection of Returns for Auditing Purposes
Whether, or to what extent, a taxpayer may be subject to audit depends, in part, on the nature of the taxpayer; ie, individual or smaller entity versus large entity.
Individuals and organisations that do not meet the requirements of the IRS’s Large Business & International (LB&I) Examination Process may be subject to an audit for any year. For such taxpayers, the IRS uses several methods for selecting a tax return for audit, including random selection and computer screening, related examinations and information matching.
Some returns will be selected for audit simply based on a statistical formula where the IRS compares returns against “norms” for similar returns. The “norms” are developed from audits conducted by the IRS as part of its National Research Program. A return may also be selected for an audit because it involves an issue or transaction with other taxpayers whose returns have been selected for audit. In addition, since 1984, certain investment transactions are required to be registered with the IRS by the investment organiser as a tax shelter, increasing the likelihood of audit for any person claiming a tax benefit from the tax shelter. Information matching may result in an audit where, for example, a bank issues an interest statement but the income reported on a return does not match. Other methods for audit selection may occur; for example, where there is a local compliance initiative.
If a return is selected for audit, the IRS will notify the taxpayer by mail. There have been a number of phone and email “scams” in recent years as a result of various data breaches and many people have, unfortunately, responded to these fake requests and either lost a considerable amount of money or released Trojan horse programs into their computer systems. The IRS has warned about these scams and reiterated that it will not initiate an audit by telephone or email. The IRS encourages people who receive such scam calls or emails to report them to the IRS.
Assuming an audit is undertaken, it will be managed either by mail or through an in-person interview to review relevant records. The interview may be held at an IRS office or at the taxpayer’s home or office. The IRS will request various documents that the examining agent wishes to see. Additional requests may follow. The length of the audit is dependent on the facts and circumstances.
The LB&I Division of the IRS serves entities (including pass-through entities such as partnerships) with assets greater than USD10 million. Some LB&I taxpayers are audited every year. The examination process has three phases: planning, execution and resolution.
In the planning phase, the scope of the audit is set, the issues that will be audited are determined, and an examination plan is created. In the execution phase, the facts will be developed and the auditor’s position developed. In the resolution phase, the goal is to try to reach agreement, if possible, on the issues examined during the audit.
If no agreement is reached, the taxpayer may opt to attempt resolution of an issue through various alternative dispute resolution options. Alternatively, the taxpayer could “protest” the proposed changes and attempt to resolve the unagreed issues with the IRS Office of Appeals. To the extent resolution of an issue would result in double taxation and an income tax treaty exists between the countries at issue, the taxpayer could attempt to seek relief through the competent authority process.
Tools exist to resolve disputes before they occur, including pre-filing agreements, advance pricing agreements for transfer pricing issues and private letter rulings. In addition, where an issue affects a particular industry, it is possible that the issue could be resolved on an industry-wide basis.
To the extent an audit is not fully resolved, the taxpayer may pursue litigation. Litigation may be pursued in the United States Tax Court after the IRS issues a notice of deficiency. The taxpayer need not pay the deficiency in order to litigate its dispute in the Tax Court. Alternatively, the taxpayer could choose to pay the asserted deficiency, file a claim for refund, and later file a lawsuit in either the United States Court of Federal Claims or the relevant United States District Court. The decision as to choice of forum will generally depend, in large part, on an analysis of the relevant law in that court and the court to which a decision would be appealed.
The USA has a comprehensive tax regime, which it believes satisfactorily addresses the issues raised by the BEPS Action Plan. Although the USA has only adopted one of the BEPS Actions, it does not oppose many of the concepts. Indeed, many of the underlying policies of the BEPS Action Plan are already reflected in US law or in bilateral treaties signed by the USA.
Country-by-country reporting, as recommended by BEPS Action 13, is the only proposal that the USA has adopted thus far. Action 13 proposed that countries require their multinational enterprises to report the following information annually and for each tax jurisdiction in which they do business:
The CbC report is required to identify the amount of revenue, profit before income tax, and income tax paid and accrued. It also requires multinational enterprises to report the number of personnel employed, stated capital, retained earnings and tangible assets in each tax jurisdiction. Finally, the CbC report should identify each entity within the corporate group doing business in a particular tax jurisdiction, and provide a description of the business activities each entity is engaged in. Action 13 envisions that the CbC reports will be exchanged automatically pursuant to double tax conventions and under tax information exchange agreements.
In June 2016, the Treasury Department released final regulations that require annual CbC reporting by US entities that are the ultimate parent entity of a multinational enterprise with annual revenue of USD850 million or more. The IRS has issued Form 8975 (Country-by-Country Report) and the accompanying Schedule A (Tax Jurisdictions and Constituent Entity Information), along with accompanying instructions for both forms. Revenue Procedure 2017-23 describes the process for filing Form 8975 and Schedule A for reporting periods on or after 1 January 2016 but prior to the required reporting period as prescribed in Treasury Regulations §1.6038-4 (TD 9773). On 30 March 2018, the IRS released Notice 2018–31, modifying the CbC reporting requirements for certain MNEs qualifying as specified national security contractors. The IRS intends to amend Regulations Section 1.6038–4 to reflect this guidance.
Citing confidentiality concerns and adequate data security protocols, the USA has opted to enter into specific bilateral agreements on the basis of double tax conventions or tax information exchange agreements, rather than sign the multilateral competent authority agreement for the automatic exchange of CbC reports. The USA has signed bilateral competent authority arrangements with approximately 50 treaty partners for the exchange of CbC reports, with more competent authority arrangements still being negotiated.
The USA believes that its existing tax statutes, rules and regulations sufficiently address the issues raised by the BEPS recommendations, and is generally supportive of the OECD’s BEPS initiative. Representatives of the US Treasury Department have actively participated in various OECD working committees, and have negotiated to ensure that US interests are properly represented and protected. There is some concern amongst US lawmakers, however, that BEPS proposals may allow foreign jurisdictions to unfairly target US-developed intellectual property, even in the absence of critical factors such as local IP development, assumption of entrepreneurial risk and presence of significant assets.
International tax has a high public profile in the USA. However, as discussed above, the USA believes that its current regime already addresses the key BEPS proposals.
BEPS reforms have had a modest impact on US tax laws and their interpretation, administration and enforcement. Currently, implementation of tax reform is a significant issue for the USA.
No information has been provided in this jurisdiction.
BEPS Action 2 is intended to help neutralise the effect of cross-border hybrid mismatch arrangements that produce multiple deductions for a single expense or a deduction in one jurisdiction with no corresponding taxation in the other jurisdiction. The USA has certain rules intended to address certain of the arrangements covered in BEPS that pre-date BEPS. Additionally, the USA has adopted a new Section 267A, which is in line with Action 2. Section 267A denies deductions for interest or royalties paid to a related foreign person in accordance with a hybrid transaction or hybrid entity if such amounts are excludable from income or entitled to a deduction under the local tax laws of the related person’s country.
As discussed in further detail in 6.1 Foreign Income of Local Corporations, the USA taxes the worldwide income of local corporations but has some aspects of a territorial tax regime with respect to foreign subsidiaries. The USA already has certain restrictions on the deductibility of interest under Section 163(j).
As discussed above, the USA has some aspects of a territorial tax regime. The USA has recently significantly expanded the definition of CFCs. First, Section 958(b)(4), which generally prevented foreign-owned stock from being attributed downward to a domestic subsidiary, was repealed. Now, a US person can be attributed ownership of a foreign corporation when determining CFC status. Second, the definition of “US Shareholder” was altered. Previously, a US Shareholder was defined as a US person who owned, directly or indirectly, at least 10% of the voting power of the stock of a CFC. Now, the 10% includes both vote and value of the stock of a CFC. That is, non-voting stock is no longer excluded from the 10% calculation for purposes of determining whether a taxpayer is a US Shareholder. Together, these changes have turned many foreign corporations that were not previously CFCs into CFCs.
The US tax system currently has judicially created anti-avoidance doctrines (economic substance, business purpose, substance over form, step transaction, sham transaction) in addition to rules and regulations that address anti-avoidance. Furthermore, certain US tax treaties have LOB provisions consistent with the LOB provision in the 2016 US Model Treaty.
The general view is that the US transfer pricing rules are consistent with the BEPS Actions. Thus, the general view is that there will not be radical changes.
The application of transfer pricing rules to intangibles has been a source of controversy in the USA. Since the early 2000s, and as recently as 2016, the IRS has voiced the view that transfer pricing disputes involving intangibles is a significant focus for the USA.
There are two new regimes affecting the taxation of intellectual property. The first, Section 951A, addresses GILTI, and aims to reduce the incentive to relocate intangibles to low-tax jurisdictions. See 6.5 Taxation of Income of Non-local Subsidiaries Under CFC-Type Rules. The second, Section 250(a)(1)(A), addresses foreign-derived intangible income (FDII), and aims to incentivise development of intangibles in the USA. FDII allows taxpayers to deduct a portion of income earned from exporting products derived from certain (generally intangible) assets held in the USA.
The USA has mandated the submission of country-by-country reports by US multinational enterprises with annual revenue of USD850 million or more. However, the USA has raised concerns regarding the misuse of taxpayer information and confidentiality, and the administrative and enforcement burdens associated with adhering to the proposals for greater transparency and country-by-country reporting. In addition, there is concern that US taxpayers will be forced to simultaneously comply with multiple conflicting tax rules, which carries with it increased tax burdens and compliance costs, and defending disputes in multiple jurisdictions. Moreover, leakage of confidential or proprietary, competitive information remains a significant concern.
The USA has implemented base erosion and minimum tax provisions that, while not specific to digital economy businesses, would apply to such businesses.
The USA generally opposes any approach that would isolate digital economy businesses rather than apply generally and also opposes individual country approaches to taxation of the digital economy. The Office of the United States Trade Representative has determined that digital service taxes adopted by various countries – including France, India, Italy, Spain, Austria, Turkey and the United Kingdom – are “unreasonable or discriminatory”, or otherwise actionable under Section 301 of the Trade Act of 1974.
The USA prefers arriving at a mutually agreed-upon approach through the OECD’s Programme of Work to Develop a Consensus Solution to the Tax Challenges Arising from the Digitalisation of the Economy, supporting the Modified Residual Profit Split method and voluntary application of the Pillar One allocation method. This approach would allow multinational enterprises to choose between the new formulary apportionment of taxing rights between jurisdictions or the traditional principles of international taxation.
The USA generally supports the base erosion principles of Pillar Two, pending agreement on the mechanics of co-existence with similar rules under domestic law, particularly the GILTI rules discussed under 6.5 Taxation of Income of Non-local Subsidiaries Under CFC-Type Rules.
Offshore intellectual property deployed within the USA may result in taxation under generally applicable US principles. In particular, royalties paid to foreign recipients are among the categories of income subject to withholding tax. The 30% withholding rate may be reduced by treaty.