Foreign corporations need to evaluate their U.S. activity to ensure they stay in compliance with the Internal Revenue Service’s filing obligations. Several factors, including the existence of a trade or business and nature of and extent of economic activities can impact or otherwise create a filing requirement. This FGMK article highlights key considerations for foreign corporations as they evaluate the extent of their U.S. activity and understand their U.S. filing obligations.
BACKGOUND
Trade or Business
A central premise of the U.S. taxability of foreign corporations is the existence of a trade or business in the U.S. If such a trade or business exists, effectively connected income (“ECI”) is taxed at the current U.S. corporate tax rate of 21%. The enactment of the branch profits tax under Internal Revenue Code (“IRC”) Section 884 has created an additional risk to foreign corporations whose investment activities are determined to rise to the level of being engaged in a trade or business. In such a case, ECI of the foreign corporation may be subject to the branch profits tax, as well as to the tax under IRC Section 881 related to U.S. source non-business type income (i.e., interest, dividends, etc.). Whether a foreign corporation is subject to U.S. tax depends, in part, on whether it is engaged in a U.S. trade or business. If engaged in a U.S. trade or business, absent treaty protection, a foreign corporation will generally be taxed on their ECI associated therewith.
A U.S. trade or business is not well-defined in the IRC. Rather, the determination of whether a trade or business exists has developed over years of case law and Internal Revenue Service ("IRS") rulings. The trade or business determination generally is based on the unique facts and circumstances of each situation.1 The nature and extent of the foreign corporation's activities in the U.S. play a critical role in the analysis. The general standard holds that a U.S. trade or business exists if activities are “considerable, continuous, and regular.”2 This well-established standard highlights the dual nature of this determination, requiring a close examination of (1) the types of U.S. activities in which the foreign corporation is engaged; and (2) whether those activities are substantial enough to qualify as a trade or business. The analysis is based not only on the activities directly performed by the foreign corporation but also on those activities of agents, partnerships, or trusts that can be attributed to the foreign corporation.3
Economic Activities
A foreign corporation needs to consider the nature and extent of its economic activities in the U.S., either directly via its employees or through its agents. The following have been considered to be important factors by the courts and/or the IRS:
It is important to remember that an agent’s activities in the U.S. may result in a U.S. trade or business for the foreign corporation.
U.S. FEDERAL FILING OBLIGATION
Form 1120-F
If it is determined that a trade or business exists for the foreign corporation, the foreign corporation is required to file a U.S. income tax return – Form 1120-F – reporting the income effectively connected with that trade or business.
Treaty benefits do not absolve the requirement to file. If there is a bilateral income tax treaty between the U.S. and the foreign corporation’s jurisdiction which exempts the income from U.S. taxation, this does not mean the foreign corporation does not need to file a U.S. return. Rather, the Form 1120-F must be filed with a Form 8833 which provides specific details of the treaty position being taken.
If a foreign corporation conducts limited activities in the U.S. in a tax year in which the foreign corporation determines that such limited activities do not give rise to gross income that is effectively connected with the conduct of a trade or business within the U.S., the foreign corporation could follow the instructions for filing a protective return to safeguard its right to receive the benefit of the deductions and credits attributable to that gross income in the event that it is subsequently determined that the original determination was incorrect. A foreign corporation should also file a protective return if it determines initially that it has no U.S. tax liability under the provisions of an applicable income tax treaty (e.g., its income is not attributable to a permanent establishment in the U.S.). A foreign corporation that does not file a return will lose the right to take deductions and credits against its ECI.
Due Dates
The due date for the Form 1120-F filing depends on the filer’s context, as summarized below:
The foreign corporation must file Form 7004, Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns, by the return due date specified above to request an extension of time to file.
IRS ENFORCEMENT EFFORTS – THE TRAIN IS COMING (ARE YOU ON THE TRACKS?)
IRS Campaigns
The LB&I division of the IRS currently has four active enforcement campaigns related to Form 1120-F. One of these campaigns relates to identifying non-filers, and it typically results in a notice from the IRS that shows up in the mail as an initial background information request. It will typically resemble a questionnaire and request information as to the foreign corporation’s connections to the U.S. This notice commonly precedes an IRS examination.
Another of the IRS campaigns is focusing on delinquent filers and the ability to claim deductions or credits to offset any ECI reported. Hence, the importance of a timely filed protective filing as previously mentioned. The due date is somewhat relaxed in the protective return filing context, which provides that the return generally must be filed by 18 months after the due date (or, for corporations that had an obligation to file a U.S. return in the preceding year and failed to do so by the date, the IRS contacts the taxpayer regarding the current year’s non-filed return).
Waiver Process
The IRS has the power of discretion to waive the timeliness requirement if it deems the taxpayer acted in good faith or otherwise acted reasonably in regard to its filing obligations. A taxpayer has the right to request a waiver, and the IRS, with newly received practice unit instructions (released July 2022), can evaluate the taxpayer’s request.
TO FILE, OR NOT TO FILE - THAT IS THE QUESTION
A foreign corporation should file a Form 1120-F when it is determined that it has a U.S. trade or business. If there is uncertainty surrounding this trade or business determination, it would generally be advisable to file a protective Form 1120-F to preserve the claim of deductions and/or credits against any ECI that could be attributable to the foreign corporation in the context where the IRS were to audit the foreign company and make its own determination that a trade or business exists. Granted, while this position could always be challenged by the taxpayer, the protective filing also avails the taxpayer of the statute of limitations which provides the basis to avoid any failure-to-file penalties that otherwise could exist.
For additional information regarding a foreign corporation’s filing obligations, as well as analysis of whether or not a trade or business in the U.S. exists, please contact FGMK’s International Tax team.
1Lewenhaupt v. Comm'r, 20 TC 151, 162 (1953), aff'd, 221 F2d 227 (9th Cir. 1955); see also Rev. Rul. 88-3, 1988-1 CB 268.
2Pinchot v. Comm'r, 113 F2d 718, 719 (2d Cir. 1940) ; de Amodio v. Comm'r, 34 TC 894, 906 (1960) , aff'd, 299 F2d 623 (3d Cir. 1962) ; Spermacet Whaling & Shipping Co. v. Comm'r, 30 TC 618, 634 (1958) , aff'd, 281 F2d 646 (6th Cir. 1960).
3InverWorld, Inc. v. Comm'r, TC Memo. 1996-301 (1996).
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