In this second part of the series, we therefore work through the decision points that determine whether a corporation has a filing obligation. Typical examples are a German AG setting up a sales office in the United States, a German GmbH that holds and leases U.S. real property, and the passive holding company that many of our clients use to structure and hold their U.S. investments. A third article will then cover foreign partnerships.
Index
Note: The following discussion addresses the U.S. federal level only. Most states – and, in some states across the board, cities and counties as well – levy their own income taxes, among others, with separate filing obligations that may attach, for example, to the place where services are performed or to the location of rental real property. In addition, the German-U.S. income tax treaty covers U.S. federal taxes only; relief under the treaty therefore does not automatically carry over to the state and local level.
First Decision Point: Is the Entity Treated as a Foreign Corporation for U.S. Tax Purposes?
Before looking at the income, a threshold question has to be answered. Is the entity considered foreign from a U.S. perspective, and is it treated as a corporation?
An entity is foreign if it was not created or organized in the United States or under the law of the United States, any U.S. state, or the District of Columbia. Entities organized in U.S. territories such as Puerto Rico are expressly treated as foreign for U.S. federal income tax purposes. For German entities, this is straightforward: they are always foreign, and their place of effective management does not matter in this respect.
For foreign entities, U.S. law contains a country-by-country list of the legal forms that are treated as so-called per se corporations for tax purposes. For these legal forms, per se corporation status is final, which means they cannot elect a different tax treatment. For Germany, this applies, for example, to the Aktiengesellschaft (AG) and the Societas Europaea (SE). In addition, certain entities must be treated as corporations regardless of their legal form, such as insurance companies.
All other entities are so-called eligible entities. For these, U.S. law provides a default classification that applies without any further action. Under these rules, a German GmbH is generally classified as a corporation. For a German partnership, such as a GmbH & Co. KG, the structure and the ownership of its partners must be examined more closely to determine its default status.
An eligible entity that wants to be treated differently from its default classification can elect a different status under the so-called Check-the-Box regime. The options available depend in particular on the number of owners. With two or more owners, the entity can choose between corporation and partnership status. With a single owner, it can choose between corporation status and treatment as a so-called disregarded entity, which does not exist as a separate taxpayer for tax purposes.
Second Decision Point: ECI or FDAP
Once the entity has been classified, the next step is to determine what type of U.S. income it earns. For foreign corporations as well, U.S. tax law distinguishes in particular between two fundamentally different income categories:
Effectively Connected Income (ECI) covers income that is connected with a U.S. trade or business. It is taxed on a net basis, after deduction of related expenses, at the regular U.S. corporate income tax rate, currently 21 percent. In addition, the Branch Profits Tax generally applies: 30 percent on profits not reinvested in the United States. Under the income tax treaty between Germany and the United States (the treaty), this rate may in certain situations be limited to 5 percent, or even to 0 percent where the so-called Limitation on Benefits clause (Art. 28 of the treaty) is met.
Fixed, Determinable, Annual, or Periodical Income (FDAP), by contrast, is recurring U.S.-source income that is not connected with a U.S. trade or business. This may include, for example, dividends, interest, royalties, or rents (absent an election under IRC § 882(d)). FDAP is generally taxed on a gross basis at a standard rate of 30 percent, unless an applicable income tax treaty provides for a lower rate.
Third Decision Point: U.S. Withholding Tax
U.S. withholding tax applies at the point of payment. Withholding Agents, in particular paying agents, brokers, and U.S. entities, must withhold U.S. tax on certain payments to foreign recipients unless valid documentation establishes an exemption or a reduced rate.
The withholding rate depends on the income category. On FDAP income, the standard rate is 30 percent. For corporations, under a treaty may reduce this rate in particular as follows: for dividends to 15 percent as a general rule, for direct holdings of at least 10 percent of the voting stock to 5 percent on dividends, for holdings of at least 80 percent of the voting stock to 0 percent on dividends, subject to additional requirements, for interest and royalties typically to 0 percent. For ECI, separate regimes with sometimes higher rates apply to corporations as well. Examples are FIRPTA withholding of 15 percent of the gross proceeds on the sale of U.S. real property, or a 10 percent withholding on the transfer of an interest in a U.S. partnership engaged in a trade or business. However, the tax withheld under these regimes works as a prepayment that is credited against the corporation’s later U.S. corporate income tax liability. By contrast, where the corporation has no U.S. trade or business, complete and correct withholding on FDAP generally satisfies the U.S. tax in full.
For a foreign corporation, documentation for FDAP income is generally provided on Form W-8BEN-E. On this form, the corporation, as the beneficial owner of the income, certifies its foreign status and, where applicable, its entitlement to a treaty-reduced withholding rate. For income that is effectively connected with a U.S. trade or business (ECI), Form W-8ECI is used instead. The Withholding Agent later issues Form 1042-S to the corporation, showing the amounts paid and the tax withheld. This form is also the key document for any later credit or refund of the withheld tax, whether in the U.S. or, where applicable, the German assessment proceedings.
The Final Check: Is There a Filing Obligation?
Once the entity’s classification, the income category, and the withholding position have been assessed, the corporation’s filing obligation can be determined conclusively.
The central return is Form 1120-F (U.S. Income Tax Return of a Foreign Corporation), which is also used to report any Branch Profits Tax. A filing obligation arises in particular in two cases. First, the corporation engaged in a U.S. trade or business during the relevant tax year. Second, the corporation is allocated income, gains, or losses that are treated as ECI by statute, such as a FIRPTA gain from the sale of U.S. real property. The obligation applies even if the activity produced no income, if no positive result remains after netting, or if the treaty fully exempts the income from U.S. tax. The formal filing obligation must therefore be kept separate from the substantive tax liability.
Importantly, if the return is not filed on time, the IRS may treat the corporation as having lost the right to claim deductions and tax credits against ECI. As a result, the corporation risks being taxed on a gross basis. For this purpose, a return is generally still considered timely if it is filed within 18 months of the regular due date. Credit for U.S. tax already withheld is preserved even where the return is filed late.
For this reason, corporations that cannot yet conclusively assess their U.S.-source income or the nature of their U.S. activities are advised to file a so-called Protective Return. It preserves the right to claim deductions and tax credits even if the characterization of the U.S. activities changes later.
If there is no U.S. trade or business and tax on FDAP was withheld completely and correctly, there is generally no formal filing obligation. If too little tax was withheld, however, an original filing obligation arises regardless of any U.S. trade or business. This can happen, for example, because the Form W-8BEN-E documentation was incomplete or missing. In that case, the U.S. tax has not been fully satisfied. If too much tax was withheld, the corporation may file a corporate income tax return to recover the difference. This is the case, for example, where the Withholding Agent applied the full 30 percent rate although the treaty provides for a lower rate. For pure refund cases without any U.S. trade or business, the IRS allows a simplified approach under certain conditions, which reduces the parts of the form that must be completed.
In addition to the corporate income tax return, foreign corporations have in particular two further reporting obligations that may need to be reviewed separately:
- Form 5472 to report certain transactions with related parties, such as sales of goods, loans, licenses, or services, in connection with the corporation’s own U.S. trade or business. German holding companies should note that this obligation can also apply to their U.S. subsidiary where they hold an interest of at least 25 percent, even if the subsidiary has no U.S. trade or business. This is also the case where the subsidiary is a so-called disregarded entity for U.S. tax purposes.
- Form 8833 may be required where the corporation relies on a treaty provision that reduces or eliminates its U.S. tax. Examples are positions relating to a permanent establishment or to the Branch Profits Tax. Where this disclosure obligation applies, it also triggers a separate requirement to file Form 1120-F.
Key Takeaways
- Whether a U.S. tax return filing obligation exists depends on several successive decision points. These are the entity’s classification as a corporation, the categorization of its U.S. income, whether withholding at source fully satisfies the U.S. tax, and the formal filing requirements that follow from these determinations.
- The first decision point is the entity’s tax classification. Foreign entities are either so-called per se corporations (e.g., AG, SE) with no election available, or eligible entities. Where the default status of an eligible entity is corporation, it may be changed under the Check-the-Box regime.
- The second decision point is the income category. ECI is taxed on a net basis at the regular corporate income tax rate of 21 percent, plus a Branch Profits Tax of generally 30 percent that may be reduced under the treaty. FDAP is taxed on a gross basis at a standard rate of 30 percent, which may also be reduced under the treaty.
- S. withholding tax applies at the point of payment. For FDAP, it satisfies the U.S. tax in full when withheld at the correct rate. For ECI and certain special regimes such as FIRPTA, it is a prepayment that is credited in the return.
- The central S. tax return (Form 1120-F) is required in particular where the corporation engaged in a U.S. trade or business (even without income or where an exemption applies). It is also required where the corporation received FDAP income on which withholding did not fully satisfy the U.S. tax.
- If the return is not filed on time, the corporation risks losing deductions and tax credits against ECI and being taxed on a gross basis. The relevant deadline is generally 18 months from the regular due date, and credit for U.S. tax already withheld is preserved regardless. Where the corporation is uncertain about its U.S. income or activities, filing a so-called Protective Return may be advisable.
- In addition to Form 1120-F, corporations may have separate reporting obligations. Form 5472 covers transactions with related parties, including for a U.S. subsidiary without its own trade or business where the ownership interest is at least 25 percent. Form 8833 may apply where the corporation relies on a treaty provision.
Questions About Your Corporation’s U.S. Filing Obligations? We are happy to help you analyze your corporation’s U.S. tax classification and the income it earns, and to review U.S. tax withholding and Form W-8 documentation. We also prepare and file Forms 1120-F and 5472 and align treaty positions with both your U.S. and your German tax filings.
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