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Chapter 2 Foreign Branches

      Learning objectives

Operating through a foreign branch — summary

      After exporting goods from the United States, the next step for a U.S. business is conducting direct business operations overseas, either through foreign branch operations or through foreign subsidiary corporation(s). A foreign business operation may manufacture goods, provide services, or perform special functions (for example, advertising, financing, and sales). Frequently, a foreign business operation requires a significant number of full-time personnel, including people who are transferred from the United States to the foreign country.

      U.S. taxpayers typically use the following approaches to establish a foreign branch.

      Foreign Branch Income Taxation — Post-TCJA

      For U.S. federal income tax purposes, a foreign branch is a division that operates a trade or business in a foreign country and maintains a separate set of books and records. The foreign branch generally is also subject to the income tax laws in the foreign country in which it operates.

      The term branch describes a complete, distinct business operation of a U.S. corporation. Although a branch may be separate with respect to function, personnel, or location, it is part of the same U.S. corporation. As before the TCJA, income, deductions, losses, and credits of the foreign branch are considered in calculating the tax liability of the U.S. consolidated group (that is, flow-up). The income of a foreign branch is subject to the 21% corporate tax rate.

      Losses of the branch flow into the U.S. consolidated group and reduce taxable income of the group. Dual consolidated loss (DCL) rules, however, provide that such losses cannot be used currently if the losses can also be used by a foreign subsidiary to reduce its income under foreign law.

      Definition of a foreign branch for U.S. federal income tax purposes post-TCJA

The proposed rules define a foreign branch by reference to the Section 989 regulations, with modifications, such that a foreign branch must carry on a trade or business outside the United States and maintain a separate set of books and records. Therefore, activities undertaken within the United States would be excluded when determining whether activities rise to the level of a trade or business outside the United States. Under Section 1.989(a)-1(c), for activities to constitute a trade or business, they “must ordinarily include the collection of income and payment of expenses.” This requirement created the possibility that a branch that does not earn any regarded income is not a qualified business unit (QBU) under Section 989, regardless of the level of activity within the branch (for example, a maquiladora). In contrast, the proposed rules provide that, for purposes of determining whether this test is met in the context of Section 904, disregarded transactions are considered and may give rise to a trade or business for this purpose.

      The decision to provide a rule considering disregarded transactions in determining whether the trade or business test is met for purposes of the foreign tax credit rules represents a departure from the Section 989 regulations. Accordingly, a branch that does not earn any regarded income (for example, because all of its transactions are with its owner) may constitute a foreign branch for purposes of the foreign tax credit limitation and Section 250, but might not be treated as a QBU for purposes of Section 987, which applies the definition in the Section 989 regulations. The foreign branch definition would not import the Section 989 regulations’ per se QBU rule for partnerships, but rather would provide that if a partnership’s activities constitute a trade or business conducted outside the United States, then those activities will constitute a foreign branch even if the partnership does not maintain books and records for the trade or business that are separate from the partnership’s books and records. Activities that constitute a permanent establishment in a foreign country under a bilateral U.S. income tax treaty would be presumed to constitute a trade or business conducted outside the United States.

      Under new foreign branch regulations, post-TCJA, foreign branch category income is limited to the income of a U.S. person attributable to foreign branches held directly or indirectly (via disregarded entities, partnerships, or other pass-through entities) by such U.S. person. Foreign persons (including controlled foreign corporations or CFCs) cannot have foreign branch income. The proposed rules would define a U.S. person for this purpose to exclude pass-through entities (for example, partnerships). As such, foreign branch category income would be determined at the U.S. corporate or individual level, applying an aggregate theory for partnerships. Generally, the proposed rules would attribute gross income to a foreign branch to the extent such gross income is reflected on the foreign branch’s separate books and records, but would exclude the following.

These exclusions from foreign branch category income, and in particular the presumption for related party interest, intend to prevent taxpayers that may otherwise try

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