This little FAQ is a simple (for certain values of $SIMPLE) explanation of the branch profits tax for nonresident investors in U.S. real estate.
As a general principle it is a Very Bad Idea for nonresidents to own income-generating U.S. real estate through foreign corporations. If you live in a country that has an income tax treaty with the United States, there may be a solution to the branch profits tax via the treaty.
What is the branch profits tax?
The branch profits tax is an extra income tax imposed by the United States on foreign corporations which earn profit from their U.S. investments or U.S. business operations.
How much will the branch profits tax cost?
The branch profits tax is imposed on a non-U.S. corporation’s after-tax net profit. Simply put, the branch profits tax works like this:
- Calculate the non-U.S. corporation’s profits derived from U.S. investments or business operations.
- Pay regular corporation income tax on that profit.
- Whatever is left over is your after-tax net income. Pay 30% of that after-tax net income as the branch profits tax.
Example of calculating branch profits tax
Let’s assume that a non-U.S. corporation owns U.S. real estate that is rented. At the end of the year, after paying all business expenses, the corporation has a profit of $100.
First, the corporation will pay income tax. The tax rate is on a sliding scale (higher income means higher tax rate). But let’s use 34%, the rate that applies for income of about $350,000 and up. After paying the regular income tax, the corporation has $66 remaining.
Then the corporation pays the branch profits tax, which is 30% of the $66 remaining after payment of the regular income tax. The branch profits tax is $19.80.
The total tax paid is $34.00 + $19.80 = $53.80, or 53.8% of net profit.
Only foreign corporations pay the branch profits tax
The branch profits tax is only imposed on foreign corporations. This means two things:
- The entity must be viewed as a corporation from the perspective of the U.S. tax authorities; and
- The entity must be formed under the laws of a country other than the United States.
People, then, do not pay the branch profits tax, even if they are nonresidents of the United States. Nor do partnerships or trusts.
What is a foreign corporation?
Be careful. Sometimes you may have an entity that is called a corporation but is treated in the United States for tax purposes as something else. Similarly, you may have an entity that is not called a corporation, but is treated as a corporation in the United States for tax purposes.
Many countries attribute residence of a corporation to its place of management. This does not matter for U.S. tax purposes. A corporation is foreign if the organizing documents (Articles of Incorporation or similar) say something to the effect of “This corporation is formed under the laws of ________” and the place named is not a place in the United States.
Why the branch profits tax exists
The branch profits tax is intended to cause non-U.S. corporations (and their shareholders) to be taxed identically to U.S. corporations (and their shareholders). The idea is that a nonresident investor should be indifferent–from a U.S. tax perspective–between investing in the United States through a non-U.S. corporation or through a U.S. corporation.
If a non-U.S. person owned a U.S. corporation which made the equivalent investment, the net profit would be taxed at 34%. Under the example I gave, this means that the corporation would contain $66.00 after paying its income tax. If the shareholder wanted that cash, the corporation would pay a dividend to the non-U.S. shareholder. As the dividend money leaves the United States there is a withholding tax imposed, at a default rate of 30% of the amount of the dividend. (It can be less if the recipient lives in a country that has an income tax treaty with the United States.)
Thus, a non-U.S. investor who used a U.S. corporation would pay two levels of tax: the regular corporate tax calculated at 34% of income, and the 30% withholding tax on the dividend paid by the corporation to the shareholder.
Compare that to the same investment made by a non-U.S. investor through a non-U.S. corporation. The non-U.S. corporation earns $100. It pays the regular income tax at 34%.
It has $66.00 remaining in its bank account. Now the shareholder wants a dividend. The United States cannot tax that dividend because it is paid from a non-U.S. corporation to a non-U.S. shareholder. The second level of tax–the 30% tax on dividends–will not be paid.
The branch profits tax plugs that hole.
The branch profits tax applies automatically
The branch profits tax automatically applies if there is a profit generated in a fiscal year for the non-U.S. corporation. Compare that to the tax on a dividend: here the corporation controls if and when the withholding tax on the dividend will be paid, by deciding to pay (or not) a dividend.
How a non-U.S. corporation avoids the branch profits tax
The branch profits tax is imposed in an automatic and mechanical way. There are only a few ways to eliminate it:
- Reinvest your profits in the United States;
- Find an exemption in the income tax treaty between the United States and the country in which the corporation was formed (the United Kingdom, for instance, has an exemption); or
- Completely terminate all business and investment operations in the United States (also know as “sell your assets and take your money home”).
When the branch profits tax is harmless to real estate investors
The branch profits tax is harmless to nonresident real estate investors if the non-U.S. corporation owns one piece of U.S. real estate, and that property is not producing income. Direct ownership of land is fine. So is direct ownership by a non-U.S. corporation of a house which is used for personal purposes.
The branch profits tax does not matter in these situations because there is no annual rental income collected. No income means nothing to tax.
In the year of sale there will be profit and the branch profits tax will apply. But there is a simple exception which can be used to eliminate the branch profits tax in the year of sale–the branch profits tax will not apply if the non-U.S. corporation ceases all U.S. business and investment operations in the year of sale.
When the branch profits tax applied to rental property
The branch profits tax will apply to nonresident investors in U.S. real estate who have rental income held directly by a non U.S. corporation. The income collected (after expenses) will be subjected to the branch profits tax.
When the branch profits tax applies to multiple properties
A non-U.S. corporation which owns many pieces of U.S. real estate will have a branch profits tax problem.
If any of the properties are rented, the rental income will be subjected to the branch profits tax.
If one of the pieces of real estate is sold, the profit on sale will be subjected to branch profits tax, and the exception traditionally used to eliminate the branch profits tax (the non-U.S. corporation ceases all U.S. investment and business operations in the year of sale) cannot be used, because the corporation continues to hold other pieces of real estate.
What to do if branch profits tax is a problem
If you have an existing situation which triggers branch profits tax, consider adding a U.S. corporation to the holding structure. Instead of the non-U.S. corporation owning U.S. real estate directly, the non-U.S. corporation will own all of the shares of a U.S. subsidiary corporation, which in turn owns the U.S. real estate.
This type of restructuring will not trigger any tax if done correctly. It is purely a paperwork exercise.
Since the owner of the real estate is now a U.S. corporation, the branch profits tax will no longer apply. (Branch profits tax only applies to non-U.S. corporations).