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Rental Income and Branch Profits Tax
Phil Hodgen
Attorney, Principal
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I received a call today from a reader in Florida. His question was about the branch profits tax and foreign investors in U.S. real estate. The conversation triggered this blog post. (So, thanks for the call.)There are many other tax questions to think about when a foreign corporation owns U.S. real estate--the regular income tax, the capital gains tax when the property is sold, estate tax, and gift tax. That's too much for one blog post.Instead, we will focus on one overlooked topic--the branch profits tax. My caller said he became aware of this when he went to a conference. He had not seen it in real life. I suspect that is the experience of many people.
You rent the house to someone. In the first year the tenant pays $20,000 of rent to your corporation. There are expenses of $12,000 for repairs and property taxes. This means you have a profit of $8,000. ((Yes, I know this is too simple. Yes, I know about depreciation. I am trying to keep this example really easy to understand.))
The actual income tax your Bahamas corporation owes on the $8,000 of rental income is computed at Form 1120-F, Part II, Schedule J.
I won't bother to make up numbers here. Let's just pretend that the income tax is $2,000. In other words, your corporation made $8,000 of rental income after expenses, and paid 25% tax on it.
In other words, on $8,000 of profit your corporation paid $3,800 of tax. That is a 47.5% tax rate. At higher levels of income, the combined corporate income tax plus branch profits tax can be above 50%.
In this case the property is owned by a U.S. corporation. The branch profits tax only applies to foreign corporations. Therefore, if a U.S. corporation earns $8,000 of rental income (rent collected minus expenses), it will only pay corporate income tax of $2,000, based on my purely fictional tax rate of 25%, chosen to make the math really easy.The U.S. corporation will not pay branch profits tax because the branch profits tax is only imposed on foreign corporations.
Simple Example
Let us pretend that you are a nonresident of the United States and you want to buy a house in the USA, rent it for a few years, and then sell it. Prices are low, and you think it is a good investment.You set up a corporation in the Bahamas, and put $250,000 cash into the bank account for the corporation. Then you find a nice house in the United States that you want to buy. The corporation signs a contract to buy the house for $250,000--all cash. Thirty days later, the purchase is complete and you have received a grant deed transferring the house to your corporation.You rent the house to someone. In the first year the tenant pays $20,000 of rent to your corporation. There are expenses of $12,000 for repairs and property taxes. This means you have a profit of $8,000. ((Yes, I know this is too simple. Yes, I know about depreciation. I am trying to keep this example really easy to understand.))Form 1120-F and Regular Income Tax
At the end of the year, your Bahamas corporation must file a U.S. income tax return reporting its rental income. It uses Form 1120-F. ((Yes, I know that there will probably be a State income tax return, too. Again, I am trying to keep this example really simple.))The place on Form 1120-F where this information goes is Part II. ((The rental income goes here because your foreign corporation is engaged in the conduct of a trade or business in the United States--rental of real estate. If you are not sure if this is true, you will make a special election to force this result. The election is called the "net election" and this will be a topic for another blog post.)) This is what it will look like:The actual income tax your Bahamas corporation owes on the $8,000 of rental income is computed at Form 1120-F, Part II, Schedule J.I won't bother to make up numbers here. Let's just pretend that the income tax is $2,000. In other words, your corporation made $8,000 of rental income after expenses, and paid 25% tax on it.Form 1120-F and Branch Profits Tax
Let us now continue to the "Scary Monsters" part of this example.Flip over to page 5 of the Form 1120-F. This is Part III. This is where the branch profits tax is computed. Look at Line 1 there. It tells you to enter the amount from Form 1120-F, Part II, Line 29. This is the corporation's taxable income (total income minus total expenses) before a couple of adjustments that do not matter to our example.So we put $8,000 there on Line 1. That is the taxable income for the corporation.Line 2 is cryptic until you read the instructions, and then it is only slightly less cryptic. Honestly, I do not understand how the U.S. government expects normal people to deal with the tax laws of this country.Line 2 asks for certain adjustments to be made. I will not get into every little detail that goes here. For our example, only one item matters: the Federal income tax the Bahamas corporation owes on its rental income. That is $2,000. We write that number in.Simple subtraction yields $6,000 on Line 3. This is basically your corporation's "really, truly" income, after paying corporate income tax.Let's skip Lines 4a through 4e for our example. They are adjustments (up or down) to the amount on Line 3. We are pretending that nothing happened to create these adjustments.Line 5, then, is simply the same amount as on Line 3: $6,000.Line 6 says "multiply Line 5 by 30%" and this is your corporation's branch profits tax: $1,800.Total Income Tax
Finally, let us go back to the first page of Form 1120-F to compute your corporation's total tax payable to the U.S. government on its rental income.You write in the corporate income tax computed in Part II at Line 2. You write in the branch profits tax computed in Part III, at Line 3. The total tax payable by your corporation is $3,800.In other words, on $8,000 of profit your corporation paid $3,800 of tax. That is a 47.5% tax rate. At higher levels of income, the combined corporate income tax plus branch profits tax can be above 50%.Automatic
Note that the branch profits tax is automatic. If your corporation has a profit in the year (as shown in Part II, Line 29), the tax return automatically triggers Part III and the branch profits tax is computed.No Income Tax, but Branch Profits Tax
There is another problem with the branch profits tax. Go back to Part II, Line 29. Do you see how this is the corporation's income before net operating losses? Branch profits tax is computed on the corporation's taxable income. The branch profits tax does not care about your net operating loss.This means that you can have years where the corporation pays no income tax (because it has a net operating loss from the prior year that eliminates the taxable profit generated in the current year). But the corporation will pay the branch profits tax.Simple Solution
The simple solution for the branch profits tax is to hold U.S. real estate in a "foreign parent, domestic subsidiary" structure.In this case the property is owned by a U.S. corporation. The branch profits tax only applies to foreign corporations. Therefore, if a U.S. corporation earns $8,000 of rental income (rent collected minus expenses), it will only pay corporate income tax of $2,000, based on my purely fictional tax rate of 25%, chosen to make the math really easy.The U.S. corporation will not pay branch profits tax because the branch profits tax is only imposed on foreign corporations.