U.S. Income Tax Reporting Requirements for Foreign Businesses

A foreign business is any enterprise, such as a corporation or partnership, formed under the laws of a country other than the United States. The federal government imposes specific income tax reporting requirements on these businesses based on the nature and extent of their activities.

Determining Your U.S. Taxable Presence

A foreign business’s requirement to file a U.S. tax return hinges on its level of economic engagement within the country. This is not determined by a single rule but by a collection of standards that assess the business’s activities. The primary threshold is whether the company is considered to be engaged in a “U.S. trade or business.”

The concept of a U.S. trade or business (USTB) is not explicitly defined in the Internal Revenue Code, so its meaning has been established through court cases and IRS guidance. For an activity to be considered a USTB, it must be “considerable, continuous, and regular.” For example, providing ongoing services in the U.S. or having employees or dependent agents who regularly solicit sales would likely constitute a USTB. In contrast, merely purchasing goods in the U.S. for use abroad would not.

Once a foreign business is determined to have a USTB, it is taxed on its “Effectively Connected Income” (ECI). ECI is taxed at the same graduated rates that apply to domestic businesses, and deductions related to that income are permitted. Two main tests help determine this connection for investment-type income: the asset-use test and the business-activities test. The asset-use test examines whether an asset is held for use in the business, while the business-activities test looks at whether the activities of the U.S. business were a material factor in generating the income.

Income that is not ECI may still be subject to U.S. tax under a different regime. This category, known as Fixed, Determinable, Annual, or Periodical (FDAP) income, includes passive income streams like interest, dividends, rents, and royalties from U.S. sources. Unlike ECI, FDAP income is taxed on a gross basis, meaning no deductions are allowed. The tax is collected through a flat 30% withholding at the source of payment, although this rate is often reduced by an applicable income tax treaty.

The existence of an income tax treaty between the United States and the foreign business’s home country can significantly alter these rules. Treaties often provide a higher threshold for taxation than the USTB standard. Under many treaties, a foreign business’s profits are only taxable in the U.S. if the business operates through a “permanent establishment” (PE) in the country. A PE is a fixed place of business, such as an office, factory, or branch, through which the enterprise’s business is carried on.

Required Information and Key Forms

The Filing Process

Understanding the Branch Profits Tax

The branch profits tax is an additional U.S. tax imposed on foreign corporations that earn ECI through a U.S. branch. This tax is intended to create parity between foreign corporations operating through U.S. branches and those operating through U.S. subsidiaries, where dividend payments to a foreign parent would be subject to a 30% withholding tax.

The tax is levied at a 30% rate on the foreign corporation’s “dividend equivalent amount,” though this rate can be reduced or eliminated by an applicable tax treaty. The dividend equivalent amount is the corporation’s ECI for the year, with adjustments for any increase or decrease in the net equity of its U.S. branch. This tax applies on top of the regular U.S. corporate income tax on the ECI.

Considerations for Pass-Through Entities

When a foreign person or entity is a partner in a partnership that is engaged in a U.S. trade or business, the partnership itself is required to pay a withholding tax on the effectively connected income that is allocable to its foreign partners. This withholding is mandatory for the partnership, regardless of whether any distributions of funds are actually made to the partners.

The foreign partners must still file a U.S. income tax return, such as a Form 1040-NR for an individual or a Form 1120-F for a corporation, to report their share of the partnership’s income. On this return, they can claim a credit for the amount of tax that the partnership withheld and paid on their behalf.