What Is the Branch Profits Tax & How Is It Calculated?

The branch profits tax is a component of the U.S. tax system applied to foreign corporations operating in the United States. It is a tax on profits generated by a U.S. branch that are considered sent back, or repatriated, to the corporation’s home country. The goal of this tax is to establish tax parity between foreign corporations that conduct business in the U.S. through a branch and those that operate through a U.S. subsidiary. When a U.S. subsidiary pays dividends to its foreign parent, that payment is subject to a 30% withholding tax, and the branch profits tax, introduced by the Tax Reform Act of 1986, was designed to mirror this effect for branch operations. This tax is separate from and in addition to the regular U.S. corporate income tax paid on the branch’s earnings.

Determining Applicability

The branch profits tax targets foreign corporations that are engaged in a trade or business within the United States. The simple ownership of passive investment assets in the U.S. is not sufficient to trigger this tax; the foreign corporation must be actively involved in commercial activities that are considerable, continuous, and regular.

Once it is established that a foreign corporation is engaged in a U.S. trade or business, the next step is to determine if it has “Effectively Connected Income” (ECI). ECI is the portion of the corporation’s income that is considered to be from sources within the United States and connected to its U.S. business operations. For instance, income from the sale of products or the performance of services within the U.S. would be classified as ECI. The concept of ECI is broad and can include not only U.S.-sourced income but also certain types of foreign-sourced income under specific circumstances, as long as the income is attributable to the U.S. operations.

Calculating the Tax Liability

The calculation of the branch profits tax uses the “dividend equivalent amount” (DEA), which is subject to a standard tax rate of 30%. This rate can sometimes be reduced by an applicable income tax treaty. The DEA represents the portion of a branch’s after-tax earnings that are presumed to have been repatriated to the foreign parent corporation rather than being reinvested in the U.S. operations.

To arrive at the DEA, the starting point is the branch’s effectively connected earnings and profits (ECEP) for the year. This figure is similar to ECI but is adjusted according to corporate earnings and profits principles, which align more closely with a company’s economic ability to make distributions. From this ECEP, an adjustment is made based on the change in the branch’s “U.S. net equity” from the beginning of the year to the end of the year. U.S. net equity is defined as the adjusted basis of the branch’s U.S. assets minus its U.S. liabilities.

If U.S. net equity increases during the year, it signifies that the branch has reinvested its earnings into its U.S. operations, for example, by purchasing more assets or paying down debt. This increase in U.S. net equity reduces the DEA, thereby lowering the branch profits tax liability. Conversely, if U.S. net equity decreases, it implies that profits have been withdrawn from the U.S. business and repatriated. This decrease is added to the ECEP, increasing the DEA and potentially the tax.

For a simplified example, assume a foreign corporation’s U.S. branch has $500,000 in ECEP for the year. At the start of the year, its U.S. net equity was $2 million, and at the end of the year, it was $1.8 million, a decrease of $200,000. This $200,000 decrease is added to the ECEP, resulting in a DEA of $700,000 ($500,000 + $200,000). The branch profits tax would then be 30% of $700,000, which is $210,000, assuming no treaty relief applies.

The Role of Tax Treaties

Income tax treaties between the United States and other countries can alter the application of the branch profits tax. A treaty may provide for a reduced tax rate, often lowering it from the standard 30% to a rate comparable to the treaty’s dividend withholding rate, which can be as low as 5%. In some cases, a treaty might offer a complete exemption from the tax.

These treaty benefits are not automatically granted to any foreign corporation from a treaty country. To access these advantages, the corporation must be a “qualified resident” of that country. This requirement is found in the “Limitation on Benefits” (LOB) article of most modern U.S. tax treaties. The purpose of the LOB article is to prevent “treaty shopping,” a practice where a corporation from a non-treaty country sets up a shell company in a treaty country merely to gain access to that treaty’s benefits.

To be considered a qualified resident, a corporation must meet one of several objective tests outlined in the treaty’s LOB article. Common tests include being a publicly traded company on a recognized stock exchange in that country, or meeting specific ownership and base erosion tests. These tests require that a certain percentage of the company’s owners are residents of the treaty country and that the company is not simply being used to pass income through to residents of non-treaty countries.

Reporting and Paying the Tax

All calculations and liabilities related to the branch profits tax are reported on Form 1120-F, U.S. Income Tax Return of a Foreign Corporation. The calculation of the branch profits tax and the dividend equivalent amount is detailed in a dedicated section of Form 1120-F. The final tax liability is then carried to the main part of the return to be included in the total tax due.

Form 1120-F must be filed with the Internal Revenue Service (IRS) by the appropriate deadline. Corporations that are required to file 10 or more returns of any type during the year must file Form 1120-F electronically. Payment of the tax is due by the filing deadline of the return and can be made through several methods, including the Electronic Federal Tax Payment System (EFTPS) or by electronic funds withdrawal if filing electronically.