Federal Income Taxation of U.S. Branches of Foreign Corporations: Separate Entity or Separate Rules?

Abstract

Foreign corporations conduct U.S. business activities either through U.S. subsidiaries or U.S. branches. A U.S. subsidiary of a foreign corporation generally is taxed as any other domestic corporation, that is, as a separate taxable entity apart from its foreign parent. In contrast, a U.S. branch of a foreign corporation is not treated as a separate taxable entity; instead, the Code and regulations employ a set of special rules that allocate and apportion to the U.S. branch a portion of the foreign corporation's income in order to determine the net income subject to U.S. tax.

The rules used for taxing U.S. branch activities are problematic in a number of respects. They fail in some cases to accurately reflect the income produced by U.S. branch activities. In addition, these rules may differ substantially from methods employed by other countries to assign income to U.S. activities, thereby raising the risk that a portion of a foreign corporation's income will be taxed by two counties. The rules for U.S. branches also appear to add to the complexity of the tax law. The end result of a separate entity method for U.S. subsidiaries and different rules for U.S. branches is unwarranted variation in tax treatment based on the form of business used by a foreign corporation.

This article considers the use of the separate entity method for taxing U.S. branches of foreign corporations, focusing on four fundamental policy concerns in the taxation of international business operations: accurate reflection of income, tax administration and simplicity, harmonizing different countries' tax laws, and neutrally taxing different forms of conducting businesses. The article recommends that the separate entity method be used for U.S. branches of foreign corporations, provided its use continues for U.S. subsidiaries.

Keywords: tax, international tax, effectively connected income