The
income of foreign corporations is segregated into two categories,
each
of which is taxed separately:
- Non-business
income: Certain types of US source investment and other
passive income that are not effectively
connected with a US business.
- Business
income: Income related (i.e., effectively connected)
to a business carried on in the United States.
Worldwide income effectively connected with the conduct
of a trade or business in the United States is taxed on a
net basis at the regular graduated rates. US source non-business
income is taxed on a gross basis at a flat 30-percent rate
(unless reduced or eliminated by statute or income tax treaty
such as the US-Canada Income Tax Treaty).
Foreign corporations that operate businesses in the United
States may pay, in addition to the regular corporate income
tax, a branch profits tax equal to 30 percent of their effectively
connected earnings (after regular tax) that are not reinvested
in the United States. Provided certain requirements are satisfied,
the application of the branch profits tax may be modified
or eliminated by an applicable income tax treaty.
Foreign corporations may be exempt from US tax on gross
income derived from the operation of ships or aircraft if
the foreign countries where such corporations are organized
grant an equivalent exemption to US citizens and domestic
corporations and the foreign country provides the US Treasury
Department with an official notice of an equivalent exemption.
To date, the Canadian government has not provided the US
Treasury Department with notice of an equivalent exemption
in Canada.
The concepts of fixed or determinable annual or periodical
income and other non-business income, trade or business within
the United States, effectively connected income, and source
of income are discussed below. These concepts are important
for the taxation of both foreign corporations and non-resident
alien individuals.
Non-business Income
Only certain types of non-business income from US sources
are subject to US tax. The principal types of this income
are:
- Fixed
or determinable annual or periodical income (FDAP)
- Certain
original issue discount on debt obligations when payments
of principal or interest are received or when the
obligations are sold
- Certain
gains from the disposal of timber, coal, or domestic
iron ore
- Certain
gains from the sale of patents and other intangible property
to the extent the proceeds are contingent on the
future productivity, use, or disposition of the
property.
“Fixed or determinable annual or periodical income” is
a descriptive term relating to a class of income, rather
than a highly technical definition. It includes interest,
dividends, rents, certain wages, and annuities (i.e., fixed
amounts, paid periodically), as well as items that are potentially
within the class, such as royalties. The payor's perspective,
and not the recipient-taxpayer's, determines whether any
income item is fixed or determinable. In line with this perspective,
gain from the sale of personal property by non-dealers generally
is not fixed or determinable. The following types of US source non-business income are
not taxable to a foreign corporation:
- Gains
from the sale of capital assets and other property, except
interests in US real property
- Interest
received on deposits with banks and certain other financial
institutions
- Interest
received on portfolio debt investments
- Interest
on certain obligations issued by US state and local governments.
Source of Income The source of income is important for several reasons, chief
among them being the taxation of non-business income and
the determination of business income itself. Source of income
also plays a major part in determining the limitation on
the foreign tax credit. Items of income not considered to
be from US sources are treated as foreign source income.
Interest income is considered to be from US sources if
it is paid by the US government, the states or the District
of Columbia, or on bonds, notes or other interest-bearing
obligations of non-corporate residents or domestic corporations.
US source income also includes interest paid by a foreign
corporation that is attributable to a US trade or business
(e.g., a US branch).
US source interest income, however, does not include the
following:
- All
interest received from an unrelated domestic corporation
where at least 80 percent of the payor' s gross income
from all sources for the three-year period preceding
the taxable year of payment is derived from foreign sources
and is attributable to the active conduct of a trade
or
business in a foreign country or US possession.
- Interest
on deposits with foreign branches of domestic banks and
savings and loan or similar institutions.
Dividends are considered to be from US sources if received
from the following:
- Domestic
corporations, other than certain corporations operating
in the US possessions
- Foreign
corporations if 25 percent or more of the foreign corporation's
gross income for the testing period (i.e.,
the three years preceding the year of the dividend
declaration) was effectively connected, with the conduct
of a US trade
or business.
Business Income
Trade or Business
The trade or business concept is an amorphous one which depends
on the facts and circumstances of a particular case. A
degree of activity in the United States that is regular
and continuous, as opposed to sporadic, is generally needed
for a finding of trade or business status. Income tax treaties,
however, generally exempt from taxation income arising
from a US trade or business unless the income is attributable
to a US permanent establishment (e.g., a US branch).
Moreover, the taxpayer's primary purpose for engaging in
the activity must be for income or profit. An element also
usually considered necessary to a finding of trade or business
status is an income-producing transaction, such as a sale.
The mere purchase of goods in the United States for sale
elsewhere will not ordinarily be viewed as the conduct of
a US trade or business. If both the purchase and sale occur
in the United States, however, a trade or business would
probably be deemed to exist, even if the goods are destined
for export.
Despite the existence of all facts necessary for finding
a trade or business, certain activities are statutorily excluded
from the definition of US trade or business. For example,
trading in stock or securities through a resident broker,
commission agent, custodian, or other independent agent,
whether for one's own account or for that of another, is
generally not treated as engaging in a US trade or business.
Effectively Connected Income
For foreign entities not engaged in a US trade or by business,
generally no income is treated as effectively connected
with a US trade or business except for gains from the disposition
of US real property interests. For foreign entities engaged
in a US trade or business, the determination of whether
income is effectively connected is based in part on the
type of income and in part on the source of that income.
US source fixed or determinable income and US source gain
or loss from the sale or exchange of capital assets, excluding
US real property interests, are treated as effectively connected
only if: (1) such income is derived from assets used in or
held for use in the conduct of a trade or business; or (2)
the activities of the trade or business are a material factor
in the realization of the income.
Foreign source income generally is not treated as effectively
connected. However, foreign source income can be treated
as effectively connected if the foreign entity has an office
in the United States to which the income is attributable,
and the income consists of: (1) rents or royalties for the
use of certain intangible property outside the United States
or gains from the sale or exchange of such property; or (2)
dividends, interest, or gains from the sale of stock and
financial instruments derived from carrying on a banking,
financing, or similar business in the United States, or received
by a corporation whose principal business is trading in stock
and securities for its own account.
For purposes of determining whether foreign source income
is effectively connected, the presence or absence of a
US office, the office of an agent is disregarded unless
the agent can and does negotiate and conclude contracts
for its principal or has a stock of goods from which he
or she regularly fills orders on behalf of its principal
and is not an independent agent acting in the ordinary
course of his or her business.
Disclaimer
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"The
information contained herein is of a general nature and
is not intended to address the circumstances of any particular individual
or entity. Although we endeavor to provide accurate and
timely information, there can be no guarantee that such information
is accurate as of the date it is received or that it
will continue to be accurate in the future. No one should act on such information
without appropriate professional advice after a thorough
examination
of the particular situation.
KPMG and the KPMG logo are registered trademarks of KPMG
International, a Swiss cooperative.
© 2006 KPMG LLP, the
Canadian member firm of KPMG International,
a Swiss cooperative. All rights
reserved."
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