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Modern corporations can easily conduct operations from almost anywhere in the world, and are creating revenue streams which originate and travel internationally before arriving wherever those corporations call home. If a corporation has even a small amount of operations in the United States, or has a physical presence here, the IRS may try to reach out and tax its revenue stream. These types of operations have become increasingly common in the internet age where minimal contacts with a foreign country can create substantial revenue.
While foreign corporations would likely prefer not to be taxed by the IRS at all, there are steps they can take to insure their tax burden is minimized if tax is imposed. This brief overview attempts to give a broad-strokes summary of when a foreign corporation might owe tax to the IRS, as well as a more detailed look at what steps might be taken to alleviate some of that burden in the form of so-called “protective 1120-F filings.”
Part I – Effectively Connected Income
Foreign corporations are subject to US taxation under the Effectively Connected Income (“ECI”) regime of the Internal Revenue Code.
[1] Generally speaking, foreign corporations must pay tax on income when they are “engaged in a U.S. trade or business.”
[2] This is a facts and circumstances inquiry based on the nature and extent of the corporation’s activities in the US.
[3]Having established that the foreign corporation is in fact engaged in such a business, the IRS will then impose tax on income which is “effectively connected with the conduct of a trade or business within the United states.”[4] This income will be taxed at the normal corporate tax rates in place at the time the revenue is generated.
Assuming a foreign corporation meets the above definitions and does in fact owe tax on revenues connected to the US, the corporation must file form 1120-F. The purpose of this form is to report the income, gains, losses, deductions, credits, and to figure the US income tax liability of a foreign corporation. 1120-F is also used to claim any refund that might be due to a foreign corporation as well.
[5] The IRS’s instructions for filing form 1120-F cast a wide net as to who must file, and includes language from the above-mentioned code sections, stating that any foreign corporation that “[w]as engaged in a trade or business in the United States, whether or not it had U.S. source income from that trade or business…” must file. The same is true if the corporation “[h]ad income, gains, or losses treated as if they were effectively connected with the conduct of a U.S. trade or business.”
[6]
Part II – Protective Form 1120-F
For foreign corporations that are on the fringes of the definitions utilized by the IRS (for example, a corporation that does very limited business with or in the US, or is protected by a different regime in the US tax code
[7]), it may not be entirely clear whether the foreign corporation is subject to US tax. These foreign corporations may wish to file what is known unofficially as a “Protective Form 1120-F.”
[8] Where it is unclear a foreign corporation will owe tax, this filing can be extremely beneficial because it preserves the right of the corporation to later claim any deductions against gross income to which it may have been rightly entitled.
[9]
There is substantial downside risk for a foreign corporation that may owe US tax in failing to file a protective 1120-F. If a determination is made after the fact by the IRS that tax was in fact owed on the foreign corporation’s activities connected to the US, the foreign corporation will not be allowed to take any deductions from gross revenue in computing the tax owed. This means that all normal business expenses which would typically be deductible in the calculation of taxable income will be forfeited.[10] Filing a protective form 1120-F solves this potential problem by preserving the ability to deduct normal business expenses if tax is later imposed by the IRS.
One potential downside to making this preemptive filing is that filing an 1120-F may be tantamount to alerting the IRS that tax is owed, prompting the Service to take a second look at a foreign corporation’s operations. That being said, the IRS has recently started a campaign known as the “Form 1120-F Non-Filer Campaign” which seeks to zero in on foreign companies doing business in the US and not submitting the appropriate filings.[11] It is unclear how the data for this campaign is being collected or how effective it has been thus far, but it does imply that the Service is interested in this issue.
Even considering this potential downside, depending on the relevant facts and circumstances, it may be advisable to have clients operating foreign companies with US connections file a protective Form 1120-F. The potential reduction in tax owed by utilizing deductions versus the amount of tax that would be owed without the filing, will likely outweigh the effort and potential risks associated with the filing in most cases.
[5] See IRS, Form 1120-F Instructions, available at https://www.irs.gov/instructions/i1120f
[7] See generally, IRC §1291
[8] Tres. Reg. §1.882-4(a)(3)(vi)
[11] See IRS Active Campaigns, available at https://www.irs.gov/businesses/corporations/lbi-active-campaigns#:~:text=Form%201120%2DF%20Non%2DFiler%20Campaign&te
