Direct taxation of businesses
i Tax on profitsDetermination of taxable profit
The United States imposes tax on ‘taxable income’, which is defined as ‘gross income’ less allowable deductions.8 Gross income is defined as gross revenues (receipts) less cost of goods sold. Allowable deductions include those for expenses that are ordinary and necessary to the conduct of the trade or business, such as salary and rental expenses of the business.9 Other expenses that may be deducted, subject to certain limitations, include interest expense, depreciation and amortisation, state and local income taxes and real estate taxes, and certain losses and bad debts.10 A non-US person engaged in business in the United States is generally entitled to the same wide range of deductions as a US person, with a notable exception for the deduction for FDII.
Among the expenses that are non-deductible are most capital expenditures, certain excessive employee remuneration, ‘golden parachute payments’ made to executives in connection with a corporate change in control, expenses related to the production of tax-exempt income and certain federal taxes.11 In addition, the interest expense deduction to which certain businesses would otherwise be entitled is subject to limitations (discussed further below).
Taxable income is not based on accounting profits, but instead on the method required by the Code and applicable Treasury Regulations. US corporations with assets above a certain threshold are required to reconcile their book and tax income on a separate schedule attached to their tax return.
Generally, taxpayers must compute their taxable income using the method of accounting that the taxpayer uses to compute book income.12 These methods could include the cash receipts method, the accrual method or any other permitted method. However, corporations and partnerships with a corporate partner with average annual gross receipts exceeding $26 million generally may not use the cash receipts method.13 If the US Internal Revenue Service (IRS) successfully determines that the taxpayer’s method does not ‘clearly reflect’ its actual income, it may require the taxpayer to use another method. Once a taxpayer adopts a method of accounting, it generally must obtain the consent of the IRS to change its method.
US citizens and residents are taxed on worldwide income, while US corporations are taxed on a modified territorial basis. Previous law allowed deferral for US shareholders for certain active income earned abroad by a non-US corporation until distributed as a dividend to such shareholder. The Tax Cuts and Jobs Act (TCJA), signed into law on 22 December 2017, moved away from this system of taxation by establishing a participation exemption for US corporate shareholders on certain foreign income, a one-time ‘transition tax’ on certain past accumulated foreign earnings, and a current inclusion in income for such shareholders with regard to certain global intangible low-taxed income (GILTI) of such non-US corporations. GILTI is generally defined as all income of a non-US corporation that is in excess of a fixed return on such corporation’s tangible assets. Although the United States generally grants a ‘credit’ for certain non-US income taxes incurred by US taxpayers (foreign tax credit), no such credit is allowed for any taxes paid with respect to income that qualifies for the participation exemption.14
Non-US taxpayers are generally taxed only on income that is effectively connected with a US trade or business (which generally includes US-source income and very limited types of foreign-source income) (ECI), and on US-source income that is passive income, such as interest, dividends, rents and royalties. Non-US persons also may generally claim a foreign tax credit for non-US income taxes paid on income that is considered effectively connected with a US trade or business (other than taxes paid to their country of residence).15
Capital and income
In general, for US corporate taxpayers there is no difference in the rate of tax applied to ordinary business income as opposed to capital gains. As discussed below, non-US persons generally are not subject to US tax on capital gains (the main exceptions being gains related to certain US real property, including gains realised on an interest in certain domestic corporations that hold US real property, and gains realised in connection with a US trade or business, including gains realised on an interest in a partnership conducting a US trade or business).
A US net operating loss (NOL) generally cannot be carried back but can generally be carried forward indefinitely (with special rules for insurance companies and for farming losses), subject to a limitation that the NOL used in a particular subsequent year cannot exceed 80 per cent of taxable income for such year.16 The CARES Act provided a limited exception that permits the carry-back of any NOL arising in a taxable year beginning after 31 December 2017, and before 1 January 2021, to each of the five taxable years preceding the taxable year in which the loss arises.17 The deduction of losses is limited following certain types of ownership changes.18 An ownership change is generally deemed to occur if there is a change in the stock ownership of a corporation aggregating to more than 50 percentage points over a three-year period. In such a case, the amount of ‘pre-change’ NOLs that may be deducted in each future year is generally limited to an amount of income each year equal to the value of the target corporation immediately before the ownership change multiplied by the long-term tax-exempt rate of interest published by the IRS for the month of the ownership change.
A capital loss can only offset capital gains.19 Excess capital losses may be carried back three years and forward five years.20 Because of the shorter carry-forward period for capital losses, taxpayers may seek to accelerate a capital gain to ensure that the capital loss does not expire unused.
Non-US corporations conducting a trade or business in the United States through a branch or other fiscally transparent entity must file an appropriate and timely tax return in the United States reporting any credits, deductions or losses to preserve their ability to use any credits, deductions or losses in future years.21
Under previous law, corporations were subject to graduated rates and an alternative minimum tax (AMT) to the extent that tax exceeded the regular corporate tax.22 The TCJA reduced the federal corporate rate and repealed the AMT such that for tax years beginning after 2017, the corporate tax rate is a flat 21 per cent rate.23
The TCJA also introduced the BEAT, a minimum tax imposed in addition to any other income tax. The BEAT imposes a tax equal to the excess of 10 per cent of the taxpayer’s ‘modified taxable income’, less the taxpayer’s regular tax liability and certain specified tax credits (but without reduction for any foreign tax credit). Modified taxable income is taxable income computed without regard to base erosion tax benefits (i.e., deductions for payments to related foreign parties or depreciation or amortisation deductions on property purchased from related foreign parties). The BEAT only applies to (1) corporations, other than regulated investment companies (RICs), real estate investment trusts (REITs), or S corporations; (2) with annual gross receipts of at least $500 million for the three-tax year period ending with the preceding tax year; and (3) a base erosion percentage of 2–3 per cent. With certain limited exceptions, tax credits, including foreign tax credits, cannot be used to reduce the minimum tax due pursuant to the BEAT regime.
The rate of US withholding tax for outbound payments of US-source passive ‘investment’ income such as dividends, interest, rents and royalties is generally 30 per cent. This rate may be subject to reduction or elimination pursuant to an income tax treaty between the United States and the recipient’s country of residence. If withholding does not properly occur, the foreign recipient of the payment must file a US tax return and pay the appropriate tax, or else the payor of the income may be liable for the tax. Similarly, as discussed above, branch profits tax, if applicable, is also imposed at a rate of 30 per cent, and may be subject to reduction or elimination by treaty.
A US corporation must generally file its income tax return on or before the 15th day of the fourth month following the end of its taxable year, although an automatic six-month extension is available and typically taken.24 As a result, a calendar year corporation usually files its returns by the following 15 October. A foreign corporation required to file a US income tax return with respect to its conduct of, for example, a US trade or business is required to file its income tax return on or before the 15th day of the sixth month following the end of its taxable year, although an automatic six-month extension is available.25 The tax owed for the year must be paid on or before the due date of the tax return (without extensions). Further, corporations must make estimated tax payments on a quarterly basis during the year, generally in an amount each equal to 25 per cent of the required annual payment.26 Special provisions apply to corporations with assets of $1 billion or more. The total quarterly payments must equal at least the lesser of (1) 100 per cent of the tax shown on the final return for the current year or (2) 100 per cent of the tax shown on the final return for the immediately preceding taxable year. Penalties apply if the estimated tax payments are less than these safe harbour amounts. For corporations with taxable income of at least $1 million during any of the three preceding taxable years, the required annual payment must equal 100 per cent of the current year’s tax liability; that is, the preceding year’s safe harbour in point (2) above cannot be used.
The most significant taxing authority for non-US taxpayers is the IRS, a division of the US Treasury Department.27 States and local jurisdictions, such as counties and cities, may impose additional taxes.
In general, there is no regular audit cycle. Special audit regimes may apply. For example, certain eligible taxpayers may be part of the compliance assurance process (CAP), which allows compliant taxpayers to resolve certain issues on an expedited basis, with the taxpayer and the IRS agreeing to the treatment of items by the time the tax return is filed, or shortly thereafter. The IRS expanded the CAP programme in 2011 to include pre-CAP (readying taxpayers to enter the CAP programme) and post-CAP (a maintenance stage for taxpayers with a low-compliance risk and low controversy rate) stages of the process. Certain large corporations may also be under continuous audit. Although no specific length of time is used for audit cycles, US corporations, for example, are typically audited for two to four taxable years at any one time.
Before a transaction is undertaken, taxpayers may seek private letter rulings from the IRS when there is uncertainty regarding the treatment of a transaction or an item of income. Each year, the IRS publishes a revenue procedure that details the steps to be taken in requesting a private letter ruling; the revenue procedure also describes those areas in which the IRS normally will not issue a private letter ruling. This general guidance is set forth in the first revenue procedure for the year.28 In addition, the seventh revenue procedure of each year29 discusses certain international issues regarding which the IRS will not, or ordinarily will not, issue a private letter ruling. Other forms of administrative filings for rulings are available. Among the most noteworthy are the ‘pre-filing agreement’ with the IRS and an ‘advance pricing agreement’ (APA) for transfer pricing issues with the ‘advance pricing and mutual agreement’ programme, which was formed from the recent combination of the APA Office and certain functions of the US competent authority.
If a taxpayer wishes to challenge a published IRS position on the treatment of an item, the taxpayer can minimise penalties (in the event that it ultimately fails in its challenge) by disclosing on its tax return that it is taking a position contrary to IRS guidance.30 If the IRS specifically challenges a taxpayer’s position on a tax return, the taxpayer generally has the opportunity to make an administrative appeal of the IRS determination. If the taxpayer does not succeed in its appeal, it may either file a petition in Tax Court (which does not require the taxpayer to pay the asserted deficiency in advance), or it may pay the asserted deficiency and file a suit for refund in either a US federal district court or with the US Court of Federal Claims.
In addition, in certain cases where the IRS has proposed adjustments that result in a taxpayer being subject to double taxation or that should appropriately give rise to a correlative adjustment for a related person in a foreign country, the taxpayer may invoke the mutual agreement procedure of an applicable US tax treaty to attempt to resolve the issue.
An affiliated group of US corporations may elect to file a consolidated income tax return.31 Non-US corporations generally are not ‘includible corporations’ in an affiliated group (with exceptions for certain Canadian and Mexican corporations), and therefore are not included in the consolidated group.32 The stock ownership requirements for an affiliated group are that the common parent must directly own at least 80 per cent of the stock (by vote and value) of at least one subsidiary in the group, and each other subsidiary in the group must be at least 80 per cent directly owned (by vote and value) by one or more of the other members of the group. An election made by the common parent to file a consolidated return applies to all corporations for which the ownership requirements are met. The common parent files the US tax return for the consolidated group.33
Under the theory that a consolidated group is a unified entity, assets, losses, dividends and interest can generally move within a group without current tax cost.34 The consolidated group rules focus, however, on an item of income’s location, and therefore intercompany transactions will ultimately trigger tax when the item is no longer capable of being reflected in the consolidated group. Income and losses of a group member generally give rise to adjustments to tax basis in the stock of that member held by other members.35
In general, a consolidated group determines its income tax liability by computing the separate taxable income of each member as if it were filing a separate return, but excluding income and deductions that are determined on a group basis, and computing income and deductions on a group basis, such as the NOL deduction.36 Credits, determined on a group basis, may be available to offset the consolidated income tax liability. Each member of the group is jointly and severally liable for the total tax liability of the entire group.37
Losses incurred by a corporation while it is a member of the group are available to offset another member’s income. Losses incurred before a corporation joins a consolidated group are subject to ‘separate return limitation year’ rules, generally permitting use of such losses only to the extent of the corporation’s contribution to the consolidated group’s positive net income. Special limitations also apply to ‘dual consolidated losses’, generally defined as an NOL of a domestic corporation (or component thereof) that may also be used to reduce tax in a foreign country.38 Thus, for example, a US corporation tax resident in the United Kingdom generally cannot offset its NOL against another member’s income unless it elects to use the loss only in the United States. If such an election is made, the loss could be used in the United Kingdom after five years, provided that UK law permits the loss to be claimed.
ii Other relevant taxes
The United States does not impose value added tax (VAT) or sales tax at the federal level, although many states, counties and cities do impose a sales tax on the sale of goods. The United States also does not impose stamp duty, capital duties, registration taxes or net wealth taxes. US employers have payroll tax obligations, including paying obligations for US social security and Medicare taxes and withholding from employee wages.39 The United States has considered a federal VAT (or similar tax) from time to time, either as an additional tax or as a replacement for income tax. So far, however, no such tax has been enacted.
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