US: IRS updates guidance on branch-level interest tax

The US Internal Revenue Service (IRS) has released an updated practice unit on Branch-Level Interest Tax Concepts.

Below is a general overview of the key points covered in this publication:

Note: This Practice Unit was updated to remove references to resources that are no longer current or available, to update the image of the form 1120-F, Section III on slide 14 to the 2023 version, and to correct minor typographical or formatting errors. It supersedes the 07/06/2015 Practice Unit of the same title.

In general, a foreign corporation is subject to the branch-level interest tax if it is engaged in a U.S. trade or business (or it has gross income that is treated as effectively connected with such U.S. trade or business) and it has U.S. liabilities. The purpose of the tax is to subject all interest borne by the U.S. branch to withholding if the interest on the debt was owed to a foreign person. This places a branch in a similar position to a domestic corporation if it conducted that trade or business with the same debt. Therefore, because the source of the interest depends on the residence of the payor, and a U.S. branch is not a resident of the United States, IRC 884(f) was necessary to treat the payments as if they were made by a domestic corporation, which is a U.S. resident.
Prior to the enactment of IRC 884 as part of the Tax Reform Act of 1986, interest paid by a foreign corporation with a U.S. branch to a foreign lender was wholly exempt from withholding taxes unless more than 50% of the corporation’s worldwide gross income was effectively connected income (ECI) for the 3-year period ending at the end of the year prior to the payment of the interest. There was no tax on interest paid by the branch itself to direct lenders or to its home office. The disparity in the tax treatment of interest expense of a branch compared to interest expense of a U.S. subsidiary did not seem equitable to Congress. As such, IRC 884(f) was enacted to impose a 30% tax on the payment of all interest borne by a U.S. branch of a foreign corporation and paid to a foreign person.
For purposes of the branch-level interest tax, “interest” includes all categories of interest under the Code, and the statutory tax rate is 30%. The branch-level interest tax is comprised of two parts: a withholding tax imposed on interest paid by a U.S. branch to a foreign person (referred to as “branch interest”) and a tax imposed on the excess of the foreign corporation’s interest allocable to income connected to ECI (need not be deductible) over its branch interest (referred to as “excess interest”). Branch interest, which is interest paid by a branch’s U.S. trade or business, is considered U.S. source income and is subject to U.S. withholding tax at a rate of 30%, unless the tax is reduced or eliminated by a specific treaty or Code provision. For example, branch interest may qualify for a portfolio interest exemption if the recipient of branch interest is foreign but not a bank or related party. For more information about the portfolio interest exemption, please see the LB&I Transaction Unit “Portfolio Debt Exemption – Requirements and Exceptions” (under UIL 9424 – Financial Intermediary Payor – U.S. Withholding Agent)
Additionally, to the extent a branch has interest allocated to it under Treas. Reg. 1.882-5 in excess of the interest actually paid by it to third parties, the excess is treated as interest paid by a U.S. subsidiary to the foreign corporate taxpayer on a notional loan on the last day of the taxable year. Excess interest can be reduced only by the foreign corporation’s treaty.
As mentioned previously, the operative Code section is IRC 884(f) which changes the source of these payments from foreign to U.S. by treating them as if they were paid by a domestic corporation. Under IRC 884(f)(1)(A), branch interest is treated as paid to the obligee, and the branch becomes a withholding agent if the interest is paid to a foreign person. Furthermore, branch interest is limited by the total amount of interest allocable under Treas. Reg.1.882-5 (after any elections for liability reductions under Treas. Reg. 1.884-1(e)).
Moreover, the interest is treated as U.S. source income for all purposes of the Code, e.g., for earnings stripping.

Treaty implication

Before beginning an audit of branch-level interest tax, please determine if the foreign corporation is a resident of a treaty country and if it qualifies for an exemption from tax under the “interest” article in that treaty by being a resident of that country and meeting the “limitation on benefits” article in the treaty, assuming there is one. If the corporation qualifies for an exemption from tax under the “interest” article, there is no point in auditing this issue. Many foreign banks are residents of treaty countries and will likely qualify for an exemption or reduced rate of tax under the “interest” article.

For corporations that are not residents of treaty countries, do not qualify for treaty benefits due to the “limitation on benefits” article, or qualify for a reduced rate of tax but not an exemption from tax under their treaty, a branch-level interest tax audit should be considered.

You may consult the Treaties Practice Network for assistance in determining the general treaty eligibility including the qualifications under a “limitation on benefits” article.

Additionally, it is important to note that a foreign corporation that has no dividend equivalent amount for any reason is precluded from making an election to reduce its liabilities solely to reduce its tax on branch interest or excess interest. See Treas. Reg. 1.884 1(e)(3)(iii).
Furthermore, if a foreign corporation repays or otherwise decreases its U.S. liabilities and one of the principal purposes of such decrease is to artificially decrease its U.S. liabilities on the determination date (end of year), then such decrease shall not be taken into account for purposes of computing net equity. See Treas. Reg. 1.884-1(e)(4).
Please also be aware that branch interest is subject to the anti-conduit financing Regulations under IRC 881 and is also subject to IRC 894(c) which denies treaty benefits for certain payments made to hybrid entities. The rules under IRC 884(f) also apply to stapled entities where a foreign corporation is stapled to a U.S. corporation under IRC 269B. See Treas. Reg. 1.884-4(d).
Moreover, according to Treas. Reg. 1.884-4(b)(8)(v) if the foreign corporation is a partner in a partnership that has ECI, all interest paid by the partnership is treated as branch interest.

Consultation

If the foreign corporation is itself a hybrid entity or is engaged in business through a hybrid entity, contact local Counsel and Branch 1 of Associate Chief Counsel International (ACCI). If the foreign corporation is a bank and qualifies for the benefits of a treaty that incorporates the Authorized OECD Approach (2010 OECD Model Article 7), contact local Counsel and Branch 5 of ACCI.