I will elaborate on the following areas:
Difference between a Corporation and a Branch
Exceptions to the General Rule for Sourcing Interest and
Exceptions to the General Rule for Sourcing Dividends.
The Distinction between a Corporation and a Branch
A Corporation is a distinct legal entity. It must satisfy specific requirements in order to be recognized as an organization that is independent from its shareholders. So when a Corporation enters into contracts or takes on a loan, it is on its behalf and not on behalf of its shareholders, directors or employees.
If a US Corporation (USCo) has a subsidiary in Korea (KorCo), it means that we have two distinct legal entities that act on their own behalf. USCo owns all of KorCo’s shares but when KorCo is independent of USCo. If USCo is to buy goods from KorCo it would have to enter into an agreement with KorCo. USCo would be a US resident because it is incorporation in the US and KorCo would be a non-US resident because it is incorporated outside the US.
A Branch is not a distinct legal entity. There are no formal legal requirements to create and maintain a branch. For instance, if USCo sent some employees to start a sales office in Korea (but did not formally incorporate that office), then USCo would have a Korean branch. If employees in the Korean branch obtained a loan or entered into a contract, they would be doing so on behalf on USCo since the branch is not a separate entity. Consequently, interest payments made by the Korean branch would be US source to the party receiving the interest.
The distinction between a Corporation and a Branch may be rudimentary to some students in this class. However, it is a distinction that everyone should understand since the differing treatment of Corporations and Branches arises in many areas of international tax.
Exceptions to the General Rule for Sourcing Interest
The General Rule for sourcing interest payments is to base it on the residence of the payor. So if a foreign corporation (ForCo) makes a loan to a US corporation (USCo) and USCo makes interest payments on that loan, then that interest is US source income.
Remember from the Residence rules that a corporation is sourced based on where it is incorporated. So when a US corporation is making interest payments, that interest is US source.
Exception No. 1: Foreign Branch of a US bank
As we just saw, the payment of interest by a foreign Branch of a US Corporation will be US source income. However, there is an exception for US banks with foreign branches. In order to encourage the competitiveness of US banks abroad, interest payments by foreign branches of US banks are foreign source income. If a Korea resident made a deposit with the foreign branch of Wells Fargo Bank, the interest received on that deposit would not be US source income and not subject to the 30% tax. Note that most US banks incorporate their foreign branches so this exception is rarely applied.
Exception No. 2: 80/20 Rule
If a US Corporation (USCo) performs 80% or more of its activities outside the US, then ALL interest paid by the USCo would be foreign source income even though USCo is a US resident. So regardless of whether USCo performs 85% or 99% of its activities abroad, 100% of its interest payments will be foreign source. However, if USCo pays the interest to a “related person”, it is necessary to apportion the sourcing of interest according to the percentage of foreign activities. A “related person” is one that owns 10% or more of the interest payor.
Assume that all of USCo’s shares are owned by a Korean corporation (KorCo) and KorCo makes a $100,000 loan to USCo with interest payments of $10,000. Also assume that 90% of USCo’s business activities occur in China. In this case, $9,000 (90%) of the interest would be foreign source and $1,000 would be US source.
Exception No. 3: Foreign Corporations with a US trade/business
When a Foreign Corporation (ForCo) is engaged in a US trade/business it basically has a branch in the US. As we saw earlier, a branch is not a distinct legal entity. Under the General Rule, if the US trade/business of ForCo makes interest payments, those payments would be foreign source since the corporation is incorporated outside the US. However, there is an exception in this case, and the US trade/business is treated as if it is an independent corporation for purposes of the interest sourcing rules. As a result, such payments would be US source income.
Exception to the General Rule for Sourcing Dividends
The General Rule for sourcing dividends is not unlike the rule for sourcing interest: it is based on the residence of the party making the payment. Since only corporations pay dividends, all you have to do is determine where the corporation was incorporated.
There is only one exception to the General Rule and it concerns the scenario where a Foreign Corporation is paying a dividend AND that corporation is engaged in a US trade/business. In this case, if 25% or more of foreign corporation’s income is from the US trade/business, then at least a portion of the dividend will be US source income despite the fact that the corporation was not incorporated in the US.
Assume, for instance, that a Belgian corporation has $1,000,000 in sales and $300,000 of those sales are from a US trade/business. Also assume that the Belgian corporation pays a dividend of $5,000 to its shareholders. In this case, 30% of the Belgian corporation’s income is from a US trade/business so 30% of its dividend will be deemed to be US source income to the recipient. Hence, $1,500 of the dividend is US source income and the remaining $3,500 is foreign source income.