Category: International; Corporations Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayer is a U.S. citizen interested in shielding income from U.S. income tax. Taxpayer controls a closely held U.S. corporation. Taxpayer proposes to establish a Cayman Islands corporation for the purpose of owning and leasing equipment to the taxpayer's U.S. corporation. It is assumed that the rents charged to the U.S. corporation would be comparable to arms-length rates available from unrelated parties. Issue 1: Will the income of the Cayman corporation be viewed as income
from a U.S. trade or business subject to U.S. corporate taxation? If Issue 1 is negative, will the rental income stream paid to the Cayman Islands corporation be subject to U.S. tax withholdings? If so, at what rate? Issue 3: What are the tax consequences to the taxpayer at the time the earnings from the Cayman corporation are repatriated to the U.S.? Discussion Foreign corporations engaged in a trade or business in the U.S. are subject to U.S. income tax at normal corporation tax rates on U.S. source income effectively connected with a U.S. trade or business. §882(a). Any U.S. source income earned by a foreign corporation engaged in a U.S. trade or business is considered effectively connected income. §864(c)(4). Accordingly, to the extent the Cayman corporation is deemed to engage in a U.S. trade or business, the income from that business will be subject to the normal rules of corporate taxation in essentially the same way as would a U.S. corporation. In addition to the corporate income tax, foreign corporations engaging in a U.S. trade or business through a U.S. branch (as in this case) are subject to an additional tax. The branch profits tax is an additional 30% tax on the corporation's effectively connected earnings and profits. This tax is supposed to place the U.S. branch of a foreign corporation in the same tax position with respect to repatriation of earnings back to the foreign corporation as would be the case if the business were structured as a U.S. subsidiary of the foreign corporation. Foreign corporations which are not considered engaged in a U.S. trade or business are also subject to taxation. Certain kinds of U.S. source income such as rental income not effectively connected with a U.S. trade or business are taxed at the rate of 30% (or lower treaty rate if applicable) based on gross rental income. §881(a)(1). Income from rental of property located in the U.S. is U.S. source income. §861(a)(4). Based on the foregoing, the Cayman corporation will be subject to U.S. taxation in one of two manners. 1. If the equipment leasing activity is viewed as a trade or business, the net income from the activity will be taxed at normal corporate tax rates. The branch profits tax should also apply. The Cayman Islands corporation would be required to file a corporation tax return, Form 1120F, to report this income. 2. If the equipment leasing activity is not viewed as a trade or business, gross rental income will be taxed at the rate of 30%. No deductions are allowed against this income. The tax is paid through a withholding obligation against the payor of the income, and no corporate tax filing is required. As stated above, the normal 30% rate set forth in §881 can be mitigated by treaties between the United States and the country of residence of the payee corporation. There is no treaty in effect between the United States and the Cayman Islands; accordingly, there is no reduction of the basic 30% rate. It is clear that much depends on whether the leasing activities of the Cayman Islands corporation are viewed as a trade or business. The term trade or business is not specifically defined in the Internal Revenue Code or the Treasury Regulations. Whether a taxpayer's activities constitute a trade or business is a question of fact to be determined by taking into account all the surrounding facts and circumstances. The courts over the years have provided certain guidelines which essentially boil down to the concept that an activity must be regular, continuous, and substantial in order to be considered a trade or business. In the specific area of rental of property, there is a spectrum of possible activity levels and whether the taxpayer's activity is considered a trade or business depends upon where the taxpayer's activities fit within that spectrum. On one end of the spectrum is the taxpayer holding a net lease. The taxpayer in this case does nothing except collect rent payments. All operating expenses are borne by the lessee. Chances are this type of activity will not be viewed as a trade or business. On the other end of the spectrum is the taxpayer who holds a large fleet of assets for lease and must engage in considerable activity to exert the necessary level of control over that fleet. For example, a car rental company would fall into this category. Clearly, this kind of leasing activity would be considered a trade or business. Since the taxpayer in this case is in the stage of simply considering establishment of a foreign corporation to hold leased assets, sufficient facts do not exist at this time to make the determination of whether the Cayman Islands corporation would be deemed to be engaging in a trade or business. However, given the practical difficulties which one would encounter in order to actively conduct a business through a foreign corporation, it seems to me that the taxpayer might ultimately opt for a set of circumstances fairly close to the net lease example set forth above. If that were the case, the gross rental income paid to the Cayman Islands corporation would be subject to a 30% withholding tax. Finally, the issue of repatriation of earnings from the Cayman corporation must be considered. Presumably, the taxpayer would ultimately want or need to recover some of the profits earned by the Cayman corporation. U.S. citizens and residents are taxed on their worldwide income. In other words, the income of a U.S. citizen or resident is taxed in the U.S. no matter where it is earned or paid. Because the income from the leasing activity is actually earned by the corporation and not the taxpayer in his personal capacity, the taxpayer will not pay U.S. income tax on those earnings until such time as they are paid over to the taxpayer, presumably in the form of dividends or on the ultimate liquidation of the corporation. At the time the earnings are paid to the taxpayer, dividends would be subject to U.S. personal income tax at ordinary income rates and liquidating distributions in excess of the taxpayer's stock basis would be subject to personal income taxation at capital gains rates. It is possible that the Cayman corporation could be considered a foreign personal holding company. These rules are extremely complex, but in general, the effect of the foreign personal holding company rules is to tax the U.S. shareholder as if the earnings of the foreign corporation had been distributed annually in the form of dividends. The determination of whether the Cayman corporation would be considered a foreign personal holding company is based in part on the composition of the corporation's income. To the extent that all the income of the Cayman corporation consists of rental income, it does not appear that the foreign personal holding company rules would apply. If other types of income are anticipated, the provisions should be carefully considered before proceeding. |
