CCA 200851107: A reverse cap on the branch profits tax when the branch shuts down

Plain-English summary

The branch profits tax exists to put a foreign corporation operating through a United States branch on roughly the same footing as one operating through a United States subsidiary. A subsidiary paying a dividend to its foreign parent bears withholding tax. A branch has no dividends to pay, since it is the same corporation. Section 884 supplies the missing layer by taxing the dividend equivalent amount, which measures earnings that are effectively connected and no longer reinvested in the branch's United States assets.

Because the measure is reinvestment, the tax turns on the branch's net equity from year to year. Earnings that stay in the business are not taxed; earnings that leave, or that are matched by a decline in the branch's investment, are. The regulations allow a foreign corporation to elect to reduce liabilities, which raises net equity and so defers the tax. The deferral is real but conditional. What was sheltered by an election has to be sustained, and there are rules for what happens when the branch finally terminates.

That termination rule is what this internal email is trying to pin down. The writer describes the regulatory language as working like a reverse cap on the dividend equivalent amount: it looks to the lesser of the election made prior to the year of termination, or the accumulated earnings and profits that resulted from an election in a previous year. Taking the smaller of the two is what stops the final-year tax from reaching earnings that are no longer there.

The explanation for why the rule points back to the prior year's election is the substance of the message. If earnings are not reinvested under that prior election, then as of that year they are already accounted for, either treated as distributed or treated as reinvested because of an increase in assets. The consequence the writer draws is that a prior year's reinvestment can be cleansed by asset increases in later years before a complete termination. In plain terms, the shelter created by an election does not stay outstanding forever waiting to be clawed back at the end. Later growth in the branch can satisfy it.

The writer supports this by pointing out that the accumulated earnings and profits can be wiped out by other events anyway, such as deficits in later years. If a subsequent loss can eliminate the amount at stake, it would be strange for subsequent asset expansion not to. The conclusion offered is that a general asset expansion in a year before liquidation should be sufficient, particularly since a liability-reduced base must be made up each year, or a further liability reduction has to be made year over year to cover the original accumulation from the original election.

Two qualifications belong on this. A long passage in the middle is redacted, so part of the reasoning is missing from the released text. And the email is tentative throughout, in its own words "this is what I have found" and "I think," ending with an offer to call someone. It is a working note, not a considered position, and it does not identify the regulation it is reading.

This is a clean digital release rather than a scan, so no OCR correction was needed. Kept as released: "This means that i a prior year reinvestment can be cleansed," where "i" appears in place of a missing word.

Ruling snapshot

• Question: How does the branch profits tax rule limit the dividend equivalent amount in the year a United States branch terminates, where an election to reduce liabilities was made in an earlier year?
• Outcome: Advice given, tentatively. The regulation operates as a reverse cap, taking the lesser of the election made before the year of termination or the accumulated earnings and profits produced by an earlier election; a prior year's reinvestment can be cleansed by asset increases in later years before a complete termination, and a general asset expansion in a year before liquidation should suffice.
• Key authorities: IRC section 884.

Full text (IRS public release)

ID: CCA-101611-08 Number: 200851107
Office: ------------ Release Date: 12/19/2008

UILC: 884.00-00

From: --------------------
Sent: October 16, 2008
To: ------------
Cc:
Subject: Branch Profits Tax Reg

This is what I have found re election to reduce liabilities.

From----------------
Sent: Tuesday, May 13, 2008 12:18 PM
To: -----------------------
Subject: RE: Branch Profits Tax Reg

--------------

It appears that the reg language is like a reverse cap on the DEA. It looks to the lesser of the election prior to the year of termination or the accumulated E&P that resulted from an election in a previous year. The reason the reference is to the prior year election, is that if the E&P is not reinvested under the prior year election, then as of the prior year it is either treated as distributed or treated as reinvested as a result of an asset increase. This means that i a prior year reinvestment can be cleansed by asset increases in subsequent years prior to a complete termination. This makes sense because other events such as subsequent year deficits can wipe out the accumulated E&P as well. ------------------------------------------------
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-----------------------------------------------------------------------------------------Otherwise, I think a general asset expansion in a subsequent year prior to a year of liquidation is sufficient, especially since the liability reduced base has to be made up in each subsequent year or else an additional liability reduction has to be made from year to year to cover the original accumulation resulting from the original election. I can call --------on this if you need me to.