U.S. Income Tax Return of a Foreign Corporation

Special Rules for Foreign Corporations

Source of Income Rules

The source of income is important in determining the extent to which income is taxable to foreign corporations. Each type of income has its own sourcing rules.

Interest Income

The source of interest income is usually determined by the residence of the obligor.

For example, interest paid by an obligor who is a resident of the United States is U.S. source income, and interest paid by an obligor who is a resident of a country other than the United States is foreign source income.

Exceptions. The following types of interest income are treated as foreign source income:

• Interest income received from foreign branches of U.S. banks and savings and loan associations and
• Interest income received from a U.S. corporation or a resident alien individual, if 80% or more of the U.S. corporation's (or resident alien individual's) gross income is active foreign business income during the testing period.

  Active foreign business income is income from sources outside the United States attributable to the active conduct of a trade or business in a foreign country or U.S. possession.

  The testing period is generally the 3 tax years of the U.S. corporation or resident alien individual preceding the tax year during which the interest is paid. If the payer existed for fewer than 3 years before the tax year of the payment, the testing period is the term of the payer's existence before the current year. If the payment is made during the payer's first tax year, that year is the testing period.

• The interest allowable as a deduction to a foreign corporation (under Regulations section 1.882-5) in figuring its effectively connected taxable income is treated as paid by a domestic corporation. This interest is treated as U.S. source interest, although the actual payer of the interest is a foreign corporation. For details, see Part II - Tax on Excess Interest on page 20.

Look-thru rule. If the foreign corporation is a related person to a U.S. corporation or resident alien individual that meets the 80% rule described above, the foreign corporation will have foreign source income only when the income of the payer was from foreign sources. See section 861(c)(2) for more information.

Dividend Income

The source of dividend income is usually determined by the payer. For example, dividends paid by a corporation that was incorporated in the United States are U.S. source income and dividends paid by a corporation that was incorporated in a foreign country are foreign source income.

Exceptions.

• Dividends paid by a U.S. corporation are foreign source income:
  1. If the U.S. corporation has made a valid election under section 936 (or section 30A), relating to certain U.S. corporations operating in a U.S. possession or
  2. To the extent the dividends are from qualified export receipts described in section 993(a)(1) (other than interest and gains described in section 995(b)(1)).
• Dividends paid by a foreign corporation are U.S. source income:
  1. If the dividend is treated under section 243(e) as a distribution from the accumulated profits of a predecessor U.S. corporation or
  2. To the extent the foreign corporation's effectively connected gross income for the testing period (defined below) bears to all of the foreign corporation's gross income for the testing period, but only if 25% or more of the foreign corporation's gross income during the testing period was effectively connected with the conduct of a U.S. trade or business.

The testing period is generally the 3 tax years of the foreign corporation payer preceding the tax year during which it declared the dividend. If the foreign corporation existed for fewer than 3 years before the tax year of declaration, the testing period is the term of the foreign corporation's existence before the current year. If the foreign corporation declared the dividend in its first tax year, that year is the testing period. Regardless of source, however, there is no tax imposed on any dividends paid by a foreign corporation out of earnings and profits for a tax year in which the foreign corporation was subject to the branch profits tax (determined after application of any income tax treaty).

Rent and Royalty Income

The source of rent and royalty income for the use of property is determined based on where the property is located.

Income From the Sale or Exchange of Real Estate

The source of this income is determined based on where the property is located.

Income From the Sale or Exchange of Personal Property

Income from the sale of personal property by a foreign corporation is sourced as follows.

• Income from the purchase and sale of inventory property is generally sourced under sections 861(a)(6) as U.S. source and under section 862(a)(6) as foreign source.
• Income from the production and sale of inventory property is generally sourced under section 863(b)(2).
• Income from the sale of depreciable property is generally sourced under section 865(c).
• Income from the sale of intangibles is generally sourced under section 865(d).

Foreign corporations with an office or fixed place of business in the United States. Income from the sale of personal property attributable to such office or fixed place of business is U.S. source income regardless of any of the above rules relating to the source of income from the sale or exchange of personal property unless the foreign corporation is an export trade corporation (see sections 865(e)(2)(A) and 971).

Exception. Income from the sale of inventory property is foreign source income if the goods were sold for use, disposition, or consumption outside the United States and a foreign office of the corporation materially participated in the sale.

Other Special Rules

Basis of Property and Inventory Costs for Property Imported by a Related Person

If property is imported into the United States by a related person in a transaction and the property has a customs value, the basis or inventory cost to the importer cannot exceed the customs value. See section 1059A.

Income of Foreign Governments and International Organizations

Income of foreign governments and international organizations from the following sources is generally not subject to taxation:

• Investments in the United States in stocks, bonds, or other domestic securities owned by such foreign government or international organization;
• Interest on deposits in banks in the United States of money belonging to such foreign government or international organization; and
• Investments in the United States in financial instruments held (by a foreign government) in executing governmental financial or monetary policy.

Exception. The income described in section 892(a)(2) that is received directly or indirectly from commercial activities is subject to both tax and withholding.

Period Covered

File the 2001 return for calendar year 2001 and fiscal years that begin in 2001 and end in 2002. For a fiscal year return, fill in the tax year space at the top of the form.

Note: The 2001 Form 1120-F may also be used if:

The corporation must show its 2002 tax year on the 2001 Form 1120-F and take into account any tax law changes that are effective for tax years beginning after December 31, 2001.

Address

Include the suite, room, or other unit number after the street address. If a preaddressed label is used, include this information on the label. If the Post Office does not deliver mail to the street address and the corporation has a P.O. box, show the box number instead.

If a foreign address, enter the information in the following order: city, province or state, and country. Follow the country's practice for entering the postal code. Do not abbreviate the country's name.

Employer Identification Number (EIN)

Show the corporation's correct EIN. If the corporation does not have an EIN, it should apply for one on Form SS-4, Application for Employer Identification Number. If the corporation has not received its EIN by the time the return is due, write Applied for in the space for the EIN. See Pub. 583 for details.

Initial Return, Final Return, Amended Return, Name Change, or Address Change

Check the applicable box(es). If the corporation's address has changed from the last time Form 1120-F was filed, check the box for Address change.

Note: If a change in address occurs after the return is filed, use Form 8822, Change of Address, to notify the IRS of the new address.

Computation of Tax Due or Overpayment

Line 4. Personal Holding Company Tax

If the corporation is a personal holding company (as defined in section 542) but not a foreign personal holding company (as defined in section 552), it must file Schedule PH (Form 1120) with Form 1120-F and report the personal holding company tax on line 4. See section 542 and the instructions for Schedule PH (Form 1120) for details.

Line 6b. Estimated Tax Payments

Enter any estimated tax payments the corporation made for the tax year.

Beneficiaries of trusts. If the corporation is the beneficiary of a trust, and the trust makes a section 643(g) election to credit its estimated tax payments to its beneficiaries, include the corporation's share of the payment in the total for line 6b. Write T and the amount on the dotted line next to the entry space.

Line 6f. Credit for Tax Paid on Undistributed Capital Gains

Enter the credit (from Form 2439, Notice to Shareholder of Undistributed Long-Term Capital Gains) for the corporation's share of the tax paid by a regulated investment company or a real estate investment trust on undistributed long-term capital gains included in the corporation's income. Attach Form 2439 to Form 1120-F.

Line 6g. Credit for Federal Tax on Fuels

Complete and attach Form 4136, Credit for Federal Tax Paid on Fuels, if the corporation qualifies to take this credit.

Credit for tax on ozone-depleting chemicals. Include on line 6g any credit the corporation is claiming under section 4682(g)(2) for tax paid on ozone-depleting chemicals. Write ODC on the dotted line to the left of the entry space.

Line 6i. Total Payments

Backup withholding. If the corporation had income tax withheld from any payments it received due to backup withholding, include the amount withheld in the total for line 6i. Do not include these amounts on line 6h. (Include on line 6h only amounts withheld under Chapter 3 of the Code.) Show the amount withheld in the blank space in the right-hand column between lines 5 and 6i, and write Backup Withholding.

Line 7. Estimated Tax Penalty

A corporation that does not make estimated tax payments when due may be subject to an underpayment penalty for the period of underpayment. Generally, a corporation is subject to the penalty if its tax liability is $500 or more and it did not timely pay the smaller of:

• Its tax liability for 2001 or
• Its prior year's tax.

See section 6655 for details and exceptions, including special rules for large corporations. Also, no estimated tax payments are required with respect to a foreign corporation's liability for the branch profits tax. See Regulations section 1.884-1(a).

Use Form 2220, Underpayment of Estimated Tax by Corporations, to see if the corporation owes a penalty and to figure the amount of the penalty. Generally, the corporation does not have to file this form because the IRS can figure any penalty and bill the corporation for it. However, even if the corporation does not owe the penalty, complete and attach Form 2220 if:

• The annualized income or adjusted seasonal installment method is used or
• The corporation is a large corporation computing its first required installment based on the prior year's tax. (See the Instructions for Form 2220 for the definition of a large corporation.)

If Form 2220 is attached, check the box on line 7 of Form 1120-F and enter any penalty on this line.

Line 10. Direct Deposit of Refund

If the corporation has a refund of $1 million or more and wants it directly deposited into its checking or savings account at any U.S. bank or other financial institution instead of having a check sent to the corporation, complete Form 8302 and attach it to the corporation's tax return.

Section I - Income From U.S. Sources Not Effectively Connected With the Conduct of a Trade or Business in the United States

Include in Section I amounts received by the foreign corporation that meet all of the following conditions.

• The amount received is fixed or determinable, annual or periodic (FDAP) (see below).
• The amount received is includible in the gross income of the foreign corporation. Therefore, receipts that are excluded from income (e.g., interest income received on state and local bonds that are excluded under section 103) would not be included as income in Section I.
• The amount received is from U.S. sources (see Source of Income Rules on page 7).
• The amount received is not effectively connected with the conduct of a U.S. trade or business (see Section II on page 10). The amount received is not exempt (by Code) from taxation. For example, interest on deposits that are exempted by section 881(d) would not be included as income in Section I.

Amounts fixed or determinable, annual or periodic include:

1. Interest (other than original issue discount (OID) as defined in section 1273), dividends, rents, royalties, salaries, wages, premiums, annuities, compensation, and other FDAP gains, profits, and income. Certain portfolio interest is not taxable for obligations issued after July 18, 1984. See section 881(c) for more details.
2. Gains described in section 631(b) or (c), relating to disposal of timber, coal, or domestic iron ore with a retained economic interest.
3. On a sale or exchange of an OID obligation, the amount of the OID accruing while the obligation was held by the foreign corporation, unless this amount was taken into account on a payment.
4. On a payment received on an OID obligation, the amount of the OID accruing while the obligation was held by the foreign corporation, if such OID was not previously taken into account and if the tax imposed on the OID does not exceed the payment received less the tax imposed on any interest included in the payment received. This rule applies to payments received for OID obligations issued after March 31, 1972.

   Certain OID is not taxable for OID obligations issued after July 18, 1984. See section 881(c) for more details. For rules that apply to other OID obligations, see Pub. 515.

5. Gains from the sale or exchange of patents, copyrights, and other intangible property if the gains are from payments that are contingent on the productivity, use, or disposition of the property or interest sold or exchanged.

For more information, see section 881(a) and Regulations section 1.881-2. Note: For purposes of determining whether its income is taxable under section 881(a), a corporation created or organized in Guam, American Samoa, the Northern Mariana Islands, or the U.S. Virgin Islands will not be treated as a foreign corporation if it meets the rules of section 881(b).

Line 9. Gross Transportation Income

A 4% tax is imposed on a foreign corporation's U.S. source gross transportation income for the tax year. U.S. source gross transportation income generally is any gross income that is transportation income if such income is treated as from U.S. sources.

Transportation income is any income from or connected with:

• The use (or hiring or leasing for use) of a vessel or aircraft or
• The performance of services directly related to the use of a vessel or aircraft. For this purpose, the term vessel or aircraft includes any container used in connection with a vessel or aircraft.

Generally, 50% of all transportation income that is attributable to transportation that either begins or ends in the United States is treated as from U.S. sources. See section 863(c)(2)(B) for a special rule for personal service income.

Exceptions. U.S. source gross transportation income does not include income that is:

• Effectively connected with the conduct of a U.S. trade or business or
• Taxable in a possession of the United States under the provisions of the Internal Revenue Code as applied to that possession.

Transportation income of the corporation will not be treated as effectively connected income unless:

• The corporation has a fixed place of business in the United States involved in the earning of transportation income and
• Substantially all of the corporation's U.S. source gross transportation income (determined without regard to the rule that such income does not include effectively connected income) is attributable to regularly scheduled transportation (or, in the case of income from the leasing of a vessel or aircraft, is attributable to a fixed place of business in the United States).

For more information, see section 887.

Enter the foreign corporation's U.S. source gross transportation income on line 9, column (b). Also, attach a statement showing the dates the vessels or aircraft entered or left the United States and the amount of gross income for each trip.

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