What is a disregarded entity . . . and how is it taxed?

A foreign disregarded entity is treated as a foreign branch of a U.S. corporation for U.S. tax purposes.

The IRS defines a foreign disregarded entity (DE) as an “entity that is not created or organized in the United States and that is disregarded as an entity separate from its owner for U.S. income tax purposes.”

The IRS has issued a Chief Counsel Advice (CCA 201349015) providing guidance on the proper reporting of U.S. taxable income and the proper standard for calculating creditable foreign taxes imposed in transactions between a U.S. corporation and:

  • Its DE or unincorporated branch; and
  • An affiliated U.S. corporation’s foreign branch or disregarded entity.

All of the income of a foreign branch is included in the taxable income of its owner regardless of whether any of the income is actually distributed to the owner.

Transactions between a foreign branch or disregarded entity and its owner are generally disregarded for U.S. tax purposes, although a payment from the foreign branch or DE to its owner may be treated as a branch remittance requiring recognition of currency gain or loss.

The CCA concludes that, because a foreign branch or disregarded entity and its owner are treated as a single entity, transactions conducted between them do not give rise to income or expenses for U.S. tax purposes.

However, U.S. transfer pricing principles could be relevant to determining whether non-arm’s-length transfer pricing has occurred in transactions between a foreign branch or disregarded entity and its U.S. owner that has resulted in a noncompulsory payment of foreign tax that may not be eligible for a U.S. tax credit.

Transactions that are disregarded for U.S. tax purposes may nevertheless impact foreign taxes.

According to the CCA, a primary concern of a non-arm’s-length price between a U.S. taxpayer and its foreign branch or disregarded entity is that it may report too much income in the foreign country, resulting in the overpayment of foreign income tax.

The foreign tax credit regulations include a noncompulsory payment rule, which provides that a foreign tax is not creditable to the extent that the amount paid exceeds the amount that should have been owed under the applicable foreign law.