Foreign Persons:  Nonbusiness U.S. Source Income - Ch. 4

Code §871(a) & §881(a) – imposing a 30% gross tax on U.S. fixed or determinable annual or periodic income (FDAP) of a foreign person.

But, FDAP can be “effectively connected” with a U.S. trade or business and, then, will be taxed on a net income basis. §864(c)(2).

Possible modification of the applicable gross income withholding tax rates by (1) a U.S. Code section, or (2) a bilateral U.S. income tax treaty provision.

 

Why impose tax on a gross basis?                         p.229

Flat tax on a gross income facilitates the tax collection at source (through withholding) without a taxpayer filing an income tax return.

Limited potential to collect tax in a foreign place (i.e., applicability of the “revenue rule”).

Gross income and net income are approximately the same amount in many situations involving investment income (i.e., no significant expenses are incurred to generate the investment income).

Is 30% the appropriate tax rate? Cf., the corporate tax rate of 35% on “net income” or 39.6% top bracket for individual taxation of net income.   

What is “FDAP Income”?
p.230

Interest, dividends, rents and royalties and other fixed or determinable annual or periodic “gains, profits and income.”  Code §871(a)(1)(A) & §881(a)(1).

Consider other income sources: annuities,  retirement plan distributions, alimony.

Is a recovery of (any) tax basis permitted in determining the gross amount subject to this withholding at source? 

 

Wodehouse case             p.231
Payment for Asset Disposition

Lump sum amount was received for an exclusive book right in the United States.

Payment for entire property interest in a copyright.

Held:  one lump sum amount (not contingent) represented the acceleration of all the royalties and, therefore, FDAP.

Do not need multiple payments to have "annual or periodic" payments. 

Is this case correctly decided? Note the dissent that transaction was a “sale.”

FDAP Income
Additional Examples       p.232

1)  Rental income gross-up for expenses or real  estate taxes paid by tenant – Rev. Rul. 73-522

2)   Annuity payments from a U.S. insurer.  Rev. Rul. 2004-75 (p. 232).  Treated as having a U.S. source even though sold by a foreign branch in a foreign country.  Cf., branch bank sourcing rules.  How much annuity “income” included?

3)            §871(m) – “dividend equivalent payments” – (e.g., sale of corp. pre-dividend distribution) treated as dividends for tax withholding  at source purposes.

Chihuahua Gas                p.234
§881(a) as Basis for Decision

Rent not paid by Hidro (a Mexican corporation) ETBUS to a related Mexican corporation (Gas) for U.S. use of Gas trucks.

Tax liability results from a Code §482 adjustment.  No payments had been made from which the tax could be withheld.  Tax obligation of the recipient of the imputed rent exists under §881.

Must an actual payment be made to trigger (1) §881(a) liability (no),  & (2) withholding at source??

 

Treatment of OID
p.238

Consider original issue discount (OID) which is accruing on a non/low interest bearing financial instrument held by a foreign party.

Is this the economic equivalent of “interest,” but not actually paid, rather accruing until maturity?

What treatment when OID to a foreign party is not ECI USTB?  No tax event when income accruing.

The 30% withholding tax is applicable when (1) the obligation is paid, or (2) the obligation is sold.

But, the OID may be (1) tax-exempt & withholding is then not relevant, or (2) short-term & no tax.

U.S. Source Interest & Tax Exemptions                p.238

1) Bank (& S&L) account interest paid:

                Code §§871(i)(2)(A) & 881(d) – tax exemption.

2) “Portfolio debt” investment interest:

                Code §§871(h) & 881(c) – tax exemption.

“Bearer” form permitted for financial instrument?  Note: registered form required in 2012 & after.

No statutory exemption for (1) loans by 10%+ owners, or (2) contingent interest (§871(h)(4)).

What is the impact of these income tax exemption provisions on the U.S. capital markets?

Interest from a U.S. 80-20 Corporation                p.240

Interest paid by U.S. corp. is domestic source.

But, interest paid by a U.S. corporation was previously foreign source if more than 80% of U.S. corp. income was from foreign source (i.e., an 80-20 corporation). 

See prior §861(a)(1)(A) and §861(c).

2010 legislation:  this interest is now treated as U.S. source (subject to various grandfathering rules).

Dividends from a U.S. Corporation                p.240

1) Dividends from a U.S. corporation.                    Code §861(a)(2)(A) – U.S. sourced

2) Prior rule: U.S. corp. and 80%+ foreign source dividend income: Code §871(i)(2)(B) – untaxed proportion based on the foreign percentage.  Eliminated in 2010 (Hire Act). 

    Now: U.S. sourcing & U.S. withholding at source.

3) Foreign corp. with U.S. source dividends.

                The branch profits tax rule eliminates the tax liability on a dividend distribution by foreign corp.

Wagering Income       p.241

1) Las Vegas gambling - Code §871(j).  Slots?

2) Horse & dog racing - Code §872(b)(5)

3) Lottery winnings?

How prove net gambling winnings? 

                Any offset for invested funds/tax basis?

                Any offset for gambling losses?  Note §861(a) & 165(d) – losses allowed to the extent of gains.

Any withholding at source imposed on foreign parties?  Domestic parties?  Form 1099s?

See Anti-injunction Act & Code §7421(a), p. 242.

Impact of Income Tax Treaty Provisions       p.242

Tax treaty reduction & impact on withholding rates:

Dividends  (Art. 10):  15%; but, 5% for certain corps. (note recent U.S. income tax treaties – zero withholding tax for payments from U.S. subs).

Interest (Art. 11):   -0-

Royalties (Art. 12):  -0-  (cross-licensing – next slide)

Pensions, annuities & alimony (Art. 17):    -0-    Annuity defined – see Abeid case, p.243;

    gambling income is not an annuity (with basis).

   Child support not included - not gross income.

Royalty Withholding & Cross Licensing  

Rev. Proc. 2007-23  - cross-licensing – two parties grant licenses to each other.

Withholding obligation on gross value?  Net?

Rev. Proc. states:  (1) No §1001 gain (or loss) when mutual grants of licenses;

                (2) “Net consideration” to be taken into account for (withholding) tax purposes – assuming a “qualified patent cross licensing arrangement” (QPCLA).

                (3) Financial statement conformity (i.e., “booking”) requirement is imposed.

“Treaty Shopping” – Funds Inbound into the U.S.      p.244

Historical background:   (1) Netherlands Antilles finance sub created by (2) U.S. Corp.  (or by a foreign corp.).

Purpose: to facilitate borrowing arrangements through Antilles and utilize (prior) U.S. income tax treaty exemption on interest expense paid outbound from U.S. Corp. to the N.A. lender affiliate (who borrowed from outside U.S.). 

This income tax treaty functioned as a “treaty with the world.” Why & how?

Aiken Industries        p.245 Conduit Arrangement

                                ECL-Bahamas

Aiken-US (parent)            CCN-Ecuador (parent)      

MPI - US (sub)            Industrias-Honduras (sub)

1)  MPI borrows from ECL & MPI issues its note.

2)  ECL sells MPI note to Industrias (in exchange for Industrias notes payable to ECL).

3)  MPI then pays interest expense to Industrias. 

4)  Honduras-U.S. (former) income tax treaty exempted interest paid from source taxation.

Valid business purpose for this transaction? No.

Industrias merely a conduit to ECL & Industrias was not really receiving the interest payments.

Rev. Rul. 84-152
(now obsolete)           p.250

Swiss parent owns (1) a U.S. operating sub, and (2) a Netherlands Antilles financing sub (i.e., brother-sister subsidiaries). 

N.A. sub loans funds to U.S. brother-sister, with N.A. sub funds sourced from Swiss parent corp.

Conduit analysis - U.S. to Antilles to Switzerland.  Antilles entity was not recognized. But, tax determination under the U.S.- Swiss treaty?

But, is a “derivative benefits” concept applicable here (& 5% withholding tax at source)?  Yes.

Rev. Rul. 84-153
(also obsolete)           p.252

Companion to Rev. Rul. 84-152.

Re U.S. corporation borrowing from outside the U.S. and using a Netherlands Antilles finance subsidiary to issue the debt (with this debt guaranteed by the U.S. parent corporation?)

Parent then borrowed funds from Antilles sub.

Protection under U.S.-Antilles tax treaty from withholding on interest from parent to N.A. financing sub.

Northern Indiana Public Service                      p.253

Borrowing by N.A. subsidiary of U.S. parent corporation to exploit the N.A.-U.S. income tax treaty interest income exemption.

Tax Court decision:  Finance subsidiary is to be recognized as the real borrower.  Sub treated as adequately capitalized (& earning funds from its financing activities). 

What debt-equity ratio is necessary to recognize a finance subsidiary transaction?

                Other suggestions re sub’s capitalization?

 

Limitations on “Treaty Shopping” - Treaty & Code

1)  Treaty Shopping - Article 22. Does an active trade or business exist in the treaty country?

2)  Anti-conduit regulations - Code §7701(l) - conduit entities are to be disregarded.  p.254. 

    Anti-conduit regs. §1.881-3 & 4.  Disregard a conduit (i.e., an intermediate entity)?

Does the conduit itself perform significant financing activities?  Or, should the conduit be disregarded?  Tax “treaty override” here?  p.256

3)  Economic substance doctrine - Code §7701(o).  Relevant to “treaty shopping” arrangements?

Hybrid Entities                p.257
& cross border arbitrage               

Foreign (forward hybrid) entity:  Corporate status in the foreign country but partnership (conduit) status in the U.S.

Foreign (reverse hybrid) entity: Corporation for U.S. tax purposes but flow-through entity status for foreign country tax purposes (i.e., flow-through in treaty partner country)

See §894(c) re limitations on treaty benefits in hybrid situations.  E.g., deductible interest becomes a dividend.

Treaty Shopping
Problem 1                   p.259              

Swedish investors own ILL (a Swedish corp).

ILL is organized in a jurisdiction (Sweden) where all its shareholders reside.   

Article 11 of the Sweden-U.S. income tax treaty exempts the interest payments from income tax withholding at source (i.e., the U.S.).

No Art. 22 “treaty shopping” here – all ILL owners are Swedish residents (& are not U.S. persons). 

Interest therefore is not subject to U.S. withholding.

Treaty shopping problem, cont.                   Problem 2

2016 Treaty Art. 22(2)(e) - 50% rule.

(i) At least 50% is owned by a resident for at least 1/2 of the days of year;  &  

(ii) Less than 50% of the gross income is paid directly or indirectly to nonresidents of the two treaty countries in a deductible form, i.e., the limiting “base erosion test” is not applicable. 

No evidence here of deductible payments.

Therefore, interest payments are still immune from U.S. withholding at source.

Problem 3                        p.260
2016 Treaty Article 22(2)(e)

Sale of all stock (when? – after July 1, then not 50% of year, Art. 22(e)) to a corp. (Superrich) located in a 3rd country (i.e., Brazil - no tax treaty with U.S.).

Tax treaty benefits are probably jeopardized. 

But, what if 50 percent of the stock of the Superrich (Brazil) stock is traded on a U.S. stock exchange or in Sweden?  No income tax treaty protection. 

Cf., interest connected with active trade or business in Sweden – see Article 22(3)(a).  Must be substantial in relation to trade or business of  the resident.

 

Prob. 4   ILL Shares Listed on Swedish Exchange

ILL shares are all traded on Swedish exchange.

Treaty Article 22(2)(c)(i)(A) & 22(5)(a)).   

Treaty benefits are preserved if all ILL shares are trading on the Swedish stock exchange (one of the tax treaty partner countries).  What relevance of “treasury shares”?

Why preserve tax treaty benefits in this context?  Is the presumption that locals are the predominant owners of ILL?

 

Problem 5                  p.260 
ILL Shares Traded & Sold

Shares are listed (in Sweden) and 75 percent of the shares are sold mostly to non-treaty country residents.  Art. 22(2)(c)(i) says principal class of stock to be regularly traded on a local stock exchange.    Note:  25% of shares are not traded.

Treaty benefits are preserved if 75% of  shares are trading on Sweden exchange?  Must all the shares (of each class of stock) be listed? Apparently not – change from the 1996 U.S. Model Treaty (requiring all shares to be traded).

Problem 6         Shares Are Sold Directly to 3rd Country

75 percent of the ILL shares are sold directly by the two Swedish shareholders to non-treaty country (3rd country) residents.  Article 22.

Treaty benefits are denied to ILL (unless the sale occurred in last one-half of the year, and then only for that year).

Why deny the income tax treaty benefit when the shares are not publicly traded?

 

Problem 7                   p.260
The “Base Erosion” Test

Loan from bank in Norway to Partsub (Sweden) and then, loan of these funds to Amcar, parent in U.S.

Partsub being used as a financing subsidiary, although already an operational (?) sub.

Article 22(3) (which preserves tax treaty benefits in certain trade or business situations) will probably not protect Partsub since no relationship between the lending transaction & trade or bus. in Sweden.

Ultimate question:  loan funds (1) directly from Norway bank to U.S., or (2) to a Swede borrower?

 

Problem 8                   p.260
Base Erosion Test

Loan from bank in Norway (1) to Amcar sub in Sweden and (2) then loan of borrowed funds from Sw. sub to parent (Amcar) in U.S.  Same strcture. 

But, Amcar (Parent corp) guarantees loan to partsub

Even if OK under the treaty (Art. 22(3)), note that the guarantee of the loan by Amcar would trigger the application of the anti-conduit rules. 

See Reg. §1.881-3(c)(2). Why does sub participate in the transaction if the Parent corp. provides a guarantee (and the Parent then gets the funds)?

Problem 9                        p.260
Base Erosion Test

Loan from (1) bank in Norway to Amcar’s sub (Partsub) in Sweden & (2) then loan from the Swedish sub to Amcar parent in U.S.  

Partsub was organized shortly before the loan agreements were concluded.

Anti-conduit rules would almost certainly apply.  Reg. §1.881-3(a)(4) factors appear to be present.

Objective for the creation of the intermediary (Partsub) is to reduce U.S. income tax.

Capital Gains                  p.260 Source to the Residence

Capital gains are (1) not FDAP, and (2) assume, are not treated as effectively connected (i.e., ECI) with a U.S. trade or business (USTB).

See U.S. Model Income Tax Treaty, Article 13(6).

Code §865(a) - source of capital gains from sale or exchange of personal property is at the residence of the taxpayer. Therefore, cap. gain as foreign source income for a foreign taxpayer.

Cf., intellectual property deals.  Sale; but, contingent payments & royalty at source?

Withholding at Source Mechanisms                    p.262

Code §§1441 & 1442 - Withholding at source at a 30% rate on FDAP income.

No withholding requirements for ECI  - ETBUS income. Code §§1441(c) &  1442(b).  Why?

How protect the (U.S.) payer from IRS responsibility for failure to collect at source? Documentation is to be provided to the payor:  e.g.,  IRS Form W-8ECI (re effectively connected income; formerly IRS Form 4224 was relevant for this purpose).

What Amount Is Subject to Withholding?              p.262

Consider Rev. Rul. 72-87, p.262  - concerning the corporate E&P calculation (to determine “dividend” status).  Must the payor assume the existence of adequate E&P for dividend characterization of the corporate distribution? Obsoleted by Reg. §1.1441-3(c)(2)(i).

Consider other situations where recovery of tax basis (i.e., basis received is not gross income).

    E.g., bond purchased with accrued interest.

What if a nontaxable stock dividend? §305(a)?

 

Cascading Royalties       p.263
Foreign Withholding Agent

U.S. withholding obligation on a foreign person.

Rev. Rul. 80-362 - licensing arrangements re U.S. patent (& U.S. source):

   A - foreign country - license from A to X

      (no foreign country income tax treaty with U.S.)

   X - Netherlands corporation – sublicense to Y

        (Dutch-U.S. tax treaty royalty exemption)

   Y - U.S. Corporation  

Royalties from X (foreign) to A are not tax exempt.

X is required to withhold at source.  How?

SDI Netherlands              p.265
Withholding agent issue

SDI Bermuda licenses to

SDI  Netherlands (Dutch) which sublicenses to

SDI USA.  Why use a Dutch intermediary?

Issue:  Is the Netherlands to Bermuda royalty payment U.S. sourced and subject to U.S. gross withholding at source?  Held:  No, not U.S. sourced. Source disappeared in a “mixing bowl.”  Is this the correct result? Apply proportionality?

No conduit argument (i.e., Aiken) made by IRS.

The SDI Bermuda deal was separate.

Held: Payments by N. A. are not U.S. source.

Withholding Agent Responsibilities              p.270

Who is the withholding agent?

How does one know whether the payee is domestic or foreign?  IRS Form W-9 to show U.S. status.

Possible exception in ECI & USTB, with a representation provided by recipient. W-8ECI.

Use alternative approaches:  (1) obtain certification

from the home country re tax status as being a

resident in the other (tax treaty) country?

(2) Withhold from the gross amount and use refund

procedure (after proving qualifying tax status)?

Withholding for          p.271     Compensation Income

(1) Normal wage withholding applies (rather than a 30% flat rate) for employee (ECI is status not relevant in this situation);  (2) 30% withholding at source for an amount paid to an independent contractor; & (3) no withholding when ETBUS.

Rev. Rul. 70-543,  p. 272,  involving self-employed individuals and horse racing operator:  (1) 30% gross withholding at source is required for fighter and golfer, and §871(b) graduated rate tax;  but, (2) not for horse racing operation (if prior IRS Form 4224 provided, now IRS Form W-8ECI).

Defining Services Income for Withholding Purposes

Container Corp. v. Commr. (successor to Vitro), 134 T.C. 122  (2010),  aff’d. 5th Cir. (prior at p. 128).

Mexican Corp. (Vitro) charged U.S. sub a fee to guarantee U.S. sub’s debts.  IRS says failure to withhold on the guarantee fee payments to Vitro.

Tax Court: Guarantee fee is a payment for services and, therefore, not U.S. source income (sourced in Mexico) and, therefore, no withholding required.

Cf., subsequently guaranty fees paid by U.S. party to foreign guarantor treated as U.S. source income (§861(a)(9)) (interest equivalent and not for services) & is withholding at source required (?).

Partnerships & Withholding
at Source                        p.275

Code §1446.  The partnership must withhold an amount equal to: (1) the allocable share of partnership ECI income, times (2) the maximum marginal income tax rate (§1 or §11).

Any actual distribution is not relevant for this purpose.  Note similarity to the branch tax.

The withheld (gross) amount will not equal the amount of the net income tax liability.

Consequently, an income tax return is required to be filed by the foreign partner.  (cf., Balanovski).

Additional Withholding Tax Regime (2010) - FATCA  p.276                 

IRC, Chapter 4, Code §§1471-1474.

“Foreign Account Tax Compliance Act,” (FATCA), in Hiring Incentives Act (P.L. 111-147, 3-2-2010).

Effective in 2013.

To impose a 30% withholding tax at source on payment to foreign recipient bank (§1471) or other party (§1472, non-financial foreign entity) unless bank provides information about U.S. owners of payments made by bank.

Objective: Be a “filter” for Chapter 3 withholding.

Taxation of U.S. Real Property Gains  (FIRPTA)              p.277

Code §897 - gain by a foreign party on U.S. real

property sale is treated as ECI of USTB (even

though realized by a passive investor).

What is the U.S. tax policy reason for this special

tax regime pertinent to real property gains?

What was prior U.S. tax regime/planning: 

1)  Operational income – use “net basis” election.

2)  Sale and gain realization  - when not having a

USTB (e.g., §453 payment in later year) – U.S. income tax immunity on disposition (capital) gain.

Defining a U.S. Real Property Interest (FIRPTA)            p.279

What is the definition of a “U. S. real property interest” for this purpose?  P.279

§897(c)(1)(A)(i). Real property interests, mines, wells, etc.

“Associated personal property” (e.g., consider a hotel operation & furniture sale).

Leasehold interests;  options to purchase.

See §897(c)(6)(A)&(B).

Not including interests “solely as a creditor” -  but, is an “equity kicker” loan includible?

 

US Real Property Holding Corporation                     p.280

USRPI includes an interest (e.g., stock) in a “United States real property holding corporation” (next slide);  all gain is subject to tax, not only the U.S. real property percentage; unless all prior (5 year) internal gain is recognized on U.S. real property.

Cf., sale of stock of foreign corporation (but foreign corporation itself may have a USRPI); & foreign corp. may have future accrued FIRPTA liability.

USRPHC not including publicly traded stock (except for a 5%+ shareholder).  §897(c)(3).

Definition of U.S. Real Property Holding Corp.

Holds U.S. real property greater than 50% of both (1) all its real property and (2) trade or business assets of the corporation. §897(c)(2).  P.280.

Note: comparative asset values (& foreign currency fluctuations) could cause constant change of Corp. being above or below the 50% level.

Why exclude liquid assets from this calculation?  Is this an “anti-stuffing rule”?

Look-through rules apply to determine the FIRPTA status of a corporation. §897(c)(4 )&(5).

Treatment of the Foreign Corporation - Special Rules

1)  Sale of shares of foreign corporation is not subject to FIRPTA; but, what if a liquidation distribution & redemption distribution?

2)  Any other distribution (in kind) by the foreign corporation of its appreciated U.S. real property triggers Corp. gain recognition.Code §897(d)(1).

3)  Possible applicability of tax non-recognition provisions.  E.g., Rev. Rul. 84-160 (p. 282) & Code §351 drop-down of U.S. corp. shares into a U.S. holding corp.  Code §897(e).

Code §1445     Withholding at Source                   p.284

Transferee must withhold 10 (15) % of the gross “amount realized” by seller upon the disposition transaction.  Is this the real “final tax”?

Applies to the proceeds (including assumed debt on property) and not to the gain realized from the real estate sales transaction. 

A U.S. income tax return is required from the foreign seller (to determine net gain/loss), but may not be forthcoming if no refund eligibility.

Cf., possible information reporting of the disposition gain.  See §6039C.   P.286.

Code §1445     Exceptions to FIRPTA Withholding at Source

Exceptions to the withholding requirements - Code §1445(b) (p.285):

1)  Not a foreign seller, e.g., a U.S. individual.

Transferor certifies that he is not a foreign person.

2)  Corporation is not a USRPHCo.  How prove this

status when selling shares?  Corporate affidavit.

3)  IRS “qualifying statement” received

(re security arrangement with IRS to pay the tax).

4)  Future buyer use for certain residence purposes.

5)  Regularly traded shares (+/- 5%); cf. 5%+ tax.

Code §1445 Withholding & 
Entity Distributions         p.286

Foreign corporate distribution in kind  to shareholders - withhold 35% of the gain amount. Tax applies to corporation which knows its own tax basis for the distributed asset. §1445(e)(2).  

U.S. corp.? 10 (15)% gross withholding on liquidation distributions. §1445(e)(3). Shareholder tax applies here.

Partnership & trust distributions –

                1) Withhold 35% of the disposition gain realized to the extent allocable to a foreign partner/ foreign trust beneficiary. §1445(e)(1).

                2) Withhold at 10 (15)% of the gross on a property distribution. §1445(e)(4).

FIRPTA & Tax Treaties
p. 287

Is any FIRPTA tax immunity provided in the U.S. under an applicable U.S. bilateral income tax treaty? No. Why? Tax real property at situs?

See U.S. Model Treaty, Article 13, re jurisdiction to tax real estate income – including any disposition gain - in the country of situs (including the stock of a USRPHCo.).

Note the treaty override, later-in-time rule, and phase-in of §897 applicability when a tax treaty override did occur. 

Financing the Foreign Enterprise                  p.287

Foreign shareholder capitalizes the U.S. subsidiary with both (1) debt and (2) equity.

Dividends are subject to possible withholding at source; & are not deductible by the payor corp.

Interest is (1) deductible by the payor (subject to §163(j)) and (2) not subject to outbound withholding (under most bilateral tax treaties).

What is “debt,” as contrasted with “equity”?

See §385 re debt/equity differentiation (p. 288), & current §385 regulations.

Excess Interest & Deduction in U.S.    p.288-9

“Earnings-stripping” - re (tax-exempt) interest paid to a related party - §163(j).  E.g., U.S. tax treaty exempts interest from U.S. withholding tax.

The income tax deduction to the payor for

“disqualified interest” expense is postponed when: 

1) “Excess interest expense” - Interest expense is above 50% of adjusted gross income; and,

2)  Debt to equity ratio of debtor exceeds 1.5 to 1.

Applicable when a U.S. income tax treaty provides a tax exemption or tax rate reduction on interest (latter situation:  a proportionate reduction).

Treatment of Guaranteed Debt?                       p.289

The “disqualified interest” includes unrelated party loan interest where a related foreign person guarantees the debt.

Guaranteed debt also includes debt where, e.g., the parent corporation provides a “comfort letter.”

What is a “comfort letter”?

Not relevant when the subsidiary is the guarantor. §163(j)(6)(D)(ii)(II). Why?

Note: U.S. Treasury Jobs Act Study (2007) re §163(j) earnings stripping provision effectiveness.

Problem 1                        p.292
Securities Income & Trading

NRA has U.S. securities transactions.  Dividends of $30,000 from shares and $200,000 gains and $100,000 losses; total net income of $130,000.

Not ETBUS - §864(b)(2)(A)(i) (safe harbor).

Capital gains are not taxable in the U.S. (& are foreign source income).

Dividends are subject to U.S. tax in U.S. (U.S. source), so $9,000 tax on $30,000 of dividends (30% tax rate; unless a 15% rate applies under a U.S. income tax treaty, then $4,500 tax).

Problem 2                        p.292
Excess  Capital Loss

NRA has $200,000 gains and $230,000 losses; net capital loss of $30,000.

Plus, dividend income of $30,000.

The capital loss of $30,000 is not available to offset the tax on the $30,000 of dividend income (unless this capital loss is effectively connected & taxpayer is ETBUS). 

Withholding tax is imposed at the source on the dividends (i.e., possible tax treaty reduction).

Problem 3                        p.292
Discretionary Authority

Discretionary authority to buy and sell securities is to be granted to the U.S. based broker for the foreign citizen/resident NRA.

NRA will not be treated as ETBUS.

The Code §864(b)(2) safe harbor provision (from having ETBUS status) will continue to apply to the NRA.

Problem 4                        p.292
No §864(b)(2)(B) Safe Harbor

Foreign commodities dealer takes title to wheat in U.S. and the wheat is then sold to the Government of India FOB NYC.

 Income from this sale is not FDAP and, arguably,  dealer is not ETBUS (since only sporadic U.S. transactions) and, therefore, no U.S. tax liability even though U.S. source income under the title passage test for inventory sale.

No P.E. if an income tax treaty is applicable.

Events are solely in the U.S., but no U.S. income tax.

Problem 5                        p.292
Cf., Balanovski scenario

Foreign sales reps send orders to purchasing agents in the U.S. and goods are purchased in the name of  the foreign corporation.  Orders are accepted in the foreign country. 

Title is transferred at the port of destination.  Customers pay for transit insurance. Is title passage rule (outside the U.S.) recognized?

Not a USTB or P.E. (if a treaty)?  Purchasing agent as not causing USTB status?

Even if USTB, foreign source income (and, therefore, no U.S. tax)?  &,  no partnership arrangement.

Problem 6                        p.293
Related US & Foreign Parties

Foreign corp. sells machinery parts in Europe.

Bought parts from a related company (brother-sister) in the U.S. and took title to the parts in U.S. and delivered the parts in Europe. 

Foreign corp. receives foreign source income from the sale of inventory.  U.S. tax?  No.

And, no imputed U.S. tax status because the transaction is between related companies.   See Model Treaty, § 5(7), re related corporations.

But, a possible “transfer pricing” issue?

Problem 7                        p.293
Foreign Corp – Services

Parts are delivered to customers at the U.S. factory and customers pay all shipping costs.  Foreign sub receives a 20% commission from U.S. co.

Empire receives services income and this services income is sourced where those services are rendered.  Presumably, those services (producing a sales commission) are performed outside U.S.

Model Treaty, Article 5(7) – no attribution from Colonial to Empire for causing U.S. income tax status of Empire.

Problem 8                        p.293
Royalties or Compensation?

Soprano from France made recording in L.A.; similar to the earlier Boulez case?

 Receives 10 percent of gross revenue from worldwide sales, described as “royalties” under the contract between her and U.S. recording Co.  Holding a property interest in the copyright?

1) Copyright (royalty) or compensation?

2) Cf., tax treaty treatment:  compensation (taxable) or royalty (exempt)?  See Art. 16 re entertainer taxability in the U.S.   If a royalty – income is taxed where sourced – but a treaty exemption.

Problem 9                        p.293
Community Property Income

U.S. citizen moved from U.S. to Peru as an employee of a sub of U.S. shipping co.

He marries a Peruvian citizen/resident.

Peru is a community property jurisdiction  (remember Poe v. Seaborn?) & 50-50 split?

Code §879 says community earnings belong to the working spouse.  Result here: All income is his (and any §911 exclusion eligibility?).  Similar if foreign worker spouse & U.S. non-worker.

No income tax treaty coverage of this issue.

 

Problem 10                      p.293
Outbound Alimony & Interest

Issues re withholding obligations.  Facts: Employee returns  to U.S. without his NRA wife and she has become an ex-wife.

He sends alimony (gross income; payor location is US source) and child support (not gross income) to Peru.  Withholding on alimony, but exempt under Treaty, Art. 17(5) & (6).  (No Peru treaty).

Also, he pays (US source) interest (FDAP) to Peru bank on his personal loan. Interest payment is subject to 30% US tax withholding at source.  How does the foreign bank protect itself?

Tax treaty applicable?  Exemption for these items.

Problem 11                      p.294
Partnership Services     §1446

NRA partner in U.S. partnership with USTB.  Equal share in profits and losses. NRA works in Ireland.

To what extent are the services provided in the U.S.?   U.S. source income is realized if U.S. based services but not for foreign provided services.

Code §875 partnership attribution. Required §1446 partnership withholding & actual payment is not relevant.  Include a “special allocation” provision in the partnership agreement?

Transform the NRA into an employee? Code §707.

 

Problem 12                      p.294
U.S. Land Ownership   USTB?

ETBUS? If not ETBUS, 30% withholding at source on the $100,000(?) annual rental income, plus any real estate taxes paid by the tenant (also gross income - total $180,000 income). And, no deductions for expenses.  Tenancy in common?

Therefore, elect Code §871(d) deemed USTB treatment. Then, NRAs are taxable at Code §1 progressive income tax rates on the net income  each is treated as realizing.  

U.S. Model Treaty – Article 6(5) permits the net election.  Election is binding for the future.

Problem 13                      p.294
Sale of U.S. Land & FIRPTA

NRA sale of U.S. land (i.e., real property).

U.S. income tax treatment of the profit? Ordinarily capital gain is allocated to the residence.

Here - Code §897 imposes tax - FIRPTA rules.

Also – Code §1445 imposes a withholding obligation at source on the payor/buyer. 

U.S. Model Income Tax Treaty,  Article 13(1), confirms that U.S. jurisdiction exists to tax these real property gains even if the NRA owners are from an income tax treaty jurisdiction.

 

Problem 14                      p.294
USRPHCo Status?  50%+ Test

NRA invested in wholly owned U.S. corporation:

1)            NYC apartment for $2 million

2)            stock (publicly traded):  $2 million

3)            art gallery:  $2 million  (rented space; annual lease & no renewal right; i.e., not real property).

Consider (for FIRPTA purposes) the various alternatives (below) concerning the relative fair market values of the several properties.

What % in U.S. real property for §897 purposes?

continued

 

Problem 14(a)               p.294
USRPHCo Status?  50%+ Test

NRA invested in wholly owned U.S. corporation:

1)            apartment bldg. is worth $60 million

2)            stock (publicly traded) is worth $20 million

3)  art gallery assets:  $20 million

What % in U.S. real property for §897 purposes?

Fraction is 60/80   (80 including the gallery assets); i.e., more than 50% is U.S. real property,  & FIRPTA applies to the stock sale.

 

Problem 14(b)               p.295
USRPHCo Status?  50%+ Test

NRA invested in wholly owned U.S. corporation:

1)            apartment bldg. worth $40 million

2)            stock (publicly traded) worth $40 million

3)  art gallery assets:  $20 million

What % in U.S. real property for §897 purposes?

Fraction is 40/60   (60 including gallery assets) & FIRPTA applies (i.e., more than 50%) to stock sale.

 

Problem 14(c)               p.295
USRPHCo Status?  50%+ Test

NRA invested in wholly owned U.S. corporation:

1)            apartment bldg. worth $40 million

2)            stock (publicly traded) worth $20 million

3)  art gallery assets:  $40 million

What % in U.S. real property for §897 purposes?

Fraction is  40/80 (or 50%).  The 80 includes the gallery assets & FIRPTA applies.

 

Problem 14(d)               p.295
USRPHCo Status?  50%+ Test

NRA invested in wholly owned U.S. corporation:

1)            apartment bldg. worth $100 million (subject to an $80 million mortgage) & net value $20 million.

2)            stock (publicly traded) worth $40 million

3)  art gallery assets:  $40 million

What % in U.S. real property for §897 purposes?

Fraction is  100/140 (or 71.4%).  Value of the real property is based on gross value, rather than net.  See Reg. §1.897-1(o)(2)(i)&(iii) permitting limited netting, such as for acquisition debt. 

Problem 15                      p.295
Foreign Corp. Stock Sale

NRA invested in wholly owned foreign corporation (Cayman Islands).

The interest in a foreign corporation is not a U.S. real property interest. Code §897(c)(1)(A)(ii).

Sale of this stock would not be taxed under FIRPTA; but, the stock value to be paid by a purchaser ordinarily will be reduced by the embedded potential internal federal income tax liability (FIRPTA).  Alternative: making the §897(i) election & then FIRPTA applies on the stock sale (if a treaty is applicable – not here).

Problem 16                      p.295
Indirect U.S. Ownership

Status of Bluewater as a USRPHCo.?

Yes, became a USRPHCo. when acquiring shares of foreign corp. (Paradise) with U.S. real property (even though U.S. assets had a low tax basis).   

40 (FMV) U.S. assets & 30 (FMV) foreign assets.

Values (40-30), not tax basis (5-10) control determination of corp’s FIRPTA status.

See Code §897(c)(5) re attribution to U.S. Corp.

The sale of Bluewater shares by Casino (NRA) for $1 mil. profit results in FIRPTA gain and U.S. income tax liability to Casino.  How enforce?

The “less than 5% rule” is not applicable.

Problem 17                      p.295
Disqualified Interest & §163(j)

Interest stripping issue:   Interest of $280,000 is disqualified interest under Code §163(j)(3)(a) –

(1) interest is paid to a “related party,” and,

(2) under the treaty no U.S. tax applies to interest. 

Debt/equity ratio of 2.8:1 exceeds 1.5:1 limit. 163(j). 

Disqualified interest ($30,000) results from the $280,000 interest expense over 50% ($250,000) of the adjusted taxable income: $500,000 - resulting from gross income of $200,000 + depreciation  ($20,000) + interest expense  ($280,000).

See Code §163(j)(1)(A) re adjusted taxable income.

Problem 18                 p.295
Internet Commerce

Use a tax haven enterprise with only a server in the U.S. to conduct an internet sales operation (therefore, no USTB or PE, if a tax treaty)?

Does the failure to tax internet profits create an unacceptable advantage for “electronic commerce” taxpayers over “bricks and mortar” taxpayers? Should internet sales be favored?

What relevance of this question for sales taxation by states in the U.S.?

Tax Planning Problem 1 
p.296

Panco to acquire U.S. real property & stocks and bonds of U.S. real estate companies

1)            Current income - 30 percent tax, unless net election available.

2) Branch profits tax if ETBUS

3) Listed securities investments - interest and dividends, subject to 30 percent withholding.

4) Sale of real estate - FIRPTA

5) Sale of securities - no tax, unless connected with real estate trade or business

 

Problem 1, continued

6)  Dividends from PANCO producing U.S. taxable income, unless branch profits tax.

7)  Use debt  leveraging?? - but Section 163(j) may be applicable.

8)  Cayco -

     where rendering services?

     Not subject to FIRPTA.

Problem 2      Constructing the Business Plan           p.297

How much investment to occur?

What profit projections?

What cash flow expectations?

How to deal with U.S. profits?

Income tax status of the individual?

Anticipated structure and management of the venture?

Problem 3                        p.297
Tax Projections

Nontax considerations, e.g., limitation of liability.

What alternative structures for tax planning?

Debt financing?

Resident alien status of individual?

Branch profits tax & FIRPTA applicable?

Summary                    p.298

Investment environment in U.S. - are the tax burdens on foreign investment less onerous than for domestic based investment?  Is the U.S. a “tax haven” (except for real estate)?

Cf., “force of attraction” rule vs. P.E. test (with only P.E. income being taxed in U.S.).

What impact for the U.S. capital markets?

Consider, also, the focus of U.S. income tax treaties (p.300), particularly comparing developed vs. developing country treaty structures.