Chapter 3      Foreign Persons:  U.S. Trade or Business Income

Fundamental issues to consider:

   1) U.S. source for the income?

   2) Does a U.S. trade or business (USTB) exist?

    3) Is the income “effectively connected” (ECI) with the USTB? Cf., “force of attraction” rule.

§871(b)(1) & §882(a)(1) impose a net income tax on U.S. business income realized by a foreign person.

U.S. Trade or Business,
cf., “P.E.” under Tax Treaty

Code rules concerning U.S. income tax status:

U.S. taxation if regular and continuous business activities - See Code §864(b).

         “P.E.” contemplates a “fixed place of business”.

Performance of personal services as USTB - Code §864(b)(1); but, de minimis rule applies.  P.143

Trading in stocks, securities & commodities - Code §864(b)(2)(A)&(B).  P.144. 

U.S. Trading in Stocks & Securities                             P.145

Not ETBUS:  Foreign persons can trade in stocks or securities on U.S. markets without having a U.S. trade or business.

   Code §864(b)(2)(A). But, not if having a trading office in U.S.  §864(b)(2)(C).

Exercise of discretionary authority by the broker in U.S. does not cause ETBUS.

Similar exceptions for commodities trading.  

§864(b)(2)(B).

ETBUS - Other Situations
“Regular & Continuous”

Continental Trading (p. 146) - investment and limited trading; Panamanian Corp. & Mexico City principal office.

Taxpayer position that ETBUS and is entitled to deductions; but, IRS asserts not ETBUS, i.e., isolated & noncontinuous transactions.

Activities relate to investment in stocks and to borrowing funds,  not an active business.

Held:  Not ETBUS (& no investment expense deductions, e.g., interest).

Inverworld case              p.149
Parent Corp. & ETBUS

LTD, a Cayman Islands corporation, holds stock of Holdings (US) which holds stock of Inc. (US).

Merely ministerial activities by Inc. for LTD in U.S. or conduct of a business?

Held:  LTD conducted activities in the U.S. directly and through agents.  LTD activity was making investments in the U.S. for Mexican clients.

Exclusive Agency Situation Rev. Rul. 70-424         p.152

Q, a domestic corporation, as agent for M, foreign corporation, for sales of products in the United States. 

Q assumed full responsibility for sales of M's product and acts as guarantor.

Held:  Principal and agent relationship existed.  ETBUS; M is subject to Code § 882 tax.

Cf., Code §864(c)(5)(A) - independent agent;  and Model Tax Treaty, Article 5(6).

Handfield case                p.153
Dependent Agent?

Was an NRA engaged in USTB?

Were cards purchased in Canada for delivery into the U.S.? 

IRS says an agency relationship existed.

All cards were fully returnable & the petitioner would allow credit.

Held:  News Company was an agent.

Consignment arrangement existed;  U.S. tax effect of this arrangement?

Partnerships and Trusts 
p.157

Partnerships and trusts are conduit entities for federal income tax purposes.

Code §875(1) requires attribution of

         partnership activities to the partners (whether U.S. or foreign); and

Code §875(2) - trust’s activities are attributed to the trust beneficiaries (wherever located).

Does a “trust” conduct business?  If so, can it be treated as a “trust” under federal tax entity characterization rules?

Balanovski case             p.157
Attribution to Partners

Partners in an Argentine partnership.

   Balanovski came to U.S. to transact

   partnership business.  Significant purchasing activities through a NYC office as being ETBUS.

Holding:  CADIC (partnership) was ETBUS and all the partners were taxable in US on their shares of that partnership income.

Balanovski was not a mere purchasing agent in the U.S. (meaning CADIC would not be ETBUS).

Additional Partnership, etc., Issues                              p.160

Disposition by foreign partner of an interest in a partnership which is ETBUS. 

Rev. Rul. 91-32 – gain is considered as ECI with USTB (but not for other property).

How collect tax on partnership income paid to foreigner?  Withholding under §1446.

No foreign shareholders in an S corporation- §1361(b) specifies no foreign and no corporate shareholders in an S corporation.

Management of Real Property
ETBUS – Gross or Net Taxation?

1)  Lewenhaupt,    p. 161 – property sales gain;

  continuous activities (by agent) and ETBUS.

2)  Rev. Rul. 73-522,   p. 163 – gross, not net tax;

   long-term “net leases” and not ETBUS.

3)  Election available to enable ETBUS status

a) §§871(d) & 882(d).

b)  When make this election? 

c)  Limitations on election? Binding in the future.

              Rev. Rul. 91-7 – some gross income required.

Determining the Total Amount to be Included in Gross Income

“Force of attraction” rule vs.

“Effectively connected income” rule

         (or “limited force of attraction” rule)

§864(c)(3) - a “limited force of attraction” rule  (but, not normally including investment income).

§864(c)(2) - When include investment income in ECI?   i) asset use test (used in  USTB?); 

    ii) business activity test (active business by an investment company?)

Rev Rul. 86-154                    p.168
Defining Income Tax Base

Banking business impact for ECI income

determination:  U.S. branch of a foreign bank.

Types of “securities” transactions - effectively connected income in the U.S.?

1)  Negotiated loans – yes, ECI;  U.S. branch solicits loans and does credit analysis.

2)  Related party loans – not ECI, since U.S. sub a passive participant

3)  Loan participations – U.S. sub actively negotiated collateral &, therefore, ECI.

Deferred Income & Look Back Rules                               p.171

1)  Deferred Income Rule – cannot avoid ETBUS  categorization by postponing receipt of operating income from a current ETBUS year to a non-ETBUS subsequent year.  §864(c)(6).

2)  Look Back Rule – 10 year “claw-back” rule for that income derived from the sale of ETBUS related property after ETBUS terminated.  §864(c)(7).

Foreign Source Income of a Foreign Person        p.171

Is foreign source income included in the ECI of a USTB of a foreign person?

 Code §§864(c)(4)(A) & (B).

   U. S. office to be a “material factor.”

Note Code §865(e)(2) - sourcing rule for inventory sales – U.S. source, but a foreign office participation exception to U.S. source rule.  P.173.

Rev. Rul. 75-253    p. 174  - Banking & securities income – USTB & LDC loans & interest income which is ECI of USTB.

Deductions & Credits
§§873(a) & 882(c)(1)  p.176

Deduction for expenses connected with ECI. §873(a) and 882(c)(1).

Foreign tax credit available - §906(a).   For the    foreign tax imposed on foreign source ECI; no credit for foreign tax on U.S. source income.

U.S. income tax return required to get deductions - §882(c)(2) & §874(c);  therefore tax on gross income if no filing?  Note Swallows Holding, Tax Court case – regs (p. 176) are invalid. But, 3^rd Cir. reversed  this decision (requiring a timely return).

Interest Expense Deduction                   p.177

Interest expense deductions -

   fungibility concept applies and allocations required. Reg. §1.882-5.

Loans can easily be structured to achieve tax planning objective.

§864(e)(2) – provides for allocation of interest expense on the basis of assets – rather than gross income.

Problem                      p.179
Re:  Community Autos A.G.

Re:   allocation of interest expense to the U.S. trade or business:

1) Average value of U.S. assets? 

2) Liabilities connected with U.S assets?

3) Allocation, based on (a) “adjusted U.S. booked liabilities method” or (b) separate currency pools method

Problems                    p.180
Re:  African Art Traditions

a. No representation in the U.S.

No USTB - even if U.S. source income, no USTB,  and this is not FDAP subject to withholding taxation under Code §881.

b. Periodic visits to the U.S.  Are the activities continuous, regular and considerable, i.e. USTB? If so, then, sourcing. Where does title pass when the inventory is sold? Note, the Code §861(a)(6) title passage rule.  & Reg § 1.861-7(c).

Problem, cont.           p.180

c. U.S. permanent sales office but no warehouse.  Goods are shipped directly from foreign country. U.S. sales office constitutes a USTB.  §865(e)(2)-

    re office in the United States.  Income is ECI under force of attraction rule.

d. No sales office in the U.S. but a contract with an independent (?) agent marketing and selling in U.S. on behalf of Traditions.   §864(c)(5)(A) – that office of U.S. agent is disregarded.

Problem, cont.           p.180

e. No sales office in the U.S. but Traditions has a contract with an independent agent who markets and, additionally, accepts orders in U.S. on behalf of Traditions.  

         See §864(c)(5)(A)(ii) – the agent’s office is not attributed to Traditions for purpose of making the USTB determination -  where in the ordinary course of the agent’s business.

Problem, cont.           p.180

f. Establish shop in NYC with inventory.  Direct sales and mail order fulfillment and sending orders to home country for fulfillment.

Inventory would generate U.S. source income.   §865(e)(2)(A).

Orders by mail - also USTB?  Not if (real) participation of foreign office - §865(e)(2)(B).

Tax Treaty Provisions   p.181
Article 5 - P.E. Status

Article 5(1) – P.E. as a “fixed place of business.”

Article 5(2) concerning various types of a P.E. – what types of activities?

Article 5(4) re preparatory and auxiliary activities (not causing P.E. status);  e.g., storage or display of goods.

Article 5(5) re dependent agents – constitutes a P.E..

Article 5(6) re independent agent – not P.E. for the principal.  Can include subsidiary of foreign co.

Article 7 re determining the P.E.’s taxable income.

Simenon decision           p.183
P.E. Status for an Individual?

Did the author have a U.S. office which was a U.S. permanent establishment? 

Issue:  Were royalties associated (or not associated) with a P.E. in the U.S.?  Held:  U.S. based P.E.

Note: Schedule C - Claimed depreciation deduction for his U.S. residence.   Also,  business expenses claimed.  Note the eventual cost of claiming the “office in the home” income tax deduction!

Therefore, tax treaty exemption for royalty (source to residence) is not applicable.

Taisei Fire and Marine Insurance Co. Ltd.     p.186

Did Japanese taxpayers have a P.E. in the U. S. (under the Japan-U.S. income tax treaty) because of their relations with Fortress Re (not a subsidiary) and its U.S. activities?

Issue under P.E. treaty article is whether Japanese companies had a P.E. because of dependent agent status, or was Fortress an independent agent.  Answer:  No P.E.; Fortress as independent entity.

Legal and/or economic independence?

Tax on P.E. activities          p.195
Determining Taxable Profits

Model Art. 7 re allocable profits & Art 7(2).

See also Model Treaty Article 13(3) re gains from the sale of personal property attributable to a permanent establishment.

Article 7(3) - availability of deductions, including for general and administrative expenses and for R&D expenses.

Result: net income tax for a specific activity.

Cf., limited “force of attraction” rule; See Code §864(c)(3).

National Westminster Bank                              Article 7 Issue                p.197

Accuracy of the interest expense allocation on an intra-corporate loan (i.e., between bank branches).   Disregard interbranch transactions? 

Is Reg. §1.882-5 inconsistent with the UK-US  Income Tax Treaty?     Yes.

Relying on OECD materials the Court determines that income determination of the U.S. branch can be based (1) on its books of account, with adjustments, as if a separate enterprise, and (2) not on a regulatory formula (premised upon being a business unit of a worldwide enterprise).

Treatment of Personal Services                         p.211

Treaty Art. 14 (now Art. 7) - exemption for NRAs  performing personal services of an independent character.   Art. 7 re P.E. determinaton of business profits.

Note Rev. Rul. 2004-3 (p. 211) re cross-border service partnerships (law firms & accounting firms).  Cf., Balanovski case.

Art. 14- limited exemption for dependent personal services; cf., §861(a)(3).

Art. 15 – Corporate directors – tax on U.S. income.

Art. 16-  “artistes and sportsmen.”

Additional Treaty Provisions
p.212

Treaty Art.  19 – exemption for government employee services.

Treaty Art. 20 – foreign sourced scholarship to foreign student in U.S. not subject to U.S. tax.

Treaty Art. 6(5) -  Net basis election for real estate income – inclusion in current U.S. Model Treaty? (yes, even though statute).

Treaty Art. 13(1) – U.S real estate gains – taxed in U.S. (under Code §897).

Relation of Tax Treaty & Code Provisions            p.213

Rev. Rul. 84-17 - Polish corporation inbound into the United States.                  

Elect part P.E. income tax treaty status (for non-P.E. income) and part Code status – ETBUS -ECI (for non-P.E. loss)?  no

1st activity    P.E.     product A   gain

2nd activity   not P.E.,  but ECI USTB gain

3rd activity   not P.E.,  but ECI USTB loss

Partnerships and Trusts - under the P.E. clause of tax treaties

Rev. Rul. 90-80  Barter Income                          p.216

Situation One:  Partnership has U.S. P.E.

Activities of partnership attributable to the partners.   The foreign partner has a P.E. in the United States.   Income attributable to the P.E. is taxable to the foreign partner.

Situation Two:  Dependent agent; attribution to the principal;  P.E. exists;  NRA is taxed.

See Unger case (p. 218 & 220) re real estate partnership and foreign limited partners.

Problem 1 – Tax Treaty 
PE Status Requirement  p.220

Traditions problem (page 180) - in the income tax treaty context. No U.S. income tax liability arises unless a P.E. exists in the U.S.

P.E. status:  a & b – no; c – yes (sales office as P.E.);  d & e – independent agent & no P.E.;  f – P.E. status

Problem 2                        p.220 Tax Treaty Applicability

Factual variations:

a)  Acceptance at the home office;  no P.E. since no fixed place of business in the U.S.

b)  Warehouse & showroom, including for delivery; no P.E; Article 5(4)(a) &(b).

c)  Manufacturing in the U.S.?  But completed by a third (independent) party.  Are Article 5(4)(c)  - processing by another -  and Article 5(4)(e) - auxiliary activity – applicable to enable a tax exemption?

Problem 2, cont.            
p. 220

d)  Market research/advertising office in U.S. - Article 5(4)(d) provides an exemption from  P.E. for “collecting information”?  Similarity to enable exemption?

e)  Power to negotiate contracts in the U.S.  -      sales activities sufficient to supersede any other exceptions & P.E. exists.  See Art. 5(5) of the U..S. Model Treaty.

Problem 3                        p.221
Agency Status

Handfield case revisited - p. 153

         consignment of goods situation.

P.E. exists because the U.S. agent has a stock of merchandise to fill orders.

What if the agent were independent? Then no P.E. for the principal.

Treaty Article 5(5) & (6).

Problem 4                        p.221
Inbound Individual (NRA)

Consultant or employee? Issue re U.S. tax treatment of income earned in U.S. (not outside the U.S.).

If employee, see Article 14 (2006 Model).   Taxed in U.S. because remuneration paid by an employer who is a resident in U.S.

If an “independent consultant,” see Art. 5 (2006 Model).      No income tax in the U.S. since no U.S. P.E.  (prior, no fixed base in U.S.) 

Query:  Is this individual really independent?

Problem 5                        p.221
Foreign Lawyer in the U.S.

Sally Suarez:  30 days in U.S. working on a deal for foreign law firm;  she earns 10k;  her firm receives 30k.

Employee taxation:  protected from U.S. tax under Art. 14(2) (2006 Model), unless working from a P.E. in the U.S.

Firm taxation:  No U.S. tax unless a P.E in the U.S.   The hotel room is not a P.E.

Working from the law firm office in NYC?  P.E. and U.S. tax (unless remuneration not borne by P.E.)

Problem 6                        p.221
Electronic Website

Electronic publishing;  independent web site in the U.S.  (i.e., an ISP).

Global History:  Regular, continuous activities in the U.S. & exploiting the relevant U.S. market;  but, delivery from India.

No U.S. P.E.?   See p. 194, note 2, indicating probably no P.E. existing (and, therefore, no U.S. income tax even though extensive sales into U.S.)

Branch Profits Tax          p.222
Division of Foreign Corp

Code §884     30% tax on a “dividend equivalent amount” (in addition to regular corporate tax).

Tax applies currently and without any actual funds repatriation:  100x less 35% (Corp. tax) = 65x times 30% (Br. Tax) = 19.5x = 54.5 total tax.

Concept of “effectively connected E&P” is:

    1)  Reduced by an increase in branch equity; and,

    2)  Increased by any reduction in branch equity

to determine the taxable amount.

Branch Profits,  cont.

The “2nd dividends tax” is not to apply when the branch profits tax applicable - §884(e)(3).

§884(e)(2) – the amount of branch tax is reduced to the treaty dividend withholding rate on dividend payments upstream from U.S. subsidiaries to foreign shareholder in recipient treaty country.

§884(e) – a “treaty shopping” limitation is applicable.  Necessity for a “qualified resident” in the recipient country to get treaty benefits.

Branch Profits Tax Problem 1                   p.225

The after tax profit of the U.S. branch is $650,000.

The adjusted basis of the branch assets is increased by $2.3 million, but liability of $1.8 million is incurred, and, therefore, the net branch equity increase is $500,000.

Dividend equivalent amount is $150,000:  $650,000 less net branch equity increase of $500,000.  Branch profits tax is $45,000.

Branch Profits Tax Problem 2                   p.225

The after tax profit of the U.S. branch is $650,000.

Adjusted basis of the branch assets is increased by only $2.0 million, but liability of $1.8 million is incurred, and, therefore, the net branch equity increase is $200,000.

Dividend equivalent amount is  $450,000:  $650,000 less net branch equity increase of $200,000.  Branch profits tax is then $135,000.

Branch Profits Tax Problem 2, part 2       p.225

After tax profit of U.S. branch is $650,000.

Adjusted basis of the branch assets is increased by  $2.5 million, but a liability of $1.8 million is incurred, and, therefore, the net branch equity increase is $700,000.

Dividend equivalent amount is  $0:  $650,000 less the net branch equity increase of $700,000.    Branch profits tax is $0.

Foreign Policy Exceptions
p.226

Code §892 exemption for foreign government for U.S. source investment income (i.e., foreign government sovereign immunity), and

Code §893 exemption for govt. employee (reflecting diplomatic immunity).

Code §892(a)(2) - no exemption for commercial activities of government.

But, concept of restrictive sovereign immunity. 

Note:  Quantas Airlines decision.

Problem 1                        p.227
Currency (?) Production

Gold coins marketing by foreign govt.

Coins are legal tender but have a much higher “numismatic value,” or “financial instruments”?

Is this a commercial or a governmental activity under Code §892(a)?

Minting of coins is a governmental activity.   But,  is this engaging in a trade or business in the United States?

Problem 2                        p.227
Govt. Employee Income

Code §893(a).  Salary as ambassador is excluded from U.S. income tax applicability.

No protection from U.S. income tax is available for U.S. based consulting activity income.  §871(b) & U.S. based income.

No U.S. income taxation for the foreign source income, however, since not a U.S. resident, i.e., foreign governmental status.