Inbound Transactions – Business Income
“Business Income” is income that is earned through an active business in the US rather than merely through ownership of investments.
In order to be subject to US tax on business income, the non-US person must have a “US trade/business” and the income must be “Effectively Connected with that US trade/business.” We will refer to US trade/business as “USTB” and to Effectively Connected Income as “ECI”.
You will note that generally tax law is heavily codified and a great deal of clarification can usually be obtained by reading the Internal Revenue Code and the Treasury Regulations. Unfortunately, the definitions of USTB and ECI are not very clearly defined in the statutes. When confronted with USTB and ECI issues it is necessary to look at them on a fact-by-fact basis to reach a decision. Because of the lack of clarity it is always best to err on the side of caution when conducting tax planning in this area.
US Trade/Business
A USTB is generally defined as regular, continuous and considerable business activities in the US. As you have seen in the reading, case law has set a low threshold as to what constitutes a USTB.
There are many examples that are clearly a USTB such as manufacturing in the US, maintaining a research & development facility, carrying inventory, maintaining a sales force that actively sells and negotiates deals in the US, or performing services in the US.
A physical office in not necessary to create a USTB, if a foreign corporation has a sales force in the US that may be sufficient.
Agency
It is possible that a Foreign person (or corporation) has no presence in the US but will still be deemed to have a USTB as a result of an agent in the US that acts on its behalf.
In order to determine whether a US party is an agent to a Foreign person you should look for three things in the arrangement between the parties:
Does the Foreign Person have control over the US party’s activities? Does the US party need approval from the Foreign Person in order to take important actions?
Does the Foreign Person maintain Risk of Loss with respect to the activities in the US?
Does the US party act exclusively on the Foreign Person’s behalf?
Consider the facts of Revenue Ruling 70-424:
ForCo and USCo enter into an agreement under which ForCo conveys to USCo sole agency for sale of its products in the US. USCo will receive a commission of the sales price. [Exclusivity]
USCo agrees not to make sales of the same kind of products of any other company without ForCo’s permission. [Exclusivity]
USCo agrees not to sell ForCo’s products outside the US without permission. [Approval/Control]
USCo will secure yearly contracts with US end-buyers, subject to the approval of ForCo [Approval/Control]
USCo assumes full responsibility for the sale of ForCo’s products and acts as guarantor. [Risk]
ForCo will share equally any loss incurred by USCo. [Risk]
The IRS concluded that this created an agency relationship and ForCo was deemed to have a USTB even though it wasn’t directly conducting activities in the US.
In short, what you’re asking is whether the US party is acting more like an employee of the Foreign Person than an independent third party acting on its own behalf. So if there is a legitimate Buy-Sell arrangement between the Foreign Person and the US party, then the US party would not be an agent but merely a business partner acting on its own behalf.
Effectively Connected Income
Once you’ve determined that there is a US trade/business, you must now look at that business’ income and determine whether that income is Effectively Connected with the US trade/business.
The short answer is: If a Foreign Person has a USTB and he/she earned US source income that is not FDAP income, then that income is ECI.
Income that is Effectively Connected with a US trade/business is taxed under a Net Tax regime in much the same way US persons are taxed:
– Start with Gross Income that is Effectively Connected with the US trade/business
– Reduce it by deductions
– Apply the marginal tax rate to the net amount
There are certain situations in which FDAP income and Foreign Source income can be ECI as well:
FDAP income that is ECI
FDAP-type income (interest, dividends, royalties, rent, capital gain) are generally taxed under the withholding tax regime as we discussed last week. However, if the FDAP income passes the Asset-Use test or the Business Activities test, then it will be taxed according to the USTB regime.
Asset-use test: If the asset that is producing the FDAP income is used in the USTB, then the FDAP income will be ECI. Examples of a FDAP asset used in a USTB include the following:
– Plant, equipment or vehicle used in the daily conduct of the business,
– Securities and investments if they are held to meet the present cash needs of the business,
– FDAP-type assets acquired with the funds of the USTB and actively managed by the USTB.
Business Activities test: If the USTB consists of making investments or licensing then, under the Business Activities test, any dividends, interest and royalties would be ECI and taxed accordingly.
Foreign Source Income that is ECI
Foreign source income will only be ECI if the foreign source income is attributable to a US office or fixed place of business.
If a Foreign Corporation has a sales force present in the US, then it would have a USTB but not necessarily a US office or fixed place of business.
With respect to the sale of inventory, even if the Foreign Corporation has a US office/fixed place of business, and foreign source income is attributable to that office, the foreign source income may still avoid being ECI if a foreign office materially participates in the sale and that inventory is not used in the US.
Treaty Modifications: Replace the USTB analysis with the PE analysis
The ECI/USTB standard of analysis only applies if the Foreign Person is from a country that does not have an Income Tax Treaty with the US.
If there is an Income Tax Treaty in effect, then a similar, but more lenient standard is applied: In order to be subject to US tax on business income, the Foreign Person/Corporation would need to have a Permanent Establishment (PE) in the US rather than merely a US trade/business. The threshold for having a PE is must higher than for having a USTB. There are generally two types of PEs, a physical PE or an agency PE:
Physical PE
In order to have a physical PE, you need a fixed place of business. So, unlike a USTB, it is not enough to have a sales force roaming the US, they actually need to be working out of an office. Unless you have some type of physical structure like an office, factory, laboratory, a warehouse, etc…you do not have a PE. Basically, you are looking for a distinct place with some degree of permanence.
Most treaties also list a number of activities that do not constitute a PE including a facility in the US that is used merely for storing, purchasing, displaying and delivering goods, collecting information or other auxiliary or ancillary functions.
Agency PE
Earlier we saw that an agent can create a USTB for a foreign person. Similarly, under a tax treaty an agent can create a PE. In order for an agent to create a PE, the agent must be a Dependent Agent of the Foreign Person (as opposed to an Independent Agent). A Dependent Agent is one with the authority to conclude contracts in the name of the Foreign Person and habitually exercises that authority. If a Foreign Person has a Dependent Agent in the US, they would have a PE even though the Foreign Person or the Dependent Agent has no physical structure in the US.