Continuing our series on Famous Tax Quotes (quotes from court opinions and rulings with language that is colorful or that concisely states an important tax principle) today's tax quote is from Rawat v. Commr., T.C. Memo 2023-14.
In Rawat, the Tax Court held that a partnership should be treated as an aggregate for purposes of Code §751 with respect to “inventory items”. By treating the partnership as an aggregate for this purpose, the inventory sourcing rule in Code §865(b) applied to the gain. If the gain was U.S.-source income, it would be effectively connected income (“ECI”) under the limited force of attraction rule in Code §864(c)(3).
The taxpayer argued that the partnership should be treated as an entity, and not as an aggregate, under Grecian Magnesite v. Commr., 149 T.C. 63 (2017), aff’d, 926 F.3d 819 (D.C. Cir. 2019). The Tax Court held that the partnership should be treated as an entity for purposes of Code §741, but not for purposes of Code §751. To emphasize this distinction, the court stated:
[T]o tautologize, section 741 applies only where it applies. As we have noted, section 741 has an explicit exception: “except as otherwise provided in section 751 (relating to unrealized receivables and inventory items).” Section 751 provides that the “inventory items” portion of proceeds “shall be considered as an amount realized from the sale or exchange of property other than a capital asset”. Section 741, by its own terms, does not apply to the “inventory items” portion addressed by section 751, to which section 741 yields. The singular “capital asset” treatment of section 741 is thus partially disaggregated by section 751.
Treasury regulations published over the past few years have been heavy on definitions:
Many of the terms are defined by cross reference to definitions found elsewhere in the regulations:
Treas. Reg. §1.245A(d)-1(c) defines "inclusion percentage" and "Section 904 category" by cross referencing Treas. Reg. §1.960-1(b). But those two definitions just cross reference to other regulations.
Treas. Reg. §1.245A(d)-1(c)(17) defines the term "remittance" by cross referencing Treas. Reg. §1.860-20(d)(3)(v)(E)(8). However, Treas. Reg. §1.904-4(f)(3)(xii) has its own definition of remittance.
We created a chart showing the tangled web of the cross references between the different regulations.
Today we published 16 new situational tax charts to AndrewMitchel.com. We have over 1300 charts for FREE on our website. The recently published charts include:
Yesterday the IRS published a new practice unit titled “Deferred Compensation Received by Nonresident Alien Individuals.”
The practice unit discusses payments to NRAs from four types of deferred compensation plans:
Generally, the practice unit only applies to deferred compensation received by NRAs who were treated as employees, and not as independent contractors, during the period in which the deferred compensation was earned.
This new practice unit has been added to our Practice Units By Topic page.
Today we published a new situational chart to AndrewMitchel.com discussing certain 861-865 Income Classifications as well as a corresponding video discussing this chart to our YouTube channel. The links are below:
Yesterday the IRS published a new practice unit titled “IRC Section 250 Deduction: Foreign-Derived Intangible Income (FDII)”.
In addition, Wednesday they published the practice unit “Revised ASC 730 Directive - Computing Qualified Research Expense”, and last week they published the practice unit "Foreign Tax Redeterminations".
These 3 practice units have been added to our Practice Units By Topic page.
On August 24, 2019, the Treasury Department and the IRS issued proposed regulations regarding the classification of cloud transactions for purposes of the international provisions of the Code. The proposed regulations also modify the rules for classifying transactions involving computer programs, including by applying the rules to transfers of digital content.
We have created charts of certain examples included in the proposed regulations. View these charts and over a thousand other free charts at andrewmitchel.com (listed in topical order or listed in alpha-numeric order).
Prop. Reg. 1.861-18(h)
Example 19 (E-Book Downloads Are Sales (e.g., Amazon))
Example 20 (Non-Perpetual Right to Downloaded Songs Are Leases)
Example 21 (Movie Streaming is a Cloud Transaction, Movie Downloading is a Lease or a Sale)
Prop. Reg. 1.861-19(d)
Example 1 (Supplying Computing Capacity: Provision of Services)
Example 2 (Supplying Computing Capacity on Dedicated Servers: Provision of Services)
Example 5 (Downloaded Software Not a Cloud Transaction)
Example 6 (Online Word Processing, Etc. Via Browser or App: Provision of Services)
Example 7 (Downloaded Word Processing, Etc.: Lease of Copyrighted Article (e.g., Office 365))
The IRS publishes Practice Units (“PUs”) (formerly "International" Practice Units) on its website. PUs provide IRS staff with explanations of general tax concepts, as well as information about specific types of transactions. These PUs discuss many U.S. international tax issues that are applicable to businesses. The IRS website does not categorize them by topic therefore it can be difficult to find PUs on a particular topic. Our page Practice Units by Topic categorizes the PUs that relate to international activities by topic.
We have recently updated the page to include 29 new international related practice units published over the last several months.
The topics include:
Is it a good idea to set up a Belize IBC to sell products to U.S. customers thru Amazon FBA? Perhaps not.
Let’s assume the situation is as follows: An individual (let’s call her Jane) resides in a foreign country --- say, for example, Australia. Jane is not a U.S. citizen or a U.S. tax resident.
Jane decides she wants to sell products to U.S. customers where the products are manufactured in China and sold to the U.S. customers via Amazon FBA.
Under Fulfillment by Amazon (“FBA”), Jane stores her inventory in Amazon’s fulfillment centers/warehouses. Amazon picks, packs, ships, and provides customer service for those products.
Jane wants to minimize her taxes. She reads online that if she forms a Belize IBC, she can avoid paying tax in Australia and not have to pay any tax in the U.S. Since there is no Belize corporate tax on IBCs, it is a great deal!! No tax anywhere!!
So Jane contacts an advisor to set up a Belize IBC. The advisor informs her that an even better structure is to have the Belize IBC form a U.S. limited liability company (“LLC”) in a U.S. state such as Nevada or Wyoming. The LLC, Jane is told, will be a “disregarded entity” and will help in setting up a U.S. bank account. The U.S. LLC will get a U.S. employer identification number (“EIN”) that can be provided to the bank.
Jane hesitates. It seems a bit too good to be true. No tax anywhere? No tax in the U.S.? Jane’s advisor concedes that she will probably need to collect sales taxes for sales to customers located in U.S. states where Amazon stores her products. However, the advisor assures her that no U.S. Federal corporate income tax is due because her IBC and her U.S. LLC do not have any dependent agents in the U.S. Without dependent agents in the U.S., the advisor maintains, no U.S. Federal corporate income tax can be imposed.
Based on this advice, Janes forges ahead. She sets up the Belize IBC. Her Belize IBC sets up a Wyoming LLC. The LLC gets an EIN, opens a U.S. bank account, and starts selling products through Amazon FBA. The business blossoms. By the fourth year of operations, sales through the IBC/LLC total $10 million and profits are $1,000,000. All sales are to U.S. customers. The average value of the inventory stored with Amazon FBA during the year is approximately $800,000. The LLC has registered to collect (and actually collects) sales taxes on sales to customers in 3 states.
The cash profit of $1,000,000 is moved from the LLC’s U.S. bank account to an offshore account held by the IBC, but the IBC retains the profits of $1,000,000 and no income taxes are paid in any country.
If it turns out that the U.S. tax advice is wrong, Jane’s Belize IBC will owe some pretty hefty U.S. taxes. U.S. Federal corporate income taxes of $340,000 would be due on the $1,000,000 of profit. Code §11. In addition, a 30% U.S. Federal branch profits tax of $198,000 would be due on the after tax profits (1,000,000 – 340,000 = 660,000; 660,000 x 30% = 198,000). Code §884(a). Thus, the total U.S. Federal tax on the profit of $1,000,000 would be $538,000 (340,000 + 198,000). With a U.S. Federal tax rate of almost 54%, it is important that the U.S. tax advice be accurate.
Under U.S. domestic law, foreign corporations are subject to U.S. tax in two different circumstances. First, foreign corporations are subject to a flat 30% tax on their gross U.S.-source “fixed or determinable annual or periodic” income (“FDAP income”). Code §881(a)(1). FDAP income includes items such as dividends, interest, rents or royalties, etc. Gains on sales of personal property, such as gains on sales of inventory, are generally not considered FDAP. Treas. Reg. §1.1441-2(b)(1)(i) and (b)(2)(i). Consequently, the IBC should not be subject to the flat 30% tax on gross FDAP income.
The second circumstance in which a foreign corporation can be subject to U.S. tax is if: (1) the foreign corporation is engaged in the conduct of a trade or business in the U.S. (“ETOB”) and (2) the income is “effectively connected with the conduct of” that U.S. trade or business. Code §882. We first discuss whether the income would be effectively connected income if the foreign corporation were to be ETOB.
Non-FDAP income from U.S. sources is treated as effectively connected with a U.S. trade or business. Code §864(c)(3). Gains on sales of inventory (where the seller of the inventory has not itself manufactured the product being sold) is sourced 100% to the location of where title transfers. Treas. Reg. §1.861-7(a) and (c).
Since the IBC’s sales to the U.S. customers will occur at the time that the products are held in Amazon’s U.S. warehouse, the shipping point will be in the U.S. In addition, since the products will be shipped to customers located in the U.S., the destination points will also be in the U.S. Under these circumstances, it would seem inescapable that title to the inventory will transfer in the U.S.
Consequently, if the Belize IBC (directly or through its disregarded LLC) is ETOB, then (1) 100% of the profit from its sales to U.S. customers would be U.S.-source income, (2) 100% of this profit would be effectively connected with the conduct of the U.S. trade or business, and (3) 100% of this profit would be taxed in the U.S. This puts a lot of pressure on the issue of whether the Belize IBC is ETOB. If it is ETOB, all of the profits from sales to U.S. customers will be subject to a U.S. Federal tax at a rate of nearly 54%. If the IBC is not ETOB, none of the profits from sales to U.S. customers will be subject to U.S. Federal tax.
Neither the statute nor the regulations define when a foreign corporation is ETOB. Code §864(b) provides that the term “trade or business within the United States” includes the performance of personal services in the U.S.
Courts have generally held that foreign persons are ETOB if they have “considerable, continuous, and regular” business activities in the U.S. Pinchot v. Commr., 113 F.2d 718 (2d Cir. 1940), Lewenhaupt v. Commr., 20 T.C. 151 (1953), and De Amodio v. Commr., 34 T.C. 894 (1960). In Spermacet Whaling & Shipping Co. S/A v. Commr., 30 T.C. 618 (1958), the Tax Court addressed whether a foreign corporation, was “engaged in trade or business within the United States.” In interpreting the statute, the Court stated:
We have consistently held that before a taxpayer can be found to be “engaged in trade or business within the United States” it must, during some substantial portion of the taxable year have been regularly and continuously transacting a substantial portion of its ordinary business in this country. * * *
In Scottish Am. Inv. Co. v. Commr., 12 T.C. 49 (1949), the Tax Court made “a quantitative and a qualitative analysis” to determine if the foreign corporation was ETOB.
Unfortunately, the standard the courts have adopted is vague. However, as described above, whether full U.S. tax or no U.S. tax will be imposed is riding solely on the issue of whether the Belize IBC is ETOB. Clearly, the Belize IBC has some significant activities in the U.S. (directly or through the U.S. disregarded LLC). These activities include:
Is the making of $10 million of sales to U.S. customers, having sales solely to U.S. customers, and averaging $800,000 of inventory in the U.S. considerable, continuous, and regular activity in the U.S.? From a quantitative perspective, it would seem that $10 million in sales and $800,000 in inventory are quite large. From a qualitative perspective: (1) 100% of the Belize IBC’s sales were to U.S. customers, (2) 100% of its inventory was located in the U.S., (3) the Belize IBC arguably has no activity in Belize, and (4) the Belize IBC is presumably not claiming that is has any activity in Australia. From a qualitative perspective, it seems like the Belize IBC has a large portion of its business activities in the U.S.
While the standard is vague, there would certainly seem to be a very large risk that the Belize IBC would in fact be considered ETOB.
But wait! The U.S. advisor had assured Jane that no U.S. corporate income tax would be due as long as her IBC and her U.S. LLC did not have any dependent agents in the U.S. Unfortunately, there is no such rule. It is unclear where the confusion lies.
There is a rule regarding dependent agents in most U.S. income tax treaties. See Article 5 of the Model U.S. Income Tax Treaty and Article 5 of the OECD Model Income Tax Treaty. However, there is no income tax treaty between the U.S. and Belize.
There is also a rule regarding dependent agents in Treas. Reg. §1.864-7. This regulation defines whether the foreign corporation is treated as having a U.S. office for purposes of determining whether certain foreign source income is considered effectively connected income. The first sentence of Treas. Reg. §1.864-7(a)(1) provides in part:
This section applies for purposes of determining whether * * * a foreign corporation that is engaged in a trade or business in the United States at some time during a taxable year * * * has an office or other fixed place of business in the United States * * *. [Emphasis added]
The foreign corporation must already be ETOB in order for the regulation to apply. The regulation does not determine whether the foreign corporation is ETOB. Further, as described above, all of the IBC’s income would be U.S.-source income, and therefore this regulation would not be applicable.
In De Amodio v. Commr., 34 T.C. 894 (1960), the Tax Court held that a nonresident alien was engaged in a trade or business in the U.S. when the nonresident alien acquired real property through a real estate agent and managed the properties through other local real estate agents. The Tax Court concluded that the nonresident alien’s conduct of considerable, continuous, and regular activities “through his agents in the United States” caused the nonresident alien to be ETOB. The Tax Court held that the nonresident alien’s agents were independent agents.
It is unclear why some advisors continue to assert that a foreign corporation must have dependent agents in the U.S. in order to be ETOB.
No. This analysis does not only apply to Belize companies. The analysis applies to any company formed in a country that does not have an income tax treaty with the U.S. For example, companies in Hong Kong, Singapore, or Dubai would have the same issues as a Belize company.
If Jane had formed an Australian company and had operated her business through the Australian company, she may have been able to avoid U.S. tax entirely. In general, the business profits of an Australian company that qualifies for benefits under the Australia-U.S. Income Tax Treaty would be exempt from U.S. tax unless the company had a permanent establishment in the U.S. See Articles 5 and 7 of the Australia-U.S. Income Tax Treaty.
Last week, the Tax Court released an important opinion in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, 149 T.C. No. 3, where the court declined to follow Rev. Rul. 91-32.
For more than 25 years the IRS has maintained that gain on a foreign partner’s disposition of an interest in a partnership that conducts business in the U.S. is subject to U.S. tax. To arrive at this conclusion, the IRS applied the “aggregate theory” of partnerships for the disposition of the partnership interest. In Grecian, the Tax Court held that the “entity theory” of partnerships should apply when a foreign partner disposes of an interest in a partnership that conducts business in the U.S. The result of applying the entity theory is that the gain on the disposition of the partnership is not subject to U.S. tax.
Summary of the Case
In 2001, GMM, a foreign corporation, purchased an interest in Premier, a U.S. limited liability company that was treated as a partnership for U.S. income tax purposes. From 2001 to 2008 income was allocated to GMM from Premier, and GMM paid income tax in the U.S. In 2008 GMM's interest was redeemed by Premier, and GMM received two liquidating payments, one in July 2008 and the second in January 2009. GMM realized gain totaling over $6.2 million, of which $2.2 million was deemed attributable to U.S. real property interests (which GMM conceded was taxable under the FIRPTA rules of Code §897(g)).
The court held that the non-FIRPTA portion of the gain ($4 million, referred to by the court as the "disputed gain") was capital gain that was not U.S. source income. As a result, the disputed gain was not effectively connected with a U.S. trade or business and was not subject to U.S. income tax. The court applied the "entity theory" (as opposed to the "aggregate theory") with respect to the sale or exchange of the interest in the partnership. The court declined to follow Rev. Rul. 91-32.
In discussing Rev. Rul. 91-32, the court stated:
Rev. Rul. 91-32 is not simply an interpretation of the IRS's own ambiguous regulations, and we find that it lacks the power to persuade. Its treatment of the partnership provisions discussed above in part II.B is cursory in the extreme, not even citing section 731 (which, as we set out, yields a conclusion of “gain or loss from the sale or exchange of the partnership interest” * * *. The ruling's subchapter K analysis essentially begins and ends with the observation that “[s]ubchapter K of the Code is a blend of aggregate and entity treatment for partners and partnerships.” We criticize the ruling's treatment of the subchapter N issues in notes 22 and 24 below. We decline to defer to the ruling. We will instead follow the Code and the regulations to determine whether the disputed gain is effectively connected income.
The court echoed arguments that have been made in numerous articles criticizing Rev. Rul. 91-32 since its release over 25 years ago. The Obama administration also tried to codify the result of Rev. Rul. 91-32, which could reasonably be interpreted as a concession that there was no statutory authority for Rev. Rul. 91-32 in the first place. Given the thrashing the IRS received from the court on seemingly every argument it made in the opinion, it is surprising that it has taken over 25 years for a court dismiss Rev. Rul. 91-32.
If Congress pursues tax reform this year, it should consider allowing inflation adjustments for the items discussed below.
Each year, the IRS publishes inflation adjustments that modify the tax law as originally enacted. We regularly post about the inflation adjustments in the international tax arena. However, there are some significant values in the international tax area that are not adjusted for inflation. In one case, the value has remained unchanged for over eighty years.
FBAR (FinCEN Form 114)
The FBAR first became required in 1970. Below is an image from the top of Page 2 of the 1970 Form 1040, asking about foreign bank accounts:
The filing threshold of $10,000 has never been adjusted for inflation (in fact the original threshold of $10,000 was lowered to $1,000 in 1978, increased to $5,000 in 1983, and increased to $10,000 in 1985). Using an inflation calculator, $10,000 in 1970 is the equivalent of approximately $65,000 today. The effect of not adjusting the FBAR filing threshold for inflation is that each year more and more people will need to file the FBAR.
When FATCA was enacted in 2010, it created the requirement to file Form 8938 (which reports interests in foreign financial assets). A single individual living in the U.S. only needs to file a Form 8938 if his or her foreign assets are valued at over $50,000 at the end of the year or $75,000 at any time during the year. The creation of those thresholds implies that foreign assets under the thresholds are not significant enough to be reported. The $50,000 / $75,000 thresholds roughly approximate the inflation adjusted FBAR threshold of $65,000. However, given that the FBAR filing requirement is not indexed for inflation, an individual may have to file the FBAR but not have to file a Form 8938. For forms that report essentially the same information, this does not make sense.
U.S. Estate Tax for Nonresident, Noncitizen Individuals.
Nonresident noncitizen individuals ("NRNCs") are subject to U.S. estate tax on their U.S. situs assets. NRNCs can generally invest in the U.S. stock market and avoid U.S. tax on their capital gains. However, many NRNCs are unaware that if they die while owning stock in U.S. companies (or other U.S. situs assets), the stock is subject to U.S. federal estate tax at rates of up to 40%.
While U.S. citizens and U.S. domiciled individuals enjoy an effective exemption on the first $5.49 million of their estate, NRNCs only have an effective exemption of $60,000 on their U.S. estate. Thus, if an NRNC has over $60,000 of U.S. situs assets, he or she will owe U.S. federal estate tax. The $60,000 threshold was established in 1966, over 50 years ago, and has never been adjusted for inflation. That $60,000 threshold in 2017 dollars is approximately $462,000!
Nonresident Aliens Performing Services in the U.S. for a Foreign Employer
In general, a nonresident alien can perform personal services in the United States as an employee of a foreign employer (that itself is not engaged in a U.S. trade or business) and not be subject to U.S. tax as long as the nonresident alien is in the U.S. for less than 90 days and the pay for the services is not more than $3,000. The $3,000 threshold was established in 1936, over eighty years ago, and has never been adjusted for inflation. That amount in 2017 dollars is approximately $57,000.
U.S. Exit Tax
U.S. citizens that give up their U.S. citizenship and long-term green card holders that give up their green cards can be subject to a U.S. exit tax. One way that an individual can be subject to the exit tax is if the individual has a net worth of $2 million or more. This threshold was established in 2004 and has not been indexed for inflation. The $2 million threshold in 2017 dollars would be approximately $2,642,000.
Another way that an individual can be subject to U.S. exit tax is if the individual’s average annual net income tax for the five years prior to expatriation is greater than $162,000 (for 2017). Interestingly, this value is indexed for inflation for each year, whereas the net worth test is not indexed for inflation. This must have been intentional and not an oversight, because the two tests are in consecutive paragraphs of Code §877(a)(2).
Other Miscellaneous Non-Adjusted Values
Several other items that are not adjusted for inflation include:
If Congress is planning to update the Internal Revenue Code this year, it should consider updating (and then adjusting for inflation) these antiquated values.
Recently, the IRS published 11 new International Practice Units (“IPUs”) on its website. We have updated our resource page that categorizes the IPUs by topic. The new IPUs include:
Today we added 15 new situational charts to andrewmitchel.com dealing with a variety of topics.
Recently, the IRS published 5 new International Practice Units (“IPUs”) on its website. We have updated our resource page that categorizes the IPUs by topic. The new IPUs include:
Continuing our series on Famous Tax Quotes (quotes from court opinions and rulings with language that is colorful or that concisely states an important tax principle) today's tax quote is:
The question where an income is earned is always a matter of doubt when the business is begun in one country and ended in another.
Barclay & Co. v. Edwards, 267 U.S. 442 (1924).
In this case, the Supreme Court held that it was not unconstitutional to levy a tax on domestic corporations which manufactured in the U.S. and sold abroad, whereas foreign corporations which similarly manufactured and sold would not be taxed. This exemption for foreign corporations manufacturing in the U.S. and selling abroad no longer applies. Under current law, the income must be allocated between the production activity and the sales activity. See Treas. Reg. §1.863-3(b).
The IRS drafts publications that summarize in plain English U.S. tax rules for a variety of tax topics. A few of the publications discuss U.S. international tax issues. However, most of the IRS international publications deal with the U.S. taxation of individuals, and not with the U.S. taxation of businesses.
For example, IRS publications do not cover Subpart F Income, outbound transfers to foreign corporations, transfer pricing, etc. To learn about these rules, one would often have to go to specialized training, read the underlying law (e.g., statute, regulations, cases, etc.), or read what advisors provide on the Internet.
Recently, the IRS has been publishing International Practice Units (“IPUs”) on its website. IPUs provide IRS staff with explanations of general international tax concepts, as well as information about specific types of transactions. These IPUs discuss many U.S. international tax issues that are applicable to businesses.
To date, the IRS has published over 100 IPUs. However, the IRS website containing these IPUs does not categorize them by topic. Therefore, it can be difficult to find IPUs on a particular topic.
We have created a web page that categorizes the IPUs by topic. The topics include:
Recently the IRS published the following Chief Counsel Advice relating to international taxation.
CCA 201446020 - Loans were made from CFC1 to a lower tier CFC with limited earnings and profits ("E&P"). The lower tier CFC then loaned the cash to the U.S. parent. The U.S. parent claimed that the Code §956 inclusions were limited to the E&P of the lower tier CFC. The IRS applied Treas. Reg. §1.956-1T(b)(4) and argued that one of the principal purposes of the back-to-back loans was to avoid the application of Code §956 to CFC1. Accordingly, the U.S. parent must include in income the Code §956 amounts derived from CFC1 indirectly holding the U.S. parent loans rather than the Code §956 amounts which would be derived if the lower tier CFC were considered to hold the loan.
We created a chart for a similar CCA that was released earlier this year. The blog post can be viewed here.
CCA 201447030 - Interest paid by a U.S. corporation's foreign disregarded entity is U.S. source income and subject to withholding under Code §1442. Code §861(a)(1).
Today our sister website, Tax-Charts.com, published a free flowchart regarding the requirements for a “tax-free” exchange under Code §351. The flowchart is a simplified version of the previously published (and also free) Code §351 flowchart. The simplified version addresses the three primary requirements under Code §351 (transfer of property, in exchange for stock, and control) in an abbreviated manner.
Visit Tax-Charts.com to access the Code §351 exchange flowchart, to view other free tax flowcharts, or to purchase flowcharts.
We also added three new flowcharts (available for purchase) to Tax-Charts.com dealing with the sourcing of income. The three flowcharts include:
The inventory sourcing flowchart deals with both manufactured inventory (including the 50/50 method and the independent factory price ["IFP"] method) as well as non-manufactured inventory (including the special rules for inventory sales by foreign persons thru U.S. offices or fixed places of business).
The non-inventory sourcing flowchart includes sourcing of depreciation recapture, the special rules dealing with intangible property sold for contingent consideration, the special sourcing residency rules under Code §865(g), and the special office or fixed place of business rules for residents and nonresidents.
The “other” sourcing flowchart deals with the other categories of income, such as interest income, dividend income, personal services, rentals and royalties, disposition of real property, insurance underwriting, social security benefits, guarantee fees, scholarships, prizes and awards, transportation income, international communications income, space and ocean income, notional principal contracts, and analogy.
Because the sourcing rules can be quite detailed, a “simplified” version of each flowchart is included. These sourcing flowcharts are available for purchase at Tax-Charts.com.
This week the IRS published the following Private Letter Rulings and Chief Counsel Advice relating to international taxation.
PLR 201343011 - Late IC DISC election. Form 4876-A, Code §992(b)(1)(A).
PLR 201343014 - Late Canadian registered retirement savings plan ("RRSP") deferral elections. Form 8891. Rev. Proc. 2002-23.
PLR 201343017 - Late Canadian registered retirement savings plan ("RRSP") deferral elections. Form 8891. Rev. Proc. 2002-23.
CCA 201343019 - A Cypriot holding corporation qualifies for benefits under the U.S-Cyprus Income Tax Treaty and therefore its U.S. shareholders receive a reduced rate of tax on dividends.
CCA 201343020 - Earnings of a foreign distributor based on purchases of a U.S. corporation's products by lower-tier distributors in the foreign distributor’s sponsorship chain constitute income from performance of personal services by the foreign distributor.
CCA 201343023 - Where a partnership has no domestic partners eligible to be the tax matters partner ("TMP"), a foreign partner may be selected. Treas. Reg.301.6231(a)(7)-1(b)(2).
Last week the IRS published the following Private Letter Rulings and Chief Counsel Advice relating to international taxation.
PLR 201311001 - Consent was granted to change methods for measuring and timing and identifying employee stock options, restricted stock units, and performance-based restricted stock units pursuant to Treas. Reg. §1.482-7(d)(3)(iii)(C) for purposes of determining the amount the taxpayer must include in its cost sharing arrangement as intangible development costs.
PLR 201311004 - The generation-skipping transfer tax does not apply to taxable distributions or taxable terminations to the extent the initial transfer of property to the trust by a nonresident alien transferor was not subject to the federal estate or gift tax. Distributions from a foreign estate and terminating distributions from a foreign trust were not subject to generation-skipping transfer tax.
PLR 201311006 - Lawsuit damages payments were excluded from the gross income of nonresident aliens under Code §104(a)(2). Consequently, the payments were not subject to withholding under Code §1441.
PLR 201311008 - Late entity classification election for a foreign entity to be treated as an association. Form 8832. Treas. Reg. §301.7701-3(c).
PLR 201311013 - Late entity classification election for a foreign entity to be treated as a disregarded entity. Form 8832. Treas. Reg. §301.7701-3(c).
PLR 201311014 - Late passive foreign investment company ("PFIC") mark-to-market election. Form 8621. Treas. Reg. §1.1296-1(h).
PLR 201311018 - Consent granted to prospectively change method for measuring employee stock options and restricted shares as well as the method for identification pursuant to Treas. Reg. §1.482-7(d)(3)(iii)(C) and Notice 2005-99.
CCA 201311024 - 863(c), ocean activity income vs. transportation income from leasing a vessel.
Today the IRS published the following Chief Counsel Advice relating to international taxation:
CCA 201205007: Credit card interest income earned by U.S. citizens and resident alien customers living outside the U.S. was foreign source income. The CCA relied upon the substantial presence test to determine U.S. or foreign residency. In addition, ATM fees earned related to ATM transactions located outside the U.S. were considered income from services that were performed in the U.S. and were therefore U.S. source income.
[I am not sure that I agree with the conclusion related to the ATM fees.]
In a recent Tax Court case, 136 T.C. No. 27 (2011), the court was asked to determine the U.S. taxation of certain endorsement fees and bonuses received by a professional golfer --- Retief Goosen (a.k.a. the “Iceman”).
Goosen received golf tournament prize winnings as well as on-course and off-course endorsement fees. For U.K. tax purposes, Goosen’s income was paid to two corporations in which he entered into employment agreements. A portion of this income was then paid to him as a salary.
The Tax Court had to first determine whether the endorsement fees would fall within the category of royalty income or personal services income. After deciding the type of income, the court had to determine the source of the royalties and services income. Next, the court had to determine whether the different streams of income were effectively connected to a U.S. trade or business. Lastly, for the U.S. source royalties that were not effectively connected income, the court had to determine whether the U.K.-U.S. Income Tax Treaty would apply to reduce the 30% U.S. tax on the royalties.
Below is a chart which shows the types of income earned by the Iceman and how the court held each type of income should be treated. A PDF version of the chart can be found at Goosen.
Countries often impose withholding taxes on payments to nonresidents for the performance of services. For instance, the U.S. imposes a 30% withholding tax on certain U.S. source payments, including payments for services, to nonresidents. Code §§871(a)(1)(A) and 881(a)(1). The U.S. withholding tax is only imposed on “U.S. source” income. In the context of services, this generally means services performed in the U.S. Code §861(a)(3) and Treas. Reg. §1.861-4.
A number of countries, however, impose withholding taxes on services payments to nonresidents, regardless of where the services are performed. See, for instance, Chile and Costa Rica. In these circumstances, double taxation can occur.
The U.S. normally avoids double taxation by allowing a tax credit (the “foreign tax credit”) for foreign income taxes paid (foreign gross withholding taxes are generally considered “income taxes” for purposes of Code §901 --- see, for instance, Rev. Rul. 69-446 and Rev. Rul. 74-82).
However, in general the foreign tax credit is limited to the amount of U.S. tax imposed on foreign source income. If services are performed in the U.S., the services would be U.S. source income and the foreign tax credit allowed with respect to that income would be zero. Thus, if another country were to tax services performed in the U.S., the income likely would be subject to both foreign and U.S. income taxes.
U.S. income tax treaties typically prevent this double taxation under “avoidance of double taxation” articles. However, in the absence of a treaty, double taxation can occur.
Code §§ 861, 862, and 863 provide rules for determining whether a particular class of income is considered U.S. source income or foreign source income. Code §§ 861(a)(1) through (a)(7) provide rules as to when specific classes of income are sourced within the U.S. Code § 862(a) is a parallel section providing when those same classes of income are sourced outside the U.S.
The classes of income specified in Code §§ 861 and 862 include the following:
Code § 863 grants the Secretary of the Treasury authority to promulgate regulations allocating income not specified within Code §§ 861(a) and 862(a) to U.S. and foreign sources. Other sourcing rules also exist in other code sections (e.g., Code §§ 865, 988(a)(3), etc.).
When an item of income does not fall within one of the classes of income listed above, courts have sourced the item by comparison and analogy with classes of income specified with the statutes. Container Corp. v. Commissioner, 134 T.C. No. 5 (2010), Bank of America v. U.S., 680 F.2d 142 (Ct.Cl. 1982), Howkins v. Commissioner, 49 T. C. 689 (1968).
Last year the I.R.S. published Rev. Rul. 2009-14 which deals in part with the payment of death benefits under a life insurance contract to a foreign corporation not engaged in the conduct of a trade or business in the United States. In the ruling, the insured individual was a U.S. citizen residing in the U.S. and the insurance company that issued the policy was a domestic corporation.
Rev. Rul. 2009-14 properly identifies that the payment of death benefits under an insurance policy is not one of the types of income listed in Code §§ 861 and 862. The ruling then correctly identifies that “the source of such income is determined by comparison and analogy to classes of income that are specified within the statute.”
Unfortunately, the ruling does not in any way compare or analogize the payment of death benefits with the classes of income that are specified within the statute. Instead, it simply concludes that the death benefit income is U.S. source income. The conclusion seems to be based on the fact that the insured individual was a U.S. citizen residing in the U.S. and that the insurance company that issued the policy was a domestic corporation. However, it is not clear which, if any, of these factors controls.
This criticism is not to suggest that the conclusion of the ruling is inaccurate. The conclusion may very well be correct. This criticism is to simply say that there was no analysis included in the ruling to support the conclusion given.
Yesterday the Tax Court published Container Corp. v. Commissioner, 134 T.C. No. 5 (2010). This decision held that guarantee fees paid by a U.S. subsidiary of a Mexican parent were not U.S. source income, and therefore were not subject to U.S. withholding taxes of 30%.
Code § 881 imposes a 30% tax on “fixed or determinable annual or periodical” (“FDAP”) income received by foreign corporations from sources within the United States. The question presented was whether the guarantee fee paid by the U.S. subsidiary to the Mexican parent was from a source within the United States. Taxes owed under Code § 881(a) are generally withheld at the source. Code § 1442(a).
The parties agreed that the guaranty fees were FDAP income. Thus, the question was whether the source of the guaranty fees was in the United States or in Mexico.
The source of FDAP is determined by using the rules in Code §§ 861 to 863. These sections identify certain types of categories of income as being either U.S. source income or foreign source income. Before the source of the income can be determined, it is necessary to determine which category the income fits within.
The I.R.S. argued that the guarantee fees were closest to the interest category. Interest is sourced based on the residence of the obligor. Code §§ 861(a)(1), 862(a)(1); Treas. Reg. § 1.861-2. Thus, under the I.R.S.’s assertion, the guarantee fees would have been U.S. source income and subject to the 30% tax.
The taxpayer, on the other hand, argued that the guarantee fees were closest to the services category. Services are sourced to where the services are performed. Code §§ 861(a)(3), 862(a)(3); Treas. Reg. § 1.861-4. Consequently, under the taxpayer’s position, the guarantee fees would have been foreign source income and not subject to the 30% tax.
This case reminds me of Procrustes in Greek mythology. Procrustes was an inn-keeper that had a single size bed. He would force all of his patrons to fit in the bed. If they were too tall, he would cut off their legs. If they were too short, he would stretch them out.
Here, the guarantee fee doesn’t fit squarely within the category of interest or within the category of services. Consequently, the Tax Court must do some cutting and/or stretching of the guarantee fees to cause them to fit within one of the categories.
Relying on prior case law, the court proceeded to use analogy to determine whether the guaranty fees were more like interest or more like services (or, possibly, some other category of FDAP that has a specific sourcing rule).
Noting that it was deciding a close question, the Tax Court concluded that guaranties are more analogous to services than to interest. Consequently, the guarantee fees were foreign source income and the U.S. subsidiary was not required to withhold the 30% tax.
Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.
Telecommunication companies often earn several different types of income. The Internal Revenue Code and the regulations provide special sourcing rules for “international communications income.” Code § 863(e)(2) defines international communications income as income derived from the transmission of communications or data between the United States and a foreign country (or possession of the United States).
General Source Rules
Code § 863(e)(1)(A) provides that any international communications income of a United States person is sourced 50 percent in the United States and 50 percent outside the United States (50/50 source rule). Code § 863(e)(1)(B)(i) provides that any international communications income of a foreign person is sourced outside the United States, except as provided in regulations or in Code § 863(e)(1)(B)(ii).
When a taxpayer cannot establish the two points between which the taxpayer is paid to transmit the communication, Treas. Reg. § 1.863-9(f) provides a default source rule under which all the income derived by the taxpayer from such communications activity is U.S. source income.
Exception for U.S. Fixed Place of Business
The exception under Code § 863(e)(1)(B)(ii) provides that if a foreign person maintains an office or other fixed place of business in the United States, any international communications income attributable to such office or other fixed place of business is U.S. source income. Treas. Reg. §. 1.863-9(b)(2)(iii) provides that international communications income is attributable to an office or other fixed place of business to the extent of:
the U.S. office or other fixed place of business.
Exception for Controlled Foreign Corporations
The regulations provide that international communications income derived by a controlled foreign corporation, within the meaning of Code § 957, is 50 percent U.S. source income and 50 percent foreign source income (the same as for United States persons). Treas. Reg. § 1.863-9(b)(2)(ii).
Exception if Engaged in U.S. Trade or Business
Tthe regulations also provide that international communications income derived by a foreign person, other than a controlled foreign corporation, engaged in a trade or business within the United States is income from sources within the United States to the extent the income, based on all the facts and circumstances, is attributable to:
within the United States. Treas. Reg. § 1.863-9(b)(2)(iv)
The three criteria for determining the amount of U.S. source income for foreign persons with fixed places of business in the U.S. and for foreign persons engaged in the conduct of a U.S. trade or business in are the same --- the functions performed, the resources employed, and the risks assumed.
Most sourcing rules are bright-line, objective tests. The sourcing rules for foreign persons with international communications income are much more subjective. In fact, such foreign persons may require an analysis similar to a transfer pricing study under Code § 482 merely to determine the source of their international communications income.