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How the “Title Passage Rule” Can be Effectively Utilized to Avoid U.S. Income and Withholding Taxes in Cross-Border Transactions

Many foreign corporations and businesses ship goods such as vehicles, machines, parts, and electronics into the United States. These types of transactions can trigger U.S. income or withholding tax obligations. This article discusses how the “title passage rule” can be utilized by foreign entities to eliminate their exposure to U.S. income and withholding taxes.

How the U.S. Taxes Foreign Entities

The U.S. taxes foreign corporations on the net amount of income effectively connected with the conduct of a trade or business within the United States (the “U.S.”). See IRC Section 882(a). Therefore, under the U.S. Internal Revenue Code, the existence of a U.S. trade or business is the touchstone of U.S. taxation of a foreign corporation’s profits. Despite its importance, there is no comprehensive definition of the term “trade or business” in the Internal Revenue Code or its regulations. The relevant case law suggests that, in order for a trade or business to exist, the activities must be “considerable, continuous, and regular” and engaged in for profit.

A foreign corporation engaged in a U.S. trade or business is subject to U.S. taxation on the income effectively connected with the conduct of that U.S. trade or business. Effectively connected income (“ECI”) includes the following three categories of income:

  1. Certain types of U.S. source income;
  2. Certain types of foreign source income attributable to a U.S. office or other fixed place of business; and
  3. Certain types of deferred income that are recognized in a year that the foreign corporation is not engaged in a U.S. trade or business, but which would have been ECI if the recognition of the income had not been deferred. See IRC Section 882(a).

A foreign corporation engaged in the conduct of a U.S. trade or business can take deductions against its ECI. These deductions include those for expenses, losses, and other deductions that are directly related to the ECI (e.g., cost of goods sold), as well as a ratable portion of any deductions that are related to any specific item of gross income. A foreign corporation’s ECI is currently taxed at the corporate income tax rate of 21 percent. Additionally, if the foreign corporation has a branch in the U.S., the branch’s un-reinvested earnings and profits that are effectively connected with the foreign corporation’s U.S. trade or business are subject to a 30 percent “branch profits tax,” which may be reduced or eliminated by an applicable treaty. See IRC Section 884(e)(2)(B); Treas. Reg. Section 1.884-5T.

In contrast, foreign corporations not engaged in a U.S. trade or business in the U.S. are subject to a flat 30 percent withholding tax (without deduction or credit) on its U.S. source income that is not ECI. Section 881(a)(1) of the Internal Revenue Code generally describes this category of U.S. source income as “fixed or determinable annual or periodical gains, profits, and income” (“FDAP income”). FDAP income includes interest, dividends, rents, royalties, salaries, wages, premiums, annuities, compensation, and other remunerations, as well as business income or profits from the sale of inventory. The flat 30 percent withholding tax may be reduced or eliminated by applicable tax treaties.

Understanding the “Title Passage Rule”

Let’s consider a hypothetical corporation in which A, a Singaporean corporation, wishes to sell the machines to B, a U.S. corporation. The threshold question for our analysis is whether A is engaged in the conduct of a U.S. trade or business. Such a determination ultimately depends on A’s facts and circumstances, taking into account the extent and nature of its activities in the U.S., if any. As a general matter, the activities of persons subject to a high degree of control by A, such as its employees and dependent agents acting exclusively for A, are imputable to it. The activities of independent agents may also be imputed to A if the relationship between the independent agent and A is significantly regular in character.

If A does not have any employees, branches, or fixed place of business in the United States, A will not likely be considered to be engaged in a U.S. trade or business. In the absence of a U.S. trade or business conducted by A, the payment that A receives from B for the Machines cannot be ECI, which would have been subject to 21 percent U.S. federal income tax on a net basis. Instead, such payment may constitute FDAP income, in which case it would be subject to 30 percent U.S. federal withholding tax on a gross basis, but only if the payment is U.S. source income.

The Machines are finished goods purchased by A from B for the purpose of sale to customers. As such, they should constitute “purchased inventory” held by A for U.S. federal income tax purposes. Accordingly, amounts realized by A from the sale to B should be generally sourced to where the sale takes place — i.e., where title to the Machines passes from A to B. See IRC Sections 865(b); 861(a)(6); and 862(a)(6). Referred to as the “title passage rule,” this rule affords companies some degree of discretion in structuring their transactions.

In the 1990 case of Liggett Group, Inc. v. Commissioner, T.C. Memo 1990-18 (Tax Ct. 1990), the seller of purchased inventory was the exclusive U.S. distributor of whiskey made by J&B in Scotland. In the transactions in question, the U.S. distributor, a Delaware corporation, restated in its purchase orders to J&B the information contained in the purchase orders of its U.S. customers (mostly wholesalers). When the U.S. distributor later received from J&B the bills of lading issued by carriers of the ordered whisky in Scotland, the U.S. distributor endorsed and transmitted the bills to the U.S. customers who were the ones that paid the ocean freight and insurance costs. The U.S. customers were also solely responsible for clearing the whiskey through U.S. customs and transporting it locally from the port to warehouses. In view of these facts — including a stipulation by the IRS and the U.S. distributor that the transactions were not arranged for the purpose of tax avoidance — the court held that title passed from J&B to the U.S. distributor when the whiskey was delivered to the carriers in Scotland and that, immediately thereafter, title passed again from the U.S. distributor to its U.S. customers while the whiskey was still in Scotland. In the court’s opinion, the U.S. distributor’s ownership of the whiskey, though transitory, was sufficient to generate foreign source income.

In any event, the scope of the Liggett Group holding is limited by the parties’ stipulation to the absence of a tax avoidance purpose. This absence led the Tax Court to omit factors that would need to be considered if there had been a tax avoidance purpose. Treasury Regulation Section 1.861­-7(c) provides as follows:

[A] sale of personal property is consummated at the time when, and the place where, the rights, title, and interest of the seller in the property are transferred to the buyer. Where bare legal title is retained by the seller, the sale shall be deemed to have occurred at the time and place of passage to the buyer of beneficial ownership and the risk of loss. However, in any case in which the sales transaction is arranged in a particular manner for the primary purpose of tax avoidance, the foregoing rules will not be applied. In such cases, all factors of the transaction, such as negotiations, the execution of the agreement, the location of the property, and the place of payment, will be considered, and the sale will be treated as having been consummated at the place where the substance of the sale occurred. (emphasis added).

As indicated above, the title passage rule affords a business a simple mechanism for manipulating the source of income from the purchase and resale of inventory property. The most important formality is ensuring that there is evidence that the seller and buyer agree that title is to pass on the export sale at the port of origination or location abroad. If the appropriate formalities are observed, all of the income received is treated as foreign source income. Such foreign source income is not itself subject to U.S. tax. See IRC Section 864(c)(4)(B)(iii).

Applying the title passage rule to this case, if the proposed transaction were to be structured so that the payments received by A from B for the machines are foreign source, rather than U.S. source. Though not required per se, the facts in the Liggett Group case should be duplicated as much as possible (e.g., restating customers’ purchase orders, endorsing bills of lading, and making customers solely responsible for paying transportation and insurance costs and for clearing customs). All documentation, such as purchase agreements and purchase orders, should expressly provide for these terms, including the term “free on board” (F.O.B.) where appropriate and language to the effect that the customer bears all risk of loss beginning at the time when legal title to the machines passes to the customer under the laws of the relevant jurisdiction outside the U.S. and that all payments for the machines will be foreign source for U.S. income tax purposes. The proposed transaction should also be structured on the assumption that the Internal Revenue Service (“IRS”) is likely to prevail if it were to assert a tax avoidance purpose. To this end, the location of negotiations, the location where the agreement is executed, the location of the machines, and the place of payment must all be outside the U.S.

Out of an abundance of caution, compliance with all of the foregoing requirements should probably not be limited to just the transfer from A to B. In other words, there may be a need to comply with these requirements on each transfer step in the proposed transaction. If, for example, the requirements were not satisfied on the transfer from A to B, the payments received by A may still be deemed to be U.S. source income given that all the steps, taken together, can be viewed as a single transaction. If this were to happen, the payments to A would be subject to 30 percent U.S. federal withholding tax on a gross basis.

Proposed Suggestions Regarding Cross-Border Contracts

Foreign entities should carefully draft their contracts regarding the delivery terms with goods being imported into the U.S. to state that title for goods at issue pass outside the U.S. Below, please find suggested verbiage to provide a foundation for contending that A and B have agreed that title passes outside the United States is set forth below:

1. Unless otherwise indicated, the purchase price shall consist of the basic price plus all costs of delivering the products to Buyer at the port of [_______], including without limitation ocean, air or other freight charges; marine, air or other insurance expenses; consular fees; and port and forwarding fees.

2 All property rights in products shipped by Seller to Buyer, including title to, beneficial ownership of, control over, and the risk of loss or damage to such products, shall remain with Seller until such products arrive at the port or point of entry. The products shall be deemed to arrive at the port or point of entry, in the case of ocean or air shipments, at the time and place at which they are unloaded by the international carrier in Peru, the Buyer’s country and, in the case of land shipments, at the time and place in Buyer’s country at which the products enter such country. No sale shall be deemed to have taken place unless and until the products arrive at the port or point of entry. References such as C. & F., C.I.F., F.A.S., F.O.B., C.O.D. or similar terms shall be used solely to calculate prices. Such terms, the time, method or place of payment or of endorsement or delivery of shipping documents, the method of shipment, the manner of consignment, the contents of Buyer’s purchase order or Seller’s invoice or other documents or papers relating to the sales transaction shall not be deemed to limit or alter the foregoing rights of Seller in the products.

3. Buyer agrees that it will, upon request by Seller, take any actions and provide any certificates, undertakings or other papers required of Buyer to enable Seller to effect the exportation of the products from Indonesia, and that it will, when the products arrive at the port or point of entry, accept title, ownership, control over, and the risk of loss or damage to such products, accept delivery thereof and take all actions and pay all duties, taxes, fees, charges or other costs of whatever nature necessary to effect the importation.

4. Seller will insure for its own benefit products shipped to Buyer until such products arrive at the port or point of entry. Where laws or regulations of Buyer’s country require Buyer to take out insurance, the policy shall be for the benefit of Seller, whether or not Seller is named as an insured in such policy, until the products arrive at the port or point of entry in Buyer’s country. Where possible under the laws and regulations of Buyer’s country, the policy shall provide that it is for the benefit of Seller and/or Buyer “as their interests may appear.” Where Buyer insures, Buyer will be allowed an appropriate credit against the purchase price for the insurance premiums paid by Buyer, and the purchase price shall not include any insurance premiums paid by Seller. The taking out of insurance by Buyer shall not affect Seller’s property rights.

5. Where the laws or regulations of Buyer’s country require Buyer to pay the portion of the purchase price attributable to ocean, air or other freight costs, a credit in the amount of such costs paid by Buyer shall be allowed against the purchase price.

6. All orders accepted by Seller shall be subject to the terms and conditions set forth herein, and Seller’s acceptance incorporating the terms and conditions specified herein and the agreement represented thereby may be changed only by further written agreement between Seller and Buyer. In case of conflict between any of the terms and conditions relating to the sales transactions, the terms and conditions herein prescribed shall prevail.

Conclusion

The foregoing discussion is intended to provide the reader with a basic understanding of the principal U.S. considerations of foreign importers of goods into the U.S. and one potential planning option. It should be evident from this article, however, that this is a relatively complex subject. In addition, it is important to note that this area is constantly subject to new development and changes. As a result, it is crucial that the foreign importer review its particular circumstances with a qualified international tax attorney when planning to import goods into the United States. With careful planning, the foreign importer may substantially reduce his or her U.S. tax liabilities emanating from the importation of goods to the3 United States.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.

Anthony Diosdi

Written By Anthony Diosdi

Partner

Anthony Diosdi focuses his practice on international inbound and outbound tax planning for high net worth individuals, multinational companies, and a number of Fortune 500 companies.

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