By Anthony Diosdi
The U.S. source rules in general derive from an attempt to identify the geographic locus of the economic activity or financial arrangements that generate income. The source rules play a prominent role in the taxation of foreign persons, since they effectively define the boundaries of U.S. taxation. The source rules for gross income are organized by categories of income, such as interest, dividends, personal services income, rentals, royalties, and gains from the disposition of property. The rapid evolution of electronic commerce and the internet has generated many difficult conceptual issues such as how to source a foreign person’s business activities undertaken on the internet that affect the U.S. economy.
The U.S. source rules provide that the source of rental and royalty income is determined by the place where the property is located or used. The source of royalty income for intangible properties, such as patents, copyrights, trade secrets, and trademarks depends on where the rights are used, which is generally the country in which the intangible property derives its legal protection. The source of income from the performance of personal services is the place where the services are performed. See IRC Section 861(a)(3) and 862(a)(3). The application of these rather simple principles can, however, be attended by substantial complexity when dealing with foreign internet-related businesses. Often foreign internet business activities such as cloud computing, web-hosting, data warehousing, and database activities can be treated as services income for purposes of the sourcing rules. Since the performance of cloud computing, web-hosting, data warehousing, and database type can be performed outside the United States, a foreign person or corporation engaged in these activities over the internet can transact business in the United States and avoid U.S. taxation.
Piedras Negras Broad. Co. v. Commissioner, 43 BTA 297 (1941) (nonacq. 1941-1 CB 18), aff’d, 127 F.2d 260 (5th Cir. 1942) provides useful guidance to foreign tech companies regarding the U.S. source rules. Piedras Negras involved a Mexican radio station that broadcasted programming into the U.S. The radio stations studio and broadcasting plant were located, and operated by the employment of capital and labor in Mexico. The radio station earned substantial income from U.S. advertisers. The Fifth Circuit Court of Appeals said that “the source of income is the situs of the income-producing service and the source of the income was “the act of transmission.” In other words, there was no U.S. source income because the principal place of business was outside the U.S. and the labor and activities that produced the income were outside the U.S. Piedras Negras continues to be relevant to foreign tech companies today because the case held that the location of the customer is not relevant for determining the source of income for U.S. tax purposes.
Although many foreign high tech companies perform their services abroad, it is not uncommon for foreign tech companies to utilize servers that are located in the United States. The Internal Revenue Service or a U.S. court may equate servers to the broadcasting equipment discussed in the Piedras Negras case. It should be noted that the location of the broadcasting equipment was just one factor the court considered. Since a server typically only performs routine functions, a server is unlikely to warrant a determination that a foreign internet-related business that performs activities such as online advertising, cloud computing, data warehousing, and internet hosting is subject to U.S. taxation. However, complexes can arise in agency situations. For example, if a foreign corporation hires dependent or independent agents as part of a service agreement to maintain or perform maintenance on its U.S. servers, such actions may elevate the foreign entity’s presence in the U.S. such as to constitute a trade or business which could result in a recharacterization of the situs of income producing activity.
Conclusion
Servers are tangible objects that, when placed in the U.S., constitute a physical presence. Although servers typically only perform functions, servers are capable of storing and transmitting large amounts of data that foreign tech companies use to conduct business. In many cases, servers store and transmit every piece of information of the business. Arguably, when a foreign tech company utilizes a U.S. server, the foreign company may establish a permanent establishment in the U.S. and a recharacterization of foreign services income. To date, there is no direct authority analyzing whether a foreign tech company can establish a taxable presence in the U.S. The lack of legal authority should raise a red flag to any foreign tech company that utilizes a U.S. server or servers.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony 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.