By Anthony Diosdi
If a foreign person conducts a trade or business in the United States, the net income effectively connected with the U.S. business activity will be taxed at the usual U.S. marginal tax rates. This regime taxes the foreign person’s net income derived from the U.S. trade or business (effectively connected gross income minus allowable deductions attributable to the U.S. trade or business). The rules for allocating and apportioning deductions are used to determine which of the foreign person’s potential deductions are attributable to the U.S. trade or business.
In the case of a foreign corporation that conducts a U.S. trade or business through a U.S. branch, an additional 30-percent tax (called the “branch profits tax”) may apply when a foreign corporation’s U.S. trade or business earnings are not reinvested in the United States. See IRC Section 884. A foreign person’s U.S. trade or business income generally is not subject to withholding of tax at the source. However, a foreign person’s trade or business income from personal services is subject to withholding under Internal Revenue Code Sections 1441(c)(1) and 1442(a). In addition, a foreign person’s share of partnership income that is effectively connected with a U.S. trade or business is subject to withholding under Internal Revenue Code Section 1446.
The determination of whether a foreign person is engaged in the conduct of a trade or business in the United States generally involves a facts-and-circumstances analysis. A trade or business will generally be found to exist if a foreign person’s business activity in the United States is regular, continuous and considerable. Even though there may be no particular situs of the economic activity, a foreign person may be found to have conducted a U.S. trade or business because of a “considerable” volume of “regular” and “continuous” activity in the United States. The rapid evolution of electronic commerce has generated many difficult conceptual issues. A foreign person can be found to be conducting a U.S. trade or business without having a fixed place of business in the United States. Consequently, a foreign corporation that regularly and continuously undertakes to effect a substantial quantity of sales to customers in the United States through Internet advertising and sales on a web site may be treated as conducting a U.S. or business.
Effect of Agency Arrangements
While the use of agents or representatives within the United States by a foreign person does not necessarily establish a trade or business, such a result may be obtained even though the foreign person is not present and has no employees in the United States. The determination will depend upon the functions and activities performed by people and entities within the United States on behalf of the otherwise absent foreign person and in some cases the relationship between the foreign person and the people and entities undertaking the functions and activities.
Performance of Personal Services
Internal Revenue Code Section 864(b) provides that “the performance of personal services within the United States at any time within the taxable year” generally constitutes the conduct of a U.S. trade or business. This rule is subject to a de minimis exception for a nonresident alien individual who is working for a foreign employer, earns no more than $3,000 of compensation for his or her U.S. work and is present in the United States for more than 90 days during the year. See IRC Section 864(b)(1). The Internal Revenue Code also contains safe harbors for certain trading activities in stock, securities and commodities under which such trading activities will constitute a U.S. trade or business. See IRC Section 864(b)(2).
Section 864(c) and Sections 871 and 881 appear to overlap when applied to compensation for the performance of personal services. Such compensation is stated in Sections 871(a)(1)(A) and 881(a)(1) of the Internal Revenue Code. However, Section 864(b) specifically provides that the performance of personal services with the United States generally constitutes a trade or business. Compensation is, therefore, always taxed to the recipient at normal rates as effectively connected income, and expenses connected with the activity may be deducted
Trading In Stocks, Securities or Commodities
Concerned that the threat of U.S. taxes would defer foreign investors from trading on U.S. markets, Congress created a number of safe harbor provisions for foreign investors. Internal Revenue Code Section 864(b)(2)(A) provides a broad safe harbor to assure that foreign persons may trade in stocks and securities on U.S. markets without establishing a U.S. trade or business. A foreign person, including a dealer, may trade in stocks or securities through a resident broker, commission agent, custodian or other independent agent without establishing a U.S. trade or business. This safe harbor will be available to a foreign investor that maintains an office or other fixed place or business in the United States.
A foreign investor may trade for the investor’s own account either directly or through employees, resident brokers, commission or other agents or custodians. However, the safe harbor is not available to dealers in stocks or securities because they are regularly engaged in the purchase and sale of stocks and securities for profit. See Treas. Reg. Section 1.864-2(c)(2)(iv). A similar safe harbor is available to foreign persons who trade on the U.S. commodities exchange.
Election to Treat Real Estate Investment as Trade or Business
If a foreign person derives income from U.S. real property that is not effectively connected with a trade or business, the gross amount of the rental income is taxed at the flat rate of 30 percent under rules discussed below. Because real property income ordinarily is attended by substantial deductions for such items as maintenance, depreciation, taxes and mortgage interest, a tax on gross rental income could create substantial tax burdens even when the property generates a net loss. The Internal Revenue Code, however, provides relief by permitting a foreign person to elect to be treated as if it were engaged in a U.S. trade or business with respect to all of its U.S. real property held for the production of income, even if the person is not so engaged. See IRC Section 871(d) and 882(d). Such an election, which binds the foreign person in all subsequent years, enables the foreign person to be taxed with respect to its net income from real property, thereby utilizing available deductions.
Certain Foreign-Source Income
Section 864(c)(4)(A) confirms the principle that foreign-source income will generally not be treated as effectively connected with a U.S. trade or business. However, several exceptions are prescribed which can result in the subjection of foreign-source income to U.S. taxation.
Foreign-source income, gains and losses may be deemed to be effectively connected (and therefore included in the determination of the taxable income of the U.S. trade or business) if the foreign person “has an office or other fixed place of business within the United States to which [the item of] income, gain, or loss is attributable.” The regulations define “an office or other fixed place of business” as a fixed facility in which a foreign individual or corporation engages in a trade or business. See Treas. Reg. Section 1.864-7. If the foreign person does not infrequently use another’s office, the office will be considered to be that of the foreign person. See Treas. Reg. Section 1.864-7(b). The office of an agent will not create this result if the agent is not independent and either has and regularly exercises authority to negotiate and conclude contracts in the name of the foreign principal or maintains a stock of merchandise belonging to the foreign principal from which orders are regularly filled on the principal’s behalf. See Treas. Reg. Section 1.864-7(d). Income is “attributable” to a U.S. office or fixed place of business if the facility is a “material factor” in the realization of the income and if the income is realized in the ordinary course of the trade or business carried on through it. See IRC Section 864(c)(5)(A). The office or fixed place of business in the United States will not be considered to be a material factor unless it provides a significant contribution to, by being an essential economic element in, the realization of the income, gain, or loss. See Treas. Reg. Section 1.864-6(b)(1).
U.S. Trade or Business Income- The “Permanent Establishment” Provision
A foreign person is subject to the usual individual or corporate tax rates on net income effectively connected with a trade or business in the3 United States. However, as suggested by this article, there is uncertainty as to how much activity is necessary to establish a U.S. trade or business. With that said, tax treaties usually provide more predictability in the determination of when income from U.S. trade or business activities will be taxed to the foreign person. They generally provide that “business profits” will not be taxed within the United States unless the foreign person carries on a U.S. trade or business through a “permanent establishment to which the profits are attributable.” See Article 7 of the U.S. Model Treaty.
Article 5 of the U.S. Model Treaty provides a description of circumstances in which a permanent establishment will be found. Article 5(1) explains that a permanent establishment generally means a fixed place of business through which the business is undertaken. Article 5(2) specifies that a permanent establishment includes a place of management, a branch, an office, a factory, a workshop, a mine, an oil or gas well, a quarry or any other place of extracting natural resources. However, the treaty expressly permits foreign persons to undertake rather substantial activities through a fixed place of business without being deemed to have a permanent establishment. To be treated as a permanent establishment, a threshold level of business activity generally must be carried on in the fixed place. If the business activities are only “preparatory or auxiliary,” the place will be deemed to be a permanent establishment. Article 5(4) lists certain “preparatory or auxiliary” activities to include, for example, use solely for storage, display or delivery of goods, solely for the purchase of goods or solely for the collection of information. Article 5(3) allows a foreign person to pursue for up to 12 months certain specified activities that would otherwise constitute a permanent establishment without being deemed to have created a permanent establishment.
The consequences of using agents to conduct activities are also addressed in detail. Article 5(5) provides that an agent who acts on behalf of the foreign enterprise and who “has and habitually exercises [within the country] an authority to conclude contracts that are binding on the enterprise” will constitute a permanent establishment of that enterprise even if the agent does not conduct the activities through a fixed place of business. However, there will be no permanent establishment attributable solely to carry on business through a “broker, general commission agent, or any other agent of independent status, provided that such persons are acting in the ordinary course of their business as independent agents. See U.S. Model Treaty, Art. 5(6).
U.S. Tax Liability On Operation of Permanent Establishment
All items of income attributable to the permanent establishment of a foreign person will be included in its U.S. gross income. Article 7 of the U.S. Model Treaty reflects the approach used in treaties to determine the extent to which income will be attributable and taxed to a permanent establishment. Article 7(2) provides that the income so attributable will be the business profits that the permanent establishment “might be expected to make if it were a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions.”
Treaties usually provide explicitly that gains from the sale of personal property attributable to a U.S. permanent establishment and gains from the disposition of the establishment may be taxed in the United States. See U.S. Model Treaty, Art. 13(3). Other U.S.-source income not attributable to a permanent establishment may be taxable under the withholding tax rules, as possibly modified by the terms of the applicable treaty.
“Business profits” means “income from any trade or business, including income derived by an enterprise from the performance of personal services, and from the rental of tangible personal property.” See U.S. Model Treaty, Art 7(7). The definition ultimately includes all income from business operations except compensation for personal services rendered by an individual (which is covered under Articles 14 and 15). In general, the business profits of an enterprise of a treaty country will be taxable only in that country unless the enterprise is undertaken through a permanent establishment in the other country. Once the enterprise is conducting business through a permanent establishment, only the income attributable thereto may be taxed in the country where the profits are being generated. See U.S. Treaty, Art. 7(1).
Article 7(2) provides that the profits attributable to a permanent establishment include only those derived from the assets or activities of the permanent establishment. This approach is consistent with the “asset use” and “business activities” analysis authorized under Section 864(c)(2). See U.S. Model Treaty, Technical Explanation, Art. 7(2).
“Business profits” requires a determination of the net income of a permanent establishment. Its gross income is reduced by allowable deductions. Tax treaties typically provide that deductions allowable in determining the net income of the permanent establishment are those “incurred for purpose of the permanent establishment” and, include “a reasonable allocation of executive and general administrative expenses, research and development expenses, interest, and other expenses incurred for the purpose of the enterprise as a whole * * *, whether incurred in the [country] in which the permanent establishment is situated or elsewhere. See U.S. Model Treaty, Art. 7(3). The provisions of U.S. law should generally apply in determining what constitutes a “reasonable allocation” for these purposes.
A foreign person may have more than one permanent establishment in the United States. Income and losses from all such permanent establishments of a foreign investor will be combined to determine the U.S. source income tax liability. As a result, loss generated by one may offset income produced by another.
Other U.S. Source Income
If a foreign person receives U.S.-source income in respect of investments not effectively connected with the conduct of a trade or business within the United States (such as dividends, interests, rents, or royalties), the gross amount of the payment generally will be subject to a tax of 30 percent. This U.S. tax on a foreign person’s nonbusiness income from U.S. sources is collected and enforced through withholding provisions, which require the payor of the income to withhold the 30-percent tax from the income and pay it over to the Internal Revenue Service (“IRS”).
Not all U.S.-source income of a foreign person is subject to U.S. withholding tax. U.S.-source interest on certain forms of indebtedness (e.g., interest from deposits in U.S. banks and interest on certain debt obligations that qualifies as so-called “portfolio interest”) and U.S. source interest and dividends from a U.S. corporation whose income consists predominantly of active foreign business income could be wholly or partially exempt from withholding tax. In addition, a foreign person is generally not subject to U.S. tax on gains from the sale of property that are not effectively connected with a U.S. trade or business, even if they derive from investments in the United States.
Conclusion
The United States taxes foreign persons (foreign corporations and nonresident alien individuals) on the net amount of income effectively connected with the conduct of a trade or business within the United States. A foreign corporation that receives income effectively connected with a U.S. trade or business will likely need to file Form 1120-F, U.S. Income Tax Return of a Foreign Corporation with the IRS. A foreign corporation may also be required to file Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, and maintain certain books and records. These requirements apply even if a foreign corporation receives no taxable income from the U.S. or the U.S. source income exempt by reason of a tax treaty provision.
A nonresident alien individual that receives income effectively connected with the conduct of a trade or business with the United States must file a Form 1040NR, U.S. Nonresident Alien Income Tax Return with the IRS. The nonresident alien individual will need to file a 1040NR with the IRSof his or her U.S. income is exempt from U.S. tax by reason of a tax treaty provision.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in cross-border 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.
