10 Oct 2013 Effectively Connected Income Guidelines for Foreign Companies with U.S. Affiliates
Foreign companies entering the U.S. market must choose their risks – either ship directly into the U.S. and risk being subject to U.S. tax, or establish a U.S. distribution subsidiary and risk a dispute over the amount of income allocable to that U.S. subsidiary. Often, business and tax considerations will favor the establishment of a U.S. distribution subsidiary, and many or most inbound distribution structures take the form of parent-subsidiary relationships.by Roger Royse
In transfer pricing planning, the temptation is almost irresistible to justify a low U.S. profit margin by limiting the functions performed by the U.S. subsidiary. This approach, however, provides only a false sense of security since the U.S. distribution subsidiary may eventually be reduced to a mere agency relationship. At that point, the IRS may find it more profitable to assert that the subsidiary is a dependent agent of the foreign parent and attempt to tax all the income earned through that agent, including the foreign parent’s share of that income.
U.S. Trade or Business
The first inquiry in determining whether a foreign corporation is subject to U.S. tax is whether the foreign corporation is engaged in a U.S. trade or business. This analysis is essentially factual, but it is clear that having a U.S. subsidiary does not, by itself, constitute a trade or business.1 Moreover, having an agent in the U.S. supervising the activities of a U.S. subsidiary does not constitute a U.S. trade or business.2 Problems may arise, however, when a foreign corporation’s subsidiary acts on behalf of its foreign parent.
If the U.S. affiliate is an agent of the foreign company, its activities on behalf of the foreign company may be imputed to the foreign company. If the activities are regular, substantial, and continuous, the foreign principal is deemed engaged in a U.S. trade or business.3
Effectively connected income. If a foreign corporation is engaged in a U.S. trade or business, absent treaty protection, it will be taxed on its effectively connected income. Effectively connected income may include U.S. source income from sales of inventory. Potentially more alarming is that the foreign company could be taxed on its foreign inventory sales through its U.S. office or fixed place of business, unless a foreign office materially participates in the sale.4
Dependant vs. Independent agent. Generally, a foreign corporation’s independent agent will not constitute a U.S. office but a dependent agent might. The office of a dependent agent is disregarded unless the agent has, and regularly exercises, the authority to conclude contracts in the name of the foreign company or has a stock of goods belonging to the foreign company from which orders are regularly filled on behalf of the foreign company.5 As a planning matter, foreign corporations generally will seek to ensure that their U.S. agents are independent and, failing that, that they neither have, nor exercise, the prescribed authority. Reg. 1.864-7(d) expands on the distinction between independent and dependent agents, and two recent cases shed some additional light on how to avoid having a U.S. office by imputation.
Two recent U.S. Court cases emphasize the risk that a foreign company may become subject to U.S. tax through the activities of its U.S. affiliate the IRS was successful in one of the cases and unsuccessful in the other. Despite the highly factual nature of the analysis, valuable insight can be gained from a careful reading of the cases.
InverWorld. Many practitioners may have overlooked the importance of lnverWorld, TCM 1996-30l, since it was issued in a 115- page memorandum decision. The case is fact-intensive, deals with a multitude of issues, and is heavy going at times. It is, nevertheless, one of the most important recent cases affecting foreign companies doing business in the U.S.
Although InverWorld involved an investment and financial services management company, and not a merchandising or technology company, the holding illustrates the potential vulnerability of the inbound parent-subsidiary structure. The taxpayer in lnverWorld was a Cayman Islands company (F). F owned all the stock of lnverWorld Holdings, Inc., which owned all the stock of D, a U.S. company. F and D entered into an agreement whereby D was to render certain advisory services to F, and would have the power to invest cash and to purchase and hold securities and other properties on behalf of F. Anticipating the Section 864 issue, the agreement also provided that D would not have the authority to bind F.
One of the issues considered by the court was whether F was engaged in a trade or business by virtue of the activities of D. Since F was engaged in a securities trading business, the case was decided under Section 864(b). The court, however, looked to Section 864(c) concepts in reaching its decision, and it is those concepts that are of interest to merchandising and technology companies.6
The court noted that F’s activity of trading in stocks or securities through an independent agent would be excluded from the definition of “trade or business within the United States” if F had no U.S. office or other fixed place of business through which its trading transactions were effected. First, the court determined that D was not an independent agent within the meaning of Section 864(b)(2)(A)(i) because D acted exclusively for F. The court then considered whether D was a dependent agent that had, and regularly exercised, the authority to negotiate and conclude contracts in the name of F.
In deciding whether D had contract authority, the court examined the agreement between D and F In anticipation of the dependent agent issue, one paragraph of the agreement set forth that D “shall for all purposes be an independent contractor and not an agent or employee of [F), and [D] shall have no authority to act for, represent, bind or obligate [F], any of its affiliates or any account managed or advised by [F].” That paragraph, however, was not the end of the inquiry. The court analyzed the language of the agreement in detail and found that other provisions gave D specific authority to carry out certain enumerated acts on behalf of F. The court thus found that D had the authority to conclude contracts on behalf of F, despite the agreement’s recitation of a disclaimer of that authority.
Significantly, the opinion quotes the agreement between F and D extensively. Although F specifically disavowed D’s agency authority in its agreement, the court was not content to accept the taxpayer’s interpretation of the contract without extensive analysis of the remainder of the agreement. Many inter-company distribution agreements similarly contain self-serving language reciting the domestic party’s lack of authority. lnverWorld first makes it clear that such language, standing alone, is not sufficient to defeat the taxability of the foreign party.
After finding that D was a dependent agent, the court went on to examine at length D’s U.S. activities. The court easily found on the facts that D regularly exercised contract authority on behalf of F.
Although not essential to its holding, the court also discussed the application of another Regulation that concerns multinationals. Reg.I.8647 (f) provides that the office of a related party will not generally be imputed to a foreign corporation, unless the facts and circumstances show that the foreign corporation is engaged in trade or business in the U.S. through that office.7
The court noted that F required a physical facility to conduct its business, which included receiving investment instructions from its clients, effecting such instructions, and maintaining records of actions. Because F used D’s office for that purpose, the court concluded that F had an office or other fixed place of business in the U.S.
Ultimately, and not surprisingly, the court concluded that (1) F’s trading in stocks or securities was not carried out through an independent agent, and (2) F bad “an office or other fixed place of business in the U.S.” through which such transactions were effected.
Taisei Fire and Marine Insurance Co., Ltd., I 04 TC 535 (1995), similarly addressed an agency issue, this time arising under the U.S.-Japan income tax treaty.8
Although the case involved treaty interpretation issues, it is relevant to companies from non-treaty countries because the “permanent establishment” concept is similar to the “fixed place of business” concept under domestic law.9
The issue in Taisei was whether a U.S. agent that accepted reinsurance on behalf of foreign insurance companies was a U.S. permanent establishment of those companies. The foreign corporations had a representative office in the U.S. that provided information on the U.S. market and assisted clients in the U.S., but that did not have authority to write any form of insurance. Each foreign company, however, granted authority to the U.S. agent to underwrite reinsurance on its behalf. Because the agent had, and regularly exercised, the authority to conclude reinsurance contracts on behalf of each foreign company, the only issue was whether the agent was an independent agent. The court determined that if the agent was both legally and economically independent of the foreign companies, it would not constitute a permanent establishment of the foreign principals.
Legal Independence. The management contracts empowered the agent to conduct the reinsurance business on behalf of the foreign principals. The IRS argued that the principals exercised control over the agent that was not reflected in the agreements, such as restrictions on the agent’s corporate affairs. Moreover, the agent consulted and reported to the principal frequently. Nevertheless, the court found that the agent was subject to no external control and was legally independent. The court viewed the agent’s consulting and reporting activity as merely in the furtherance of good relations with the principals’ longstanding clients and not as obtaining approval from the principals to enter insurance contracts.
Economic Independence. The court noted that there was no guarantee of revenue nor was the agent protected from loss in the event it had been unable to generate sufficient revenue. Again, the court cited the written contracts, under which the foreign principals could terminate the agreements on six months’ notice. The court further found that the agent bore some entrepreneurial risk, and accordingly, was economically independent.
Because the agent was both legally and economically independent of the foreign companies, it was an agent of independent status under the terms of the U.S.-Japan tax treaty and the foreign companies did not have a U.S. establishment.
Commission agents. The court’s analysis is of interest to U.S. distribution structures using commission agents. As noted above, a local distribution company would normally attempt to structure itself as an independent agent. Taisei provides a very clear discussion of what it means to be independent for treaty purposes, and the control and economic factors that a court might consider in making that determination.
Relevance of lnverWorld and Taisei to Technology Companies
The court in both cases looked first to the parties’ documentation. This is, of course, nothing new, but the extent of the courts’ focus on the language used in the contracts is significant. Many affiliated companies may not feel the need to elaborately document their relationships, since they are commonly controlled. The case law now makes it clear that properly drafted agreements, while not absolutely resolving the issues, provide a first line of defense.
Additionally, the court in both cases went beyond the parties’ written agreements and analyzed how the companies conducted business in practice. Companies that go to the trouble of documenting their relationships must act in compliance with those agreements and the Regulations.
Exclusivity. Moreover, both courts focused on the exclusiveness of the relationships. In InverWorld, the court found that the agent was not independent because it acted “almost exclusively” for the principal. The agent had few other clients, performed most of its services for the principal, derived 91% to 99% of its income from the principal, and did not market its services to clients on its own. Based on those facts, the agent was not independent.
The exclusiveness of the agency relationship in Taisei was also a major factual issue. The IRS asserted that the agent’s foreign principals, acting as a “pool” exerted common control over the agent. The IRS cited Regulations, which make exclusivity an important consideration in determining whether an agent is independent.10 The court held those Regulations inapplicable to Taisei because that agent acted separately with respect to each of its principals. The court noted, however, that even if an agent is exclusive, the facts and circumstances of a particular case must be” taken into account in determining whether the agent, while acting in that capacity, may be classified as an independent agent.
The exclusivity issue may be of interest to the typical inbound high technology company since the U.S. distribution subsidiary will often be established solely to market the affiliated group’s products. If the distribution company only handles the foreign parent’s products, it must be determined if it is “exclusive,” and if so, does that make it “dependent.”
Neither court relied solely on exclusivity in reaching a conclusion, but required further analysis of the facts and circumstances. The court in Taisei focused on other factors, while the court in lnverWorld went no further than to recite the facts that indicated that the agent acted exclusively for its principal.
lnverWorld and Taisei may at first appear troublesome to a foreign company that grants an exclusive distributorship to its domestic affiliate. However, an exclusive distributorship is not necessarily an exclusive agency. Significant factors include whether the agent has the right to market products other than those of the principal, and the extent of the control exercised by the foreign principal.11 The cases are not particularly helpful in clarifying this issue since in Taisei, the agent was not exclusive and in InverWorld, the court did not discuss those other factors.
U.S. business activity. The lnverWorld court’s citation to Reg. 1.864-7(1) is a reminder that, even if members of a multinational group are successful in avoiding dependent agency problems, there is still the issue of avoiding the conduct of business activities in the U.S.12 The Regulations generally acknowledge that a company’s U.S. office is not necessarily attributed to a foreign party solely because the foreign company is related to the domestic company, even if there is relatively sporadic or infrequent activity taken on behalf of the foreign party in thatoffice.13 lnverWorld, the U.S. office’s address was used as the principal’s return address on marketing materials and documents, files were maintained in the U.S., and the principal generally conducted business through that office. Although there appear to have been significant realization activities conducted in D’s U.S. office, the foreign company would be well advised to limit its use of the domestic office or the domestic office’s facilities for any business activities, such as its mailing address, telephone or fax services.
Common officers and employees. Finally, an issue common to both cases concerned the foreign and domestic companies’ joint use of common officers and employees. It is disturbing that both cases typically noted the commonality of management, but did not go so far as to discuss its relevance in more detail. ln InverWorld, for example, the court noted that employees or officers of D had signatory authority for F’s bank accounts. In Taisei the court noted the fact that the foreign principals had no interest in the agent, and that no representatives of any principals were directors, officers, or employees of the agent. The Taisei opinion did not indicate whether common managers would have affected the result, but it must have been viewed as relevant to the issue of the agent’s independence with respect to dayto-day affairs.
Reg. 1.864-7(1), Example (I) seems to sanction affiliated companies having common officers. The Example hypothesizes a U.S. parent “P” that owns all of foreign subsidiary “S.” Both P and S are engaged in the business of buying and selling tangible personal property. S’s chief executive officer is also an officer of P, but is permanently stationed outside the U.S. On those facts, S does not have an office in the U.S.
The Reg. 1.864-7(1) raises a number of questions. First, is the result the same if the foreign company is the parent and the U.S. Company is the subsidiary? Although logic and elegance may suggest the same result, the IRS could argue that the existence of a common officer indicates the parent is conducting business through the U.S. office of its subsidiary.
Similarly, does it make a difference in Example (I) if P and S are vertically integrated? P and S in the Example are both engaged in merchandising, whereas, in the typical distribution structure, one company may be a manufacturer and another a distributor. In the latter situation, the line between acting on behalf of the manufacturer and the distributor can become blurred even when there are no common officers.
Finally, if the common officer is not permanently stationed, but splits its time between P and S or is temporarily loaned to S, it may be difficult to argue that the officer is in the U.S. on behalf of the domestic company and not the foreign company. Foreign companies often install their own people as officers of U.S. distribution subsidiaries. That appointment may be more to satisfy state corporate law requirements than to actually grant someone operating authority. Nevertheless, the references in the above two cases should give advisers pause about engaging in that practice.
Taisei and InverWorld illustrate the importance of Section 864 planning and remind International companies that the IRS has a powerful weapon in the audit arsenal. A finding that a foreign company is taxable in the U.S. under Section 864 carries a potentially much higher tax cost than a Section 482 adjustment, since Section 864 could reach a larger portion of the multinational group’s overall gross profit. Fortunately, proper planning can minimize the risk of a Section 864 challenge. At a minimum, each member of the U.S.-foreign group should have distribution or service agreements in place that clearly define and delineate the authority of the parties. In addition, the U.S. affiliates should adopt a set of policies that, if followed, will avoid subjecting the foreign affiliate to U.S. tax jurisdiction. Finally, multinationals should review their management structures to eliminate the sort of employee or officer overlap that may invite IRS scrutiny.
- Section 864(b).
- Reg. 1.864·3(b), Example (2).
- ‘Section 864(c)(5)(A). Reg.1.864·4 preserves the “force-of-attraction” principle of pre·1966 law, see Kuntz & Peroni, U.S. International Taxation, Vol. 2 (WG&l, 1996), C1.04(5](cJIII].
- Section 864(c)(4)(B).
- section 864(c)(5)(A).
- Under Section 864(b)(2)(A)(i), the activity of trading In stocks or securities through a resident broker, commission agent, custodian, or other Independent agent Is excluded from the definition of trade or business within the United States.” The exclusion applies, however, only if the taxpayer does not have an office or other fixed place of business in the U.S. through which the securities transaction are effected (Section 864(b)(2)(C)). The court looked to Regulations under Section 864(c) in determining whether D was “independent’ and whether F had an “office”.
- Reg. 1.864-7(1) provides, “[T]he fact that a nonresident alien individual or a foreign corporation is related in some manner to another person who has an office or other fixed place of business shall not of Itself mean that such office or other fixed place of business of the other person is the office or other fixed place of business of the nonresident alien individual or foreign corporation. Thus, for example, the U.S. office of foreign corporation M, a wholly owned subsidiary corporation of foreign corporation N shall not be considered the office or other fixed place of business of N unless the facts and circumstances show that N is engaged in trade or business in the United States through that office or other fixed place of business.
- 1971 U.S.-Japan income tax treaty, 2 Tax Treaties (WG&l).55,525.
- see Date, “Effectively Connected Income4: 2 Tax law Review 689 (Summer 1987).
- Reg. 1.86H(d)(3)(ili).
- Compare Rev. Rut.70·424, 1970·2 CB 150, to TAM 8147001.
- Note 7, supra. “Reg. 1.B6H(b)(2).