2016-Issue 11 – The Internal Revenue Service (IRS) has been busy of late producing internal guidance for its examiners (both specialists and non-specialists) for use in auditing foreign and cross-border transactions. This process began with the release of 44 International Practice Units (IPUs) made public in December 2014, at which time the IRS announced it would soon be releasing another 100 IPUs. As ambitious as that seemed at the time, the IRS has been making good on that promise. At the time of this article’s publication, the IRS had published 29 IPUs related to cross-border tax issues in 2016 alone and another 23 IPUs in the last three months of 2015. In total, the IRS has published 113 to date.
The rapid pace at which cross-border IPUs are being produced suggests that the IRS wants to better inform and instruct its staff on such transactions and tax matters. It also might suggest that the IRS views these issues as a source of low-hanging fruit in stemming the tide of tax minimization or avoidance from both corporate and individual taxpayers. Therefore, it is worthwhile to consider how the IRS is thinking about international tax issues — issues that might often be overlooked and that can lead to negative and sometimes harsh tax treatment under United States tax law.
A detailed review of IPUs is unlikely to divulge any new points of law. But it can provide valuable insight into what examiners are likely to have on their mind as they review international transactions. This edition of Tax Advisor Weekly focuses on some of the issues raised by the IRS in several IPUs dealing with U.S. business activities of non-U.S. persons. These IPUs, known as “Inbound IPUs,” should be of particular interest to non-U.S. multinational companies and non-resident alien individuals. Such persons should take particular note of this focus by the IRS to ensure they are in compliance with U.S. federal income tax laws. The Inbound IPUs may also be relevant to U.S.-based multinationals that have foreign subsidiaries that conduct business activities in the United States (or that may be deemed to do so by virtue of activities conducted on their behalf by U.S. affiliates).
The Inbound IPUs suggest that foreign corporations and non-resident alien individuals that conduct business activities in the United States should be aware of several tax traps, such as the relatively low level of activity necessary to create a U.S. trade or business (USTB), the types of activities that are deemed to produce income effectively connected with a USTB, and the harsh consequences of failing to file U.S. federal income tax returns, even where a permanent establishment (PE) does not.
The IRS has instructed its staff to determine whether a foreign corporation might have operations in the United States by performing Internet searches of the foreign corporation’s website to focus on its global business lines, foreign offices and any financial statements published for public consumption. Additionally, IRS staff may look through online databases for officer names and office addresses and through online competitor search tools. If the IRS is reviewing a foreign company or non-resident alien individual, it might ask for legal organizational charts and functional organizational charts, global financial statements, intercompany agreements and documentation related to the functions of all employees based in a U.S. office or employees who perform even temporary work in the United States under a secondment arrangement.
Relatively Low Level of Activity Needed to Create a USTB
To be engaged in a USTB, a taxpayer must be involved in an activity pursued for profit that is considerable, continuous and regular. Such activities can be carried out directly by the taxpayer or through a dependent agent (described in further detail below). The determination of whether a person is engaged in a USTB is made on the basis of the particular facts and circumstances. Certain activities will not be considered as engaged in a USTB, such as trading in stocks or securities or commodities for one’s own account.
Both non-U.S. multinational companies and non-resident alien individuals should be aware that as a general rule, the performance of personal services within the United States automatically constitutes a USTB. Also, a person who solicits, negotiates or executes contracts in the United States can result in such person being deemed to have a USTB.
There is an exception for services performed within the United States on behalf of a foreign employer, but the requirements are very narrowly tailored, such that it only requires very minimal activity to fall outside the exception. If a non-U.S. employer (e.g., non-resident alien individual, foreign partnership or foreign corporation) is not engaged in a USTB and the services are performed on a temporary basis for less than 90 days within a calendar year, the services could still be deemed to constitute a USTB if the compensation for the services performed were to exceed $3,000 in the aggregate. It is important to note that the IRS may consider a person as not meeting the exception even in cases where compensation actually paid for services in any given tax year falls below the threshold, but compensation earned in one tax year exceeds the aggregate threshold amount of $3,000.
Investments in US Real Property Can Involve Special Considerations
Investments in U.S. real property by foreign persons may or may not result in being deemed to have a USTB. Non-resident alien individuals can elect to treat income from U.S. real property interests as trade or business income regardless of whether or not they engage in activities that would give rise to a USTB. One might elect to have income taxed on a net basis in order to recognize deductions related to the items of income resulting from the U.S. real property interests. The Foreign Investment in Real Property Tax Act (FIRPTA) rules dictate that any gain or loss on the disposition of a U.S. real property interest will be treated as if the foreign person were engaged in a USTB and such gain or loss were effectively connected with the conduct of the USTB.
A failure to make the election to treat U.S. real property income as trade or business income could cause the gross income to be subject to a 30 percent withholding tax. However, such an election can be made retroactively on an amended return or even a late filed return, so long as the statute of limitations has not passed. But if the taxpayer fails to make the election for a year for which the statute of limitations expires, it would lose the ability to claim a net operating loss (NOL) carryforward from that earlier year(s). This could be important in a situation where the activities in the earlier year did not rise to the level of a USTB (in the absence of an election to treat them as such), but the taxpayer is treated as having a USTB in a later year because its activities became more substantial, or if the real property was disposed of in part or in whole, in which case the gain would automatically be treated as effectively connected income (ECI) under the FIRPTA rules.
Foreign Persons Taxed on Effectively Connected Income of a USTB
Non-U.S. companies and non-resident alien individuals are subject to U.S. federal income tax at graduated rates on taxable income effectively connected to a USTB. Once a foreign person is deemed to be engaged in a USTB, all income from U.S. sources is treated as ECI, with the exception of fixed or determinable, annual or periodical (FDAP) income, such as dividends, interest, rents and royalties that are not deemed to be effectively connected with the USTB.
As a general rule, the performance of personal services within the United States is automatically treated as a USTB, and any income earned from such services is automatically treated as ECI. Capital gains and other U.S. source income that is FDAP income is ECI only if attributable to U.S. business assets (“assets use test”) or if the activities of the U.S. business are a material factor in generating the income (“business activities test”).
With respect to interest income, a determination will be made whether interest income satisfies the assets use test (whether cash was used for ordinary and necessary business expenses rather than as long-term investments). If a U.S. bank account is held for the current needs of a business, such U.S. source interest would be ECI.
Foreign source income is considered to be ECI in limited circumstances, such as if inventory is sold outside the United States but only if such sales are attributable to a U.S. office or fixed place of business, the property is not for consumption or use outside the United States and no non-U.S. office materially participated in the sale. Generally, sales of inventory within the United States should result in U.S. source income that is ECI if the rights, title and interest are transferred to the buyer in the United States. Even in the absence of a transfer of rights in the United States, the negotiation and execution of contracts at a U.S. office of a foreign person could result in income being U.S. source.
Foreign persons should be aware that in determining whether they have ECI, the IRS will seek to review documentation related to invoices, bills of lading and other shipping documentation, bank statements and brokerage statements, project logs and work orders related to U.S. and non-U.S. personnel, and organizational and personnel charts. The lack of sufficient documentation to support the taxpayer’s treatment of items reviewed by the IRS could at least raise a red flag or even result in upward adjustments to a taxpayer’s U.S. source income or a re-sourcing of a taxpayer’s income from foreign to U.S. source.
Lack of a Permanent Establishment Will Not Necessarily Result in No US Tax Obligation
If a foreign person qualifies for benefits under a U.S. tax treaty, it may qualify for an exemption from U.S. tax on the profits of a USTB, provided that the foreign person is not deemed to have a PE in the United States. However, it would be incorrect for a foreign person to assume that the lack of a U.S. PE automatically excuses it from the obligation to file a U.S. tax return. Any U.S. person that is deemed to have a USTB has an obligation to file. If a non-U.S. corporation qualifies for an exemption from tax under a treaty, it is obligated to attach Form 8833 to its Form 1120-F disclosing to the IRS that it is claiming a treaty-based return position under either Section 6114 or 7701(b) of the Code.
The definition of a PE, provided immediately below, suggests a greater level of activity than that which is necessary to constitute a USTB. Even activities of a preparatory or auxiliary nature could be considered to be a USTB.
The U.S. Model Income Tax Convention (2006) and the recently published updated U.S. Model Income Tax Convention (2016) define a PE as being a fixed place of business through which the business of an enterprise is wholly or partly carried on. This can include a place of management, a branch or office, a factory or workshop, or a site where natural materials or resources are extracted.
For purposes of most U.S. tax treaties, a permanent establishment will not include maintenance of a fixed place of business and/or inventory solely for the purpose of holding and delivering such goods and if the overall activities of the enterprise are of merely a preparatory or auxiliary character.
Lack of Timely Filed US Tax Returns Can Have Disastrous Effects
Some foreign persons might assume they do not have a filing obligation within the United States because they do not have a PE under a tax treaty or were under the impression that their U.S. activities were not substantial enough to warrant any tax filings, but as discussed above, a relatively small amount of activity is often enough to create a USTB. If a non-U.S. person has a USTB, even in cases where such foreign person does not have any income from its U.S. business activities, it should still file a U.S. federal income tax return.
All foreign persons, whether corporations, partnerships or non-resident alien individuals, should at least file protective tax returns if they have any business activity within the United States. Such persons can deduct items of expense connected with ECI, but only if there is a timely filed U.S. federal income tax return.
Non-resident alien individuals report their U.S. source income on Form 1040NR, and non-U.S. corporations report their income on Form 1120-F. If a return is not filed within 18 months after the initial tax return due date, the taxpayer forfeits the right to claim tax deductions for the tax year in question, unless it can establish to the satisfaction of the IRS that there was reasonable cause for its failure to timely file. For that reason, many non-U.S. corporations file Form 1120-Fs and non-resident alien individuals file 1040NRs on a protective bases (i.e., not reporting any ECI) in order to preserve the right to claim deductions and tax credits if the IRS later asserts that they did have a USTB.
Alvarez & Marsal Taxand Says:
The recent focus by the IRS on cross-border tax issues generally, and specifically for non-U.S. persons with respect to USTB and ECI concerns, should compel all such non-U.S. persons to take a close look at whether they are in compliance with U.S. tax laws. Additionally, all non-U.S. persons, whether they be individuals or corporations that have some U.S. business operations, however small, should review the state of their internal documentation to ensure they can support any positions taken, to defend against possible IRS inquiries and quickly take corrective steps as necessary if any omissions are discovered related to prior years.
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisers. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisers before determining if any information contained herein remains applicable to their facts and circumstances.
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