The Joint Committee on Taxation recently released a report highlighting the growth in foreign investment in the U.S. over the past two decades. Notably, from 1993 to 2009, net foreign investment increased from 6.8 percent to 18.2 percent of gross domestic investment. This increase is confirmed by the significant growth in the value of foreign-owned assets in the U.S., which grew by more than 10 percent per year on average between 1980 and 2009 (indexed for inflation), to over $20 trillion of total assets by the end of 2009.
In light of the considerable increase in foreign investment and the U.S. government’s difficulty in financing its fiscal deficit, it should come as no surprise that the IRS may turn its focus to foreign investors to capture additional revenue. These revenue-raising efforts may come in the form of new legislation, such as the Stop Tax Haven Abuse Act, reintroduced in Congress in July, but also by intensifying the IRS enforcement procedures for foreign taxpayers potentially doing business in the United States, including many of the foreign-based funds buying out U.S. distressed assets. A significant area of U.S. international tax compliance where the IRS may increase its focus is determining whether foreign corporations and funds are making accurate assessments of their U.S. trade or business (USTB) status and, where applicable, permanent establishment (PE) status.
Generally, as a precaution, astute foreign investors examine their proposed activities in the planning stages of their U.S. operations to determine the risk, or possible existence, of a USTB/PE in the United States. It is at this time that a preventive care plan is usually instituted to protect the foreign investor from inadvertently creating a USTB or PE. However, after the initial diagnosis, many investors relax and forget to submit themselves to a periodic “check-up” to review their current operations and ensure that the original plan provides adequate protection amid changes in their facts and circumstances. For less knowledgeable investors, avoiding an annual check-up seems ideal, until an IRS agent is at the door ready to conduct a much more invasive procedure.
The consequences of making an incorrect USTB/PE determination may be steep. Many foreign taxpayers may not be fully aware of the impact that a USTB/PE audit adjustment may have on their bottom line. Foreign persons who have incorrectly assessed their USTB or PE status may not only be levied for back taxes, interest and penalties, but in certain situations, may not be entitled to take deductions or use credits to reduce the assessed tax liability attributed to the USTB or PE. Effectively, the IRS may claim the authority to impose gross taxation on business income that would have otherwise been taxed on a net basis if an income tax return had been filed by the foreign corporation.
USTB and PE Defined
A USTB is a somewhat nebulous term used to define a threshold of U.S. business activity engaged in by a foreign person that causes such person to be subject to U.S. income taxation on income deemed effectively connected to the USTB. The framework for determining what constitutes a USTB is generally derived from various court decisions and other rulings published by the IRS. The determination is to be made annually, on a case-by-case basis, after weighing all of the taxpayer’s particular facts and circumstances.
Generally, a USTB is deemed to exist when a foreign person engages in profit-oriented activities in the U.S. that are regarded as “considerable, continuous and regular.” Courts generally agree that the USTB analysis involves both a quantitative and qualitative component.
When considering whether activities are considerable, it is necessary to keep in mind the relative size of the overall business to determine whether the taxpayer is in fact conducting a “business” within the United States. For example, businesses requiring few or no assets, or few persons, may have a USTB without necessarily having assets or people in the United States. Contrary to common misconception, maintaining a U.S. office, warehouse, factory or other fixed place of business is not necessary to create a USTB. In the case of personal services, a USTB can generally be deemed to exist if a foreign person performs a minimum threshold of personal services in the United States.
In terms of quality, the activities must be material to the principal business and not merely ministerial, clerical or incidental to such business. Material activities are generally those that involve the exercise of discretion or business judgment necessary for generating the revenue of the business. Accordingly, even if the foreign person has a U.S. office, if only routine or clerical functions that are not material to the real business of the foreign person are performed in such office, then there may not be a USTB. Whether the foreign person’s activities are regular and continuous depends on the frequency and number of transactions involved. One-off transactions in most cases may not create a USTB, unless their magnitude and importance to the overall business is material.
The trade or business must be carried on within the United States. In the case of foreign corporations, this may occur when the corporation’s agents or employees perform activities within the United States. This includes both U.S. agents and employees, as well as foreign agents and employees visiting the United States. However, there are numerous ways in which a foreign person can unsuspectingly fall into the trap of U.S. business taxation without so much as purchasing its own stationary in the United States. Below are some of the typical activities that should cause the foreign person to submit to a check-up:
• Maintaining an agent, whether dependent or independent, who performs U.S. activities on behalf of the foreign person;
• Performing services (consulting, technical or otherwise) within the U.S. (a 90-day, $3,000 limitation may apply);
• Owning an interest in a fiscally transparent entity (disregarded entity or partnership, domestic or foreign) that is itself engaged in a USTB;
• Engaging in construction projects in the United States;
• Managing, in an active and continuous manner, U.S. real estate for income-producing purposes;
• Maintaining inventory in the U.S. under certain arrangements (i.e., consignments);
• Selling goods in the U.S. where any sales activities are conducted within the United States;
• Managing a business in the United States; and
• Soliciting sales in the United States.
Once a USTB is created, or a USTB risk is identified, it may be necessary to consider whether a permanent establishment, or PE, exists if the foreign investor is resident of a tax treaty country. PE is used to define the threshold of U.S. activity necessary for a bona fide resident of a tax-treaty country to be subject to U.S. income taxation pursuant to the tax treaty. The USTB concept is broader than the PE rules. Therefore, a foreign person can be engaged in a USTB but still be found not to maintain a PE in the United States. However, certain U.S. federal income tax reporting obligations are triggered simply upon the finding of a USTB irrespective of whether a PE exists.
The term “permanent establishment” is not defined by U.S. tax code or the regulations. While there are subtle (and sometimes not so subtle) differences between the definitions of a PE included in the many income tax treaties maintained by the U.S., most treaties provide a reasonably reliable definition of the term. Under such treaties, a PE is generally defined as a fixed place of business in which the business of a foreign enterprise is wholly or partly carried on. A PE may include a place of management, a branch, an office, a factory, a workshop, a mine or quarry, a building and certain construction sites. In addition, tax treaties that have been entered or revised recently may include a “service PE” clause that may trigger a PE when the foreign corporation’s personnel perform services in the U.S. for a specified period of time.
Once a USTB or PE has been established, the foreign corporation maintaining such presence is subject to U.S. corporate federal income taxation on the income derived from the U.S. activities.
The rules under a tax treaty related to PE may generally override U.S. federal tax rules but, unfortunately, may not override the nexus rules of certain states and municipalities. Accordingly, the existence of a USTB may also be a symptom of possible nexus issues at the state and local tax level, even if a tax treaty applies. For a refresher on the application of these rules in the state and local area, please take a look at .”
Preserving Deductions and Credits with a Protective Federal Tax Return
A foreign corporation that conducts limited business activities in the U.S. in a year in which the foreign corporation determines it does not have a USTB may not have any filing requirements for U.S. federal tax purposes for that taxable year. However, if a foreign corporation finds itself in the USTB/PE gray area, we recommend first and foremost that a U.S. tax advisor is consulted to consider the particular facts and circumstances. Even if the conclusion is ultimately drawn that the U.S. activities may not be significant enough to trigger USTB/PE, a risk always remains that the IRS could reach a different result. Therefore, it is crucial under these circumstances to consider filing a “protective” U.S. federal income tax return to mitigate the impact of an unfavorable USTB/PE determination and preserve the foreign person’s ability to take tax deductions and credits.
A foreign corporation submits a protective return by filing Form 1120-F, U.S. Income Tax Return of a Foreign Corporation, with the “Protective Return” box checked at the top of Page 1. If Form 1120-F is filed in paper form, it is generally recommended to print “PROTECTIVE RETURN FILED PURSUANT TO TREAS. REG. SEC. 1.882-4(a)(2)&(3)” at the top of each page to ensure that the IRS agent processing the return recognizes it as a protective return. If Form 1120-F is filed electronically, a statement should be attached. Form 1120-F may be submitted as a “zero” return (e.g., no amounts are reported), and the corporation should indicate on Item K on the return that the corporation is taking the position that a USTB has not been established in the U.S., and therefore no effectively connected income is being claimed. The foreign corporation filing a Form 1120-F protective return is only required to respond to informational questions on Pages 1 and 2 of the return in accordance with the instructions of the form.
Foreign persons that are claiming tax treaty benefits must generally attach Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), to their Form 1120-F. Where a foreign person with limited U.S. activities is claiming that it has no U.S. tax liability because it does not have a U.S. PE, then the foreign person should file a protective Form 1120-F in the manner described above, attach Form 8833 and should additionally indicate on Item L of the return that a PE has not been established for the taxable year.
The general due date for Form 1120-F is by the 15th day of the third month following the close of the taxable year (e.g., March 15 for calendar-year filers). However, a foreign corporation with no office or U.S. place of business may file by the 15th day of the sixth month following the close of the taxable year. In either case, an automatic six-month extension may be granted once requested. Notwithstanding, the regulations mandate that the Form 1120-F must be filed within 18 months of the due date of such tax return in order to preserve the right of the foreign person to claim the deductions and credits related to the income should it later be determined that the foreign corporation had a USTB/PE in such year.
As beneficial as the “protective” return can potentially be, it does not come without its drawbacks. To file a protective return, a foreign corporation must obtain a U.S. tax identification number, which often requires a foreign corporation to produce private information to the U.S. tax authorities (e.g., addresses, ownership details, etc.). Furthermore, some argue that the voluntary act of submitting a protective income tax return can tip off the IRS that there may be potential USTB or PE issues for the foreign corporation filing the return.
Unfortunately, the IRS has numerous other ways to determine whether a foreign entity has any presence in the United States, aside from the filing of Form 1120-F. Some of these include:
• Reviewing the company’s website for lists of U.S. representatives, agents, offices or other U.S. activities;
• Searching the World Wide Web for the company’s U.S. activities (i.e., significant sales transactions with U.S. persons or expansions into the U.S);
• Downloading or obtaining marketing and sales materials highlighting sales capabilities in the U.S.;
• Finding evidence of advertising or participating in U.S. trade shows, conferences and other U.S. expositions of the company’s products and services;
• Reviewing newspaper or other media discussions of the company’s operations or activities within the U.S.; and
• Reviewing tax filings made by U.S. persons that provide information about the company (i.e., withholding-tax forms).
One particular target of the IRS enhanced enforcement may be the various types of “flow-through” investment funds, including hedge funds, private equity funds and real estate investment funds investing in U.S. distressed assets. An area of focus by the IRS in these audits relates to the whether or not the funds are engaged in a USTB by performing functions within the U.S. territory that are beyond the limited roles these funds are afforded under the current U.S. legislation, which is limited to trading for their own account. Considering the increased audit activity and the fact that most of these funds are not within a tax-treaty jurisdiction, it may be especially important for these funds to review their current U.S. activities and consider the extent to which there is USTB exposure.
Alvarez & Marsal Taxand Says:
Generally, when a foreign corporation commences operations in the U.S., an initial assessment is made as to whether a USTB or PE has been established. Over time, the extent of these activities may vary. If you have been charged with the responsibility of ensuring the U.S. income tax compliance of a foreign corporation with U.S. activities, it is important to subject the foreign corporation to an annual check-up of its USTB or PE health. Pay close attention to whether the quantity and/or quality of the foreign corporation’s U.S. activities has changed over the year and discuss the impact of any changes with your U.S. tax advisor. Carefully consider any information in the public domain that might draw the IRS’s attention to potential USTB or PE issues.
The U.S. government is under extreme pressure to collect more revenue, and the international area is a primary focus for the IRS. The examination of international issues and transfer pricing is on the rise, and USTB/PE examinations will inevitably follow. Therefore, if your foreign corporation has not paid close attention to these issues, now is a good time to perform a full check-up of your USTB/PE risk and take any preventative steps to avoid complications and unintended consequences.
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Kenneth Dettman, Associate, contributed to this article.
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