The rules for computing a foreign corporation's U.S. federal income tax liability resulting from a U.S. taxable presence are complex, and foreign corporations often struggle with these computations. While undertaking this analysis, foreign corporations often overlook a threshold question: What rules should be applied in determining the income associated with the U.S. taxable presence?
The answer to this question varies based on several predicates, the most important of which is the application of U.S. domestic tax law or a U.S. income tax treaty. This item provides an overview of concepts and differences when applying U.S. domestic tax law and a U.S. income tax treaty to a foreign corporation. This item also discusses the authorized Organisation for Economic Co-operation and Development (OECD) approach, a specific set of income attribution rules contained in the 2006 and 2016 United States Model Income Tax Conventions and recently enacted U.S. treaties, and provides insight into its application.
Effectively Connected Income vs. Permanent Establishment
Effectively connected income: The Internal Revenue Code and an income tax treaty with the United States each employ different rules to (1) determine whether a foreign corporation has a taxable presence for U.S. federal income tax purposes and (2) allocate and apportion the foreign corporation's worldwide income and expenses to the U.S. operations.
Pursuant to the Code, a foreign corporation engaged in a U.S. trade or business is subject to U.S. federal tax on income that is effectively connected with that trade or business. A U.S. trade or business is not well-defined in the Code, with Sec. 864 providing certain guidance regarding personal services performed in the United States. Instead, the determination of a trade or business has developed over years of case law and IRS rulings. The trade or business determination generally is based on the facts and circumstances of each situation. Important factors that seem common among the cases and rulings are the type and nature of the activity, as well as its regularity and extent.
If a foreign corporation undertakes a U.S. trade or business, the income (and expense) allocated and apportioned to the trade or business generally is based on the effectively connected approach. Whether income is effectively connected depends on factors including the source (i.e., U.S. or foreign) and type (e.g., fixed or determinable annual or periodical (FDAP) income, fee income, etc.).
Generally, under Sec. 864(c)(2)(A), U.S.-source FDAP, capital gain, and certain other income are allocable to the U.S. trade or business if (1) they are derived from assets used or held for use in the trade or business (the asset test), or (2) the trade or business activities are a material factor in the realization of the income (the business activities test). All other U.S.-source income is generally treated as effectively connected even if it is seemingly unrelated to the U.S. trade or business, under the "residual force of attraction" principle. Lastly, certain foreign-source income is effectively connected if it is attributable to the foreign corporation's U.S. office or fixed place of business.
Foreign corporations and U.S. tax professionals often overlook the residual-force-of-attraction principle and its U.S. federal tax implications. Again, residual force of attraction provides that all U.S.-source income other than FDAP, capital gains, and certain other types of income is treated as effectively connected with a U.S. trade or business. The potential impact is demonstrated with the following example (see Regs. Sec. 1.864-4(b), Example (3)):
Example 1: A foreign corporation is engaged in the U.S. trade or business of purchasing and selling electronic equipment through a U.S. branch office. The foreign corporation's home office is also engaged in the business of purchasing and selling vintage wines. The foreign corporation's home office places advertisements in periodicals sold in the United States, and U.S. customers place orders directly with the foreign corporation's home office. The foreign corporation sells the wine directly to the U.S. customers without routing such sales through the foreign corporation's U.S. branch. The foreign corporation's U.S. branch office does not participate in, and is not equipped to participate in, the sale of wine.
The foreign corporation's income from purchasing and selling electronic equipment obviously is effectively connected with its U.S. trade or business. Additionally, and less obviously, the foreign corporation's U.S.-source income from wine sales also is treated as effectively connected to the foreign corporation's U.S. trade or business under the residual-force-of-attraction rule.
Permanent establishment: If a foreign corporation qualifies for benefits under a treaty, a foreign corporation with a U.S. permanent establishment is subject to U.S. federal tax on income attributable to the permanent establishment.
Generally, a permanent establishment is a presence in a country through which the business of an enterprise is wholly or partly carried out. A permanent establishment may be created through various activities including (1) a fixed place of business or (2) a dependent agent.
Generally, a fixed place of business is traditionally thought of as an office, factory, branch, workshop, or other space at the disposal of a foreign corporation through which business activities are carried out. However, the OECD commentary to its model tax convention states, "The term 'place of business' covers any premises, facilities or installations used for carrying on the business of the enterprise whether or not they are used exclusively for that purpose." For example, a computer server in the United States may cause a permanent establishment. A treaty typically excludes certain activities from being treated as a permanent establishment. Such exclusions may include facilities for storage, display, or delivery of merchandise and construction projects of a sufficiently short duration.
A foreign corporation may have a dependent agent permanent establishment if a dependent agent conducts business activities in the United States with the authority to conclude contracts for the foreign corporation and habitually exercises such authority. If, however, the agent's authority to conclude contracts and activities associated with contracts is sufficiently limited, a dependent agent's activities in a country may not constitute a permanent establishment.
Generally, an enterprise is not deemed to have a permanent establishment in the United States merely because it carries on business through an independent agent, including a broker or general commission agent, if the agent is acting in the ordinary course of business as an independent agent. The two conditions that generally establish an agent as independent of an enterprise are: (1) The agent must be both legally and economically independent of the enterprise, and (2) the agent must be acting in the ordinary course of business in carrying out activities on behalf of the enterprise. Whether an enterprise's agent is independent is a factual determination, although employees are generally thought to be dependent agents.
The determination of a treaty permanent establishment is based on the facts and circumstances related to activities in each country, which are often fluid. If a permanent establishment exists, an enterprise is taxable on the business profits attributable to it.
Business Profits Attributable to a Permanent Establishment
General treaty approach: A foreign corporation with a permanent establishment under a treaty generally computes its income under the "business profits" article of the treaty. The foreign corporation generally is subject to U.S. tax only on business profits that are attributable to the permanent establishment. In certain treaties, the attributable concept of a treaty may be similar to the Code's effectively connected concept, with certain modifications. However, a treaty may completely override the Code with its own concept of income attributable to a permanent establishment, such as the authorized OECD approach described below.
Tax professionals generally believe that a treaty requires a direct attribution of profits to a permanent establishment, which seems to eliminate the residual-force-of-attraction principle found under the Code. In the wine sale example above, it is difficult to see how the foreign corporation's home office income from vintage wine sales may be attributable to any permanent establishment that purchases and sells electronic equipment. Note that a few older treaties do use the residual-force-of-attraction principle, and thus the wine sale example may result in the same or similar income as with the Code.
The balance of this item focuses on one such treaty-based approach to profit attribution—the authorized OECD approach.
Authorized OECD Approach
The OECD has adopted an authorized approach to computing business profits attributable to a permanent establishment, based on its transfer-pricing guidelines. Additionally, the 2006 and 2016 U.S. Model Treaties use the authorized OECD approach, as do the U.S. treaties with Belgium, Bulgaria, Canada, Germany, Iceland, Japan, and the United Kingdom. Under the authorized OECD approach, a permanent establishment is treated as a "functionally separate entity" for purposes of attribution of business profits. To put that another way, business profits are determined not based on apportionment or allocation but rather based on the arm's-length standard (i.e., transfer pricing). In its simplest terms, the authorized OECD approach applies transfer-pricing principles to branch operations to determine a foreign corporation's U.S. business profits.
Article VII(2) of the 2016 U.S. Model Treaty provides the base language for a transfer-pricing-based approach, stating:
[T]he profits that are attributable in each Contracting State to the permanent establishment . . . are the profits it might be expected to make, in particular in its dealings with other parts of the enterprise, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the other parts of the enterprise. [emphasis added]
The technical explanation to the 2006 U.S. Model Treaty (at the time this item was published, Treasury had not yet published the technical explanation to the 2016 U.S. Model Treaty) provides that an arm's-length method should be applied based on the OECD Transfer Pricing Guidelines. Additionally, Announcement 2012-31, which provides a copy of the competent authority agreement entered into by the competent authorities of the United States and Canada regarding application of the principles set forth in the OECD Report on the Attribution of Profits to Permanent Establishments in the interpretation of Article VII (Business Profits) states:
The OECD Report on the Attribution of Profits to Permanent Establishments (the "Report") was finalized in 2008 and revised in 2010 without change to the conclusions of the Report (the "authorized OECD approach" ("full AOA")). . . . The competent authorities of the United States and Canada therefore agree that, under paragraph 9 of Annex B of the Convention, Article VII of the Convention is to be interpreted in a manner entirely consistent with the full AOA as set out in the Report.
A foreign corporation's qualification under a treaty and use of the authorized OECD approach eliminate the effectively connected approach to allocation and apportionment provided under the Code. Notably, it seems the OECD transfer-pricing guidelines generally may apply and not Sec. 482 and the regulations thereunder (i.e., the U.S. transfer-pricing rules). Although the OECD transfer-pricing guidelines differ from the U.S. transfer-pricing guidelines under Sec. 482, the prescribed methodologies are generally consistent. A foreign corporation's use of the authorized OECD approach to allocate and apportion business profits has several distinct advantages and disadvantages compared with the Code.
Advantages of the authorized OECD approach may include:
- No residual-force-of-attraction rule.
- The ability to limit profits based on a functional analysis of operations performed by the permanent establishment. In certain circumstances, permanent establishment may be operationally structured as a limited risk distributor thus limiting its profitability, as compared to the Code methodology that apportions the permanent establishment a share of global income.
- Certain transactions between the permanent establishment and head office may be deemed to occur, and otherwise disregarded expenses may reduce income.
- More certainty in cross-border arbitration cases, as it reduces bias inherent in cross-border disputes involving the Code.
Disadvantages of the authorized OECD approach may include:
- Recognition of U.S. federal income based on transfer-pricing rules irrespective of a U.S. business operating at an overall loss under the effectively connected income methodology (see below).
- Increased administrative costs for transfer-pricing analysis that must be undertaken.
Income recognition under the authorized OECD approach, compared with losses recognized under the Code's effectively connected income approach, is possible when a foreign corporation commences U.S. operations (e.g., market penetration) or the foreign corporation is generating overall losses (e.g., the startup phase). If the foreign corporation established a U.S. subsidiary, the foreign corporation may wish to limit its U.S.-source income in future years by considering, where appropriate, a limited-risk transfer-pricing model (e.g., cost-plus or target operating margin). Such a model causes the U.S. subsidiary to likely incur U.S. federal income currently (irrespective of direct U.S. expenses or systemwide losses), with more limited U.S. federal income potential in the future.
Similarly, under the authorized OECD transfer-pricing approach that treats the U.S. permanent establishment as a separate entity, the foreign corporation may wish to report U.S. federal income under a limited-risk transfer-pricing model where appropriate. Such a model may cause the foreign corporation to incur income for U.S. federal tax purposes, while the U.S. permanent establishment may be in an overall loss position under the Code's effectively connected income methodology.
Note that the foreign corporation may choose to forgo a permanent establishment limited-risk model under the authorized OECD approach and use a full risk-bearing entrepreneurial model for transfer pricing that is similar to the Code's effectively connected income standard, which may result in losses for U.S. federal income tax purposes during the market penetration or startup phase. However, the foreign corporation's use of an entrepreneurial transfer-pricing model may result in significant U.S. profits becoming attributable to the U.S. permanent establishment in future years, thus increasing taxes in such years as compared with profits that would be attributable under a limited-risk distributor model.
Forgoing Treaty Benefits
If it so desires, a foreign corporation that qualifies for benefits under a treaty might not claim those benefits. However, certain treaty benefits are typically desired—in particular, a treaty's reduction (possibly to 0%) of the Code's standard 30% withholding tax on dividends, interest, and royalties. The question then arises whether a foreign corporation can forgo certain aspects of a treaty if its permanent establishment attribution methodology produces higher U.S. federal income, as compared with the Code's effectively connected income methodology.
The answer to this question is not as apparent as it would seem. The technical explanation to the 2006 U.S. Model Treaty provides:
[A] taxpayer's U.S. tax liability need not be determined under the [treaty] if the Code would produce a more favorable result. A taxpayer may not, however, choose among the provisions of the Code and the [treaty] in an inconsistent manner in order to minimize tax.
The technical explanation to the 2006 U.S. Model Treaty also provides an example of the consistency principle. This example is briefly summarized as follows:
Example 2: A resident of a foreign corporation has three separate businesses in the United States. One is a profitable permanent establishment, and the other two are trades or businesses that do not rise to the level of a permanent establishment. Of the latter two trades or businesses, one is profitable, and one is operating at a loss. Under the treaty, the income of the permanent establishment is taxable in the United States, but the other two are ignored. Under the Code, all three would be subject to tax, and the loss from the one trade or business is available to offset the income from the two profitable ventures. However, the taxpayer may not invoke the treaty to exclude the profits from the profitable venture that does not give rise to a permanent establishment and also invoke the Code to claim the loss from the unprofitable venture.
The above example from the technical explanation seems to be a direct inclusion of Rev. Rul. 84-17, where the IRS ruled similarly under such facts. The Model Treaty technical explanation further provides that the taxpayer may "invoke the Code for the taxation of all three ventures," but would not necessarily be "precluded from invoking the [treaty] with respect, for example, to any [U.S.-source] dividend income . . . that is not effectively connected with [the business ventures]."
Unfortunately, and importantly, the technical explanation does not address the impact on future years of forgoing treaty benefits. For example, could a foreign corporation annually switch back and forth between the Code and the treaty for calculating U.S. federal income, or is a foreign corporation required to keep its methodology for calculating income for a period, possibly indefinitely? Furthermore, if employing the Code's effectively connected income methodology, the foreign corporation should still be analyzing its business model if the foreign corporation is considering potential use of a limited-risk transfer-pricing model in the future.
Thus, a careful analysis must be performed, considering the consistency principle discussed above, to determine whether the treaty or Code approach to attributing business profits should be applied to the foreign corporation's current U.S. activities. The foreign corporation also must consider the impact this choice may have on future tax years. All facts must be evaluated to accurately assess the benefits and burdens of either approach.
Calculating business profits attributable to a branch can be complex, and the authorized OECD approach is no exception. Applying the arm's-length standard to a permanent establishment is ground yet to be heavily trodden and is likely to cause increased U.S. federal compliance costs. However, the authorized OECD approach provides potential for a foreign corporation to develop and implement a transfer-pricing model that limits its U.S. federal income tax exposure. Therefore, foreign corporations should proactively evaluate their U.S. permanent establishment—weighing the pros and cons of both the Code and the authorized OECD approach methodologies for calculating U.S. taxable income. Of course, a foreign corporation requires an informed U.S. tax adviser who can advise the foreign corporation of its choices and help determine the current and future U.S. federal tax impact of the foreign corporation's potential business models.
The authors thank Allen Brandsdorfer for his helpful comments, edits, and insights.
Greg Fairbanks is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.