The article below is a technical discussion on how investors investing or doing business within the United States could run into some serious tax problems. For those that prefer to avoid problems, planning before they take action is the best approach. For those already doing business in the US must ask the question of whether they are operating correctly or are they at risk?
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FOREIGN INVESTORS BEWARE: ATTRIBUTION OF U.S. TRADE OR BUSINESS THROUGH U.S. AGENTS
Authored by JACOB STEIN - from the Checkpoint Tax Research Service
JACOB STEIN is an attorney with Klueger & Stein, LLP, in Los Angeles. His practice focuses on international taxation and structuring cross-border transactions. He may be reached at firstname.lastname@example.org
Foreign investors, almost uniformly, dislike paying U.S. taxes and filing U.S. tax returns. In many countries, for cultural, political, or personal safety reasons, privacy is paramount. Disclosure of one's financial affairs to any government is viewed as risky and something to avoid. Taxation of income earned in the U.S. may be unavoidable, and many foreign investors recognize that. However, with proper planning, it is possible that the U.S.-sourced income, while taxed by the U.S. at the corporate level, will not be taxed to the foreign investor personally. It is also possible that the foreign investor will avoid U.S. tax return filing obligations. As the Practice Alert (excerpted from a more extensive article in the September issue of the Journal of International Taxtion ¶ 09201413 ) explains, with proper planning for U.S.-sourced income, a foreign investor can avoid U.S. tax return filing obligations.
A foreign investor (business entity or individual) is subject to U.S. federal income tax if the investor has passive income sourced to the U.S. (e.g., interest, dividends, rents, or royalties earned in the U.S.) or the investor is engaging in a trade or business in the U.S. If the investor has passive income sourced to the U.S., the income is taxed at a flat rate of 30%. Income that the foreign investor derives from a U.S. trade or business is subject to the standard U.S. income tax rates and requires that a U.S. income tax return be filed. Both passive income and business income can be redirected and taxed in the hands of a "blocker" entity. This is usually a U.S. or a foreign corporation (and sometimes both, in a foreign parent-U.S. subsidiary structure) owned by the foreign corporation. The blocker entity in turn will own passive assets or conduct U.S. business and will be taxed on such income and have to file U.S. tax returns. The foreign investor will hold shares of a corporation (U.S. or foreign) and will not be subject to a U.S. tax return filing requirement.
An area of law that has received little attention or guidance involves a foreign investor that does not own assets in the U.S. and does not engage in a business in the U.S. Instead, the foreign investor uses a third party, located in the U.S., to transact its affairs. When can the activities of the third party be attributed to the foreign investor, causing the foreign investor to be subject to U.S. taxation and a U.S. tax return filing requirement?
Trade or Business. A foreign investor will be deemed engaged in a U.S. trade or business if it conducts commercial activity in the U.S., directly or through an agent. The amount of the commercial activity is not as important as the fact that the foreign investor was active in the U.S. and its level of activity was "considerable, continuous, and regular." The U.S. business must be active, not a mere passive investment or ownership of property. Activities that will not be deemed a U.S. trade or business include preparation for or expectation of engaging in a trade or business; investigation of business opportunities; engaging in activities that are incidental, ministerial, or clerical (as opposed to profit-generating); and ownership of stock in a U.S. corporation.
Use of Agents. A foreign investor may be deemed engaged in a U.S. trade or business by using an agent in the U.S. This is a conjunctive three-part analysis:
1. Does the foreign investor have an agent in the U.S. (i.e., is there an agent-principal relationship)?
2. Are the activities of the agent attributable/imputed to the principal?
3. Is the agent engaging in a trade or business in the U.S.?
The agency relationship will be deemed to exist when the U.S. agent is "dependent" (see below) and:
1. Has the authority, which he regularly exercises, to conclude contracts in the name of the foreign principal; or
2. Carries inventory that belongs to the foreign principal from which orders are regularly filled.
If an agency relationship exists, the Regulations provide further that the agent's office or fixed place of business may be deemed an office or fixed place of business of the foreign investor.
Dependent vs. Independent. Under common law principles, existence of an agency relationship is tested using four factors:
1. The existence of a contract (express or implied) between the agent and principal;
2. The agent's ability to bind the principal;
3. The existence of a fiduciary relationship between the parties; and
4. The principal's right to control the agent's conduct.
According to the Restatement (Third) of Agency, the second factor is the most probative. These common law principles serve as a foundation for all of the statutes and cases discussed below but they are not followed strictly. Internal Revenue Code sections that deal with attribution of activities from agents to foreign principals (Code Sec. 864(c)(4) and Code Sec. 864(c)(5)) are based on the agency rules in the permanent establishment Articles of U.S. income tax treaties.
An agent will be deemed independent if he is a general commission agent or broker, acting independently of the principal and in the ordinary course of his own business. A truly independent agent has his own business, acts on behalf of multiple clients, and does not receive detailed instructions from the principal.
The IRS has published a list of factors that it uses internally to test for independence. It is not an exhaustive list, and in each case different factors may be assigned different weight, but generally, if an agent satisfies a majority of these factors, he will be deemed independent.
If an agent is determined to be independent, his activities are not imputed to the principal. If the agent is dependent, his activities are always imputed to the principal. Once a determination has been made that an agent is dependent, the only remaining inquiry is whether the agent's activities rise to the level of a trade or business.
Determining whether an agent is engaging in a U.S. trade or business is compartmentalized into two inquiries. The first inquiry follows the "trade or business" discussion above and looks to see if the agent is engaging in a business activity that is considerable, continuous, and regular. The second inquiry turns on whether an agent:
1. Has the authority to negotiate or conclude contracts and regularly exercises that authority; or
2. Regularly fills orders to sell the principal's inventory.
The two inquiries overlap and the IRS often muddles them together.
Authority to Conclude Contracts/Fill Orders. Authority to conclude contracts or fill orders is relevant only if that authority is exercised with some frequency over a continuous period. Regularity will not be evidenced by occasional or incidental activity. An agent will not be considered to negotiate and conclude contracts on behalf of his foreign principal regularly if the agent's authority to negotiate and conclude contracts is limited only to unusual cases or the agent must secure authority separately from his principal for each transaction effected.
Special Rules for Trading Stocks and Securities. There are special rules for foreigners who trade stocks and securities in the U.S. Generally, trading stocks and securities in the U.S. is not a U.S. trade or business, even when trading is frequent and the trades are accomplished through a U.S. broker. If a foreigner trades stocks and securities for his own account, he will not be deemed engaged in a U.S. trade or business, even if he has employees or an office in the U.S. This is the exemption that foreign hedge-funds and private equity funds investing in the U.S. often use.
Conclusion. Attorneys are often called to issue legal opinion letters to their foreign clients and use the rules discussed above to guide them on the issue of attributing activities of U.S. agents to foreign principals. When possible, they want to head off the inquiry from the outset. That is accomplished by formalizing the relationship between the foreign investor and its U.S. "consultant" through a written agreement that is mindful of the factors discussed in this article. For example, the agreement will state that the foreign investor has no right to detailed oversight of the consultant's activities, acknowledge that the consultant has other clients, and have the consultant bear his own expenses. Even small details, like referring to the U.S. party as a consultant and not an agent, and setting up a business website for the consultant, are helpful in this line of inquiry.