Tax Court's Taisei case sheds light on the definition of "permanent establishment."

• Author: Pollack, Lawrence A.

EXECUTIVE SUMMARY

Foreign corporations resident in a country that has a tax treaty with the U.S. can avoid Federal income tax on effectively connected income if they do not have a U.S. permanent establishment. Even if they do have a permanent establishment, business profits are exempt if they are not attributable to such establishment. This article focuses on the definition of a "permanent establishment" and examines agency relationships that can result in permanent establishment status. Further, it analyzes Taisei Fire and Marine Insurance Co., Ltd., a recent Tax Court decision that elucidated the distinction between dependent and independent agents in the treaty context.

Foreign corporations resident in a country with which the U.S. has an income tax treaty generally can avoid Federal income tax on effectively connected income (ECI) if they have no permanent establishment in the U.S. U.S. income tax treaties, which generally override the Code, typically provide that a resident of the treaty jurisdiction is exempt from Federal income tax(1) on business profits except to the extent attributable to a permanent establishment maintained by the resident in the U.S. "Business profits" are generally defined to include ECI from commercial activities.

This article analyzes the definition of a "permanent establishments," with particular emphasis on agency relationships that can result in permanent establishment status. Much-needed guidance regarding the distinction between dependent and independent agents in the treaty context was recently provided by the Tax Court in Taisei Fire and Marine Insurance Co., Ltd.(2)

Taxation of ECI Under the Code

Absent treaty protection, under Sec. 882 (a) (1), foreign corporations are subject to Federal corporate income tax on taxable income effectively connected with the conduct of a U.S. trade or business. The threshold determination of whether a foreign corporation's activities in the U.S. rise to the level of a trade or business is subjective, with little guidance provided in the Code or regulations. Case law has held foreign corporations to be engaged in the conduct of a U.S. trade or business based on activities that are "considerable, continuous and regular."(3) In general, the quantum of activity or presence in the U.S. needed to trigger trade or business status is much less than that needed to constitute a permanent establishment.

Under Sec. 864(c) (3), foreign corporations engaged in the conduct of a U.S. trade or business have ECI with regard to U.S.- source income from the sale of inventory or performance of services (the "residual force of attraction" doctrine). In addition, certain foreign-source income may also be ECI under Sec. 864(c) (4) (B) (iii), to the extent attributable to a foreign corporation's U.S. office. For example, U.s.-source ECI would arise if a foreign corporation engaged in the conduct of a U.S. trade or business sold goods into the U.S. with title and risk of loss(4) passing to the purchaser there. On the other hand, if title and risk of loss were to pass to the purchaser outside the U.S., such income would be foreign-source, not ECI. However, if the foreign seller maintained an office in the U.S. to which such income were attributable, it would generally be treated as ECI under Sec. 864(c) (4) (B). Income is attributable to a U.S. office of the taxpayer under Sec. 864(c) (5) (B) if the office is a material factor in the realization of the income and the income is realized in the ordinary course of the trade or business carried on through that office. According to Regs. Sec. 1.864-6(b) (2) (iii), this may occur, for example, if the U.S. office participates in the solicitation, negotiation or conclusion of the sales contract or performs other significant services necessary for the consummation of the sale that are not the subject of a separate agreement between the seller and the buyer.

As was noted, for foreign-source income from the sale of goods to be ECI, the foreign person must have a U.S. office to which such income is attributable. In certain instances, a U.S. office of a dependent agent (or subsidiary acting in the capacity of a dependent agent) can be attributed to the foreign principal. For this purpose, a dependent agent's office may be attributed to its foreign principal under Sec. 864(c) (5) (A) if the agent (1) has the authority to negotiate and conclude contracts in the name of the foreign principal and regularly exercises that authority or (2) has a stock of merchandise belonging to the foreign principal from which orders are regularly filled on its behalf. In contrast, an independent agent's office will not be attributed to the foreign principal, regardless of the agent's contractual authority or maintenance of inventory. Regs. Sec. 1.864-7(d) (3) (i) defines an independent agent as a "general commission agent, broker, or other agent of an independent status acting in the ordinary course of his business...and for compensation, sells goods or merchandise consigned or entrusted to his possession, management and control for that purpose by or for the owner of such goods...." Regs. Sec. 1.864-7(d) (3) (ii) states that die determination as to whether an agent is dependent or independent is made regardless of whether the principal or the agent directly or indirectly owns stock of the other entity.

An important exception under Sec. 864(c) (4) (B) (iii) applies when goods are sold by a foreign corporation for use outside the U.S. and a foreign office of the taxpayer also materially participated in the sale; in such instance, the participation by the U.S. office is neutralized by the foreign office's participation.

Taxation of Business Profits

Under U.S. Income Tax Treaties

As noted above, Federal income tax on business profits can be avoided by a foreign corporation when: 1. the foreign corporation is resident in a country with which the U.S. has an income tax treaty ("foreign resident"), 2. the foreign resident satisfies any limitation on benefits (LOB) article contained in the treaty, 3. the foreign resident's presence within the U.S., either directly or through agents, is not a permanent establishment as defined in the relevant income tax treaty, and 4. the foreign resident elects to be taxable under the treaty rather than the Code.(5)

Alternatively, if the foreign resident has a permanent establishment in the U.S., only that portion of its business profits attributable to the permanent establishment would be subject to Federal income tax in accordance with the treaty. In certain instances, the business profits attributable to a permanent establishment may be less than the amount of ECI otherwise taxable under the Code.(6)

Resident of Treaty Jurisdiction and LOB Articles

The starting point in determining whether a foreign corporation may be entitled to tax treaty benefits is to determine whether the foreign corporation is a resident of the treaty country, as defined in the particular treaty. Most tax treaties generally provide that a foreign...