Foreign Company Engaged in U.S. Trade or Business

When is a Foreign Corporation Engaged in a Trade or Business in the U.S.?

I. INTRODUCTION

Many foreign corporations (hereafter "FC") which are based in countries that do not have an income tax treaty with the United States (hereafter "U.S."), sell products to purchasers located in the U.S.. Often, the contracts for the products are negotiated overseas and shipment of the goods is made directly from the FC to the U.S. customer.

This explanation will discuss, in general terms, how U.S. tax law applies to those sales. In particular, this document will discuss under what circumstances the FC will be liable for the payment of U.S. income taxes on those sales.

This explanation will consider the following hypothetical situations:

Example I: Parent Corporation (hereafter "Parent"), an FC based in Taiwan negotiates the sale of computer display screens (hereafter "screens") to Compac, a U.S. corporation based in Texas. All negotiations take place in Taiwan and the contract is signed in Taiwan. Shipment will be made to ACME TRADING (U.S.A), Corp. ("ACME") who will then clear the shipment through customs and place the screens in its bonded warehouse.

Example II: This example is the same as Example I, except that the FC has a wholly-owned subsidiary (hereafter "Sub") with a fixed place of business in California and has employees located at its business site. Sub’s employees will engage in after-sales service of the screens, will call on Compac to determine its satisfaction with the screens and to make further sales of the screens.

Situation A: In this situation, ACME merely ships the entire order of screens to Compac once the screens have cleared customs.

Situation B: In this situation, Parent will use ACME as its agent to warehouse the screens and will provide Compac with "just-in-time" (hereafter "JIT") inventory of the screens. Under JIT, Compac will either notify Parent or ACME when it needs a shipment of screens and ACME will then ship the screens. Legal title to the screen will remain with Parent until the screens are shipped to Compac.

II. ISSUES TO BE DISCUSSED

Whether Parent will be considered as having engaged in a trade or business in the U.S., and, therefore, be liable for U.S. income taxes on that portion of its income that is effectively connected with its U.S. trade or business, under:

a. Example I, Situation A: When Parent merely ships goods directly to its customer in the U.S.;

b. Example I, Situation B: When Parent ships goods to ACME who will inventory the goods in its bonded warehouse under the concept of JIT inventory; or

c. Example II: When Parent has a U.S. subsidiary with a fixed place of business in which the subsidiary provides sales and services in connection with the sale of the screens.

III. CONCLUSIONS

1. Under Example I, Situation A, Parent will not be engaged in a trade or business in the U.S. and will not file a U.S. tax return.

2. Under Example I, Situation B, the activities of ACME with respect to the JIT inventory of Parent’s screens, where the sale of those screens occurs once Compac decides to purchase the screens, will cause Parent to be engaged in a trade or business in the U.S. and Parent and will have to file a U.S. tax return.

3. Under Example II, Parent will be engaged in a trade or business in the U.S. and will have to file a U.S. tax return. This would be true even if the subsidiary was engaged in a totally separate line of business, such as the sale of vintage wines in the U.S..

Note: Even if Parent is engaged in a trade or business in the U.S. and, therefore, will have to file a U.S. income tax return, the actual taxes may be minimal.

IV. ANALYSIS

A. General Explanation of the Law

Income from sources within the U.S. is subject to taxation under IRC Sec. 861. Under IRC Sec. 864(b) and (c), when a FC is engaged in a trade or business in the U.S. (hereafter "ETB"), it is taxed on the portion of its income that is effectively connected with its trade or business (hereafter "ECI"). The tax is computed, in general, in the same manner as a U.S. corporation or individual doing business in the U.S.. Taxes are computed on a net income basis (gross income less deductions). Corporations generally pay tax on their net incomes as follows:

Taxable Income Rate

No income to $50,000 15%

From 50,001 to $75,000 25%

Over 75,000 to $10,000,000 34%

Over $10,000,000 35%

Therefore, a FC with taxable income of $10,000 will pay a $1,500 tax on its income. Distributions of dividends from the Sub to Parent will be taxed at a flat rate of 30% under IRC Sec. 881(a) when the dividend is paid.

In general, a FC uses the same rules as a domestic corporation to calculate its net book income which is subject to taxation; however, the FC is subject to tax only on its effectively connected net book income. In other words, income and deductions are determined with respect to the FC’s U.S. business operation, as determined on its applicable financial statement. See IRC Reg. 1.56-1(b)(6)(ii)(B).

In addition, if the FC operates a branch in the U.S., rather than a corporation, there could be a branch profits tax of 30% under IRC Sec. 884 (as though a dividend were paid to Parent under IRC Sec. 881(a)), in addition to the regular tax on ECI under IRC Sec. 11. The purpose of the branch profits tax is to equalize the tax treatment between a FC that uses a corporate subsidiary or an unincorporated branch in the U.S. Therefore, using a branch office in the U.S. will subject the FC to an immediate double taxation on its ECI.

B. U.S. Trade or Business

A FC engages in a trade or business in the U.S. when it is involved in a profit-oriented activity within the U.S., either directly or indirectly, or through agents, when the activity is regular, substantial and continuous. CM v. Spermacet Whaling and Shipping Co., 281 F2d. 646 (6th Cir. 1960). The court in Spermacet found that a company that hunted whales on the high seas for sale to a U.S. oil refiner was not engaged in a U.S. trade or business despite close financial links to the U.S..

Sales by a FC to U.S. customers directly, without the use of an office, agent or employees in the U.S. is generally not a trade or business. U.S. v. Balanovski, 131 F Supp. 898 (S.D.N.Y. 1955). Green Export Co., v. U.S. 285 U.S. 383 (Ct. Cl. 1961); Perry Group, Inc. v. U.S., 1980-2 USTC ś 9603 (D.C. N.J. 1980). Use of a sales person in the U.S., however, will cause the FC to become ETB. Revenue Ruling 56-165, 1956-1 CB 849.

In Example I, Situation A, Parent has no office or employees in the U.S. and is not conducting business through an agent located in the U.S.. Consequently, FC is not engaged in a U.S. trade or business.

In Example I, if the FC sells screens and then sends its employees to the U.S. to advise Compac in connection with the screens, the FC will not be ETB, according to Private Letter Ruling 7739023. If, however, the FC sends its employees for the purposes of selling additional screens and if the employees have the power to enter into binding contracts with Compac, then the FC will be ETB according to Revenue Ruling 56-165, 1956-1 CB 849 and Revenue Ruling 55-282, 1955-1 CB 634.

C. Effectively Connected Income From U.S. Sources

ECI is taxed by IRC Sec. 882(a) at graduated rates and a FC deducts all expenses incurred in earning ECI, just like a domestic corporation. U.S. source income that is not ECI is generally considered "fixed or determinable, annual or periodic" income (hereafter "FDAP") and is taxed at a flat rate of 30%. FDAP income includes, interest, dividends, rents and royalties.

Income that is not FDAP is considered ECI if it comes from sources within the U.S., such as inventory and other property held for sale to customers in the ordinary course. This rule applies, whether or not the income is actually connected with the FC’s U.S. trade or business. IRC Sec. 864(c)(3). To illustrate this point, Rhoades and Langer in their treatise, Taxation of Foreign Investors, ś 2.31[2][a] use the following example (which has been modified by this explanation):

Bettco Company, SA, a Brazilian corporation, engages in business in a number of unrelated fields. For the last few years, it has sold vintage wines throughout the world, including, on infrequent occasions, the United States. Although title to the wine passes upon acceptance of the buyer in the United States with the result that the income is from U.S. sources, Bettco has been properly classified as a passive investor taxpayer because its contacts with the United States are not sufficiently broad to cause Bettco to be doing business in the United States.

Hence, since Bettco is not engaged in business in the United States and since its income from U.S. sources is not FDAP, none of Bettco’s income has been subject to federal income tax under IRC Reg. 1.1441-2(a)(3).

In 1995, Bettco opens an office in the United States for the purpose of assembling and selling certain radio components Bettco manufactures in Brazil. Bettco thereby begins to engage in business in the United States. As a result, even though the sales of wine have nothing at all to do with Bettco’s U.S. office, the income from sales of the wine in the U.S. will be taxed at ordinary income rates, despite the fact that the wine sales are not conducted in the U.S. because the presence of Bettco’s office in the U.S. makes all U.S. source income (which is not FDAP income) ECI.

Based on IRC Sec. 864(c)(3) as illustrated by the above example, if Parent conducts any business through Sub or branch office, or through an agent, all U.S. source income will be ECI. Therefore, under Example II, Parent will have to file a U.S. tax return by virtue of its operations in the U.S. This result will occur even if the U.S. Sub or branch office was engaged in a business that was wholly unrelated to the sale of screens to Compac.

D. Activities of an Agent

In Situation B, Parent will use ACME as its agent to warehouse its screens and to provide shipment of those screens under the principles of JIT inventory. When a FC employs an agent to do acts that would be considered ETB if the FC had performed those acts through a subsidiary or branch office, the Parent will be considered ETB. Therefore, the agent’s acts are attributed to the Parent for purposes of determining whether the Parent is ETB. This is the result even if the Parent has never been physically present within the U.S.

When the agent is employed to sell goods or products in the U.S., the FC generally holds title to the goods until they are sold and, therefore, it is the FC which is ETB. If, however, the agent is acting on behalf of the buyer and title passes outside the U.S., there would be no agency relationship between the FC and agent. Also, if FC establishes a distributorship with its subsidiary under an independent and arm’s length relationship, the FC will not be ETB. Handfield v. CM, 23 TC 633 (1955), Private Letter Ruling 7931056.

In Private Letter Ruling 7909063, the IRS found that a FC which sold goods exclusively outside the U.S., and which formed a subsidiary to maintain an inventory of its goods in a warehouse, provided general accounting operations relating to the inventory, received payments from customers and paid all expenses relating to the operation of the facility, was not ETB. This ruling determined that the warehousing and accounting of goods in the U.S. was not a material factor in the sale of such goods since all sales occurred outside the U.S. The ruling substantiates the conclusion that operation of a warehouse to maintain an inventory of goods in the U.S. for sale in the U.S., will cause Parent to be ETB and will subject it to U.S. taxation.

In Situation B, ACME’s activities with respect to JIT will cause Parent to be ETB in the U.S. This result will occur whether or not Parent has an office or employees located in the U.S. Direct sales made by Parent to its customers in which title to the screens is transferred to Compac outside the U.S., and in which ACME merely clears the shipment through customs, will not cause Parent to become ETB.

E. Observations and Suggestions

1. Use of ACME to perform JIT inventory functions or otherwise operate on Parent’s behalf with respect to the sales of screens in the U.S., will cause any FC to become ETB and will subject its ECI to U.S. income tax at graduated rates.

2. If goods are sold by Parent directly to U.S. customers in which title passes outside the U.S. and in which ACME merely provides customs brokerage services to Parent, Parent will not be ETB and no U.S. taxes will be owed.

3. Even if Parent sells goods directly to U.S. customers under Paragraph 2 above, if Parent has an office, employees or uses an agent to represent it in the U.S., it will be ETB in the U.S., and all of its U.S. source income will be ECI, even if the goods sold have no relation to the business activities in the U.S..

4. The payment of U.S. taxes may be minimal since the Parent is entitled to the same deductions as any domestic corporation would receive under the U.S. tax code, and its taxable income will be taxed at graduated rates, starting at 15%. Therefore, if the Sub can generate sales of 20% or more, the U.S. tax will be offset by the increased sales. Also, all the Sub’s expenses can be deducted from any taxable income generated by the sales of the screens. Furthermore, the profit attributable to the sale of the screens could be reduced by allocating indirect expenses, such as general overhead, interest costs and R&D costs, to the cost of producing the screens.

5. The transaction might be restructured so that ACME does not engage in significant business activities on behalf of Parent in the U.S. If JIT inventorying of the screens could be performed: (i) in another country (possibly Mexico or Canada, depending on how those countries would treat the warehousing of goods destined to the U.S.); or (2) by ACME, as agent for the purchaser, in which the purchaser took title to the screens overseas, but ACME warehoused the screens for purchaser in the U.S., Parent might avoid ETB status under Example I.