Hot Topics: Memorandum: Tax Planning Opportunities for Foreign Consultants Working in the U.S.

I.  FACTS:

            In 1995, Taxpayer Smith (“Taxpayer”), a non-resident alien and citizen of France, formed ABC Limited, an Isle of Man company (“ABC”).  The taxpayer was the sole shareholder of ABC.

            On December 1, 1997, XYZ Dotcom, Inc. (“XYZ”), a U.S. corporation, wrote ABC inquiring about utilizing the services of Taxpayer as a consultant to XYZ in the field of high-tech software programming.  The letter stated that ABC, as Taxpayer’s employer, would be responsible for taxes, worker’s compensation and medical insurance.

            On January 1, 1997, ABC and XYZ entered into a Consulting Agreement wherein ABC was obligated to provide a qualified consultant to perform high-tech engineering services for XYZ.  Under the Consulting Agreement, ABC had the exclusive right and responsibility to hire the person who would perform the consulting services.  Both the contract between ABC and XYZ and the agreement between ABC and the Taxpayer were negotiated outside the U.S.

            On January 6, 1997, ABC entered into an agreement with Taxpayer to perform the services requested by XYZ.

            On March 1, 1997, XYZ applied for an H-1B nonimmigration visa for a “European Communications Software Specialist”  naming Taxpayer as the beneficiary of the visa request.  The request was subsequently granted.

            Taxpayer began working in the U.S. in March, 1997 for XYZ and was physically present in the U.S. during that time.  Payments for the consulting services were made directly to ABC.  Taxpayer was paid by ABC, in accordance with his agreement with ABC.  ABC maintained no office or other fixed place of business in the U.S. and was not engaged in any trade or business within the U.S.

II.   ISSUES:

1.       Was ABC a U.S. company or was it engaged in a trade or business in the U.S. by virtue of Taxpayer’s consulting services for XYZ.

2.         Are there tax reporting requirements imposed on ABC or Taxpayer arising from receipt of payment by ABC from XYZ and payment of fees by ABC to Taxpayer?

III.   CONCLUSION:

            1.  ABC was not engaged in a trade or business in the U.S.  It merely contracted with an individual outside the U.S. to provide consulting services to a company located within the U.S.  ABC did not receive income under the personal holding company rules since the consulting agreement did not generate personal holding company income.

            2.  ABC did not have a foreign shareholder since its sole shareholder, Taxpayer, was a U.S. resident for tax purposes by virtue of his physical presence in the U.S. during the time he performed the consulting services.  Thus, Form 5472, which must be filed when a corporation has a foreign shareholder who owns, directly or indirectly, 25% or more of the stock, does not apply in this instance.

IV.   ANALYSIS:

            A.  ABC was not engaged in a trade or business in the U.S.

            A corporation is considered a foreign personal holding company when five or fewer individuals own, directly or indirectly, more than 50% of the corporation, provided those shareholders are U.S. taxpayers (U.S. citizens or residents – see IRC Sec. 7701 (b) and the regulations regarding the definition of U.S. taxpayers).  ABC met the definition of a personal holding company since a U.S. taxpayer controlled 100% of the company’s stock by vote and value.  As such, it could be subject to U.S. tax if the company had personal holding company income.  However, the sole source of the company’s income was its Consulting Agreement with XYZ, a personal services contract, and only under certain circumstances, will a personal services contract generate foreign personal holding company income.  IRC Sec. 553(a)(5)

            The personal services contract income provision was intended to prevent the diversion of personal services income to a controlled corporation.  The tax-planning concern expressed by Congress related to the issue whereby individual taxpayers could choose to divide personal services income between themselves and their corporation, thereby lowering the effective tax rate on the income because corporations historically pay tax at lower rates than individuals, especially in the 1930’s when this provision was enacted.

            Foreign personal holding company income constitutes amounts received by a foreign corporation under a written or oral contract for that corporation to provide personal services only when two conditions are met:

(1)  Some person other than the foreign corporation has the right to designate the individual performer(s) of the services, or the contract designates the performer by name or description, IRC §553(a)(5)(A) and

(2)  At some time during the tax year in which the foreign corporation receives the income, the designated performer(s) under the contract owns 25% or more in value of the outstanding stock of the corporation, IRC Sec. 553(a)(5); and IRC Regs. 1.553-1, 1.543-1(b)(8)).

            Proper drafting of a personal services contract generally should avoid foreign personal holding company income.  As long as the contract gives the foreign corporation the actual right to designate the service provider and retains the legal authority to select the person(s) who will perform the services, the foreign company will not have income under the personal services rules described above.  The fact that the contracting parties understood which individual(s) would provide the services is irrelevant, provided their understanding was not included in the agreement.

            The IRS has privately ruled that the designation of an individual by name or by description must be explicit in the agreement, and generally cannot be inferred.   In PLR 8237109 – a corporation’s sole employee performed legal services under a personal services contract, however, the person was not actually named or described.  The IRS ruled the corporation’s income was not personal holding company income under IRC Sec 543(a)(7)(A), an analogous provision to IRC Sec. 553(a)(5).

            IRS looks to whether or not third parties have a contractual right (either written or oral) to require the performance of services by the controlling shareholder in determining whether personal services contract income exists.  Thomas P. Byrnes, Inc. v. Cm., 73 T.C. 416, 422-23 (1979).  In Byrnes, the court held that a corporation’s right to veto the selection of a service provider made by a corporation did not constitute a right to actually select the person designated to perform services, thus, no personal holding company income arose from the contract.

            IRS has ruled that income earned by shareholder employees of foreign corporations under personal services contracts was not foreign personal holding company income where clients of the corporations did not have a contractual right to receive the specific personal services of the shareholder employees and where the services involved were not so unique as to preclude substitution.

            In TAM 9810002, IRS privately ruled that a corporation which retains the right to designate personal service providers should one of two people named in the original contract be unable to perform, does not have personal service income.   Citing a series of Revenue Rulings, IRS concluded:

            Under Rev. Ruls. 75-67, 1975-1 C.B. 169, 75-249, 1975-1 C.B. 171, and 75-250, 1975-1 C.B. 172, if a corporation or employee/shareholder of the corporation contracts with a client that the employee/shareholder personally will perform particular services for the client and the service provider has no right to substitute another individual to perform these services, the employee/shareholder is designated to perform personal services under the contract for purposes of section 543(a)(7).

            In this case, B and C are named in the Agreement as the individuals who will provide the management services.  ... the Agreement provides that in the event of death, retirement, disability, or other occurrence that prevents one of B and C from providing the services contemplated by the Agreement, Taxpayer [corporation] must retain the services of someone acceptable in good faith to [customer] to provide the full-time management services. Consequently, Taxpayer has the right to substitute another individual for B or C when B or C ceases or fails to perform the management services contemplated by the Agreement. The substitution could be made without any apparent effect on the contractual relationship. Further, only Taxpayer has the right to designate the individual who will perform these services. Therefore, although B and C are named in the Agreement, they are not designated to perform personal services under the Agreement.

            In the ABC-XYZ Consulting Agreement, XYZ had no contractual right to receive the specific personal services of ABC’s sole shareholder and his services were not so unique that he was the only person qualified to perform them.  Thus, ABC did not have personal services income under the Consulting Agreement with XYZ.

            B.  Reporting Requirements  - Form 5472

            Under IRC Sec. 6038A, transactions between a U.S. corporation and a foreign shareholder or shareholders owning 25% or more of the corporation must be reported on Form 5472.  However, for the reporting requirements of Form 5472 to apply, there must be a 25% foreign shareholder.   In the present situation, Taxpayer was the sole shareholder of a foreign corporation and because he was physically present in the U.S. throughout the period of the Consulting Agreement, he was a U.S. taxpayer and not a foreign shareholder.

            Even if Form 5472 were to apply, there are liberal “reasonable cause” exceptions to penalties for small corporations that would place ABC beyond the reach of this requirement. Also, it is the corporation and not the shareholder who is penalized, and in this instance, ABC has liquidated, so that there is no extant entity to which penalties can apply.