Documente Academic
Documente Profesional
Documente Cultură
Course Overview:
Outbound Transactions: Citizens, residents, Domestic Corporation
Inbound: Non-residents, Foreign Corporations
Safeguards: Foreign Corporation owned by United States persons
I. OUTBOUND TRANSACTIONS:
Taxed on worldwide income
Source rules become important subject to §911
Foreign Tax Credit ameliorates double-taxation: direct, indirect, limitation
Reg. §§ 1.1-1 (b); 301.7701-1 (a), (b); 301.7701-2(a), (b)(1) - (3), (b)
(8)(i),
(c)(1) - (2)(i); 301.7701-3(a), (b)(1) - (2), (c)(1)(i);
301.7701(b) (2a)-(d)(2) ; 301.7701(b)-3 (a); 301.7701(b)-4a.
Skim: Code §§ 2(d); 11(a),(d); 881(a)(1) and (4); 882(a)(1) and (2).
General Notes:
Under §7701, individuals belong to one of two categories; (1) United States
citizens and resident aliens, who are domestic persons; and (2) non-resident alien
who are foreign persons. According to Regulations §1.1-1 © “every person born or
naturalized in the United States and subject to its jurisdiction is a citizen.” An
individual who has filed a declaration of intent to become a citizen, who is not
admitted to citizenship through naturalization, is deemed an alien and not a
citizen. All US citizens, even if they are citizens of another jurisdiction are subject
to worldwide income taxation.
Under §7701 (b), an alien individual will be considered a United States resident
with respect to any calendar year if: (1) the individual is a lawful permanent
resident of the United States at any time during the calendar year (the “green card
test”), or (2) the individual meets a “substantial presence test”. In addition to
limited elections are available, which we will not take up.
1
1.02
The substantial presence test focuses on the alien individual’s actual physical
presence in the United States. Individual who spends substantial amount of time
in the United States over a period of years have a sufficiently close relationship
with the United States to justify taxing them as residents.
Section 7701 (b) (3) and the Regulations thereunder determine whether the 183
days are met using a composite, weighted measure of the days of physical
presence in the United States over the three-year period including the year in
question and the two preceding years. If an alien’s individual presence equals or
exceeds 183 days using the multipliers set forth in the statute, and equals or
exceeds 31 days during the year in question, the alien individual meets the
substantial presence test and is treated as a US resident, unless the exception
applies.
In the absence of an exception, actual presence of 183 days or more in a year is
incontrovertible evidence of residence.
Section 7701 also negates resident status under the substantial presence test
where the facts and circumstances and the individuals physical presence during
the current year indicate that the individual has more significant ties to another
jurisdiction.
2
Under the “tax home exemption”, an alien individual is treated as a non-resident
even if he meets the substantial presence test for any current year if the individual
(1) is present within the United States on fewer than 183 days during the current
year; (2) establishes that, for the current year, his “tax home” is in a foreign
country; and (3) has a closer connection to such foreign country than the United
States.
§7701 (b) certain alien individuals and their activities are accorded special
exemptions from resident status. Certain days of presence of these “exempt” and
special aliens are not counted towards the individuals United States residency.
Under §7701 (b) (3), special rules apply to four categories of exempt individuals, as
well as to individuals unable to leave the United States for medical reasons, and
certain individuals commuting to or travelling through the United States. In
general, days spent in the commuting or traveling through the United States will
not be counted for purposes of determining presence under the substantial
presence test.
Exempt Individuals
3
Foreign government-related individuals, teachers, trainees, students and
professional athletes competing in charitable sporting events. § 7701 (b) (5) and
Regulation §301.7701 (b)-3 provide detailed definition of the individuals in these
exempt categories. These limitations prevent a timeless pursuit of experience and
knowledge in the United States without contributing to the national revenues.
Medical Conditions
Presence does not arise for any day on which an individual objectively intended to
leave the United States but was unable to leave due to a medical condition or
problem arising when the individual was present in the United States.
Regulation §301.7701 (b)-3 (c) provides that the condition causing the failure to
leave must not be a pre-existing problem or condition known at the time the
individual entered the United States.
Days in Transit
Pursuant to §7701(b)(7)(C) and Regulations §301.7701 (b)-3 (d), days in transit
between the foreign points are excluded as days of presence for the substantial
presence test, presumably because such a traveler must likely cannot utilize his
brief stay in the United States for any purpose sufficiently significant to extend
residency nexus. The exemption is designed to protect individuals who must travel
between airports to change planes or who experience brief US layovers. The
exemption is conditioned on physical presence of less than 24 hours and the
absence of any non-travel activities. Thus, for example, should the individual
attend a business meeting while in transit, the exemption will not apply.
A resident individual’s period of residency in the United States depend on the test
under which the individual obtained residency status. If an alien individual satisfies
the green card test but does not meet the substantial presence test, the
individual’s “residency starting date” is the first day of his physical presence
during a calendar year as a lawful permanent resident, pursuant to §7701 (b)(2)(A)
and Regulation §301.7701 (b)-4. If an alien individual satisfies the green card test
for the current year but is not physically present in the United States during the
current year, the residency starting date is the first day of the following year.
If the substantial presence test is met, residency generally commences on the first
day the individual is present in the United States. However, §7701 (b)(2)(c)
provides for a diminis rule which disregards nominal presence in some cases for
purposes of the substantial presence test. For example, if an individual during a
4
period of actual presence (for example, a house-hunting trip) can establish that he
had a closer connection to a foreign country than to the United States, up to ten
days of presence can be disregarded for purposes of determining the residency
start date.
Under §7701 (b)(2) (a), if an individual meets both the green card and substantial
presence tests, residency commences on the earlier of the residency
commencement dates provided under both tests. Similar rules apply for
determining the alien individual’s residency termination date. Regulation
§301.7701 (b)-4(b) provides the general rule that, for an individual who ceases to
be a resident during a calendar year and is not a resident at any time during the
following calendar year, the residency termination date is the last day of the
calendar year.
Under the substantial presence test, §7701 (b)(2) provides that an individual’s last
day of physical presence will close the period of residency, provided that after such
date the individual has a closer connection to a foreign country for the balance of
the calendar year and is not a United States resident in the next year. The nominal
presence rules may be used to disregard up to ten days of actual presence.
Although these days are disregarded for purposes of determining residency
commencement and termination dates, they are still considered for determining
whether an individual meets the substantial presence test.
5
o If no, non-residents will be taxed under separate regime focusing on
source rules; taxes only specific items of income § 871, 881, 882
Entity Classification:
US Domestic Non-Domestic
Individual US Citizens § 61 Non-citizen, non-resident §
2(s)§ 871
Residents (non-citizens) Foreign Corporation § 881, 882, 11 (d)
– foreign corporation should be taxed
in accordance with 881, 882
Domestic Corporations § 11(a)
Partnership (look at nature of partners)
1-1 Determine the entity classification for United States tax purposes of
the following entities:
(a) A Delaware corporation owned entirely by citizens and residents of Japan.
(b) A Limited Company formed in Singapore.
(c) A Gesellschaft mit beschrankter Haftung (GmbH) formed in Germany and
owned by United States persons, with respect to which neither has any
personal liability under German law.
(d)
(e) A Limited Company formed in Ghana and owned entirely by two United
States persons, one of whom is personally liable for the debts and
obligations of the entity under Ghanaian law.
(f) How would your answer to (d) change if the Ghanian company was owned by
a single United States person who was personally liable for the company’s
debts?
6
§ 7701(a)(4) Domestic-created or organized in US Federal or under US state law.
May not elect
If this were an LLC could use check the box regs to choose corp or P
taxation – if taxed as a P, classification is dependent on the partners (so
probably would be foreign); Delaware LLC Corp. is not a per se corporation,
you can elect.
No default rule?
Individual parties may have income tax from the corporation under the CFC
and PFIC rules
Not on the per se list for corp. Therefore it is eligible to elect tax treatment as a
corporation or partnership under the “Check the Box” regulations in 301.7701-3.
Default rule: International companies are default treated as corporations
under check the box if there is limited liability for all members
(d) A Limited Company formed in Ghana and owned entirely by two US persons,
one of whom is personally liable for the debts and obligations of the entity under
Ghanaian law. Foreign? Yes. Corp? NO
Not a per se corp, company may elect treatment under check the box
By default it will be treated as a partnership because only one party has
limited liability
o Note: Foreign companies have greater flexibility to use check the box
rules in US
(e) Same as (d) except owned by single US person who was personally liable.
Foreign? Yes. Corp? No
Still default will be treated as a disregarded entity (single owner; sole
proprietorship/branch). May elect
Policy Side-Note:
A US entity/citizen/resident is taxable by US on worldwide income regardless of
source, graduated rates
7
Cook v. Tait – US Citizen moved to Mexico. SC says that citizenship confers
benefits no matter where you live, can be taxed as a nonresident on worldwide
income.
Questions to Answer:
Is the individual a United States resident?
If so, when does their residency begin/end?
o Begin: §7701(b)(2)(A) - first day present while lawful permanent resident
o End: §7701(b)(2)(B) - after last day present
o
1-2 Paulina has never been in US prior to move to San Francisco February 1, Year
1. Paulina moved after applied for (and received) a green card from US. She has
lived in San Francisco since that time.
(a) Is Paulina resident alien Year I? Under what test(s) is she be a resident alien?
Residency start date?
Yes resident under the “green card test” § 7701(b)(6) lawfully accorded
privilege of residing permanently in US and not revoked or abandoned
Residency begins on Feb 1st because Green card was already received. Prior
to Feb 1, non – resident.
(b) Like (a) instead Paulina moved to San Francisco under a temporary visa on
February 1, Year 1, and she lived there until her application for permanent
residence was approved on November 15, Year 1?
Issue: Here, Paulina satisfies both the substantial presence and green card test.
Meets substantial presence test under 7701(b)(3). Date is important because
once she becomes a US resident she is taxed on foreign income. Bifurcation
of her tax year.
Under substantial presence test - start date first day present in qualifying
year
Rule: Under the regulations, if you meet both the green card test and
substantial presence test your presence state begins as the earlier of the two
dates
8
(i) In general.--For purposes of subparagraphs (A)(iii) and (B), an individual shall
not be treated as present in the United States during any period for which the
individual establishes that he has a closer connection to a foreign country than to
the United States.
(ii) Not more than 10 days disregarded.--Clause (i) shall not apply to more than 10
days on which the individual is present in the United States
Nominal Presence: May affect the starting date if you can disregard those
days, then the green card may be the earlier of the two dates; Then question
of the first day of counted presence.
(c) How would the answer to (a) change if, instead, Paulina moved to San Francisco
on October 15, Year 1, and her application for permanent residence in the United
States was granted on December 1, Year 1?
Only Green card test satisfied, residence for tax purposes begins December
1, first day lawful
1-3 Eduardo citizen of Peru, present in US for 90 days during Year 1, 120 days in
Year 2, and 125 days in Year 3. Not a lawful permanent resident during any of
those years and not present in US before Year 1.
Note: Actual presence for 183 days or more for the year under review is
incontrovertible evidence of residence, as long as the individual is not exempt
under the statute.
Tax Home Exception: Where the facts and circumstances indicate that the
individual has more significant ties to another jurisdiction, an individual will be
treated as a non-resident if they are (1) present less than 183 days during the
current year; (2) establish that for current tax year their “Tax home” was in a
foreign country; and (3) have closer connection to the foreign country
§162(a)(2) Tax Home: located at an individuals regular place of business, or
abode
9
Factors for indicating tax home are in §301.7701(b)-2(d) “more significant
contacts”
(a) What is Eduardo's residency status in the United States for each of the three
years?
Eduardo fails aggregation prong of the Substantial presence test, as such he is a
non-resident all years.
Year 1 residency status: 90 days aggregate – fails second prong. Non-resident
Year 2: 120 days + 90 * 1/3 = 150 days aggregate. Non-resident
Year 3: 125 days + 120 * 1/3 + 90*1/6 = 125 + 40 + 15 = 180. Non-Resident
(b) How would answer to (a) change if Eduardo was present in the United States
for 190 days in Year 3?
Year 1 and 2 would remain the same
Year 3: 190 + 40 + 15 = 245. Resident under substantial presence for year 3
(c) How would (a) change if present for 360 days in Year 1, 300 days in Year 2, and
30 days in Year 3?
Year 1: Resident for Year 1 regardless because >183 days in Year 1
Year 2: Resident for Year 2 regardless because >183 days in Year 2
Year 3:
§7701(b)(3)(A)(i) – De minimis exception because now you are in the country
for less than 31 days
o Reg §301.7701(b)-1(c)(4)
Non-resident for Year 3, despite residency in Year 1 and 2 and fact that
aggregate is > 183
(d) How would (a) change if Eduard was present for 90 days in Year 1, and 180
days in Year 2 and 150 days in Year 3? Assume Eduardo spent the remainder in
Peru where his wife and children still live, where he operates a thriving business,
and where he is registered to vote and licensed to drive, and that Eduardo travels
to the United States in order to sell the widgets produced by his Peruvian
business.
Result: Under (a), Eduard would typically satisfy the residency requirement in
Years 2 and 3. However, under 7701(b)(3)(B) qualifies with a closer connection tax
home exception because the factors weight heavily in Eduardo’s favor that his
actual tax home and lifestyle nexus is that of Peru
NOTE: With weighted average substantial presence ONLY, there is Tax Home
exception; can argue has a closer connection to foreign country. (cannot be present
183 days or more or applied for green card…)
10
Connections: List of factors are outlined in §301.7701(b)-2(d) regs, similar to §
162(a)(2) including:
(b) After four years in the United States, Geir's student visa was set to expire upon
his graduation on May 1. He did not find a job, so he planned to skip
commencement ceremonies and return to Ghana. As Geir was driving to the
Tucson airport on April 28 to catch his flight home, he was distracted by the
beauty of the Tucson countryside and drove into an embankment. Geir recovered
from the accident but only after being immobilized in a body cast until December
28 of the year of his graduation. He flew home on December 31 of that year. What
was his residency status that year?
Geir was a lawfully exempt student until May. After May 1, he would have to
account for the days spent in the United States but for exemption for persons
suffering from medical conditions, which “arose while the individual was present in
the United States.” §7701(b)(3)(D)(ii).
The regs further explain the conditions for exemption of medical condition
(301.7701(b)-3(c)). Because he left within a reasonable period of time after being
totally immobilized (Dec. 31) No days would count for residency status that year,
and he is considered a non-resident because of intend to leave.
11
NOTE: Family members are not specifically listed in statutes; but there would be a
good faith argument
* Also if there was no real presence don’t worry about the reasonableness of
departure
1-5. Lidia, a citizen and resident of Bolivia, considered moving to US even though
she had never been to the country. She visited the United States for 15 days in
February of Year 1. The trip convinced her to make the move. In May of Year 1, she
spent 20 days in Atlanta on a house-hunting trip and on September 3, Year 1, she
moved to the United States where she continues to be present and reside
domestically.
(a) What is Lidia's residency status for Year 1?
Lidia has neither applied for a green card, nor will she meet the substantial
presence test for Year 1.
o Total days was 154 (15 + 20 + Sept. 3 – Year End)
(b) May Lidia elect to be treated as a resident for any portion of Year 1? If so,
under what circumstances would she want to make this election?
The rules for election are in 7701(b)(4) and allow a non-resident alien to make a
residency election if:
Lidia does not meet the green card or substantial presence test,
Lidia will meet the substantial presence test for the calendar year following
the year of election
Lidia must remain in US for 31 consecutive days in Year 1 and from the start
of that 31 day period she was present for 75% of the time. Residency
begins when she is here and stays till end of year
Result: Lidia will be able to make an election provided she can meet substantial
presence test in Year 2.
§ 6013(g) allows a limited election for non-resident alien spouses of US residents to
file joint tax returns
NOTE: Foreign individuals and corporations not resident in tax treaty jurisdictions
are subject to US taxation only if they derive income from within the US (i.e.,
United States source income) or if they derive income which is effectively
connected to a US trade or business. Passive income (not portfolio interest)
derived by a non-resident is typically subject to a 30 percent tax rate with no
12
allowance of deductions; business income (reduced by attendant deductions) is
subject to tax at the same graduated rates applicable to US citizens and residents.
Incentives for domestic persons to utilize foreign enterprise
(c) If Lidia did not arrive permanently in US until December 8 of Year 1, what is
her residency status? May she elect a different result?
Lidia is a non resident and cannot elect residency status for Year 1 because she
will not meet the 31 consecutive day requirement
(d) If Lidia arrived on September 3, Year 1, but took a vacation in Bolivia for the
entire month of December, Year 1, what is her residency status for Year 1? May she
elect a different result?
Now the issue is whether or not Lidia will be able to meet the 75% of the start date
of the 31 consecutive run. The total number of days to the end of the year
beginning Sept 3, are 27+31+30+31 = 89 days. If Lidia is present only for 65% of
the year (out of 120), does not meet the strict 75% presence requirement
Can elect to treat 5 of the days absent as “present” 301.7701b-4 regs so she
can have the election.
Example:
Person comes to the US, commits a crime and then is detained – are they a
resident?
Congress never thought of this – they did not think about jail
In spite of the statute and regulations, this would be something you would
most likely argue
If you are taken against your will and brought to U.S. soil - unclear
Days transit between foreign points (nonbiz, 24 hrs)– excluded §7701(b)7(C)
from subs. presence
Mexico and Canadian Contiguous Commuters- §7701(b)7(C) to workplace in
US on 75% of days
13
PROBLEM SET II: SOURCE RULES
READ: Code §§ 861 (a) (1)-(6); 862(a) (1)-(6); 863(b) (New Act); 864(a);
865(a), (b), (c), (d) and (g).
Reg. §§ 1.861-2(a); 1.861-3(a)(1); 1.861-7(a), (c), (d);
Overview:
§ 861
§ 862
§ 863 (new)
§ 865
General rule: source of income is the jurisdiction from which the income is derived.
14
Important on outbound activity for citizens, residents and domestic
corporations
o §911 – Citizens or residents of the United States get a foreign earned
income credit.
o Foreign Tax Credit
o §904(a) –limitation on the credit
Safeguards: §951 with CFC and PFIC; as well as §1241
Types of Income §861: The following types of income will be treated as sourced
from in the US
Interest from a domestic corporation or arising from US activities (residence
of the payor)
Dividend - domestic corp & foreign unless < 25% effectively connected with
US for last 3 years
Personal Services - Compensation for labor or personal services performed
in US
Rents and Royalties – from interests in property located (used) in the United
States
US Real Property - Gains, profits, and income from the disposition
Personal Property (governed by §865 as well) residence of seller or having a
US tax home
Inventory - sold or exchanged within US even if purchased outside US
Note: Losses not sourced under § 861; they are allocated and apportioned under
Reg §1.861-8 (source rules) to class(es) of gross income to which they relate.
Separate rules for personal property under Reg §1.865-1
Interest Payments:
15
§861(a)(1) General Rule: Source of the interest income is controlled by the
residence or place of incorporation of the obligor (i.e. the person who owes the
interest on the loan; person paying the interest).
Interest from United States residents and domestic corporations possess a US
source.
Regs §1.862-2 (a)(2)
- In addition to noncorporate residents and domestic corporations, foreign
partnerships and foreign corporations, that are engaged in trade or business
in the US are also considered to residents of the United States for purposes
of interest sourcing rule. Interest paid by a foreign entity will be considered
US source if the entity is conducting trade or business in the US.
Interest paid by (1) foreign partnership and foreign corporations (2)engaged
in trade or business in the US are US source. They are considered resident
for purpose of interest sourcing rules.
(b) $1k interest payment made by Texas Co., a Texas corp, on a general obligation
bond.
16
Interest - look to the obligor to determine source. This payment made by a
“domestic corporation.” This is a corporation that was organized within the US,
and as such this is a US source under § 861(a)(1).
(c) How would (b) change if the interest is paid not by Texas Co. but by its
Singapore branch on a deposit at that branch? Like Texas Co., the branch is
engaged in the commercial banking business.
Exception Covered in 861(a)(2)(A)(i)– interest paid by foreign banking branch
considered foreign source.
NOTE: Under the rule because it’s a branch and not a subsidiary, the payor is a
domestic corporation, BUT there is a specific exception for the branch banking.
(d) How would the answer to (b) change if Texas Co.’s interest payment is made in
Year 4 and Texas Co. derives both US source income attributable to active conduct
of its business in the US and foreign source income attributable to active conduct
of its business outside US? Texas Co.’s gross income is as follows:
Dividends:
General Rule
§ 861 (a) (2) Dividends are generally sourced according to the situs of the
incorporation of the payor corporation.
17
Corporations: typically the situs of incorporation unless effectively
connected US business
(c) How would the answer to (b) change if the dividend was declared in Year 3 but
not paid until Year 4?
* Dependent on when dividend was declared – look at preceding 3 year period.
* Years 1-2 = $5M/$20M. All foreign sourced because only 25% US income, no US
dividend.
18
Once we move from the interest/dividend and receipt of a single item there are a
multiplicity of factors that need to be involved - Apocalypse Now filming and
income, teaching in Seoul/preparatory work
2-3 Evita is a citizen and resident of Argentina. Evita came to US in Year 1 to sell
clothing on behalf of Patagonia, an Argentine corp. Evita is one of many agents
that Patagonia sent to the US in Year 1. Evita makes $3,000 in commissions on
sales to domestic customers during her five-month stay in the US.
(a) What is the source of Evita’s commissions?
Because Evita does not fit into this exception (fails first and third prong) her
income will be considered sourced in the US – where her services were performed
§ 851(a)(3).
(b) How would the answer to (a) change if Evita was in the United States for only
60 days?
Tricky, depends on facts & circumstances whether foreign corp is engaged in trade
or biz in US
19
General Rule for Unlisted Items: §863(a) provides that items not covered in 861
and 862 will be covered by regulations.
1.863-1(d) covers scholarships/fellowships – usually follows situs of grantor,
unless used abroad
General Rule: Fellowship paid by a US institution is US sourced income.
(b) A $100,000 jackpot from the Oregon State Lottery paid to Soledad.
Prize! Under 1.863-1(d) for prizes you look to the location of the payer – so
this is US Source.
Sale of Inventory Property
Inventory that is purchased and soled to customer that is generally sourced, under
the long-standing title passage rule, according to the jurisdiction in which legal
title passes.
§ 1.861–7: An inventory sale takes place “at the time when, and the place where,
the rights, title, and interest of the seller in the property are transferred to the
Buyer.”
General Source Rule for Inventory: Focus is on jurisdiction where title passes;
i.e. DELIVERY
§ 861(a)(6) income derived from purchase of inventory outside US and sale
inside US (under title of passage rule) is US source
§ 862(a)(6) Purchased within and sold without the United States is foreign
source income
§ 1.861–7 restates the rule of § 861 (a) (6): gains derived from the purchase and
sale of personal property are treated as derived entirely from the property where
the property is sold.
§865 (e)(2) (A)- Exception to Title Passage Rule(title passage rule states that
source if US if title passes in the US, and not US if title passes out of US. The
Exception is only relevant only for title passing outside the US)– Applicable to Sale
of personal property including inventory by non-residents.
If the sales income is attributable to an office or fixed place of business maintained
by seller in the United States, the income is deemed United States source.
In determining whether an office or fixed place of business exists, §865(e)(3)-
factory, store or site through which a foreign person engages in a trade or
business.
§865 (e)(2) (B)-Exception to Override in case of inventory property: the presence
of a domestic office or fixed place of business will not cause the gain to be US
source when such inventory is property is destined for export and a foreign source
“materially participates in the sale.”
§ 1.864–6 (b)(3)(1) participation is material if it involves active participation in
solicitation,
contract negotiations, or other “significant” services related to the sale, but not if
participation merely involves giving final approval, displaying samples, holding and
distributing the sale property, providing a place for title passage, or providing
other related clerical functions.
20
If title passes in the US, the inventory gain will be considered US source,
regardless of existence of domestic office but if title passes outside of US, the
inventory gain may be resourced to the US under §865 (e)(2)
Note: Title Passage rule governed by UCC usually at delivery of goods. § 1.861–7:
An inventory sale takes place “at the time when, and the place where, the rights,
title, and interest of the seller in the property are transferred to the Buyer.” Except
attributable to an office or fixed place of business maintained in US
21
Current Section 863(b) provides special rules that source income derived from the
sale of inventory produced within the US and sold outside of the US (or vice versa)
(a Section 863(b) sale) as partly from US sources and partly from foreign sources.
H.R. 1 provision
The bill would amend Section 863(b) to require income from a Section 863 Sale to
be apportioned between US and foreign sources solely on the basis of the
production activities with respect to the inventory sold.
Effective date
Amended Section 863(b) would apply to tax years beginning after 31 December
2017.
Implications
Under current law, the place of sale of inventory for purposes of Section 863(b)(2) is
determined under the “title passage rule.” This rule effectively permits a taxpayer
to elect whether a sale of inventory constitutes a Section 863 Sale — and therefore
whether the associated income is sourced as partly within and partly outside the
US. Amended Section 863(b) would eliminate this bifurcation, and thus would
generally be unfavorable.
2-5 Straw Co. is a domestic corporation that sells drinking straws. Determine the
source of Straw Co.’s income from the sale of its inventory in each of the following
alternative situations:
(a) Straw Co. purchases its inventory from an Ohio manufacturer and sells it to
distributors in Nigeria, with title passing in Nigeria. Foreign Source – title passage
controls
(b) Straw Co. manufactures its own inventory at a factory plant in Ohio and sells it
to distributors in Nigeria, with title passing in Nigeria.
Old answer:
Production & Sales: Most likely for administrative convenience Straw would
employ the 50/50 method to allocate foreign/domestic source income. 1.863-3(c)
(iii) Determination of gross income. The amount of a taxpayer's gross income from
production activity is determined by reducing the amount of gross receipts from
production activity by the cost of goods sold properly attributable to production
activity.
New Answer:
Where manufactured
2-6 $60,000 gain from the sale of an antique automobile located in US and owned
by Soledad, Chilean.
Real Property Interests
Gains from disposition of real property, or an interest in real property, located in
the US is generally sources in the US. If the property is located in the US, it is
foreign sourced.
22
§865. Rules for Personal Property Sales: depends on residence of seller, unless
fixed US business place
Definition of resident under §865(g)(1)(A): (§
865e2A override)
a United States citizen or a resident alien and does not have a tax home in a
foreign country, or
a nonresident alien and has a tax home in the United States, and
any corp, trust, or estate which is a US person (as defined in section 7701(a)
(30)).
Intangible Property
§865(d)(1)(A) different treatment than that accorded to income derived from
personal property
Gain from disposition of an intangible asset (other than goodwill) is sourced under
the regular §865 (a) rule (Residence of seller is Source Rule) but only to extent the
payments in consideration of the sale are not contingent on the productivity, use or
disposition of the intangible.
§865(d)(1)(B) provides that sales of intangible assets for contingent consideration
are sourced under royalty source rules of §861(a)(4) (source rule for royalty is
where used)
§865(d) Exception to Rule on Treatment of Intangible Property (rule being:
Intangible property general source rule is residence of seller, exception source rule
is where property is used if payment is contingent on use of property) GOODWILL.
- Source Rule: Sale of Goodwill is sourced in country where it is generated.
Rents & Royalties:
General Rule: §861(a)(4) and §862(a)(4) – Rents and royalties are generally
sourced according to the jurisdiction where the property giving rise to income is
located or used
§1.861-5 rents and royalties derived from the use or right to use property located
in the US are classified as US income. Covers IPR, intangible assets
§1.861-4 US Patents, copyrights, secret processes and formulas, good will, trade-
marks, trade brands, franchises and other like property.
License characterization
Revenue Ruling 60-226, 1960 -1 CB 26 – in cases where interests resembling
royalties are retained by copyright proprietor along with other rights in the
23
transferred interest, the transaction may under some conditions fail to have the
required characteristic of a sale.
(a) US publisher offers to pay for the exclusive right to publish and sell the work in
the US. Under the proposed contract, Tarek would receive five percent of the
publisher’s gross revenues from each sale.
General rule is the nexus of the use; § 865d1B throws us back to 861a4, so
US Source
24
Still US Source – does not matter who is making the offer – it matters where it will
be used.
(c) A US publisher offers to pay Tarek a fixed sum in exchange for all rights to the
composition.
Non-contingent rent/royalty is either treated as a sale or personal service?
Facts and circumstances lean towards sale – §865 (because sale of personal
property)
o Exception for sale of intangibles – §865 only applies to non-contingent
sales
Fixed fee likely means sale of personal property, residence of seller, foreign
source
(d) The offers in (a) and (b) were made and accepted before Tarek started
composing the symphony.
25
III. OUTBOUND – FOREIGN EARNED INCOME OF UNITED STATES PERSONS
(UNIT 3)
A. 911 Overview
1. Qualified individual?
2. Foreign earned income?
3. Housing cost amount do this next
4. Foreign earned income exclusion subject to a cap
B. 911 Eligibility for Exclusion Must be Qualified Individual Under 911(d)
1. Must have a foreign tax home under 1.911-2(b):
a. Principal place of business, but if no principal place of business, then
b. Place of abode in a real and substantial sense
1) If individual’s place of abode is in the U.S., then typically no
foreign tax home
2) But may maintain a dwelling in the U.S. for family and still be
considered to have a foreign tax home
AND
2. Meet the bona fide residence test of 911(d)(1)(A) and 1.911-2(c):
a. Is a U.S. citizen (or U.S. resident aliens who are citizens or nationals of an
applicable treaty country)
b. Is a bona fide resident of a foreign country continually for at least a
taxable year
1) Facts and circumstances under 1.871-2(b), whether an
individual is a resident for purposes of 911 generally depends upon
the individual’s intentions regarding the purpose of the travel and
the nature and length of the stay abroad
a) Things that can weigh heavily against bona fide residence:
i. Failure to buy or rent a house or room abroad unless
can show it was unreasonable to do so
ii. An individual is not a bona fide resident of a foreign
country if the person makes a statement to the
authorities of that country claiming to be a non-
resident
iii. Excessive absence from the stated jurisdiction of
residence undercuts assertions of residency
OR
3. Meet the physical presence test of 911(d)(1)(B) and 1.911-2(d):
a. Is a citizen or resident of the U.S.
b. Is present in the foreign country for at least 330 full days in a consecutive
12 month period (doesn’t have to be the person’s tax year like the bona
fide residency test)
1) This test is not concerned with intention or the nature and purpose
of the stay abroad
26
C. Excludable Income Amounts
Once foreign tax home and either bona fide residence test or physical presence test have been
satisfied, a taxpayer is eligible to make the election under 911 to exclude from gross income (1)
the “foreign earned income” and (2) the “housing cost amount” (remember that housing cost
amount is determined first because the amount of FEI that can be excluded is equal to the lesser
of (1) the excess of the individual’s FEI over the excluded HCA and (2) the annual exclusion
amount prorated to reflect the individual’s qualifying days)
27
b. The annual exclusion amount prorated to reflect the individual’s
qualifying days (e.g., $80,000 multiplied by the number of qualifying days
in the taxable year / the number of days in the taxable year)
G. Deferred Payments
1. Income earned for services performed abroad must be attributed to the taxable
year in which the employee performed those services pursuant to 911(b)(2)(B)
a. For purposes of computing the FEI limitation, FEI deferred until the
taxable year after the year in which the services generating the income
were performed is not taken into account in the year of receipt but is rather
deemed earned in the year of performance and thus absorbs the limitation
for the taxable year of performance
b. If income is deferred in excess of one taxable year beyond the year in
which the services were performed, the income no longer constitutes FEI
for purposes of 911
H. Computation of Tax Liability Where Exclusion Applies
1. Tax liability must be computed under 911(f), which causes amounts over and
above the excluded income amounts to be taxed at the rates that would have
applied if the excluded income had been included as the first dollars earned
(pushes up into higher tax bracket)
28
foreign country “for an uninterrupted period” which includes an
entire taxable year.
o §1.871-2 -determines whether an individual qualifies largely on the
basis of relevant facts and circumstances. Failure to purchase or rent
a home abroad will weigh heavily against the establishment of
bonafide residence unless taxpayer can show, considering the
demands of employment that it would be unreasonable to do so.
Extended absence from the stated jurisdiction undercuts
residency claims
§ 911d5 cannot make a statement to that country you are a non
resident
Individual who makes such a statement is denied 911 benefits
even if there is prove to the contrary.
Must meet requirement for the entire taxable year (may reside in more than
one foreign country)
A fixed time period (in employment contract) does not preclude you from
becoming a resident of a foreign jurisdiction under §1.871-2; too little time
may keep you from qualifying as a resident. Indefinite stay will qualify the
taxpayer; but it also allows for an extended stay, if necessary for
accomplishing the taxpayer’s purpose in going abroad. The purpose cannot
“be promptly accomplished”
29
Earned Income includes: cash or property, wages, salaries,
professional fees and other amounts received as compensation for
personal services actually rendered
§911(1)(A) – earned income is “foreign” if it is attributable to the
individual’s services performed in a foreign country or countries
during the individual’s qualifying period of bonafide residence or
presence.
Deferred Payments: deemed earned in the year of performance
§911(b)(2)(B)
o Unutilized exclusion from deferred income cannot be carried
over to following years – if you defer more than 1 year you lose
it. If income is deferred in excess of one taxable year beyond
the year in which the services were performed, the income no
longer constitutes foreign earned income for purposes of §911
Income Exclusion: $80,000 per year §911 (b) (2) (D)(i)
(2) The housing cost amount of such individual.
Definition: all reasonable expenses paid by or on behalf of individual
for housing for taxpayer, spouse, dependents, and includes rent, fair
rental value, utilities and insurance, and salary for housing expense
(does not include interest, taxes, or co-op expenses§911 (c) (3))
Applies in addition to $80,000 earned income exclusion
Calculation§911 (c) (1): Housing cost amount is the amount of housing
expenses that falls between the statutory ceiling (cap) and floor
o Floor: 16% x $80,000 = $12,800
o Ceiling: 30% x $80,000 = $24,000
Individual with housing > ceiling will exclude $11,200
(Difference between ceiling and floor$24,000 -$12,800 =
$11,200)
Housing Amount x Number of qualifying days / Number days in
taxable year
Final Excluded Housing Amount: Lesser of housing cost amount or
foreign source income
Foreign Earned Income exclusion is the lesser of (1) FEI reduced by housing cost
amount, or (2) the exclusion amount ($80,000). Reg § 1.911–3d(2) Limitation
Reg § 1.911–4 Determination of housing cost amount eligible for
exclusion or deduction.
(d) Housing cost amount exclusion (housing expenses do not include
the cost of purchasing a house, capital improvements, and other
capital expenditures, furniture) (3) Housing cost amount attributable
to employer provided amounts (different if self-employed)
911(f) –the exclusion comes off the bottom so you get taxed on the
highest brackets
Steps for Computing FEI Exclusion:
Step 1: Compute Qualifying Period
Qualifying Day is a day within the individual meets the tax home
requirement and is either a bonafied resident or meets the presence test
30
Normally if you are meeting the test this will be 365; only time it will not be
is during arrival/departure years. Can elect different computation period for
qualifying days each year
31
Foreign Earned Income is lesser of (1) FEI reduced by housing cost amount, or (2)
exclusion amount
(1) 100,000+36,000 (3,000 x 12)-11,200 =124,800
(2) 80,000 + 11,200 = $92,000 total foreign earned income exclusion amount
(b) How would the answer to (a) change if her annual salary was $40,000?
The foreign earned income exclusion (including housing) would be $
40,000+36,000 = 76,000
(c) How would the answer to (a) change if Casey's assignment to work in Serbia
was for the period of January 11, Year 2 through December 27, Year 3?
Can still get entire year with physical presence test qualifying period
For BRT you most likely would need to be there for over a year
o §1.911-2(a)(2)(i) – have to be an uninterrupted resident for an entire
taxable year.
Now Casey would could have as little as 354 qualifying days, don’t have to prorate
because of § 1.911–3d2
(d) How would the answer to (a) change if Casey paid income tax of $12,000 to
Serbia on her salary? Is there a difference if, under Serbian law, she was not liable
for any tax? If she declared herself a non-resident of Serbia and therefore under
Serbian law was not liable for tax, should the result be different?
The income tax payment is evidence of residency for the taxable year for
purposes of the Bona Fide residence test. Nothing changes with tax
payment, no foreign tax credits when using § 911
Exemption from income tax under a treaty or the like will not in itself
prevent a citizen from being a bona fide resident of a foreign country
If Casey declared herself a non-resident in Serbia then no § 911 exclusion
(§911(b)(5))
32
Because Douglas arrived mid-year need to wait until qualifying 330 days,
then file amended return
Bona Fide Residency Test:
When contractual terms have a fixed end date, Douglas may be treated as a
non- US resident
Physical Presence Test:
Must be physically present in a foreign country for 330 full days of 12
consecutive months
Step 1: Qualifying Period
Can extend 35 days before first day physically present – total qualifying days
= 183 days
Result: Qualifying period 183 + 35 = 219
Step 3: Amo
unt of Foreign income received during year
$50,000 (no employer provided housing assistance)
Step 4: Year to which FIE is attributable:
Douglas earned $50,000 in Year 1 as such that amount is attributable for
Year 1
Step 6: FIE Computation
Housing Cost Exclusion - §911(c)
o Floor: 219/365 * 40,000*.16= ______
o Ceiling: 219/365 * 40,000*.30 = ______
Excludable housing cost amount is $6,720
Foreign Earned Income is lesser of (1) FEI reduced by housing cost amount, or (2)
exclusion amount
(1) 50,000-6720 =43,280 <- this one gets us to excluding entire amount of
income
(2) 48,000 + 6,720 = $54,720 total foreign earned income exclusion amount,
50k income
Self-Provided housing exclusion
Treated as a deduction in computing adjusted gross income under §911(c)(4)
(A)
Limited to Excess of Foreign Earned Income less exclusion from foreign
earned income.
(b) How would the answer to (a) change if Douglas invests a portion of his salary in
a Guyanese bank, earning interest of $5,000 per year?
Under 1.911-3, the definition of foreign earned income does not include gains from
investments or passive income made using earned income from providing services
abroad. May not be offset
This income is foreign sourced, but it is not considered “earned income”
(c) How would the answer to (a) change if, at Douglas's request, his employer pays
$30,000 of his Year 1 and Year 2 salary in Year 3 and Year 4 respectively?
If income is deferred in excess of one taxable year beyond the year in which the
services were performed, the income no longer constitutes “foreign earned
income.” Under §911(b)(1)(B)(iv). If Douglas’ employer pays $30,000 of his salary
for Year 1 and 2 in Years 3 and 4 he will forfeit the right to use the §911 exclusion
for those amounts. (gives only 1 extra year)
33
Deferred compensation is excluded because the fear is that you claim
residency in the foreign jurisdiction and are negotiated to get paid later, if
they use cash method approach then you receive the exclusion AND not
paying tax on the income in foreign country
Notes:
§911(c)(4) – Housing expenses paid by self-employed treated as amounts
deductible from AGI
Still qualify for housing cost in amount of expenditures even if not
specifically compensated
3.5.02 Limitations
§951 Only domestic corporation that qualify as “United States Shareholders” can
claim the deduction.
Dividend is limited to only the “foreign source portion” of the dividend received
under the following formula:
34
§245(c)(3) Earnings and profits will be considered Foreign Source if – these
earnings are not attributable to a US trade or business
Additionally, the recipient domestic corporate United States shareholder can claim
neither a foreign tax credit nor a deduction for any foreign income taxes (e.g.,
withholding taxes) actually imposed on any such hybrid or dividend.
3.5.04
But where the participation DRD has eliminated United States tax on the dividend,
it makes no sense to allow the taxpayer to claim a foreign tax credit on what is
effectively tax-exempt income. The credit might then be used to offset tax on other,
unrelated foreign source income earned by the taxpayer and not eligible for the
participation DRD.
§245 (d)
Eliminates this potential double benefit by disallowing a foreign tax credit (or
domestic deduction) for any taxes paid or accrued with respect to any dividend
eligible for the participation DRD
35
Gain and Loss on the Sale of Specified 10-Percent Owned Foreign Corporation
Stock
What is Domco’s United States Liability with respect to the dividend received from
Venco?
May DOmco claim a foreign tax credit against its US tax liability for $34,000
Venezualan tax payment? What about $7,500 Venezuelan withholding tax?
US corp cannot claim foreign tax credit neither for withholding taxes nor income
paid taxes (245) with respect any dividend for which deduction is allowed.
Conclusion: Deduction for dividends is allowed and tax paid for said deduction
cannot be claimed as tax credit.
3-5-2 Assume the same facts as 3.5-1 except that the Venco stock is owned by
Domco LLC, a Delaware limited liability company wholly owned by Domco. How
your answers in 3.5-1 change?
LLC-sole proprietorship.
3-5-3
Assume the same facts as in 3.5-1, except that Domco forms Venco on February
1,2018, and sells all Venco for no gain or loss on January 15, 2019. How would your
answers to 3.5-1 change?
Holding Period Requirement
Law says that the domestic corporation does not meet the holding period
requirement, no deduction allowed. Shareholder has to hold the stock for more
than 365 days in a period of 731 days (2 years and 1 day) .
No deduction allowed.
Such 365 days, you have to start counting backwards from which dividend is paid.
3-5-4
36
Empire Co Inc., a New York Corporation, owns all the stock of IrishCo LTD, an Irish
corporation. Empire Co’s basis in its Irish Co stock is $600,00. During the 2018
and 2019, Irish Co earns a total of &800,000 providing financial services to
companies with operations in Ireland, and pays $120,000 in Irish income taxes. On
January 1, 2020, Empire Co sells the Irish Co stock to an unrelated company for
$2,000,000. What is Empire Co’s US tax liability with respect to its sale of Irish Co
Stock?
What is the tax liability?
Empire Co.,
Dividend is limited to only the “foreign source portion” of the dividend received
under the following formula:
800,000 income of Irish Co for financial services and it was taxed 120,000.
3.5-4 Assume the same facts as in 3.5-4, except that Irish Co pays a $650,000
dividend to Empire Co, and immediately thereafter Empire Co sells the Irish Stock
for 500,000. What are the US tax consequences to Empire Co from the dividend
and sale of Irish Co stock.
Empire Co sell it for a less amount that bought. Loss is 100,000. Dividend of
650,00 but sold for 500,000. No taxes for capital gain.
37
PROBLEM SET IV – FOREIGN TAX CREDIT
READ: Code §§ 164(a)(3), (b)(3); 275(a)(4); 901(a) – (b), (j) – (k); 903; 904(a).
Reg. §§ 1.901-1(c); 1.901-2(a), (b), (c)(1), and (f).
OUTBOUND
Double Taxation
Deductions
Credit
Limitation S
Baskets
Reconsideration
A. Overview
1. 901(b)(1) provides credit against taxes actually paid by U.S. citizens and
domestic corporations to foreign countries
a. Purpose is to avoid double taxation
b. Extends a dollar-for-dollar credit for foreign taxes paid against the
domestic taxes imposed on foreign source income
B. Credit Versus Deduction
1. May select either a credit under 901(b)(1) or a deduction under 164(a)(3), and the
election is made on an annual basis (275(a)(4) prevents their simultaneous use)
a. In most cases, 901 credit is more advantageous than the deduction because
a credit reduces tax on a dollar-for-dollar basis while a deduction merely
reduces the amount of income upon which the tax will be levied
C. Creditable Taxes – General Principles
1. 1.901-2(a) two-pronged test to determine whether a foreign levy is a creditable
tax
a. A foreign levy is an “income tax” for which a credit is allowed if:
1) It is a tax (requires compulsory payment to foreign country under
1.901-2(a)(2)), AND
2) The predominant character is that of an income tax in the U.S.
sense
a) To have predominant character of an income tax in the U.S.
sense must be likely to reach net gain under the realization,
gross receipts, and net income tests 1.901-2(a)(3)
i. Realization test met if the event that gives rise to
the tax would result in the realization of income
under the standards of the Code
39
ii. Gross receipts test a creditable tax may in some
cases be imposed on gross receipts
iii. Net income test foreign tax must be structured to
reach net income, meaning that the tax must permit
either recovery of actual significant costs (including
capital expenditures) or an allowance that closely
approximates these amounts
D. Payor of a Tax
1. 1.901-2(f) legal liability under foreign law is the determinative factor for
treatment as payor of a tax, regardless of who actually pays the tax
2. 909 “matching rules” designed to match foreign tax credits to the income to
which they relate
E. Amount of Tax Paid
1. 1.901-2(e) precludes credit for refundable amounts, subsidies, multiple levies,
and non-compulsory payments
F. Subsidies
1. “Tax payments” made to a foreign government are not creditable if the
government uses the money to provide any direct or indirect benefit to the
taxpayer, to a related party, or to any party to the transaction
G. Multiple Levies
1. 1.903-1(b)(3) if a foreign country imposes both an excise and an income tax
and the excise tax is creditable against the income tax, the amount of the income
tax for purposes of 901 would not reflect the portion of the income tax sheltered
by the excise tax
H. Economic Benefits
1. 1.901-2(a)(2)(ii) payments in exchange for specific economic benefits is
bifurcated into its component parts and a credit is available only if the taxpayer
can establish the distinct element of the foreign levy which constitutes a tax
a. These taxpayers are called “dual-capacity taxpayers”
b. A specific economic benefit is one that is not readily available to others
subject to the general tax
I. Soak-up Taxes
1. 1.901-2(a)(3)(ii) prohibits the use of “soak-up” taxes which are those for
which liability depends upon the availability of the credit against the taxpayer’s
tax obligation to another country
J. Taxes “In Lieu Of” Income Taxes 903
1. Must meet the general definition of a “tax”
2. Must be imposed as a substitute for (and not in addition it) an income tax or series
of income taxes otherwise imposed
3. The foreign jurisdiction’s purpose for imposing the tax, whether administrative or
otherwise, is irrelevant in assessing creditability
4. If a domestic person is subject both to the general tax of a foreign jurisdiction and
also a surtax, the surtax should not qualify as a creditable tax under 903
40
K. Section 904 Limitation Upon the Amount of Taxes Which May Be Credited
Foreign Source taxable income U.S. tax on
Maximum foreign tax credit = Worldwide taxable income x worldwide income
L. Denial of Credit for Taxes Paid to Certain Countries
1. 901(j) the foreign tax credit is denied for tax payments to specific countries
a. Intent of the legislation is to deny the tax benefits for activity in these
hostile countries
Majority of individuals cannot take advantage of the §911 exclusion for foreign
sourced earned income derived in the year; however you are still taxed on earnings
in the foreign country.
Have to choose either the deduction or the credit; make election at time of filing
and you can alternate annually between the credit or deduction – depending on
which is most favorable
41
Tax: compulsory payment to a foreign government that is intended as such
[i.e. no fines, penalties, interest royalties] and predominant character is that
of an income tax in U.S. sense
Net Gain: (1) Realization Test 1.901-2(b)(2): met if the event, which is taxable,
would result at the occurrence and there would be realization of income under IRC
Tax triggered by manufacture of product rather than sale-would violate the
realization test since none of these events give rise to realization in §1001
Exceptions:
o Tax may be credited if it represents a slight (as opposed to
substantial) deviation from US tax concept
o Taxes levied on non-realization events which would result in domestic
realization
o Taxes on transferor processing of readily marketable properties (i.e.
inventory ready for sale/export) serve as a substitute for later
triggering event
(2) Gross Receipts Test1.901-2(b)(3): creditable tax can in hard to value situations
be imposed on gross receipts
(3) Net Income Test1.901-2(b)(4): Tax must permit recover of actual significant
costs including capital expenditures or a surrogate allowance to approximate that
amount [i.e. must permit cost recovery – No VAT]
Payor of Tax is the party incurring liability – risk and remedy run against him
Biddle v. Comm.
§ 909 adopts “matching rules” preventing Foreign tax credits until related income
taken into account
42
Source of Income Rules control – first source income before determining if it
is creditable
Separate Foreign Tax Credit Limitation Basket for Foreign Branch Income
In general, under Section 904, a taxpayer is permitted to claim a foreign tax credit in an amount
equal to the U.S. tax imposed on such taxpayer's foreign source income. This limitation applies
separately to the taxpayer's "general basket" and "passive basket" income.
The Act adds as a new basket "foreign branch income," which is defined as the business profits
of a U.S. person that are attributable to one or more qualified business units in one or more
foreign countries. However, foreign branch income does not include any income that is
otherwise treated as passive basket income.
This provision is effective for taxable years beginning after December 31, 2017
4- 1. Todd, a United States citizen, opened a coffee shop in Honduras. During the
year, Todd incurred the following tax liabilities which he paid promptly: (i)
Honduran real property tax; (ii) Honduran value added tax; (iii) Honduran federal
income tax on Todd's business income; (iv) Honduran state income tax;
(v) Honduran withholding tax (at a rate of 25 percent) on dividends; and (vi)
Honduran "social security"
43
(b) With respect to the creditable taxes, may Todd credit some and deduct others?
§275(a)(4) disallows a deduction if the credit is taken - so you must choose
one versus the other; however you can alternate year by year on whsich is
the better tax position – deduction v. credit. Taxpayer may elect his
preferred
4-2. DelCo is a domestic corp. Principal business activity manufacture and sale of
industrial machinery, and its main plant and offices are located in Delaware. DelCo
also has a branch plant located in France where DelCo manufactures and sells its
products in Europe. During the year, DelCo realized $100,000 of taxable income
from its US plant activities, and $75,000 of taxable income from foreign branch
activities. Assume DelCo's US liability is $50,000. The foreign branch paid $40,000
in corp income taxes to France.
Delco has a branch, Part of US, if it were a subsidiary, subsidiary would have been
a separate corporation.
(a) Determine if tax in France is Foreign Income Tax, qualified for credit?
The result is consistent with the United States tax policy of denying credit for taxes
imposed at rates about the United States rate. Here, the French tax rate on the
branch earnings is about 53% - will about the 28.6 percent effective US on Del Co.
worldwide income.
Total Tax Liability = $50K – 20,000 = $30,000 Foreign taxes less than limitation
Excess of Foreign Tax - There would be an “excess limitation” which under §904(c)
could be carried forward ten years/back one year. High tax income in Foreign
Place, carry over
44
This means that the §904 limitation applies to the French taxes paid in this
example; the taxpayer has an “excess limitation”.
NOTES: Always work out entire available amount of credit – may not get it this
year, but you can carry it backwards and then forwards; usage delayed is still ok.
You can roll it over but if earning pattern continues, you will have the
carried over amount from the current year, and you will roll it over until you
get to the 10th year and it becomes useless
45
1) Income that is not included in the passive category income basket
904(d)(2)
C. Special Rules for Capital Gains
1. Applies only with respect to persons who are eligible for a reduced rate on certain
preferred income items under 1(h)
2. Effect is to reduce the overall foreign limitation by excluding from the calculation
a part of the capital gain income
3. Also applies with respect to any 1231 gain taxed to an individual at long-term
capital gains rates
4. 904(b)(2)(B) “capital gain differential” (the taxpayer’s foreign source income
only includes the amount of “foreign source net capital gain” in excess of “the
rate differential portion”)
a. Foreign source net capital gain is defined in 904(b)(3)(B) as the lesser of
foreign net capital gain or all net capital gain
b. The rate differential portion is determined by finding the difference
between the highest applicable tax rate and the alternative tax rate,
dividing that amount by the highest applicable tax rate, and multiplying
that amount by the net foreign source capital gain amount
c. The rate differential portion is deducted from both foreign source income
and overall income
D. Special Rule for Capital Losses
1. 904(b)(2)(A) in determining the 904 limitation, foreign source capital gain can
be included only to the extent of foreign source capital gain net income, defined
as the lesser of capital gain net income from foreign sources or capital gain net
income
2. The purpose of this rule is to prevent domestic capital losses from offsetting
foreign capital gain in determining taxable income while the capital gain retains
its foreign source character for purposes of the limitation
E. Recapture of Foreign Losses: 904(f)
1. The confinement of losses to separate baskets
a. 904(f) provides a mechanism for allocating foreign losses first to baskets
in which the taxpayer has foreign income against which the foreign losses
can be offset
2. Allocating foreign losses
a. Under 904(f)(5)(A) losses in one basket can offset domestic source
income only to the extent that the aggregate amount of such losses exceeds
the aggregate amount of foreign income earned in both baskets
b. Works to reduce the numerator of the credit limitation first
3. Recapture rules
a. Allocating income earned in subsequent years to categories that previously
absorbed the foreign loss
b. Foreign source losses offset foreign source income regardless of its basket
label and thereby reduce the 904 numerator and the benefits of the FTC
4. Overall foreign loss
46
a. If a domestic taxpayer sustains an overall loss from foreign activities
during the year, that loss offsets the taxpayer’s domestic income in the loss
year
1) If the taxpayer in subsequent years earns an overseas profit, 904(f)
(1) requires that foreign source income in an amount equal to that
previously deducted loss to be recharacterized as having been
derived from a domestic source
2) The amount of transformed income is limited to the lesser of the
amount of the previously unrecaptured loss or 50% of foreign
taxable income for that year (a larger percentage may be
recaptured if the taxpayer so elects might do this if have a
domestic loss)
F. Carryback and Carryover of Excess Taxes Paid 904(c)
1. If foreign taxes paid exceed limitation can carry back one year and forward 10
years under 904(c)
47
Result: Carryforward of excess credit of $10K
This is high-taxed income and we need low-taxed income from foreign
jurisdictions
(b) What result if, in addition to the above transactions, she derived $50,000 of
Canadian-source interest income subject to a reduced tax rate of five percent. She
paid $2,500 in Canadian income taxes. Assuming a 35 percent rate of tax by the
United States, compute Jennifer's foreign tax credit for Year 1.
37,500
Result: Without separate baskets, could plan without high risk to blend low-tax and
high tax income.
The ceiling $17,500. But the credit cannot exceed the actual taxes paid on such
foreign source passive income of $2,500.
Active Income Limitation: $100 (active)/$300 * $105K = $35,000 but only applied
against active income tax paid, Columbia tax 45,000
Results in a Carryforward for the active income of $10,000
48
(a) In Year 2, its Brazilian operations resulted in taxable income of $100,000
with an attendant tax payment of $45,000, while its domestic operations
generated taxable income of $75,000. What is Z’s tax liability for Year 2 if it’s pre-
credit United State tax liability was $61,250?
1. In year 1, there is no liability, the losses are more than the gain.
2. In year two, treat as domestic income the lesser of: amount of loss (40,000)
or 50% of foreign taxable income for that year. (50% of 100,000= 50,000)
Overall Foreign Loss: amount by which tp’s gross income from foreign sources is
exceeded by deductions
Note: If Basket and recapture apply – use recapture rules first
3. 100,000 – 40,000 = 60,000 (because you are try to recover the loss; income
in year 2 minus the loss in year 1)
49
net foreign income over the two year period is 60
A. Overview
1. A non-resident alien is subject to U.S. tax only on specifically defined categories
of income under 871
a. Major category 871(a)(1) includes items generally associated with
passive investment assets, including interest, dividends, and rents but also
other forms of income such as wages, premiums, annuities, and “other
fixed or determinable annual or period gains, profits and income”
commonly referred to as FDAP
b. 871(a)(2) domestic source income from the sale or exchange of capital
assets, but only if the non-resident individual is present in the U.S. for at
least 183 days during the taxable year
c. Unless otherwise exempt taxed on a gross basis at a flat 30% tax rate (no
deductions or credits)
1) Sometimes referred to as “withholding tax” because in most cases
it is enforced via 1441 and 1442 by imposing an obligation to
withhold on the payor of the income item rather than by collecting
the tax directly from the recipient
2. Foreign corporations are subject to tax on specific domestic source investment
income items described in 881 which generally parallel the investment-related
items listed in 871(a)(1) for individuals
3. Non-resident alien individuals and foreign corporations are also subject to U.S.
tax on a net basis and at the graduated tax rates of 1, 11, and 55, as applicable, on
income that is effectively connected with a U.S. trade or business
B. Income Items Included in 871(a) and 881(a)
1. Income must be derived from U.S. sources and not effectively connected to U.S.
trade or business
a. Passive non-business activities
C. Income from Intangible Property
1. Royalties not listed in the statute but 1.871-7(b) makes clear that these royalties
are so included
2. 871(a)(1)(D) includes gains from the sale or exchange of intangible assets or
of any interest therein, to the extent such gains are contingent on the productivity,
use, or disposition of the property, from gains from the from the sale or exchange
of all other property are excluded from the scope of 871(a)(1)(D)
3. Patents (special rule) under 1235, any transfer of a patent or patent right is
considered to be the sale or exchange of a capital asset even if the payments in
consideration for the transfer are contingent on the productivity, use, or
disposition of the transferred property
50
a. 1.1235-1(d) payments made pursuant to a 1235 transfer are “payments
of the purchase price and are not the payment of royalties”
b. Would generally be addressed under 871(a)(2) which addresses capital
gain but 865(d)(1)(B) override this rule in the case of contingent gains and
state that such gains are treated as royalty payments for sourcing purposes
c. Non-contingent gain 865(d)(1)(A) causes the gain to be sourced as a
sale of personal property under 865 and potentially subject to tax under
871(a)(2)
d. Contingent gain sourced under 865(d)(1)(B) and 861(a)(4) and
potentially subject to tax under 871(a)(1)(D)
D. Exception for Most Interest Payments
1. Most U.S. source interest is not in fact taxable to foreign persons due the portfolio
interest exceptions (found in 871(h) and (i) for individuals and 881(d) and (d) for
corporations)
a. Provided such interest is not effectively connected with the payee’s U.S.
trade or business and provided it is not received by a person who owns
10% or more of the stock of the payor, measured by voting power
b. Additional rules for U.S. source interest received by foreign corporations
under 881(c) exception only applies if the payor or other withholding
agent receives a statement that the beneficial owner of the obligation is not
a U.S. person
E. Exception for Certain Dividends
1. Dividends from U.S. sources typically subject to tax as FDAP under 871(a) with
exceptions provided in 871(i) and 881(d)
a. Transition rule exists for dividends paid by certain domestic
corporations that meet the active foreign business income test under
former 881(c)(1)
b. Dividends paid by a foreign corporation that are treated as U.S. source
under 861(a)(2)(B) are also exempt from withholding tax under 871 and
881 (less than 25% U.S. income 3-year period rule) but may not be for
effectively connected trade or business
Thus even though the source rules require an assessment of the extent to which the
foreign corporations earn income that is effectively connected with a US trade or
business, the designation may have no gross basis tax implications for foreign recipients,
due to the operation of §871 (1) and 881 (d)
Creditability for foreign taxes on dividends will be determined by the source designation.
As a result, the designation as US Source is not without consequence for US recipients of
these dividends. For non resident foreign corporation, it is inconsequential.
F. Capital Gains
1. 871(a)(2) general rule is that non-resident alien individuals are subject to tax
of 30% on net capital gains derived from domestic sources if such individual is
present in the U.S. for 183 days or more during the taxable year
a. In practice, the present requirement will generally result in a determination
that the taxpayer is a U.S. resident under 7701(b) and would be taxed
under 1, including the preferential capital gains rates provided in 1(b)
51
b. 871(a)(2) is typically imposed only on non-resident alien individuals
whose presence is excluded for purposes of determining residency but
whose presence is counted for purposes of 871(a)(2), such as foreign
government officials, teachers, students, and certain professional athletes
c. The 183 day standard only applies to non-resident alien individuals after it
has been determined that the individual has a U.S. tax home under 865(g),
such that the sale of the property would give rise to U.S. source gain in the
first place (if the taxpayer has no U.S. tax home, the gain will not be U.S.
source under 865 and therefore 871(a)(2) would not apply)
d. 871(a)(2) – also precludes any deduction for capital losses other than
those that would be recognized and taken into account if they were
effectively connected with the conduct of US trade or business. (Surya’s
$1,000 loss of the UruCo stock is not deductible)
52
II. INBOUND TRANSACTIONS
Foreign persons (classification rule first); US only taxes non-citizen under limited taxing
formula
Return to source rules that applicable to foreign persons on most of the statutory
provisions, it requires a domestic source and if that is absent then except for a limited
category no tax
US Tax of inbound transactions varies depending upon the country of the foreign person
o Treaty Countries: modifies the statutory rules [once you determine someone is
Non-US, need to determine if they are subject to treaties]
o Non-treaty Countries are then subject to the statute - Look at passive/active rules
Passive income is lightly taxed to encourage investment in US
PROBLEM SET VII: TREATMENT OF FOREIGN OWNED UNITED STATES INVESTMENT INCOME
Read: Code §§ 871(a), (d), (h), (i); 873(a); 881(a), (c), (d).
Reg. § 1.871-7.
PASSIVE
Looking at Inbound Transactions Enforcement: Use withholding taxes
§871: Nonresident Alien Individuals
§881: Foreign Corporations
Passive Income:
§881(a) imposes a 30% tax on all passive income derived within the United States on a gross
basis
53
§ 871(d) Taxed on net basis with graduated rates. No mandatory withholding, personal
exemption.
7-1. Surya, a citizen and bona fide resident of Nepal, has never been present in the US.
During Year 1, he had no US Trade or Business (871 B) , but he owned a nu(87mber of assets
that produced the following items of income:
$20,000 dividend on the stock of Delaware Corporation, a corporation formed in
Delaware;
$5,000 gain on sale of ten shares of stock in UruCo., a corporation formed in Uruguay;
$13,000 dividend on the UruCo. stock, of which $5,200 is US source and $7,800 is
foreign source;
$10,000 in rents from rental property located in the United States;
$1,000 of foreign-source interest on a loan made to Emily, a citizen and resident of
Bolivia:
$2,000 of interest on a deposit at a Chicago, Illinois bank; and
$8,000 in cash from the sale of the United States rights to a patent Surya created for five
percent of the net profits from products produced through its use.
Surya's potential deductions for the year consisted of depreciation and expenses with respect to
the rental property of $3,000, a $1,000 loss on the sale of five shares of UruCo. stock, and
medical expenses of $4,500. Assume that Surya would be subject to a 20 percent effective tax
rate on his taxable income.
(a) What is Surya’s United States taxable income and his tax liability for Year 1?
Step 1: Is this an inboud/outbound activity? Surya is a nonresident alien so this is inbound.
Step 2: Is there a trade or business? No. Therefore we are unconcerned about §864 or §871(b)
Do not need to worry if you have income effectively connected with a trade or
business which would push you into §871(b)
US Source
54
$20K dividend: US 30% tax
(§ 871a),
$5,000 gain on sale of ten shares of stock in UruCo., a corporation formed in Uruguay;
$5,000 gain: Foreign (§ 865a)
$13,000 dividend on the UruCo. stock, of which $5,200 is US source and $7,800 is
foreign source
$5200 US § 871i2(D) US source, exempted from tax
$7800 Foreign
$10,000 in rents from rental property located in the United States
10,000 Rent US 30% tax, Foreign interest- foreign source n0 tax.
$1,000 of foreign-source interest on a loan made to Emily, a citizen and resident of
Bolivia – source rules, residence of payor
$1,000 Foreign (see rules from previous class)
$2,000 of interest on a deposit at a Chicago, Illinois bank; and
$2,000 US § 871i2(A) US source but exempt from US tax
$8,000 in cash from the sale of the United States rights to a patent Surya created for five
percent of the net profits from products produced through its use. (contingent)
$8000 – 865(d) – sale on contingent basis source by royalty rule – US, 30% tax
Expenses: Under 873(a) you are only allowed deductions with respect to income effectively
connected with trade or business.
the tax under §871 is on gross amounts – does not say net amounts
Step 4: Exclude Foreign Sourced Income – they will not be subject to US Tax
(B) What result if Surya elects under § 871(d)? If One Piece of Property- no way you can argue
that this is trade or business. You can deem it to be active income not passive.
§871(d) Election to treat real property income as income connected with United States
business.--
(1) In general.--A nonresident alien individual who during the taxable year derives any income--
(A) from real property held for the production of income and located in the United States,
or from any interest in such real property, including (i) gains from the sale or exchange of
such real property or an interest therein, (ii) rents or royalties from mines, wells, or other
natural deposits, and (iii) gains described in section 631(b) or (c), and
(B) which, but for this subsection, would not be treated as income which is effectively
connected with the conduct of a trade or business within the United States, may elect for
such taxable year to treat all such income as income which is effectively connected with
the conduct of a trade or business within the United States.
55
Under §871(d) an individual taxpayer can elect to treat a certain subsection of investment
income as treated under 871(d) and tax that at the (more likely) preferential rates under §1 and
§55.
Only time you make the election is once you determine that the activity is insufficient to
constitute a trade or business; and rental real estate can then be treated as a trade or
business
7-2 In Year 1, Shaida, a citizen and resident of Guyana, purchased ten shares of stock in DelCo,
a Delaware Corp, for $7,000. In Year 3, Shaida sold the shares for $10,000 in cash to an
unrelated individual residing in US. To what extent will US impose income tax ON $3,000 gain
in Year 3?
Capital Gains: §871(a)(2). In the case of a nonresident alien individual present in the US for a
period or periods aggregating 183 days or more during the taxable year, there is hereby
imposed for such year a tax of 30 percent of the amount by which his gains, derived from
sources within the United States, from the sale or exchange at any time during such year of
capital assets exceed his losses, allocable to sources within US, from the sale or exchange at
any time during such year of capital assets. For purposes of this paragraph, gains and losses
shall be taken into account only if, and to the extent that, they would be recognized and taken
into account if such gains and losses were effectively connected with the conduct of a trade or
business within US, except that such gains and losses shall be determined without regard to §
1202 and losses shall be determined without the benefits of the capital loss carryover provided
in § 1212.
(a) Shaida was never physically present in the United States at any time in Year 1, Year 2, or
Year 3.
Non-resident, non US source, not subject to tax – did not meet the taxing standard or
capital gain
(b) Shaida was not physically present in the United States at any time in Year 1 or Year 2, but
she was physically present in the United States for 200 days in Year 3.
56
If in US for more than 183 in year, taxed under §1 because you are considered a resident
alien – so you are kicked out of §871 (only for non-resident!), and move up to outbound
transactions – taxed on worldwide income!
(c) Same as (b), except that for 100 of the 200 days of presence in US in Year 3, Shaida was a
student residing in the US under a "J Visa," issued under The Immigration and Nationality Act.
Note that §871 does not define presence same as §7701; therefore you are just looking at
183 days; however she has 183 days for purposes of this statute but she is still a non-
resident under §7701b
She is a nonresident alien with tax home in US under § 865g(1)A(i)(ll). This is foreign
source, § 871 only taxes capital gains derived from sources within the US, this is foreign
source
7- 3 SaudiCo is a corp in Saudi Arabia. Except as otherwise provided, all of SaudiCo's shares
are owned by citizens and residents of Saudi Arabia who have no connections to US. SaudiCo
has investments in US, but it does not conduct a trade or business within US. For each situation
described below, determine whether the interest received by SaudiCo is subject to US taxation
under §881(a).
(a) Interest from a certificate of deposit issued by a California bank:
Step 1: Determine Inbound/Outbound and if Trade/Business
Step 2: Is this Foreign or US sourced?
Foreign Corporation with US Source so look at §881
§881(d) Tax not to apply to certain interest and dividends.--No tax shall be imposed under
paragraph (1) or (3) of subsection (a) on any amount described in section 871(i)(2)(A).
§871(i) Tax not to apply to certain interest and dividends.- No tax imposed
(2) (A) Interest on deposits, if interest is not effectively connected with conduct of Trade or
Business within the US.
(b) Interest from a certificate of deposit issued by the Italian branch of a California bank.
Sourced to the residence of obligor – i.e. foreign source 861(a)1A(i)
(d) Same as (c), except that the amount of interest payable to SaudiCo is dependent upon the
domestic corporation's net profits each year.
Taxable under §871(h)(4)(A)(i) – contingent tied to income can be considered equity
(dividend withholding) so not portfolio interest.
Taxed at 30% gross, no exemption on dividends – effectively a return on earnings is
taxable
(e) Same as (c), except that the amount of interest payable to SaudiCo is determined with
reference to changes in the Dow Jones Industrial Average index.
Exclusion from exception under § 871h4(C)v(iii), not taxed (portfolio interest)
(f) Interest from a loan to its wholly-owned United States subsidiary corporation.
881(c)(3)(C) – Deny preferential treatment to subsidiary
57
o Related person § 871h3, no portfolio interest exception for 10% shareholders
o Get a deduction on one end and need tax on the other, US source, 30% gross
withholding.
Portfolio Interest:
Allows and encourages investment with no tax – Congress wanted to broaden investment
incentives in US
General Policy: Anyone who loans and receives interest from a US source will not be
taxed
881(c) refers back to 871 (h and I for individuals)
§881(c) Repeal of tax on interest of foreign corp received from certain portfolio debt
investments.--
(1) In general.--In the case of any portfolio interest received by a foreign corporation from
sources within the United States, no tax shall be imposed under paragraph (1) or (3) of
subsection (a).
(2) Portfolio interest.--For purposes of this subsection, the term “portfolio interest” means any
interest--
(A) would be subject to tax under subsection (a) but for this subsection, and
(B) is paid on an obligation--
(i) which is in registered form, and
(ii) with respect to which--
(I) the person who would otherwise be required to deduct and withhold tax
from such interest under section 1442(a) receives a statement which meets
the requirements of section 871(h)(5) that the beneficial owner of the
obligation is not a United States person, or
(II) the Secretary has determined that such a statement is not required in
order to carry out the purposes of this subsection.
58
VIII. INBOUND – TREATMENT OF FOREIGN-OWNED U.S. BUSINESS INCOME (UNIT 8)
A. Overview
1. In contrast to passive investment income taxed at 30% gross, income effectively connected with
the conduct of a trade or business in the U.S. is potentially taxed on a net income basis at the
regular graduated rates
B. Engaged in a Trade or Business in the United States
1. Whether a foreign person is engaged in a trade or business within the U.S. is a facts and
circumstances test
a. As part of the analysis, may draw, in some circumstances, upon the distinction between
activities giving rise to 162 business expenses and those giving rise to deductions under
212 related to the production of income
2. A U.S. trade or business is generally characterized by progression, continuity, or sustained
activity that occurs during some substantial portion of the year
a. If a foreign person’s presence in the U.S. is limited to maintaining an office for merely
ministerial or collection functions, it is probably not a U.S. trade or business
b. If a foreign person’s domestic activities are directly related or pivotal to the active
pursuit of profit, however, a trade or business probably exists
1) “Core activities” (those activities that are essential to deriving a profit) must be
conducted in the U.S.
a) For example, a foreign person rendering material services or soliciting
sales domestically is probably engaged in a trade or business
1. No trade or business should typically arise from isolated sales by employees or minimal
operational or export activity in the U.S. however, extensive sales activity or domestic
marketing conducted through dependent agents (such as employees) has been found to
constitute a trade or business for the principal or employer
a. To be considered a dependent agent, it is not necessary for the U.S. person or entity to
be related or affiliated with the foreign person, instead, it is sufficient that the U.S.-based
person or entity acts exclusively (or nearly exclusively) for such foreign person in
order to be considered such foreign person’s dependent agent
b. Less clear when it comes to independent agents activities of licensees and lessees are
not typically imputed to the foreign licensor or lessor
c.
2. Trade or business activity of a pass-through entity is generally imputed to its foreign owners
under 875(1) in the case of both general and limited partners
a. A partnership is akin to an agent with the partners as principals
3. For corporations no similar look-through rule for corporations and their shareholders
59
a. A foreign person, whether corporate or individual, and regardless of the level of
ownership interest, will not typically be considered to be engaged in a trade or business
by virtue of its ownership of shares in a domestic corporation that is so engaged
D. Performance of Services as a Trade or Business
1. Aside from a special de minimis rule, 864(b) provides that a foreign person who performs
services within the U.S. at any time within a taxable year is automatically deemed to be engaged
in a domestic trade or business, regardless of duration, frequency, or other factors
a. Whether or not person performs services as an employee or as an independent contractor
b. De minimis rule 864(b)(1) foreign employer and not present in the U.S. for more than
90 days and compensation does not exceed $3,000 (not deemed to be engaged in a
domestic trade or business- all three should be met)
E. Real Property Activity as a Trade or Business
1. Under 871(d) and 881(d) foreign persons may make a “net income election” to treat income
derived from U.S. real property as ECI
a. Does not otherwise cause a person to be engaged in a trade or business
2. 897(a) treats gains and losses derived from sales and other dispositions of U.S. real property
interests as if that gain or loss were ECI (not a pro-taxpayer rule because if sourced on the basis
of the seller’s residency could avoid tax altogether)
1. It is generally assumed that a domestic trade or business probably exists if a foreign person
maintains a stock of inventory in the U.S. and has a dependent agent pursuing sales efforts
2. Although less clear-cut, a foreign person will also probably have a domestic trade or business if
it or its dependent agents conduct significant marketing activity and maintain a stock inventory
in the U.S. from which it fills orders
4. consignment basis, such shipments, coupled with the sales efforts of the agent, will probably
constitute a domestic trade or business
1. Foreign person should not be viewed as being engaged in a U.S. trade or business simply
because it purchases products in the U.S. for sale outside the U.S. (but if high volume and
sophisticated service component together with certain sales activities, even if such sales are not
to U.S. persons, may be U.S. trade or business)
1. When this was the rule, all domestic source income was subject to U.S. tax under regular
graduated rates regardless of its connection to a U.S. trade or business
60
2. Rule has changed so that income must bear an “effective connection” to the taxpayer’s business
before being subject to tax in the U.S. (used to stifle unrelated passive investment)
1. 1.864-3(a) without a trade or business, a foreign person cannot generally have ECI
J.
K. Step One: Identification of Gross Effectively Connected Income (Three Principal Categories
Under 864(c)
a. 864(c)(2) foreign person who conducts a domestic trade or business and receives
domestic source FDAP income items described in 871 and 881 may be required to treat
these items as ECI
b. 1.864-4 rules for segregating domestic source passive income from other domestic
source income and establishes two tests for assessing whether FDAP income items will
be treated as ECI:
61
Exception:
1) 865(e)(2) if the inventory sale originates from a foreign office or other fixed
place of business which materially participates in the sale in that case, if the
sale is by a non-resident, the property is sold for use, disposition, or
consumption outside the U.S., and title passes outside the U.S., the inventory
may be deemed foreign source
a. 864(c)(4) main types of foreign source income that will be treated as ECI:
1) Certain rents or royalties from intangibles
2) Certain dividends or interest derived in banking, financing, or trading activities
3) Gains from foreign inventory sales
b. Only treated as ECI if the foreign person maintains a U.S. office or other fixed place of
business and the income is attributable to that other fixed place of business
1. Once taxpayer ascertains the amount of gross ECI, the next step is to determine the extent to
which deductions against that income is permitted
a. Can only deduct to the extent that the expenses are related to ECI
b. Procedure for the allocation of deductions in 1.861-8
1) Two-tiered method under the regulations:
a) Allocation
i. Threshold determination that focuses on whether an expense is
directly related to a particular class of gross income
b) Apportionment (if necessary)
i. Necessary only if within a class of gross income there is both U.S.
and foreign source income
1. Entails matching deductions to the category of gross income to which those deductions most
factually relate
62
a. A deduction is definitely related to a class of gross income if it is incurred as a result of,
or incident to, an activity or in connection with property from which such class of gross
income is derived
b. It is entirely possible that a deduction may not bear a definite relationship to any
particular class of gross income and in such a case the deduction is treated as definitely
related and allocable to all of the taxpayer’s gross income
a. Allocations must be made even if no gross income has been received or accrued within
the relevant class of gross income
b. Allocation is appropriate even though the deduction to be allocated exceeds the amount
of income in the gross income class
1. Once a deduction has been allocated to a class of gross income, the source of the gross income
items comprising that class must be determined
a. If the class consists exclusively of foreign source income (the “statutory grouping”) or
exclusively of U.S. source income (the “residual grouping”), the taxpayer may end its
analysis after the allocation process is complete and the deduction is allocated in its
entirely to the income in the statutory or residual grouping, whichever is appropriate
2. If a class of gross income to which a deduction has been allocated is comprised of both U.S. and
foreign source income, then the deduction must be apportioned between those two groupings of
income
a. “Reflects to a reasonably close extent the factual relationship” between the deduction and
the gross income grouping
3. 1.861-8(e)(2), 1.691-9T through 1.861-13T interest expense, as a general rule, is fungible
because borrowing money for one activity allows more money to be devoted to other activities,
so deductible interest expense is usually allocated among all activities
ACTIVE RULES
Issue: Is income derived from a trade or business within the United States?
If we have that, then we move into 882 and 871(b)
Investment (Passive) vs. Trade or Business
63
Investment:
o 30% Rate
o US Source
o No deductions
Trade or Business
o Graduated Rates
o Deductions
o Predominantly US Source
o Trade or Business in US
Personal Service de minimis exemption
o Almost none fall within this small amount – however the $3K amount was from
1954
8-1. Reconsider Problem 7-1 regarding Surya, a citizen and bona fide resident of Nepal, was
never present in US. During Year 1, he owned a number of assets that produced the following
items of income:
$20,000 dividend on the stock of DelCo., a corporation formed in Delaware;
$5,000 gain on sale of ten shares of stock in UruCo., a corporation formed in Uruguay;
$13,000 dividend on the UruCo, stock, of which $5,200 is United States source and
$7,800 is foreign source;
$10,000 in rents from rental property located in the United States;
$1,000 of foreign-source interest on a loan made to Emily, a citizen and resident of
Bolivia;
$2,000 of interest on a deposit at a Chicago, Illinois bank; and
$8,000 in cash from the sale of the United States rights to a patent Surya created for five
percent of the net profits from products produced through its use.
Surya's potential deductions for year consisted of depreciation and expenses from rental
property of $3,000, a $1,000 loss on the sale of five shares of UruCo. stock, and medical
expenses of $4,500.
64
On the ToB Spectrum you can have pure T/B; T/B with Investment; or merely Investment
activity
§864(b) delineates what is not a trade or business
Business is generally characterized by progression, continuity, or sustained activity
o No Trade or Business if purely Administrative: Foreign corporation which
merely collects revenues, or performs other ministerial functions will not be seen
as engaged in a T/B.
o Real Property Income Election (or by degree of activity – so you are a dealer)
under §871(d) or §882(d) for rental income.
o §897 Real Property Dispositions treated as effectively connected with the
conduct of a domestic trade/business
o T/B for Personal Services Foreign person who renders services in US at any time
within taxable year is automatically deemed to be engaged in a T/B apart from de
minimis rule.
De-minimus: if individual satisfies all three criteria, not be considered a
T/B:
Physically present for 90 days or less
Compensation for the services is $3,000 or less; and
Individual is employed by a foreign person not engaged in a US T/B or
a foreign office of a United States person
(a) The facts of Problem 7-1 assumed that Surya did not have a trade or business in US.
Without that assumption, would Surya be engaged in a domestic ToB with respect to any of his
activities in Year 1?
Result: Surya only engaged in passive activities; received dividends, interest and rent and as
such this is not a trade/business. Probably not a dealer in securities. Question is on rents on
real property, probably one is not enough. Interest on loans no. Interests on deposits is a
question of where that money came from – was it rental property income? Question of whether
it was taken out of business and never tied to biz operations again. Patents – depends on
whether it’s a regular activity and would want more facts.
(b) Would Surya be engaged in a domestic ToB if either DelCo. or UruCo. conducted a ToB in
US? Does the result depend upon whether Surya is a minority sh? A significant sh? A majority
sh? The sole sh?
Does the taxpayer have a trade or business because the enterprise in which it owns shares is a
ToB?
Doesn’t matter – if they are operating in the US the corps are already being taxed,
doesn’t matter
Don’t want to discourage investment in US enterprises when we have a taxing formula
that will already tax those corps on income. Separate identity of subsidiary from owner
even if owns 100%.
No reason to impute ownership status as though they were conducting a ToB (maybe
depending on really high control + ownership then might be an agent for owners) not a
factor here
(c) Would Surya be engaged in a domestic ToB if DelCo. and UruCo. are general Ps or LLCs
(rather than corps) that conducted a ToB in US? Does result depend upon whether Surya had a
65
minority interest in the entities? A majority interest? What if both entities are LPs and Surya is
the general partner?
When there is a partnership, then the income will be imputed to the owner because the entity is
a “pass through” so there is no separate taxing instrument at the entity level.
Rule does not depend upon level of interest; you can own only 1% and still have to pay
tax
§875 states that this situation is taxable – if the partnership has a US trade or business
then you will be deemed to have a trade or business as well; regardless of how active or
passive you are.
Does not depend on owners’ status as general or limited partner, still have to file US tax
returns
§ 875. Partnerships; beneficiaries of estates and trusts. For purposes of this subtitle--
(1) a nonresident alien individual or foreign corp shall be considered as being engaged in a ToB
within the US if the partnership of which such individual or corpo is a member is so engaged,
and
(2) a nonresident alien individual or foreign corp which is a beneficiary of an estate or trust
which is engaged in any ToB within US shall be treated as being engaged in such trade or
business within the US.
(d) Now assume that Surya is engaged in a trade or business in the United States with respect
to the rental property. What is Surya’s federal income tax liability to the United States? Assume
that Surya would be subject to a 20 percent effective tax rate on his taxable income under §§ 1
and 55.
Rental income of $10,000 would be taxable at 20% = $2,000 tax liability, same as Prob 7-
1b
8-2. To what extent is each taxpayer described below engaged in a trade or business within the
US?
Trade or Business: Sales Activity
General Assumption: Maintenance by a foreign person of a stock of inventory in the US + sales
efforts of a dependent agent will mean that such person is engaged in a domestic trade or
business
Dependent Agents: An agent is dependent if a united states-based person or entity acts
exclusively or nearly exclusively for such foreign person.
Independent Agents: unclear if activities of US-based indep agent imputed to a foreign
person
Consignment arrangements: If a foreign person ships inventory to a US-based dependent
or independent agent on a consignment basis, such shipments, coupled with sales efforts
by the agent will result in trade/business designation
Tax Treaties: Must be consulted if applicable.
Purchasing Activity: foreign person should not be viewed as engaged in US trade or
business simply because it purchases products in US for sale in foreign jurisdiction –
even if it maintains a substantial fleet of trucks and ships to transport products outside
US
Representative Office Activity: As long as you are not engaged in any activity for profit,
you can have a rep office that gathers/disperses information
66
(a) X Corp. is organized in Ecuador. X Corp. entered into a contract with DomCo, a domestic
corporation, under which DomCo serves as X Corp.'s exclusive agent in selling X Corp.'s
products in the United States. DomCo receives a commission for each sale to a United
States customer, the contract prohibits DomCo from selling any competing products in the
United States and from acting as the agent for another in selling any competing products in the
United States.
There is agency imputation of a US trade or business here to the extent that DomCo is a
dependent agent conducting sales efforts in the US on behalf of X. Exclusivity agreement
gives X corp economic leverage, but could be just a loose sales agreement where
exclusive agents are doing a ton of outside business too. (Dick’s selling light blue
wristbands under an exclusivity agreement with an Ecuador company)
(b) Y Corp. is organized in Panama, has branch office in US. Y Corp.'s products are sold in US
by domestic employees working out of rented office in Tulsa, OK. All orders from US customers
must be approved by Y Corp.'s home office in Panama, and no domestic employee has the power
to bind Y Corp, in any way.
Agency is engaged – deriving income by activities taking place; seems similar to a
consignment situation. Physical presence with employees in an office. They are
dependent agents even though they can’t bind the company. It is a branch, probably a US
trade or biz
(c) Z Corp. is organized in Belize. Z Corp. purchases goods in the United States for sale to
customers in foreign countries. Z Corp. maintains an office in San Diego, California, that is
staffed by domestic employees who facilitate purchases and arrange for shipping,
Representative Office: back office not engaged; even if you are buying significant
quantities of materials within the US and selling outside/ will not be taxable.
8-3 Fabio, a citizen and resident of Paraguay, is a professional model. Last summer, Fabio posed
in front of the Washington Monument for the cover of a forthcoming romance novel to be
published exclusively in Paraguay by a Paraguayan publisher that is not engaged in a trade or
business within the United States. To what extent is Fabio liable for United States income tax in
each of the following alternative scenarios?
(a) The photo shoot took only a single day and Fabio received total compensation of $2k from
publisher.
Performance of Service will always be treated as trade or business unless de minimis rule
§ 864b1 De minimis rule here is satisfied here – so no TB, also § 861(a)3
Revenue Ruling: “Petit Dejeuner Example” gave rise to a trade or business in the United States
(b) The photo shoot took three days and Fabio received total compensation of $6,000 from the
publisher.
Now Fabio is outside the de minimis rule – so it is a TB
(c) How would the answers to (a) and (b) change if Fabio received his compensation under a
contract with a US modeling company which performed the photo shoot on behalf of the
Paraguayan publisher?
Fails third prong of de minimis rule (works for US company) – so it will be a TB. § 861a3
8-4 ForCo is a foreign corp purchases zippers. It has facilities in the US, Argentina, and
Bolivia.
67
The zippers bought in the United States are sold exclusively in the United States.
Likewise, the zippers from Argentina are sold exclusively there, and same for Bolivia.
ForCo generates all of its income from these three countries. ForCo does not have a United
States subsidiary, nor a separate division that oversees operations in the United States.
In addition, ForCo purchases wine from a distributor in Argentina and sells it exclusively
therein.
Year 1, ForCo had $50,000 in general admin expenses related to both US and non-US
operations.
In addition, ForCo incurred $80,000 in deductible interest expense in Year 1 from its
borrowings used to improve the Bolivian facility.
Additionally, it has $150,000 expense for labor/wages regarding the zippers and $70,000
expense for labor/wages regarding the wine.
ForCo's sales and gross income from each country in Year 1 were as follows:
Zippers Wine
Gross
Country Asset Bases Sales Gross
Income
Income
United
$50,000 $250,000 $100,000 0
States
Argentina $100,000 $1,500,000 $200,000 $600,000
Assuming the income from the sale of zippers in Argentina and Bolivia is not effectively
connected with ForCo’s US operations, what is ForCo’s taxable income in Year 1 for US tax
purposes?
68
From Directly Allocable Expenses
Wine Wages – Foreign
Zipper Wages –
Problem tells us 90k from US, otherwise apportion based on where performed/used for
sales
Net loss of over (5k)
The Foreign Source Spectrum
Pure Investment
Pure Investment but election under 871(d)
Pure Business
o That is “Effectively Connected”
o §864(c)(3) – Catch all for most gain or loss from income within the United States
Pure Trade or Business with Secondary Activity
o §864(c)(3) says ALL income
o Regulations – even though wine activity wasn’t related to what you did in the US it
brings in other income, unless it is not US SOURCE
Pure Trade or Business with Passive Income
o §864(c)(2) – Using assets from the business for a quick return but its still an asset
Pure Trade or Business with unrelated non-864(c)(2) passive income
o Then some will be taxed as investment (see above) and some will be taxed ToB
o Reg § 1.864.4 provides two tests for segregating domestic source passive income:
“Asset use” test distinguishes holding investment assets from those used
day-to-day in the operation of the business
“Business Activities” passive income that arises directly from the conduct of
a ToB
Foreign Source Trade or Business (pg 130)
o §864(c)(4) types of foreign income that might be treated as ECI
Typically rents, royalties, foreign inventory sales, made US source under
§865(e)(2)
Source rules for inventory (typically its title passage unless mere conduit)
Intended to capture otherwise foreign source income with economic genesis
in US
Requires there to be a US office or other fixed place of business (OFPB)
§897 Deemed Trade or Business Effectively Connected Income
o Not a trade or business, US real property
Non-Resident Foreign Corporation/ Foreigner. If activity has some nexus to US, that US can tax
them. Has to be US Source/Effectively Connected.
PROBLEM SET IX: BRANCH PROFITS TAX AND INVESTMENT IN REAL PROPERTY
Read: Code §§ 884(a)-(d), (f)(1)-(2); 897(a)-(c)(4)(A), (e), (g); 1031(h).
Reg. §§ 1.884-1; 1.897-1(b)(1)-(4); 1.897-1(d)(1)-(2); 1.897-2(a)-(c)(1); 1.897-6T(a)
(1)-(3).
26 U.S. CODE § 1031 - EXCHANGE OF REAL PROPERTY HELD FOR PRODUCTIVE USE OR
INVESTMENT
69
(h)SPECIAL RULES FOR FOREIGN REAL PROPERTY
Real property located in the United States and real property located outside the United States are
not property of a like kind.
IX. INBOUND – TAXATION OF BRANCH PROFITS AND INVESTMENT IN U.S. REAL PROPERTY
(UNIT 9)
70
a) If U.S. net equity increases during the year the corporation’s effectively
connected E&P is reduced (but not below zero) by the amount of this
reinvestment in the U.S. (so would be reduced by $500 and thus no branch
profits tax)
4) If U.S. net equity decreases during the year, it’s effectively connected E&P are
increased by the amount of the reduction
a) So if in Year 2 the corporation withdrew $150 from its domestic branch
and had no effectively connected earnings for the year, the $150 decrease
in U.S. net equity appropriately increases the DEA and thus a 30% tax
would be imposed on the $150 withdrawal
5) Any increase in the DEA, however, cannot exceed the foreign corporation’s
accumulated effectively connected E&P
a) In the above example if the corporation withdrew $700 it should not give
rise to a DEA of $700 since this would exceed the corporations domestic
earnings of $500
C. Effectively Connected Earnings and Profits
1. 884(d)(1) effectively connected E&P represents E&P attributable to its effectively connected
income
a. 312 applies for computing E&P
b. In general, all corporate expenditures are allowable as deductions from E&P, no matter
whether they are deductible for income tax purposes
c. Items of income that would otherwise be exempt from tax are included
d. Regular corporate income tax is deducted in computing effectively E&P
e. E&P not reduced by distributions made by the foreign corporation during that year
D. The Branch Interest Tax
1. 884(f) 30% withholding tax on interest paid by a foreign corporation’s U.S. trade or business
a. Amount of branch interest subject to tax under 884(f)(1)(A) is generally capped at the
amount of interest apportioned to effectively connected income under the provisions of
1.882-5
b. No branch interest arises from liabilities incurred in the ordinary course of the foreign
corporation’s foreign business operations
c. No branch interest generally arises from liabilities secured by non-U.S. assets or from
inter-branch liabilities
E. The Branch Excess Interest Tax
1. 884(f) 30% tax on the amount by which the interest deduction allowed to a foreign
corporation under 882 exceeds the amount of interest paid by that foreign corporation’s U.S.
trade or business
a. The excess is treated as if it were interest paid to that foreign corporation by a wholly-
owned U.S. subsidiary
b. The foreign corporation accounts for and itself pays the tax along with its U.S. tax return
F. Background on the Taxation of U.S. Real Property
1. Foreign Investment in Real Property Act of 1980 (FIRPTA) 897 enacted to prevent tax-free
dispositions of U.S. real property by foreign investors and to put domestic and foreign investors
on equal tax footing with respect to such property
a. Gain or loss from the disposition of a “U.S. real property interest” by a foreign investor is
treated as if the gain or loss were effectively connected with a U.S. trade or business
71
b. Amount of gain or loss determined under 1001 unless one of the 897 non-recognition
exceptions applies to shield it from taxation
c. A non-resident need not satisfy a physical presence test or have a U.S. tax home to be
subject to the tax
G. Section 897: The Big Picture
1. Gain or loss from the disposition of a U.S. real property interest as defined in 897 is considered
effectively connected to a domestic trade or business under 871 and 881
a. Absent a special non-recognition exception the gain will be taxed at the graduated rates in
1 and 55
b. Deductions are allowed under 873 and 882(c)
H. Direct Investment in U.S. Real Property
1. Disposition of a direct investment of property actually and directly owned by the taxpayer is
clearly subject to tax under 897(a)
a. Two critical definitional issues arise for the application of 897:
1) The determination of whether “United States real property interest” is involved,
AND
2) Whether a “disposition” of that interest has occurred
I. United States Real Property Interests
1. 897(c)(1) generally is defined as any interest in real property (including interest in a mine,
well, or other natural deposit) located in the U.S. and any other interest (other than an interest
solely as a creditor) in any domestic corporation that is (or was, during certain specified time
periods) a U.S. real property holding corporation
a. Thus includes both direct and indirect investment via outright ownership, co-ownership,
options, and leaseholds
J. Tangible Property
1. U.S. real property interest includes not only land, but also any un-severed natural products,
improvements, and any personal property associated with the use of the land (also includes
leaseholds)
a. Buildings, permanent structures, and the structural components thereof are subject to 897
2. “Associated personal property” 897(c)(6) and 1.897-1(b)(4) four categories (significant
expansion of the statute’s reach to include personal property):
a. Property predominantly used in mining, farming, and foresting
b. Property used predominantly in the improvement of real property
c.
d. Property used predominantly in the operation of a lodging facility
e. Property used predominantly in the rental of a furnished office and other work space
K. Intangible Property
1. Intangibles included under 897 could employ an installment sale and then sell the obligation
to a third party (want to avoid this kind of arbitrage)
2. Installment sales under 453 may also be subject to 897
3. 897(g) look-through rule under which the disposition of an interest in a pass-through entity, to
the extent that the consideration received by the taxpayer is attributable to U.S. real property
interests held by the entity, is considered to be received directly by the taxpayer and thus is
subject to the rules applicable to direct investment
L. Dispositions
72
1. 1.897-1(g) a disposition of a U.S. real property interest is “any transfer that would constitute a
disposition by the transferor for any purpose of the Code and regulations”
a. An outright sale, its transfer in satisfaction of a claim, or any other taxable transfer will
constitute a disposition
b. Non-recognition transfers where boot is received
c. With regard to a gift, the relief of a liability in excess of the taxpayer’s basis
d. Most non-recognition transfers are respected as long as the interest received in exchange
carries the same 897 taint upon its disposition
1) 897(e) conditions any otherwise available non-recognition treatment upon the
continued application of 897 to the property received in the non-recognition event
2)
M. Indirect Investment – Interests Held Through Domestic Corporations
1. The interposition of a U.S. corporation between a foreign taxpayer and a U.S. real property
interest will not insulate the foreign investor from the application of 897
2. May even have double taxation in this situation
3. Gain from the sale by a foreign person of shares in a U.S. corporation will be taxed under 897 if
that corporation has at any time within the past five years (or, if shorter, the taxpayer’s holding
period) been a “U.S. real property holding corporation”
a. Determination predicated upon the extent of the corporation’s investment in U.S. real
property interests
b. Applied regardless of percentage of ownership or whether he disposes of all or only a
portion of his holdings
c.
N. United States Real Property Holding Corporations
1. 897(c)(2) Any corporation if the FMV of its U.S. real property interests equals or exceeds
50% of the value of all its combined foreign and domestic real property interests and business
assets
a. 897(c)(3) If publicly traded its shares will not constitute an interest in a real property
holding corporation unless the shareholder owns more then 5 percent of the stock
b. Holdings by that domestic corporation in other business entities are taken into account
c. If the domestic corporation owns a controlling interest of 50% or more of the value of the
stock of another corporation attribute a proportionate share of the subsidiary’s assets to
the parent corporation
1) An all or nothing proposition if owns less than a controlling interest then the
sole issue is whether the shares in the domestic or foreign subsidiary constitute a
U.S. real property interest (if so, entire interest considered a real property interest,
if not, none of the interest is so considered)
1. No gain or loss recognized under 897 when a foreign taxpayer disposes of shares in a foreign
corporation, thus foreign shareholders in a foreign corporation holding a U.S. real property
interest enjoy greater latitude
73
1. Under 311 and 336(a) a foreign corporation that distributes a U.S. real property interest will
recognize gain equal to the full unrealized appreciation in the distributed property at distribution,
however such gain would not ordinarily be subject to tax absent FIRPTA
a. 897(d) safeguard that imputes the requisite trade or business and effective connection
status to encompass any such gain
b. Examples:
1) Distributions “with respect to” shareholders stock 301
2) Distributions in redemption of shareholder’s interest 302
Distributions in liquidation where the transferee receives a stepped-up basis
§ 884(a) Branch profits tax (a) Imposition of tax.-- there is hereby imposed on any foreign
corporation a tax equal to 30 percent of the dividend equivalent amount for the taxable year.
Tax on Foreign Corporations
Dividend Equivalent Amount: represents foreign corporations’ current E&P from
domestic trade or business adjusted for net increases and decreases in United States Net
Equity
§884(f) Branch Interest Tax: 30% withholding tax on interest paid by a foreign corp’s
domestic ToB.
Applies if the recipient of interest payment is a foreign person not engaged in a domestic
ToB
Ex 2: F. Corp. parent forms a foreign subsidiary, which derives $100K ECI in the United States
Foreign person with ECI will be taxed at §1 trade or business at 35%
If all of the foreign subs’ earnings are effectively connected, the dividend will still have a
US source and will be taxed at 30%
Ex 3: F. Corp. uses a branch will still pay taxed at 35% but the payment from the Foreign
corporation to shareholders will not be US source because §861(a)(2)(b) will only tax if
more than 25% is ECI
74
If the Foreign corporation has significant foreign earnings they have prevented the
second level of tax – because the dividend income is foreign sourced
Foreign source dividend not subject to tax, missed out on second level of tax
9-1v Vietindo is a privately-held corp organized in Vietnam that sells luxury automobiles in its
showroom in NYC to US customers. In all cases, title to cars passes to customers in US.
Vietindo purchased the showroom building two years ago. Vietindo for Year 1 earned $100,000
of US net income and paid tax of $35,000 on it. In Year 2, it earned $200,000 net income, paid
tax of $70,000, and repatriated $50,000 to Vietnam. In Year 3, Vietindo earned $300,000 of net
income, paid tax of $105,000, and repatriated $250,000. What is the amount of the branch
profits tax, if any, for Years 1-3?
Dividend Equivalent Amount (DEA): means the foreign corporation's effectively connected
earnings and profits for the taxable year with adjustments up and down for increases/decreases
in U.S. Net Equity
Note that this is not the actual dividend – just the equivalent
If there is a DEA then it is taxed at US rate of 30%
Note that effectively connected income means that if a foreign corporation is not
conducting a US trade or business at first level there would be no effectively connected
income
Year 2:
Net Income: $200,000
Tax: ($70,000)
EC E&P $130,000
75
Apply $80,000 as a decrease in the Effectively connected EP of $130,000
Year 3:
Net Income: $300,000
Tax: ($105,000)
EC E&P $195,000
NOTES:
There is no threshold on how much ECI is from the United States; which means that this
foreign corporation might actually distribute a dividend to shareholders - could that be
U.S. sourced?
If this is true then there is a triple tax: ECI (as earned), Branch Profits (movement in Net
Equity)
9-3 FC has $120,000 of interest expense allocable to effectively connected income. It pays
branch interest in the same amounts as problem 9-2. To what extent is the branch excess
interest tax applicable?
Tax Excess ($20,000) at 30% to the foreign corporation.
9-4 Teo, an individual, is a citizen and resident of Argentina who has never been present in US.
Teo owned the following assets: (i) 100 shares of common stock of domestic X corporation; (ii)
100 shares of common of foreign Y Corp; (iii) rental real estate located in Modesto, CA (Teo’s
activities in this connection do not constitute engaging in a domestic ToB); and (iv) vacant land
located in OR held as investment property.
76
General Rule: Gain or loss of a foreign taxpayer from the disposition of US real property
interest is considered effectively connected to a domestic trade/business
Absent special non-recognition exception, gain will be taxed at graduated or capital gain
rates for non-resident individuals and §11 for foreign corporations
“Disposition” – broader sweep than a mere sale; any effort to sever ownership
Indirect Investment
Gain from the sale of shares in a US corp taxed under §897 if in past five years been a US
Holding Corp
US Real Property Holding Corporation: Any domestic corporation which fair market value
of US real property equals or > 50% of value of all combined foreign and domestic real
property interest and business assets
o Imputation for (1) Corp owning partnership interest, etc. and (2) Corporation
owning 50%
Publicly Traded: if corporation publicly traded, shareholder needs to own more than 5%
for USRPH Corp.
(a) Assume that Teo realized a $13,000 gain on the sale of the vacant land in Oregon. What are
the United States income tax consequences, if any, to Teo? § 897c1 real property
Result: Under §897(a) this would be taxed at the normal graduated rates – treated as effectively
connected – possible capital gains treatment (election is only on income on real property not
property gain) Without 897, this would have been passive income. This would not have been
taxed because Foreign Person has to have residence. If you can buy land, without being in the
US.
Only applies if you buy only one piece of land, if more than one piece, it will be engaged in trade
or business (Active).
(b) How would the answer to (a) change if Teo exchanged vacant land in OR for vacant land in
Ireland?
§1031(h) – U.S. Land for foreign land is not a like-kind exchange; therefore taxable as in
(a) above. Provisions that postpone the tax, if what is getting back if foreign property. If
its exchanged for US Property then postpone gain.
77
o §897e and -6T regulations say that this would not be treated as a non-recognition
event
Basic Principle: If you have something that would be recognized if sold to something that
would not be recognized if sold (i.e. out of hands of US) then it will be taxable.
(c) How would the answer to (a) change if Teo contributed the vacant land in Oregon to Z
Corporation, a domestic corporation, in return for all of its stock?
Non-taxable. Ordinarily this would be a non-recognition under §351
Non-recognition-postpone the impostion of tax.
EVERY time there is a sale of stock by a foreign person you need to ask first: Assuming
corporation is not US real property corp… If you hold land think about §897; if you hold stock
think about US real property interest
(d) Assume the facts in (c) occurred in Year 1. In Year 2, Teo sold the Z stock for a gain of
$20,000. What are the United States income tax consequences to Teo in Year 2?
Treated as disposing a piece of real property – taxed as normal capital gain; this is a US
real corporation so §897, FIRPTA applies.
(e) How would the answer to (a) change if Teo contributed the vacant land in Oregon to Q
Corporation, a foreign corporation, in return for all of its stock?
§897(e) – Blocks this; Foreign corporation is not treated as a US Real Property holding company
– it simply looks through to include this as taxable. § 897c4A applies seeming to make foreign
corp a USRPHC, but § 897c(1)(A)(ii) only taxes domestic corporations
(f) Assume Y Corp owned exclusively real property located in US. If Y Corp sells a parcel of real
property to an unrelated purchaser, what US income tax consequences, if any, arise? §
897a
Y is a foreign corporation; does not matter if it is an individual or foreign corporation –
still taxable (except at corporate rates)
(g) How would the answer to (f) change if Y did not sell any of its holdings but Teo sold all or a
portion of his shares in Y?
Teo sold his shares in foreign corp, not included in the definition of a US Real
property interest
What Happens?
Still have US real property held by foreign corporation; so when this is sold tax will arise
Because assets will be subject to tax when sold; then net value of property is less because
of tax
78
Seller of stock is not taxed, purchase price should reduce with knowledge of inherent tax
liability
(h) Assume that Teo buys stock in domestic W Corp, the exclusive holdings of which are US real
property. If Teo sells the stock four years later for a gain of $5,000, what are the US tax
consequences, if any?
U.S. real property interest subject to tax under FIRPTA subject to § 897c2
Even if they bought
(i) How would (h) change if Teo purchased and sold a ten-year debenture rather than stock?
§897c1A(ii) – does not include interest solely as a creditor (“any interest”)
o Make sure debenture is not actually disguised equity - because you could see
people attempting to cloak debt as equity to avoid §897 tax
(j) How would the result in (h) change if W was publicly traded?
§897(c)(3) – Exception for publicly traded; will only be taxed if Teo owns >5% of the
corporation classified as a US Real property interest, no change
(k) How would the result in (h) change if W’s real estate holdings comprised only 30 percent of
its asset base on the date of sale?
Now this is below the 50% threshold for US Real Property interest – not a US holding
corp if 5 year taint under §897c1A(ii)(ll)
§897(c)(2) – If it did at some other time period meet the definition you will still be taxed
as if it was a sale of a US Real Property interest (see further definition in regs).
Solution:
(l) How would the result in (k) change if Teo sold his stock ten years after its purchase?
Regs: Shorter of holding period or 5 years before sale; would avoid the US holding corp
classification. Even if it was in the beginning a real property holding corporation classification.
A. Overview
1. Purpose is to mitigate the potential for double taxation
2. Provide consistent rules specifically governing which treaty country has the primary right to tax
income items or certain classes of persons
3. Double taxation arises most often when one country asserts taxing authority on the basis of the
residence of the person receiving the income (the home country) and another on the basis of
source of the income (the host country)
4. May introduce complexities because they provide a second source of authority
a. Have the same effect as acts of Congress and possess authority that overrides the tax
treatment otherwise provided by the Code
5. Treaties are generally drawn from model income tax treaties
79
B. The Treaty Process
1. The date that ratification instruments are exchanged generally marks the date upon which the
treaty is considered to be “in force”
a. A treaty which is in force is not, however, always “in effect”
b. Treaties may contain prospective or retroactive effective dates
C. Interpretive Resources
1. Protocols may amend existing and proposed tax treaties and must be duly enacted via proper
ratification procedures
2. Technical Explanations serve as official guides to the tax treaties
3. Model treaties
4. Letters of understanding
5.
D. Relationship of Tax Treaties to U.S. Federal Law
1. Establishing the directional flow of the income item is therefore an imperative first step in
analyzing how the treaty will apply
2. Treaties and the Code are generally accorded equal weight as 894(a)(1) and 7852(d)
acknowledge
3. Courts have adopted a “last in time rule” of construction which provides that the later enacted
provision controls
4.
E. Double Taxation
F. Saving Clause
1. The U.S. reserves its right to subject its own citizens, including those permanently living abroad,
to domestic tax on their worldwide income as if the treaty were not in effect, as provided in
Article 1, paragraph 4 of the 2006 Model Tax Treaty
a. Called a saving clause, presumably because it saves U.S. taxing jurisdiction over its
citizens
b. U.S. citizens are thus generally not permitted to avoid taxation by establishing foreign
residency and claiming U.S. treaty benefits extended to foreign residents
80
1. In most cases, only a corporation or other person that is a “resident” of one of the foreign
signatory countries may claim the benefits of an income tax treaty
a. Treaties generally define those individuals and entities that qualify as residents and the
2006 Model Tax Treaty, Article 4 provides a definition
2. Because a person may be a resident of both signatory countries, most treaties contain a
“tiebreaker rule” to place a dual resident in only one country for purposes of applying the treaty
1. Often found in the “limitation of benefits” clause and operates to restrict treaty benefits to those
individuals and entities legitimately connected to the treaty countries
a. Prevent citizens of other countries that do not have U.S. tax treaties from exploiting treaty
benefits by selectively conducting their affairs in favorable treaty countries
I. Non-Discrimination
1. Attempt to ensure that the residents of each signatory country are not discriminated against in a
tax sense by the tax authorities of the other country by incorporating a “non-discrimination
clause”
a. Promises not to tax a foreign person residing in a treaty country at a higher rate than a
U.S. person in the same circumstances, nor to deprive that person of any deduction
or credit available to U.S. citizens in the same circumstances
81
However if code section does not plainly show intent to supercede treaty, treaty may
prevail
§7582 states that they should be considered in tandem
o Note – renegotiating treaties tough; protocols can tweak rather than rewriting
whole.
10-1. In what ways do income tax treaties fulfill their articulated objective of "eliminating
double taxation"? What other avenues (besides treaties) are available for eliminating double
taxation'? If unilateral measures are available, to what extent is a reduced rate under treaty
valuable?
Purpose is to avoid double taxation of individuals; do so by providing sole means for
taxation of individual subject to treaty
Move from source to residence based taxation
Gives tp more certainty and relief by allowing appeal to competent authority
Other avenues are the foreign income exclusion, credit, deduction etc.
10-2. Melinda, a US citizen, retired to Canada on January 1, Year 1. If Melinda derives $30,000
of dividend income from US sources after her move, what country or countries might tax
income and at what rate(s)?
Eligibility for Treaty Benefits:
Defined in the treaty – but normally it is limited to “Residents”
If a person is considered a resident of both countries, then a tie-breaker is applied
82
Article IV Resident: means any person that, under the laws of that State, is liable on tax
therein by reason of that persons domicile, residence, citizenship, place of management, incorp,
or other criterion.
Yes - assumption that she is a resident of Canada.
Melinda’s residence depends on Canadian law – because a “resident of the Contracting
State” means a person who, under the laws of the state is liable to be taxed therein.
“Savings Clause” Operates to subject United States citizens living abroad to continued
domestic taxation
Canada – Article 29(2), Treaty shall not effect taxation of a country’s own citizens
Prevents US citizens from shielding themselves in foreign residency to avoid taxation by
US
29 (2) (a) and 29((b)
Tie breaker rules on residency does not apply to US Citizens.
10-3. Hans, a citizen and resident of Canada, works in US each year from January 1 to July
31. During his stay in US, Hans rents an apartment in NYC. Hans owns a home in Canada,
where his spouse and children live all year. Hans is a registered voter in Canada, and Canada is
location of bank accounts, stocks, and automobiles. Is Hans subject to US taxation on the
dividends he receives from his Canadian stock?
83
The Corporation in Canada
Look at Article IV Part 1: look at place of management/place of incorporation so
corporation would be a resident of Canada
Step 2: Will this work under the Treaty?
o No – because the treaty includes an anti-treaty shopping clause
o Article 29(a) – Limitation of benefits; if 50 % of ownership of corporation is
Canadians it may be ok – but because only shareholder is from Argentina, they are
trying to accomplish indirectly what they cannot do indirectly
Even if you are a resident, you have to be a qualifying person, if it’s a FCThis
collapses the transaction so that the corporation is treated as Argentine – subject
to normal 30% tax rate (not reduced rate of Canadian tax treaty)
A. Overview
1. Taxation on investment income may be reduced or eliminated altogether pursuant to tax treaties
between the U.S. and other countries
2. Treaties generally assign the right to tax investment income to the residence country and active
income to the source country
3. Savings clause in U.S. treaties prevent these agreements from applying to reduce the taxation of
U.S. citizens or residents, or both, the transactions here generally focus on inbound
transactions, that is, the U.S. taxation of U.S. source investment income earned by foreign
persons
a. Generally tax passive income at flat 30% rate under 871 and 881
b. Foreign persons in countries with tax treaties may be entitled to a reduced rate of tax,
since these agreements impose a rate far lower than the statutory 30% rate for most types
of passive income
1. Dividends not effectively connected to U.S. trade or business generally taxed at 30%
a. Tax treaties generally reduce the statutory tax rate significantly and the recent trend has
been towards complete exemption of dividends with respect to certain inter-company
dividends paid between companies resident in contracting states
b. Most treaties reduce the rate to 15% “general rate” for individual shareholders and for
corporate shareholders holding less than 10% of the company’s shares
1) There is a 5% direct dividend rate for dividends paid to corporate recipients that
own at least 10% of the stock of the paying corporation, so long as the dividend
is not attributable to a permanent establishment
a) Rev. Rul. 75-118 ruled that a foreign corporation was entitled to the
direct dividend rate under the treaty even though the company had
restructured its subsidiary from Canada to the U.S. solely to take
advantage of the treaty with the U.S.
84
2) Reduced rate for dividends applies only if the dividends are not attributable to the
operation of a permanent establishment
a) If attributable to a permanent establishment the provisions of Article 7
(Business Profits) apply
b)
C. Interest – Model Tax Treaty Article 11
1. Most U.S. source interest is not in fact taxable to foreign persons due to the bank deposit and
portfolio interest exceptions
2. The Model Tax Treaty generally provides that interest received from a U.S. payor and
beneficially owned and derived by a treaty country resident may be subject to tax of up to 15%,
so long as the interest is not attributable to a permanent establishment
a. If attributable to a permanent establishment, the provisions of Article 7 (Business Profits)
apply
3. Majority of treaties do not completely exempt domestic source interest from taxation but provide
a reduced rate typically between 10% and 15%
4. Anti-abuse exceptions:
a. Contingent interest calculated on the basis of profits, cash flow, property appreciation,
and similar items
b. Certain interest payments connected to a real estate mortgage investment conduit which
are typically subject to full source country taxation
1. Royalties derived from the U.S. are generally exempt from tax or subject to a reduced rate of tax
under most tax treaties
2. 2006 Model Tax Treaty provides for complete source country exemption of royalties derived
and beneficially owned by a resident of the other contracting state
a. Royalties derived by a foreign licensor from U.S. sources are exempt from U.S. taxation
b. Accordingly, so long as the royalties are not attributable to a permanent establishment,
they are also exempt from the flat 30% tax
3. Royalties that are attributable to a permanent establishment are addressed in Article 7 (Business
Profits)
1. Under most treaties, gains derived from the transfer of property are generally table only in the
country of the transferor’s residence
a. However, the U.S. retains jurisdiction to tax those gains derived from the transfer of
intangible assets where the amount of the gain is contingent on the productivity, use, or
disposition of the intangible asset
1. Most treaties do not provide for a reduction of the statutory rate for income derived from real
property and typically subject to tax in the situs jurisdiction regardless of whether the income is
85
derived annually (e.g., rental income) or whether the income is derived from a disposition of the
property (e.g., gain from the sale of property)
G. Residual Income – Model Tax Treaty Article 21
1. Will typically eliminate the U.S. tax on such income, generally granting taxing authority to the
recipient’s home country only
a. Applies so long as the income is not attributable to a permanent establishment in the U.S.
Inbound Transactions:
I. Statutory Rules
o Active
o Passive
o US Source
o Passive
o Tax applied is 30% on gross [implicitly no deductions allowed]
Dividends/Interest
o Gains – look at presence test etc. §97
o Real Property – treated as T/B so taxed according to normal rate schedule
Result: Look at result under Statute and Under Treaty and choose the lesser of the two
11-1. Tom, a citizen and bona fide resident of Canada, has never been present in US. During
Year 1, he had no US trade or business, but owned a number of assets that produced the
following items of income:
(a) $20,000 dividend on the stock of DelCo., a corp formed in Delaware. – taxed at 15% under
treaty
Dividends. Article X
Contracting State can impose a tax on its residents for dividends paid by a company
which is a resident of the other Contracting State
Limitation: Amount of tax that may be imposed on dividend by “other Contracting State”
[i.e. state where company is a resident] if owner of dividend is resident of Contracting
State
o 10% for Companies with beneficial ownership owning 10% or more of voting stock
o 15% on the gross amount in all other cases [individuals]
Not parallel with passive income treatment where deductions are not
allowed.
Dividend Defined: similar to definition in statute
Beneficial Ownership: requires permanent establishment etc.
86
o You can have passive income; but there will be a similar determination if you have
business activity so that it moves from passive treatment in article X to Article VII
(Business profits)
II. Source rules are often defined in the treaty/may be different from statute:
Notice that this is not source dependent – although the Dividend is from a US corporation; does
the source rule as defined by the statute carry extreme significance under the treaty.
Do the provisions refer back to the US Source rules?
Article X, 2 is a source rule in the treaty
Result: Although there is some element of sourcing, the rule is often provided in the
treaty itself – no need to go to the statute.
(b) $5,000 gain on sale of ten shares of stock in UruCo., a corporation formed in Uruguay;
Gains - Article XIII
If it’s a Foreign Corporation – only three situations where gain will be recognized
Real property
Capital stock
Interest in partnership
(c) $13,000 dividend on the UruCo. stock, of which $5,200 is US source and $7,800 is foreign
source;
Article X: Not taxed because UruCo. Is not a resident of either country.
Notes:
When we worked through this problem from a source rule point only; we noticed that dividends
from a foreign corporation can have a US source if some of the earnings (greater than 25%) had
a US source
871(d) – Dividends arising under this provision are not subject to tax
o Branch profits tax
At time source rule was designed, branch profits in 884 was not yet in force
Branch profits combined with effectively connected will tax as earned and if removed it
will be taxed at 30%
IF it is ultimately a dividend leaving US it will not be taxed – this would be a third tax
87
(d) $10,000 in rents from rental property located in the United States;
Article VI. Income from Real Property
Income derived by resident of Contracting State (Canada) from real property in other
Contracting State (US) may be taxed by that other State. “May be taxed in the U.S.”
o Treaty provision clarifies who can tax the income but silent on rate of tax to be
applied
Rule: Where treaty is silent on tax rate to be applied, look to statute
Result: Rental income subject to tax; but it will be taxed according to U.S. treatment of passive
income, which is 30% of the gross amount
Because there were expenses for the rental property these will not be allowed – so you
would not be able to take the expenses.
Under US rules would want to elect to treat the income as income from t/b – get
graduated rates
(e) $1,000 of foreign-source interest on a loan made to Emily, a citizen and resident of Bolivia;
$2,000 of interest on a deposit at a Chicago, Illinois bank;
Interest – Article XI
Interest in CS beneficially owned by a resident of the other CS can only be taxed in that
other state
Result: Taxable in Canada (not US) under Article XI(1)
(f) $8,000 in cash from the sale of US rights to a patent Tom created for five percent of the net
profits from products produced through its use.
Royalties Article XII (3)
General rule is that both states can tax the income; however certain royalties which arise
in a contracting state owned by a resident of the other State, can only be taxed in that
Other State (treaty provision: contingent portion0.
Cap on patent tax of 10% if it is taxable
Result: Under Article XII this is not subject to tax
Notice Themes:
If we looked at this problem under the statute – go back and look if this is taxed first
Article XII pulled this out of Article XIII - gains from patents are handled here because a
royalty
Tom’s potential deduction for the year consisted of depreciation and expenses with respect to
the rental property of $3,000, a $1,000 loss on the sale of five shares of UruCo. stock, and
medical expenses of $4,500. Assume Tom would be subject to a 20 percent effective rate on his
taxable income.
(a) What is Tom’s US taxable income and his tax liability for Year 1 assuming none of his
holdings constitutes a permanent establishment under the United States – Canada treaty?
Income Taxable by US
88
11-2 Shaida is a citizen and resident of Canada. In Year 1, purchased ten shares of DelCo
stock,a Delaware Corp, for $7,000. In Year 3, Shaida sold the shares for $10,000 cash to an
unrelated individual residing in US. To what extent will US impose tax on $3,000 gain in Year 3
under each of the following scenarios?
(a) Shaida was never physically present in the United States at any time in Year 1, Year 2, or
Year 3.
Gains – Article XIII
US real property does not include shares of capital stock
Under Part 4, any other property other than specifically listed is taxably in the State in
which the person selling the property is a resident – i.e. not taxable by Us because Shaida
Canadian resident
Note: If this is a Domestic Corporation you must determine if it is a real property holding
company, and the time period, because it could be dragged in by §897 or the Treaty
Capital Gains Provision Notes: Most gains will not be subject to tax
Step 1: Start with the Statute:
Physical Presence Test: For a foreign person have to be present > 183 days
Then you are a US resident and fall out of §871(a)(2)
If you are there for 200 days/some were exempt – you are not a resident but you have presence
Still not taxed because under §865 if tax home not in US, not US source and therefore its
not taxed
Under statute if you are resident of the U.S.
Then you cannot even look at the treaty – savings clause
STILL need to determine if you are a resident of Canada and regulations under §7701(b)
says that the Treaty tie-breaker will control
Step 2: Once you figure out it is a foreign person then you head to Article XIII to answer the
question.
(b) Shaida was not physically present in US at any time in Year 1 or Year 2, but she was
physically present in US for 200 days in Year 3. Tie breaker rules make her Canadian resident
under treaty. Look at Gains in Article 13(4) taxable only in country of residence under treaty –
in Canada.
(c) Same as (c), except that for 100 of the 200 days of presence in the United States in
Year 3, Shaida was a student residing in the United States under a “J Visa,” issued under
Immigration and Nationality Act. Now clearly a non resident – student presence 183, but no tax
home - taxable in Canada.
11-3 ForCo is a corp organized in Canada. All of ForCo's shares are owned by citizens and
residents of Canada who have no connections to US. ForCo has a number of investments in US,
but does not have a PE within US. For each determine whether the interest received by ForCo is
subject to US tax under §881(a).
Interest - Article XI
Tax rate is 0% [this has been the same in most statutory provisions]
Except: Portfolio interest rules – does this look like a disguised dividend?
o Exempts withholdings for interest paid on certain obligation held by foreign
persons
89
(a) § 871a2D not subject to tax
(b) Foreign source, not subject to US tax § 861a1
(c) § 871h not subject to tax, portfolio exception
(d) Tied to earnings, subject to tax under Article XI 6 (b) dividend rate, not to exceed 15%
(e) Not subject to tax
(f) 30% tax under statue, Article XI does not specify this type of interest, meets general treaty
exception
Answer (e)It is contingent and does not qualify for portfolio interest-???
Still subject to tax but at a lower rate
Contingent Earnings and Portfolio Interest rules
Note that contingencies not tied to earnings are 0%
Look at Article XI (a)
Treatment gets you $0
But notice that under (b) if its Canadian gross amount may be taxed not exceeding rate
for dividends – treated as disguised equity
A. Overview
Under statutory law, foreign persons are subject to U.S. taxation on all income derived from the conduct of
trade or business in the U.S., while under most treaties, income derived from the conduct of a trade or business
is taxable by the U.S. only if it constitutes “business profits” that are “attributable to” a “permanent
establishment” maintained in the U.S.
90
permanent establishment conduct of a trade or business
in the U.S.
Rate of tax Graduated rates (1 or 11) Graduated rates (1 or 11)
Deductions allowed? Yes Yes
1. Interpretive steps:
a. Step One determine whether a person is carrying on a business in the U.S. for treaty
purposes
b. Step Two determine whether that business is conducted through a “permanent
establishment”
1) If no income will not be taxed as business profits (but might be taxed under
another treaty provision)
2) If yes profits must be appropriately attributed to the permanent establishment
c. Step Three deductions must be appropriately allocated to the permanent establishment
2. Corporate form respected a foreign person investing in a domestic corporation that carries on
a trade or business will not need to invoke a treaty with respect to the business profits of the
domestic corporation (only when a foreign person is itself involved in carrying on a domestic
business)
1. Pretty much the same standard under 864 (regularity and continuity)
1. Rev. Rul. 58-63 qualitative difference between a trade or business and a permanent
establishment
a. Permanent establishment provision serves as a higher threshold to the taxation of
business profits
b. Instead of triggering U.S. tax upon meeting the more easily satisfied trade or business
standard, a foreign person will be able to avoid triggering U.S. tax if the activities do not
constitute a permanent establishment
2. Treaties generally equate a permanent establishment with a fixed place of business through
which the business of an enterprise is wholly or partly carried on
a. Will possess a permanent establishment in the U.S. if it either maintains such fixed place
of business in the U.S. or if the activities of another person who maintains such fixed
place of business are imputed to the enterprise
1) “Physical presence test supplemented by an agency rule and restricted by an
activity rule”
a. Place of management
b. Branch
91
c. Office
d. Factory
e. Workshop
f. Warehouse
g. Place of extraction of natural resources
a. Use of facilities or the maintenance of a stock of goods solely for the purpose of storage,
display, or delivery
b. Use of facility for ancillary business purposes
c. Fixed place of business solely for the purpose of purchasing goods or merchandise,
collecting information, or carrying on any other activity of a preparatory or auxiliary
character
d. Website
e. Showroom or demonstration room to display or demonstrate the use of its products to
domestic customers
5. A permanent establishment may indirectly arise by virtue of a foreign person’s ownership
interest in a pass-through entity
a. A permanent establish may be imputed to a foreign partner in a limited or general
partnership if the partnership itself has a U.S. permanent establishment
b. However, stock ownership, or affiliation with, entities or persons with a U.S. permanent
establishment does not in and of itself appear to be sufficient grounds to impute a
permanent establishment to the owner or affiliate
D. Duration
1. Permanent establishment should not arise if the use of an office or fixed place of business is brief
or transitory rather than permanent
2. However, conducting significant business operations at a site for abbreviated time periods has
been found to give rise to a permanent establishment
F. Use of Agents
1. Permanent establishment will exist when a foreign person conducts business through an agent
who effectively serves as its U.S. alter-ego
92
commission agent, or any other independent agent, so long as that agent acts in
the ordinary course of business
2) 2006 Model Tax Treaty Article 5(5) dependent agent’s activities are imputed
to a foreign principal only if the agent has and habitually exercises in the U.S.
the authority to conclude contracts in the name of the principal and the agent’s
activities themselves constitute a permanent establishment
2. Independent agent paid to sell good or merchandise consigned or entrusted to the agent
3. Dependent agent one who truly stands in the stead of the principal and may have the authority
to negotiate and conclude contracts or fill orders and must be exercised with “some frequency
over a continuous period of time”
G. Dependent Agents
a. 2006 Model Tax Treaty Article 14(2) compensation derived by a foreign individual
eligible for treaty benefits is not subject to U.S. income taxation if the recipient is present
in the U.S. for 183 days or less, the compensation is paid on by or on behalf of a foreign
employer, and it is not borne by a U.S. permanent establishment or fixed base
b. A bona fide employer-employee relationship must exist in order to ensure treaty
exemptions
1) If foreign individual establishes a foreign corporation to “employ” him shortly
before coming to U.S., probably no bona fide employer-employee relationship
2) If corporate employer lacks substance
c. In some situations treaty benefits cannot be extended if the compensation sought to be
excluded is deducted on a U.S. tax return filed by the foreign employer
93
d. Some tax treaties limit the amount of income that may be received by a claimant for
dependent services
1. Typically subject this kind of income to tax only if the services are performed in the U.S. and the
income is attributable to a domestic fixed base that is regularly available to the individual for
performance of services
b. Canada Treaty two separate tests for when services will be considered provided
through a permanent establishment:
2) Services provided in the other contracting state for 183 days or more in any 12-
month period for the same or a connected project, for customers resident in that
other contracting state, or who maintain a permanent establishment there, if the
services are provided in respect of that permanent establishment
1. After having determined that a foreign taxpayer has a permanent establishment in the U.S., the
next step is to ascertain the “business profits” of the taxpayer that are “attributable to” the
permanent establishment
94
K. Business Profits – Model Tax Treaty Article 7
1. “Business profits” generally includes income derived from any trade or business, including the
rental of tangible personal property and the performance of services
a. Business profits article generally overrides other treaty articles dealing with specific
types of income
b. If there is a permanent establishment, the business income will be subject to tax on a net
basis even if it is exempt from tax under a separate treaty article
1. Business profits are “attributable to” a permanent establishment if the assets or activities of the
permanent establishment play a meaningful role in generating those profits
2. Generally only income from assets used, risks assumed, and activities performed by, the
permanent establishment will be attributable to the permanent establishment
95
N. Waiver of Business Profits Article Protection
1. A foreign person not maintaining a U.S. permanent establishment may decline to use an
otherwise available tax treaty exemption for business profits
a. May want to do this to create a U.S. net operating loss carryforward
b. May also dislodge income attributable to a permanent establishment to absorb losses not
so attributable
General Rule: Tax treaties provide business income is taxable only if an enterprise possesses a
PE in USs
Without PE, income is not taxable even if a domestic trade or business exists
If PE exists, tax is usually only on business profits which are attributable to the PE
96
Use of facilities for storage, goods are solely maintained for processing by another
Maintenance of stock/merchandise for storage/display/quick delivery to domestic
customers
Purchase of goods/merchandise for sale elsewhere, or combination of above
II. Treaty
Business Profits – Article VII
Independent & Dependent Agents
Permanent Establishment
o Deductions, Branch Profits, Graduated Rates – on net, §884/§897
o Whether asset held with principal purpose of promoting present conduct of ToB
o Whether acquired and held in ordinary conduct
o Whether held in direct relationship to ToB (3 Factors whether asset tied to PE)
12-1. CanCo was organized under the laws of Canada. Its principal business activity consists of
the worldwide sale or goods purchased in Canada. All of CanCo's office facilities are located in
Canada.
Note: With nothing more, US could not tax CanCo; need US activity that creates a “presence”
(a) If CanCo receives unsolicited orders from US residents, is its income subject to taxation in
US?
97
PE - Article V: Canco is exempt from income tax in the US because there is no permanent
establishment
Three types of permanent establishments:
Doesn’t matter if you have business profits – if there is no PE there is no income tax.
o NOTE greater activity may constitute trade or business under the statute but will not be
a permanent establishment in the treaty (so not tax still)
o This also shelters US businesses which may do the same thing in the other country.
(b) How does the answer to (a) change if CanCo sends catalogs to various individuals in US
and advertises on US television, all of which leads to the placement of orders by US residents?
PE Article V, 6(e) – NO permanent establishment even with the increased activity because no
fixed presence either owned or rented.
Notes:
Is it possible to have a trade or business in US and not a PE? Alternatively can we have a PE
and not a TB?
o The PE requirement is more rigorous so more likely you will have a TB under the statute;
however you can possibly have a TB under the statute but not PE under the treaty.
(c) How does (a) change if, respecting sales made in US, orders for CanCo's goods are solicited
by their traveling salespersons operating out of the home office on a commission
basis? Assume purchase orders are sent to the Canadian office where they are accepted by
CanCo and filled from inventory warehoused in Canada. Also assume that CanCo maintains no
inventory, plant, office, or other facilities in US. Yes Trade or Business and No PE
Agents:
Is this an independent or dependent agent?
o Salespersons would probably be a dependent agent - see Article 5, Part 5
o More likely independent agent if authority to conclude contracts and exercises that
Article 5,Part 7
Result: Here because you have to send it back for final approval the real decision (needs to
be a real process of finalization to avoid abuse) is made in Canada, it’s a dependent agent
Strategy: If you have a factual setting where once the agent concludes it always gets approved
and its simply done this way to avoid PE so you may want to look at substance over form
o To avoid taxation would want to document that actual decision-making occurs in Canada
o Independent agents usually represent multiple clients – no permanent establishment
o This is most likely a ToB, individual without treaty taxed on income – but under treaty no
tax!
(d) How does the answer to (c) change if CanCo maintains a branch office located in leased
office space in Chicago, the branch maintains a leased warehouse for storage of
purchased inventory, and US sales staff operates out of the Chicago office, but all orders
had to be accepted in Canada?
98
Article 5, Par. 6 (a) – No PE if the facilities are used to store inventory, display or deliver
goods/merchandise
Combination – Agents sitting in an office giving the company a competitive advantage;
here in this situation there are a multitude of activities – but each would have to be
examined to determine whether or not there was a permanent establishment. Probably
yes a PE
Article 5, Par 8 – Mere fact that you own an interest in a corporation with a PE will not be
imputed to you – because its already being subject to tax in the US
(g) Would the answer to (e) change if CanCo was a significant sh? A majority sh? The sole
shareholder?
Unless more facts given; it is not considered the foreign enterprises PE through mere
ownership.
Assuming Domestic Corporation is held by foreign parent but will use the DC to sell
product of the foreign parent – then there is an agency issue where the DC is acting as
the agent for the parent
RULE: Requires more than mere ownership.
(h) Would the answer to (e) change if CanCo instead invested in a general P or LLCrather than a
corporation?
Rule for Disregarded Entities: If the partnership itself has a PE then this will be attributed to
the partners regardless of their ownership level. In the treaty, this is not defined specifically.
Code § 875 (partner engaged in US trade or biz if P is). Unger Case
(h) X Corp is organized in Canada. X entered into a contract with DomCo, a domestic corp,
under which DomCo serves as X's exclusive agent in selling X's products in US. DomCo
receives a commission for each sale to a US customer. The contract prohibits DomCo from
selling any competing products in the United States and from acting as the agent for another in
selling any competing products in the United States.
Question of independent v dependent agent
99
Article 6 (6)(d) – purchase of merchandise, gathering information is not a trade or business
12-2 George is a Canadian architect representing a client that is constructing a building in San
Francisco, As part of his services. George was on site on six different days during the year.
Remember that the magic threshold amount is $3,000 so services would most likely be
instantly subject to tax because its very easy to be a TB - However under the treaty
things may be different
(a) Is George subject to taxation in the United States?
(b) Would the answer to (a) change if George was on site for nine consecutive months during
the year?
Because he is present >183 days there is PE + all of income came from the activity (see Par. 9
(a))
Article 3 says if a construction project lasts less than 12 months there is no permanent
establishment
o If it was just construction for less than a year – the Construction company does not have
a PE; however architect is independent that does not tell us whether or not he will fall
into subpart 9
(c) Suppose George is a commissioned salesperson who works for Canadian corp selling
products in US. George spends 130 days in US in pursuit of employment. Is George subject to
taxation in United States?
George is now commissioned & dependent agent; and therefore you look at Article 15 for
employment
If the payment is under $10K doesn’t matter and no PE; if you make more than $10K you will
escape the tax if you are there for 183 days and the remuneration is not paid by a resident of
US or a PE
100
12-3 ForCo is foreign corpo organized in Canada that purchases zippers. It has facilities in
US, Canada, and Brazil. The zippers bought in US are sold exclusively in US. Likewise, the
zippers bought in Canada are sold exclusively there, and same for Brazil. ForCo generates all of
its income from these three countries. ForCo does not have a US subsidiary, nor separate
division that oversees operations in the US. For Year 1, Forco incurred $50,000 in general
administrative expenses related to both US and non-US operations. In addition, ForCo incurred
$80,000 in deductible interest expense in Year 1 from borrowings used to improve the Brazilian
facility. ForCo's sales and gross income in Year 1 were as follows:
Zippers Wine
Gross Gross
Country Asset Bases Sales
Income Income
United
$50,000 $250,000 $100,000 0
States
Argentina $100,000 $1,500,000 $200,000 $600,000
Assuming income from purchase and sale of zippers in Canada and Brazil is not attributable to
ForCo’s US operations, what is ForCo’s taxable income in Year 1 for United States
income tax purposes?
Does a PE exist? - Yes therefore taxed on the profits attributable to United States
Deductions
861-8 regulations
Article VII, Par 3: Allows to take general and executive/admin expenses
o General Proposition start as 861-8 to determine deductions; tech explain
acknowledges that as we look to allocations under the statute, some not tied as
closely to the business activity
o Look at what it would have deducted if it existed separately on its own.
Final Point:
We have focused in our problems on passive and active; in the treaty context each of those
activities that we discussed in the spectrum would/should be looked at in a treaty context -
business profits.
Need to ask question on this?
A. Overview
1. The purpose of subpart F is to accelerate U.S. taxation of certain earnings of foreign corporations
that are controlled by U.S. shareholders
a. Exception to the general rule that U.S. does not impose tax on foreign-source income
earned by foreign persons
101
b. 951(f) subpart F subjects certain U.S. shareholders of CFC’s to current taxation on
certain of the CFC’s earnings and investments regardless of whether they are distributed
to the shareholder
B. CFC Defined
1. 957(a) a CFC is a foreign corporation of which more than 50% of the stock, as measured by
either vote or value, is owned or considered to be owned by “United States shareholders” on any
day during the corporation’s taxable year
1. 951(b) a U.S. shareholder is a U.S. person who owns, or is considered to own due to
attribution rules, 10% or more of the foreign corporation’s total combined voting power of all
classes of stock entitled to vote
a. 957(c) U.S. person is generally defined as provided in 7701(a)(30)
b. 958(a) and (b) ownership of a CFC determined via shares held directly, indirectly
through other entities, and constrictively by attribution from other shareholders
D. Direct Ownership
1. Substance-over-form approach
1. A foreign corporation is not a CFC so long as no single U.S. shareholder owns 10% or more
of the voting stock, even if more than 50% of its total voting power or value is owned by U.S.
persons
102
2. A foreign corporation is not a CFC even if a U.S. person owns exactly 50% of its stock, so long
as all other U.S. persons each own less than 10% of the stock and are unrelated
G. Flowchart
Policy behind safeguards is to prevent US citizens from forming foreign corps and trapping
profits abroad
Which system are we and which system would you recommend for the future?
Under the safeguard regime examine whether we are closer to deferral or imputation
Primary purpose: insulate income from US tax within a foreign corporation – defer tax on that
income
Otherwise enjoy better tax rate or lower statutory rate and stockpile ordinary income
abroad
Effectively provides shareholder with an interest free loan from the federal government
103
Where a CFC exists, all US Shareholders are subject to current taxation on
(1) Proportionate share of CFC subpart F income and previously excluded Subpart F income;
and
(2) Shareholder’s amount of CFCs investment in US property
Controlled Foreign Corporation: More than 50% vote and value owned by US
Shareholders
§ 957. Controlled foreign corporations; United States persons
(a) General rule.- “controlled foreign corporation” means any foreign corp if more than 50
percent of--
(1) the total combined voting power of all classes of stock of such corporation entitled to
vote, or
(2) the total value of the stock of corp, is owned or considered owned by rules of
ownership of section 958(b), by US shareholders on any day during the taxable year of
such foreign corp.
CFC: If, for a given taxable year, more than 50% of the vote OR value of stock owned, directly
or indirectly or constructively on any day of the taxable year by a US Sh. Substance over form
test
104
o Even if you get rid of stock, may still get brought in under imputation rule §951
13-1. X Corp is foreign corp with three classes of capital stock outstanding, consisting of 60
shares of Class A stock, 40 shares of Class B stock, and 150 shares of Class C stock. The
owners of a majority of Class A stock are entitled to elect three of the five corp directors,
and the owners of a majority of the Class B stock are entitled to elect other two. The
Class C stock has no voting rights. Dividends are paid on a per share basis and there are
no liquidation preferences.
Y Corp is a foreign corp with one class of stock outstanding, 90 shares. Danielle, a US person,
owns 25 shares of X Corp Class A stock and 45 shares of Y Corp stock for the yea r. Y
Corp owned 15 shares of X Corp Class A stock. Remaining shares of X Corp and Y Corp stock
owned by unrelated foreign persons.
Determine the status of Danielle, X Corp, and Y Corp in Year 1 for purposes of §951.
o Is this a foreign corp – i.e. check the box! (if election is made to be treated as US ToB, no
CFC)
o If its not a corporation (passthrough) then you are done with this analysis
o If you check the box to be treated as a disregarded entity – no worries
o Are there United States Shareholders under the statute? – 10% or more of the vote
o Even if there is a US Shareholder, has to total more than 50% of the vote or value
105
Total Voting Shares – 100
Danielle owns at least 25 shares independently – so there is a US Shareholder
o Note that if all of these shares had equal voting rights, you might not have control
for the foreign controlled corporation
(2) Is there something here that suggests that we might have control even though with all of the
voting shares we do not have > 50%
For voting power you look at ability to vote for the BoD
Assuming that there are 5 members of the BoD and everything is done by majority rule
(looking at side agreements) a controlling vote is 3 directors.
Here is where you can look at voting or also value; under the question the majority owner
of A gets to vote 3/5 BoD and therefore control decision making of the enterprise
**Have to Apply Attribution Rules** owns indirectly § 958
Danielle owns 25 shares + 7.5 shares = 32.5 out of 60 voting shares of A, Sheffield thinks
this is probably a CFC, need more facts
However, Danielle’s
Note – For this problem try to be familiar with the regs §1.957-1
13-2. At all times in Year 1, three individuals owned the shares of FC, a French corp. As of
January 1, Year 1, Jacques, a citizen and resident of France, owned 50 shares of FC stock,
while Ken and Lisa, both US citizens and residents, each owned 25 shares of FC stock.
On July 1, Year 1, FC redeemed ten shares held by Jacques.
On July 2, Year 1, American counsel for FC warned of potential US income tax problems
associated with the redemption, Accordingly, on July 4, Year 1, FC redeemed five shares from
each of Ken and Lisa, The holdings of the shareholders remained unchanged for the balance of
Year 1.
Do the July 4, Year 1, redemption transactions avert the United States income tax problems
raised by FC's counsel?
(1) Is this a foreign corporation? Yes
(2) DO we have US Shareholders – Yes
(3) Is there a CFC? No. They only own 50% of voting/value therefore this is a non-CFC
Results: French Corporation redeems 10 shares of stock from Jacque
7/1/ Year 1: If Jacque drops ownership Ken and Lisa have more than the 50% necessary
for control
o Rule: The day the redemption took place there was a CFC
FC Corporation was a CFC immediately after the July 1 redemption transaction, because at that
point FC Corporation’s
United States shareholders (Ken and Lisa each owns at least 10% of FC Corporation voting
stock at all times) own more than 50% of the stock in FC Corporation. FC Corporation is still a
CFC for purposes of Year 1 because it was a CFC for at least one day during the year.
But under §951 (a) (1), unless a FC Corporation were a CFC for a consecutive 30 day period
during Year 1, there is no required income inclusion under subpart F. Such was not the case, so
neither US shareholder will be subject to current taxation with regards to FC Corporation’s
activities.
7/4 Year 1 the FC redeemed 5 shares each from Ken and Lisa, results in a return to non-
CFC status.
106
July 4 redemptions restored FC Corporation’s non CFC status, since after the
redemptions, the US Shareholders no longer own more than 505 of at FC corporation
stocl.
Result: For some portion of year tainted enterprise with potentially negative consequences
attached
Step 4: §951 Now that you have a CFC (for any portion of the year) will you be taxed on that
income?
Even with a CFC not everything is included in gross income.
For an uninterrupted period of 30 days, it suggests that you might flip in and out of CFC
status, can also adjust your taxable year
Note: If you are not a US Sh; even if you hare a member of a tainted enterprise, not taxed on
that income
(a) Amounts included.- (1) In general.--If a foreign corp is a controlled foreign corporation for an
uninterrupted period of 30 days or more during any taxable year, every US shareholder who
owns stock on last day, includes in gross income, in his taxable year in in which taxable year of
corp ends—
Note: In some settings determining whether you own 10% or more you may have enough to
classify the entity as a CFC; however if you are a US Sh you are only imputed for income upon
958(a) ownership
If you are a US Sh in CFC there are only two portions of income for which you will have to pay
taxes
Subpart F income
Certain investments in real property
XIV. CONTROLLED FOREIGN CORPORATIONS – SUBPART F INCOME (UNIT 14)
A. Overview
1. General rule if a corporation is a CFC for 30 consecutive days or more during any taxable
year, its U.S. shareholders that hold stock on the last day in the year on which the corporation is
a CFC must include in gross income a “pro rata share” of its “subpart F income” under 951
2. Determining the tax consequences of being a U.S. shareholder of a CFC requires a two-step
analysis:
B. Subpart F Income
107
a. 953 insurance income
b. 954 foreign base company income (main category)
c. 901(j) bribes and kickbacks
d. 999 certain income of CFCs earned in countries that participate in international
boycotts
2. Foreign base company income defined under 954 as the sum of (reduced by allocable expenses
pursuant to 954(b)(5):
a. Foreign personal holding company income
b. Foreign base company sales income
c. Foreign base company services income
d. Foreign base company oil related income
108
functions are carried out or where the materials are purchased will not be subpart F
income (requires “substantial transformation of the property”)
1) Additional complication where property sole is comprised of purchased
component parts, two tests:
a) General test of facts and circumstances
i. If purchased property is used as a component part in the personal
property that is ultimately sold, the integration activity is deemed
to constitute manufacturing if it is substantial in degree
b) Overriding 20% cost of goods sold test
i. No FBCSI arises if 20% or more of the total costs of goods sold is
comprised of direct labor and overhead incurred by the CFC in
converting the purchased item into the finished product
E. Foreign Base Company Services Income
1. 954(e) income derived in connection with the performance of services which are performed
for, or on behalf of, any related person and performed outside the country under the laws of
which the CFC is created or organized
2. FBCSI includes:
a. Services paid for or reimbursed by a person related to the CFC
b. Services which a related person is obligated to perform
c. Services which were a condition of a related-party sale of property
d. Services to which a related person gave “substantial assistance”
1) Notice 2007-13 income would only constitute FBCSI if the cost to the CFC of
the assistance furnished by the related U.S. person equals or exceeds 80% of the
total cost to the CFC of performing the services
a) No FBCSI will result so long as more than 20% of the costs incurred by
the CFC in performing the services are attributable to services it performs
directly or through a related CFC
109
a. 954(b)(3)(A) de minimis rule that says that if the gross foreign base company income
is less than the lesser of 5% of the CFC’s gross income or $1,000,000, the CFC’s foreign
base company income will be deemed to be zero
b. 954(b)(3)(B) the full inclusion test provides that if the CFC’s gross foreign base
company income exceeds 70% of its total gross income, all of its gross income will be
considered gross foreign base company income
c. 954(b)(4) a taxpayer may elect to exclude from the subpart F income computation any
item of income subject to an effective tax rate that exceeds 90% of the maximum
domestic corporate tax rate
1) 1.954-1(d)(5) election must be made by controlling U.S. shareholders and is
binding on all of the U.S. shareholders of the CFC
H. Pro Rata Share
1. Only U.S. shareholders who own (directly or indirectly) CFC stock on the last day in a tax year,
on which the foreign corporation was a CFC must include this pro rata share of subpart F income
2. Calculated on the basis of both direct and indirect ownership but not on the basis of constructive
ownership under 951(a)(2)
I. Basis Adjustments
1. 961(a) a shareholder’s basis for each share of CFC stock or other property is increased by the
amount of income imputed to the shareholder under 951
a. The basis adjustment only applies to “other property” when the U.S. shareholder is only
deemed to own stock through indirect ownership
2. 961(b) a shareholder’s basis in each share of CFC stock or other property is reduced when
subsequent dividend distributions comprised of previously taxed earnings are actually made
J. Exclusions from Gross Income – Previously Taxed Earnings and Profits
The CFC provisions impute income to US shareholders even if the corporation does not actually
distribute any income to these owners. When no actual distribution occurs, §961 treats the shareholder as
if he contributed to the deemed dividend back to the corporation, in turn increasing his basis in the stock.
If, after imputation of income, a distribution of dividends from the CFC actually occurs
1. 959 in situations where particular E&P have been subjected to imputation, provides that such
E&P (and the distributions from them) are thereafter insulated from taxation (also exclusion for
E&P attributable to imputed amounts which have been reinvested by the CFC in U.S. property)
2. 959 invokes the normal ordering rules of 316
a. Distributions are deemed to come first from current E&P to the extent thereof and
thereafter from accumulated E&P
1) Through this priority scheme, previously taxed earnings are deemed distributed to
shareholders first
K. Sale of CFC Stock
In many cases, CFCs earn income which is not subject to current US taxation under this regime and may
benefit from deferral as long as they are retained offshore and not distributed to the US Shareholders.
This untaxed retained earnings could then be converted into capital gain upon the sale of the stock.
1. 1248 upon certain dispositions of CFC stock, this provision recharacterizes a portion of gain,
representing the previously deferred earnings, as a dividend
a. Provides that if the sale of stock or the liquidation of a CFC occurs and if the taxpayer
owned 10% or more of the stock, whether directly, indirectly, or constructively, at any
time during the five-year period preceding the sale, the portion of the taxpayer’s gain
equal to the E&P attributable to that ownership period will be treated as a dividend
110
1) The foreign corporation must have been a CFC for some portion of that 10%
ownership period, but not necessarily on the date of the disposition or exchange
2) Most straightforward means to avoid 1248 is to sell stock after the CFC has
ceased to be a CFC for the requisite five year period
3) Only pertains to gain, so any loss recognized would typically be a capital loss
L. Subpart F Income Flowchart
1.
2. Did the CFC earn income?
a. No no U.S. tax consequences
b. Yes did the CFC earn any foreign base company income as defined by 954?
1) No check for other (unusual) items listed in 952 and if none, no U.S. tax
consequences
2) Yes Is any of the CFC’s income excluded from the definition of FBCI under
954?
a) Yes this income is excluded from FBCI and therefore not subpart F
income under 952(a) and no U.S. tax consequences as to this income
b) No Was the CFC a CFC for 30 straight days during the taxable year?
i. No no current income inclusion of subpart F income
ii. Yes Did the U.S. shareholder own (as described in 958) the
CFC stock on the last day in the year on which the CFC was a
CFC?
I. No no current income inclusion of subpart F income
Yes the U.S. shareholder must include in gross income his pro rata share of the CFC’s subpart F
income
Constructive ownership rules do not apply for imputing income – direct, proportional
ownership.
Calculation:
Determine CFC’s Subpart F Income
Apply ratio of number of Days of CFC status per taxable year
Then determine each taxpayer’s pro-rata share of Sub F income according to portion that
would have been distributed on last day of taxable year
One Class of Stock: pro-rata share determined on per share basis
Multiple Classes of Stock: Allocated in same manner as distribution rights
SubPart F Income – Definition:
Income from foreign corp’s insurance of risks outside of its country of
creation/organization
111
Foreign base company income
o Foreign Personal Holding Company Income: Targets Passive income from items of
dividend, interest, royalties, rents and annuities
o Foreign base company sales income
o Foreign base company services income
o Oil related income
Amounts attributable to international boycott participation
Illegal bribes/kickbacks
Income from Foreign country subject to foreign tax restrictions
Hypothetical: A and B are unrelated shareholders in X Corp in the Bahamas. They each put in
$50K to the Corporation that engaged in the Tourist industry.
o X corporation makes $200K in fees
A and B are US Shareholders; X is a CFC; do we have to worry about the imputation of income
tax?
o Do we have Subpart F Income?
o Do we have income from investment in US property
In the hypothetical here it does not sound like personal holding company income
If we stipulate that this is neither foreign base company sales income or PHC income you
may still have a CFC but if you go back to §951 there is nothing to impute
Only if you are in the tainted categories will you have imputation
Result: Deferral of income until it is repatriated into the United States
Note that this was a policy choice to allow certain income to stay abroad
112
This is the heart of the Foreign Personal Holding Company Income
o Step 1: Ascertain whether CFC has PHC Dividends, interest, royalties, rents, and
annuities
Passive that there is no reason to allow deferral for this type of income
Individuals don’t defer, we don’t allow individuals through a CFC to do the
same
14-1 A, B, and C are US residents, own 1/3 of Z foreign corp.
(a) 100k interest income, 200k dividnend
Foreign based company income § 954(a)1
$300,000 foreingn based income, each US sh gets pro rata share.
A,B,C each get $100k, increase basis in their stock
(b) Same as (a) but opens travel biz with $7MM in gross income
§ 954b3, Subpart F income includes services income § 954a3. Defined in
§ 954 (e) Foreign base company services income.--
(1) In general.-- means income (whether in the form of compensation, commissions, fees, or
otherwise) derived in connection with the performance of technical, managerial, engineering,
architectural, scientific, skilled, industrial, commercial, or like services which--
(A) are performed for or on behalf of any related person (within the meaning of subsection (d)
(3)), and
(B) are performed outside the country under the laws of which the CFC is created or organized.
Here not performed for a related person, $7MM is not subpart F income. Only $300k is, §
954b3A deminimus applies, none of this is subpart F income
If only 90k in services income, then deminimus no longer applies. Now § 954b3B > 70% of total
income so all income is now subpart F
14-2. Abe, US citizen, and DomCo, a domestic corp wholly-owned by Abe, form Chala Co., a
corp under Peruvian law, on January 1, Year 1, with a contribution of $5,000 each in return for
50 shares of' common stock. Chala Co. purchases equipment in US from DomCo and sells it to
independent parties in Peru and other South American countries. In Year 1, Chala Co. made
$50,000 of net income from sales in other South American countries and $100,000 of net
income from sales in Peru. No foreign income taxes paid
100%
Abe DomCo
50% 50%
(a) What are the United States income tax consequences for Abe, DomCo, and Chala Co, in Year
1
(1) Is there a US Shareholder? Yes – Two
(2) Is there a CFC? Yes
(3) What was the income generated by the CFC?
Receives personal property from DomCo.
113
o $100K net income from sales in Peru
o $50K net income from sales in other countries
(4) Does this meet the None/All Inclusion test under §954(b)? No.
(d)(3) Related Person – possesses >50% of the total voting power but this is subject to the
imputation rules of §958(a) – direct, indirect, constructive ownership. § 318a3(C) Attribution to
corporations.--If 50 percent or more in value of the stock in a corporation is owned, directly or
indirectly, by or for any person, such corp shall be considered as owning the stock owned,
directly or indirectly, by such person.
Results:
Related person under § 954b(1) referring to § 318a3(C)
Who has purchased personal property
Purchased/manufactured/sold outside of the foreign country
o NOTE that this is “foreign base company income” if the property was
manufactured in Peru we would not have an issue here
o Issue here is because the property was manufactured in the US and sold outside
Peru
Income that will be imputed back is $50K but it is pro-rata share. In this instance it is the pro-
rata share of each US Shareholder
o A - $25K, DomCo - $25K. § 951 pro rata share is not determined by constructive
ownership
o They get basis increase in § 961 (only direct)
o 100k sold in Peru is not subpart F income
Notes: Things you can infer – if you are doing this it means that Peru is not going to tax this
transaction
Underlying assumption: Peru will tax its own income but not the income going to other
countries
Policy: Why is the US unwilling to allow the deferral as it will in so many other cases
Manufacturing outside country of CFC organization and sold outside the CFC organization is
that Peru will probably will not tax Columbia
If Peru was willing to tax it will Congressional rationale fall short?
114
o §954(b)(4) – High Tax Exception: There is a high tax exception so you are not
effectuating the abuse congress was concerned about
Abe and Domco only get $15k income now. Need to calculate Domco’s FTC
§ 902 = 20 x (15/130) = $2,308 FTC [15 numerator comes from US deemed income of
Domco)
Not subject to § 904 limitation because paid only 20k tax on 150k income.
(c) § 961, the money has already been taxed so it can come out without tax, but the basis is
decreased (previously taxed income)
(d) How would the answer to (a) change if Damien, an unrelated shareholder, owned eight
percent of the stock of Chala Co. and Abe and DomCo owned 46 percent each?
Changes pro-rata share, $23k
Damien is not a US person (8%), therefore would not have current imputation while
others would (See earlier discussion)
(e) Suppose Chala Co. makes the same $150,000 of income for each of Years 1 through 5. On
January 1, Year 6, Abe sells his shares to Martin, an unrelated Peruvian citizen, for $400,000.
What are the United States income tax consequences of the sale to Abe?
115
dividend, to the extent of the earnings and profits of the foreign corporation which is
attributable to the stock you own
(d) Exclusions from earnings and profits.--For purposes of this section, the following amounts
shall be excluded, with respect to any United States person, from the earnings and profits of a
foreign corporation:
(1) Amounts included in gross income under section 951.--Earnings and profits of the foreign
corporation attributable to any amount previously included in the gross income of such person
under section 951
Ordinary income under §1248(d) Exclude EP when it’s been included by a US person. Earned
150k for 5 years = $750k x ½ =
$375K - $125 K= $250K
Result of this the $250K is ordinary income and $20K is LTCG. If Domco sells dividend could
carry up FTC
(f) How would the answer to (c) change if Damien owned eight percent of the stock of Chala
Co., Abe and Domeo owned 46 percent each, and Damien sells his shares?
He is not US shareholder, never included subpart F income, not touched by § 1248 on sale
The basic United States tax regime applicable to foreign corporations has a relatively narrow focus, generally
reaching only certain domestic source income and income effectively connected with a United States trade or
business.
As such, domestic investors have found foreign corporations to be an attractive vehicle for deferring or even
completely avoiding United States taxation on foreign earnings. Congress has enacted.
Congress has enacted a litany of statutory mechanisms to prevent what may be considered an excessive amount
of tax-motivated offshore investment, but as we have been seen, these regimes may often be avoided with
excessive tax planning.
For instance, as discussed in Unit 13, because the controlled foreign corporation (CFC) regimes applies only to
United States person owning at least 10% of the voting power of the foreign corporation, these rules can be
avoided by structuring the ownership of the foreign corporation so that no United States person holds the
requisite amount.
116
Likewise, as discussed in Unit 14, the ordinary income conversion rules of §12 48 applicable to the disposition
of CFC stock may be circumvented by limiting United States ownership.
One way to limit ownership is simply expand the pool of investors- i.e., use a mutual fund model to bring
investors together and dilute any one person’s share of the whole. Foreign investment companies were
established in favorable tax jurisdictions (those imposing little or no taxation on investment earnings) where
shareholders both accumulate untaxed earnings and convert ordinary income items, such as interest and
dividends, to capital gain of the sale on the investment company shares.
In response, Congress enacted the passive income foreign investment company (PFIC). These provisions are
targeted at the deferral benefits accruing to US shareholders who escape the CFC regime by holding less than a
10% stake in a foreign corporation that invests in passive assets. The PFIC rules are secondary to the CFC rules-
if a person is subject to income inclusion under the CFC rules as a US shareholder in a CFC, the PFIC rules will
not apply.
A. Overview
1. PFIC provisions are targeted at the deferral benefits accruing to U.S. shareholders who escape
the CFC regime by holding less than a 10% stake in a foreign corporation that invests in passive
assets
2. PFIC regime provides two elections that result in current taxing schemes for U.S. shareholders
designed to roughly approximate how the PFIC’s earnings would have been taxed had the assets
been held directly by the shareholders
B. The 1291 Tax and Interest Regime
1. Default tax regime that applies unless the shareholder makes an election to prevent its
application
2. 1291 in general imposes a special shareholder tax and interest charge on deferred income
which is triggered upon the realization of gain from the disposition of PFIC stock and upon the
shareholder’s receipt of certain PFIC distributions attributable to earnings on which the
shareholder enjoyed tax deferral (so-called “excess distributions)
C. The 1295 QEF Election
1. 1295 allows domestic shareholders to elect to have their share of PFIC earnings taxed
currently if certain requirements are met
a. Must elect to treat the PFIC as a “qualifying electing fund” (QEF)
1) In general, the result of QEF status is to create a current year ordinary income and
net capital gain inclusion for U.S. shareholders
2. Lower rate of tax may be imposed on the earnings, both as a result of the segregation of ordinary
income and net capital gain and because the default regime applies the highest taxable rate in
effect
D. The 1296 Mark-to-Market Regime
1. 1296 may be able to avoid the default regime of 1291 if the stock is marketable on a public
exchange and the shareholder makes the election to recognize income or loss on the PFIC stock
on an annual basis
a. The difference at year-end between the basis of the stock and its FMV constitutes either
income or a deduction
1) Deductions are limited to the extent of prior income inclusions
2) Characterized as ordinary income or loss
117
3) Basis adjustments to the PFIC stock are provided under 1296(b) for any income
or loss taken into account
E. Classification of a PFIC: The Passive Income and Passive Assets Tests
1. Significantly more difficult to escape PFIC status than to escape status as a CFC
F. Passive Income Test
1. 1297(a)(1) a foreign corporation is a PFIC if 75% or more of its gross income for the taxable
year consists of passive income (any income comprising FPHCI under 954(c))
2. Generally does not include any income derived by a foreign corporation from a related party if
the related party generated the income in the active conduct of a business
G. Passive Assets Test
1. 1297(a)(2) and 1297(e) a foreign corporation is a PFIC if the average annual percentage of
the FMV or adjusted basis of its passive income-producing assets represents at least 50% of the
value or adjusted basis, as applicable, of all of the entity’s assets
a. Determined on a quarterly gross basis
b. Generally applied on the FMV basis
1) 1297(e) if election made can be applied to the adjusted basis of the assets
(avoids complicated and uncertain valuation issues)
H. Special Look-Through Rule
1. 1297(c) provides that for purposes of determining whether a foreign corporation is a PFIC, a
foreign corporation is deemed to owns its proportionate share of the assets of a subsidiary of
which it owns directly or indirectly, by value, 25% or more of the subsidiary’s stock
a. Also deemed to receive its proportionate share of the subsidiary’s income
b. Applies regardless of whether the subsidiary is domestic or foreign
c. If the look-through rule applies then the subsidiary’s underlying assets and income factor
into the foreign parent’s passive asset and income calculations for testing purposes
d. Stock ownership and dividends are not factored in to the parent’s assets and income for
PFIC determination purposes
I. Exceptions to Passive Foreign Investment Company Status
1. 1298 two relief provisions for newly-formed corporations and those corporations undergoing
a change in the nature of their business operations:
a. 1298(b)(2) shields a start-up foreign corporation from PFIC status for the first taxable
year in which it derives gross income (“start-up year”)
1) Only extended to those start-up corporations with no past or future ties to PFIC
status
a) Must not have had a PFIC predecessor
b) Must establish that it will not be, and is in fact not, a PFIC for either of its
two taxable years following the year in which the corporation first earns
gross income
b. 1298(b)(3) a foreign corporation in the process of changing businesses will not
constitute a PFIC for any taxable year if all ties to PFIC status are severed
1) Cannot have been a PFIC for any prior taxable year
2) Must establish that substantially all of its passive income for the taxable year is
attributable to proceeds from the disposition of one or more active trades or
businesses
3) Must assure the Service that it will not be a PFIC for either of the two subsequent
taxable years and must, in fact, not be so classified
118
J. The 1291 Tax and Interest Regime – Excess Distributions and Dispositions
1. 1291 recoups the tax on income previously subject to deferral and tacks on a penalizing interest
charge when that income is repatriated from the PFIC
a. When income is realized by U.S. shareholders through certain “excess distributions” of
PFIC income, OR
b. Upon a shareholder’s actual or deemed disposition of PFIC stock
K. Mechanics of 1291
1. “Excess distribution” income which has effectively been lodged in the PFIC during the
shareholder’s holding period of the stock and direct or indirect disposition of PFIC stock
a. The excess distribution is generally the shareholder’s ratable portion of the excess, if any,
of the amount of PFIC distributions received during the taxable year over 125% of the
average amount of PFIC distributions received by the taxpayer during the three preceding
taxable years (or the shareholder’s holding period, whichever is shorter)
b. The excess distribution on a disposition is the amount of gain, if any, realized on the
transaction (made on a share-by-share basis)
L. The Deferred Tax Amount
1. Taxed at ordinary income rates, however, the amount of the tax owed by the PFIC shareholder is
further increased by a specially computed tax on the excess distribution allocated to PFIC taxable
years within the shareholder’s holding period (i.e., the deferred tax amount)
a. The deferred tax amount is computed at the highest tax rates that would have applied had
the PFIC income actually been received in those years and also reflect an appropriate
interest charge
2. The deferred tax amount is the sum of:
a. The tax on the excess distribution allocated to each relevant prior PFIC taxable year
computed at the highest applicable tax rate in effect for that year, PLUS
b. Interest on the tax so computed (using the 6621 rates and methods for the computation of
underpayments of tax)
3. Even if the distribution represents a tax-free return of capital under normal taxing rules, it may
still give rise to a tax and interest liability
M. QEF Election
1. 1291 generally steers taxpayers to the QEF election current taxation regime
2. Governed by 1293 (current imputation and taxing regime)
3. If election is made after first year that the person is a shareholder, then 1291 will govern the prior
taxable years
119
c. The gain is treated as a disposition forcing the shareholder to also pay the appropriate
1291 deferred taxes and interest
d. If the stock has minimal appreciation, the deemed sale election is a cost-efficient means
of avoiding the continued application of the 1291 deferral tax and interest regime
P. The Deemed Dividend Election
1. 1291(d)(2)(B) if the shareholder holds the stock on the first day of a given year, the
shareholder may elect to include in gross income for that year a deemed dividend equal to the
post-1986 earnings and profits attributable to that stock
a. The 1291 taint is stripped from the PFIC stock as the deemed dividend is treated as an
excess distribution to be allocated to the days in the holding period underlying the E&P
(this excess distribution is subject to tax and to the special deferral tax and interest
provisions of 1291)
Q. Requirements for Making the QEF Election
1. QEF subject to current taxation under 1293 if two general requirements are satisfied:
a. The shareholder must make an election on a timely filed tax return for the election year
b. The PFIC must comply with all reporting and other requirements for both determining its
ordinary earnings and net capital gain and for otherwise carrying out the purposes of the
PFIC rules
2. QEF election is irrevocable without permission from the Service
3. The election is shareholder specific and not to subsequent transferees
R. Current 1293 Taxation of U.S. Shareholders Electing QEF Status
1. 1293 requires an electing shareholder to include in gross income its imputed pro rata share of
the PFIC’s current E&P regardless of whether the PFIC actually distributes any earnings
a. Includes in gross income his or her pro rata share of the PFIC’s ordinary earnings and net
capital gain to be taxed to the shareholder as ordinary income and long-term capital gain
2. Any gain realized on the disposition of stock in a QEF will be treated as capital gains
Purpose:
CFCs only apply to US persons owning 10% or more of voting power of corporation
Imputation can be avoided by structuring ownership to avoid the classification
120
§1248 Apply to CFC stock disposition but can be circumvented by limiting US ownership
as well
PFICS: enacted to target deferral benefits accruing to US persons who escape CFC regime by
holding less than 10% of voting power
Imposes a tax on domestic shareholders of foreign corporations who derive passive
income but are beyond scope of other anti-deferral regimes and stock disposition
provisions
Application: PFIC status is applied to any foreign corporation (including CFCs), which satisfies
either passive income or passive assets test
No ownership requirement – focus is on character of entity and predilection for deferral
(US shs of CFCs are exempt)
Definition in §1297(a)
(a) In general.--For purposes of this part, the term “passive foreign investment company” means
any foreign corporation if--
(1) “Passive Income Test” 75 percent or more of the gross income of such corporation for
the taxable year is passive income, or
(2) “Passive Assets Test” the average % of assets (as determined in accordance with
subsection(e)) held by such corporation during the taxable year which produce passive
income or which are held for the production of passive income is at least 50%.
(3) §1296 Mark to Market Regime: IF the stock is marketable, can elect to recognize income
or loss on an annual basis
15-1 All of the single class of stock in Venn Corporation, a Venezuelan corporation, is owned
by Theo (6 percent), Remi (47 percent), and Paloma (47 percent) (all unrelated United States
citizens and residents). Venn’s only asset is an office building in Brazil that is currently leased
121
to an unrelated Brazilian operating company under a 50-year lease. Venn derives substantial
rental income from the property but does not make distributions to its shareholders.
(a) Are the shareholders subject to the CFC rules and/or the PFIC rules?
(1) Is this a Foreign Corporation?
o §7701 etc.
o If it is a Foreign Corporation, is it doing something in the US (inbound); Is it owned by US
interests and therefore a safeguard issue?
Note: Safeguard regimes will deprive you of full benefits of deferral in one way or another
Result: Sole asset is passive office building, this is also a PFIC (under the Income Test), taxed
on excess distributions
If you are a US Shareholder subject to CFC rules you will be taxed under those rules;
other parties in the CFC will then be subject to the PFIC rules
(b) How would the answer to (a) change if Remi was a citizen and resident of Brazil?
If Remi was foreign, the corporation would not be a CFC, but the corp would still be a PFIC.
Theo and Paloma now subject to PFIC
122
Enterprise is not a CFC but is a PFIC (No 50% majority of US Shareholders/US person
owners with Passive Income)
15-2 Assume the same general facts from Problem 15-1. In addition, assume the following
facts:
Theo purchased his Venn stock on January 1, Year 1, from an unrelated seller for $5,000 and
sold all of his stock on December 31, Year 10, to an unrelated purchaser for $15,000.
No election was ever made under § 1295 or §1296.
o §1295: Allows shareholder to elect to defer tax payment at the cost of an interest
charge
o §1295: Allows election to recognize income on marketable stock/loss on an annual
basis
The United States tax rate on long-term capital gains at all times relevant to this Problem is
15 percent.
The highest marginal tax rate under § 1 in each of Years 1-10 was 35 percent, and Theo’s
taxable income placed him in this bracket each year.
The interest rate under § 6621 for underpayments of tax at all times relevant to this Problem
is seven percent. Ignore the compounding aspect of the determination and round up to the
nearest dollar.
(a) What are the United States income tax consequences of Theo’s ownership of the Venn stock
in Years 1-10 and the gain from his stock sale in Year 10?
AB: $5,000
AR: $15,000
Gain: $10,000 (without PFIC this would be LTCG)
During 10 year period does anything happen to Theo? He gets to seemingly enjoy 10 years of
deferral on taxable income under CFC rules
Why are we not forcing the current imputation here?
To extent that you have “Tainted income” and you are a US person under the CFC you wind
up imputing it, but under the PFIC rules we are not
Under the PFIC there is not a minimum ownership requirement for the domestic
shareholder; so Congress is assuming that you have no control over the governance of the
corporation so it would be unfair to impute income for distribution that you never receive
o In the CFC to avoid imputation you don’t need CFC regime if you have an actual
distribution. But under the CFC rules the theory is that there is enough ownership
centered in US persons that you can control the distribution/taxation
o But no imputation where someone is a small shareholder they cannot control the
distribution.
Given the lack of power Congress waited until an event or point in time to play
“catch-up” to treat as if it had been imputed
To extent that you can make the election you can affirmatively elect and create an
imputation regime (to avoid interest)
Because Theo Made no Election, he is going to be taxed under Regime (1) Special Tax and
Interest §1291
Tax is on both distributions and dispositions
If loss on disposition then PFIC rules don’t apply (only gains are affected)
123
§1291(a) (2) Dispositions.--If the taxpayer disposes of stock in a passive foreign investment
company, then the rules of paragraph (1) shall apply to any gain recognized on such
disposition in the same manner as if such gain were an excess distribution.
Deferred Tax Amount: Aggregate increase in tax, plus aggregate increase in interest
Aggregate increase in taxes = multiply gross income allocated for the year by highest
taxable income
o Sum of aggregate increase in taxes + aggregate interest
o Taxed at highest rate applicable during the year - i.e. 35% (just assume for our use
that it was always 35
Note the gain is coming back as ordinary income – which is why you are applying the highest
rate of tax of 35%. The entire $10K will be taxed as ordinary income.
Even though you were able to get the deferral you pay a penalty because normally the
sale of stock would be capital gain
o Penalty one is that the sale of the stock will be treated as ordinary income
o It then has the highest tax rate § 1291c2;
o THEN there is an additional 7% simple interest application to deferred tax
payments – so you will have 9 years of interest accumulating on the tax § 1291c3
Deferred Tax Amount is the increased tax + interest = $4,245 which will be added on to overall
tax liability for the year. Year 10 gain of 1k is taxed at 28%, total tax now is $4,535 (effectively
none of the gain is classified as capital gain – can’t offset with capital losses)
(b) How would the answer to (a) change if Theo made a timely § 1295 election with respect to
the Venn stock in Year 1?
If we make a §1295 election:
Have to, on an annual basis determine ordinary income and capital gains
Many PFICs are Mutual Funds and because the United States has no jurisdiction
many will not or cannot do this.
Must be made by each shareholder, considered “pedigreed” if made at beginning
of first year sh owns the stock
124
o Under 1291 everything is coming back as ordinary
Result: This will most likely be favorable to the taxpayer; remember that the final sale at $10K
does not tell us the fluctuations in value over the course of the ownership.
Each year you are told that the PFIC had certain amount of ordinary income and
capital gain
Each year ordinary income is taxed at his marginal rate, also gets benefit of capital
gains
(c) How would the answer to (b) change if Theo made the § 1295 election at the beginning of
Year 6? (stock worth 10k on that day)
From year 6 through year 10 can make inclusion; however previous 5 years you will receive
treatment under §1291 when sold.
When you elect the QEF you can elect on the year that you make the election to
treat the differential as a gain to go back and make the calculation. Can make
deemed sale or deemed dividend election
§1291(d)(2) Election to recognize gain where company becomes qualified electing fund.--
(A) In general.--If--
(i) a passive foreign investment company becomes a qualified electing fund with respect
to the taxpayer for a taxable year which begins after December 31, 1986,
(ii) the taxpayer holds stock in such company on the first day of such taxable year, and
(iii) the taxpayer establishes to the satisfaction of the Secretary the fair market value of
such stock on such first day,
the taxpayer may elect to recognize gain as if he sold such stock on such first day for
such fair market value.
(d) How would the answer to (a) change if Theo in Year 1 made a valid and timely election
under § 1296 with respect to the Venn stock, which was publicly traded, and the stock
appreciated $100 annually?
125
Loss is deferrable until you sell it
Exam Discussion:
Use code sections; get all the requirements down
Use policy at end of your answer
126