Navigating the Effectively Connected Income Tax Regime ...media.straffordpub.com/products/navigating-the... · 3/23/2017 · MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING

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Navigating the Effectively Connected Income Tax Regime:

Avoiding Devastating Impact on Taxes and Financial Statements Implementing Compliant Tax Strategies to Avoid or Mitigate Punitive Taxation

THURSDAY, MARCH 23, 2017, 1:00-2:50 pm Eastern

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March 23, 2017

Navigating the Effectively Connected Income Tax Regime

Steven Hadjilogiou, Partner

Baker & McKenzie, Miami

[email protected]

Raimundo Lopez-Lima Levi, Founder and Managing Partner

Lopez Levi Lowenstein Glinsky, Coral Gables, Fla.

[email protected]

Daniel W. Hudson


[email protected]

Sean J. Tevel


[email protected]





Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

Navigating the Effectively Connected Income Tax Regime Strafford Continuing Education Webinars Presenters: Steven Hadjilogiou, Raimundo Lopez-Levi, Daniel Hudson and Sean Tevel

March 23, 2017

© 2017 Baker & McKenzie LLP

Example No 1

6

•Foreign corporation manufactures goods outside of the United States

•All goods are sold to distributors and customers outside of the United States

•All title to goods passes outside of the United States

•CEO of foreign corporation spends most of the year in Miami, FL

•CEO engages in business activities out of Miami limited to oversight of foreign operations and the negotiation of the sales of manufactured products outside of the United States

1. What are the foreign corporation’s ECI risks?

2. What can be done to mitigate such ECI risks?


Example No 2

7

•Foreign corporation manufactures goods outside of the United States and sells goods primarily to customers outside with U.S.

•The foreign corporation is considering expanding its U.S. business.

•Foreign corporation forms a U.S. subsidiary for purposes of performing services for the non-U.S. operations of the foreign corporation such as market research and marketing activities. Eventually, the U.S. subsidiary will act as a “reseller” in the U.S.

1. What strategies may be used to mitigate ECI risks for the foreign corporation?


Example No 3

8

•Foreign Corporation has a purchase agreement in U.S. (Branch), the Branch does administration and source pricing. The Foreign Corporation also has a bonded warehouse, that product would be shipped to the U.S., then from the U.S. would ship to other countries in the world.

•The Branch then started to negotiate pricing, contract, hedge contract, invoice in U.S. Dollar. Products are shipped from the bonded warehouse to the world from the U.S. The invoicing is generated on the Foreign Corporation but with the U.S. office address. The Custom invoice was sanitized to reflect only the Foreign Corporation, as opposed to the Agency.

1. Is this ECI?

2. What can be or could have been done to avert ECI?


Example No 4

9

•Foreign Corporation has a “Fantasy Soccer” game on the Internet.

•The player can go onto the website as a team and play for prizes. Each player can win “Fantasy Bucks” as winnings and can utilize the winnings to purchase soccer shoes and apparel as well as memorabilia off the same website.

•The website also earns monies from U.S. advertisers and inventory is shipped from the U.S. independent warehouse.

1. Does this constitute ECI?

2. Should federal and state tax be withheld from the winnings?

3. What can be done to avoid ECI?

4. What can be done to avoid state and local taxes?


General Summary of U.S. Source Rules for Income

11

Item of Income – usually FDAP General Factors Determining

Source, exceptions may apply

Resources

Interest Residence of Payer Section 861(a)(1)

Dividends Nationality/place of incorporation of

payor/issuer ** Section 861(a)(2)

Substitute dividends or substitute

interest, as paid in securities lending

and repo transactions

The same source as the interest or

dividend paid on the transferred

securities

Treas. Reg. 1.861-2(a)(7) and

1.8613(a)(6)

Rents Location of property Section 861(a)(4)

Royalties: Natural resources Location of property Section 861(a)(4)

Royalties: Patents, copyrights, etc. Where property is used Section 861(a)(4)

**Part of a dividend paid by a foreign corporation is U.S. source if at least 25% of the corporation's gross income is

effectively connected with a U.S. trade or business for the 3 tax years before the year in which the dividends are declared.


General Summary of U.S. Source Rules for Income

12

Item of Income – usually NOT FDAP General Factors Determining

Source, exceptions may apply

Resources

Business income: Personal services, whether

paid to an entity or an individual Where services performed Section 861(a)(3)

Business income: Sale of inventory – Produced

Sale of personal property (usually not FDAP)

Where produced (Allocation may be

necessary)

Production of Service

Sale of Inventory

Seller's tax home (but notable exceptions)

Section 863(b) ; Section 865; See

Personal Property, in Chapter 2 of

Publication 519, for exceptions

Business income: (to a foreign corporation) when

a U.S. payor purchases inventory (usually not

FDAP)

Where title passes

(Inventory)

foreign source recharacterization

Section 861(a)(6)

Sale of real property (may be subject to FIRPTA.

Usually not FDAP) Location of property

Section 861(a)(5); But see Section

897.

Sale of natural resources (may be subject to

FIRPTA. Usually not FDAP)

Allocation based on FMV of product at

export terminal.

Treas. Reg § 1.863–1(b); But see

Section 897.

Salaries, wages, other compensation, whether

paid to an entity or an individual (usually not

subject to withholding)

Where services performed Section 861(a)(3)


Source of Property Sales

13

Inventory

• Purchased inventory – the passage of title. §§ 861(a)(6), 862(a)(6); but see anti-avoidance provision. Treas. Reg. § 1.861-7(c).

• Green Export Co. v. U.S., 284 F.2d 383 (Ct. Cl. 1960) - express agreement evidencing the parties' clear intentions regarding the place of passage of title controls.

• Produced inventory:

• Allocate between sales income and production income. § 863(b)(2), Treas. Reg. § 1.863-3:

• 50/50 ~ Default. Treas. Reg. § 1.863-3(b)(1)

• IFP ~ Elective. Treas. Reg. § 1.863-3(b)(2)

• Own books ~ With permission. Treas. Reg. § 1.863-3(b)(3)

• Sales portion allocated under § § 861(a)(6), 862(a)(6) [passage of title]; Production portion allocated in proportion to basis of production assets.

Exception: Inventory treated as U.S. source if sale is attributable to an office or other fixed place of business in the U.S. However, will remain foreign sourced if sold for use or consumption outside the United States and a foreign office or fixed place of business materially participated in sale.


Source of Property Sales

14

Non-Inventory Personal Property

• Source determined by residence of the seller

U.S. resident for these limited purposes is: a U.S. citizen or a resident alien with no “tax home” in a foreign country,

a nonresident alient with a “tax home” in the United States, and

U.S. corporations, trusts and estates

Income may be resourced to the extent of U.S. depreciation recapture


General Rule

15

- Under Section 882, a foreign corporation engaged in a U.S. trade or business (“USTB”) is subject to tax at regular corporate rates on its income which is effectively connected with the conduct of the USTB (a.k.a. “effectively connected income” or “ECI”).

- Deductions are allowed to the extent that they are connected with the income.


ECI: U.S. Trade or Business

16

• A USTB is found to exist only if there are “regular, continuous and considerable ” business activities in the U.S.

• The determination of whether a USTB exists is based on facts and circumstances analysis and is determined on a case-by-case basis.

• A foreign corporation’s U.S. activities are considerable only if the activities are those by which income is directly earned is not merely incidental to the taxpayer’s principal business activities.

• To determine whether an activity is regular and continuous, the number of transactions completed in the U.S. is frequently relevant.

• Even if the amount of income earned, or loss incurred, is generally not substantial, courts will focus on the character and nature of an activity to determine whether the activity is considerable, regular or continuous.

© 2017 Baker & McKenzie LLP 17

Statutory Inclusions/Exceptions – Section 864(b)

• Performance of personal services within the U.S. at any time within the taxable year generally constitutes the conduct of a U.S. trade or business.

• However, there is a de minimis exception if a nonresident alien is present in the U.S. for no more than 90 days during the tax year and receives no more than USD 3,000 as compensation while working for a foreign person who themselves is not engaged in a trade or business within the U.S. (Section 864(b)(1))



Statutory Inclusions/Exceptions (cont.)

• Trading in stocks or securities. (Section 864(b)(2)(A))

• A foreign person does not have a USTB as a result of trading in stock or securities through a resident broker, commission agent, custodian, or other independent agent.

• (i) Applies to both traders/brokers and dealers; (ii) Can be trading for accounts of customers; and (iii) Volume of transactions irrelevant.

• However, applies only if the foreign person at no time during the taxable year has an office or other fixed place of business in the U.S. through which, or by the direction of which, the transactions in stocks or securities are effected.

• A foreign person generally does not have a USTB as a result of trading in stock or securities for the taxpayer's own account.

• (i) Applies whether the trading is by the foreign person or the foreign person's employees or through a resident broker, commission agent, custodian, or other agent; (ii) Applies even if the employee or agent has discretionary authority to make decisions in effecting the transactions, and it does not matter whether the foreign person, employee, or agent is within U.S. when trading occurs; (iii) Agent can be independent or dependant; and (iv) Volume of transactions irrelevant.

• However, does not apply to dealers, and generally does not apply to a foreign corporation the principal business of which is

trading in stocks or securities for its own account if its principal office is in the U.S.; also special rules for partnerships.




• Trading in commodities. (Section 864(b)(2)(B))

• A foreign person does not have a USTB as a result of trading in commodities (including hedging transactions) through a resident broker, commission agent, custodian, or other independent agent, if:

• (i) the commodities are of a kind customarily dealt in on an organized commodity exchange, such as a grain futures or a cotton futures market,

• (ii) the transaction is of a kind customarily consummated at such place, and

• (iii) the foreign person at no time during the taxable year has an office or other fixed place of business in the United States through which, or by the direction of which, the transactions in commodities are effected.

• Volume of transactions irrelevant.

• A foreign person generally does not have a USTB as a result of trading in commodities (including hedging transactions) for the foreign person's own account if (i) the commodities are of a kind customarily dealt in on an organized commodity exchange and (ii) the transaction is of a kind customarily consummated at such place.

• (i) Applies whether the trading is by the foreign person or the foreign person's employees or through a resident broker, commission agent, custodian, or other agent; (ii) Applies even if the employee or agent has discretionary authority to make decisions in effecting the transactions, and it does not matter whether the foreign person, employee, or agent is within U.S. when trading occurs; (iii) Agent can be independent or dependant; and (iv) Volume of transactions irrelevant.

• However, does not apply to dealers, and there are special rules for partnerships.




• Trading in stocks, securities or commodities – Broker (Trader) vs. Dealer

• Regulatory Definition

• Dealer in stocks or securities defined as “a dealer in stocks or securities is a merchant of stocks or securities, with an established place of business, regularly engaged as a merchant in purchasing stocks or securities and selling them to customers with a view to the gains and profits that may be derived therefrom.” Treas. Reg. § 1.864-2(c)(2)(iv). No specific definition of ‘dealer in commodities’ but analogous.

• However, foreign persons who buy and sell, or hold, stocks or securities for investment or speculation, irrespective of whether such buying or selling constitutes the carrying on of a trade or business… are not dealers in stocks or securities within the meaning of this subparagraph solely by reason of that activity.

• Judicial Interpretation

• A primary distinction for U.S. federal tax purposes between a ‘trader’ and a ‘dealer’ in securities or commodities is

that a dealer does not hold securities or commodities as capital assets if held in connection with his trade or

business, where as a trader holds securities or commodities as capital assets whether or not such assets are held

in connection with his trade or business. King v. Commissioner, 89 T.C. 445, 458-59 (1987)




21

Activities not constituting a USTB:

• Passive investment or property ownership;

• Collecting interest, rents, royalties, and dividends;

• Mere sale of property;

• Ministerial or clerical activities;

• Stewardship, and

• Investigatory, promotional, or purchasing activities (Higgins, Scottish American Investment Co.)


Management of Real Property

22

•Ownership and rental of real property does not necessarily constitute a trade or business

•However, in Lewenhaupt v. Commissioner, a nonresident alien individual who owned several real properties in the U.S. was found to have a USTB, even though the taxpayer was not physically present in the U.S.

• The nonresident alien individual had a U.S. resident agent who had the authority to act and manage real property on his behalf

• The agent’s exercise of authority on the foreign principal’s behalf, created a USTB for the foreign principal


Active U.S. Business Profits – Effectively Connected Income

23

•If a nonresident alien or foreign corporation is found to be engaged in a USTB, the taxpayer is taxable at rates applicable to U.S. residents on the income they earn that is effectively connected to the USTB.

•The nonresident alien or foreign corporation is taxed on a net basis and can take deductions against the income earned, so long as it files a timely return.

• See Treas. Reg. § 1.882-4.

•U.S. source sales income is considered to be effectively connected to a USTB of a nonresident alien or foreign corporation

•Foreign source sales income is considered to be effectively connected to a USTB if:

• The foreign corporation has an office or other fixed place of business in the U.S. to which such income is attributable; and

• such income is derived from the sale or exchange (outside the U.S.) of property through such office or other fixed place of business.

• If a foreign office materially participates in the sale, then it remains foreign source income. This exception only applies in the case of inventory property.



24

•An agent’s activities on behalf of a foreign principal can be imputed to the foreign principal and create a USTB for the foreign principal if:

• The agent has the authority to negotiate and conclude contracts in the name of the foreign principal and regularly exercises that authority.

• The determination of independence usually depends on whether the principal has control over the agent

•The agent’s activities must be more than clerical or ministerial (See, e.g., Scottish Am. Inv. Co. v. Comm'r,

12 T.C. 49 (1949), Spermacet Whaling & Shipping Co. v. Comm'r, 30 TC 618 (1958), aff'd , 281 F2d 646 (6th Cir. 1960)

• Receiving bank statements and correspondence addressed to the foreign corporation may only be clerical or ministerial because these activities involve little exercise of discretion or business judgment


ECI: When Is Income “Effectively Connected”?

25

– U.S. source dividends, interest, rents, and capital gains are ECI only if

“effectively connected” with the USTB. Section 864(c)(2).

– Asset Use Test: Is income derived from assets used, or held for use, in

the business?

– Business Activities Test: Are the activities of the business a material

factor in the production of income?

– All other U.S. source income: “force of attraction” principle.

– If there is a USTB, all U.S. source income other than FDAP and capital

gain is treated as ECI. Section 864(c)(3).

– Non-U.S. source income generally not ECI, subject to limited exceptions.

Section 864(c)(4).


Active Business Profits in a Treaty Context

26

– Permanent Establishment Business profits are taxed under Article 7 of the

U.S Model Income Tax Convention • Article 7 provides that the profits of an enterprise of a Contracting State shall be taxable

only in that State unless the enterprise carries on business in the other Contracting State through a “permanent establishment “ situated in the other Contracting State

• If a permanent establishment is found to exist, the profits of the enterprise may be taxed in the other Contracting State, but only to the extent that the profits are attributable to the permanent establishment in the other Contracting State

• If no permanent establishment is found to exist, then the taxpayer is generally not subject to tax in the other Contracting State, with the exception of non-business income (FDAP) that may be subject to gross basis withholding

• The concept of a permanent establishment is similar to the U.S. domestic law concept of a USTB, however, permanent establishment is defined in the U.S. Model Income Tax Convention, whereas USTB is not clearly defined anywhere in the Code


Active Business Profits (Treaty Context) – Permanent Establishment

27

•Permanent Establishment is defined under Article 5 of the U.S. Model Income Tax Convention

• A permanent establishment is defined as a fixed place of business through which the business of an enterprise is wholly or partly carried on

• Permanent establishment includes especially:

• A place of management

• A branch

• An office

• A factory

• A workshop

• An oil or gas well, quarry, or any other place of extraction of natural resources

•A building site, construction, installation project or drilling rig or ship used for the exploration of natural resources, constitutes a permanent establishment only if it lasts, or the exploration activities continue for more than twelve months



28

•The IRS will generally not rule whether a taxpayer has a permanent establishment in the U.S.

•A permanent establishment does not necessarily have to be “permanent”

The Service held that a foreign corporation had a U.S. PE when it operated a restaurant for two, separate six-month periods at the New York World’s Fair

Generally, however, a project of short duration may avoid PE status

•Article 5 contains a list of activities that is not included in the definition of permanent establishment:

The use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise

The maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery or for the purpose of processing by another enterprise

The maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or collecting information for the enterprise

The maintenance of a fixed place of business solely for the purpose of carrying on for the enterprise, any other activity of a preparatory or auxiliary character

Any combination of activities provided that the overall activity is of a preparatory or auxiliary character.



29

•Similar to a USTB, a permanent establishment can also be created through the activities of an agent

• If the agent is a dependent agent, acting on behalf of an enterprise and has and habitually exercises the authority to conclude contracts that are binding on the enterprise in a Contracting State, the enterprise shall be deemed to have a permanent establishment in that Contracting State with respect to the activities that the person undertake on behalf of the enterprise,

• The activities of the dependent agent will not be considered to create a permanent establishment to the extent the activities are of a preparatory or auxiliary nature, that if exercised through a fixed place of business would not make the fixed place of business a permanent establishment

• An enterprise shall not be deemed to have a permanent establishment merely because it carries on business through a broker, general commission agent, or any other agent of an independent status, provided that such person is acting in the ordinary course of their business as an independent agent

•The Final Report of the OECD on BEPS Action Item 7 (Preventing the Artificial Avoidance of Permanent Establishment Status) recommends an overhaul of the definition of the term “dependent agent” and also looks at whether the person “habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise.”



30

•Also, an agent shall no longer be considered an independent agent, if that person acts exclusively or almost exclusively on behalf of one or more related enterprises.

•However, the mere fact that a company that is a resident of a Contracting State controls or is controlled by a company that is a resident of the other Contracting State or that carries on business in that other Contracting State, shall not be taken into account in determining whether either company has a permanent establishment in that other Contracting State



31

•If a permanent establishment is found to exist, the profits attributable to the permanent establishment are those that it would be expected to make if it were a distinct and independent enterprise engagement in the same or similar activities

•Profits shall include only the profits derived from the assets used, risks assumed and activities performed by the permanent establishment

•In computing the business profits attributable to a PE, a taxpayer generally may subtract the deductions reasonably connected with the profits, including executive and general administrative expenses incurred by the permanent establishment

•If the profits or a permanent establishment include items of income that are dealt with in other articles of the treaty (such as interest, dividends, royalties, etc.), the provisions of those articles shall not be affected by the provisions of Article 5


Questions?

32

Steven Hadjilogiou

Partner, Miami

+1 305 789 8909

[email protected]

Daniel W. Hudson

Associate, Miami

+1 305 789 8986

[email protected]

Contact Information

Sean J. Tevel

Associate, Miami

+1 305 789 8965

[email protected]

Raimundo (“Ray”) Lopez-Lima Levi, CPA, CVA, CFF

Managing Partner, Lopez Levi Lowenstein Glinsky, P.A., Miami

+1 305 774 2945

[email protected]

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Documents

Navigating the Effectively Connected Income Tax Regime ...media.straffordpub.com/products/navigating-the... · 3/23/2017 · MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING