Entering The U.S. Without Entering Its Tax System: Holding Company Structures For U.S. Operations

Reproduced with permission from Daily Tax Report, 191 DTR J-1, 10/2/15. Copyright 2015 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com

Foreign companies entering the U.S. market for the first time will want to consider how their operations can be structured to minimize U.S. taxes. Although sales into the U.S. can be arranged in some cases to keep profits offshore, a sufficient presence ''on the ground'' can pull sales income (and possibly other income) into the U.S. tax system.

This article discusses how business profits of a foreign corporation generally are taxed in the U.S. and suggests possible holding company structures that a foreign parent corporation can use to help insulate itself from direct U.S. tax exposure while taking advantage of treaty exemptions to reduce federal income taxes.1

Federal Income Taxation of Business Profits: General Rules in the Absence of a Treaty

Foreign corporations are taxed under Section 882(a) of the Internal Revenue Code of 1986, as amended, at graduated rates topping out at 35 percent on ''taxable income which is effectively connected with the conduct of a trade or business in the United States'' (hereinafter, ''effectively connected income''). A flat 30 percent tax applies under I.R.C. Section 881(a) to certain types of passive income, including interest, dividends, royalties, rents and annuities. There are a number of exemptions under the code and applicable treaties.

A foreign corporation doesn't have effectively connected income if it isn't engaged in a trade or business in the U.S.2 For example, a foreign corporation potentially could earn millions of dollars in revenue selling goods to U.S. customers without generating any effectively connected income if:

title to the goods sold and risk of loss pass outside the U.S., and the corporation's activities in the U.S. don't rise to the level of a trade or business. However, the determination of whether a foreign company (or other foreign person) is engaged in a U.S. trade or business is ''highly factual'' and depends on the facts and circumstances of each case.3 Courts historically have focused on whether such activities, including the activities of the foreign person's agents in the U.S., were ''considerable, continuous and regular.''4

Broadly stated, a foreign company sending employees or other agents into the U.S. or otherwise establishing a physical presence (for example, servers or other assets) might be considered to be engaged in a U.S. trade or business. However, there is no bright-line test.

Federal Income Taxation Of Business Profits Under a Treaty

The U.S. business profits of a foreign corporation that is eligible for tax benefits under an income tax treaty generally aren't subject to federal income taxes unless the corporation has a ''permanent establishment'' in the U.S. As with a trade or business, there is no bright-line test for what constitutes a permanent establishment, but it generally requires a more substantial physical presence or greater level of activity.5

As with a trade or business, there is no bright-line test for what constitutes a permanent establishment, but it generally requires a more substantial physical presence or greater level of activity.

Article 5 of the U.S. Model Income Tax Convention of Nov. 15, 2006 (the ''Model Treaty''), defines a permanent establishment as a ''fixed place of business through which the business of an enterprise is wholly or partly carried on.'' The U.S. Model Technical Explanation accompanying the Model Treaty (the ''Technical Explanation'') provides:

[A] general principal to be observed in determining whether a permanent establishment exists is that the place of business must be ''fixed'' in the sense that a particular building or physical location is used by the enterprise for the conduct of its business, and that it must be foreseeable that the enterprise's use of this building or other physical location will be more than temporary.

Under Article 5 of the Model Treaty, permanent establishments include, among other things, places of management, branches, offices, factories, workshops, mines, oil and gas wells, quarries and certain construction sites or installations put in place for more than a year. There are exceptions for facilities used solely to store, display or deliver merchandise belonging to the enterprise and the maintenance of a stock of goods solely for storage, display or delivery or for processing by another enterprise. This carve-out can be particularly helpful for a foreign company selling goods to U.S. customers without a physical storefront (e.g., through online sales).

Article 5 also carves out fixed places of business that exist solely for the purpose of purchasing goods or merchandise, collecting or supplying information, advertising or other activities of a ''preparatory or auxiliary character'' for the enterprise.

Activities of Agents

An enterprise generally won't be deemed to have a permanent establishment solely on account of the activities of an ''independent agent'' acting in the ordinary course of such agent's trade or business (i.e., an independent contractor working on a non-exclusive basis who isn't otherwise economically dependent on the enterprise).6 However, the activities of employees, as well as agents who regularly exercise contracting authority on behalf of the enterprise (other than for ancillary matters), can be imputed to the enterprise.7

Although the particulars of each treaty vary, most reflect the general principles laid out in the Model Treaty. The permanent establishment threshold under a typical treaty can give a foreign corporation that doesn't have significant assets or employees on the ground some leeway to operate in the U.S. before its business profits are subject to federal income taxes. Moreover, even if a foreign corporation has a permanent establishment in the U.S., only business profits attributable to the permanent establishment are taxable under most treaties (including Article 7 of the Model Treaty).

Note on Updates to Model Treaty

The U.S. Treasury Department announced proposed updates to the Model Treaty on May 20, 2015.8 The...