I will elaborate on the following four areas:
Capital Gains Received by Non-US Persons
The Mechanics of the Withholding Tax
Foreign Source ECI and
the Consequences of Having a US Subsidiary
Capital Gains Received by Non-US Persons
Generally, if a Non-US Person receives US source capital gain AND the capital gain is not effectively connected with a US trade/business, then the Non-US Person is not subject to US tax on that gain.
If the non-US person has no US trade/business, then no taxes will be imposed on the capital gain earned by such a person.
If the non-US person has a US trade/business, then capital gain may be subject to US tax if it is ECI. In order for it to be ECI it must meet the asset-use test or the business activities test (see Lecture 4).
The policy behind the limitations on taxation of capital gains received by non-US persons is to encourage foreign investment in the US.
Typically, when an intangible asset is sold, the gain constitutes capital gain and it would not be subject to withholding tax. However, if the sales price is contingent on the property’s productivity, use or disposition then it will be sourced as a royalty and subject to withholding tax accordingly.
Mechanics of the Withholding Tax
The reason the Tax Code imposes a withholding tax on investment revenue received by non-US persons is because it is the most practical way of collecting the tax. Generally, the withholding agent must withhold 30% of the revenue (or a lesser amount directed by a Treaty). The withholding agent is the person in the US who last handles the item of income before it is remitted to the taxpayer or a foreign intermediary. So if a corporation pays a dividend to a foreign person, the corporation is the withholding agent. However, if the corporation pays a dividend to a US stock broker who then remits it to a foreign person, then the stock broker is the withholding agent.
The withholding agent has an obligation to withhold if they have been notified that the payee is foreign or if they have reason to assume that the payee is foreign. For instance, if the payee provides a foreign address or does not present a Taxpayer Identification Number, the withholding agent should assume the payee is foreign. A foreign person should notify the withholding agent of their foreign status by providing them with a withholding certificate (Form 8233). If there is an Income Tax Treaty that reduces the rate, it is the payee’s obligation to inform the withholding agent that a lower rate applies.
Foreign Source ECI
Last week we saw that when you’ve established that a non-US person has a US trade/business, all US source income will be ECI except FDAP income that does not meet the “Asset-Use” test or the “Business Activities” test.
Foreign Source income may also be ECI with a USTB; however there are a number of restrictions for it to be included as such.
First, you need an office or fixed facility in the US. Remember it is possible to have a USTB without an office or fixed facility. However, it is not possible to have Foreign Source ECI without an office or fixed facility. So if a Foreign Corporation has a sales force present in the US without an actual office, no Foreign Source income would be ECI no matter how related it is to the activities in the US.
Also, be aware that if the Foreign Corporation merely has a US subsidiary with an office that, in and of itself, will not create an office for the Foreign Corporation. If the US subsidiary is acting as the Foreign Corporation’s agent, then its office may create an office for the Foreign Corporation (more on the consequences of having a US subsidiary later).
Once you’ve determined that there is a USTB with an office or fixed facility it is time to ask the second question: Is the item of Foreign Source income ATTRIBUTABLE to the US office? In other words, does the US office MATERIALLY PARTICPATE in the production of the item of Foreign Source income?
This is where things get tricky. Establishing that there is an US office if pretty straight forward. But it’s harder to determine if the US office materially participates in the production of an item of Foreign Source income. The standard of “materially participates” is difficult to grasp. It is necessary to apply it on an item-by-item basis:
Royalties and Rents
We can conclude that a US office materially participates in the production of Foreign Source Royalties and Rents if that office actively participates in soliciting, negotiating, or performing other activities required to arrange or service the lease/license. General supervision by the US office of such activities is insufficient to constitute materially participation. The US office’s personnel must actually perform such services. The following activities alone will not constitute material participation:
Creation, development or purchase of licensed property,
Collecting or accounting for royalties or rents,
Performing clerical functions
Exercising final approval over the execution of licenses/leases
Dividends and Interest
In order for dividends and interest to be attributable to a US office, the dividends/interest must be derived in the active conduct of a banking, financing or similar business in the US. This is not unlike the “business activities” for FDAP income. Basically, if you are not dealing with a banking or financing business then Foreign Source dividends/interest will not be ECI.
The General Rule is that Foreign Source income from the sale of personal property is ECI if it is made through the taxpayer’s office.
Assume that a Foreign Corporation (ForCo) has a sales office in the US that sells encyclopedias. There is a sales force in the US that calls individuals in the US and Canada and sells them the encyclopedias. The terms of the contract state that title transfers upon receipt by the customer. Since title transfers to the Canadian customers upon receipt in Canada, such income is foreign source income (the sourcing rule for inventory is based on where title is transferred). Because the sale was made through the US office, the foreign source income from the sale is ECI.
There is an exception to the above rule. Even if the sale is made through a US office, the Foreign Source income will NOT be ECI if an office of the taxpayer in a foreign country participates materially in the sale.
So back to our example: Assume the same facts as above except that ForCo also has an office in Canada that produces marketing material for the encyclopedias sold in Canada. One may argue that the Canadian office also materially participates in the sale and therefore the Foreign Source income from the sale of encyclopedias in Canada is not ECI.
Consequences of Having a US Subsidiary
A general rule that you should remember is that if a Foreign shareholder (or a Foreign Corporation) owns shares in a US corporation, that alone is not enough to create a US trade/business.
Assume that a Foreign Corporation, a foreign corporation, (ForCo) owns 100% of the shares of a US Corporation (USSub). ForCo makes bicycles and sells them in France directly to retailers. ForCo also sells the bicycles to USCo and USCo sells them to retailers in the US.
The fact that ForCo owns 100% of USCo is not enough to create USTB for ForCo. Remember that mere ownership is not enough to create a USTB.
Since ForCo does not have any of its own employees in the US (the US sales force is employed by USCo), the only way that ForCo could have a USTB is if USCo was acting as ForCo’s agent. In the facts above, there is an arm’s length Buy-Sell arrangement between ForCo and USCo. USCo assumes all risk on the sales of the bikes and concludes contracts on its own behalf. Since USCo is acting independently of ForCo, USCo is not ForCo’s agent and ForCo does not have a USTB. Note that USCo will be subject to US tax on the sale of the bikes just as any other US person would be, however ForCo would not be subject to US tax.
Now assume that the terms of the agreement between ForCo and USCo are different. Assume that instead of a buy-sell arrangement, ForCo commissions USCo to sell the bikes for it and compensates USCo with a percentage of the sale. ForCo maintains ownership of the inventory and has final approval of all contracts. In this case USCo is not acting independently of ForCo. We can conclude that since USCo is ForCo’s agent, ForCo has a USTB through USCo and ForCo will be subject to US tax on its ECI.
Assume that ForCo also had a wine business that was wholly unrelated to the bike business and ForCo sold wine through mail-order directly to US consumers (without the involvement of USCo). If title to the wine passes upon receipt by the customers in the US the income would be US source income. Even though it has nothing to do with the bike business and USCo played no role in the wine sales, the wine income would be ECI because it is US source income and ForCo had a USTB (through USCo).
I know this is complicated but here are some simple rules that you should remember:
Ownership of a US corporation is not enough to create a USTB.
You should analyze the relationship between a Foreign person/corporation and its US corporation the same way you would analyze the relationship between the Foreign person/corporation and an unrelated agent in the US.
If you have a USTB, all non-FDAP US source income earned by the non-US person will be ECI even if it is entirely unrelated to the USTB.
Planning Note: It is generally preferable for a Foreign Person to incorporate its US activities and to have the US corporation act on its own behalf in order to prevent the Foreign Person from having ECI. The only time a Foreign Person would want to conduct activities in the US directly (i.e. without incorporating) is if it had losses in the US.