INCOME RECEIVED BY NONRESIDENT ALIEN BENEFICIARY OF FOREIGN TRUST THAT IS A LIMITED PARTNER IN U.S. PARTNERSHIP IS NOT EXEMPT FROM TAX UNDER TREATY

Rev. Rul. 85-60

ISSUE

Whether, in the situation described below, income received by a nonresident alien from a trust is exempt from federal income tax pursuant to an income tax treaty provision concerning business profits?

FACTS

A is a citizen and resident of a foreign country (FC), A is the sole beneficiary of TR, a testamentary trust established in FC for the benefit of A. A is not treated as the owner of any portion of the trust under any provision of Chapter 1, Subchapter J, Part I, Subpart E of the Internal Revenue Code.

Pursuant to the trust instrument, TR became a limited partner in PRS solely for the purpose of protecting and conserving the assets of the trust for A. PRS, a limited partnership formed in the United States under the State S Uniform Limited Partnership Act, is engaged in the real estate development business in State S and maintains a business office there. TR derives some of its income from the limited partnership interest in PRS. TR is required by the trust instrument to currently distribute all of its income to A, which TR does.

LAW AND ANALYSIS

Section 871(b) of the Code provides that a nonresident alien individual engaged in a trade or business within the United States shall be taxable on income that is effectively connected with the conduct of a trade or business within the United States.

Article VI(1) of the Income Tax Treaty between the United States and FC (Treaty) provides that industrial or commercial profits of a resident of FC shall be exempt from tax by the United States unless such resident is engaged in industrial or commercial activity in the United States through a permanent establishment situated therein. If such resident is so engaged, tax may be imposed by the United States on the industrial or commercial profits of such resident, but only on such profits as are attributable to the permanent establishment. The intent of the treaty is to allow the source country to tax business profits if the economic contact is sufficient to constitute a permanent establishment.

Article VII of the Treaty provides that the term "permanent establishment" means a fixed place of business through which a resident of FC engages in industrial or commercial activity. The term "fixed place of business" includes an office, PRS has an office in the United States.

When a limited partnership conducts business activity in the United States through a fixed placed of business (such as an office), the office of the limited partnership is a permanent establishment in the United States with regard to each limited partner. Donroy, Ltd. v. United States, 301 F.2d 200 (9th Cir. 1962), Johnston v. Commissioner, 24 T.C. 920 (1955). Therefore, the office of PRS is a permanent establishment in the United States with respect to each partner, including TR.

Article II of the Treaty defines the term "industrial or commercial profits" as including income derived from real property. Accordingly, PRS has industrial or commercial profits. Section 702(b) of the Code provides that the character of income included in a partner's distributive share, and accounted for separately under section 702(a), shall be determined as if such income were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership. Because the amount of industrial or commercial profits will affect the income tax liability of TR or A, TR must take such item into account separately. See section 1.702-1(a)(8)(ii) of the Income Tax Regulations. Therefore, pursuant to the principles of section 702(b), the commercial profits derived by PRS maintain their character as commercial profits for TR.

TR cannot claim an exemption from tax on business income earned in the United States through its permanent establishment under Article VI(1) of the Treaty. Since TR is required to distribute all of its income currently, TR distributes all of its income attributable to the industrial or commercial profits to A. Generally, section 651(a) provides that a trust, the terms of which require it to distribute all of its income currently, shall be allowed a deduction in computing its taxable income in the amount of the income required to be distributed. Under section 651 of the Code, TR will not owe any federal income tax.

The issue arises as to whether the beneficiary of TR, A, is subject to tax on the business profits of PRS that are passed through TR to A. If A did not reside in a country that has a treaty with the United States, such profits received by A would be subject to United States taxation. Section 875(2) of the Code provides that a nonresident alien individual or foreign corporation that is a beneficiary of a trust or estate that is engaged in any trade or business within the United States shall be treated as being engaged in such trade or business in the United States. Under section 875(2), A would be treated as engaged in the real estate development business in the United States because, for purposes of section 875(2), TR is treated as engaged in the real estate development business through its limited partnership interest in PRS. Section 652(b) of the Code provides that income distributed from a trust described in section 651 shall have the same character in the hands of the beneficiary as in the hands of the trust. Thus, absent the treaty, A would be in receipt of business profits from a trade or business conducted within the United States subject to tax under section 871(b).

Article VI(1) of the Treaty provides that A is not subject to tax by the United States on industrial and commercial profits unless A is engaged in industrial or commercial activity in the United States, through a permanent establishment. Two factors must be satisfied to tax the income under the Treaty. The income received by A from TR must be industrial or commercial profits and A must have a permanent establishment in the United States to which such profits are attributable.

Neither the Treaty nor its legislative history contains specific rules as to whether a permanent establishment of a trust will be considered a permanent establishment of the beneficiaries. The Treaty will be interpreted in a manner consistent with the Code and the intent of the Treaty. As previously indicated, the permanent establishment of PRS is attributable to TR. Under domestic tax principles, reflected in section 875(2) of the Code. A will be treated as having a permanent establishment in the United States as a result of the permanent establishment of TR. In addition, consistent with the principles of section 652(b), the income resulting from the activities of PRS and distributed from TR to A will be treated in the hands of A as industrial or commercial profits attributable to a permanent establishment in the United States.

HOLDING

The income received by A from TR is not exempt from federal income tax under Article VI(1) of the Treaty because A is considered to be in receipt of industrial or commercial profits attributable to a permanent establishment that A has in the United States. Such income will be included in the gross income of A under section 871(b) of the Code.