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Individual Comments on Effectively Connected Income, Treaty Issues

MAY 6, 2019

Individual Comments on Effectively Connected Income, Treaty Issues

DATED MAY 6, 2019
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Email RE §863(B), ECI, U.S. TAX TREATIES, AND OTHER ISSUES

May 6, 2019

Doug, I hope that you've been well.

Let me first say a few things about the items in this email. (Also, note that I've attached an MS Word copy of this for your convenience.)

In attempting to put something down on paper regarding the overlap between §864(c)(4)(B)(iii) and §865(e)(2), I've ignored the former. I'm not sure how else to effectively deal with it. Maybe I'm just not imaginative enough. I think I recall hearing or reading in the past that there's something obscure that could be covered by the one, but not the other. In my old age, my memory is fuzzy on this. In any case, I look forward to seeing what you eventually do with this overlap issue and hope that my efforts and below thoughts are useful to you.

When we had our phone discussion recently, I had expressed my concern that a position of zero U.S. source income under the §865(e)(2) override sourcing rule seemed the strongest argument. You made a point of saying that you and others in Treasury believe that there's still an argument for some taxability. While I don't recall exactly how our phone conversation proceeded regarding this point, let me say that I agree with you that there is an argument that the §865(e)(2) override should be applied on the “properly allocable” basis as that term is used in §864(c)(5)(C). I stated this in my November 5, 2018 article and believe this even more strongly now, though I do continue to see ambiguity caused by the §864(c)(4)(B)(iii)/§865(e)(2) overlap and its somewhat convoluted language.

In any case, it seems to me that if you and your other Treasury colleagues are not already considering this, perhaps in conjunction with the new §863(b) regulations, Treasury could provide some brief, but pointed regulation under §§865(e)(2) and (3) that applies this “properly allocable” basis. This regulation would state clearly that the §863(b) 100% foreign source treatment is overridden for any foreign manufactured property that is sold through a U.S. sales office, which of course makes §865(e)(2) applicable. (The only exception is where there is a foreign office of the taxpayer that materially participates in the sale and the relevant property is sold for use, disposition, or consumption outside the United States.) By adding such a regulation under §§865(e)(2) and (3), it should be easy to focus only on how §864(c)(5) works in connection with §§865(e)(2) and (3) (i.e. U.S. source income) and simply remain silent about how §864(c)(5)(C) works for §864(c)(4) (i.e. non-U.S. source income).

For your convenience in considering this, please note the following concerning the intent behind the “properly allocable” language from an October 11, 1966, Senate report (S. Rep. 89-1707, at 21).

The committee received considerable testimony requesting that the general foreign source effectively connected rules be modified so as to ensure in all cases that only income generated in the United States would be subject to U.S. tax. It is your committee's understanding that this was the intention of the House bill and, therefore, the addition of the 'properly allocable' test is considered to constitute a clarifying amendment.

Application of §863(b) and §865(e)(2) under domestic law

The June 5, 2018, submission that my old colleague and I made to Treasury and the IRS concerning the Priority Guidance Plan included several suggestions regarding the §863(b) (found on page 12ff). Those suggestions, though, did not consider any changes to Reg §1.864-6(c). Please consider that the following suggested changes to Reg §1.864-6(c). Also please consider placing these in some manner within new regulations that you could issue under §865(e).

Reg §1.864-6(c)(2) presently reflects pre-§865 law. Following the addition of §865(e)(2), which defines certain otherwise foreign source income as U.S. source income, it is important to both update this regulation and provide within the updated section a clear statement of Treasury's position that the “properly allocable” language of §865(c)(5)(C) still applies following the TCJA §863(b) amendment.

With the above in mind, I suggest the following possible language for an amended and updated Reg §1.864-6(c)(2) and (c)(3).

(2) Special rule for sales of goods or merchandise through U.S. office.

Notwithstanding subparagraph (1) of this paragraph, in the case of any sale of inventory property that is attributable to an office or other fixed place of business that a nonresident alien or foreign corporation maintains in the United States, which is not a sale to which section 865(e)(2)(B) applies, the amount of income which shall be attributable to the office or other fixed place of business which the nonresident alien individual or foreign corporation has in the United States shall be the amount which is properly allocable to that office or other fixed place of business. See, for example, paragraph (b) of section 1.863-3 as in effect for taxable periods beginning on or before December 31, 2017, which prescribes, as available methods for determining income from production activity and sales activity, the 50/50 method, the independent factory price method, and the books and records method.

(3) Illustrations

The application of this paragraph may be illustrated by the following examples:

Example (1). Foreign corporation M manufactures machinery in a foreign country and sells the machinery outside the United States through its sales office in the United States for use in foreign countries. Title to the property which is sold is transferred to the foreign purchaser outside the United States, but no office or other fixed place of business of M in a foreign country participates materially in the sale made through its U.S. office. Under section 865(e)(2), income from M's sale of machinery attributable to its sales office is sourced in the United States. During the taxable year M derives a total taxable income (determined as though M were a domestic corporation) of $250,000 from these sales. Using the independent factory price method, the taxable income from sources within the United States from such sales is determined to be $100,000. The taxable income which is allocable to M's U.S. sales office pursuant to this paragraph and which is effectively connected for the taxable year with the conduct of a trade or business within the United States by that corporation is $100,000.

Example (2). Foreign corporation N has an office in a foreign country which purchases merchandise and sells it through its sales office in the United States for use in various foreign countries, such sales being made outside the United States and title to the property passing outside the United States. No other office of N participates materially in these sales made through its U.S. office. Under section 865(e)(2), income from N's sale of merchandise attributable to its sales office is sourced in the United States. By reason of its sales activities in the United States, N is engaged in business in the United States during the taxable year. During the taxable year N derives taxable income (determined as though N were a domestic corporation) of $300,000 from these sales made through its U.S. sales office. The taxable income which is allocable to N's U.S. sales office pursuant to this paragraph and which is effectively connected for the taxable year with the conduct of a trade or business in the United States by that corporation is $300,000.

Example (3). The facts are the same as in example (2), except that N has an office in a foreign country which participates materially in the sales which are made through its U.S. office. Under section 865(e)(2)(B), income from N's sale of merchandise attributable to its U.S. sales office, but for which N's office in a foreign country participates materially, is not converted into U.S. source income. The taxable income which is allocable to N's U.S. sales office is not effectively connected for the taxable year with the conduct of a trade or business in the United States by that corporation.

In addition to the above, an additional example could be added to Reg §1.864-4(b). The June 5, 2018, submission on page 10 suggested the addition of an additional Example (4) to this regulation. As part of your §863(b) regulation update, it seems that the following Example (5) could be added as well. I've drafted it to be relevant both before and after the TCJA §863(b) amendment.

Example (5). In 2005, U.S. Parent (USP) and its wholly owned Foreign Subsidiary (FS) execute a cost sharing agreement (CSA) concerning product P. Under the CSA, each of USP and FS owns its share of the economic rights for exploitation of the IP for product P within its respective geographic territory (for USP, North America, and for FS, the rest of the world). FS (including its disregarded entity subsidiaries) conducts marketing, customer service, logistics, and related activities within its territory. Under a service agreement, FS contracts with USP for USP to conduct services and other activities that contribute to FS's production of product P. These services and other activities include selection of and negotiation with vendors of product P components and contract manufacturers for product P production services. The services and other activities also include product P production planning and management involving, for example, quantities of production, control of inventory levels of raw materials, work-in-progress, and finished goods, quality control, and other functions listed in section 1.954-3(a)(4)(iv)(b). It is determined that the facts and circumstances of USP and FS cause FS to be engaged in trade or business within the United States under the provisions of section 1.864-2 and that FS has U.S. source income under section 863(b) since the location of manufacture is partially or wholly within the United States. FS's income or loss from sources within the United States is treated as effectively connected for 2005 with the conduct of a business in the United States.

While I am suggesting these various approaches to assure U.S. taxation of income that is “properly allocable” to the U.S. office or other fixed place of business, I do believe that there remains undesirable ambiguity within the relevant Code sections. As such, it seems to me that a legislative solution providing clarity as detailed in my November 5, 2018, article and covered in our recent phone discussion is called for.

Application to residents of treaty countries with which the U.S. maintains a tax treaty

Where a resident of a treaty country maintains a permanent establishment within the U.S. that is involved in the sale of property produced by the resident outside the U.S., §863(b) provides for full foreign source treatment of all income. However, an application of §§865(e)(2) and 864(c)(5)(C) could find that income “properly allocable” to the U.S. office or other fixed place of business is U.S. source and therefore effectively connect income under domestic law.

Where a resident of a treaty country

(i) directly through its own employees,

(ii) through an agent,

(iii) through the actions of other persons (whether related or unrelated) acting as putative independent contractors who direct or otherwise conduct the business of the resident, or

(iv) through a partnership,

maintains a permanent establishment within the U.S. that is involved in the production of property or the management, maintenance, or other operation of an internet platform or other business mechanism through which the resident earns gross income, then §863(b) or Reg §1.861-4(b)(1) applies to create some amount of U.S. source income that will be effectively connected income under domestic law.

The suggestions made in the June 5, 2018, submission and the §863(b) and other matters covered in this email create two treaty issues. One is the issue that you raised in our phone discussion regarding what effect amended §863(b) might have in relation to Article 7 regarding taxation of business profits. The other possible issue is the suggested clarification of a U.S. trade or business to include actions by another person who conducts within the U.S. important portions of the business of a foreign taxpayer. This raises the permanent establishment definition in Article 5 as a second treaty issue.

(While not a technical matter, it seems appropriate to raise the point that many profit shifting structures that move profits into low-taxed foreign group members use entities that are not treaty country residents. If we think of publicly available information about a number of major household-name multinationals, many have used pure tax haven companies (including companies in jurisdictions like Singapore with which the U.S. maintains no tax treaty) or group members in treaty-partner countries where the group member is not resident in that country under the applicable treaty (e.g. non-tax-resident Irish company). In such cases, pure domestic U.S. tax law will apply. You will have seen that the June 5, 2018, submission included some suggestions concerning treaty coverage in a number of situations, including where foreign group members are disregarded entities that attempt to claim treaty benefits. This seems an area that is ripe for some regulation amendments, rulings, or other approaches that will prevent inappropriate uses of tax treaties.)

Clarification of U.S. trade or business

In regard to the second possible treaty issue (i.e., U.S. trade or business and existence of a permanent establishment), the June 5, 2018, submission included adding the following at the end of paragraph (a) of Reg §1.864-2 to clarify the definition of “engaged in trade or business within the United States”:

The term also includes the performance of activities within the United States (for example the purchasing or production of products, the substantial contribution to the manufacturing of personal property within the meaning of section 1.954-3(a)(4)(iv)(b), the sale of products, the maintenance and management of an internet-based platform through which sales are made or advertising or other internet based service revenues are earned, the rental or licensing of intangibles, etc.) by another person (whether related or not and including activities performed under any independent contractor service agreement or agency) who conducts all or any material portion of these activities or manages the commercial risks thereof for or on behalf of any taxpayer when the taxpayer itself has insufficient personnel or capacity to conduct all or any material portion of its business or manage the commercial risks thereof. The actual conduct and activities of the persons will control rather than any contractual label or description that provides, for example, that the person conducting the activities or managing the commercial risk is an independent contractor providing a service.

This language is, of course, meant to make clear that where a person conducts activities within the U.S. for the benefit of a foreign person where those activities represent the conduct of that foreign person's business, then that foreign person will have a U.S. trade or business. The essence of this, of course, is that the person conducting the activities is a de facto agent of the foreign person.

Where the foreign person is a resident of a treaty country, then the permanent establishment article in the treaty will, of course, apply. Assuming that Treasury issues an amendment to Reg §1.864-2(a) that clarifies that these activities conducted by other persons will cause a U.S. trade or business, then some guidance regarding the interaction of this clarification and the Article 5 definition of permanent establishment would be useful.

One point is what guidance to provide. A second point is where to provide that guidance.

Regarding the first point, it seems to me that where the person conducting the activities within the U.S. is factually managing risks and/or making decisions on the foreign person's business within the meaning of Reg §1.864-2(a) as clarified, thereby creating a de facto agent, then guidance should provide that that will equate to exercising “an authority to conclude contracts that are binding on the enterprise”. Doing so will allow paragraph 5 of Article 5 to apply, which will cause the foreign person to have a permanent establishment.

As for where to provide that guidance, I suppose that something could be issued under §894(b). Or, perhaps something could be added to Reg §1.864-2 to provide guidance where a treaty applies. I haven't tried to look generally through the regulations to see where there are examples of regulatory guidance on treaty application, but nothing of the same nature as might be included in Reg §1.864-2 in this instance comes to mind.

This makes me think of several other potential places for such guidance. One, of course, could be within the explanation section of the Treasury Decision within which the amendment is made adding the clarifying language to Reg §1.864-2(a). Another is through a revenue ruling. A third would be to add this guidance to the Technical Explanation of the 2016 U.S. Model Tax Convention. (I understand that the Technical Explanation to the 2016 U.S. Model has not yet been issued. If the issuance of this Technical Explanation is not expected anytime soon, perhaps there could be an amendment of the Technical Explanation for the 2006 U.S. Model.) Needless to say, this guidance could be usefully placed in all of these three places.

Effect of amended §863(b)

It was indicated above that an application of §§865(e)(2) and 864(c)(5)(C) could find that income “properly allocable” to the U.S. office or other fixed place of business is U.S. source and therefore effectively connect income under domestic law. This is also true where Reg §1.861-4(b)(1) applies to create some amount of U.S. source income. In these cases, the applicable tax treaty's Business Profits article could limit the amount of taxable effectively connected income to the profits that are attributable to the permanent establishment. The 2016 U.S. Model Tax Convention provides in Article 7, paragraphs 1 and 2:

“1. Profits of an enterprise of a Contracting State shall be taxable only in that Contracting State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits that are attributable to the permanent establishment in accordance with the provisions of paragraph 2 of this Article may be taxed in that other Contracting State.

“2. For the purposes of this Article, the profits that are attributable in each Contracting State to the permanent establishment referred to in paragraph 1 of this Article are the profits it might be expected to make, in particular in its dealings with other parts of the enterprise, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the other parts of the enterprise.”

[Emphasis added.]

The above from the 2016 U.S. Model reflects the Authorized OECD Approach (AOA). Some tax treaties entered into by the U.S. have been more consistent with the pre-AOA approach and the still current approach in the U.N. Model Double Taxation Convention. Paragraph 2 in both the pre-AOA version and the current U.N. version is:

“2. Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment.” [Emphasis added.]

One other item worthwhile noting is the following from page 22 of the 2006 U.S. Model Technical Explanation:

The "attributable to" concept of paragraph 2 provides an alternative to the analogous but somewhat different "effectively connected" concept in Code section 864(c). In effect, paragraph 2 allows the United States to tax the lesser of two amounts of income: the amount determined by applying U.S. rules regarding the calculation of effectively connected income and the amount determined under Article 7 of the Convention. That is, a taxpayer may choose the set of rules that results in the lowest amount of taxable income, but may not mix and match. [Emphasis added.]

For domestic law purposes where §865(e)(2) and §864(c)(5)(C) are applicable, I suggested above including in Reg §1.864-4(c)(2) (and perhaps in new regulations under §865(e)(2) as well) an effective definition of “properly allocable” through referencing the methods included in paragraph (b) of Reg §1.863-3 as in effect for taxable periods beginning on or before December 31, 2017.

In addition, as detailed in the June 5, 2018, submission (pages 8 – 10), we suggested that an Example (4) be added to Reg §1.864-4(b) to make clear that there could be U.S. source income earned by a foreign person from the management, maintenance, or other operation of an internet platform through which the foreign person earns gross income. (Although not suggested in the June 5, 2018, submission, it seems sensible to now consider providing some source guidance for such income through a revenue ruling or other means. The 2017-2018 Priority Guidance Plan (page 23 at F.2.) promises “Regulations under §861 on the character of income, including income arising in transactions involving intellectual property and the provision of digital goods and services.” Until these new regulations are issued, guidance provided now through a ruling or other means could simply make clear that where group members manage, direct, or conduct critical aspects of a foreign group member's internet platform-based business, then Reg §1.861-4(b) must be applied to determine the amount of U.S. source income.)

In both these cases, whether through the operation of §865(e)(2) and §864(c)(5)(C) or Reg §1.861-4(b), there would be some amount of taxable effectively connected income under domestic law.

Where a treaty applies to a foreign person, then that person has the option to apply Article 7 of the treaty to arrive at a lower amount of taxable profits.

Doug, when we spoke by phone, you mentioned having concerns regarding the interaction of the AOA approach and new §863(b). After looking through and considering this area some, I'm not yet seeing issues that should cause concerns. With a treaty-protected foreign person able to “choose the set of rules that results in the lowest amount of taxable income”, there does not appear to be any need for consistency between the alternative bases for calculating effectively connected income under domestic law and calculating profits attributable to a permanent establishment under Article 7 of the particular treaty using any applicable domestic or OECD guidance.

For example, say that in the application of Article 7 of a treaty that applies the AOA approach there is recognition of certain dealings between the permanent establishment and other parts of the enterprise. However, these dealings are not recognized under U.S. domestic law, thereby creating a significant difference. In such a case, a foreign person would make its calculations and the IRS would audit those calculations. Whether the particular Article 7 includes the AOA approach or pre-AOA language doesn't change the basic procedures for either the taxpayer or the IRS or the analysis conducted by each.

Doug, I do not know what you might be contemplating for guidance in this area or how that guidance might be made available to taxpayers. Maybe in another phone discussion or through email exchange we could chat about this further. In any case, with the Technical Explanation of the 2016 U.S. Model not yet being issued, I suspect that you and your colleagues are considering putting additional guidance into it.

Application to U.S. residents under tax treaties

While the above-described inbound situation for foreign persons covered by a tax treaty is relatively complex, that for U.S. residents applying the treaty seems relatively straight-forward.

Paragraph 3 of Article 23 of the 2016 United States Model Income Tax Convention provides:

“For the purposes of applying paragraph 2 of this Article, an item of gross income, as determined under the law of the United States, derived by a resident of the United States that, under this Convention, may be taxed in __________ shall be deemed to be income from sources in __________.”

I expect that most if not all existing U.S. tax treaties will include this provision. Assume a situation where a U.S. resident manufactures products in the U.S. and sells them through a sales branch in a country with which the U.S. has a tax treaty that includes this provision. Assume further that the sales branch constitutes a permanent establishment and that the country taxes that U.S. resident on the income attributable to that permanent establishment.

Although the §863(b) source rule provides for full U.S. source treatment based on the location of the production activities, this tax treaty source rule should override and allow the U.S. resident foreign source treatment for the foreign tax credit limitation computation. Where there is no tax treaty in place, though, all income would be U.S. source.

During our phone discussion, we covered some the double-taxation situation that can arise for applicable U.S. manufacturers that was detailed in my November 5, 2018, article. You will separately consider whether some sort of legislative solution is desirable and should be pursued.

* * * *

Doug, I hope that the above is useful to you. Please let me know how you would like to proceed further.

All the best,

Jeff

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