By Patrick J. McCormick, JD, LLM
Multinational businesses invariably encounter questions as to whether their activities create a “permanent establishment” outside their country of domicile. If the nonresident business either maintains a permanent establishment (under income tax treaties) or is engaged in a U.S. trade or business (under statutory requirements), it faces more significant tax consequences in the country where the establishment is located. If no permanent establishment exists, the business usually is taxable only on specified income items sourced outside its home country.
This blog provides background on nonresident business from a U.S. perspective – specifically, the standards applicable to foreign businesses entering the U.S. market.
Taxation of Nonresident Businesses
A nonresident business with American activities must consider numerous U.S. tax issues, but the threshold issue is how a business will be classified for American tax purposes. Like domestic entities, foreign businesses can be classified either as corporate entities (separately taxable on income earned in its name) or flow-throughs (with income passing through to the entity’s owners).1 Foreign entities are usually able to elect their classification for American tax purposes, but if no election is made default rules dictate classification. Default classifications are dictated not by reference to classification in the home country, but rather by whether stakeholders in the business have limited liability. If all do, the entity is classified as a corporation.2
Nonresidents are subject to U.S. tax on fixed or determinable income sourced to the United States and income “effectively connected” to the nonresident’s “United States trade or business.” The former category, referenced as “Fixed, Determinable, Annual, Periodical (FDAP) income,” includes noncapital gains income sourced to the United States; tax is collected through withholding by U. S. payor (without deductions/credits for costs associated with income generation), with a 30% withholding rate (often lowered by treaty provisions) applicable.3
Nonresident aliens are taxed on income effectively connected with a U.S. trade or business at graduated rates, with deductions allowed.4 Determinations as to whether income fits within the effectively connected income (ECI) category hinge on whether a “United States trade or business” is found; case law provides that a U.S. trade or business exists where profit-oriented activities are carried on in the United States that are regular, substantial, and continuous.5 Passive asset ownership (i.e., a securities portfolio of U.S. domiciled companies) will not create a “United States trade or business,” outside special statutory inclusion.6 What is instead required is some level of profit-oriented activity beyond merely a customer locale. Where this exists, classification of activities as a “trade or business” is likely; income is “effectively connected” with a U.S. trade or business if meeting either an asset use test (looking to whether income was derived from an asset used in conducting an American trade or business) or a business purpose test (focusing on whether U.S. trade or business activities were a material factor in income generation).7
Where a U.S. trade or business is found, the scope of American tax expands significantly. Nonresidents not engaged in a U.S. trade or business are subject to American tax only on FDAP income, leaving significant gaps in American-sourced income items (most notably non-real property capital gains, but also including most U.S.-sourced interest).8 If a nonresident is engaged in an American trade or business, the nonresident is taxed on all income effectively connected to that trade or business – not just FDAP income, but capital gains, inventory sales, and certain foreign-sourced income items connected to a U.S. office.9 The ramifications of maintaining a trade or business are thus nonresident-specific. For those solely generating income that would be subject to U.S. tax irrespective of the existence of a trade or business, trade or business classification can be preferred (given the aforementioned ability to be taxed on a net basis). For businesses with more expansive operations, however, creation of a “U.S. trade or business” can carry significant tax consequences.
Income tax treaties apply where a taxpayer resides in one country (the residence country) and has income taxable by a second country under the latter’s statutory rules (the source country). Where the residence country and the source country have in place an income tax treaty between them and the applicable taxpayer can establish valid residence in the former, the source country’s default tax rules can (by election) be overridden by treaty terms. While each treaty between two countries has its own distinct articles, most share general concepts and terms (with the overarching goal of any income tax treaty being the minimization of double tax).
Nonresidents eligible for treaty benefits alter their American tax scope from income effectively connected with the conduct of a U.S. trade or business to profits attributable to the carrying on of a business through a U.S. permanent establishment.10 Existence of a permanent establishment permits a source country generally to tax the nonresident as if separately incorporated within the jurisdiction – further replicating the trade or business statutory standard.11 Functionally, treaties provide that a business enterprise is taxable only in its country of residence unless it takes steps of enough significance to create a “permanent establishment” in the other country. Given that the United States has executed tax treaties with a majority of other countries with prominent global economies, the “permanent establishment” standard is more likely to determine a nonresident business’s American tax exposure.
A permanent establishment is a fixed place of business through which the business of an
enterprise is wholly or partly carried on.12 While the permanent establishment standard is elevated from that applicable for an American trade or business, the standard can nonetheless be low. As an example, maintenance of a small office in the United States solely to solicit orders for work done outside the United States has constituted a permanent establishment.13 Offices, places of management, and branches all are included within the “permanent establishment” concept. However, maintenance of a fixed place of business solely for auxiliary or preparatory activities does not cause a permanent establishment to be created. Agent activities within the United States create a permanent establishment for a nonresident business if the agent has, and habitually exercises, an ability to conclude contracts in the name of the business within the United States. Where a nonresident business forms a U.S. subsidiary, the subsidiary’s acts are not attributed to the parent for purposes of permanent establishment creation (rather, the subsidiary is taxed separately on its own activities).14
Whether a “fixed place of business” exists for a nonresident business is ultimately determined under U.S. standards for the same. To constitute a “fixed place of business,” an establishment need not be immovable or perpetual. A permanent establishment does, however, need an element of permanence: whether a place of business is sufficiently permanent is fact specific, with connection to the United States over a multiyear period often sufficient.15 A facility need not be actually attached to the ground as long as it remains at a given site.16
1 26 C.F.R. Section 301.7701‐3(b)(2).
2 26 C.F.R. Section 301.7701‐3(a).
3 26 U.S.C. Section 871; 26 U.S.C. Section 881.
4 26 U.S.C. Section 871(b).
5 U.S. v. Balanovski, 236 F.2d 298 (2d Cir. 1956); U.S. v. Northumberland Insurance Company, 521 F.Supp. 70 (DNJ 1981).
6 The primary statutory inclusion is FIRPTA, automatically classifying gains from the disposition of U.S. real property interests as effectively connected to a U.S. trade or business. See 26 U.S.C. Section 897(a). See Higgins v. Com’r, 312 U.S. 212 (1941).
7 26 U.S.C. Section 864(c)(2).
8 26 U.S.C. Section 881(a).
9 26 U.S.C. Section 864(c).
10 United States-Canada Income Tax Treaty, Art. 7(1).
11 United States‐Canada Income Tax Treaty, Art. 7(3).
12 United States Model Income Tax Convention, Art. 5(1).
13 Revenue Ruling 65‐263.
14 United States Model Tax Convention, Art. 5(2), 5(4), 5(5), 5(7).
15 Revenue Ruling 67‐322.
16 OECD Model Treaty Commentaries, Art. 5 (2014).
Patrick J. McCormick, JD, LLM, is a partner with Culhane Meadows PLLC. He can be reached at email@example.com.
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