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U.S. Tax Considerations for Foreign E-commerce Sellers
Sales on digital marketplaces pose assorted tax questions for sellers and buyers, but some of the most complex questions arise for nonresident international businesses making sales to U.S. consumers. Historically, countries placed a sizeable weight on a nonresident’s physical ties to a jurisdiction in deciding its tax obligation. This has, to some extent, become antiquated.
By Patrick J. McCormick, JD, LLM
Sales on digital marketplaces pose assorted tax questions for sellers and buyers, but some of the most complex questions arise for nonresident international businesses making sales to U.S. consumers.
The U.S. tax system has historically looked at a nonresident’s ties and connections to the United States to determine the extent/scope of the nonresident’s tax obligations. Nonresidents generating income effectively connected to a U.S. trade or business – or, in specified cases, with business profits attributable to a U.S. permanent establishment – expand the scope of U.S. tax. Income not otherwise subject to U.S. tax – including noneffectively-connected U.S.-sourced capital gains – becomes subject to taxation, making determinations in this context critical.
Countries historically placed a sizeable weight on a nonresident’s physical ties to a jurisdiction in deciding whether the nonresident has created a trade or business establishment. This has, to some extent, become antiquated.
Nonresident Taxation Statutory Rules
As a general concept, countries tax income based on being either the source of the income item or the residence of the income recipient (with exceptions, such as special rules in the U.S. tax system to tax citizens/green card holders on worldwide income irrespective of physical presence). Under U.S. statutory rules, nonresidents are taxed on income effectively connected with a nonresident’s trade or business and fixed or determinable annual or periodic (FDAP) income.
Nonresidents are taxed on income effectively connected with a U.S. trade or business at graduated rates, with deductions associated with generating the income item permitted if a timely return is filed.1 Determinations as to whether income is effectively connected to a U.S. trade or business hinge on whether a “United States trade or business” exists, with longstanding case law looking to profit‐oriented activities carried on in the United States that are regular, substantial, and continuous.2
Whether or not gains of a nonresident are “effectively connected” to the United States – and thus subject to a greater scope of tax – is determined by whether the gain meets either an “asset use” test or a “material factor” test. While narrow categories of foreign-sourced income can be taxed by the United States if associated with a U.S. office or fixed place of business, effectively connected income is generally limited to U.S.-sourced income.
FDAP income is an overarching inclusion for U.S.-sourced ordinary income of a nonresident not connected to a U.S. trade or business. Included within the FDAP income category are interest (subject to expansive exceptions), dividends, rent, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodic gains, profits, and income.3 Where income meets the requirements to be taxed as both effectively connected income and FDAP income, the effectively connected rules are applicable.4 As mentioned, effectively connected income is taxed at graduated rates with deductions and credits permissible. FDAP income, however, is taxed at a flat 30% rate, with no deductions permitted, and primarily collected through payor withholding.5
Where a U.S. trade or business is found, the scope of tax expands significantly. Nonresidents not engaged in a U.S. trade or business are subject to U.S. tax only on FDAP income, leaving significant gaps in U.S.-sourced income items.6 If a nonresident is engaged in an U.S. 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 limited foreign-sourced income items.7
Income Tax Treaties
Income tax treaties permit qualified residents of a treaty party country to modify the statutory U.S. trade or business standard, replacing it (usually) with analysis of whether business profits are attributable to a U.S. permanent establishment. Specifically, treaties apply where a taxpayer resides in one country (the “residence country”) and has income taxable by another country under that country’s default sourcing rules (the “source country”). Where the residence country and the source country have an income tax treaty in place between them and the applicable taxpayer can establish qualification in the residence country, the source country’s tax rules can (by election) be overridden by treaty terms.
Nonresidents eligible for treaty benefits alter the business tax scope from income effectively connected with the conduct of a U.S. trade or business to (generally) profits attributable to the carrying on of a business through a U.S. permanent establishment.8 A permanent establishment is a fixed place of business through which the business of an enterprise is wholly or partly carried on.9 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.10
Sourcing Rules – Sales of Property
As a general rule, income from the sale of nondepreciable, noninventory personal property by a U.S. resident is sourced to the United States; personal property sold by a nonresident is sourced outside the United States.11 An exception to the residency-based sourcing rule applies for a U.S. resident who maintains an office or other fixed place of business in a foreign country. Income is (subject to exceptions) sourced outside the United States if attributable to the foreign office or other fixed place of business, and if the income is subject to tax of at least 10% in a foreign country.12 Conversely, if a nonresident maintains an office or other fixed place of business in the United States, any sale of personal property attributable to the office or other fixed place of business is sourced to the United States. Income is attributable to an office or other fixed place of business maintained by a nonresident in the United States only if the office or other fixed place of business is a material factor in the realization of the income, and if the income is realized in the ordinary course of the trade or business carried on there.
Depreciable personal property – any personal property if the adjusted basis of the property includes depreciation adjustments – is sourced under separate rules. Gains not in excess of depreciation adjustments from the sale of depreciable personal property are allocated by treating the same proportion of the gains as sourced in the United States as United States depreciation adjustments bear to the total depreciation adjustments; the remaining portion is treated as sourced outside the United States.13 Gains in excess of depreciation adjustments are sourced as if the property were inventory (with inventory sourcing rules provided below).14
Where an intangible is sold, the general rules apply unless payments are contingent on the productivity, use, or disposition of the intangible. Any payments classified as contingent are treated for tax purposes as royalties. “Intangibles” subject to these special rules include patents, copyrights, secret processes or formulas, goodwill, trademarks, trade brands, franchises, or other like properties.15
Permanent Establishments in a Digital Economy
Historically, a foundational element of whether or not a nonresident maintains a U.S. business has been the nonresident’s level of physical presence within the United States. Permanent establishments, by definition, use a fixed place standard (with the U.S. trade or business standard requiring even less U.S. connection). For both, a paramount factor has been physical connection. This requirement traditionally has been sensible – for a nonresident to actively avail itself of benefits of the U.S. market, some U.S. footprint has been needed.
Difficulty with the traditional standard arises when applied to a digital economy. Substantial physical connection with the United States is not required to be engaged in active U.S. operations. By necessity, the standards for evaluating nonresident business have begun to be adapted.
What specifically constitutes a “permanent establishment” in the digital context is unsettled, both in the United States and in other jurisdictions.16 Given both the infancy and significance of the issue, it has generated continuous attempts to define a scope. (See Clarification on the Application of the Permanent Establishment Definition in e-Commerce.)
1 IRC Section 871(b)
2 See U.S. v. Balanovski, 236 F.2d 298 (2d Cir. 1956); U.S. v. Northumberland Insurance Company, 521 F.Supp. 70 (DNJ 1981).
3 See IRC Section 1441(b)
4 See IRC Section 871(b)
5 See 26 U.S.C. Section 871(a). Persons having control, receipt, custody, disposal or payment of FDAP income items of a nonresident is required to deduct and withhold a tax equal to 30% thereof. 26 U.S.C. Section 1441(a). Withholding is required on the gross amount of the payment made. 26 C.F.R. Section 1.1441-3(a)(1). A withholding agent is personally liable for any amount required to be withheld, whether or not tax is actually withheld. 26 U.S.C. Section 1461.
6 See IRC Section 881(a)
7 IRC Section 864(c)
8 See United States-Canada Income Tax Convention, Art. 7(1)
9 See United States Model Income Tax Convention, Art. 5(1)
10 United States Model Tax Convention, Art. 5(5)
11 26 U.S.C. Section 865(a)
12 26 U.S.C. Section 865(e)(1)(A)
13 26 U.S.C. Section 865(c)(1)
14 26 U.S.C. Section 865(c)(2)
15 26 U.S.C. Section 865(d)
16 As one would suspect, tax treaty provisions apply jointly to each treaty party; a United States taxpayer operating in Mexico is subject to Mexico’s permanent establishment rules in the same fashion as a Mexican taxpayer is subject to the American permanent establishment standard.
Patrick J. McCormick, JD, LLM, is a principal with Offit Kurman Attorneys at Law. He can be reached at patrick.mccormick@offitkurman.com.
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