A foreign corporation engaged in a trade or business within the United States during the taxable year is subject to US federal income tax on its taxable income that is effectively connected with the conduct of a trade or business within the United States.1
A foreign fund that originates loans in the US through the origination services of an independent agent that does not have the power or the authority to bind and conclude contracts on behalf of the foreign fund may find itself having a trade or business within the US that produces income effectively connected with that business in the form of the interest received on the loans to US borrowers. That, at least, is the view of the IRS.
Whether a foreign lender has a “trade or business within the United States” (“USTB ”) is generally a question of fact that depends on the nature and extent of the foreign investor’s US-based activities.2 A clear definition of a USTB is not provided anywhere in the Internal Revenue Code. Instead, the applicable standards have been developed by case law and are highly fact-specific.3 In general, a USTB exists if the taxpayer engages in profit-oriented activities in the US that are considerable, continuous and regular.4 A single transaction or operations that are limited in scope and take place over a limited period of time, would typically not be considered considerable, continuous and regular. Furthermore, ministerial, clerical or collection-related activities are not sufficiently profit-oriented to constitute a USTB.5 Rather, the activities must be of a type that is closely and directly related to the derivation of profit.6 Thus, the existence of a USTB depends upon both the quality and the quantity of the foreign corporation’s activities within the US.
Generally, “trade or business within the United States” includes the performance of personal services within the United States at any time within the taxable year.7 Trade or business within the United States does not include trading in stocks or securities through a resident broker, commission agent, custodian or other independent agent.8 This safe harbor does not apply if the taxpayer has an office or other fixed place of business in the United States at any time during the taxable year through which the transactions in stocks or securities are effected.9
In addition, trade or business within the United States does not include trading in stocks or securities for the taxpayer’s own account, whether by the taxpayer or his employees or through a resident broker, commission agent, custodian or other independent agent, and whether or not any such employee or agent has discretionary authority to make decisions in effecting the transaction.10 °
The unavailability of any of the two safe harbors described immediately above is not a determination that such foreign corporation is engaged in a trade or business within the United States. Rather, whether a foreign corporation is treated as engaged in a trade or business within the United States is determined on the basis of all relevant facts or circumstances.11
Once a foreign corporation is found to be engaged in a trade or business within the United States, the foreign corporation’s income must be “effectively connected” with the US trade or business to be taxable in the US. Section 864(c) defines when such foreign corporation’s income, gain or loss will be treated as effectively connected with the conduct of a United States trade or business.
With respect to US source interest income,12 when determining that such income is effectively connected with the conduct of a trade or business within the United States, the factors taken into account include whether (i) the income is derived from assets used in or held for use in the conduct of such trade or business (“the Assets Test ”), or (ii) the activities of such trade or business were a material factor in the realization of the income (the “Business Activities Test ").13
The Business Activities Test provides a special rule for determining whether income is effectively connected with a “banking, financing or similar business activity.” Specifically, any US source interest received by a foreign corporation during the taxable year in the active conduct of a banking, financing or similar business in the United States is treated as effectively connected to the conduct of that business “only if the stock or securities giving rise to such income, gain or loss are attributable to the US office through which such business is carried on.”14 A stock or security is deemed to be attributable to a US office “only if such office actively and materially participates in soliciting, negotiating or performing other activities required to arrange the acquisition of the stock or security.”15
Generally, when determining whether a foreign corporation has an office or other fixed place of business, the office or other fixed place of business of an agent is normally disregarded, unless the agent (i) has the authority to negotiate and conclude contracts in the name of the foreign corporation and regularly exercises such authority, and (ii) is not a general commission agent, broker or other independent agent acting the ordinary course of business.16
Nonetheless, in a 2009 Legal Advice Memorandum (the “2009 HM ”),17 the IRS concluded that a foreign lender receives taxable effectively connected US source interest income on loans generated in the United States, by an independent agent without the power or the authority to bind the foreign lender. This questionable position is discussed immediately below.
The 2009 ILM, from the Internal Revenue Service Associate Chief Counsel (International) to the Large and MidSize Business Division, Financial Services, concluded that a foreign lender receives taxable effectively connected US source interest income on loans generated in the United States. Curiously however, the loans in question seem to have been generated by an independent contractor without the power or authority to bind the foreign lender.
The memorandum describes a foreign lender, organized in a non-treaty country (perhaps the Cayman Islands?), that makes loans to multiple US borrowers. It has no office in the United States. It outsources the origination activities to a US corporation (“Origination Co. ”), which does have an office in the US. Origination Co. takes all steps necessary to generate the loan applications and send them to the lender abroad, including soliciting US borrowers, negotiating the terms of the loans, performing the credit analyses with respect to US borrowers, and all other activities relating to loan origination other than the final approval and signing of the loan documents. Origination Co. is not authorized to conclude contracts on behalf oldie foreign lender. The foreign lender approves (or not) the loan applications outside the US and physically signs the loan documents outside the US. Origination Co.’s activities are “considerable, continuous and regular,” and it is being compensated for its services with an arm’s length fee. However, there is no indication that Origination Co. is related to the foreign lender, performs similar services for others or is otherwise controlled by the foreign lender.
The issue for the Associate Chief Counsel was whether the foreign lender is engaged in a USTB that produced income effectively connected with that business in the form of the interest received on the loans to the US. Based on the facts and circumstances of the case, the Associate Chief Counsel concluded that the foreign lender is engaged in a USTB.
Relying,inter alia, on Inverworld, Inc. v. Commissioner, 18 the Associate Chief Counsel concluded that although Origination Co. acts on behalf of the foreign lender pursuant to a service contract and does not have authority to conclude contracts, Origination Co. performs activities that are a component of the foreign lender’s lending activities. As a result, an agency relationship exists in fact, to attribute the activities of the US agent to the foreign principal, in determining whether the foreign principal conducted considerable, continuous and regular activity within the US. Because the lending activities of the foreign lender, which were carried out by Origination Co., were considerable, continuous, and regular, the foreign lender is engaged in a USTB.
Further, because the foreign lender was deemed to regularly and continuously originate loans to customers, such activities constitute a lending trade or business, and not trading or investing activities for the purpose of the trading safe harbors of § 864.
Next, the Associate Chief Counsel concluded that the foreign lender is to be treated as engaged in a banking, financing or similar business activity within the US because its business, through the activities of Origination Co., includes making loans to the public. Because the foreign lender is engaged in a banking, financing or a similar business activity, its income from that business may be effectively connected with a trade or business in the US, not withstanding the “asset use test” or the “business activity test.”19
However, the relevant regulation (Treas. Reg. 5 1.864-4(c)(5)(ii)) also requires that the income be attributable to “the US office through which such business is carried on.”20 A common position taken by taxpayers is that the interest income is not effectively connected with banking, financing or similar business activity because the income is not attributable to a US office of the foreign lender, and that the office of the foreign lender’s agent should not be attributable to the foreign lender. Because Treas. Reg. § 1.864-4(c)(5) does not provide guidance defining the phrase “the US office,” taxpayers argue that the definition of the phrase “office or other fixed place of business” provided in Treas. Reg. § 1.864-7 should apply to interpret the phrase “the US office.”21 Under the Treas. Reg. § 1.864-7 rule, because the lender’s agent (e.g., Origination Co.) is either an independent agent or does not have the authority to conclude loans on behalf of the foreign lender, the office of the agent is not attributable to the foreign lender.
Unfortunately, the Associate Chief Counsel reasoned that this argument taken by taxpayers misapplies both the statute and the regulations. To his view, § 864(c) (2) (that deals with US source income), unlike § 864(c)(4)(B) (that deals with foreign source income), contains no “office or other fixed place of business” requirement, and Treas. Reg. § 1.864-7 applies only for the purpose of foreign source effectively connected income described in § 864(c)(4)(B) and the regulations thereunder.22 Because the interest income received by the foreign lender with respect to loans made to US borrowers is US source income, the definition contained in Treas. Reg. § 1.864-7 does not apply.
If the regulations intended that interest income must be attributable to the taxpayer’s office to be treated as effectively connected with a banking, financing or other similar business, the regulation would have explicitly stated that the income must be attributable to “the taxpayer’s office.” Because the regulation requires only that the interest income be attributable to “the US office,” a US office of a person other than the taxpayer may satisfy the requirement. Specifically, Origination Co.’s office satisfies the office requirement because Origination Co. has an office in the United States and the day-to-day activities required of the foreign lender’s lending business take place from the office of Origination Co.
In order to have effectively connected income, the loans originated by the foreign lender must be attributable to a US office. A loan is attributable to a US office “only if such office actively and materially participated in soliciting, negotiating or performing other activities required” for the acquisition of such loan.23 In this case, the foreign lender has engaged Origination Co. to perform its origination activities in the US, including the solicitation of borrowers and the negotiation of contractual terms.
The Associate Chief Counsel concluded that it is enough that Origination Co. is an agent (dependent or independent) of the foreign lender, that performs loan origination activities from an office in the United States, to treat it as materially participating in the origination of the foreign lender’s loans to US borrowers. Therefore, the foreign lender’s income from loans to US borrowers is attributable to “the US office” of Origination Co. through which the foreign lender carries on its lending business, even though the foreign lender concluded the loans outside the United States. The foreign lender’s interest income with respect to loans made to US borrowers, therefore, is effectively connected with a trade or business within the US.24
The Associate Chief Counsel seems to have taken the view that regular and continuous domestic activities of any person who is on the ground in the United States, carried out on behalf of the non-resident, can be attributed to a nonresident, for purposes of making the nonresident engaged in a trade or business within the United States, and for having income that is “effectively connected” with the conduct of a trade or business within the United States, even without any evidence of either control of the agent by the nonresident, or the agent having power to bind the nonresident.
This view may exist for state sales tax purposes, where an independent contractor without power to bind the vendor, that is carrying on a non-ministerial part of the business, can give the vendor nexus for state tax purposes. But why should the same principal apply also for determining whether income is effectively connected with a USTB? This is currently not the law and probably should not be the law.25
Moreover, attributing to the foreign lender the activities of the office of an agent that is either an independent agent or does not have the authority to conclude loans on behalf of the foreign lender is inconsistent with general international tax and income tax treaty principles - particularly those that apply to permanent establishments, as further discussed in the next section. Notably, the 2009 ILM carefully avoided this issue by assuming the foreign lender was not in a treaty jurisdiction.
The treaty permanent establishment rules act as both a threshold for and limitation on source country taxation. The existence of a PE is a threshold for taxation, while the “attributable to” concept serves as a limitation on the taxation that is permitted once that threshold is crossed. Thus, the PE concept is relevant to the question of whether taxation is permitted, and the concept of “attributable to” is employed to determine how much income may be taxed. In this way, the “PE” and “attributable to” concepts are rough analogues to the US domestic tax law concepts of being engaged in a US trade or business and having income that is effectively connected with that business.26
Maintenance of a US PE has similar consequences for foreign corporations entitled to treaty benefits as engaging in a US trade or business has for foreign corporations not so entitled (or for treaty-entitled foreign corporations that elect to apply the Code rather than the applicable treaty). Thus, a foreign corporation entitled to treaty benefits that does not maintain a US PE, like a non-treaty foreign corporation that does not engage in a US trade or business, generally is subject to US tax only on certain US-source investment-type income. A foreign corporation entitled to treaty benefits that maintains a US PE is subject to US tax only on business profits that are “attributable to” the PE, and a nontreaty foreign corporation that is engaged in a US trade or business is subject to US tax only on non-FDAP income that is “effectively connected” with that business.
A foreign corporation that maintains a fixed place of business in the United States has a US PE regardless of whether it does business in the United States “itself” or operates through dependent or independent agents. Even a foreign corporation that does not maintain a fixed US place of business itself, however, may in some circumstances be deemed to have a US PE if its business activities are carried out in the United States through an agent. This agency PE rule extends the scope of PE beyond fixed places of business if the relevant transactions “belong economically” to the principal’s rather than the agent’s business operations and so can be imputed to the principal.
The 2006 and 2016 US Model Treaty sets forth the requirements for an agency PE: (1) a person, other than a broker, commission agent, or other agent of independent status acting in the ordinary course of its business, acts on behalf of the corporation in the United States; and (2) that person has and habitually exercises in the United States an authority to conclude contracts that are binding on the corporation.27
Both these conditions must be met in order to create an agency PE. Thus, a dependent agent will not create a PE if it does not have the authority to conclude contracts in the name of the foreign corporate principal. Conversely, even an agent that has and regularly exercises such authority will not create a PE if the agent is independent from the principal and is acting in the ordinary course of its business. If both requirements are met, however, a PE will exist to the entire extent the agent acts for the principal.28
As long as a foreign corporation’s US agent is “independent,” the agent can do anything for the foreign corporation that it would do for any other principal while acting in the ordinary course of its business — including regularly concluding contracts in the name of the foreign corporation — without thereby giving rise to a US PE for the corporation.
The OECD Commentary states that in order to be independent, an agent must be both “legally” and “economically” independent.29 According to the Commentary, legal independence depends on the degree of control that the principal exerts over the agent, and economic independence depends on who bears the entrepreneurial risk of the agent’s business.30 This two-part standard of independence was officially adopted by the Tax Court for US tax treaties that are based on the OECD Model Treaty.31
Factors to consider in determining whether the agent is both legally and economically independent include: (i) the degree of control and the extent to which the agent operates on the basis of instructions from the principal, (ii) the extent to which the agent bears entrepreneurial or business risk, (iii) the level of profits earned by an agent and whether the agent is economically independent from the principal, and (iv) whether the agent has an exclusive or nearly exclusive relationship with the principal.
Either a dependent agent or an independent agent that is not acting in the ordinary course of its business may give rise to a PE for the principal, but only if the agent “has and habitually exercises” the authority to conclude contracts that are binding on the principal.32 This requirement has two elements.
First, the agent must have “sufficient authority to bind the [principal’s] participation in” business activity in the United States.33 More than mere negotiating authority is required. The agent must have the ability actually to “conclude” contracts on the principal’s behalf, i.e., to negotiate contracts that will be accepted by the principal. Furthermore, this authority must cover contracts relating to the “core” business activities of the principal. Thus, for example, the authority to conclude personnel hiring contracts for the principal or to conduct other matters of internal administration (such as ordering office supplies) would not be sufficient. Second, the agent must “habitually exercise” its authority. Whether authority is “habitually exercised” depends on the commercial realities of the situation. For this purpose, the agent will be considered to exercise its authority if it negotiates elements and details of a contract in a way binding on the enterprise, even if the contract is actually signed by another person outside the country in which the agent is located. A foreign corporation cannot avoid creating a PE in a treaty country merely by ensuring that contracts are signed outside that country if the dependent agent in the country “binds” the corporation in substance.34
The Treaty PE rules are relatively straightforward on this issue — there is no PE by imputation from an agent that is independent or does not have the power or authority to conclude contracts on behalf of the foreign person.
The Associate Chief Counsel position expressed in the 2009 ILM is that it is enough that loan origination activities take place in the US through an agent, dependent or independent, from an office in the US, to treat the agent as materially participating in the origination of the foreign lender’s loans, and for the income from loans to US borrowers, to be attributable to that US office, and result in income that is effectively connected to a US trade or business.
That position seems questionable and inconsistent with existing domestic law and international tax and tax treaty rules and principles, particularly those that apply to PEs. Perhaps it is time for the IRS to further clarify its position on this issue of common law agency attribution or to provide taxpayers with clear, reliable guidance.
1 §§ 882(a)(1), 882(a)(1). All section (“§ ”) references are to the Internal Revenue Code of 1986, as amended (the “Code ”), and the Treasury Regulations (“Treas. Reg.”) promulgated thereunder, except where specifically indicated otherwise.
2 See Treas. Reg. § 1.864-2(e);Higgins v. Commissioner, 312 US 212, 217 (1941); Spermacet Whaling & Shipping Co. v. Commissioner, 30 TC 618, 634 (1958), aff’d, 281 F.2d 646 (6th Cir. 1960).
3 Rev. Rul. 88-3, 1988-1 C.B. 268 (“[T]he determination whether a taxpayer is engaged in a trade or business within the United States is highly factual”);Higgins, 312 US at 217 (“To determine whether the activities of a taxpayer are ‘carrying on a business’ requires an examination of the facts in each case”); Calvao v. Commissioner, 93 TCM 988 (2007) (“Whether the taxpayer is carrying on a trade or business requires an examination of all the facts in each case”).
4 De Amodio v. Commissioner, 34 TC 894, 906 (1960), aff’d, 299 F.2d 623 (3rd Cir. 1962) (finding that the taxpayer’s activities were “considerable, continuous and regular,” and therefore constituted engaging in business in the US); see alsoLewenhaupt v. Commissioner, 20 TC 151, 163 (1953),aff’d, 221 F.2d 227 (9th Cir. 1955).
5 Scottish American Investment Co. v. Commissioner, 12 TC 49, 58-59 (1949) (holding that a US office which “functioned primarily as a clerical department performing a number of useful routine and incidental services for petitioners” was not sufficient to constitute a USTB).
6 See, e.g., Investors’ Mortgage Security Co. v. Commissioner, 4 TCM 45 (1945) (holding that the taxpayer’s “management of real estate... for income producing purposes required regular and continuous activity of the kind which is commonly concerned with the employment of labor; the purchase of materials; the making of contracts; and many other things which come within the definition” of business, and therefore constituted a USTB).
7 § 864(b).
8 § 864(b)(2)(A)(i).
9 § 864(b)(2)(C).
10 § 864(b)(2)(A)(ii). This exception does not apply in the case of a dealer in stocks or securities.
11 Treas. Reg. § 1.864-2(e).
12 The source of interest income as foreign or domestic depends upon the borrower. In general, interest income from loans made to US borrowers will be sourced as income from sources within the United States. § 861(a)(1).
13 § 864(c)(2); Treas. Reg. § 1.864-4(c)(2), (3) and (5).
14 Treas. Reg. § 1.864-4(c)(5)(ii). In addition, the securities must be acquired in one of the specified manners enumerated in the regulations, which includes making loans to the public. Treas. Reg. § 1.864-4(c)(5)(iv) provides rules for determining when a stock or security was acquired in the course of making loans to the public.
15 Treas. Reg. § 1.864- 4(c)(5)(iii).
16 § 864(c)(5)(A); Treas. Reg. § 1.864-7(d).
17 CC: INTL:BR5 - PRENO-119800-09 (September 22, 2009).
18 TC Memo. 1996-301 (finding that the activities of a US corporation, although nominally an independent contractor and not an agent, were attributed to a foreign corporation where the activities of the US corporation were in fact those of an agent.)
19 Treas. Reg. § 1.864-4(c)(5)(0).
20 Treas. Reg. § 1.864-4(c)(5)(ii).
21 Generally, under § 864(c)(4)(A), foreign source interest income is not treated as effectively connected with the conduct of a United States trade or business. Foreign source interest income of a foreign corporation derived from the active conduct of a banking, financing or similar business within the United States, however, is treated as effectively connected with the conduct of a United States trade or business “if such person has an office or other fixed place of business within the United States to which such income, gain or loss is attributable.” § 864(c)(4)(B). For purposes of § 864(c)(4)(B), when determining whether a foreign corporation has an office or other fixed place of business, the office or other fixed place of business of an agent will be disregarded unless the agent (i) has the authority to negotiate and conclude contracts in the name of the foreign corporation and regularly exercises such authority and (ii) is not a general commission agent, broker or other independent agent acting the ordinary course of business. § 864(c)(5)(A). See also Treas. Reg. § 1.864-7(d).
22 Treas. Reg. § 1.864-7(a)(1).
23 Treas. Reg. § 1.864-4(c)(5)(iii).
24 A similar view, although with very little discussion or authority to rely on, was expressed by the Associate Chief Counsel in ILM 201501013 (1/2/2015), where the IRS considered whether a fund manager that repeatedly originated loans and acted as an underwriter in various stock offerings from its US office on behalf of a family of hedge funds was engaged in a US trade or business. The fund manager negotiated directly with borrowers, conducted extensive due diligence, originated a large portfolio of loans, solicited business with borrowers and issuers, and received fees and other compensation for its services. The IRS determined that the activities imputed to the funds did not qualify as “trading in stocks or securities” under § 864(b)(2)(A)(i) for two reasons.First, because they received fees, commissions and discounted property in exchange for their lending and underwriting services, the funds were acting as dealers in stocks and securities, not traders. And second, the lending activities of the funds constituted the active conduct of a banking, financing or similar business. According to the IRS, activities undertaken on behalf of an entity by an agent can be considered to be performed by the entity itself.
25 See e.g., Standard Pressed Steel Co. v. Department of Revenue, 419 US 560 (1975), Goldberg v. Sweet, 488 US 252 (1989), and Scripto, Inc. v. Carson, 362 US 207 (1960), where courts have concluded that the state could impose use tax even though the only connection with the state was to sell inventory using independent contractors.
26 See generally, Rosenbloom, Sutherland, & Ring, “Taxation of Permanent Establishments: The United States,” in The Taxation of Permanent Establishments (IBFD 2006).
27 2006 US Model Treaty Arts. 5(5), 5(6). See also OECD Model Treaty Arts. 5(5), 5(6).
28 See, e.g., Rev. Rul. 55-617, 1955-2 C.B. 794 (corporation doing extensive business in the United States through the medium of an independent commission agent has no US PE).
29 OECD Commentary, 1992 and 2005, Art. 5, 37. See also Taisei Fire and Marine Insurance Co. v. Commissioner, 104 TC at 549-51.
30 OECD Commentary, 1992 and 2005, Art. 5, 38.
31 See generally Taisei Fire and Marine Insurance Co. v. Commissioner, 104 TC 535 (1995), acq., 1995-2 CB 1. Despite the attempts in Taisei and the OECD Commentary to distinguish “legal” and “economic” independence, the two concepts overlap to a significant extent. The Technical Explanation lists a number of factors that are relevant to the overall determination of agency independence. These factors are substantially similar to the criteria set forth in the OECD Commentary for determining legal and economic independence. See US Model Treaty Technical Explanation, 2006, Art. 5, 6.
32 2006 and 2016 US Model Treaty Art. 5(5); OECD Model Treaty Art. 5(5).
33 OECD Commentary, 2005, Art. 5, 32.
34 Even a dependent agent who has and habitually exercises the authority to conclude contracts binding the principal, however, will not constitute a PE if the agent’s activities are limited to activities of a preparatory or auxiliary nature, as defined in Article 5 of the 2006 and 2016 US and OECD Model Treaties.
Originally published in Global Tax Weekly on March 31, 2016.