This sidebar accompanies the article “Profit Shifting: Effectively Connected Income and Financial Statement Risks” in the February 2016 issue of the JofA.
This sidebar provides a brief explanation of the Internal Revenue Code’s effectively connected income (ECI) rules that may impose direct U.S. tax on certain income earned by any foreign corporation. This includes foreign corporations that are subsidiaries of U.S.-based multinational corporations. For a more detailed understanding of how this ECI approach can apply to typical profit-shifting structures, see Kadet, “Attacking Profit Shifting: The Approach Everyone Forgets,” 148 Tax Notes 193 (July 13, 2015). The full article is available at http://ssrn.com/abstract=2636073.
The overall concept
The Internal Revenue Code, in a manner roughly similar to the tax laws of most other countries, imposes tax on the business income of a foreign corporation only when the business activities of that foreign corporation within the United States rise above some minimum threshold. This generally involves business activities conducted by the employees of the foreign corporation or by agents acting on the corporation’s behalf. When there is no specific agency agreement granting agency powers, an agency relationship may be inferred from the actions of the parties.
It is fair to say that the low-taxed foreign group members that are the subject of the accompanying JofA article seldom, if ever, conduct business in the United States through their own employees. Rather, they typically enter into service or similar agreements with U.S. group members under which a U.S. group member performs various activities for the foreign group member.
Under normal circumstances, a service agreement will not cause the service provider to become an agent of the person for whom the provider performs the services. However, in many profit-shifting structures, the foreign group member has no personnel of its own capable of managing or conducting its own business. Further, the foreign group member has no CEO or other management personnel regularly working in a foreign group member office outside the United States who are capable of directing the U.S. group member service provider in its activities.
Through the mechanism of a service or similar agreement, the U.S. group member service provider will typically make day-to-day business decisions and take actions independently that directly benefit the foreign group member and obligate it with respect to third parties in a manner that far exceeds what a typical unrelated service provider would be permitted to do. These decisions and activities, which are conducted on a regular and continuing basis, also go far beyond any normal shareholder oversight of a foreign subsidiary’s conduct of its own business. The effect is that the totality of these services performed by the U.S. group member service provider on behalf of the foreign group member may equate to the exercise of agency powers, which results in the conduct of a U.S. trade or business by the foreign group member.
In addition, many foreign group members effectively conduct significant joint activities with one or more of their U.S. group members. For example, teams of personnel typically located within the United States will control and direct all contract manufacturers that are producing products that will be directly acquired by the foreign group member and one or more U.S. group members. As another example, personnel from both U.S. group members and foreign group members will work together in marketing, sales, and customer support both from a strategic perspective and on specific sales opportunities to new and existing customers. Where there are such joint activities, they may create a partnership for U.S. tax purposes. The broad statutory definition of partnership and the judicial interpretations characterizing joint activities, whether in legal entity form, through contractual relationships, or by the actual activities of the related companies, will often make a compelling case that a foreign group member and certain of its U.S. group members should be seen as operating in partnership form for federal tax purposes.
When the joint activities carried on by a foreign group member and its U.S. group members constitute a partnership for U.S. tax purposes, then by statutory definition, the foreign group member will be engaged in a trade or business in the United States.
Once the foreign group member is engaged in a trade or business in the United States, certain defined business income will be treated as ECI, and the foreign group member will be directly taxable on this income in the United States. This condition of being engaged in a trade or business within the United States is a threshold test. If a foreign group member is not engaged in a trade or business within the United States, there can be no ECI and no U.S. taxation.
What U.S. tax applies to ECI?
When a foreign group member earns ECI, it is subjected to several levels of tax as well as special rules applicable to any tax year for which the IRS assesses tax and for which the foreign group member has not previously filed a U.S. tax return on Form 1120-F, U.S. Income Tax Return of a Foreign Corporation. The taxes and special rules applicable to the ECI of a foreign group member are:
- The regular, up-to-35% corporate tax rates applicable to all corporate taxpayers;
- The branch profits tax applied at a flat 30% rate to ECI after reduction for the up-to-35% regular tax and other possible adjustments (a rate lower than 30% may apply if the foreign group member is entitled to tax treaty benefits that the foreign group member’s country of residence maintains with the United States);
- A loss of deductions and credits for any tax year if the foreign group member has not filed a U.S. tax return on Form 1120-F for that year; and
- An open statute of limitation on IRS assessment of tax for any tax year if the foreign group member has never filed a U.S. tax return on Form 1120-F for that year. (The statute remains open for a tax year, even though that same year may already be closed to further IRS assessment for related U.S. group members.)
The combined effect of the above is:
- Where no tax treaty is available to reduce the branch profits tax below its normal 30% rate, the effective tax rate on ECI could reach 54.5% or higher. The 54.5% calculation includes the 35% corporate income tax + 30% branch profits tax on earnings after imposition of corporate income tax (0.3 × 0.65, or 19.5%). The phrase “or higher” signifies the loss of deductions and credits that occurs if no tax return was filed.
- When a foreign group member is entitled to the benefits of a tax treaty that reduces the branch profits tax rate, then the above-calculated rate of 54.5% or higher will be lower. For example, when the normal 30% branch profits tax rate falls to 5%, as it does under the Switzerland–United States tax treaty, the combined rate is 38.25% or higher. The 38.25% calculation is: 35% corporate income tax + 5% branch profits tax on earnings after imposition of corporate income tax (0.05 × 0.65, or 3.25%).
The above 54.5% or 38.25% or higher rates that apply when a foreign group member is directly taxed compare very unfavorably with the maximum 35% corporate tax rate imposed when income is taxed within a U.S. corporation and the branch profits tax and the potential loss of deductions and credits are not applicable. Further, a foreign group member that has earned ECI in any early years that are still open because the foreign group member filed no Form 1120-F may be assessed tax by the IRS at any time.
Technically, as a foreign corporation, a foreign group member may claim a foreign tax credit as an offset to its U.S. tax liability for any foreign taxes that it may have paid or accrued on its ECI. However, it seems likely that the foreign tax credit limitation would often prevent a full credit, since the ECI being taxed will be defined as U.S.-source income under the Code’s applicable income-sourcing rules. Therefore, unrelieved double taxation could result in some circumstances. Despite this, instances of significant double taxation should be rare, since most profit-shifting structures will have been planned to avoid not only current U.S. taxation but also taxation in foreign countries where operations occur or sales are made.
What is ECI?
Assume that a foreign group member earns sales income from purchasing and selling products. The foreign group member has no employees or offices of its own but, rather, has a service agreement with a related U.S. group member under which personnel operating from within the United States control all product purchasing, control and maintain relationships with major distributors and key customers worldwide, and negotiate the terms of the sales contracts with these major distributors and key customers.
Assume further that the foreign group member, through its disregarded entity (DRE) subsidiaries (see explanation below) maintains some local warehousing and customer support functions in various countries around the world. The activities performed by the U.S.-related company under the service agreement amount to that company’s exercising agency powers for the benefit of the foreign group member. Furthermore, assume this has met the above-mentioned threshold test of being engaged in a trade or business within the United States. Finally, assume the foreign group member has no CEO conducting its day-to-day trade or business from a foreign office.
A DRE subsidiary is a creation of the IRS check-the-box rules, under which a qualifying 100% owned subsidiary can elect to be treated, solely for U.S. tax purposes, as a branch or division of the subsidiary’s owner. For example, when this election is made, a warehouse operated by the subsidiary of a foreign group member, along with the subsidiary’s employees, will be treated for U.S. tax purposes as being owned and operated by, and employed within, a branch of the foreign group member.
Certain U.S. tax rules define the source of different types of income. Where a foreign group member has met the test of being engaged in a trade or business within the United States, all of certain types of income that are U.S.-source, including sales income, will be ECI subject to tax.
The following questions must be answered to determine whether sales income is sourced within the United States and is therefore treated as ECI. If the answer to every question is yes, the income will be U.S.-source and taxable as ECI:
1. Does the foreign corporation maintain an office or other fixed place of business in the United States (a U.S. office) (see Secs. 865(e)(2) and (3) and 864(c)(5)(A))?
2. Does the foreign corporation have income from any sale of personal property (including inventory property) attributable to that U.S. office (see Secs. 865(e)(2) and (3) and 864(c)(5)(B))?
3. For any such income attributable to that U.S. office, does any arise from:
- Inventory property sold for use, disposition, or consumption inside the United States; or
- Inventory property sold for use, disposition, or consumption outside the United States where no office or other fixed place of business of the taxpayer in a foreign country (foreign office) materially participated in the sale (see Secs. 865(e)(2)(B) and 864(c)(3))?
Detailed regulations provide rules and examples for applying each of these three questions. Regarding the above-described foreign group member for which its related U.S. group member is performing the described activities, these rules and examples would likely find that the first two questions have “yes” answers. For example, in regard to the first question, the fact that the foreign group member has no CEO conducting its day-to-day trade or business from a foreign office is an important requirement of the regulations. As for the second question, the answer generally will be “yes” where a foreign corporation’s U.S. office actively participates in solicitation, negotiation, or performance of other significant services necessary for the consummation of a sale.
Regarding the third question, where the foreign group member is making sales of inventory property for use, disposition, or consumption inside the United States, then all such income will be U.S.-source and therefore ECI. On the other hand, where the foreign group member is making sales of inventory property for use, disposition, or consumption outside the United States, it is necessary to examine for each sale what part, if any, the foreign group member’s foreign office played in making the sale and whether that part is significant enough to satisfy the material-participation requirement. If it does satisfy the requirement, then the answer to the third question is “no,” and the relevant sales income will be foreign-source and therefore not ECI. If the material-participation requirement is not met, then the answer is “yes,” and the relevant income is U.S.-source and ECI.
In brief, if the foreign office “actively participates in soliciting the order resulting in the sale, negotiating the contract of sale, or performing other significant services necessary for the consummation of the sale which are not the subject of a separate agreement between the seller and buyer,” then the requirement will be met (Regs. Sec. 1.864-6(b)(3)(i)). Under the above assumptions, neither the foreign group member nor its DRE subsidiaries are performing any of these functions.
Suppose that the DRE subsidiaries do maintain some local warehousing and perform some customer support functions. Will that be sufficient to meet the material-participation requirement? A detailed review of actual activities conducted by the DRE subsidiaries would, of course, be necessary. However, the likely answer is that the activities would not be sufficient. Under U.S. tax regulations, a foreign office will not be considered to have materially participated in a sale merely because (1) the sale is made subject to the final approval of the foreign office, (2) the property sold is held in and distributed from the foreign office, (3) samples of the property sold are displayed (but not otherwise promoted or sold) in the foreign office, (4) the foreign office is used for purposes of having title to the property pass outside the United States, or (5) the foreign office performs only clerical functions incident to the sale. Considering this, the local warehousing from which deliveries are made by the DRE subsidiaries will not constitute material participation. Whether the customer support functions might be significant enough to achieve material participation for some or all of the sales would require a careful review.
Assume that a foreign group member has entered into a cost-sharing agreement with, or has licensed certain intellectual property from, a related U.S. group member so that the foreign group member holds the rights to manufacture or have manufactured certain products for sale outside the United States. The foreign group member has no employees or offices of its own but rather has service agreements with one or more U.S. group members under which personnel of these entities operating from within the United States control all arrangements with related and unrelated contract manufacturers. The various contract manufacturers conduct their product manufacturing services at their facilities both within and outside the United States.
Through the efforts of these U.S. group members’ personnel, the foreign group member enters into contract manufacturing agreements with these related and unrelated contract manufacturers and acquires directly from them the finished products that it sells to its customers. The related U.S. group members are neither a party to any of the foreign group member’s contract manufacturing agreements, nor do these related U.S. group members take title to any products produced by the contract manufacturers for sale to the foreign group member. (The related U.S. group members may enter into their own contract manufacturing agreements with these same contract manufacturers and acquire the products directly from them for sale within the United States.)
Because the discussion in this section focuses solely on production income, it is assumed that the foreign group member, through its DRE subsidiaries, controls and maintains relationships with all distributors and customers outside the United States, with DRE personnel negotiating the terms of the sales contracts. The DRE subsidiaries also maintain local warehousing and perform customer service functions from their various locations around the world.
Finally, assume that the foreign group member, because of the agency activities performed by the related U.S. group members on the foreign group member’s behalf, has met the above-mentioned threshold test of being engaged in a trade or business within the United States.
As indicated earlier, certain U.S. tax rules define the source of different types of income. Where a foreign group member has met the test of being engaged in a trade or business within the United States, all of certain types of income, including production income, to the extent they are U.S.-source, will be ECI subject to tax.
Rarely, if ever, will a foreign group member directly conduct production activities within the United States in its own name. However, sometimes U.S. group member employees conduct critically important functions for related foreign group members that may be sufficient to constitute manufacturing. U.S. tax regulations recognize that even if a company does not itself conduct physical manufacturing operations, it still may be treated as a manufacturer if it performs certain functions to direct a contract manufacturer that performs the physical manufacturing. (See Regs. Sec. 1.954-3(a)(4) concerning the manufacturing exception from foreign base company sales income treatment under the Subpart F controlled foreign corporation (CFC) rules.) The IRS added this recognition of contract manufacturing business models to the regulations within the past decade to modernize them and take into account what has now become a common business model.
While there has been no similar modernization of the relevant income sourcing and ECI regulations as yet, the concept that a company can be a manufacturer even though it does not itself conduct physical manufacturing should apply as well to the characterization of activities performed for sourcing of income and ECI purposes. The modernized regulations for Subpart F list the following functions (Regs. Sec. 1.954-3(a)(4)(iv)(b)) that will allow a company to be considered a manufacturer when it uses a contract manufacturer for the physical manufacturing:
- Oversight and direction of the activities or process pursuant to which the property is manufactured, produced, or constructed;
- Material selection, vendor selection, or control of the raw materials, work-in-process, or finished goods;
- Management of manufacturing costs or capacities (e.g., managing the risk of loss, cost reduction or efficiency initiatives associated with the manufacturing process, demand planning, production scheduling, or hedging raw material costs);
- Control of manufacturing related logistics;
- Quality control (e.g., sample testing or establishment of quality-control standards); and
- Developing, or directing the use or development of, product design and design specifications, as well as trade secrets, technology, or other intellectual property for the purpose of manufacturing, producing, or constructing the personal property.
Where an IRS examination determines that any related U.S. group member performs these functions as an agent for the foreign group member, the IRS may reasonably conclude that the foreign group member is manufacturing inventory property in the United States. Note in this regard that the location of the contract manufacturer is not relevant. Rather, what matters is where the related U.S. group member performs these various listed functions. As such, even where the physical manufacturing is performed outside the United States, if the functions are performed by the U.S. group member within the United States, then the manufacturing is considered to be taking place in the United States.
Say that an IRS examination determines that the foreign group member is manufacturing its inventory property within the United States and selling the finished property outside the United States. For those transactions, half of the income would likely be attributed to the production activity in the United States and half to the sales activity occurring outside the United States. In such a case, the half attributable to the production activity in the United States is U.S.-source and ECI. The other half would be foreign-source and escape ECI treatment.
Although this latter one-half would escape ECI treatment, for any foreign group member that is also a CFC under the Subpart F rules, the manufacturing branch rule described in Regs. Sec. 1.954-3(b)(1)(ii) may apply to cause this latter one-half to be foreign base company sales income. If so treated, then it would be included immediately within the U.S. tax return of its U.S. shareholder.
Assume that a foreign group member earns services income from an internet-based business. The group of which the foreign group member is a part maintains an extensive online presence through which it provides cloud application services to paying customers and earns commissions from the sale or rental of third-party-owned digital products including applications, music, movies, books, etc. In addition, the group provides users around the world with certain free services and earns advertising revenues from clients wanting to connect with and display ads to these users.
The group personnel in the United States primarily performed the extensive work to create the group’s online presence, including design, software architecture, and coding, under a cost-sharing agreement that spread the costs among various group members, including the foreign group member. The foreign group member’s share of costs reflects its future anticipated benefits from income it expects to earn from services provided in its market area, which, for example, is defined as Europe and Africa. Ongoing management and further development, enhancement, maintenance, protection, and exploitation of the group’s online presence are performed primarily in the United States, with the various costs being shared among the group’s members under either the cost-sharing agreement or separate service agreements. Even though the foreign group member has no employees or offices of its own, it does own several DRE subsidiaries that conduct local marketing and liaison support for the group’s online presence and provide, on an as-needed basis, support for local customers and users. These subsidiaries also either own or secure from third-party providers the servers used by local customers and users to access the group’s online offerings.
Assume further that certain activities performed for the foreign group member by the related U.S. group members under service agreements amount to the exercise of agency powers, satisfying the above-mentioned threshold test of being engaged in a trade or business within the United States.
As indicated earlier, certain U.S. tax rules define the source of different types of income. Where a foreign group member has met the test of being engaged in a trade or business within the United States, all of certain types of income, including services income, will be ECI subject to tax, to the extent they are U.S.-source.
Certain income earned by a foreign group member could be U.S.-source services income and therefore ECI. For example, assume the foreign group member earns services income in the form of fees and commissions from:
- Cloud services performed for customers in its market area;
- The sale or rental of third-party digital products to purchasers in its market area; and
- Advertising directed toward users of the free services located in the market area.
To determine the source of this services income, it is necessary to ask where the foreign group member has performed these services.
Assume that the foreign group member does conduct some physical activities within its market area through its DRE subsidiaries that are clearly important to the foreign group member’s business. These activities, however, represent for the most part either marketing or as-needed support provided to a very limited number of customers or users. These services are really auxiliary in nature and do not represent the actual performance of the service for which the foreign group member is earning its services income.
The particular nature of cloud applications, third-party digital product sales/rentals, and advertising based on a platform regularly accessed by an extensive user base is relevant. In virtually all cases, the services that the foreign group member provides are supplied mechanically through the group’s various internet-based platforms and infrastructure. Seldom will any actions be required by locally based DRE subsidiary personnel that are actually the performance of services.
Considering all of this, it seems reasonable for the IRS to view the creation and ongoing management of the online platform, along with continuing development, enhancement, maintenance, protection, and exploitation, as the activities that generate the services income. Although the foreign group member is not itself performing any of these activities, it does receive the benefit of them and is bearing its share of their costs through both the cost-sharing agreement and the services agreement it has with its related U.S. group members, under which, as noted earlier, these companies exercise agency powers for the benefit of the foreign group member.
Finally, the use of a cost-sharing agreement that covers the platform creation and ongoing development, enhancement, etc., of it causes the foreign group member to be characterized for tax purposes as having directly created its share of the intangibles developed under the cost-sharing agreement (see Regs. Sec. 1.482-7(j)(3)). This means that the foreign group member is treated as directly conducting these activities within the United States, to the extent that the related U.S. group member cost-sharing agreement participants conduct them in the United States.
The clear and simple conclusion is that the foreign group member is earning services income primarily through activities performed in the United States. This would result in U.S.-source services income taxable as ECI.
—Thomas J. Kelley (firstname.lastname@example.org) is a retired CPA who worked in the former Soviet Union and has taught at Seattle University. David L. Koontz (email@example.com) is a retired CPA who worked in an international accounting firm in Hong Kong, Japan, and Singapore. Jeffery M. Kadet (firstname.lastname@example.org) is a retired CPA who worked in public accounting internationally and as a lecturer in the University of Washington Law School.