Cross-Border Management: Managing U.S. PE Risks

Cross-Border Management: Managing U.S. PE Risks Paul Seraganian March 11, 2014 U.S. Tax (IRS Circular 230): Any U.S. tax or other legal advice in this...
Author: Nathan Skinner
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Cross-Border Management: Managing U.S. PE Risks Paul Seraganian March 11, 2014 U.S. Tax (IRS Circular 230): Any U.S. tax or other legal advice in this communication (including in any attachment) is not intended and is not written to be used, and it cannot be used, by any person to (i) avoid penalties under U.S. federal, state or local tax law, or (ii) promote, market or recommend to any person any transaction or matter addressed herein.

Common Cross-Border Management Scenarios • Canadian Parent Company with U.S. subsidiaries: 

conducts Board of Director meetings in the U.S.;



has a U.S. based CEO (or other senior officer);



has U.S. “headquarters”;



has senior managers who travel frequently to the U.S.;



has U.S. employees who supervise/direct Canadian employees.

• Canadian Subsidiary of U.S. Parent: 

centralization of management decisions in U.S. headquarters 2

Consequences of having a U.S. PE • If a Canadian corporation (“Canco”) has (or is

perceived to have) a U.S. PE this can result in: 





Business profits of Canco becoming subject to higher marginal U.S. tax rates on a net basis (and branch profits tax); Potential for double taxation in some cases; Potential for increased tax-compliance and dispute costs.

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Addressing the PE concern in context • Addressing PE risk in a way that’s practical and

sustainable requires a balancing of:

• technical tax considerations on both sides of the

border;

• practical business constraints; • compliance burdens; • internal organizational dynamics.

• As a result, there is no universally correct way to

address PE concerns.

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Breaking down the U.S. Tax Analysis • The framework for analyzing whether a Canco has

a taxable presence in the United States for U.S. federal income tax purposes is a 2 step process: 1.

2.

Does the Canco have “effectively connected income” within the meaning of the U.S. Internal Revenue Code? If the answer above is “yes” (and assuming Canco meets Treaty LOB requirements), does the Canco have business profits attributable to a U.S. PE?

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“Effectively Connected Income” • The effectively connected income or “ECI” analysis

under domestic U.S. tax law involves two distinct components: 1.

2.

Is Canco engaged in a U.S. trade or business? Is any income of Canco “effectively connected” with that trade or business?

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What is a U.S. trade or business? • The Code does not provide clear guidance on what

constitutes a trade or business and instead provides exceptions for certain narrowly defined activities (i.e. the provision of limited personal services or trading in securities or commodities for a taxpayer’s own account).

• Under case law, “trade or business” generally includes any

profit-oriented activities if they are “considerable, continuous and regular”.

• In making the determination of whether a taxpayer is

engaged in a U.S. business one must consider direct activities and activities conducted through an agent [Restatement (Third) of the Law of Agency].

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What is a U.S. trade or business? • In general, holding Board of Directors meetings in the

United States should not constitute a trade or business. 

“…the business in which the [taxpayer] was engaged…was that of managing [whaling expeditions], and its activities which produced the income in question took place almost entirely on the high seas or in Norway. It was not, during some substantial portion of the taxable year regularly and continuously transacting a substantial portion of its ordinary business in the United States, which is a necessary requirement before a taxpayer can be found to be engaged in trade or business within the United States”. Spermacet Whaling & Shipping Co., 281 F.2d 646 (6th Cir., 1960).

• Back-office or clerical functions do not constitute a

trade or business. Scottish American Investment, 12 T.C. 49 (1949).

• Treasury Regulations support position that corporate

“stewardship activities” are not a trade or business.

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What is a U.S. Trade or Business? Canadian HOLDCO

CAN OPCO

MEXICAN OPCO

U.S. OPCO

“x”

• X is the CEO of U.S. OPCO & Canadian HOLDCO. • Canadian HOLDCO has an office in the U.S. where X spends a substantial

portion of his time “supervising” Holdco’s investment in the operating subsidiaries and engaging in his function as CEO of U.S. OPCO. • Canadian HOLDCO is not engaged in a U.S. trade or business by reason having a CEO in the U.S. that oversees its operating subsidiaries. • Drawing lines between “supervision” and more active management is often difficult in practice. 9

When is income “effectively connected”? • Pivotal importance of source. • U.S. source interest, dividends, rents, salaries

compensation, other fixed or determinable annual or periodical income or gain/loss from sale of capital asset is ECI if it satisfies either: 



the asset-use test - is the income derived from an asset directly used, or held for use in, the U.S. trade or business; or the business-activities test - are activities of the U.S. trade or business a material factor in the realization of the income in question.

• other U.S. source income (business income from sale of

inventory) is automatically ECI under the “force of attraction” rule (whether or not this income is derived from the U.S. trade or business). 

Inventory sales generally sourced to place where title transfers.

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When is income “effectively connected”? • Non-U.S. source income is effectively connected only in

limited cases.

• Specifically, non-U.S. source income of a Canco is ECI if: 1.

Canco has a “fixed place of business” in the U.S.,

2.

Income in question is attributable to that FPB, and

3.

Income in question must be: • •





Rents or royalties for the use of certain foreign intangibles (patents, copyrights, goodwill). Dividends, interest or guarantee fees derived in the active conduct of a U.S. banking, financing or similar business. Sales of inventory through the U.S. FPB (unless sold for use outside the U.S. and a non-U.S. FPB of taxpayer participated materially in the sale). Certain income from a U.S. life insurance business. 11

What is a Fixed Place of Business • Under the Code, the concept of a “FPB” loosely corresponds

with the “fixed place of business” PE concept under Treaties.

• Treasury Regulations provide that the fact that top

management decisions affecting a Canco are made in a country shall not of itself mean that Canco has a FPB in that country. 

Ex. Canco, a wholly-owned sub of USCo, does not have a FPB in the U.S. merely because of U.S. officers of USCo who are generally responsible only for policy decisions of Canco, provided that Canco has a CEO, whether or not he is also an officer of USCo, who conducts the day-to-day trade or business of Canco from a Canadian office.

• Accordingly, U.S. based management can give rise to a FPB

for Canco if such activity surpasses general supervision and extends into day-to-day operational aspects. 12

Agent’s Fixed Place of Business • FPB of an dependent agent is generally not

imputed to a principal Canco unless the agent: 





Has the authority to negotiate and conclude contracts in the name of Canco and regularly exercises that authority; or Has a stock of merchandise belonging to Canco and regularly fills orders from such merchandise; or is an employee.

• FPB of an independent agent is not imputed to the

principal.

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When is foreign income “attributable to” a FPB? • In general, in order for foreign source income in one of

the classes defined above to be “attributable to” a U.S. FPB, that FPB needs to be a “material factor” in the realization of the income. 





Requires that the FPB make a significant contribution to, by being an essential economic element in, realizing the income. For example, in the case of income from sales of inventory, the FPB will be a material factor if it actively participates in soliciting the order, negotiating the contract or performing other significant services necessary for the sale. FPB is not a material factor merely because of one or more of the following: (i) sale is made subject to final approval of the FPB, (ii) the property sold is held in and distributed from the FPB, or (iii) the FPB performs merely clerical functions incident to the sale. 14

Example Canco

EuroCo

USCo

Managerial Team

• U.S. based managerial team is involved in day-to-day management/oversight of Canco • •

• •

& EuroCo operations (and negotiates/concludes contracts for Canco and EuroCo). Canco and EuroCo manufacture and sell widgets to unrelated retailers in their home jurisdictions Canco and EuroCo income is limited to these widget sales and (1) a non-U.S. FPB of Canco or EuroCo (as applicable) materially participates in such sales, and (2) widgets are sold for use, consumption or disposal outside of the U.S. The income of Canco and EuroCo should not be ECI Canco and EuroCo required to pay USCo on arm’s length fee for services rendered by USCo employees.

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Treaty Considerations • Under U.S. tax treaties, a non-U.S. corporation that

maintains a “place of management” in the United States will have a U.S. PE. 



Intercompany shared support activities (HR, accounting, tech) should not create a U.S. PE under exclusion for “preparatory and auxiliary” activities. Corporate stewardship/oversight should not result in a U.S. PE.

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Profit Attribution to a Place of Management PE • The Canada—U.S. Tax Treaty contains a unique provision that

specifies that:

“no business profits shall be attributed to a permanent establishment of a resident of a Contracting State by reason of the use thereof for either the mere purchase of goods or merchandise or the mere provision of executive, managerial or administrative facilities or services for such resident” • JCT Explanation of U.S. – Canada Tax Treaty (April 25, 1984):

“Thus, where a permanent establishment purchases goods for its head office, the business profits attributed to the permanent establishment with respect to its other activities will not be increased by a profit element on its purchasing activities. Likewise, the permanent establishment could be the headquarters office for the company without being taxed in the country on profits generated by that activity.” 17

Possible Changes in U.S. Tax Law • In September 2013, a Senate bill entitled the “Stop Tax Haven Abuse Act” was

introduced in Congress.

• If enacted, this bill would materially affect the matters described in these slides. 



The bill contains a provisions that would treat certain foreign corporations as U.S. corporations for U.S. tax purposes if the “management and control” of the corporation is treated as occurring primarily within the U.S. A foreign corporation would be treated as “managed and controlled” primarily within the U.S. if “substantially all of the executive officers and Cross-Border Management of the corporation who exercise day-to-day responsibility for making decisions involving strategic, financial and operational policies of the corporation are located primarily within the United States”.

• The bill, if enacted, would have a 2 year delayed effective date which would allow

taxpayers a period of time to restructure their affairs.

Best Practices 1.

Review Code & Treaty analysis and put together an overall plan for responding to U.S. PE concerns.

2.

User-friendly documentation of this analysis (e.g. file memo).

3.

Put internal controls in place – operating guidelines; annual compliance statements.

4.

Protective U.S. Tax Return (Form 1120F) and, if applicable, Treaty-based return (Form 8833).

5.

Intercompany Services Agreement.

6.

Transfer Pricing Study.

7.

Monitor collateral compliance issues: payroll, withholding, secondment agreements, individual compliance.

8.

Consider State tax ramifications. 19

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Inbound Financing into the U.S.

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Inbound Financing into the U.S.

TYCO BermudaCo

Luxembourg Sarl

Notes

US CO

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Inbound Financing into the U.S.

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• In somewhat similar circumstances the IRS has also challenged crossborder financing arrangements of Ingersoll-Rand. The IRS has asserted that interest paid by a U.S. Affiliate to financing intermediaries in Barbados, Hungary and Luxembourg was not eligible for treaty benefits and, therefore, subject to U.S. withholding tax at 30%. Withholding tax deficiency for 2002 of $84 million (with penalties totalling $25 million). Tax/penalties could escalate to $665 million for 2003-2006 period. Simplified Diagram 2) BarbadosCo loaned amounts received as interest to BermudaCo pursuant to new upstream loans

BarbadosCo

BermudaCo

Note

U.S.Co

1) Payment of interest

•The legal basis of the IRS challenge is currently unclear but could include arguments based on: (i) anti-conduit regulations, (ii) “beneficial ownership” case law (e.g. Aiken Industries, 56 T.C. 925 (1971)), or (iii) limitation-on-benefits requirements 24

Inbound Financing into the U.S.

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Inbound Financing into the U.S.

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ILM 201334037 (Simplified) Foreign Parent 1) Primary Loan

2) Secondary Loan made at or around time interest on primary loan is due

3) Payment of interest

U.S. Parent

U.S. Sub

• Funds necessary to pay interest to Foreign Parent were obtained shortly before or shortly after a claimed payment of interest, either through new loans from Foreign Parent or pursuant to drawdowns on an existing line of credit with Foreign Parent • In many cases, the proceeds of new loans from Foreign Parent were deposited in a “general account” of U.S. Parent (taxpayer argued that such funds could not be “traced” to funds used to pay interest)

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ILM 201334037

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