Foreign Companies Should Be Careful In Structuring Their U.S. Sales
Many foreign companies are successfully increasing the market for their products by breaking into United States’ (“U.S.”) markets. A critical consideration for these companies to successfully entering U.S. markets is the extent to which they become entangled with the U.S. tax system.
Foreign companies would love to generate new sales in the U.S. without having the administrative and cash flow burdens of having to file U.S. Income Tax Returns. As with many other aspects of the Internal Revenue Code, there are a substantial series of tax hurdles a foreign company must negotiate to accomplish these objectives. The most significant U.S. income tax hurdle is avoiding triggers related to what the Internal Revenue Service (IRS) calls the “permanent establishment” of the foreign corporation in the U.S.
Most often, ”permanent establishment”, or tax residency as it is sometimes called, is defined and established via a country’s Tax Treaty with the United States, if one exists. Most, if not all, of these treaties generally consider tax residency in the U.S. to be established if a foreign company has a “Fixed place of business” on U.S. soil from which operations are conducted. For example, if Japancorp were to rent an office in San Francisco and employ a U.S. citizen to help organize their U.S.-based sales, Japancorp might be required to file a U.S. Form 1120-F to report their U.S. income and pay any tax due.
There are a variety ways that Japancorp could avoid the permanent establishment designation and, consequently, the Form 1120-F filing requirement:
1) The use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise
2) The maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of
a. Storage, display or delivery; or
b. Processing by another enterprise
3) The maintenance of a fixed place of business solely for the purpose of
a. Purchasing goods or merchandise or of collecting information, for the enterprise;
b. Carrying on, for the enterprise, any other activity or a preparatory or auxiliary character; or
c. Any combination of activities mentioned above provided the end result is solely of a preparatory or auxiliary nature
These general exceptions seem to provide broad leeway for a foreign company to avoid having a U.S. income tax filing requirement. In the basic example above, it can be argued that Japancorp does not have a fixed place of business, because the employee is only conducting activities of a “preparatory or auxiliary nature.” However, the IRS uses all facts and circumstances available to determine if the permanent establishment of a foreign company exists. The crux of these facts and circumstances generally hinges on whether the U.S. activities are completely independent of the foreign company.
Again, using our Japancorp example, provided the U.S. citizen is not acting solely on behalf of Japancorp, a very strong, supportable argument can be made that Japancorp has no U.S. nexus for filing. However, there are certain very strong indicators that the U.S. citizen is not independent, which include, but are not limited to the following:
1) The ability to negotiate and conclude contracts on behalf of Japancorp
2) Being a direct employee of Japancorp
3) Generating sales only for Japancorp
4) Maintaining an inventory of Japancorp goods that he/she resells
5) The employee having benefits, such as health insurance, directly paid for or reimbursed by Japancorp
No one, or even multiple, of these indicators will definitely establish U.S. Nexus for Japancorp. The facts and circumstances taken as a whole will paint a complete picture of the foreign company’s interaction with the U.S., and a determination with regard to “permanent establishment” made from these facts.
As you can see, a foreign company trying to generate new sales in the U.S. should be careful not to trigger an income tax filing requirement through establishment of a permanent residence in the U.S. Ensuring that no fixed offices or buildings (including an individual’s home office) are in place for the foreign company’s U.S. operations, that there are no direct employees conducting business in the U.S. on a regular and ongoing basis, and that the independence of any agents working for the foreign company is not impacted by certain acts of seeming “non-independence” are all ways to aid in constructing an argument for non-nexus. Ultimately U.S. tax rules regarding the taxation of foreign companies generally favors the function of a foreign company’s involvement with the U.S. rather than strictly its form. It’s possible that, even though all hurdles have been technically cleared by the foreign company, they will still incur a U.S. income tax filing requirement, as the economics of any given situation will govern the foreign company’s taxability in the U.S.
Careful consulting with your tax advisor in advance of setting up these international operations can greatly help to avoid unpleasant tax results later.