If a foreign taxpayer conducts work in the U.S., do they owe taxes? It’s a question that, for many foreign taxpayers, has created headaches and uncertainty.
Foreign individuals who engage in a United States trade or business (“USTB”) very likely owe tax on what is considered to be “Effectively Connected Income” (“ECI”). In general, when the activities of a foreign taxpayer are deemed to trigger a USTB designation, all income from sources within the United States that are connected with the conduct of that USTB are considered to be ECI and taxable in the U.S.
The relevant question, however, is what activities would give rise to a USTB designation?
The U.S. tax code has not strictly defined the term “U.S. trade or business.” As such, the Internal Revenue Service (“IRS”) applies a facts-and-circumstances analysis when determining whether a foreign taxpayer has (or has not) engaged in a USTB. The IRS has also relied on relevant case law in informing its determination of what activities give rise to a USTB designation, finding that activities in pursuit of profit that are “considerable, continuous, regular, and substantial,” likely will trigger a USTB subject to American taxation.
This level of activity distinguishes a USTB giving rise to ECI from passive investment activities. For example, a foreign taxpayer’s ownership of real property in of itself will not trigger a USTB designation. However, if that foreign taxpayer actively manages the property and utilizes it to generate regular rental income, that level of activity may trigger a USTB designation.
It is important to note that when determining whether a foreign taxpayer is engaged in a USTB, the activities of the taxpayers’ agents within the U.S. can potentially be what trigger a USTB designation. This rule extends not only to the activities of a dependent agent acting on behalf of the foreign taxpayer, but an independent agent as well.
Such a determination depends almost entirely on the specific facts at issue. A relevant example seen commonly in practice is when a foreign business has agents actively soliciting and negotiating contracts on its behalf in the U.S. In such a case, the activities of these agents may expose the foreign business to a USTB designation. Care must be given to limit such agents’ activities to promotional, business development, ministerial or clerical activities to help protect the foreign parent from USTB exposure.
For foreign taxpayer residents in countries that have a bilateral income tax treaty with the U.S., the concept of triggering a “permanent establishment” (“PE”) is generally analogous to triggering a USTB designation for non-treaty eligible foreign taxpayers. This concept creates a minimum threshold of presence to protect a business located in one treaty country from being taxed in the other. Typically, a PE is triggered when a resident corporation of one contracting state has a “fixed place of business” within the other contracting state, or through the actions of a dependent agent of the resident corporation. Tax advisors should note that specific tax treaties should always be consulted for differences in the language used to define what constitutes a PE.
Given the highly fact-intensive nature of determining whether a foreign taxpayers’ activities in the U.S. might give rise to a USTB designation, it is highly recommended to engage experienced counsel to give careful consideration to potential cross-border structures and review service agreements to ensure that nothing in the language exposes foreign taxpayers to a taxable presence in the U.S.
David A. Kianpour, is a Senior Tax Attorney in ZMF’s tax practice group. David counsels private companies and high net worth individuals on various domestic and international tax planning strategies, assists with complex compliance issues, and represents clients in controversy matters before the IRS.
