News
International
Jul. 23, 2002
Companies Expanding Abroad Must Consider the Tax Issues
Focus Column - By Joanne L. Siu - A U.S. company seeking to expand operations abroad must consider in structuring its operations not only its business objectives but also the U.S. and foreign tax issues. Before setting up a formal presence in a foreign country, a U.S. company may market and distribute its products and provide its services through its own employees who travel to the foreign country periodically.
Focus Column
By Joanne L. Siu
A U.S. company seeking to expand operations abroad must consider in structuring its operations not only its business objectives but also the U.S. and foreign tax issues. Before setting up a formal presence in a foreign country, a U.S. company may market and distribute its products and provide its services through its own employees who travel to the foreign country periodically. Without appropriate oversight and management, the employees' activities in the foreign country inadvertently may create tax exposure for the U.S. company in that foreign jurisdiction.
In the absence of an applicable income tax treaty between the United States and a foreign country, the domestic tax laws of that foreign country govern in determining whether the activities of the U.S. company's employees within that country are sufficient to subject the U.S. company to taxation by that country.
However, where a foreign country has entered into a tax treaty with the United States, the provisions of the tax treaty would control the circumstances under which the foreign country may tax a U.S. company and the extent of such taxation. This article discusses typical treaty provisions governing the circumstances under which the business profits of a U.S. company may be subject to foreign income taxation.
The United States has entered into income tax treaties with more than 60 countries in an effort to reduce double taxation on the income of the residents of the two countries by allocating taxing jurisdiction between the United States and the other country and providing for a mechanism to credit the taxes paid to one country against the taxpayer's tax liability to the other country. I.R.S. Publication 901, "U.S. Income Tax Treaties" (April 2001), available at http://www.irs.gov.
Because the United States has published a Model Income Tax Convention, this discussion is based on the provisions of the U.S. Model Tax Convention of Sept. 20, 1996, available at www.treas.gov/taxpolicy/t0txmod1.html. The convention is the Treasury Department's point for negotiating new tax treaties.
Article 7(1) of the Model Income Tax Convention provides that a U.S. corporation shall be taxable by the other country only if it carries on business in the other country through a "permanent establishment" situated therein and only on its "business profits" that are attributable to such permanent establishment.
Therefore, in determining whether a U.S. corporation is taxable on its business profits by a country that has a tax treaty with the United States, the threshold question is whether that company has a permanent establishment in that foreign country.
Under a tax treaty, a corporation could have a permanent establishment in a country either through the establishment of a fixed place of business (i.e., a branch or office) or through the activities of its employees or dependent agents. Articles 5(1) and (2) define a "permanent establishment" as a fixed place of business through which the business of an enterprise is wholly or partly carried on, including a branch, office, workshop or factory.
However, under Article 5(4), a corporation will not have a permanent establishment in a foreign country if it undertakes only certain specified exempted activities, which are generally preparatory or auxiliary activities. Furthermore, the maintenance of a fixed place of business that performs a combination of any of the specified activities does not constitute a permanent establishment, provided that the overall activity of the fixed place of business is of a preparatory or auxiliary character.
In most cases, before a U.S. company establishes a foreign subsidiary to market and distribute its products, it sends its own employees to develop the local market. Many U.S. companies assume erroneously that they do not have tax exposure in the foreign country because they have not registered a branch presence or established an office or factory. However, the activities of an employee can create tax exposure even in the absence of a branch office.
Under Article 5(5), a U.S. company has a permanent establishment in a foreign country if a dependent agent, acting on its behalf, has and habitually exercises contract-concluding authority on behalf of the U.S. company in that country.
Thus, absent a fixed place of business, a U.S. company has a permanent establishment (and may be subject to foreign income taxation) if it has a dependent agent acting on its behalf in the foreign country and if the dependent agent concludes contracts on its behalf. Both of these factors are determined based on all relevant facts and circumstances.
A "dependent agent" is defined as a person who is not an independent agent. An "independent agent" is a person who is legally and economically independent of the company on whose behalf he or she is acting and who is acting within his or her ordinary course of business. See U.S. Treasury Technical Explanation to Article 5(6), available at www.treas.gov/taxpolicy/t0txmod2.html.
An employee of the U.S. corporation is a dependent agent. However, the U.S. company may appoint an entity to act on its behalf. Under Article 5, a related company may be treated as a dependent or independent agent depending on the specific facts and circumstances of the relationship between the agent and the U.S. principal.
For example, if a U.S. company established a subsidiary in the foreign country to market and distribute the U.S. company's products, the commercial arrangement between the related companies must be structured to reflect arm's length dealing, with the agent bearing sufficient economic and business risk. The companies must preserve corporate formalities in their interactions to demonstrate their legal independence.
If the subsidiary is treated as an independent agent, although the subsidiary would be subject to tax in the foreign country, its U.S. parent would not be taxed in the foreign country.
When an agent is a dependent agent acting on behalf of the U.S. company, its activities could create a permanent establishment for the U.S. principal if the agent is concluding contracts on behalf of the U.S. company. It is the de facto authority to conclude contracts that creates a permanent establishment for the enterprise.
For example, if a U.S. company's employee is authorized to negotiate all elements and details of a contract in a way that is binding on the company, he or she is considered to have exercised contract-concluding authority, even if someone else in the United States signs the contract on behalf of the U.S. company. U.S. Treasury Technical Explanation to Article 5(6); Paragraph 33 of the Commentaries to Article 5(6) of the Organization of Economic Cooperation and Development Model Treaty.
Therefore, one of the principal planning goals in this area is to limit the authority of sales employees so that they do not have the authority to conclude contracts on behalf of the U.S. company within the meaning of the applicable treaty.
To create a permanent establishment for the U.S. company, the authority to conclude contracts must cover contracts relating to operations that constitute the "essential business operations of the enterprise, rather than ancillary activities." U.S. Treasury Technical Explanation to Article 5(5).
In other words, an employee who signs a lease for a warehouse to store the U.S. company's products would not create a permanent establishment for the U.S. company because the contract-concluding authority extends to activities that otherwise would not create a permanent establishment for the company.
In contrast, an employee who concluded a contract for the sale of products to a customer in the foreign country would create a permanent establishment for the U.S. company.
Because its officers, executives and sales personnel inadvertently could create foreign income tax exposure for a U.S. company, it is extremely important for a company to provide internal training and guidelines to any employees and officers who travel to foreign countries to promote the company's products.
For example, company representatives should communicate to customers that they do not have the authority to conclude contracts and that final approval of contracts is made in the United States. The U.S. company must ensure that the person appointed to approve contracts in the United States is not rubber-stamping deals made in the field but has authority to accept, revise or reject the contracts.
Joanne L. Siu is a tax associate at Baker & Mckenzie's San Francisco/Palo Alto office. She advises multinational corporations on structuring their international operations and cross-border transactions.
By Joanne L. Siu
A U.S. company seeking to expand operations abroad must consider in structuring its operations not only its business objectives but also the U.S. and foreign tax issues. Before setting up a formal presence in a foreign country, a U.S. company may market and distribute its products and provide its services through its own employees who travel to the foreign country periodically. Without appropriate oversight and management, the employees' activities in the foreign country inadvertently may create tax exposure for the U.S. company in that foreign jurisdiction.
In the absence of an applicable income tax treaty between the United States and a foreign country, the domestic tax laws of that foreign country govern in determining whether the activities of the U.S. company's employees within that country are sufficient to subject the U.S. company to taxation by that country.
However, where a foreign country has entered into a tax treaty with the United States, the provisions of the tax treaty would control the circumstances under which the foreign country may tax a U.S. company and the extent of such taxation. This article discusses typical treaty provisions governing the circumstances under which the business profits of a U.S. company may be subject to foreign income taxation.
The United States has entered into income tax treaties with more than 60 countries in an effort to reduce double taxation on the income of the residents of the two countries by allocating taxing jurisdiction between the United States and the other country and providing for a mechanism to credit the taxes paid to one country against the taxpayer's tax liability to the other country. I.R.S. Publication 901, "U.S. Income Tax Treaties" (April 2001), available at http://www.irs.gov.
Because the United States has published a Model Income Tax Convention, this discussion is based on the provisions of the U.S. Model Tax Convention of Sept. 20, 1996, available at www.treas.gov/taxpolicy/t0txmod1.html. The convention is the Treasury Department's point for negotiating new tax treaties.
Article 7(1) of the Model Income Tax Convention provides that a U.S. corporation shall be taxable by the other country only if it carries on business in the other country through a "permanent establishment" situated therein and only on its "business profits" that are attributable to such permanent establishment.
Therefore, in determining whether a U.S. corporation is taxable on its business profits by a country that has a tax treaty with the United States, the threshold question is whether that company has a permanent establishment in that foreign country.
Under a tax treaty, a corporation could have a permanent establishment in a country either through the establishment of a fixed place of business (i.e., a branch or office) or through the activities of its employees or dependent agents. Articles 5(1) and (2) define a "permanent establishment" as a fixed place of business through which the business of an enterprise is wholly or partly carried on, including a branch, office, workshop or factory.
However, under Article 5(4), a corporation will not have a permanent establishment in a foreign country if it undertakes only certain specified exempted activities, which are generally preparatory or auxiliary activities. Furthermore, the maintenance of a fixed place of business that performs a combination of any of the specified activities does not constitute a permanent establishment, provided that the overall activity of the fixed place of business is of a preparatory or auxiliary character.
In most cases, before a U.S. company establishes a foreign subsidiary to market and distribute its products, it sends its own employees to develop the local market. Many U.S. companies assume erroneously that they do not have tax exposure in the foreign country because they have not registered a branch presence or established an office or factory. However, the activities of an employee can create tax exposure even in the absence of a branch office.
Under Article 5(5), a U.S. company has a permanent establishment in a foreign country if a dependent agent, acting on its behalf, has and habitually exercises contract-concluding authority on behalf of the U.S. company in that country.
Thus, absent a fixed place of business, a U.S. company has a permanent establishment (and may be subject to foreign income taxation) if it has a dependent agent acting on its behalf in the foreign country and if the dependent agent concludes contracts on its behalf. Both of these factors are determined based on all relevant facts and circumstances.
A "dependent agent" is defined as a person who is not an independent agent. An "independent agent" is a person who is legally and economically independent of the company on whose behalf he or she is acting and who is acting within his or her ordinary course of business. See U.S. Treasury Technical Explanation to Article 5(6), available at www.treas.gov/taxpolicy/t0txmod2.html.
An employee of the U.S. corporation is a dependent agent. However, the U.S. company may appoint an entity to act on its behalf. Under Article 5, a related company may be treated as a dependent or independent agent depending on the specific facts and circumstances of the relationship between the agent and the U.S. principal.
For example, if a U.S. company established a subsidiary in the foreign country to market and distribute the U.S. company's products, the commercial arrangement between the related companies must be structured to reflect arm's length dealing, with the agent bearing sufficient economic and business risk. The companies must preserve corporate formalities in their interactions to demonstrate their legal independence.
If the subsidiary is treated as an independent agent, although the subsidiary would be subject to tax in the foreign country, its U.S. parent would not be taxed in the foreign country.
When an agent is a dependent agent acting on behalf of the U.S. company, its activities could create a permanent establishment for the U.S. principal if the agent is concluding contracts on behalf of the U.S. company. It is the de facto authority to conclude contracts that creates a permanent establishment for the enterprise.
For example, if a U.S. company's employee is authorized to negotiate all elements and details of a contract in a way that is binding on the company, he or she is considered to have exercised contract-concluding authority, even if someone else in the United States signs the contract on behalf of the U.S. company. U.S. Treasury Technical Explanation to Article 5(6); Paragraph 33 of the Commentaries to Article 5(6) of the Organization of Economic Cooperation and Development Model Treaty.
Therefore, one of the principal planning goals in this area is to limit the authority of sales employees so that they do not have the authority to conclude contracts on behalf of the U.S. company within the meaning of the applicable treaty.
To create a permanent establishment for the U.S. company, the authority to conclude contracts must cover contracts relating to operations that constitute the "essential business operations of the enterprise, rather than ancillary activities." U.S. Treasury Technical Explanation to Article 5(5).
In other words, an employee who signs a lease for a warehouse to store the U.S. company's products would not create a permanent establishment for the U.S. company because the contract-concluding authority extends to activities that otherwise would not create a permanent establishment for the company.
In contrast, an employee who concluded a contract for the sale of products to a customer in the foreign country would create a permanent establishment for the U.S. company.
Because its officers, executives and sales personnel inadvertently could create foreign income tax exposure for a U.S. company, it is extremely important for a company to provide internal training and guidelines to any employees and officers who travel to foreign countries to promote the company's products.
For example, company representatives should communicate to customers that they do not have the authority to conclude contracts and that final approval of contracts is made in the United States. The U.S. company must ensure that the person appointed to approve contracts in the United States is not rubber-stamping deals made in the field but has authority to accept, revise or reject the contracts.
Joanne L. Siu is a tax associate at Baker & Mckenzie's San Francisco/Palo Alto office. She advises multinational corporations on structuring their international operations and cross-border transactions.
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