Chapter 11 - Outbound
International Sale of Goods
Choices for export sales entity arrangements:
1) U.S. sales office/export subsidiary
2) Foreign country subsidiary
3) Independent local agent
4) Dependent local agent
5) Internet – websites
Cf, the prior discussion of inbound U.S.
business investment.
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Tax Exposure in the
Foreign Jurisdiction
p.883
1) No foreign country tax exposure if no
representative office in the jurisdiction – but,
dependent upon local country tax law.
2) Tax liability if a local agent exists, unless that
agent is “independent” of the U.S. principal.
3) Foreign country tax liability arises for a local
country subsidiary (but a possible exception
exists if the corporate “place of mind and
management” is elsewhere).
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U.S. Foreign Tax Credit
Planning
p.883
Assuming foreign country income tax
jurisdiction does exist – the U.S. tax planning
objective is to limit foreign income taxes to
assure that no excess foreign tax credits arise.
Consider: the §904(d)(1)(B) general limitation
basket & the §904(d)(3) look-through rules.
U.S. income tax multiple objectives to generate
income as: (i) foreign source, (ii) low taxed in
the foreign country, & (iii) in the FTC “general
limitation” category.
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Possible Impact of an
Income Tax Treaty
p.884
For the U.S. taxpayer the foreign country
income tax result may be moderated by a
bilateral income tax treaty between (1) the
foreign destination country and (2) the U.S.
(or, perhaps, between an intermediary third
jurisdiction and the destination country).
Query: Does a P.E. exist? However, a foreign
country may impose less extensive tax
jurisdiction than under the tax treaty (e.g.,
using a “participation exemption” system).
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Application of a Bilateral
U.S. Income Tax Treaty
1) Business profits allocation – Art. 7(1) determination of the amount of business profits
subject to foreign country income tax.
2) Amount of income subject to tax - choices
are: (a) only that income attributable to the
P.E., or (b) a “limited force of attraction” rule,
similar to U.S. rules (or unlimited force of
attraction).
3) Income tax deduction available for expenses?
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Tax Treaty Concept of
“Permanent Establishment”
P. 887. A “permanent establishment” is a fixed
place of business for engaging in industrial or
commercial activity. See U.S. Model Treaty,
Article 5(1).
How distinguish between a “dependent” and an
“independent” agent? Art. 5(5) & (6).
Remember the Taisei Fire case (U.S. Tax
Court) in the inbound reinsurance context
where the agent had multiple principals.
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Income Tax Treaty
Interpretation Tools
p.895
1) OECD Commentary (p. 895) - under
continual revision by OECD
2) U.S. Treasury Dept. (unilateral?)
“Technical Explanation” of a particular
bilateral U.S. income tax treaty (& the 2006
U.S. Model Tax Treaty).
3) Court decisions in the U.S. and other
jurisdictions (e.g., Taisei, concerning definition
of an “independent agent”).
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Problem 1
p.898
Independent Distributor
Cosmos, U.S. corporation, makes export sales to
independent distributor in S. Korea that buys
from Cosmos and resells for its own account.
Cosmos has no sales office in S. Korea. Minimal
contacts in S. Korea. Cosmos P.E in S. Korea?
No. Article 9 (p.890).
Is income realized by Cosmos on these sales
subject to S. Korea income tax? No, since no
P.E. Independent distributor is not a P.E. of
Cosmos.
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Problem 2
p.898
Orders Accepted in Country
Cosmos employees had (and exercised) authority to
accept orders when visiting the distributor in South
Korea.
P.E. would exist in S. Korea because Cosmos
employees are deemed to be persons acting on
behalf of Cosmos – they have and habitually
exercise authority to conclude sales contracts in the
name of Cosmos. Article 9(4)(a). P. 891.
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Problem 3
Greece treaty
p.898
p.888
Distributor in Greece and Cosmos export division
employees had no authority to negotiate a sale but
only to solicit and accept orders on the standard
terms and conditions of sale as required by the
Cosmos.
Greece treaty, Article II(1), requires that an agent
(including an employee?) must have authority to
negotiate and conclude contracts for foreign
enterprise before being a P.E.
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Problem 4
Agents as P.E.?
p.898
Mfg. Reps.
What is the possible authority (without P.E. status)
if an agent is in Belgium or South Korea?
Agent as independent only if legally and
economically independent of the principal.
What is the degree of control by the principal in
these situations? Limited control?
Agents here seem to be independent (do they have
their own risk of loss?) And, they are not subject to
comprehensive control or detailed instructions.
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Problem 5
p.898
Market Research - Purchasing
Market research and purchasing offices established
in South Korea and Greece:
1) S. Korea treaty - (a) Article 9(3)(d) & (e) market
research/advertising and purchasing office does
not create a P.E.
2) Greece treaty - No counterpart of Article 9(3).
See Article II(1) re possible income taxation for
advertising (but not purchases – Article II(1)(i))?
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Problem 6
Local manufacture
p.899
Locally manufactured components are resold by
the Cosmos offices to Belgian or Greek
manufacturers.
1) S. Korea - See Article 9(5)(b) (p. 891) indicating
that the Article 5(3)(d) exemption does not apply if
all or part of the goods purchased in S. Korea are
sold by Cosmos for use, consumption or disposition
in S. Korea.
2) Greece - same result. See Article II(1).
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Problem 7
p.899
Engineers in S.Korea &Greece
Offices with staffs of engineers to
(a) provide advice to potential customers
and (b) provide after-sales warranty services.
1) S. Korea treaty - no explicit exemption from P.E.
characterization & these services are not of a
preparatory or auxiliary character.
2) No exemption under the Greece treaty.
P.E.s in both situations? Probably.
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Problem 8
p.899
Warehouses in All Countries
Are warehouses exempt from a P.E. classification
and deliveries are made to distributors?
1) Belgium treaty - Article 5(4)(a), yes (p.892)
2) S. Korea treaty - Article 9(3)(a), yes (p.890)
3) Greece treaty - Article II(1)(i) – a warehouse is
not excluded from P.E. classification (note: an
agent with a “stock of goods”). P.888.
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Problem 9
Local processing
p.899
Products shipped for local processing before
delivery to local distributors who purchase under
export orders accepted in U.S.
Exclusion from P.E. definition for a stock of goods
belonging to the enterprise for processing by
another enterprise? Belgium treaty Article 5(4)(c).
Cf., S. Korea treaty, Art. 9(5), a P.E. exists if items
sold for consumption in S. Korea.
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Problem 10
p.899
Out-of-country Delivery
Products shipped for local processing before being
delivered to out-of-country distributors.
Belgium (Art. 5(4)(a)) & S. Korea (Art. 9(3)(a))
treaties - no P.E. exists.
Greece treaty – a P.E. exists without regard to
where the products are sold (Article II(1)).
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Problem 11
p.899
Subsidiaries of U.S. Parent Co.
Subsidiaries as permanent establishments of
Cosmos? These subsidiaries act as “independent
distributors.” Subsidiary is not regarded as a P.E.
of Cosmos under any of the three treaties:
Belgian Treaty, Article 5(7)
S. Korea Treaty, Article 9(7)
Greece Treaty, Article II(1)
OECD Commentary, see p. 896.
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Problem 12
Subsidiaries as Agents
p.899
Subsidiaries function as agents of Cosmos and
employees of subsidiaries regularly negotiate export
sale contracts and enter into contracts on behalf of
Cosmos for commissions paid to subsidiaries. Sales
are made directly by Cosmos to local customers.
If subsidiaries function as Cosmos agents and
exercise authority specified, P.E. status for Cosmos.
Belgian Treaty, Article 5(5); S. Korea Treaty,
Article 9(4)(a), Greece Treaty, Article II(1).
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Problem 13
p.899
“Force of Attraction” Rule
Cosmos has three divisions: radios, refrigerators,
and toys. Toy division has sales offices in Belgium,
S. Korea and Greece. Other two divisions handle
sales by solicitation in country but home office
acceptance of orders. Each toy division's sales
offices constitute a P.E. Impact on other income?
Greece, Art. III(1) - “force of attraction” rule
applies; Others - attributable income only is taxed;
Belgium Treaty, Art. 7(1); S. Korea, Art. 8(1).
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Problem 14
p.900
Treaty Income Definition
Tax treaty impact – controls the amount of:
1) Includible gross income; and,
2) Expenses (including non-local country expenses
G&A, etc. expenses).
Belgium: Art. 7(2)
S. Korea: Art. 8(2)
Greece: Art. III(2), “profits” means deductions?
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Problem 15
Construction Project
p.900
U.S. architectural firm designed Belgian, S. Korea
and Greece motels - design activities occurred in its
U.S. offices. Temporary offices at building sites
with employees of U.S. firm responsible for
supervision. Project completed within one year.
Income tax exposure in foreign country? (1) 12
months rule in the treaty? Belgium, Art. 5(3)(a);
(2) S. Korea, Art. 9(2)(h)& 3(f) – 6 months rule;
(3) no provision in the Greece treaty.
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Electronic Commerce & P.E.
Status
p.900
Computer equipment as a P.E. where located in a
foreign country. Fixed situs? Where goods are
shown or returns are received?
What if no tangible connection with a country?
Distinction between (1) computer equipment and
(2) software for purposes of establishing P.E.?
Distinction between website & server. P.902.
Independent service provider (ISP) as not an agent
for the U.S. seller?
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Problem 1
Independent ISP
p.904
Website on a server maintained by an unrelated
ISP in Brazil. Orders are transmitted to U.S. from
the website. Orders will be filled from U.S.
No fixed business place in Brazil for Cosmos.
If the ISP is an “agent,” then the status of the
agent’s activities would be as “preparatory and
auxiliary” (since not concluding contracts binding
on Cosmos).
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Problem 2
p.904
Website Acceptance in Brazil
Website accepts orders and the customer tenders
payment (credit card info) to the website.
Website then issues electronic delivery instructions
to the U.S. warehouse.
Website is not an “agent.” Need for a “human
agent” under OECD rules? Computer program oK
to establish tax status? Correct result if the
website is established and controlled by Cosmos
and orders are completed there?
Should this be P.E. status?
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Problem 3
p.904
Manufacturer Owns the Server
Cosmos owns the server in Brazil.
The server will be treated as a “fixed place of
business” in Brazil. The activities include accepting
orders, beyond preparatory and auxiliary activities.
Therefore, the server will constitute a P.E. in Brazil.
[Remember that a “P.E.” is a tax treaty term and
Brazil actually has no tax treaty with the U.S.]
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Problem 4
Bermuda based server
p.904
Cosmos owns, maintains and operates the server
located in Bermuda (where no income tax applies).
Therefore, the server cannot be a fixed place of
business in Brazil. Therefore, no P.E. in Brazil.
But, should the server’s physical location be the
controlling factor (or be irrelevant) in this context?
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Problem 5
p.904
Physical Status Controlling?
Should a website and server located outside the
destination country be treated as precluding P.E.
status for purposes of tax jurisdiction in the
destination country?
Too much emphasis on traditional jurisdictional
concepts?
What is the comparable situation in the U.S.
concerning state sales taxation?
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Use of Export Corporation U.S. Tax Planning
p.905
Choices: 1) U.S. corporation, including a special
purpose U.S. subsidiary.
2) Foreign corporation - including a third country
corporation. Categorized as a CFC for Subpart F
purposes.
3) Previously, (a) FSC (or, earlier, DISC; note,
however, the “interest-charge DISC” is still
available); or, (b) gross income (ETI) exclusion
(i.e., prior Code §114), determined to be illegal.
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Use of Foreign Export
Corporation
p.907
Foreign organized corporation is not subject to
U.S. income tax, except for its U.S. source income.
Assume foreign source income is received for:
1) Services performed at a location outside the
United States.
2) Sale of inventory if the title passes outside the
United States.
Locate in low-tax third country?
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Commission Approach
p. 908
Pay a commission for the sales activities rendered
in the foreign jurisdiction.
If related: Issue concerning an appropriate §482
allocation for the services rendered.
Avoid having any activities of the foreign
corporation conducted in the United States. But,
possible Subpart F exposure for these sales
activities (FBCo sales income).
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Purchase and Sale
Approach
p.908
Purchase at arm's length price and then sell
outside the United States, i.e., “buy-sell.”
§862(a)(6) re sourcing rule outside U.S.
Title passage test under Reg. §1.861-7(c).
(i.e., where does title pass to the buyer?).
Passage of title at the port of destination?
How assure complying with “terms of the deal”?
Might have FBC sales income for Subpart F.
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Impact of CFC Rules
§954(d)
p.910
Defining foreign base company sales income status §954(d). Possible issue concerns whether the
“manufacture” of the product by the foreign
subsidiary (CFC) has occurred to enable an escape
from the “FBC sales income” definition.
Note: Dave Fischbein Mfg. Co. case., p.911.
Significant major assembly by the Belgian sub. is
treated as manufacturing in Belgium and,
therefore, as not causing FBC sales income (even
though not 20% of value contributed).
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Sales & Manufacturing
Branch Rules
p.916
§954(d)(2), i.e., the “branch rule”.
What objective of establishing a sales branch
outside the country where the manufacturing
occurs? (or, a manufacturing branch?)
Effect of branch rule treatment is to cause the
“deemed subsidiary” to be treated (for Subpart F)
as (1) a wholly owned subsidiary of U.S.
corporation, (2) a CFC, and (3) a party to the sales
transaction, with FBC sales income generated.
Apply a “tax rate disparity
test.”
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Rev. Rul. 75-7 (p.917)
revoked by Rev. Rul. 97-48
CFC incorporated in country M. CFC purchased
metal ore in U.S. and Canada from related persons.
Conversion of ore by CFC under contract with an
unrelated foreign corp. in Country O. Only
contractual relationships between CFC and the
unrelated foreign corporation.
Here foreign (contract manufacturer) corp. treated
by IRS as a branch – for purposes of “branch rule.”
But, a higher income tax rate in the sales co. country
makes the branch rule not applicable!
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Ashland Oil, Inc.
p.920
Contract Manufacturing
Issues concerning foreign branch rule:
1) Does the §954(d)(2) branch rule apply to a
“contract manufacturing” arrangement between a
CFC and an unrelated corporation? Not in this
situation - no “branch.”
2) Is the “manufacturing branch” rule in the
regulations invalid? Not determined in this case,
since determining that no branch existed.
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Rev. Rul. 97-48
p.929
Revoking Rev. Rul. 75-7 and holding that activities
of a contract manufacturer can not be attributed to
a CFC for purposes of the branch rule for
determining FBCSI status.
Also, holding that the manufacturing activity can
not be treated as undertaken by the CFC if contract
manufacturing for the FBCSI rule of §954(d)(2).
Correct position by IRS? Was Ashland a “facts &
circumstances” determination?
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“Substantial Contribution”
Test
p.930
Revised regulations provide for a “substantial
contribution” test to determine whether the
participation of taxpayer (through its employees)
with the contract manufacturer should cause the
branch rule to be invoked for those activities.
Test: Appropriate to treat contract manufacturing
as done by a CFC?
See Reg. §1.954-3(a)(4)(iv), p. 932.
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2009 FBCSI Regulations
Contract Manufacturing
T.D. 9438 (2-2-2009); See Reg. §1.954-3(a)(4)(iv)(b).
Re: Contract manufacturing arrangements.
CFC substantial contributions made by the CFC to
the manufacture process can include: (1)
Oversight, (2) Material selection, (3) Management
of manufacturing costs, (4) Control of
manufacturing logistics, (5) Quality control, (6)
Product design.
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Problem 1
Sales branch
p.933
§954(d)(2)
U.S. corp has manufacturing subsidiary in the
Netherlands and this Dutch sub establishes its
branch office in Switzerland.
Swiss branch handles sales of Dutch manufactured
products to non-Dutch customers. Tax rate
disparity exists (e.g., less than 90 percent of higher
rate – or more than a 5% rate differential).
Applicability of the foreign branch rule when goods
are (1) manufactured in the Netherlands and (2)
sold by Swiss branch? Yes & FBC sales income.
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Prob. 2 - §954(d)(2) P.934
Manufacturing branch
Alternative situation of:
1) Dutch manufacturing branch of a
2) Swiss organized CFC. The Swiss corporation
handles the sales of products manufactured by the
manufacturing branch based in the Netherlands.
Reg. §1.954-3(b)(1)(ii) applies a reverse tax-rate
disparity test. The manufacturing branch is treated
as a separate wholly owned sub. for purposes of the
Subpart F rule & Swiss corp. has FBC sales income.
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Prob. 3 P.934
Substantial Contribution?
U.S. parent; Bermuda sub.
Mexico contract manufacturer for the Bermuda
sub with the Bermuda sub having significant
participation in activities of the Mexican based
contract manufacturer.
Because of these activities by the Bermuda sub the
Bermuda sub’s income on sales to U.S. parent does
not produce foreign base company sales income.
Bermuda sub is a “manufacturer.”
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Prob. 4 P.934
Substantial Contribution?
a) Singapore involved in manufacturing by CM-C
to make Singapore as providing a substantial
contribution.
b) Distinction between employee of CFC and
parent corp. for purposes of the substantial
contribution test.
c) Independent contractor causing Singapore as to
not be deemed as making a substantial
contribution?
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Other Tax Savings Using
Foreign Export Corp. p.938
1) Organize a 50-50 corporation - no CFC status.
10-50 rule for FTC and “look-through” rule.
2) Manufacture in the country of incorporation the Fischbein scenario.
3) Generate low/no taxed foreign source & correct
FTC basket income, so as to moderate the impact
of the foreign tax credit limitation provisions.
4) Use foreign tax haven base company to reduce
the foreign tax liability.
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Export Tax Incentives
Summarized
p.941
1) Domestic International Sales Corporations (or
DISC) regime – but remaining is the “interestcharge DISC.”
2) Foreign Sales Corporation (FSC)
3) Extraterritorial Income Exclusion, including
favorable transition rules.
All declared illegal under GATT.
2004 Act: §199 – deduction (up to nine percent)
for “qualified production activities” income.
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Prior Tax Incentive - The
Foreign Sales Corporation
Prior Domestic International Sales
Corporations (or DISC) Regime
Code §991-994; Revenue Act of 1971
Deferral of a diminishing portion of the
income derived from qualified export sales.
1984 – Remaining DISC provisions limited
to small DISCs for deferral only of taxable
income attributable to a maximum of $10
million of qualified
export
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P. Streng receipts.
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Tax Incentive System for
Exports
Year 2000 enactment FSC replaced with a gross income exclusion
for “extraterritorial income”.
Code §114.
U.S. manufacturers can permanently exclude
a portion of their export profit.
WTO declares illegal export subsidy.
Repeal transition rules also illegal.
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Prior Tax Treatment of
FSCs
Code §§921-927 and Code §291(a)(4).
Permanent exemption of a portion of the export
income from U.S. income tax.
FSC must be a foreign corporation with a
substantial presence abroad.
FSC operates as a wholly owned sub of the U.S.
parent and sells U.S. goods produced by the U.S.
parent or an affiliate.
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Formal FSC Qualification
Requirements
1) Foreign corporation - in qualified foreign
country or a U.S. possession
Exchange of information agreement with the
foreign country or adequate exchange of
information provision in the applicable income tax
treaty. U.S.V.I. or Barbados
2) Number of shareholders - not more than 25.
Usually one.
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FSC Requirements
continued
3) No preferred stock, but more than one class of
common is possible.
4) At least one nonresident director. What if
death? May be a nonresident U.S. citizen.
5) Maintain a foreign office. Computer diskette OK
to establish a foreign office?
6) U.S. location for tax records.
7) Election to be treated as a FSC.
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Treatment of FSC Income
Exemption for a portion of the FSC's "foreign
trade income"
Must be gross income attributable to "foreign
trading gross receipts”:
1) Management of the FSC carried on outside the
United States and
2) Economic processes from which the income is
earned take place outside the United States.
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Defining Foreign Trading
Gross Receipts
1) Sale of export property
2) Lease of export property
3) Services concerning export property
4) Engineering and architecture for foreign
construction projects
5) Managerial services for unrelated FSC or DISC
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Defining Export Property
Export property is property manufactured in U.S.
from majority of U.S. components. Code
§927(a)(1).
Exclusions from export property when:
1) ultimate use in the U.S.
2) use by U.S. Government
3) U.S. subsidized transaction
4) receipts from another FSC
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Foreign Management Test
1) Meetings of Board of Directors and shareholders
outside the U.S.
2) Principal bank account in a country where
exchange of information rules are satisfied.
3) Dividends, legal and accounting fees, and officers
and directors compensation paid from this account.
Code §924(c).
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Foreign Economic
Processes Test
Economic processes to generate the income must be
located outside the United States.
1) Participation in the solicitation (other than
advertising), the negotiation or the making of the
contract relating to the transaction.
2) At least 50 percent of the direct costs
attributable to the transaction for five categories of
sales-related activities.
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Foreign Direct Costs
Requirement
a) advertising and sales promotion.
b) processing of customer orders and arranging for
delivery.
c) transportation to the customer.
d) preparation and sending of the final invoice or
the statement of account and the receipt of
payment.
e) assumption of the credit risk.
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Defining Foreign Trade
Income Amount
Pricing rules where the purchase of goods is by the
FSC from its U.S. parent corporation:
1) Arm's length pricing - Code §482.
2) Administrative pricing rules. Statutory pricing
rules.
Code §925(a)(1) and (2).
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Taxation of the FSC
Exempt foreign trade income treated as foreign
source income not effectively connected with the
conduct of a trade or business within the United
States. Code § 921(a).
Remaining income treated as effectively connected
with the conduct of a trade or business in the
United States. Code § 921(d).
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Taxation of FSC
Shareholders
1) U.S. corporation is entitled to a 100 percent
dividends received deduction for distributions from
E&P attributable to foreign trade income, other
than Code § 923(a)(2) non-exempt income.
2) Exemption from foreign base company sales
income rules for the exempt foreign taxed income-Code § 951(e).
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Interest Charge DISC
p. 951
Deferral of tax on taxable income attributable to
$10 million or less of qualified export receipts for
each tax year.
Interest charge imposed on the shareholders of the
DISC.
Taxable income of the DISC attributable to
qualified export receipts that exceed $10 million is
deemed distributed but the DISC is not
disqualified.
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Archer-Daniels-Midland Co.
p. 957
ADM argument that 4 percent of qualified export
receipts from agricultural exports is permitted in
establishing the transfer price for determining
DISC taxable income.
ADM position that even if combined taxable income
from the export transactions is zero it can still
allocate four percent of the gross to the DISC.
Held: no such allocation permitted.
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Small FSC
Need not meet the
(i) foreign management and
(ii) foreign economic processes requirements
Up to $5 million gross receipts limitation.
If exceeding $5 million, can then pick the $5
million receipts to which this limitation is
allocated.
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(c) William P. Streng
62
Financing of Exports
p. 962
Export financing interest is excluded from a
separate basket for passive income for FTC
purposes.
Included in the general limitation basket.
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(c) William P. Streng
63