Taxation of Inbound
Transactions
Recall definition of an inbound
transaction
 Two taxing regimes:
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Passive investment income
• 30% tax on gross income (many exclusions)
• Tax withheld by payor
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Income ‘effectively connected’ with a US
‘trade or business’
• Net income taxed under graduated rates
• US tax return required
Passive Investment Income

‘Fixed or determinable’ income
Taxed under the passive investment rules
if not ‘effectively connected income’
 Interest, dividends, rents, royalties,
annuities, prizes, found money, etc.
 All gross income measurable by the payor
 Wages, salaries, other compensation are
‘fixed and determinable’ but are often also
‘effectively connected income’
 Gains from property sales not included
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Investment Income
Excluded from US Taxation

US source interest income
Deposits in US financial institutions
 Portfolio interest

• Interest on debt held by identifiably foreign
persons
• Interest paid on any obligation either
• In registered form with a foreign owner, or
• If in bearer form, issued with restrictions on US
ownership
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Exceptions to Nontaxability
of Interest Income

US-source interest received by ‘10percent shareholder’ of the issuer is
subject to flat tax
10% or more of combined voting power
 10% or more partner in a partnership
 Attribution rules apply in determining
ownership
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Example 1: Investment
Interest Exclusion

In each case below, is interest earned by
Guy, a foreign person with no ‘effectively
connected’ income, subject to US tax?
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Guy earns $200,000 of interest from deposits of
funds held in US banks
What if the interest was paid by a US corporation
of which Guy is not a shareholder?
What if Guy owns 1% of the US corporation’s
outstanding common stock? 10%? 50% of its
nonvoting preferred stock?
What if the interest is paid by a foreign
corporation?
Example 2: Planning without
the 10% Shareholder Rule

Kim, a foreign person with no ‘effectively
connected’ income, wishes to invest in a US
business
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What are Kim’s tax consequences without
the 10% shareholder rule? With the rule?
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She forms a corporation to buy the US business
The business issues Kim 1 share of common
stock and bonds with a face amount of $1 million
paying 12% interest
Does it matter if the corporation is a US
corporation or a foreign corporation?
Other Exceptions to Nontaxability of Interest Income
US-source interest income of foreign
banks on the extension of credit in the
ordinary course of its trade or business
 Contingent interest based on

Sales, receipts, cash flow, income, or
profits of the debtor
 Change in value of property of the debtor
 Dividends or similar payments by the
debtor
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Income from Intangible
Property
Royalties considered ‘fixed or
determinable’ and sourced to country
of use of the property
 Income from sale of intangible
property sourced to residence of seller
 Sale versus license

Sale must transfer all substantial rights
 Contingent payments treated as royalties
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Trade or Business
Direct ownership of income-producing
property with related risks and
responsibilities
 Ownership of rental real estate and
mineral interests may or may not
qualify

Depends on level of owner’s control and
involvement in operations
 Can elect to treat income as ‘effectively
connected’
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Example 3: Rental Income

Li, a foreign person, owns rental real
estate generating $200,000 of rental
income per year on which he pays
$120,000 of expenses
If Li’s rental activities are not considered a
trade or business, how will he be taxed?
 Should Li elect to treat his rental activity
as effectively connected? Why or why
not?
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Other Trade or Business
Activities
Income from performing services
 Income from sale of inventory
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But not income from sale of investment
assets
Income from manufacturing
US Trade or Business

Requires economic activity in the US,
but no clear threshold as to how much
presence is a ‘US trade or business’

Insufficient activity includes
• Promotional activity alone
• Purchase of goods in US for sale elsewhere
• Sales through independent contractors/brokers
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US trade or business can be imputed
between agent and principal, from
partnership to partners
‘Effectively Connected’
Income

Only a foreign person who at some
time has been engaged in a US trade
or business can have effectively
connected income

US source ‘fixed or determinable’ income
and capital gains may be effectively
connected under two tests
• ‘asset use’
• ‘activities’
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‘Effectively Connected’
Income continued

‘Asset use’ test
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‘Activities’ test
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Income from the use of assets is effectively
connected if the rental operation is a trade or
business
Interest income is effectively connected if earned
on funds supporting current business operations
Income is effectively connected if the ‘activities’
of the business are a ‘material factor’ in its
realization
Captures income from performance of services
Other ‘Effectively Connected’
US Source Income

All other US source income of a foreign
person engaged in a US trade or
business is ‘effectively connected’
Includes sales of inventory and other US
source business profits
 Applies beyond US source income directly
from the US trade or business in which the
foreign person is engaged
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Example 4: Other US Source
Income

Euro Inc., a foreign corporation with no
permanent US place of business,
manufactures products sold by mail to
US catalogue customers
Is Euro’s income from such sales
‘effectively connected’?
 Now suppose Euro opens a store in NYC.
Is income from the store ‘effectively
connected’? What about income from the
catalogue sales?
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‘Effectively Connected’
Foreign Source Income

If a foreign taxpayer has an office or other
fixed place of business in the US (directly or
through a dependent agent), certain foreign
source income of that business is considered
‘effectively connected’
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Rents and royalties for the use of intangible
property outside the US
Financial gains from a US banking business or
active securities investment company
Gains from the sale ‘through’ the US office of
inventory, unless sold for use outside the US and
a foreign office of the taxpayer participates
materially in the sale
Example 5: Foreign Source
Income

Recall example 4 in which Euro sells
products by mail to US customers
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Would the treatment of income from these
sales change if Euro establishes a sales
office in NYC to market its products, which
are still manufactured and shipped from a
foreign country?
Sale of US Real Property

Gains/losses of foreign persons from
sale of ‘US real property interests’ are
considered ‘effectively connected’ with
a US trade or business

‘US real property interest’ includes
• Direct interest in real property located in the
US or the US Virgin Islands
• Interest in a ‘US real property holding
company’ (USRPHC)
• Does not include less than 5% ownership of
stock in a publicly traded US corporation
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Real Property
Land, buildings
 Mineral deposits, natural resources
 All permanent structures on land
 Structural components
 Furnishings and other personal
property associated with the use of the
real property
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‘Interests’ in Real Property
Fee ownership, co-ownership,
leasehold, options
 Interest in any domestic corporation
qualifying as a USRPHC at any time
during the shorter of

The period of time the interest was held
by the foreign person, or
 Five years ending on the date of
disposition of the interest
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USRPHC

Any corporation for whom the FMV of
its US real property is 50% or more of
the FMV of its combined worldwide real
property and assets used in the
conduct of a trade or business
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Passive investment assets not included in
this test
Example 6: USRPHC

Rap Inc. owns assets with the following
values on 1/1/2002:
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US real property
$4 million
Foreign real property
2 million
Foreign business assets 1 million
Investments
2 million
Is Rap a USRPHC?
If Ted, a foreign person, sells his 10%
interest in Rap during 2002, how will any
gain or loss be treated for US tax purposes?
Example 7: Interest in
USRPHC

Refer to Example 6. Suppose that the
value of Rap’s foreign assets increases
to $5 million by 1/1/2003.
How long would Ted need to wait before
selling his stock in order to avoid US
taxation?
 If Joan, another foreign person, buys Rap
stock on 2/1/2003, and sells it on
12/31/2003, how will her gain or loss be
treated for US tax purposes?
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Foreign Corporations Owning
US Real Property

An ownership interest in a foreign
corporation owning US real property is
not a US real property interest
Sales of such shares will not trigger
‘effectively connected’ income
 However, when the foreign corporation
sells the real estate, it has sold a US real
property interest and is taxed on the gain
in the US
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