Taxation of Inbound Transactions

1
Taxation of Inbound Transactions

• Recall definition of an inbound transaction
• Two taxing regimes
• Passive investment income
• 30 tax on gross income (many exclusions)
• Tax withheld by payor
• Income effectively connected with a US trade
  or business
• Net income taxed under graduated rates
• US tax return required

2
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

3
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

4
Exceptions to Nontaxability of Interest Income

• US-source interest received by 10-percent
  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?
• 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 corporations
  outstanding common stock? 10? 50 of its
  nonvoting preferred stock?
• What if the interest is paid by a foreign
  corporation?

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Example 2 Planning without the 10 Shareholder
Rule

• Kim, a foreign person with no effectively
  connected income, wishes to invest in a US
  business
• 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
• What are Kims tax consequences without the 10
  shareholder rule? With the rule?
• Does it matter if the corporation is a US
  corporation or a foreign corporation?

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Other Exceptions to Non-taxability 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 owners control and
  involvement in operations
• Can elect to treat income as effectively
  connected

10
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 Lis 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
• But not income from sale of investment assets
• Income from manufacturing

12
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
• US trade or business can be imputed between agent
  and principal, from partnership to partners

13
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
• 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
• Activities test
• Income is effectively connected if the
  activities of the business are a material
  factor in its realization
• Captures income from performance of services

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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 Euros 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
• 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

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Example 5 Foreign Source Income

• Recall example 4 in which Euro sells products by
  mail to US customers
• 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?

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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
• Passive investment assets not included in this
  test

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Example 6 USRPHC

• Rap Inc. owns assets with the following values on
  1/1/2002
• 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?

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Example 7 Interest in USRPHC

• Refer to Example 6. Suppose that the value of
  Raps 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