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FDAP Income: Introduction | US International Tax Lawyer & Attorney

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Let’s go to another chart. Remember when I said we were going to discuss a situation where a non-US person does not engage in US trade or business activities? In this case, we have to ask: Is this US-source income classified as FDAP income (fixed determinable, annual or periodic) FDAP income generally includes passive investment income: interest, dividends, rents, royalties, etc.; but, it may also include some active income like US-source salaries as well as US-sourced deeds from the sale of intangible properties. However, please remember that except US real estate, non-ECI capital gains from the sale of tangible property of a non-US person are generally exempt from US taxation.

This is why, for example, foreign persons who own stocks in the United States, when they sell them, they are not subject to US tax withholding. They are going to be paying taxes in their home countries on the capital gains but they are not going to be paying taxes in the United States.

If this indeed is an FDAP income, then we have to ask whether it is subject to a treaty exemption or to a special tax provision in the Internal Revenue Code, which would exempt this FDAP income from taxation. If it is subject to any of these exceptions, then this FDAP income will not be taxed in the United States. However, if it is not subject to any treaty exemption, then it would be taxed at 30% withholding rate on gross income. Or a treaty rate – here, treaties play a crucial role in lowering tax liability. That’s why it is very important that when you invest in the United States, when you engage in an inbound transaction, to invest in the right foreign jurisdiction; so you have to do some foreign treaty shopping.

Effectively Connected Income: Introduction | US International Tax Lawyer & Attorney

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Let’s suppose we find a US trade does exist. If it doesn’t, then we’ll talk about the FDAP a little bit later in the presentation.

If a non-US person engages in US trade or business activities, then the next question is: Is the income that he derives connected to these US trade or business activities, called ECI or Effectively Connected Income? Now, ECI is arguably the most important concept concerning inbound transactions. It may be the only source of income, per se, that is inbound, but ECI is such a central concept and a complex issue as well.

Basically, ECI includes three different types of income:

All active US-source income: One thing to keep in mind is the attraction rule; I give you an example here. A German corporation sells washing machines through a US office in the United States; in addition, it sells dryers directly to the distributors in the United States, but without any involvement of that US office. The sales are structured so that they are considered to be US-source income. For one reason or another, let’s say they signed a contract here in the United States. Even though the sale of dryers is not related to a US trade or business, because of the attraction rule, the income from both the washing machines and the dryers is considered to be the same. Obviously, this is all active-source income.

The second category: General passive US-source income – sales of capital assets and other passive income is considered to be ECI, if this income passes one of two tests: the Asset-Use test and the Business Activities test. I gave you the definition; but we wont have the time to go into more details on this. But, be aware that even passive US-source income may be considered ECI.

What I mentioned before: Certain foreign-sourced income may be considered ECI; generally speaking, in order for this to happen, the non-US person has to have an office or other permanent establishment here in the United States.

Only these three types of income which I have listed are related to this exception from the general rule that foreign-sourced income of a non-US person is non-taxable in the United States.

Let’s suppose that we indeed had ECI income. The next question is going to be: How is the income going to be taxed? There are special tax regimes that exist in the United States, for example, Branch taxes or BEAT, which is something that was introduced by the 2017 tax reform. If an ECI income falls under the special tax regime, it’s going to be taxed according to the special tax regime; however, if no special tax regime applies, the ECI is going to be taxed at US graduated rates, including, by the way that’s important to keep in mind, including capital gains tax rates.

Tax Definition of “US Trade and Business Activities” | US International Tax Lawyers

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Let’s suppose it is indeed US-source income; then the next question that we have to deal with is whether this non-US person engages in US trade or business activities. Just to repeat myself, if it is not a US-sourced income, generally speaking, it’s not taxable; but you see here and there that in order to get there, we still have to find out if this income is somehow effectively connected to a US trade or business.

The issue of US trade or business activities is another complex issue. As I’ve said, all of the questions that are contained in this flowchart – all of them are complex with exceptions upon exceptions; all with difficulties. As I’ve said before, a lot of things concerning inbound transactions are fact-dependent. It is even more-so when we talk about US trade or business activities because there is no actual definition of what a US trade or business activity is; it is highly factually-dependant. However, based on the cases and the IRS guidance I’ve given you sort of a general rule: A US trade or business exists if the foreign corporation activities within the United States are considerable, continuous and regular.

Let’s deal with a few examples to help us figure out what we’re looking at; common examples are:

‘Consistent attempts to market products and services in the United States’, is considered to be a US trade or business. This is very important, especially in situations concerning intellectual property and situations where the intellectual property is actually outside of the United States. Marketing within the United States may unintentionally result in US-source income.

On the other hand, clerical or collection-related activities do not produce US trade or business. This is also very common; I’m pretty sure that a lot of you have dealt with a situation like this before where a foreign person sets up an LLC, say in Delaware, simply to collect the payments for the work performed overseas or for royalties related to intellectual property which is located overseas. Just setting up an office for an LLC in the United States for collection-related activities will not result in US-source income.

Another common issue concerns agents. If there is an agent of a US corporation in the United States that has the authority to conclude contracts, and he regularly exercises this authority; then this would be sufficient to find that a US trade or business exists.

US Source-of-Income Rules | MSBA Seminar 01282021 | International Tax Lawyer & Attorney

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Once we have established that this is a non-US Person, the next question is: Is this person getting a US-source income? This is a critical question of huge importance and huge complexity. Why is it important? Because non-US Persons generally, (there are exceptions) are taxed on their US-sourced income. This means that if the income that this person is getting is not US-sourced income, then it’s not taxed in the United States at all. On the other hand if it’s a US-source income, then we have to go through a more complex situation. By the way, if it’s not a US-sourced income, as I have mentioned, we still have to look into whether this is an effectively-connected income. I will discuss this a little bit later during the presentation.

Now, I imagine this is a complex issue in how you determine what is US-source income and what is not US-source income. I am going to simplify this analysis; it’s basically a three-step process. First, you have to classify the income; that is, is it interest, is it dividends, royalties, income from services, etcetera. Then you have to find the particular tax provision that applies to this particular class of income, and the final step is to apply the particular facts of your client’s case to that tax provision.

Let’s go over a few of the most common examples:

Interest income: Interest income is generally sourced to the residence of the obligor. Most often, ‘obligor’ means ‘by the power’. Not always, but most often. This rule applies to individuals, corporations and partnerships. Now the interesting thing is that this may lead to some very unusual situations. For example, if a US Person resides in France and this US Person is an obligor and the obligee, a French person resides in the United States, and the US Person pays interest on the income on his obligation, on the loan; then, this interest would be classified as foreign-sourced income, more precisely French-sourced income, even though it’s a US person who is paying it. Again, rather than solve the obligor, not the nationality.

Dividends: aside from some limited exceptions, it depends on whether the corporation that pays the dividend is a foreign corporation or a domestic corporation. Dividends paid by a US corporation is always US-sourced income; dividends paid by a foreign corporation is almost always a foreign-sourced income but there is this important 25% income exception. Basically, if 25% or more of the corporation’s gross income for the past three years was ECI income that is effectively connected to the trade of business in the United States, then you have to apportion this dividend between the percentage income between the ECI income verses foreign-source income. Think about what it means: that a foreign dividend from a foreign company, incorporated in a foreign country, and this dividend is paid out to a foreign person who lives in a foreign country, actually may result in US-source income. This is a paradox; this tells you just how complex US International Tax Law is. Prior to 2005, unless there was an exception and there were a number of exceptions, including treaty exceptions, but technically speaking, if no exception applies, this person would have been expected to file a US tax return and pay US tax on that US portion of his foreign dividend. Of course, that would almost never happen but there was some litigation in the early years.

Rents and Royalties: sourced to the place where the property is used. This rule is going to be very important with respect to tax planning that involves intellectual property.

Sales of Personal Property: extremely complex because you really have to dig into the facts of the case. In general, sales of personal property are sourced to the residence of the seller. There are special rules, depreciable personal property and there are special rules concerning a situation where there is a permanent establishment outside of the United States or inside of the United States, actually, as well. The biggest issue, and this is going to be very relevant for the purposes of inbound transactions, is sale of inventory; this situation is very common. For example, a few years ago, I had a case where a foreign parent was producing some goods, inventory and basically sending it to a distribution center here in the United States. The general rule here is that inventory sales are sourced to the place of sale; that’s very important – sourced to the place of sale. What is the place of sale? Generally speaking, the place of sale is where the title is passed, but it gets a lot more complex; there are some exceptions that I have given to you. For tax planning purposes, this is a huge issue when it comes to inbound transactions.

Sale of US Real Property: generally, US-source income, even if this real property is held through another entity.

Income from Services: that is sourced to the place where the services are performed. For example, if you go to France, and perform some work there and get paid for that work, even though you are a US Citizen, even if you don’t reside in France, the payment that you receive for the services you performed in France is going to be considered French-sourced income. It gets more complex if you perform services in more than one country, then you have to apportion the payment between these countries and the usual method is time-basis allocation.

MSBA IBLS CLE January 28 2021: Definition of US Person | International Tax Lawyer & Attorney

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The first question, when a client comes to the office, should be: “Is it a US Person?” I say ‘it’ because a client may not be only an individual but also a corporation, a trust or an estate. This question may not be that easy to answer, as it may appear in the beginning.

Let’s talk about individuals first, who are US Persons? US Citizens and US Tax Residents. Now, ‘US Citizens’ is not a very complex category; although, there are some complexities. For example, if in the case of ‘Accidental Americans’, when the person was born in the United States but never lived here – that person spent their entire life outside of the United States, or when a person has one US parent and one non-US parent. In general, it’s not that difficult to verify if a person is a US Citizen or not.

‘US Tax Residents‘ is a more complex issue because it includes green card holders, that is, US permanent residents, the Substantial Presence Test – so basically, people who were here for enough time to pass the Substantial Presence Test and people who declare themselves as US Tax Residents. Now you may ask, who in their right mind would declare themselves a US Tax Resident? It actually happens quite often and I can tell you that in many cases, people do that without even understanding that they have declared themselves a US Tax Resident. For example, when you have one US spouse and one non-US spouse and they file a joint tax return – the non-US spouse just declared herself to be a US Tax Resident.

The second category of US Persons concerns corporations and partnerships, basically business entities. The rule here generally, I emphasize the word generally, is that any corporation or partnership organized under the laws of the United States or any of its 50 states, is a US Person.

Trusts are more complex. In order for a trust to be a US Person, it must meet both the court test and the US control test under the IRC Section 7701(a)30(e). I am going to over-generalize here; generally, if one of the trustees is a US Person and the trust document allows for a US court to exercise a jurisdiction over the trust’s administration, the test will be satisfied. That is, this trust would be a US trust; both tests must be satisfied in order for the trust to be a US trust.

Regarding estates, that doesn’t happen very often in the foreign direct investment situation, but generally speaking, a US estate is any estate that is not described in Section 7701(a)31. I provided a definition for you here. You can read it; it basically has to do with US-source income and what is includable in the gross income of Subtitle A. Now, the important thing to understand is that if you are dealing with a US person, you are not dealing with an inbound transaction, that is this entire tax-framework that I am discussing, doesn’t apply to US Persons. You have to look at a different set of rules. Us Persons, by the way, are taxed on their worldwide income. If this is not a US Person, then we deal with the inbound transactions tax frame.