class outline: international taxation (ta350a)

Module 1: General Principles
U.S. tax law distinguishes between U.S. persons and non-U.S. persons (also referred to as foreigners). We generally refer to International Taxation as the body of U.S. tax law that effects the taxation of cross-border or multinational transactions or activities. International Taxation can be distinguished further between individual taxation and corporate taxation, or inbound taxation and outbound taxation. In this course we are going to focus on what is commonly called "INBOUND" taxation, or more specifically stated, the U.S. taxation of foreign persons with U.S. income or activities.
As we all know, the United States taxes U.S. persons on worldwide income. At this point in time, Congress has not yet found an acceptable way to tax all non-U.S. persons on their worldwide income; however, there are two basic tax schemes to tax the income of foreign persons. First, a 30% withholding tax is imposed on gross amount of certain U.S. source income (this generally applies to passive types of income earned by non-U.S. persons outside the United States). Second, the regular U.S. graduated tax rates are applied to net income of non-U.S. persons actually doing business in the United States.
Definitions
The Internal Revenue Code of 1986, as amended (“Code”) provides key definitions in §7701. Please make sure you take some time to actually read the definitions of the words listed below:

·        person - §7701(a)(1): Individual, corporation, partnership, trust, estate
·        partnership and partner - §7701(a)(2);
·        corporation - §7701(a)(3);
·        domestic - §7701(a)(4): Company organized in the U.S.
·        foreign - §7701(a)(5): Company that is not domestic
·        United States - - §7701(a)(9);
·        International Organization - §7701(a)(18): Public international organization
·        United States Person - §7701(a)(30): Citizen or resident, domestic corporation, domestic partnership, trust, estate
·        Foreign Estate or Trust - §7701(a)(31);
·        Persons Residing Outside the United States - §7701(a)(39): Citizen or resident of the US not residing in any US judicial district treated as residing in the DC court jurisdiction.
·        Resident Alien - §7701(b)(1)(A): Lawfully admitted to the US, or meets substantial presence test, or makes an election to be treated as…
·        Nonresident Alien - §7701(b)(1)(B): Neither citizen nor resident of US
These definitions are used to determine who is the taxpayer. The operative provisions of the Code determine how income is taxed to foreign persons. Section 871(a) applies to individuals and Section 881(a) applies to corporations to impose a tax of 30% (reduced by treaty) on gross income from U.S. sources that are fixed or determinable, annual or periodic (“FDAP”) income. Section 871(b) and §882 provide that income which is effectively connected with the conduct of a U.S. trade or business is taxed on a net basis at the regular tax rates under §1 for individuals and §11 for corporations. (The capital gain, alternative minimum tax and other special provisions also apply.) We will spend the next 14 weeks digging into the details of these provisions and the other Code sections that help implement the tax regimes.
Definition of Resident Alien
Section 7701(b) establishes the test to determine if an individual is a resident alien or a nonresident alien. There are two separate tests:
1.    the lawful permanent residence test, also know as the “green card” test;and
2.    the substantial presence test.
If the foreign national meets either of these tests, they will be considered a resident alien, and taxed on their worldwide income during the residency period. These tests are important for inbound taxation, since a foreign individual is not treated as a foreign person unless they fail these two tests.
Lawful permanent residence test. As described in §7701(b)(6) a lawful permanent resident is based on the immigration status of the individual. A lawful permanent resident has been issued a green card (they are not actually green anymore, but PINK of all colors!).  Nonimmigrant visas are regularly issued to nonresidents who desire to work in the U.S. These visas begin with letters (from the immigration law paragraphs) and include L for intracompany transferee, H for business transfer, E for treaty trader, etc.
Substantial-presence test. As described in §7701(b)(3), the substantial-presence test is a mathematical test, where the number of days that are cranked through the formula equal or exceed 183-days physically present in the United States. The formula looks to a three-year calendar period that weights the current year more than the previous years. Thus, the formula weights the days in the current year at 100%, the days in the previous year at 1/3rd , and the days in the second preceding year at 1/6th. Examples of the computation are in the book;however, if an individual is never in the United States more than 120 days in each year, mathematically they will never meet the substantial-presence test. Therefore, in advising clients, the safest path is for them to avoid ever being present past the 120 days in each year.

Module 2
In order to read, you must know the alphabet. In order to understand international taxation, you must be proficient in the source of income rules. The source of income rules are applicable to both inbound and outbound taxation.
Statutory Bases
·        Section 861 – Income form sources within the United States
·        Section 862 – Income from sources without the United States
·        Section 863 – Special rules for determining source
·        Section 865 – Source rules for personal property sales
Importance of Rules
·        Foreign tax credit limitations (Sec. 904)
·        Expatriate foreign earned income exclusion and housing cost amount (Sec. 911)
·        U.S. tax liability for nonresident aliens and foreign corporations (Sec. 871, 872, 881, 882 and Sec. 887)
·        Withholding on income items of foreign persons (Sec. 1441, 1442, 1446)
·        Possession rules (Sec. 931 – 936)
·        Foreign Sales Corporation (FSC) and Domestic International Sales Corporation (DISC) income (Sec. 921 – 927 and Sec. 991 – 997)
·        Dividend received deduction (Sec. 245)
INTEREST INCOME – Sec. 861(a)(1)
The general rule is that interest is sourced according to the residence of noncorporate payers and the place of incorporation for corporate payers.
The major exception is known as the 80% active foreign business test. Interest payments from domestic corporations and resident alien individuals are treated as foreign source when at least 80% of the domestic corporation or resident alien individual’s gross income over a three year testing period is active foreign business income. Domestic corporations that qualify for this treatment are generally referred to as 80-20 corporations (“eighty twenty corporations”). Thus, if the resident alien or domestic corporation meeting the 80% active foreign business test were to pay interest to another person, it is all considered foreign source income unless the person receiving the interest is related. Payments received by a related person are sourced on a pro rata basis according to the source of the payer’s total gross income for the testing period.
A special sourcing rule works to pro rate interest payments from an U.S. owned foreign corporation when the interest is paid to a 10% U.S. shareholder. The pro ration is based on the portion of the foreign corporation’s gross income during the current year that is from U.S. sources. However, this rule would not apply and all the interest will be treated as foreign source if the U.S. source income of the U.S. owned foreign corporation is less than 10% of current earnings and profits.
However, there are exceptions to the U.S. source income rules.  "Portfolio interest" is one of those exceptions. Also, if a foreign corporation is engaged in a trade or business within the U.S. or has U.S. effectively connected trade or business income, interest paid by the foreign corporation's U.S. trade or business will be treated the same as that paid by a domestic corporation.   
DIVIDEND INCOME
Dividend income is sourced according the incorporation site of the paying company. Thus, dividends paid by a domestic corporation are considered U.S. source income and dividends paid by a foreign corporation
are considered foreign source income.
There are exceptions for dividends paid by special types of corporations such as possession corporations and DISCs. In addition, a look-through rule applies to treat a portion of a dividend as U.S. source if it is received from a Controlled Foreign Corporation (CFC), or a foreign personal holding company (FPHC). A special rule also applies to treat dividend income of a foreign corporation as U.S. source if the corporation has earnings and profits accumulated when it was a domestic corporation before a Type F outbound reorganization.
Similar to the interest income sourcing rule for 80-20 domestic companies, the dividend rule to resource foreign dividends into U.S. source dividends applies when a foreign corporation has at least 25% of it’s gross income from the previous three year testing period effectively connected with a U.S. trade or business. Similar to the interest rule, the proration is based on the effectively connected gross income to the total gross income over the three year testing period.
In addition, a special sourcing rule works to pro-rate dividend payments from a U.S. owned foreign corporation when the dividend is paid to a 10% U.S. shareholder. The pro-ration is based on the portion of the foreign corporation’s U.S. source earnings and profits during the current year that is from U.S. sources. However, this rule would not apply and the full dividend will be treated as foreign source, if the U.S. source earnings and profits of the U.S. owned foreign corporation is less than 10% of current earnings and profits.
PERSONAL SERVICE INCOME
Income from providing services is sourced to where the services are performed. None of the other special classifications (nationality, citizenship, residency, employee vs. independent contractor status, form, time or place of payment) are relevant in determined the source for personal service income.
Corporations can also have personal service income for services rendered by its employees and agents. The general sourcing rule still applies to look to where the services by the employee or agent were actually performed.
Retirement income and other types of deferred compensation are usually sourced to where the employee performed the services that gave rise to the employee or employer’s contributions. Income from covenants not to compete are sourced to where the services cannot be performed under the contract.
A special de minimis rule applies to treat U.S. source income as foreign source for nonresident aliens working in the U.S. for a short period. This rule applies to most business travelers into the United States for meetings and other activities. In order to qualify, the nonresident must: (1) be present no more than 90 days during the tax year, (2) the employer must be foreign (either a foreign person or entity not engaged in a U.S. business, or a foreign fixed place of business of a U.S. person), and (3) the compensation must not exceed $3,000.
RENTAL INCOME
Rental income is sourced to the location of the property. Thus, if the property is located in the U.S., it is U.S. source income and conversely, if it is located outside the U.S. it is foreign source. If the property is located both in the U.S. and outside, then a reasonable allocation must be made.
ROYALTY INCOME
Royalty income is sourced to the place where the intangible property is used. Thus, if the intangible property is used in the U.S., it is U.S. source income and conversely, if it is used outside the U.S. it is foreign source. If the property is used both in the U.S. and outside, then a reasonable allocation must be made. Gains from the sale of the intangible property are also sourced as royalties if the sale price is contingent on the productivity, use, or disposition of the property.
REAL ESTATE
Gains, profits, and income form the disposition of real estate is sourced to where the property is located.

Module 3
SALE OF PERSONAL PROPERTY
 
Back in the old days (pre-1986 Tax Act) personal property was sourced to where the sale takes place. Now, the sale of personal property has a miriyad of rules, most of which are exceptions to the general rule. The general rule contained in Section 865(a) provides that income from the sale of personal property by a U.S. resident shall be sourced in the United States, or income from the sale of personal property by a nonresident shall be sourced outside the United States. Stated another way, income is sourced to the country of residence.
Exceptions in Section 865 to the General Rule:
    * Inventory property
    * Depreciable personal property
    * Intangible property
    * Shares of foreign affiliated corporations
    * Sales through an office in another country
    * Tax treaty override provisions
    * Liquidation of possessions corporations
In addition to the Section 865 exceptions, there are other provisions in the Code which determine sourcing for specific transactions:
    * U.S. real property interest under Section 897 (FIRPTA)
    * Foreign currency transactions under Section 988
    * Railroad rolling stock in Section 861(e)
    * Farm and natural resource products in Section 863(a)
    * Section 1248 income on sale of shares in a CFC
    * Income from a person who expatriates from the U.S. under Section 877
 
RESIDENCY DEFINITION
For sourcing personal property sales income as specifically defined in Section 865, we don’t use the residency rules of Section 7701, but the special rules contained in Section 865(g). These rules revert to concept of tax home as used in Section 911(d)(3) which defines tax home for purposes of the expatriate tax benefits under Section 911. The chain continues, and Section 911 links up to the definition of home for purposes of travel expenses as ordinary and necessary under Section 162(a)(2).
Thus, U.S. residents are (1) citizens or resident aliens without tax homes in foreign countries, and (2) citizens or resident aliens with tax homes in foreign countries but don’t pay at least a 10% tax on the gain, and (3) nonresidents with tax homes in the United States.
Corporations are a bit less complicated. It follows the definition in Section 7701(a)(30) for a United States person, which we covered in Module 1.
As is usually the case with partnerships, the entity or aggregate theory complicates the application of the tax law. Section 865(i)(5) indicates that the sourcing rules apply at the partner level except as provided in regulations. (See Temp. Reg. Sec. 1.865-1T(a)(5)).
INVENTORY PROPERTY
Inventory property is the most common exception to the general rule, and a throwback to the pre-1986 Tax Act rules. Generally the profit from the sale of inventory is source to the place where the title to the goods pass from the seller to the buyer – the title passage rule.
The benefits and burdens of ownership and the risk of loss usually are transferred when title passes, and the contract generally specifies when title passes. Thus, the contract determines where title passes. If the contract is silent, shipping terms have been used to establish a presumption of intent as to where the title passes. The International Chamber of Commerce has established “Incoterms 1990 “ which are a standard 3 letter set of terms that have standard meaning in international trade. A set of the Incoterms, known as the “D” terms (such as DDU - delivered duty unpaid) provide the seller has to bear all costs and risks needed to bring the goods to the country of destination, and as such, these terms usually provide for foreign source income since title passes outside the U.S.
DEPRECIABLE PROPERTY
The portion of the gain equal to past deductions for depreciation or amortization is sourced to where the deductions were allocated. Thus if depreciation deductions were for foreign property and allocated to foreign source income, then the gain on the sale of the depreciable property is foreign source up to the amount of the depreciation.
Amounts of gain in excess of the depreciation or amortization are sources as inventory property. Thus, under the title passage rule.
STOCK OF A FOREIGN AFFILIATE
Based on the general rule, if a U.S. corporation sells shares of a foreign subsidiary, the gain is U.S. source. However, if the foreign subsidiary is at least 80% owned, and the stock is sold in a foreign country where the subsidiary meets the active business test, the gain on sale will be foreign source income. The gross income test is satisfied if the foreign corporation has been actively engaged in a business and has derived more than 50% of its gross income from the prior three years from this active business.
INTANGIBLE PROPERTY
Gain on the sale of intangible assets, such as a patent, copyright, secret process or formula, goodwill, trademark, trade brand, franchise or other like property are sourced by the exception contained in Section 865(d).
First, any gain up to the amount of depreciation or amortization adjustments of the intangible property is allocated based on the depreciable property rules -- based on where the deduction was allocated. Second, the excess gain is allocated based on whether the proceeds are contingent on productivity, use, or disposition of the intangible asset. If the sales proceeds are not contingent, then the general rule of Section 865(a) applies, and the residency of the seller determines the sourcing of the income. If the sales proceeds are contingent, then the royalty source rules are used, to source the gain to the country where the intangible property is used.
A special provision applies to Goodwill. If the sales proceeds are contingent, then the royalty source rules are used to source the gain to the country where the intangible property is used. However, if the payments are not contingent the gain is sourced in the county in which the goodwill was generated (and not the seller’s country of residence).
Section 865(h) provides a special rule which allows a treaty provision to override the source rule for the sale of intangible property. This is usually favorable, since it transforms U.S. source income to foreign source income is specifically covered in the tax treaty. The downside is that for foreign tax credit purposes, this income goes in its own “basket” so it has its own foreign tax credit limitation calculation.
SALE THROUGH AN OFFICE IN ANOTHER COUNTRY
Another exception to the general rule is contained in Section 865(e).
U.S. residents with foreign offices will have foreign source income in limited circumstances if they have a foreign office or fixed place of business. This exception applies only when the general rule applies to sale, or when there is gain from the sale of intangible property (except goodwill) that is not a contingent on productivity, use, or disposition. In order to qualify, a U.S. resident must have fixed place of business outside the U.S., and the sale must be attributed to that fixed place of business. In addition, the income must be subject to at least a 10% tax in a foreign country (not necessarily the country where the fixed place of business is located).
A similar override rule applies to nonresidents that have a fixed office in the United States. If the sale of personal property is attributable to an office or fixed place of business in the U.S. then the income will be treated as U.S. source. This applies to all type of income covered in Section 865 including inventory sales, depreciable property, and intangible property (including goodwill). An exception to the exception applies if the sales are outside the U.S. and a foreign office materially participates.
TRANSPORATION INCOME
Section 863(c) provides that transportation income which begins and ends in the U.S. is considered U.S. source income. However, if it only begins or ends in the U.S., then 50% of the income is considered U.S. source and 50% is considered foreign source.
SPACE AND OCEAN ACTIVITIES
Section 863(d) provides that space or ocean activity conducted by a U.S. person is U.S. source income. If the activity is conducted by a nonresident it is considered foreign source income.
INTERNATIONAL COMMUNICATIONS INCOME
Section 863(e) provides that international communications income earned by a U.S. person is 50% from U.S. sources and 50% from foreign sources. If the income is earned by a nonresident it is considered foreign source income.
INSURANCE INCOME
Underwriting income from insurance is sourced based on the geographic location of where the risks are insured.
SOCIAL SECURITY BENEFITS
Of course, the U.S. would not give up the right to tax anyone of the social security benefits it pays out. To ensure taxation, Section 861(a)(8) specifically provides that these benefits are U.S. source income.
FOREIGN CURRENCY TRANSACTIONS
If Section 988 applies to a foreign currency transaction, the source rule in Section 988(a)(3) will override the Section 865 provision. If Section 988 does not apply to the foreign currency transaction, the general rule of Section 865(a) will apply – the residency of the taxpayer.
 
According to Reg.Sec.1.861-18(b)(1), the four IRS classifications of transactions involving computer programs are:

1. a transfer of a copyright right in the computer program;
2. a transfer of a copy of the computer program (a copyright article);
3. the provision of services for the development or modification of the computer program; or
4. the provision of know-how relating to computer programming techniques.

In this case, I think this transaction would fall under either 1 or 2 above. In other words, we should determine if this transaction is a transfer of a copyright rights or a transfer of a copyrighted article or both. If it involves both, we should treat them as separate transactions.

Reg.Sec.861-18(c)(2) provides that a transfer of copyright rights will occur if the transferee obtains any of the following:

1. The right to make copies of the computer program to distribute to the public, for sale, or other transfer of ownership, or by rental, lease or lending;
2. The right to prepare derivative computer programs based upon the copyrighted program;
3. The right to make a public performance of the program; or
4. The right to publicly display the program.

If it is a transfer of copyright rights, the next question is to determine if it is a sale which will generate gain or loss and sourced by the residence of the taxpayer; or a license which will generate royalty income and sourced by the place where the rights are used.

If none of the above mentioned rights are obtained and the transferee acquires only a copy of the computer program, the transaction should be treated as a transfer of a copyright article. We will also need to determine if there has been a sale or lease of the copyrighted article.
Respond  


       Travis Wise 23 Jan 06    5:22 PM MST
To add to Ran’s explanation of the -16 rules, under Reg. Sec. 1.861-18(f)(1), when a transfer is classified as a transfer of a copyright right, the transaction is further classified as either a sale or a license of such right.

The transaction will be treated as a sale if there has been a transfer of "all substantial rights" in the copyright (based on the facts and circumstances of the transaction). If not all substantial rights in the copyright have been transferred, the transaction will be classified as a license. This distinction would be important for sourcing rules as well as determining Subpart F income (sale vs. royalty income).

For a sale, the income would be sourced as inventory property according to where title to the CD passes (i.e. ex works factory). For a license, the income would be sourced according to where the IP is used (Sections 861(a)(4) and 862(a)(4)).

If a computer program is transferred, but none of the rights Ran listed above are acquired, then the transfer of the computer program should be treated as a transfer of a copyrighted article under section 1.861-18(c)(1)(ii). When a transfer is classified as a transfer of a copyrighted article, under section 1.861-18(f)(2), the transaction is further classified as either a sale or a lease of the article. A transaction is a sale if the benefits and burdens of ownership have been transferred (again, based on all the facts and circumstances). If not all of the benefits and burdens of ownership have been transferred, the transaction is classified as a lease. Again, this distinction would be important for sourcing rules (sale vs. rental income, sourced at location where property is used under sections 861(a)(4) and 862(a)(4)) and Subpart F income purposes.

From a practice standpoint, it is important to be aware that neither the form adopted by the parties (i.e. in intercompany or third party sale agreements) nor the classification under copyright law (typically as a "license") is controlling for tax purposes (Reg. Sec. 1.861-18(g)(1)).

Therefore, for example, a transaction that is characterized by the parties as a “license” for copyright law purposes could be treated as a sale of a copyrighted article for tax purposes if the facts and circumstances indicate that there has been a transfer of a computer program for a one-time payment with restrictions on further trnasfer, reverse engineering, etc. This is the typical case of an individual purchasing software at the local electronics store, and contemplated in Reg. Sec. 1.861-18(h), Example 1.

(a)                       a citizen & resident of Malaysia holds CDs issued by a US Bank

This interest is sourced to the US according to Section 861(a)(1). There is no exception on source rule for this one.

However, Section 871(h)(1) states that in the case of any portfolio interest received by a nonresident individual from sources within the United States, no tax shall be imposed under Section 871(a)(1)(A). The interest in our question is qualified for portfolio interest defined in Section 871(h)(2)(B).

Therefore, there is no US tax consequence for this Malaysian citizen/resident on his interest on the CDs issued by a US bank.
 
(b). a NY branch of a swiss bank makes a loan to a Del Corp for use in its US business.

The general rules of Sec.861(a)(1) and 862(a)(1) source interest income by the debtor's residence (for an individual) or the debtor's place of incorporation (for a corporation). The following factors should NOT affect the source of the interest income:
1. purpose for which the debt is incurred;
2. nature or location of any assets securing the debt;
3. location of the interest-bearing obligations or funds used to pay the interest;
4. method and place of interest payment.

In this case, the debtor is the Del Corp, a U.S. corporation. As such, the source of the interest income should be U.S. source.

However, if at least of 80 percent of the Del Corp's gross income for a three-year period is active foreign business income, the interest will be treated as foreign source income under Sec. 861(a)(1)(A) and 861(c).
I believe that since the interest income is attributable to a p.e in the US, the entire amount of the interest will bind the swiss corp to the US taxation. Unless the 80/20 test applies, the interest paid to the swiss bank by del corp will be treated as US sourced.
(c). A swiss bank makes a loan to a swiss branch of a Del Corp.

I will just borrow the general rule from Ran

The general rules of Sec.861(a)(1) and 862(a)(1) source interest income by the debtor's residence (for an individual) or the debtor's place of incorporation (for a corporation). The following factors should NOT affect the source of the interest income:
1. purpose for which the debt is incurred;
2. nature or location of any assets securing the debt;
3. location of the interest-bearing obligations or funds used to pay the interest;
4. method and place of interest payment.

However, 861(c) provides a special rule that treats interest as foreign-source income if paid by a resident alien individual or a domestic corp that meets the 80% active foriegn business income test. Therefore, if Del meets the requirement, interest it pays to the swiss bank will be treated as foreign sourced and will not be subject to US taxation.
(d) US citizens deposit funds to a swiss bank to earn interest on such funds. 862(a)(1) throws you back to being other than 861(a)(1) effectively a negative definition of interest NOT from US. This applies regardless of residency of US citizen since it is defined by payor.
 
(e) This is one of the exceptions of the general rules for interest. IRC 861(a)(1(B) treats interest on deposits in foreign branches of U.S. banks as foreign-source income.
 
According to Rev. Rul. 60-226, the consideration received by a proprietor of a copyright for a grant transferring the exclusive right to exploit the copyrighted work in a medium of publication throughout the life of the copyright shall be treated as proceeds from a sale of property, regardless of whether the consideration received is measured by a percentage of the receipts from the sale, performance, exhibition, or publication of the copyrighted work, or is measured by the number of copies sold, performances given, or exhibitions made of the copyrighted work, or whether such receipts are payable periodically over a period generally coterminous with the grantee's use of the copyrighted work.

The key point here is whether the intellectual property is transferred for its remaining life (sale) or for a period less than its remaining life (license). The question indicates the copyright is transferred for its remaining life (entire interest). Therefore, it should be treated as a sale of personal property.

However, even if a transaction is treated as a sale, when the transaction involves an intangible, Section 865(d)(1)(B) applies the royalty source rule to payments that are contingent on the productivity, use, or disposition of the intangible.

The general source rule in Section 865(a) applies to the noncontingent payments for the sale of the intangible (other than goodwill). The result is that the noncontingent payments are treated as having a source at the seller's residence.
In this case, O'Malley is a foreign person as O'Malley is a citizen and resident of Ireland. A foreign person is normally subject to two different U.S. taxing regimes: one applies to income effectively connected to U.S. trade and business ("ECI") under Sec. 864(c) and the other applies to nonbusiness income from U.S. sources. ECI is taxed at the usual U.S. rates and nonbusiness U.S. source income is generally subject to a tax of 30 percent under Sec. 1441(a) or at a treaty rate. Sec.871(a) for individuals and Sec.881(a) for corporations.

Based on the facts provided, it is more likely than not that the income should be nonbusiness income. As such, we would need to determine the classification of the income and then the source of the income.

Under scenario 1, the contract between O'Malley and an U.S. publisher grants the publisher an exclusive license to publish the stories. The income derived from this transaction should be treated as proceeds from the sale of property according to Rev.Rul 54-409. In general, the source of gain on sale of intangible property is determined by the residence of the taxpayer if there is a fixed price. To the extent that payments are contingent on the use of the intangible property, the source of income should be determined by the source rules for royalty income. Sec.865(d)(1). O'Malley is paid a royalty for each book sold instead of a fixed price. As such, the income received by O'Malley should be sourced as royalty income, i.e. to the place where the property is used. Sec. 861(a)(4) and 862(a)(4). As the books are sold throughout the world, the income should be allocated within and without the U.S. The U.S. source nonbusiness income should normally be subject to a withholding tax of 30 percent. However, under the treaty between U.S. and Ireland, there is no withholding on royalty income.

Under scenario 2, I think there should be no US tax consequences for O'Malley. I think we should perform the income sourcing analysis based on the activities of the English publisher. The income from books sold to U.S. should be nonbusiness U.S. source income and subject to withholding tax under Sec 1442(a).

Under scenario 3, the analysis should be similar to those under scenario 1 except the sourcing rule for the $100,000 fixed payment. The $100,000 should be sourced to the resident of O'Malley, which is Ireland, a foreign source. The rest should be sourced based on the sourcing rules for royalty income.
I also wanted to summarize things for my own reference. The sourcing test for intangibles, then, is

1. determine if there the arrangment is a SALE of the right
2. if there is a SALE, source non-contingent amounts as sale of property (subject to the depreciable personal property sourcing rules if the intangible was amortizable) in accordance with residency of seller
3. consider whether there are contingent payments which would be treated as royalties for sourcing rules by sec 865; to the extent that it relates to use in US, it would be US source royalties.
4. if so, then look to treaty to determine if there is relief for any withholding tax on royalties.
 

Module 4
 
ALLOCATION OF DEDUCTIONS
The source rules concentrate on allocating gross income; however, the ultimate goal is to compute a tax liability, which is based on taxable income not gross income. Thus, we must determine the amount of expenses and deductions to allocate to the class of gross income. The allocation of deductions is necessary for many purposes such as: (a) determining foreign tax credits, Subpart F inclusions, and computing foreign sales corporation benefits, for domestic taxpayers, and (b) determining effectively connected income for foreign taxpayers.
Sections 873(a), 874(a) and 882(c) provide the statutory authority to reduce gross income by the amount of deductions to the extent that they are connected with income which is effectively connected with the conduct of a trade or business within the U.S. The regulations provide almost all of the guidance for the allocation and apportionment of expenses for foreign taxpayers. They are found beginning with Section 1.861-8 (and thereafter). However, Section 864(e) and Section 864(f) provide the statutory authority for special rules for interest expense and research and experimental expenditures.
The process of determining which deductions relate to income is much simpler than explained in the regulations. The regulations set up an elaborate hierarchy, which calls for a two step formula to -- allocate deductions to one or more classes of gross income then, apportion the deductions within each class of gross income between the statutory grouping and the residual grouping. Stated in plain English, we need to specifically assign deductions to the type of income to which they directly relate, and everything else needs to be assigned based on a reasonable formula. For instance, depreciation deductions from rented equipment should be allocated to the rental income.
Regulation Section 1.861-8(a)(3) lists the following classes of gross income:
·        Compensation for services
·        Business income
·        Gains for disposition of property
·        Interest
·        Rents
·        Royalties
·        Dividends
·        Alimony
·        Annuities
·        Income for life insurance
·        Pensions
·        Income from discharge of indebtedness
·        Partnership income
·        Income in respect of a decedent
·        Income from an interest in an estate or a trust
Deductions are allocated to one of the classes of income listed above. If the deduction is incurred as a result of, or incident to, an activity, or in connection with property from which a class of gross income is derived, then it is treated as directly allocated to that class of gross income.
Deductions that are not definitely related are then apportioned among the classes of income based on other reasonable methods. The regulations provide special rules for the following types of deductions:
·        Interest expense
·        Research and experimental expenditures
·        Income taxes
·        Net operating losses
·        Losses on sale of property
·        Tax-exempt income
·        Certain ancillary expenses
Other types of deductions can be apportioned based on a number of methods, which include but are not limited to:
·        Units sold
·        Gross sales
·        Cost of goods sold
·        Gross margin
·        Expenses directly attributable to earnings of gross income
·        Assets attributable to earnings
·        Administrative costs directly attributable to earnings
·        Gross income
INTEREST EXPENSE
Section 864(e) codifies the concept that money is fungible and interest expense is properly attributable to all business activities and property of the taxpayer regardless of any specific purpose for incurring the debt. Thus, interest expense is not usually traceable to specific uses of the funds for allocation purposes. For domestic taxpayers, the interest expense allocation rules are found in Reg. Sec. 1.861-8(e)(2) and Temp. Reg. Sec. 1.861-8T(e)(2), which refer to Temp. Reg. Sections 1.861-9T through 13T.
A foreign corporation must follow the rules provided in Reg. Section 1.882-5 to calculate its interest expense that is allocable to its effectively connected income based on a ratio of the foreign corporation’s worldwide debt for the year to its average total value assets. A three-step process is used:
1.      U.S. assets are identified
2.      The ratio of the corporations worldwide liabilities to worldwide assets is multiplied by the U.S. assets identified in the first set, to determine the amount of liabilities that are deemed associated with the U.S. business. A fixed ratio of 50% may be elected (95% for a banking or finance entity) instead of using the actual ratio.
3.      The deductible interest expense is determined by applying an interest rate to the amount of liabilities determined in the second step above. The interest rate is determined under one of two methods, a book/dollar pool method or a separate currency pools method.
RESEARCH AND EXPERIMENTAL EXPENSES
Section 864(f) provides that R&D must be allocated based on the following order: (1) to foreign sources if the expenditures are to comply with the legal rules relating to marketing or improving processes or products that generate gross income in that jurisdiction; (2) then to expenditures actually incurred outside the U.S., 50% must be allocated to foreign sources; (3) then to expenditures actually incurred within the U.S. 50% must be allocated to U.S. sources; (4) finally, the overall apportionment rule is used to allocate the remaining R&D based on either gross income or gross sales. If the gross income method is elected, the amount apportioned to foreign sources may not be less than 30% of the amount that would have been apportioned under the gross sales method.
Stewardship Expenses -- These are cost incurred by a company for its own benefit, or in relation to its equity or investments. A stewardship expense is deemed to be incurred as a result of, or incident to, the ownership of the related corporation and as such, are considered definitely related to dividend income from that corporation.
Legal and Accounting -- The allocation depends on the nature of the services rendered, and can then be apportioned based on the normal rules of apportionment.
Income Taxes -- Generally, income taxes are allocated to the classes of gross income on which the taxes are imposed.
Losses on the Sale of Disposition of Property -- Allocated to class of income to which the asset or property normally generates income.
Net Operating Losses -- A NOL is definitely related and allocable to the class of gross income to which the activity or property that generated the NOL gave rise.
Charitable Contributions -- If for foreign purposes, then foreign source. Otherwise charitable contributions are treated as not definitely related to any gross income, and therefore ratably apportioned.

Module 5
 
A. NRA's and foreign corporations (FC) are subject to 30% tax on several types of nonbusiness income. IRC 871(a)(1), IRC 881(a)

1. No deduction allowed in computing income subject to tax.
2. Often called the "withholding" tax because payors are required to withhold the tax from the income paid to the foreign person.

B. Income subject to withholding tax includes interest, dividends, rents, and any other fixed or determinable annual or periodic (FDAP) income.

C. Income is taxed only if:

1. It is received,

a) Generally, this rule puts the taxpayer/payee on the cash basis regardless of their regular method of accounting.
b) Exceptions for: (1) Income imputed under IRC 482 is subject to withholding tax. Central de Gas de Chihuahua, SA, 102 TC 515 (2) Income imputed under IRC 7872 is subject to withholding tax. Climaco, 96-1 USTC par. 50,153 (EDNY-1996)

2. Included in gross income,
a) Tax exempt interest and other amounts excluded from gross income by the IRC are not subject to withholding tax.

3. US sourced, and
4. Not ECI.
a) ECI is taxed under IRC 871(b) and IRC 882(a).

D. Payors of these types of nonbusiness income are required to withhold tax. IRC 1441-1443
1. This applies even to payments made to foreign partnerships.

E. Domestic partnerships with foreign partners are not subject to the withholding tax, but the foreign partners are on their distributive share of the income.

II. Interest

A. Generally

1. Interest is defined broadly to include OID and unstated interest. a) If a foreign person transfers securities in a "sales-repurchase" the income received from the obtained securities has the same character for withholding tax purposes as if the income came from the original securities. Reg. 1.871-7(b)(2), Reg. 1.881-2(b)(2), Reg. 1.894-1(c), Reg. 1.1441-2(b)(4)
2. Portfolio interest rules exclude most interest from withholding tax.

B. OID and Unstated Interest

1. OID and unstated interest under IRC 483 is taxed as interest.
a) Normal forced accrual rules do not apply under IRC 871(a)(1) or IRC 8819a), OID is included in income when amounts are paid. IRC 871(a)(1)(C), IRC 881(a)(3) (1) Payments are allocated first to accrued OID before principal. (2) If obligation is sold, all accrued OID is taxed.
b) OID on tax exempt bonds is withholding tax exempt. IRC 871(g)(1)(B)(ii)
c) Normal exemption from OID on obligations of less than one year does not apply to these rules. (1) Time limit to avoid these rules is payment in less than 184 days. IRC 871(g)(1)(B)(i), IRC 1272(a)(2)(C), RP 98-7 2. The rules for strip bonds apply in determining OID under IRC 871(a)(1) and IRC 881(a). IRC 871(g)(4)

C. Portfolio Interest

1. Generally a) Interest, including OID and unstated interest, is exempt from withholding tax if it is "portfolio" interest. IRC 871(h) b) The definition of portfolio interest includes most debt instruments except for: (1) Debt from related parties, and (2) Financial institutions. c) Exemption was created to aid US companies and the federal government to raise capital from foreign investors.

2. Registration; Notice to Withholding Agent a) If the debt is in registered form, the exemption is allowed only if a statement is given that the owner is a foreign person. IRC 871(h)(2)(B) (1) Statement is given to the payor of the interest. IRC 871(h)(5), Reg. 1.871-14(c)(1)(ii)(C) (2) Statement is invalid if the payor knows that the payee is a US person

3. Unregistered Instruments a) If the debt is unregistered, the exemption is allowed only if it is issued under guidelines which insure it is owned by foreign persons. IRC 163(f)(2)(B), IRC 871(h)(2)(A), IRC 881(c)(2)(A), Reg. 1.163-12(c), Reg. 1.871-14(b)

4. Banks a) Interest received by a foreign bank is not allowed the exemption if the loan is made in the banks ordinary course of business. IRC 881(c)(3)(A) b) Exemption is allowed on loans to the US government. IRC 881(c)(3)(A)

5. Interest Received by 10% Shareholders and Partners a) The exemption is not allowed for interest paid to 10% shareholders or partners. IRC 871(h)(3)(A), IRC 871(h)(3)(B), IRC 881(c)(3)(B) b) Applies to direct loans and loans made through an intermediary. 1984 Bluebook, supra note 22, at 395 c) Broad attribution rules exist for determining level of ownership. IRC 871(h)(3)(C) (1) Use rules under IRC 318(a) with following exceptions: (a) Shareholder is deemed to own the ratable portion of any stock owned by a corporation without the 50% ownership threshold. IRC 871(h)(3)(C)(i) (b) A corporation is deemed to own the ratable portion of the stock owned by its shareholders without the 50% ownership threshold. IRC 871(h)(3)(C)(ii) (c) A foreign person is considered to own any stock he holds an option on. IRC 871(h)(3)(C)(iii) (i) This stock can't be attributed under the entity to owner or owner to entity rules. d) Treasury has authority to apply ITC 318(a) concepts to partnership interest attribution.

6. CFC Exception a) Interest received by a CFC from a related person is not allowed the exception. IRC 881(c)(3)(C)

7. Residents of Countries Refusing to Supply Tax Information a) Residents of countries that refuse to supply tax information are not allowed the exemption. IRC 871(h)(6)(A), IRC 881(c)(6)

8. Contingent Interest
a) Contingent interest is not allowed the exemption. IRC 871(h)(4), IRC 881(c)(4) (1) Exception for debt instruments issued before 4-8-93.
b) Contingent interest is interest payable by reference to: IRC 871(h)(4)(A)(i) (1) Receipts, sales, profits, income, or cash flow of the debtor or a related person, (2) A change in value of property owned by the debtor or a related person, or (a) Does not include changes in "actively traded property". IRC 871(h)(4)(C)(v)(II) (3) Dividends, partnership distributions, or similar payments made by the debtor or a related person. c) A related person is the same as for IRC 267(b) and IRC 707(b)(1) with the following modification: (1) Related person includes someone who is party to an arrange to avoid the contingent interest rules. IRC 871(h)(4)(B),
d) If an instrument has both contingent and non-contingent portions, the non-contingent portions are eligible for the exemption. HR Rep. No. 213, 103rd Congress, 1st Session, 652
e) These rules do not effect treaty provisions regarding non-EC interest income. HR Rep. No. 213, 103rd Congress, 1st Session, 653
f) The contingency rule does not apply if: IRC 871(h)(4)(C)
(1) The timing of an interest payment is contingent.
(2) The debt is non-recourse.
(3) The debt is subject to a hedging transaction to reduce risk.

D. Interest on Deposits

1. Interest on deposits in financial institutions is exempt from withholding tax. IRC 871(i)(2)(A), IRC 881(d)
a) There is no related party exception to this rule.

E. Treaty Modifications
1. Most treaties either exempt of reduce the withholding tax rate on interest paid to residents of the treaty country.
2. The exemption or reduction does not apply if the interest is attributable to a PE.

III. Dividends

A. Dividends Defined

1. Dividends only includes distributions from corporate E&P. IRC 316(a)
2. If a foreign person transfers stock in a "sales-repurchase" the income received from the obtained securities has the same character for withholding tax purposes as if the income came from the original securities. Reg. 1.871-7(b)(2), Reg. 1.881-2(b)(2), Reg. 1.894-1(c), Reg. 1.1441-2(b)(4) a) This rule could lead to double tax on foreign to foreign repo's. Special rule allows a credit in withholding tax in the amount of the lesser tax imposed. Notice 97-66

B. Domestic Corporations

1. No withholding tax imposed on dividends from a domestic corporation if. IRC 861(c)(1), IRC 871(i)(2)(B), IRC 881(d)
a) 80% or more of the corporation's gross income is from foreign sources from an activity business and over the shorter of: IRC 861(c)(1)(C) (1) The three years preceding the year of distribution or (2) Since the corporation was organized.
b) The amount of the exemption is the total dividend multiplied by the foreign gross income to total income ratio. IRC 861(c)(2)(A)
c) To determine the sourcing of dividends form subsidiaries of the corporation, a pass-through principal is used. HR Rep. No. 841, 99th Congress, 2nd Session II-603 (1) This rule only applies to dividends from 50% or greater owned subsidiaries.
C. Foreign Corporations

1. Any portion of a dividend from a foreign corporation which is US sourced under the 75/25 rule is subject to the withholding tax. IRC 861(a)(2)(B)
2. Branch profits tax (BPT) is used to tax repatriation of earnings from a US branch of a foreign corporation. IRC 884(a) a) Dividends from a foreign corporation subject to BPT are exempt from withholding tax. IRC 884(e)(3)(A)

D. Treaty Modifications

1. Tax treaties usually reduce the withholding tax on dividends to 15%. a) 5% if the receiver owns at least 10% of the payor's stock.
2. IRC provides for these restrictions to treaty benefits on dividends: a) No claim for reduced withholding tax may be made under any treaty other than a tax treaty. IRC 884(e)(3)(B), IRC 883(f)(3)(A) b) No benefits under the treaty may be claimed except by a qualified resident of the treaty country. (1) Provision to prevent treaty shopping.

E. Constructive Dividends Under IRC 304

1. Deemed dividends from a domestic subsidiary to a foreign subsidiary in a brother-sister IRC 304 redemption is considered a dividend to a corporation which owns more than 10% of the payor's stock and is eligible for the reduced treaty rate. RR 92-85 a) Does not apply if the domestic or foreign subsidiaries are mere conduits for a owner who resides in a non-treaty country or one without the reduced withholding tax of dividends.

IV. Rents

A. Rents which are not attributable to a USTB or a PE are subject to the withholding tax. IRC 861(a)(4)
1. Rent includes payments by the lessee that satisfy obligations of the lessor. Reg. 1.1441-2(a)
(2), RR 73-522 B. Rents from real property may be treated as ECI with an election made by the taxpayer. IRC 871(d), IRC 882(d) V. Compensation for Services A. Compensation for services performed in the US generally constitute a USTB and therefore is subject to the ECI tax. B. Compensation income not subject to tax due to the time and amount exceptions is not subject to the withholding tax. IRC 861(a)(3), IRC 864(b)(1)

C. Pension benefits from qualified pension, profit sharing, stock bonus, or annuity plan is exempt from withholding tax. IRC 871(f)

1. The exemption only applies if the taxpayer's entire amount due under the plan originated from services performed outside the US or meets the exception for exclusion from US tax.
2. If fewer than 90% of the participants in the plan are US residents or citizens when the annuity begins, no exemption is allowed. a) Exceptions for country's with a substantial equivalent exclusion" US citizens and beneficiary developing country under the 1974 Trade Act.
3. Partial exclusion for former employees of the US government and their beneficiaries. IRC 402(e)(2)

D. Taxable scholarships and grants of NRA in the US on a F, J, M, or Q visa is subject to a 14% withholding tax. IRC 871(c), IRC 1441(b), RP 88-24 1. Treaties usually exempt this income from tax.
VI. Social Security Benefits
A. Withholding tax applies to 85% of any SSA or Railroad retirement benefits received by a NRA. IRC 871(a)(3)
B. Older treaties may exempt this income from tax.
VII. Royalties

A. Royalties are not specifically listed in the statute as subject to withholding. They fall under the other FDAP income category and are subject to the withholding tax. Reg. 1.1871-7(b) 1. Royalties are FDAP income even if payment is received in lump sum or in irregular amounts over an irregular interval. IRC 871(a)(1)(D)
B. Gains on sale of intellectual property not subject to the withholding tax. IRC 871(a)(1)(D) 1. If payments are contingent on the properties productivity, use, or disposition, then amounts are subject to the withholding tax. a) There are proposed regulations which help classify license and copyright transactions in the computer software industry. Prop. Reg. 1.861-18
2. Courts have held to an even broader standard that a transfer of anything less than all rights to the property is a license, not a sale. Wodehouse, 337 US 369
3. Gain on the sale of timber, coal, or iron ore when the owner retains an economic interest is subject to the withholding tax. IRC 871(a)(1)(B), IRC 881(a)(2)

C. Treaty Modifications
1. The model treaty bars withholding tax on royalties.
2. Many older treaties reduce the withholding tax to 10%.
3. Royalties associated with a PE may be taxed as ECI.
4. Royalties on real property and natural resource rights may be taxed in source country.

VIII. Other FDAP Income

A. This class includes all other income except for: Reg. 1.871-79b), Reg. 1.1441-2(b)(1)(i)
1. Gains on the sale of property, and a) Gain on sale of IRC 306 preferred stock is subject to the withholding tax the extent that it is characterized as ordinary income. Reg. 1.306-3(h) 2. Insurance premiums subject to excise tax under IRC 4371. RR 89-91, RP 92-39, IBM, 116 S. Ct. 1793
B. Payments which may be income based on future events that are not anticipated are not FDAP. Reg. 1.1441-2(b)(1)(iii) 1. Example: Loan proceeds may become debt discharge income if there is a default. However, if default is not anticipated at the time the loan is made, it is not FDAP.

C. FDAP includes:
1. Alimony, Howkins, 49 TC 689, Manning, 614 F2d 815
2. Commissions, RR 58-479
3. Prizes, RR 58-479
4. Gambling winnings, Barba, 2 Cl. Ct. 674 , RR 58-479 a) No deduction allowed for losses.
5. Income on surrender of a life insurance policy. RR 64-51

D. Payment of income in a lump sum does not avoid FDAP classification. Wodehouse, 337 US 369, RR 64-51

E. Most treaties eliminate withholding tax on these types of income by providing that tax may not be imposed on income not specifically addressed by the treaty.

IX. Capital Gains and Losses

A. Capital gains are generally exempt from the withholding tax.
B. A NRA who is present in the US more than 182 days is subject to withholding tax on excess capital gains. IRC 871(a)(2) 1. May offset current year losses with gains. a) No carryovers allowed. 2. All US sourced gains and losses are considered regardless of where NRA was at time of sale.
3. ECI capital gains are not included in withholding tax computation.
4. Gain subject to tax as other FDAP income under IRC 871(d) are not included in the computation.
5. No withholding at source is required for this tax. NRA must file return and pay the tax. C. Tax applies only to NRA who has a tax home in the US and is present for more than 182 days. The exceptions to the residency test under substantial presence for days in the US are not recognized for the IRC 871(a)(2) tax.

Module 6
I. Introduction
A. If a foreign person engages in a US trade or business (USTB), such income is subject to tax at the normal graduated rates. IRC 871(b), IRC 882(a)
·  1. The term for this income is "effectively connected income" (ECI).
·  2. ECI taxed in the US can include both US and foreign sourced income.
B. Foreign persons engaged in a USTB may deduct: (IRC 873(a), IRC 873(b), IRC 882(c))
·  1. Expenses associated with generating ECI,
·  2. Casualty and theft losses on US property,
·  3. Charitable contributions, and
·  4. Personal exemptions.
C. Foreign tax credit only allowed on taxes imposed on foreign sourced ECI that is not imposed by the taxpayer's country of residence. IRC 906
II. US Trade or Business
A. Generally
·  1. No complete definition within the IRC or the regulations of the term '"USTB".
·  2. Activities are considered a USTB if they are: Spermacet Whaling & Shipping Co., 281 F2d 646, Amalgamated Dental Co., 6 TC 1009, Pasquel, 12 TCM 1431 a) Profit-oriented, b) Occur in the US, and are
·  (1) Either directly by the taxpayer or through an agent. Zaffaroni, 65 TC 982, Lewenhaupt, 221 F2d 227, Handfield, 23 TC 633, RR 70-424, RR 76-322, Reg. 1.864-3(b) Ex. 2 c) Regular, substantial, and continuous.
·  3. Line of inquiry in case law is similar to IRC 162 vs. IRC 212 activities. Continental Trading, Inc., 265 F2d 40 (cert. denied), Abegg, 50 TC 145, Scottish Am. Inv. Co., 12 TC 49, deKrause, 33 TCM (CCH) 49, InverWorld, Inc., 71 TCM (CCH) 3231, RR 73-522 a) Activity must be a trade or business and substantial activities must be conducted in the US. Spermacet Whaling & Shipping Co., 281 F2d 646, Amalgamated Dental Co., 6 TC 1009
B. Securities and Commodities Trading
·  1. Trading securities through a resident agent is not considered conducting a USTB. IRC 864(b)(2)(A)(i), IRC 864(b)(2)(B)(i), IRC 864(b)(2)(C)
·  2. This rule applies to all types of foreign investors and security brokers. Reg. 1.864-2(c)(1), Reg. 1.864-2(d)(1)
·  3. A foreign taxpayer trading on their own account is not a USTB, even if conducted in the US. IRC 864(b)(2)(A)(ii), IRC 864(b)(2)(B)(ii) a) Also applies to trading conducted by employees or agents of the taxpayer, even if they have discretionary authority over the trades. b) This rules covers trading in stocks, securities, and options and closely related transaction such as obtaining credit for the transactions. Reg. 1.864-2(c)(2)(i), Reg. 1.864-2(d)(2)(i)
·  4. Security dealers operating in the US are not covered by this exception. IRC 864(b)(2)(A)(ii), IRC 864(b)(2)(B)(ii), Reg. 1.864-2(c)(2)(iv)
·  5. Before 1998 exception did not apply to a foreign corporation whose principal business was trading for its own account and its principal office was in the US. Old IRC 864(b)(2)(A)(ii), Reg. 1.864-2(c)(2)(iii) a) Exception was allowed to foreign corporation that qualify as personal holding company. Old IRC 864(b)(2)(A)(ii)
C. Personal Services
1. The performance of personal services in the US is a USTB. IRC 864(b), Reg. 1.864-2(a),
·  a) Pension income received while NRA was conducting services in the US was not ECI. RR 79-388
·  b) Single performances by athletes and entertainers qualify. RR 70-543, RR 85-4, RR 73-107
2. Exception for following services: IRC 864(b)(1)
·  a) Performed while temporarily present in the US,
·  b) The taxpayer present in US for no more than 90 days,
·  c) The compensation does not exceed $3,000, and (1) Includes total compensation for services while present in the US, not amounts received during the year. Reg. 1.864-2(b)(3) Ex. 2 (2) Travel reimbursement under an accountable plan are not considered. Reg. 1.864-2(b)(2)(iv)
·  d) The employer is a NRA, foreign partnership, or foreign corporation not engaged in a USTB, or a foreign office of a US person. (1) Services of taxpayer will not be considered a USTB for this test. Reg. 1.864-2(b)(2)(ii)
·  e) Compensation as employee or independent contractor can qualify. Reg. 1.864-2(b)(2)(iii)
·  f) Treaties usually lengthen the time period and amount of compensation eligible for the exclusion and can modify the type of payor rules.
D. Partnerships
1. A NRA or foreign corporation partner is considered engaged in any USTB of the domestic or foreign partnership. IRC 875(1), Unger, 936 F2d 1316, Donroy, Ltd., 301 F2d 200, RR 90-80
·  a) A partner's distributive share of ECI in the partnership's hands is subject to US tax as ECI.
·  b) A partnership is engaged in a USTB through the actions of a resident partner if the partner is acting as an agent for the partnership. Reg. 1.875-1, Balanovski, 236 F2d 298, Handfield, 23 TC 633, Lewenhaupt, 221 F2d 227, RR 70-424
2. A foreign partner will recognize ECI gain or loss on the sale of an interest in a partnership with a USTB conducted through an office or other fixed place of business. RR 91-32
·  a) The amount recognized is the lesser of: IRC 864(c)(2), IRC 865(e) (1) The gain or loss on the sale, or (2) The partner's share of the gain or loss the partnership would realize if all USTB assets were sold.
E. Trusts and Estates
1. NRA and Foreign corporation are deemed engaged in the USTB of a trust or estate in which they are a beneficiary. RR 85-60, IRC 875(2)
III. ECI From US Sources
A. Generally
1. There are two separate tests for ECI based on the type of income:
·  a) Passive type of income (FDAP) subject to the 30% rate under IRC 871(a)(1) or IRC 882(a). (1) Test for ECI status is based on a connection between the assets generating the income and the USTB. b) All other types of income. (1) Are ECI regardless of any actual connection with the USTB.
B. FDAP Items
1. Two tests to determine connection between income and the USTB: IRC 864(c)(2) a) Asset use test or
·  (1) Test is met if the income is derived from assets used in the USTB. IRC 864(c)(2)(A)
·  (2) Three situations where test is met: (a) An asset held for the principal purpose of promoting or conducting the USTB. Reg. 1.864-4(c)(2)(ii)(a) (i) This rule covers plant and equipment. (b) An asset acquired and held in the ordinary course of the USTB. Reg. 1.864-4(c)(2)(ii)(b) (i) This rule covers inventory and business receivables. (c) An asset held to meet the present needs of the USTB. Reg. 1.864-4(c)(2)(iv)(b) (i) Assets held to meet the future needs of the business do not met this test. (ii) This rule covers bank accounts and other short term investment. (iii) Assets meet the test if: Reg. 1.864-4(c)(2)(iv)(b) (a) They were acquired with funds generated by the USTB, (b) Income from the assets are retained by the USTB, and (c) Employees or other personnel of the USTB present in the US exercise significant management and control over the assets. (iv) For non-security dealers corporate stock is deemed not to met the rule. Reg. 1.864-4(c)(2)(iii)(a)
b) Business activity test.
·  (1) Test is met if the USTB was a material factor in the realization of the income. IRC 864(c)(2)(B)
·  (2) Applies to passive type income which arises directly out of the USTB. Business such as securities dealers are covered by this rule. (a) Trading on ones own behalf does not meet this rule unless that is its principal business. Reg. 1.864-4(c)(3)(ii) Ex. 1
·  (3) Salaries and wages of NRA working in the US are ECI due to the business activity test. Reg. 1.864-4(c)(6)(ii) (a) Exception for minor amounts earned in the US under IRC 864(b). (b) Income from property not ECI if the only USTB is the performance of services. (i) Exception if property and services have a direct economic relationship. Reg. 1.864-4(c)(6)(i)
·  2. Special rules for banking and financial businesses under Reg. 1.864-4(c)(5)
·  3. Tests are often applied together. Reg. 1.864-4(c)(2)(i)
C. Other Income
1. Is ECI if it is from US sources regardless of its connection to the USTB. IRC 864(c)(3) a) This rule usually covers sale of inventory.
IV. ECI From Foreign Sources
A. Generally
·  1. Foreign sourced income is generally not ECI.
·  2. Certain types of foreign sourced income maybe classified as ECI if earned by the USTB through a US office (USO).
B. US Office Requirement
·  1. No foreign sourced income is ECI unless the taxpayer has a office or other fixed place of business in the US and the income is attributable to that office. IRC 864(c)(4)(B) a) Office must exist during year income is realized, but not necessarily when income is realized. Reg. 1.864-5(a)
·  2. Treaties generally modify this concept and call is a permanent establishment.
C. Office Within the US
1. Determination of the existence of a USO depends on the facts and circumstances of the situation which determine: Reg. 1.864-7(a)(2)
·  a) The nature of the business and
·  b) The physical facilities actually required by the business.
2. Taxpayer's use of another persons facilities may establish a USO. Reg. 1.864-7(b)(2)
·  a) Not if use is relatively infrequent.
·  b) No USO deemed merely from an US affiliates offices. Reg. 1.864-7(f) (1) However, a foreign corporation with a US parent must have a CEO operating from a foreign location. Reg. 1.864-7(g) Exs. 1-3 (2) Is a USO if normal business activities of the foreign corporation are performed at the affiliates offices. Reg. 1.864-7(g) Exs. 1-3
3. The activities of an independent agent does not establish a USO. IRC 864(c)(5)(A)
·  a) An independent agent is a general commission agent, broker, or other agent of an independent status acting in the ordinary course of his business in that capacity. Reg. 1.864-7(d)(3)(i)
·  b) A related party to the taxpayer can be an independent agent. Reg. 1.864-7(d)(3)(ii) (1) Sales to a related party in the US does not establish an USO. Reg. 1.864-7(d)(1)(i)
·  c) A person whose sole business is acting as the taxpayer's agent may also be an independent agent. Reg. 1.864-7(d)(3)(iii)
4. The activities of a dependent agent establishes an USO only if: IRC 864(c)(5)(A)
·  a) The agent regularly exercises authority to make contracts on the taxpayer's behalf or
·  b) Fills orders from stock of the taxpayer's merchandise in the agent's possession.
D. Items Attributable to US Office
1. An item is attributable to the USO if the USO: IRC 864(c)(5)(B)
·  a) Is a material factor in the production of the item and (1) Material factor is providing a significant contribution to, by being an essential economic factor in the realization of the item. Reg. 1.864-6(b)(1) (a) Does not need to be the a major factor. (b) Does not matter if a foreign office is also a material factor.
b) Regularly carries on the activities which produced the item.
E. Royalties and Rents
·  1. Foreign sourced rents and royalties of tangible property are never ECI.
·  2. Foreign sourced rents and royalties of intangible property are ECI if they are part of a USTB and associated with a USO. IRC 864(c)(4)(B)(i)
·  3. Question of if a licensing or rental business is a USTB is dependent on the particular facts and circumstances. Reg. 1.864-5(b)(1)(iii)
·  4. Foreign sourced rental and royalties received from related foreign corporation are not ECI. IRC 864(c)(4)(D)(i)
F. Dividends and Interest
1. Foreign sourced dividends and interest are ECI if: IRC 864(c)(4)(B)(ii) a) They are attributable to the USO and are derived from the active conduct of a banking, finance, or similar type of business. (1) Sporadic trading of a foreign holding company do not qualify. Reg. 1.864-5(b)(2)(ii) b) The USO actively participates in soliciting, negotiating, or other activities required to issue or acquire the security. Reg. 1.864-6(b)(2)(ii)(a) (1) A USO that merely collects, exercises general supervision, performs only clerical functions, or exercises only final approval of the transactions.
2. Foreign sourced dividends and interest from a related foreign corporation are never ECI. IRC 864(c)(4)(D)(i)
G. Sales in the Ordinary Course of Business
·  1. Foreign sourced sales of inventory are ECI if made through the USO. IRC 864(c)(4)(B)(iii)
·  2. Exception for property to be used outside the US and a foreign office materially participates in the sale. IRC 864(c)(5)(C)
·  3. Because of the interplay of IRC 864 and IRC 865 it very unlikely that sales through a US office will be considered foreign sourced.
H. Insurance Companies
·  1. Foreign sourced insurance income is ECI if it is attributable to its USTB. IRC 864(c)(4)(C), Reg. 1.864-5(c)
I. Exceptions for Subpart F Income
·  1. An item of foreign sourced income not ECI if it is: IRC 864(c)(4)(D), Reg. 1.864-5(d)(2) a) ECI under any of the above rules, b) Earned by a CFC, and c) Is subpart F income
·  2. Exception applies to the entire amount of the income, including the part attributable to any minority foreign owners of the CFC.
V. ECI in Years When Taxpayer Not Engaged in a US Trade or Business
·  A. If income is recognized in a year different from the year the transaction occurred then ECI status of the income is determined by the situation in the year the transaction occurred. IRC 864(c)(6) 1. Applies to both income recognized before and after the transaction occurred. 2. Does not violate the PE articles of tax treaties. S. Rep. No. 445, 100th Congress, 2d Session, 320
·  B. Gain recognized on the sale of property within 10 years after it was used in a USTB and then transferred out of the US is ECI if the sale of the property would have been ECI if it had been sold on the day it was transferred outside the US. IRC 864(c)(7) 1. Gain is measured on the date of the actual sale, not the FMV at the date of departure from the US.
VI. Transportation Income
·  A. Two methods for taxing US sourced transportation income of foreign entities: 1. As ECI at regular graduated rates or 2. At a special rate (4%) of gross income.
·  B. Transportation income is derived from air or water transport or from leasing or hiring out of a vessel or aircraft.
·  C. The ECI method applies if the following test are met: IRC 887(b)(4) 1. The taxpayer has a USTB and a USO involved in the transportation business, and 2. Substantially all of the transportation income must be: a) Attributable to regularly scheduled transportation or b) If rental income, be attributable to the taxpayer's USO.
·  D. If the ECI tests are not met, then the 4% of gross US sourced transportation income method is used. IRC 887(a), RP 91-12 1. No deductions are allowed in computing gross income. 2. Taxpayer must file a return in normal manner as no withholding tax is imposed on the income.
·  E. Exemption from both methods of tax exists if the resident country of the taxpayer grants an equivalent exemption to US residents. IRC 871(b)(1), IRC 883(a)(1) 1. Exemption also applies to full or bare boat rentals. IRC 872(b)(5), IRC 883(a)(4) 2. There are provisions which prevent "flag" shopping to obtain the exemption. IRC 883(c)(1)
·  F. Tax treaties commonly exempt transportation income from tax in the non-resident country.
VII. Withholding
A. ECI is usually not subject to withholding. IRC 1441(c)(1), IRC 1442(b)
B. Exceptions for:
1. Wages and salaries of NRA.
2. Some items earned by foreign students, researchers, and teachers.
3. Foreign partners distributive share of a partnership's ECI. IRC 1446(e)
·  a) Foreign partners are any NRA, foreign corporation, partnership, estate or trust. IRC 7701(a)(30)
·  b) Domestic and foreign partnership are required to withhold if: (1) It is engaged in a USTB during the year, (2) Has at least one foreign partner, and (a) Partner's can present a certification of non-foreign status to prevent withholding. RP 89-31 (3) Some portion of its ECI is included in the distributive share of a foreign partner,
·  c) Foreign partner's are deemed to be engaged in the USTB of the partnership. IRC 875(1)
·  d) Withholding rate is: RP 89-31 (1) 39.6% for individuals, partnerships, trusts, or estates. (2) 35% for corporations.
·  e) The distributive share is the amount credited to the foreign partner's capital account. (1) Actual cash distributions have no effect on the amount of withholding.
·  f) Different rules for publicly traded partnerships. RP 89-31, RP 92-66
·  g) Foreign partner must file a return and the withholding tax can be claimed as a credit. IRC 33, IRC 1446(d)(1) (1) The credit is claimed in the same taxable year as the partner's distributive share using the normal partnership rules. IRC 706(a) (2) The amount of tax withheld is considered a cash distribution to the partner on the last day of the partnership taxable year. IRC 731(a)(1), IRC 733
VIII. Treaty Modifications
A. Generally
1. Tax treaties typically provide that business profits of a non-resident may be taxed only if the profits are attributable to the taxpayer's permanent establishment (PE) in the US.
2. A PE is defined under the model treaty as a fixed place of business through which the business of an enterprise is wholly or partially conducted.
·  a) Examples are an office, factory, mine, and place of management.
·  b) Construction sites or mines are PE's if the project continues for at least 12 months.
·  c) A facility is not a PE if used solely purchasing, storing, displaying, or delivering goods, collecting information, or any other preparatory or auxiliary character.
·  d) The mere storing of goods in the US for processing by another is not a PE.
·  e) An independent agent of a taxpayer is not a PE if the agent acts for the taxpayer in the ordinary course of the agent's business. Taisei Fire & Marine Ins. Co., 104 TC 535 (acq.)
·  f) A dependent agent is a PE if the agent has and habitually exercised authority to make contracts and the agents activities go beyond purchasing and other preparatory or auxiliary activities.
3. The concept of a PE under a treaty and a USO under the IRC are very similar and the taxation scheme is almost identical.
B. Treaty Shopping
1. Most new treaties follow the model treaty provisions which deny treaty benefits to residents of the treaty country if it is:
·  a) Owned by nonresidents of the treaty country or
·  b) Acts as a conduit for transmitting income from US sources to persons who are not residents of the treaty country.

Module 7
BRANCH PROFITS TAX
The branch profits tax and the related branch level interest tax are in addition to the other tax regimes in the Code. These rules are contained in Section 884, and provide for a tax on the U.S. branch profits of a foreign corporation equivalent to the withholding tax that would have been paid if the branch were actually a U.S. corporation and paid a dividend subject to withholding tax. This amount subject to tax is referred to as the dividend equivalent amount.
Since the introduction of the branch profits tax (another one of the substantial changes brought about by the Tax Reform Act of 1986) the use of branches in the U.S. is not as attractive as in the past. Before the branch profits tax, it was possible to repatriate earnings out of the U.S. without incurring a dividend withholding tax. With the branch profits tax, the tax is imposed on the amount deemed available to be distributed under Section 884.
In most cases, a taxpayer can structure around the branch profit tax by incorporating a U.S. subsidiary rather than conducting business through a branch. With a subsidiary corporation, the dividend withholding tax is only required when dividends are actually paid, which is in control of the taxpayer. Contrast this with the branch profits tax, where the dividend equivalent amount is subject to taxation whether or not the cash is actually distributed.
Tax Rate and Reduced Treaty Rates
Section 884(a) provides that the tax rate is 30%. This is the same rate contained in Section 881(a) which applies to the taxation of non effectively connected dividend income. The branch profits tax is in addition to the income tax liability the branch must pay on its effectively connected income as provided in Section 882.
In an effort to maintain parity with the taxation of a subsidiary, the branch profits tax may be reduced by tax treaty similar to a reduced treaty rate on dividend income. Only a few treaties specifically mention the branch profits tax, and if it does, the treaty rate will apply rather than the 30% statutory rate. In addition, if the branch profits tax is not covered in the treaty, Section 884(e)(2)(A)(ii) provides that the rate of tax will be the same as the dividend withholding rate that applies to a wholly owned subsidiary.
To prevent foreign persons from incorporating a subsidiary in a country that has a favorable treaty rate in order to reduce the branch profits tax, Section 884(e)(4) provides that the company be a qualified resident of the treaty country. There are several test that can be satisfied to be considered a qualified resident: (1) the stock ownership test, (2) the base erosion test, and (3) the publicly traded test.
The stock ownership test is met unless 50% or more of the stock of the corporation is owned by individuals that are not residents of the treaty country. Without using the double negatives in Code Section 884(e)(4)(A)(i), if more than 50% is owned by individuals from the treaty country then the stock ownership test is satisfied. Stock is attributed through entities until it ends up with an individual or a publicly traded corporation.
The base erosion test applies if the corporation uses 50% or more of its income to meet liabilities of persons who are not resident in the treaty country. In essence, the expenses of the corporation must be paid to persons who are residents of the treaty country or U.S. citizens or residents.
The third test, the publicly traded test, is satisfied if the corporation or its parent corporation is a resident of the treaty country and if its shares are primarily and regularly traded on an established securities market in that country or in the United States.
Dividend Equivalent Amount
The dividend equivalent amount subject to the branch profit tax is the foreign corporation’s branch effectively connected earnings and profits (ECI) determined without reduction for dividends paid and certain specific items. Thus the starting point is the ECI as adjusted in Section 884(d). The major adjustment to ECI is the amount that is considered reinvested in a U.S. trade or business. This reinvestment of earnings, reduced that amount of ECI that is subject to the branch profits tax. However, if the investment in the U.S. business is reduced, it could lead to additional branch profits taxation.
Thus, if the net equity of the branch at the close of the year exceeds the net equity at the beginning of the year, the ECI is reduced by the excess. The net equity of the U.S. branch is the assets less its liabilities. The net result is that a branch can reinvest its earning is additional assets and not pay the branch profits tax until the situation reverses.
The computation of net equity of the branch includes the assets that are treated as connected with a U.S. trade or business. These include:
·        depreciable and amortizable property;
·        inventory;
·        installment obligations;
·        receivables from sale of inventory, services, or leases;
·        U.S. real property interests;
·        money used in the trade or business (working capital);
·        debt that is effectively connected;
·        overpayments of U.S. federal income taxes;
·        partnership interest
Generally, U.S. liabilities are determined by taking the worldwide liabilities are multiplying them by the ratio of U.S. assets to worldwide assets. This is similar to the method used in Reg. Section 1.882-5 when determining deductible interest expense.
Termination of Branch Operations
The transfer of the branch operations for cash or exchange for shares in another company generally reduce the U.S. net equity and cause the imposition of branch profits tax. However, an exception exists if the foreign corporation completely terminates all of its U.S. trade or business during the year, is not subject to the branch profits tax for that year. This is equivalent to the tax-free liquidation under Section 332 of a subsidiary into the parent company.
BRANCH LEVEL INTEREST TAX
A U.S. branch is treated like a U.S. subsidiary, and as such, the interest paid by the branch is subject to the 30% withholding tax (reduced by treaty). These rules are contained in Section 884(f) and provide that interest paid by the business shall be treated as paid by a domestic corporation, and an allocable portion of the foreign parent’s interest expense allocated to the U.S. branch is also subject to withholding tax. This provision is designed to trigger withholding tax when the interest expense deductions allowable in the U.S. exceed the amount of interest actually paid by the U.S. branch.

Module 8
FIRPTA
Section 897, Disposition of Investment In United States Real Property, was added to the Internal Revenue Code by the Foreign Investment in Real Property Act of 1980 (“FIRPTA”). Prior to FIRPTA, many dispositions of real property were not subject to taxation as either FADAP income (Sections 871(a) or 881) nor effectively connected income (Sections 871(b) or 882). Thus, Section 897 provides that a foreign taxpayer must pay U.S. income tax at the regular rates on the net gains derived from the sale or other disposition of U.S. real estate and U.S. real property interests. The mechanics are provided in Section 897(a)(1) which provides that gains and losses from real property owned by nonresident individuals or foreign corporations are considered effectively connected with a U.S. trade or business.
USRPI
Section 897 applies to U.S. real property interests (“USRPI”) as defined in Section 897(c). A USRPI is any interest in real property located in the U.S. This includes real estate, land, building, growing crops, timber, and a mine, well, or other natural deposit. In some cases, personal property associated with the use of the real property will also be considered U.S. real property. The actual ownership of real property is considered a U.S. real property interest, as well as any other type of interest other than that of a creditor. A USRPI also includes the shares of a domestic corporation that is considered a U.S. real property holding corporation (“USRPHC”). This is a U.S. corporation as defined in Section 897(c)(2), where the fair market value of its US real property interests is 50% or more of the combined U.S. and foreign real property plus other trade or business assets. Thus, a U.S. company with a substantial amount of real estate can be considered a USRPHC. In making the determination of valuation, the regulations allow the presumption based on the book value of the assets. Based on the regulations, a corporation will not be a USRPHC if the book value of its real property interests is less than 25% of the book value of all its real estate and business assets. (Reg. Sec. 1.897-2(b)(2)(i)). An exception to an USRPHC is a publicly traded company (unless the shareholder is a 5% or more shareholder).
A USRPI includes a foreign corporation that makes an election under Section 897(i) to be treated as a domestic corporation that is a USRPHC. This is referred to as a “897(i) election” and is allowed if the foreign corporation holds a USRPI, and is entitled to nondiscriminatory treatment with respect to that interest under a U.S.tax treaty. This provision allows the foreign company to be considered a domestic company for purposes of claiming treaty benefits. [otherwise, it’s taxed like a US corp but without the treaty benefits] In order to make the election, the shareholders must consent to the election and it must be filed with the IRS before the first disposition of an interest in a corporation subject to Section 897(a).
The final type of USRPI is a publicly traded interest in a partnership or trust held by a 5% owner.
Disposition of a USRPI
The disposition of a USRPI is considered effectively connected income under Section 897(a). However, Sections 897(d) and (e) provide special rules.
Section 897(d)(1) requires that gain must be recognized, but not loss, on the distribution of real property interest to its shareholders including a distribution in liquidation or redemption. In addition, Section 897(d)(2) provides certain exceptions as long as the real property interest will ultimately be subject to tax in the U.S. (i.e., a carryover basis and distributee is subject to U.S. taxation).
Section 897(e) establishes that the nonrecognition rules of the Code will apply only if the person who exchanges the USRPI for an interest that would be subject to U.S. taxation if sold. The nonrecognition provisions governed by Section 897(e) include Sections 332, 351, 354, 355, 361, 721, 731, and 1036. Thus, the exchange of a USRPI for a non-USRPI will be subject to taxation; however, an exchange that would otherwise qualify for tax-free treatment will still qualify if the interest received is also a USRPI (which may include a USRPHC or an interest in a partnership that qualifies as a USRPI).
A contribution of a USRPHI to a foreign corporation as a capital contribution is also considered a disposition of real property under Section 897(j). Thus, if the contribution didn’t qualify as a Section 351 transaction governed by Section 897(e), it would still be taxable.
Reporting Requirements & Withholding
A tax return must be filed for the taxable year of the distribution or transfer. In addition, Section 1445 requires withholding taxes when a USRPI is transferred. This includes USRPHCs, distributions where gain is recognized under the special provisions of Section 897(d) and (e).
The withholding rules are very detailed and complex, and we need to gain a general understanding of the requirement in this class. Generally, Section 1445 requires 10% of the total price (not gain) to be withheld from the proceeds of a transfer involving a USRPI.
Exemptions under Section 1445(b) include transactions where the transferor supplies a certificate of nonforeign status, the property is shares of a nonpublic traded company which provides a certificate that it is not a USRPHC, or the property is publicly traded. In cases where the transferor gain is subject to nonrecognition treatment or the IRS has issued a withholding certificate the withholding tax may be minimized.
Section 1445(d) holds the withholding agent liable for the tax if there is failure to withhold up to the amount of their fees or commissions. In addition, Section 1461 holds the transferee personally liable for the tax underwithheld including interest and penalties.
 At first blush, it may seem that foreigners can be offered tax protection by holding US real property through foreign corporations.  Sales of the shares are not subject to US tax.  However, if the real property has increased in value, it cannot be sold or transferred without triggering taxation under section 897(d).  Therefore, at best, using a foreign corp. to hold US real estate only offers deferral of US taxation on the appreciation of the US real property.  This benefit may be further reduced because real estate cannot regain a fair market basis for depreciation without being liable for the tax.  Also, if the US real property in question is a principal residence, the $250k exclusion granted by section 121 is available only if owned directly by a foreign individual.
What is interesting is the fact that, at least initially, the Treasury did not want section 897 to be adopted.  It was enacted in 1980 when foreign money was being invested in US real property at unprecedented levels, while the US was still recovering from the oil crisis and inflation problems of the 70s.  Attempts to reduce investment of any kind in the US seemed, perhaps, unwise at the time.  What is funny is that the original proponents of 897 sought its repeal a few years later, those persons initially wanting it to combat what they saw as foreign investment causing inflation & keeping investment out of reach for US citizens.  Foreign investors then stopped investing so heavily, oil prices declined, and recession followed.  Foreign investment again seemed a good idea, and the original proponents of 897 became those who sought its repeal, while the Treasury now decided it liked the revenues of 897.
Please go to the discussion boards to answer the questions and post your comments/ questions about this subject.
 
This post is meant to supplement the initial “mini-lecture” at the beginning of this Module.

I. Gains on Dispositions of US Real Property Interests

A. Introduction

1. US does not generally tax a foreign persons' gains on sale of property not EC with a USTB.

2. IRC 897 deems gains and loss on the sale of US real property (USRP) of NRA and foreign corporations as ECI. IRC 897(a)(1)
a) This is true regardless of its actual use in a USTB.
b) The USRP interest (USRPI) gain or loss is combined with all other ECI to determine the taxpayer's taxable income.

3. IRC 897 applies to direct and certain indirect USRPI's.

4. The tax under IRC 897 is enforced through withholding imposed IRC 1445.

5. The model treaty allows the taxation of the disposition of USRPI's
a) Other tax treaties do not allow it.

6. IRC 897 could be construed to violate the nondiscrimination rules under many treaties.
a) Congress provided from an election provision to treat USRP income as ECI and stated it was the exclusive remedy for this discrimination.

B. USRPI's-Direct Ownership

1. IRC 897 applies to all interest in real property located in the US or the Virgin Islands. IRC 897(c)(1)(A)(i)

2. The term "Real Property" includes: Reg. 1.897-1(b)(3)
a) Land,
b) Unsevered natural products of the land,
(1) Includes growing crops, timber, and mineral deposits. Reg. 1.897-1(b)(1), Reg. 1.897-1(b)(2) (2) The harvesting or mining of these items is not considered a disposition of a USRPI. Reg. 1.897-1(g)
c) Buildings,
d) Other inherently permanent structures, and
e) Structural components of buildings and structures.
f) Personal property associated with the use of real property: Reg. 1.897-1(b)(4)(i)
(1) Movable walls and furnishings,
(2) Mining equipment,
(3) Farm machinery,
(4) Equipment used to construct real property improvements,
(5) Furniture in a lodging facility,
(6) Office furniture and equipment leased with office space.
(7) Exception if personal property is disposed of a substantial period of time before or after the associated USRP is sold. Reg. 1.897-1(b)(4)(ii)

3. All forms of ownership of real property may be USRPI including: IRC 897(c)(6)(A)
a) Leasehold interest,
b) Options to buy USRP,
c) Partial interests including: HR Rep. No. 1167, Supra Note 4, at 513
(1) Mineral royalties,
(2) Life estates,
(3) Remainders,
(4) Reversions, and
(5) Rights of first refusal.

4. Interest in USRP solely as a creditor is not a USRPI. Reg. 1.897-1(c)(1)
a) In certain cases equity and debt interests in the same property are aggregated and the entire interest is considered a USRPI. Reg. 1.897-1(d)(4) b) An interest is not solely as a creditor if the creditor receives a direct or indirect right to share in future appreciation or profit of/from the real property. Reg. 1.897-1(d)(2)
c) A debt secured by USRP is not an USRPI. Reg. 1.897-1(d)(2)(ii)(C)

C. USRPI's-Stock of Domestic Corporations

1. Generally
a) An interest in a domestic corporation is a USRPI if: IRC 897(c)(1)(A)(ii)
(1) The corporation is a USRP holding company, (a) An interest in a publicly traded partnerships and trusts are treated as an interest in a corporations for these rules. Reg. 1.897-1(c)(2)(iv). (i) Special rules for REIT. IRC 897(h), Reg. 1.897-1(c)(2)(I)
(2) At any time during the five preceding the taxpayer's sale of the equity interest. b) Applies to any equity interest in the corporation. Reg. 1.897-1(d)(3), HR Rep. No. 1167, Supra Note 4, at 514
(1) Does not apply to interests solely as a creditor of the US corporation.
(2) Convertible debt does qualify as an equity interest.
(3) Stock in a foreign corporation is never considered a USRPI.

2. USRP Holding Company
a) A domestic corporation is a USRP holding company if its USRPI has an aggregate FMV equal to or greater than 50% of the total FMV of the corporations: IRC 897(c)(2), Reg. 1.897-1(f)
(1) Real property and business assets (including its USRPI),
(2) Real property located outside the US, and
(3) All other assets used in its trade or business.

3. Valuations
a) Use normal willing buyer-willing seller FMV valuation. Reg. 1.897-1(o)(2)
b) Gross assets are reduced purchase money mortgages and secured debt incurred in refinancing purchase money obligations.
c) Disregard business assets or foreign real property acquired for the principal purpose to reduce the testing percentage below 50%, these assets are reduced by any debt used to finance the purchase.
d) A corporation is presumed not to be a USRP holding company if the book value of its USRPI do not exceed 25% of the corporations USRPI, foreign real property, and trade or business assets. Reg. 1.897-2(b)(2)
(1) Book value is measured in accordance with US GAAP.
(2) Presumption does not apply if the corporation has "reason to believe" it would not pass the 50% test. Reg. 1.897-2(b)(2)(iv) Ex. 2 (a) Corporation has reason to know if they have received offers to sell the USRPI at a price which would indicate the 50% would not be met.
(3) Presumption does not apply if the corporation receives written notice from the IRS stating that it may not rely on the presumption.

4. Determination Dates-Generally
a) Taken literally, the statute would require continuous monitoring of the 50% test for the five year period before the sale.
b) The regulations provide for three types of testing dates for USRP holding company: Reg. 1.897-2(c) (1) The last day of each tax year, (2) Any day the corporation acquires a USRPI, or (a) This would include transactions of a look-through entity. (3) Any day the corporation disposes of foreign real property or a business asset. (a) This would include transactions of a look-through entity. (b) Does not include disposition of inventory or cash payment of ordinary business expenses. Reg. 1.897-2(c)(2)
(c) There are also de minims rules which exclude transactions for corporations with relatively minor USRPI.
d) Even if there is more than one determination date during the year, property need be valued only once a year. Reg. 1.897-2(c)(4)

5. Determination Dates-Monthly Alternative
a) An election is available to determine USRP holding company status at the end of each month. Reg. 1.897-2(c)(3)
b) Must make inter-month determination on large USRPI acquisitions or dispositions of foreign real property or business assets. Reg. 1.897-2(c)(4)

6. Look-Through Rule Where US Corp. Controls Foreign Corp.
a) Corporations are treated as owing their proportionate share of the assets of 50% or more owned subsidiaries. IRC 897(c)(5) (
1) Use constructive ownership rules of IRC 318(a). IRC 897(c)(6)(C), Reg. 1.897-2(e)(3)
(2) Ownership percentage is determined by the percentage amount the parent would receive in a liquidation of the subsidiary. Reg. 1.897-1(e)(2) (3) The investment in the subsidiary stock is disregarded for the 50% test. Reg. 1.897-2(e)(3)
7. US Corporation with Non-controlling Interest in Another Corporation
a) A non-controlling interest in a USRP holding company is treated as a USRPI. (1) Is not considered a USRPI if the corporation is not a USRP holding company.
b) A domestic corporation's non-controlling interest in a foreign corporation is considered a USRPI if the foreign corporation would meet the 50% test. IRC 897(c)(4)(A), Reg. 1.897-2(e)(1) (1) A similar interest held by a NRA or a foreign corporation would not be considered a USRPI.

8. Partners and Beneficiaries of Trusts and Estates
a) Partners and beneficiaries are considered to own ratably their share of partnership, trust, or estate assets. IRC 897(c)(4)(B), Reg. 1.897-2(e)(2)
(1) Partnership ownership percentage is determined by the percentage amount the partner would receive in a liquidation of the partnership. Reg. 1.897-1(e)(2)
(2) Rules for determining beneficiary's ownership percentage in a trust are contained in Reg. 1.897-1(e)(3)

9. Five-year Rule
a) If the corporation meets the USRP holding company test on any determination date in the five years before the disposition, it is a USRP holding company. IRC 897(c)(1)(A)(ii)
(1) True even if the company no longer meets test at time of disposition.
(2) If shareholder has owned stock for less than five tears, test period if the holding period on the date of sale.
b) USRP holding company disappears if the corporation disposes of all USRPI in a taxable transaction. IRC 897(c)(1)(B), Reg. 1.897-2(f)(2) (1) To apply this exception, the corporation must have sold all USRPI held during the testing period in a taxable transaction and hold no USRPI at the date of the disposition of the stock.
(2) A USRP interest imputed from non-controlling interest in a corporation is considered disposed of if the subsidiary corporation disposes of all USRPI in a taxable sale.

10. Publicly Traded Stock
a) Publicly trade stock is not considered a USRPI unless: IRC 897(c)(3), Reg. 1.897-9T
(1) Class of stock owned is publicly traded, and (2) The taxpayer did not own more than 5% of the publicly trade classes of stock at anytime during the five year period.
b) Exclusion can apply to publicly trade partnership or trust interests. Reg. 1.897-1(c)(2)(iv)

11. Establishing That Stock in not USRPI
a) A non-creditor interest in a domestic corporation is presumed to be USRPI unless the taxpayer establishes otherwise. IRC 897(c)(1)(A)(ii)
b) Taxpayer can meet this standard with a statement from the corporation of a determination from the IRS. Reg. 1.897-2(g)

D. USRPI's Held Through Partnerships, Estates, & Trusts

1. A foreign person who sells an interest in a partnership, estate, or trust is considered to have sold their proportionate share of the assets of the entity. IRC 897(g)
a) Partnership ownership percentage is determined by the percentage amount the partner would receive in a liquidation of the partnership. Reg. 1.897-1(e)(2)
b) Rules for determining beneficiary's ownership percentage in a trust are contained in Reg. 1.897-1(e)(3)

2. Any USRPI's owned by the partnership would trigger IRC 897 gain or loss.
a) Amount realized and basis of the partnership interest is allocated to the USRPI based on relative FMV.

3. Partnership's status as domestic or foreign is irrelevant.

4. Rule does not apply to publicly traded partnership interests. Reg. 1.897-1(c)(2)(iv)


E. Modification of Nonrecognition Rule
1. IRC 897 makes the following modifications to nonrecognition rules to reduce the opportunity to avoid IRC 897 tax:
a) A nonrecognition rule may only apply if it is an exchange and the disposition of the received property would be taxable to the foreign person upon its sale. IRC 897(e)(1), Reg. 1.897-5T(d)
(1) Rules for corporation reorganizations transactions are at Reg. 1.897-6T
(2) Rules for liquidations of a USRP holding company into a foreign parent are at Reg. 1.897-5T(b)(3)
(3) Exchange of a USRP interest for a foreign RP interest would require gain recognition even if IRC 1031 applies.
b) Gain must be recognized when a foreign person contributes a USRPI to the capital of a foreign corporation without receiving additional stock consideration. IRC 897(j) (
1) Gain is recognized on the excess FMV of the property over its adjusted basis on date of contribution.
c) A distribution of a USRP interest by a foreign corporation is taxable to the distributing corporation. IRC 897(d)(1), Reg. 1.897-5T(c)
(1) Gain to shareholder is not taxable under IRC 897.
(2) This gain not recognized to the extent the shareholder must pick up gain on the distribution. IRC 897(d)(2)(A)
(3) There are not many corporate distribution of appreciated property which are not taxable top the corporation after the 1986 repeal of the General Utilities doctrine.

F. Special Basis Rule for Property Received in Distribution
1. The basis of a USRPI received by a foreign shareholder from a distribution from a domestic corporation may not exceed the sum of: IRC 897(f) a) The corporation's adjusted basis before the distribution,
b) Gain recognized by the corporation on distribution, and
c) Any tax paid on gain recognized by the foreign shareholder on receipt of the USRPI.
2. The significance of this rule was diminished with the 1986 repeal of the General Utilities doctrine. The foreign taxpayer will have a basis in the USRPI of its FMV on the date of distribution. The tax paid does not add to the basis, as it would increase it above what is normally allowed.

G. Election by Foreign Corporation to be Treated as US Corporation
1. IRC 897 created the possibility of discrimination claims from foreign corporations who were no longer eligible for General Utilities type of benefits on the distribution of USRPI's. 2. To forestall these claims, a foreign corporation may elect to be treated as a domestic corporation for IRC 897 purposes if: IRC 897(i) a) It holds directly or indirectly a USRPI and b) It is entitled to the benefits of a nondiscrimination clause under a treaty.
3. This election is the exclusive remedy for any person claiming discrimination under a treaty provision. IRC 897(i)(4)
4. The election must: IRC 897(i)(3) a) Include a waiver of all treaty benefits with respect to gains and losses on dispositions of USRPI. b) Include the corporation consent to be treated as a domestic corporation in determining tax on these gains. c) Be agreed to by all corporate shareholders and they must agree to be taxed on the disposition of there shares as if the corporation were domestic. (1) Shareholders owning less than 5% of a publicly trade company need not approve. d) Generally be made before the taxable disposition of stock. Reg. 1.897-3(d)(1)
5. Election is revocable only with IRS consent. IRC 897(i)(2), Reg. 1.897-3(f)
6. Election only treats the corporation as domestic for IRC 897 purposes. IRC 897(i)(1), Reg. 1.897-3(a)

H. Computation of IRC 897 Tax

1. IRC 897 deems gains and loss on the sale of US real property (USRP) of NRA and foreign corporations as ECI. IRC 897(a)(1) a) This is true regardless of its actual use in a USTB. b) The USRP interest (USRPI) gain or loss is combined with all other ECI to determine the taxpayer's taxable income. c) This rule does not convert otherwise personal losses of NRA's into trade or business losses. HR Rep. No. 1167, supra note 4, at 512
2. General tax rules determine nature, timing, and amount of the gains and losses.
3. The AMT computation is modified to insure the amount subject to AMT is not less than the net gain on disposition of USRPI's. IRC 55(b)(1)(A), IRC 897(a)(2)

I. Annual Filing Requirement

1. A NRA or foreign corporation holding direct investments in USRP must file an annual return describing the interest and providing other information provided for in the regulations. IRC 6039C(a)
2. A NRA or foreign corporation holds direct investments in USRP for this rule if: IRC 6039C(b) a) They are not engaged in a USTB, and b) The FMV of the USRPI's equals or exceeds $50,000.
(1) For this floor test: IRC 6039C(c)(3)
(a) Count all types of USRPI.
(b) Aggregate all holding of taxpayer, spouse, and children.

J. Withholding

1. Generally a) A buyer of a USRPI from a foreign seller to withhold amounts from the purchase price to cover any IRC 897 tax on the seller's gain. IRC 1445(a), Reg. 1.1445-2(a)
(1) Withholding rate is 10% unless requirements meet to withhold a lower amount.
(2) Regulation provisions allow reduction to the tax on the gain.
b) A person who fails to withhold the required amount is personally liable for the tax. Reg. 1.145-1(e)
(1) Person not liable if they can establish that the tax due was zero or paid by the seller.
2. Affidavit Procedure
a) No Withholding if:
(1) Seller is not a foreign person or IRC 1445(b)(2) (a) Foreign person defined as NRA, foreign corporations, trusts, estates. Reg. 1.1445-2(b)(2) (i) Exception for foreign corporations electing to be treated as a domestic corporation under IRC 897(i)
(2) The property is not a USRPI.
b) Withholding can be avoided in these situations if the WA receives an affidavit:
(1) From the seller claiming they are not a foreign person, or
(a) Buyer must retain affidavit five years from date of purchase. Reg. 1.1445-2(b)(3)
(b) If no affidavit is provided, WA must withhold as if the seller is a foreign person regardless of any facts suggesting non-foreign status. Reg. 1.1445-2(b)(1) (2) From the domestic corporation whose stock is being sold claiming they are not a USRP holding company. IRC 1445(b)(3), Reg. 1.1445-2(c)(3)(I)
c) Affidavits the WA knows or has reason to know are false may not be relied upon to wave the withholding requirements. IRC 1445(b)(7)
d) An agent for the foreign person or domestic corporation that makes a false affidavit or is liable for the withholding tax up to the amount of compensation he received on the transaction. IRC 1445(d)(2)
(1) Also liable if the agent knows that a false affidavit has been given. IRC 1445(d)(1), Reg. 1.1445-4
(2) Applies to a representative who does not rise to the level of an agent. IRC 1445(d)(3), IRC 1445(d)(4), IRC 1445(d)(5), Reg. 1.1445-4(f)(3)
3. Transactions Covered by Nonrecognition Rules or Treaty Exemption
a) No withholding if WA receives a statement from the transferor that is transmitted to the IRS within 20 days of the sale that: Reg. 1.1445-2(d)(2), Reg. 1.1445-9T(b)
(1) The sale is covered by a IRC nonrecognition provision or
(2) The transaction is covered by a treaty provision exempting it from tax.

4. Gifts
a) No Withholding due on property received as a gift or other transaction where the amount realized is zero. Reg. 1.1445-1(b)(1) b) If liabilities are assumed on the gifted property, then that is considered an amount realized and withhold provisions apply. Reg. 1.1445-1(g)(5)(iii)
(1) Unclear what donee withholds on, as no cash payment is made to donor.

5. Transferee's Residence
a) No withholding required if buyer: IRC 1445(b)(5)
(1) Intends to use property as their personal residence and (a) Must have definite plans to use property as residency for 12 or the next 24 months. Reg. 1.1445-2(d)(1) (b) If the violates these provisions, they are liable for the withholding tax. Reg. 1.1445-2(d)(1)
(2) The amount realized does not exceed $300,000. b) If these rules apply, the seller is still liable for the IRC 897 tax.

6. Publicly Traded Stock

a) No withholding required on the sale of publicly traded stock, partnership or trust interests. IRC 1445(b)(6), Reg. 1.1445-2(c)(2)
(1) This is true even if sale would be taxable to seller because they hold more than 5% of the stock of the entity.
b) Withholding is required if the sales transaction transfers over a 5% interest in the entity. Reg. 1.1445-2(c)(2)

7. Governmental Transferees
a) Domestic government entities are exempt from withholding. Reg. 1.1445-2(d)(5) b) Foreign governments are required to withhold. Reg. 1.1445-10T(b)(2)

8. Disposition by US Partnerships, Trusts, and Estates a) A domestic partnership must withhold tax when it sells a USRPI on any amount allocable to foreign partners. IRC 1445(e)(1), Reg. 1.1445-5(c) (1) Publicly traded partnerships withhold when proceeds are distributed to foreign partners. Reg. 1.1445-8 (2) Withholding is at the highest marginal rate for the type of partner. b) No withholding tax is due on the distribution of a USRPI to the foreign partner. (1) Exception for distributions that are taxable under IRC 897 tax. (a) Withholding rate is 10%.

9. Distributions by Foreign Corporations a) Distribution of USRPI by foreign corporations to its shareholders is taxable under IRC 897 to the foreign corporation. IRC 897(d)(1), Reg.. 1.1897-5T(c) b) Foreign corporation must pay a 35% withholding tax on the gain recognized. IRC 1445(e)(2), Reg. 1.1445-5(d) (1) Does not apply if the corporation elects to be treated as a domestic corporation under IRC 897(i). Reg. 1.1445-7(c)

10. Liquidating and Redemption Distributions by US Corporation a) A USRP holding company party to a liquidating or redemption distribution must withhold from the distribution to the extent IRC 897 applies to the transaction. IRC 1445(e)(3), Reg. 1.1445-5(e) b) Rule also applies to a foreign corporation electing to be treated as a domestic corporation under IRC 897(i). Reg. 1.1445-7(c)

11. Options a) The purchaser of an option to buy a USRPI need not withhold when option is granted or when the option lapses. Reg. 1.1445-1(b)(3) b) If option is exercised, withholding applies under the normal rules and the option price is included in determining the amount realized. c) If foreign person acquires option to buy a USRPI and then sells the option, withholding is required by the purchaser.

12. Amounts Required to be Withheld-Generally a) The purchaser must withhold 10% of the amount realized on the sale. IRC 1445(a) (1) Amount realized includes: Reg. 1.1445-1(g)(5) (a) Cash paid, (b) FMV of other property given, and (c) Liabilities assumed or taken subject to the property. (2) The amount withheld may be more than the cash consideration paid for the property. b) The 10% rate of withholding may be modified to the maximum amount of tax due on the sale: IRC 1445(c)(1)(B) (1) WA must receive a withholding certificate from the IRS to withhold less. IRC 1445(c)(1)(A)

13. Foreclosures a) Only the net proceeds received by the foreign owner in a foreclosure sale are subject to withholding. Reg. 1.1445-2(d)(3) (1) Net proceeds are amount realized less any mortgage liabilities satisfied with the sales proceeds. (2) Only applies if the mortgagor's interest in the sales proceeds is determined by a court or trustee having jurisdiction over the sale. b) No withholding due on the transfer of property in lieu of foreclosure: Reg. 1.145-2(d)(3) (1) The mortgagor receives no consideration other than the satisfaction of the mortgage, (2) The mortgagee pays nothing other than incidental fees to any person in connection with the transfer, and (3) The mortgagee is the only person having a secured interest in the property.

14. Reporting and Payment Requirements a) Amounts required to be withheld must be paid to the IRS within 20 days of the transfer. Reg. 1.145-1(c)(1) (1) The request for a withholding certificate may delay the date payment must be made until the withholding certificate is issued or the request is denied. b) Withholding tax does not relieve the seller of the obligation to file a tax return. Reg. 1.1445-1(f) (1) Seller gets a credit for any tax withheld.

15. Installment Sales a) Generally no deferral of withholding tax on installment payments. b) Buyer may request a withholding certificate to allow withholding as payments are made. Reg. 1.1445-2(d)(4), RP 88-23 c) Withholding amount based on face value of installment obligation, not its FMV. Reg. 1.1445-1(g)(5) Deferred payments of stated interest, unstated interest, or OID are not included in the amount realized.
 

Module 9: Partnerships
PARTNERSHIPS
Partnerships are generally not subject to taxation at the entity level. As pass-through or transparent entities the partners are subject to tax. Section 875(1) provides that “a nonresident alien individual or foreign corporation shall be considered as being engaged in a trade or business within the United States if the partnership of which such individual or corporation is a member is so engaged.” Thus, a foreign partner (general or limited) is considered engaged in a U.S. trade or business if the partnership is considered engaged in a U.S. trade or business. As such, the test is at the partnership level rather than the partner level.
It is common for partnerships to be formed by a domestic and foreign corporations to undertake joint activities. In many cases, the participants may draw up a contract and not realize that it falls under Subchapter K of the Code, and is treated as a partnership. Since the partnership may be considered in a U.S.a trade or business depending on its activities, the foreign partner may also be deemed to be engaged in a U.S. trade or business (and subject to tax return filing requirements).
Section 875(2) provides similar rules for estates and trusts.
Revenue Ruling 91-32 provides for the treatment of the sale of a partnership interest. The Service has held that the sale of the partnership interest, where the partnership was effectively engaged in a U.S. trade or business, is treated as a disposition by the foreign partner of an aggregate interest in the partnership’s underlying property. Thus, the sale of a partnership with a fixed place of business in the U.S. will generally be considered U.S. source ECI to the selling partner.
WITHHOLDING TAX
Section 1446 requires withholding from the foreign partners’ share of the partnership’s effectively connected taxable income without regard to distributions by the partnership. Thus, withholding is required on the ECI earned by a partnership.
Generally, partnerships should determine which partners are foreign and as such, subject to the withholding provisions. Generally, partnerships require a certificate of non-foreign status from each of its U.S. partners.
The amount of the withholding is based on the foreign partners’ distributive share for the taxable year. Thus, only a pro rata amount of the partnership’s earnings are subject to withholding. Generally, the withholding is booked as a decrease in the capital accounts of the foreign partners. It is important for partnership agreements that may limit distributions to allow for the payment of withholding taxes under Section 1446.
The rate of the withholding tax is the highest rate specified in Section 1 for individuals and Section 11 for corporations.
The tax must be withheld on a quarterly basis. The partnership must file Form 8813 with the quarterly payments, before the 15th day of the fourth, sixth, ninth, and twelfth months of the partnership’s taxable year. A Form 8804 / 8805 must be filed annually to report the yearly withholding to the IRS and the foreign partners. The annual form must be filed by the 15th of the 4th month after the fiscal year end.
Please go the discussion area to begin posting on this week's topic.

Module 10
MATCHING RULES AND EARNINGS STRIPPING
The Code has special provisions that apply to related party transactions between a U.S. corporation and its foreign owners.  These special rules provide accounting methods that are designed to match the deductions in the U.S. with the corresponding income, and limit the current deductibility of interest expense.
Matching under Section 267
The general matching rules of Section 267(a)(2) defers the deduction of an expense if it is unpaid and is owed to a related party.  The related party rules include the relationships covered in Section 267(b).  Section 267(a)(3) provides that regulations will apply to apply the principles of the matching rule to payments that are made to foreign persons.
The special rules in Section 267(a)(3) treats the payment to foreign persons as essentially a being on a different accounting method, and as such disallows the deduction until paid.  Thus, this rule puts the U.S. related party on a “cash basis” for payments to foreign persons.
Tax treaties have no effect on Section 267(a)(3), and it isn’t relevant if the income is ever taxed in the U.S. or the foreign country.
The major case in this area is Tate & Lyle, Inc. 103 TC 656 (1994), 87 F3rd 99 (3d Cir. 1996) where the Tax Court held that interest expense could be deducted since there was no withholding tax required under the U.S./U.K. income tax treaty, but the appeals court validated the regulations and held for the IRS which disallowed the interest deduction until it was actually paid.
Earning Stripping Rules
The earnings stripping rules were created to limit the deduction of interest expense paid to related foreign persons.  The issues revolves around debt vs. equity, where it is more tax efficient to repatriate profits through interest payments rather than dividend payments.  Therefor, Section 163(j) limits a U.S. corporations deduction of disqualified interest.
In order to be subject to Section 163(j) the corporations debt to equity ratio must exceed 1.5 to 1 at the close of the year, and there must also be “excess interest expense”.  If both of these conditions exist, no deduction is allowed for “disqualified interest”.
In order to compute the excess interest expense, the first calculation is adjusted taxable income.  This is the taxable income computed without deductions for interest expense, net operating losses, depreciation, amortization, or depletion.  
The second calculation is the net interest expense, which is the interest paid or accrued during the year, over the interest includible in income for the year.
Thus, excess interest expense is the amount by which the net interest expense exceeds 50% of the adjusted taxable income.  In addition, any excess limitation from prior years is carried over to the current year.  (The excess limitation is the amount that 50% of the adjusted taxable income exceed the net interest expense.)
Disqualified interest is interest paid to a related person if no U.S. tax is paid on the interest income.  A related person is defined in Section 267(b) or Section 707(b)(1).  
In order to be disqualified interest, in addition to being paid to a related person, it must not be subject to U.S. tax.  Thus, if interest is paid to a foreign related party, and 30% withholding tax is required, then the payment would not be considered disqualified interest.  If the interest were subject to only a 10% tax, based on a tax treaty, then 2/3 of the interest would be considered disqualified interest.
Special rules apply to treat interest payments to an unrelated party are disqualified interest if the debt is guaranteed by the foreign related party, or is subject to conduit type arrangements such as back-to-back loans.
The earning stripping provisions are common when U.S. subsidiaries borrow funds from their foreign parent, or through banking relationships maintained by the foreign related party.
Note, there have been a number of proposals to amend these rules in teh last few years.  See President Bush's 2004; '05 & '06 Budgets and the Thomas Bill of 2004 (not passed).
 

Brief Synopsis of Other Provisions That May Limit The Deductibility Of Interest
In general, U.S. tax rules allow a deduction for interest paid or accrued within the taxable year on indebtedness.[1]  However, several exceptions to this general rule exist for a corporation that is an accrual basis taxpayer.  Some of principal exceptions include:
1.      No deduction is allowed for interest accrued but unpaid on an original issue discount ("OID") instrument held by a related foreign person;[2]
2.      No deduction is allowed for interest accrued but unpaid to a foreign related person;[3]
3.      No deduction is allowed for interest accrued but unpaid to a related person if the amount is not includible in the gross income of such person by reason of the method of accounting;[4]
4.      No deduction is allowed for interest accrued on certain AHYDOs;[5]                        
5.      No deduction is allowed for interest on registration-required obligations if such obligations are not in registered form;[6] 
6.      No deduction is allowed for certain excess interest expense;[7] 
7.      No deduction is allowed for any interest paid or accrued on a “disqualified debt instrument,”[8] and
8.      No deduction is allowed for interest expense in excess of the applicable limits regarding “acquisition indebtedness.”[9]
Earnings Stripping

A. General
1. Payment of deductible interest by a corporation to a related person on whom there is no U.S. tax on the corresponding income is generally referred to as earnings stripping.
2. To prevent earnings stripping, a corporation's interest deduction is denied for:
IRC 163(j)(2)(A), IRC 163(j)(1)(A)
a) Disqualified interest,
b) To the extent of the corporation's "excess interest expense",
c) In any year that the corporation has a debt to equity ratio greater than 1.5 to 1. B.
Disqualified Interest

1. Is any interest paid or accrued:
a) Directly or indirectly to a related person when no US tax is imposed on its interest income or IRC 163(j)(3)(A)
b) On any debt to an unrelated person, if: IRC 163(j)(3)(B)
(1) There is a disqualified guarantee of the debt and
(2) No gross basis withholding tax is imposed on that interest.

2. Disqualified Guarantee
a) Is any guarantee by a related person which is: IRC 163(j)(6)(D)(i)
(1) An US tax-exempt organization or
(2) A foreign person
b) Does not include interest which would have been subject to a net based tax if paid to the guarantor. IRC 163(j)(6)(D)(ii)(I)
(1) Net based tax is any tax other than the FDAP tax. IRC 163(j)(6)(E)(ii)
c) Does not include a guarantee if the debtor owns a controlling interest in the guarantor. IRC 163(j)(6)(D)(ii)(II)
(1) Control is established with 80% ownership. IRC 163(j)(6)(D)(ii)
d) A guarantee includes any arrangement under which a person assures the payment of another person's obligation under a debt. IRC 163(j)(6)(D)(iii)
(1) Can be direct, indirect or through an entity, on a conditional or unconditional basis, or not legally enforceable.
(2) Includes a commitment to make a capital contribution to the debtor to maintain its financial viability or a comfort letter. H Rept No. 103-111 p. 686

3. Determining if Tax is Imposed
a) No tax is considered imposed if it is paid to a tax exempt entity or if no withholding tax is imposed on the interest. H Rept No. 101-247 pp.1244-45
(1) Interest taxed as unrelated business income to a tax-exempt is not considered paid to a tax-exempt entity.
b) Interest may be treated as part taxable and part tax exempt. H Rept No. 101-247 pp.1244-46
c) Status of interest paid to pass-through entity is determined at the owner level. IRC 163(j)(5)(A) d) If the tax rate is reduced under a treaty, a portion is treated as tax-exempt and a portion is taxable. IRC 163(j)(5)(B)
(1) Interest is prorated to tax-exempt based on the ratio of the treaty tax rate reduction over the non-treaty tax rate (usually 30%).
(2) The remainder is considered taxed interest. e) Interest is not tax-exempt to the extent that it is currently includible in a US shareholder's gross income because it was paid to a: H Rept No. 101-247 pp. 1244-45
(1) CFC,
(2) FPHC, or
(3) PFIC

C. Interaction of IRC 163(j) with BPT and BLIT

1. IRS is directed to issue regulation which coordinate the earnings stripping provisions with the branch level tax provisions. The regulations will provide for: IRC 163(j)(8)(C), H Rept No. 101-247 p. 1248
a) Treat the tax on branch-level interest tax on excess interest as imposed on the recipient; and b) Determine whether the recipient is exempt from tax on the interest before applying the earnings stripping deduction limitation.
c) For purposes of the BPT and the BLIT on interest paid:
(1) Provide that the payment of interest for which a deduction is disallowed under the earnings stripping rules won't be treated as a decrease in the foreign corporation's U.S. net equity until a deduction is allowed; and
(2) Provide that disallowed interest carried over and deducted in a later tax year won't be treated as a deemed payment of interest in that later tax year to the extent it was treated as interest paid by a domestic corporation in an earlier year.

D. Excess Interest Expense

1. Excess interest expense for any year is the excess of: IRC 163(j)(2)(B)(i)
a) Net interest expense, over
(1) Net interest expense is interest expense less interest income.
(a) IRS will prescribe regulation may require various income and expense to be recharacterized as interest when they primarily reflect the time value of the use of money. IRC 163(j)(B)(6), Conf. Rept. No. 101-386 p. 66
(b) The amount of interest expense disallowed under these rules the prior year is included in computing net interest expense. H Rept No. 101-247 p. 1247
b) The sum of:
(1) 50% of adjusted taxable income,
(a) Adjusted taxable income is taxable income computed without regard to: IRC 163(j)(6)(A)(i) (i) Deduction for net interest expense, (ii) NOL deduction, (iii) Deductions for depreciation, depletion, and amortization (iv) Any other adjustments as regulation provide. IRC 163(j)(6)(A)(ii)
(a) Regulations will add back non-cash deductions and disregard proceeds from certain capital asset dispositions. Conf. Rept. No. 101-386 p. 566
(2) Any excess limitation carryover.
(a) The excess limitation is the difference between: IRC 163(j)(2)(B)(iii) (i) 50% of adjusted taxable income over (ii) Net Interest Expense
(b) The excess in any year may be carried forward to the next three years. IRC 163(j)(2)(B)(ii) (i) Amounts from multiple excess limitation years are used on a FIFO basis. Conf. Rept. No. 101-386 p. 64

E. Debt to Equity Ratio

1. The debt to equity ratio is computed by dividing: IRC 163(j)(2)(C)
a) Total debt, by
b) Total assets less total debt.
2. For this computation:
a) All assets and liabilities, other than debt having OID, are included at their adjusted basis for purposes of determining gain, IRC 163(j)(2)(C)(i)
b) Debt having OID, the amount included in total debt is its issue price plus the portion of the OID previously accrued without reduction for any acquisition premium paid by a holder of the debt instrument. IRC 163(j)(2)(C)(ii)
c) IRS regulations may provide for other adjustments. IRC 163(j)(2)(C)(iii)

F. Related Persons

1. Use IRC 267(b) or IRC 707(b)(1) concepts to determine if the parties are related. IRC 163(j)(4)(A)
a) The constructive ownership rules of IRC 267(c) also apply. H Rept No. 101-247 p. 1243
2. Back-to-back loans involving related parties through and an unrelated intermediate entity will be treated as a loan directly between the related parties. H Rept No. 101-247 p. 1246

Module 11
WITHHOLDING
The operative provisions, such as Section 871(a) and Section 881, impose income tax on foreign persons. However, the tax is collected at source through the withholding tax provisions of Sections 1441 and 1442.
If a foreign person has effectively connected income and their tax liability is based on the graduated tax rates, they are required to file tax returns and pay the tax. In the case of FDAP income the U.S. tax authorities rely on the payor of the income to withhold the tax and forward it to the Treasury. This is an efficient way of collecting U.S. taxes since most foreign persons who receive this type of income have limited exposure to the U.S. tax system, and the withholding agent is usually the last chance for the U.S. to collect taxes as the payments leave the U.S. system. As a back up, the tax laws make the withholding agent liable for the tax if they do not withhold, making the IRS’s job even easier if the foreign person does not pay the required tax due.
The statutory outline of the withholding provisions are as follows:
·        Section 1441 – 30% withholding on FDAP income for individuals;
·        Section 1442 – 30% withholding on FDAP income for corporations;
·        Section 1445 – Real property withholding;
·        Section 1446 – Partnership withholding;
·        Section 1443 – Unrelated business income for foreign tax-exempt entities;
·        Section 3406 – Backup withholding on U.S. persons
·        Section 3402 – Withholding on wages
The statutory withholding rate under Section 1441 and Section 1442 is 30%. Special lower rates apply to certain types of income such as qualified scholarships or training. In addition, deductions may be available before withholding tax on certain (rare) types of income.
The most common and important exception is the reduction provided by a tax treaty that provides a lower rate of withholding with respect to certain income of residents of a foreign country. If the item is exempted under the treaty, there does not have to be any withholding tax. Qualification under the tax treaty is important, and the limitation of benefit clauses must be examined.
Withholding Agent
All persons having the control, receipt, custody, disposal, or payment or certain types of income foreign persons must withhold tax from such income items. In a chain of payments, the withholding agent is usually the last U.S. person to have control of the funds. Any person can become a withholding agent if they pay the type of income subject to withholding.
In addition, if the payor makes the payment to a third party on behalf of the payee, the payor must still withhold, even if the funds do not leave the U.S. Constructive receipt also give rise to an obligation to withhold. Moreover, a receiving agent may also have a withholding obligation if it receives income on behalf of a foreign person and there has not already been taxes withheld.
The obligation to withhold generally arises when the income is paid. The tax accounting methods, or when the revenue is recognized or expense deducted does not determine when the withholding tax arises, but the actual payment of the item establishes the date. However, care must be taken when the parties have an “open account” such as in intercompany account where charges are posted.
Withholding Statements
U.S. persons are not subject to withholding under Sections 1441 and 1442. Foreign persons must file a statement with the withholding agent (See form W-8). For certain interest, Form 1001 should be filed. The withholding agent must file Form 1042 / 1042S to report the withholding tax to both the IRS and the payees.
FYI: Royalties are not among the statutory listing of items subject to withholding tax (WHT), BUT royalties under licenses of patents, copryrights etc, [intellectual property, that is!] are all caught by the catchall phrase "other fixed or determinal annual..."Regs. section 1.1871-7(b).

Contrary to the implication of the phrase "annual & periodical", royalties are taxable whether received in installments over time OR as a lump sum! Gains on sales/exchanges of intellectual property are also subject to the WHT if they are recognized on the receipt of payments contingent on the property's productivity/use/disposition. IRC section 871(a)(1)(D).

BUT note gain on a sale/exchange of intell prop is NOT subject to the tax if the price is NOT contingent on the property's productivity/use/disposition, BUT the courts have shown an inclination to classify a transfer as a license rather than a sale if it conveys less than the TP's entire interest in the property. Prop Regs. 1.861-18(f)(1). Royalties received by owners of TANGIBLE property [e.g., mineral] are also covered by the catchall phrase. Under 631(b)&(c) gain on disposition of timber/coal/domestic iron ore is treated as gain on a sale even though the TP retains an economic interest.

Nevertheless, if received by a nonresident alien or foreign corp. from sources within the US, this gain is subject to the WHT UNLESS it is effectively connected with a US tarde or biz. IRC section 871(a)(1)(B)/881(a)(2)

Module 12
AMERICAN JOBS CREATION ACT OF 2004
Revision of tax rules on expatriation of individuals - See immediately below
EXPATRIATION AND INTERNATIONAL TAX AVOIDANCE - AJCA §502

Revision of Tax rules on Expatriation of Individuals
 
Background
 
THE PRESENT RULES UNDER Code Sec. 877 were designed to discourage U.S. citizens and long-term residents from giving up their U.S. citizenship or terminating residence to avoid U.S. taxation.  An individual who relinquishes or terminates his or her U.S. citizenship or residency with such a purpose is subject to an alternative method of income taxation for the 10 years ending after the relinquishment or termination.  The alternative tax regime is a hybrid of the tax treatment of a U.S. citizen and a non-citizen who is a non-resident.  For the 10-year period following citizenship relinquishment, the former citizen is subject to tax only on U.S.-source income at the rates applicable to U.S. citizens, rather than the more favourable rates applicable to non-citizens who are non-residents.  Under this regime, U.S.-source income has a broader scope than it does for normal federal tax purposes, and includes, for example, gain from the sale of U.S. corporate stock or debt obligations.  However, the alternative rules apply only if the result is a higher U.S. tax liability than would otherwise result had the individual been taxed as a non-resident non-citizen (Code Sec. 877(a)(1) and (b)).  In addition, anti-abuse rules are provided to prevent the circumvention of this alternative tax regime.
 
Comment:  There is widespread concern that the current expatriation tax rules are difficult to administer and largely ineffective.  The Joint Committee on Taxation in its February 2003 Review of the Present-Law3 Tax and Immigration Treatment of Relinquishment of Citizenship and Termination of Long-Term Residency (JCS-2-03), cited the GAO’s 2000 report, finding that the IRS does not yet have a systematic compliance effort in place to enforce the present-law alternative tax regime.  In addition, other than compiling a Certificate of Loss of Nationality (CLN) database and publishing their names in the Federal Register as required by Code Sec. 6039G, the Joint Committee concluded that the IRS has generally ceased all compliance efforts under the alternative tax regime.  And, according to this same report, the INS and the Department of State have not denied re-entry into the United States to a single former citizen under these rules.
 
A tax-avoidance motive is presumed in the expatriating individual meets either a “tax liability” or “net worth” test (Code Sec. 877, prior to amendment by the American Jobs Creation Act of 2004).  Under these rules, the presumption applies if:  (1) the individual’s average annual net income tax (defined by Code Sec. 38(c)(1)) for the five years preceding the expatriation date exceeds $100,000 (“tax liability test”); or (2) the individual’s net worth as of the expatriation date equals at least $500,000 (“net worth test”).  For calendar years after December 31, 1996, these amounts are indexed for inflation (Code Sec. 877(a)), and stand at $124,000 and $622,000, respectively, for 2004 (Rev. Proc. 2003-85, I.R.B. 2003-49, 1184).  Qualified dual residents and certain minors may avoid being deemed to have a tax avoidance motive by submitting and receiving a favourable IRS ruling request on their tax status.
 
Under the present rules, a U.S. citizen must provide a statement to the State Department or other designated government entity that includes his or her social security number, forwarding foreign address, new country of residence and citizenship, a balance sheet in the case of an individual having a net worth equal to the inflation-adjusted amount under Code Sec. 877(a)(2)(b) ($622,000 for 2004), and information detailing his or her assets and liabilities.  Additionally, the individual must supply any other information deemed necessary by the Secretary (Code Sec. 6039G(b)).
 
American Jobs Creation Act Impact
 
Income tax rules with respect to expatriates.  The American Jobs Creation Act of 2004 reflects recommendations contained in the Joint Committee on Taxation, Review of the Present Law Tax and Immigration Treatment of Relinquishment of Citizenship and Termination of Long-Term Residency (JCS-2-03), February, 2003, and according to the Conference Committee Report (H.R. Conf. Rep. No. 108-755) amends Code Sec. 877 in order to provide:
(1)    objective standards for determining whether former citizens or long-term residents are subject to the alternative tax regime;
(2)    tax-based, instead of immigration-based, rules for determining when an individual is no longer a U.S. citizen or long-term resident for U.S. tax purposes;
(3)    the imposition of full U.S. taxation for individuals who are subject to the alternative tax regime and who return to the United States for extended periods;
(4)    an annual information return-filing requirement for individuals who are subject to the alternative tax regime, for each of the 10 years following citizen relinquishment or residency termination.
 
Objective standards.  The present law subjective determination of tax avoidance has been replaced with objective rules under Code Sec. 877(a) and (c), as amended by the 2004 Jobs Act.  This alternative tax regime will apply to individuals who expatriate after June 3, 2004, if:
(1)    the individual had average annual net income tax liability in excess of $124,000 for the five-year period preceding the date of the loss of U.S. citizenship.  The $124,000 amount is increased by the cost-of-living adjustment determined under Code Sec. 1(f)(3), after calendar year 2004;
(2)    the individual’s net worth is $2 million or more on the date of the loss of U.S. citizenship; or
(3)    the individual fails to certify under penalties of perjury, the he or she has complied with all U.S. tax obligations for the preceding five years and has provided evidence of compliance as required by the Secretary of the Treasury.
 
The “tax liability test” and a “net worth test” are retained but now are used to conclusively determine whether a former citizen or long-term resident is subject to the alternative tax regime.  Use of the monetary thresholds eliminates the need to inquire into an individual’s tax motivation, and no subsequent inquiry into the taxpayer’s intent is required or permitted since the ruling process has been eliminated (House Committee Report, H.R. Rep. No. 108-548).  Second, because this objective monetary standard is less flexible than present law, the amount for the net worth threshold has been increased (Joint Committee on Taxation, Review of the Present Law Tax and Immigration Treatment of Relinquishment of Citizenship and Termination of Long-Term Residency (JCS-2-03), February 2003).
 
Exceptions.  The monetary thresholds discussed above will not be applied to tax an expatriate under the alternative regime of Code Sec. 877 if, subject to the following rules, the expatriate is a dual citizen, or is a minor.
 
An expatriate will qualify as a dual citizen if he or she:
(1)    became, at birth, both a citizen of the United States and of another country, and continues to be a citizen of that other country, and
(2)    has no “substantial contacts” with the United States.
 
An individual will be deemed to have no substantial contacts with the United States only if he or she:
(1)     never was a resident of the United States;
(2)     never held a U.S. passport, and
(3)     has not been present in the United States for more than 30 days during any calendar year that is one of the 10 calendar years preceding the individual’s loss of U.S. citizenship (Code Sec. 877(c)(2)(B), as amended by the 2004 Jobs Act).
 
The $124,000 income and $2,000,000 threshold amount tests will also not apply to a minor if:
(1)    the minor became a U.S. citizen at birth,
(2)    neither of the minor’s parents was a U.S. citizen at the time of the minor’s birth,
(3)    the minor’s loss of U.S. citizenship occurred before the minor attains age 18 1/2, and
(4)    the minor was not present in the United States for more than 30 days during any calendar year that is one of the 10 calendar years preceding the minor’s loss of U.S. citizenship (Code Sec. 877(c)(3), as amended by the 2004 Jobs Act).
 
Tax-based rules for determining when an individual is no longer a citizen or resident.  Despite the fact that an individual might otherwise qualify for treatment as a person who is no longer taxed as a U.S. citizen or resident, such an individual will continue to be taxed as such until he or she:
(1)     gives notice of an expatriating act or termination of residency (with the requisite intent to relinquishing citizenship or terminate residency) to the Secretary of State or the Secretary of Homeland Security, and
(2)     provides the statement required under Code Sec. 6039G (as amended by the 2004 Jobs Act) which includes:  the taxpayer’s TIN and the mailing address of his or her principal foreign residence; the foreign country in which the taxpayer is residing;  the foreign country of which the taxpayer is a citizen;  information detailing the taxpayer’s income, assets, and liabilities;  the number of days (or portion of which) the taxpayer was physically present in the United States during the tax year; and any other information that the Secretary of the Treasury requires (Code Sec. 7701(n), as added by the 2004 Jobs Act).
 
The above statements required under Code Sec. 6039G must be filed by an individual in each tax year that Code Sec. 877(a) applies to the individual.  Unless excused by a finding of reasonable cause, an individual who fails to file this statement for any tax year in which it was required, is subject to a $10,000 penalty (Code Sec. 6309G(d), as amended by the 2004 Jobs Act).
 
Physical presence in the United States.  An individual’s presence in the United States for more than 30 days in any calendar year during the 10-year period following citizenship or residency relinquishment or termination, will cause the alternative tax regime to no longer apply to that individual (Code Sec. 877(g), as added by the 2004 Jobs Act).  He or she becomes subject to U.S. taxation as a U.S. resident for that tax year and is taxed on his or her or her worldwide income.
 
For purposes of these rules, an individual is treated as present in the United States on any day that he or she is physically present in the United States at any time during that day.  However, under newly added Code Sec. 877(g)(2)(A), a day of physical presence in the United States is disregarded in the individual is performing services in the United States for his or her employer.  This exception will not apply if the employer is related to the taxpayer within the meaning of Code Secs. 267 and 707(b), or if the employer fails to meet anti-avoidance regulations that may be prescribed by the Secretary of the Treasury.  Under this newly added provision, not more than 30 days during any calendar year may be disregarded.
 
The alternative tax regime of Code Sec. 877 will also not apply to individuals with certain ties to countries other than the United States.  To qualify under this exception, an individual, within a reasonable time period after he or she has lost U.S. citizenship or terminated residency, must become a citizen or resident in (and fully liable for income taxes of) the country in which:
(1)    the individual was born;
(2)    the individual’s spouse was born; or
(3)    either of the individual’s parents were born (Code Sec. 877(g)(2)B), as added by the 2004 Jobs Act).
 
An individual will also fall outside of the alternative tax regime of Code Sec. 877 if the individual had minimal prior physical presence in the United States, defined as less than 30 days of presence in the United States for each year in the 10-year period ending on the date that the individual lost U.S. citizenship or terminated residence.  Under the rule of Code Sec. 7701(b)(3)(D)(ii), a day for which the person was not able to leave the United States because of a medical condition that arose while the person was present in the United States, will not be counted for purposes of the 30-day limit (Code Sec. 877(g)(2)(c), as added by the 2004 Jobs Act).

Module 13
6038A:
nformation gathering about a particular TP by the Service is accomplished:
 
[1] by information reporting as part of the tax return; and
[2] by requiring maintenance by the TP of records that must be available to the Service when the return is audited at a later date. The general record maintenance provision that applies to all TPs is section 6001.

The provision that apply to multinational operations are section 6038 for US based COs and section 6038A & 6038C for offshore COs [our course]. The Service felt, in the past, that it encountered a significant amount of difficulties in obtaining docs relating to transactions between a US Sub and its foreign related party[ies]. In response to those concerns, Congress with its OBRA '89 gave the gov't an arsenal of authority. The principal strategy was Section 6038A. Now, Section 6038A provides that if at any time during a taxable year a corp is a domestic corp and is 25% foreign owned then the reporting corp must furnish at the time and in the manner… as prescribed in the Regs all such information.

For a statement of the steps that could be pursued in order to comply with the requirements of IRC 6038A see "Ten steps to Compliance: A Foreign Owner Company's Checklist and Guide to Section 6038A, by Sherwood in 20 Tax Mgmt. Int'l J. 252 [if you have access].
Section 6614(a), enacted in 1988, requires a TP who takes the position that a treaty of the US overrules an IR law of the US, must disclose on this position on a statement attached to the TP's return. This rule requires disclosure whenever the TP takes a position on reliance on a treaty and that position is contrary to the result that a later-enacted statute would have dictated had the treaty not existed.

Section 6712 imposes a penalty on any TP failing to disclose a treaty position as required by 6114(a). According to the Senate Finance Committee these provisions were enacted in the interest of bringing issues to light expeditiously and apprising the IRS in a timely manner of treaty claims whose merit is not now known. The disclosure rule applies whether the treaty believed to override a statutory rule is an income tax treaty, an estate & gift treaty, or any other obligation to which the US is a party.

An override disclosure occurs if:
1] The TP's tax for the year, computed under the statues without regard to any treaty, exceeds the tax reported on the return in reliance on a treaty rule, OR
2] a carryback or carryover from the year is reported in an amount that exceeds the carryback/over allowable in the absence of all treaties. The disclosure rule applies to an assertion that a treaty is consistent with but alters the scope of the Code provision.

The regs at 301.6114-1 give several examples of return position that must be disclosed under 6114. Remember, a TP's assertion that the disclosure rule is inapplicable must itself be disclosed UNLESS this assertion has substantial probability of successful defense if challenged. If the TP's construction of a treaty obviates the need for the filing of a return, a return nevertheless MUST be filed in order to disclose the tr4eaty position. When disclosure is not made as required by 6114, 6712 normally imposes a penalty of $10,000 if a C Corp or $1,000 if other entity such as individual, S corp, partnership, trust or estate. The penalty is separately imposed for EACH treaty-based position that is not disclosed. So, more that one penalty can be incurred by a TP in filing one return.
 

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