tax homework

Travis A. Wise
TA350A: International Inbound Taxation
Assignment No. 1
 
Question 1 – Interest – Saudi Arabia
A citizen and resident of Saudi Arabia holds a subordinated debenture issued by a Delaware Corporation.  The debenture holder owns fifteen percent (15%) of the corporation’s stock.
Assume that the first interest payment on the debenture is made during the corporation’s first taxable year.  The corporation’s gross income for that year consists of $750 from a construction project in Saudi Arabia and $250 from interest on deposits with US Banks.
1.(a). Is interest on the obligations described above subject to US federal income tax under IRC s.871(a) or 881(a)?
I. Imposition of Withholding Tax on Nonresident Alien Individuals
Section 871(a) imposes a tax of 30% of the amount received from sources within the United States by a nonresident alien individual as, among other items, interest, other than original issue discount as defined in Section 1273, as well as other fixed or determinable annual or periodical gains, profits, and income, but only to the extent the amount so received is not effectively connected with the conduct of a trade or business within the United States.
              II. Imposition of Withholding Tax on Foreign Corporations
Section 881(a) imposes a tax of 30% of the amount received from sources within the United States by a foreign corporation as, among other items, interest, other than original issue discount as defined in Section 1273, as well as other fixed or determinable annual or periodical gains, profits, and income, but only to the extent the amount so received is not effectively connected with the conduct of a trade or business within the United States.
              III. Subordinated Debenture
A “subordinated debenture” is unsecured debt in the named corporation, such as a bond.  A subordinated debenture pays interest to the holder. 
In this case, the subordinated debenture is held by a citizen and resident of Saudi Arabia.  The holding is not effectively connected with the holder’s conduct of a trade or business within the United States.  Because the holder is a nonresident alien individual, Section 871(a) would impose a tax of 30% of the interest received.
IV. Tax Treaty
The United States does not have a tax treaty with Saudi Arabia, therefore the withholding rate is not reduced by operation of a tax treaty.
IV. Portfolio Interest Exception
The exception to withholding tax on interest for “portfolio interest” (Section 871(h)) would not be applicable to these facts because the portfolio interest exception is not allowed for interest paid to 10% shareholders (Section 871(h)(3)(A)).  Because the shareholder owns 15% of the corporation’s stock, the interest does not qualify as portfolio interest.
(b) Further, is it subject to tax under IRC ss.1441 or 1442?
I. Requirement for Withholding of Tax
Section 1441(a) provides the rules for withholding of tax on nonresident aliens.  The recipient of the interest is not a corporation, therefore Section 1442(a), Withholding of tax on foreign corporations, would not apply.
Section 1441 requires payors of certain types of United States-source income defined in Section 1441(b), including interest income, of any nonresident alien individual or partnership, to deduct and withhold from such items a tax equal to 30 percent.
II. Applicable Exceptions
Exceptions to this requirement exist in Section 1441(c) for income connected with a United States trade or  business and portfolio debt.  Based on the facts, it does not appear that the recipient in this case has any activity in the United States that could rise to the level of a United States trade or business.  As discussed above, this interest does not arise from portfolio debt.  Therefore, the tax on the interest is subject to the withholding requirements of Section 1441(a).
III. Source of Income
The income in this case is United States-source income.  Under Section 861(a)(1), interest is generally sourced according to the residence of noncorporate payers and the place of incorporation for corporate payers.  An exception to this is the 80% active foreign business test, where at least 80% of the payor’s gross income over a three-year testing period is from active foreign business income.  In this case, the test is not met because only 75% ($750 / $1,000) of the payor’s gross income during its one-year existence is from active foreign business income. 
(c) Would the US federal income tax, if any, be affected by the application of the US Model Income Tax Treaty?
Article 11 of the 2003 OECD Model Tax Treaty provides that, “Interest arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State.”  The Treaty further provides that, “such interest may also be taxed in the Contracting State in which it arises and according to the laws of that State, but if the beneficial owner of the interest is a resident of the other Contracting State, the tax so charged shall not exceed 10 per cent of the gross amount of the interest.”
In this case, the interest arises in the United States and is paid to a resident of Saudi Arabia.  Therefore, the Treaty provides that Saudi Arabia may tax the interest.  However, the interest may also be taxed in the United States, but because the beneficial owner of the interest (the recipient) is a resident of Saudi Arabia, the tax shall not exceed 10%.
Therefore, the withholding tax is reduced by operation of the treaty to 10%.
2. Would your answer change if the debenture is guaranteed by the Parent Corporation, a Panamanian Corporation.  If the Delaware Corporation defaults on interest payments then the Panamanian corporation will be obliged to pay the outstanding interest.
If the debenture is guaranteed by the Parent Corporation, and the Delaware Corporation defaults on the interest payments and the Panamaian corporation is obliged to pay the outstanding interest, the interest should still be taxable under Section 871(a).  In Rev. Rul. 70-377, 1970-2 CB 175, the Internal Revenue Service decided a similar matter in which a foreign corporation not engaged in U.S. trade or business received interest on bonds issued by domestic corporation, and interest paid by a foreign corporate guarantor of the debt was held taxable under Section 881(a).  The Internal Revenue Service also treated the source of the interest income as United States-source, despite being paid by a Panamanian corporation, due to the guarantee of the debt.
Please state any assumptions that you feel should be made.
This analysis assumes that the interest paid was on a bona-fide debt, and not treated as a return of equity (i.e., a dividend) or return of basis.
This analysis assumes that the recipient of the interest does not have a trade or business in the United States, and does not have permanent establishment in the United States.
Question 2 – Interest – Non-Resident individual
H, a non-resident individual, purchased a two year note with a face value of $10,000 from the issuer X Corp (a Delaware Corporation).  H owns twenty five percent (25%) of X’s stock. 
Answer the questions below for both of the following situations.
 (i)                  The note’s issue price was $8,264, and the note bears no explicit interest.  A year and a day after the issue date, H sells the note to B for $9,174.  Assume the note’s yield is ten percent (10%), and all computations are done with annual compounding.
(ii)                Assume the same facts as in (i) above except that the selling price is $9,000.
Question
(a)    Determine H’s liability for US federal income tax under IRC s.871(a) and withholding obligations under IRC s.1441(a).
I. Original Issue Discount
An original issue discount note is a note issued at a price below face value.  The original issue discount is the difference between the purchase price and the face value of the note. 
II. Withholding Tax on Original Issue Discount
Section 871(a) generally taxes nonresident alien individuals on United States-source original issue discount at a flat 30 percent rate when the note is sold or as payments on the obligations are received by the holder.  (Section 871(a)(1)(C)). 
III. Amount Subject to Tax
The amount of original issue discount subject to tax under sections 871(a)(1)(C) and 881(a)(3) generally is the amount of original issue discount accruing while the foreign taxpayer holds the obligations.  This amount is determined under the rules in Section 1272.
Section 1272(a)(1) specifies that the holder of an original issue discount instrument shall include in gross income an amount equal to the sum of the daily portions of the original issue discount for each day during the taxable year on which such holder held such debt instrument.  Section 1272(a)(3) specifies that “the daily portion of the original issue discount on any debt instrument shall be determined by allocating to each day in any accrual period its ratable portion of the increase during such accrual period in the adjusted issue price of the debt instrument.”  The increase in the adjusted issue price is equal to the excess of the product of the adjusted issue price of the debt instrument at the beginning of such accrual period and the yield to maturity, over the sum of the amounts payable as interest on such debt instrument during such accrual period. (Section 1272(a)(3)).
 
Under 1272(a)(3), the calculation of income subject to withholding is as follows:
 

Face Value:
      10,000
Less Issue Price:
       8,264
Yield To Maturity:
       1,736
Adjusted Issue Price:
       8,264
Plus Yield To Maturity:
       1,736
      10,000
Less Accrued Interest During Holding:
         (829)
Increased Adjustment Price:
       9,171
Less Issue Price:
      (8,264)
Increase in Issue Price:
          907

 
Because the purchase price ($9,174) was greater than the increased adjustment price, the purchase price would substitute for the increased adjustment price to determine the increase in issue price of $910 ($9,174 - $8,264 = $910).  If the purchase price was instead $9,000, the holder would still recognize income equal to the increased adjustment price of $9,171, resulting gin an increase in issue price of $907.
IV. Applicable Exceptions
The rules taxing original issue discount do not apply to obligations payable 183 days or less after the date of original issue of the obligations.  (Section IRC §  871(g)(1)(B)(i)).  In this case, the obligation was payable two years from date of original issue, therefore this exception should not apply.
The exception to withholding tax on original interest discount for “portfolio interest” (Section 871(h)) would also not be applicable to these facts because the portfolio interest exception is not allowed for interest paid to 10% shareholders (Section 871(h)(3)(A)).  Because H owns 25% of the corporation’s stock, the original interest discount does not qualify as portfolio interest.
V. Obligation to Withhold Under Section 1441(a)
Section 1441(a) provides the rules for withholding of tax on nonresident aliens.  We assume that the recipient of the original issue discount is not a corporation, therefore Section 1442(a), Withholding of tax on foreign corporations, would not apply.
Section 1441 requires payors of certain types of United States-source income defined in Section 1441(b) to deduct and withhold from such items a tax equal to 30 percent.  Section 1441(b) specifically excludes original issue discount as defined in Section 1273. Section 1273 defines the term "original issue discount" as the excess (if any) of the stated redemption price at maturity, over the issue price.  Therefore, the original issue discount in this case is exempt from withholding at source.
VI. Source of Income
The income in this case is United States-source income.  Under Section 861(a)(1), interest, including original issue discount, is generally sourced according to the residence of noncorporate payers and the place of incorporation for corporate payers.
(b)   If H resides in a country that has an income tax treaty with the US identical to the US Model Income Tax Treaty is the result changed by the application of the treaty?
Article 11 of the 2003 OECD Model Tax Treaty provides that, “Interest arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State.”  The Treaty further provides that, “such interest may also be taxed in the Contracting State in which it arises and according to the laws of that State, but if the beneficial owner of the interest is a resident of the other Contracting State, the tax so charged shall not exceed 10 per cent of the gross amount of the interest.”

Section .3 of Article 11 defines the term 'interest' as “income from debt-claims of every kind, whether or not secured by mortgage and whether or not carrying a right to participate in the debtor's profits, and in particular, income from government securities and income from bonds or debentures, including premiums and prizes attaching to such securities, bonds or debentures.”

Original issue discount is a form of premium attached to a bond, and therefore should be included in this definition.
Please state any assumptions that you feel should be made.
This analysis is based on the assumption that B is a nonresident alien individual or a nonresident corporation.
This analysis assumes that the interest paid was on a bona-fide debt, and not treated as a return of equity (i.e., a dividend) or return of basis.
This analysis assumes that the recipient of the interest does not have a trade or business in the United States, and does not have permanent establishment in the United States.
 
 
 

Question 3 – Dividends
(a)    W Corp, a US corporation, makes a pro-rata cash distribution to its shareholders when it has no accumulated earnings and profits and is in the middle of a year in which it sustains the largest loss in its operating history.
(b)   X Corp, a US corporation, distributes a stock dividend of one (1) common share for each five (5) common shares outstanding.  The stock dividend is excluded from gross income under IRC s.305(a).
Question
(a)    Are the corporations described above required to withhold US federal income tax under IRC s.1441 if the distributions described above are to shareholders who are non-resident aliens?
              I. Character of Distribution
A distribution of cash by a corporation is characterized under Section 301(c).  To the extent that a company makes a distribution of cash and does not have accumulated or current earning and profits, the distribution is characterized as a return of basis of the stock held by the shareholders.  To the extent the distribution exceeds the adjusted basis of the stock, shall be treated as gain from the sale or exchange of property.
 
Section 316(a) defines a “dividend” as “any distribution of property made by a corporation to its shareholders out of its earnings and profits accumulated after February 28, 1913, or out of its earnings and profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made.”
II. Requirement for Withholding Under Section 1441
Section 1441(a) provides the rules for withholding of tax on nonresident aliens.  We assume that the recipient of the dividend is not a corporation, therefore Section 1442(a), Withholding of tax on foreign corporations, would not apply.
Section 1441 requires payors of certain types of United States-source income defined in Section 1441(b) to deduct and withhold from such items a tax equal to 30 percent.  Section 1441(b) items include “dividends, rent, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, or other fixed or determinable annual or periodical gains, profits, and income, gains described in section 631(b) or (c), amounts subject to tax under section 871(a)(1)(C), gains subject to tax under section 871(a)(1)(D), and gains on transfers described in section 1235 made on or before October 4, 1966.”
III. Analysis of Withholding Requirement
The distribution made by W Corp. is not out of accumulated or current E&P, and does not meet the definition of “dividend” in Section 316(a).  Therefore, the distribution is a return of basis to the shareholder.  A return of basis is not a dividend, profit, income, or gain as contemplated by Section 1441(b).  Rather, it is a return of an investment to the investor.  Therefore, withholding under Section 1441(a) should not be required for the distribution made by W Corp to shareholders who are nonresident aliens.
The distribution made by X Corp. is a distribution in-kind.  Under Section 301(b)(1), a distribution in-kind is generally subject to withholding based on its fair market value.  However, Section 305(a) provides that “gross income does not include the amount of any distribution of the stock of a corporation made by such corporation to its shareholders with respect to its stock.”  Therefore, because gross income (and therefore taxable income) does not include a distribution of stock of a corporation made to its shareholders with respect to its stock, it does not seem to be in the same class of distributions subject to withholding based on its fair market value under Section 1441(a).
(b)   Will the amounts required to be withheld, if any, correspond to the taxes imposed by IRC s.871(a)(1)?
Section 871(a) imposes a tax of 30% of the amount received from sources within the United States by a nonresident alien individual as, among other items, dividends, other than original issue discount as defined in Section 1273, as well as other fixed or determinable annual or periodical gains, profits, and income, but only to the extent the amount so received is not effectively connected with the conduct of a trade or business within the United States.  This list of items is similar to the list of items withholding is imposed on by Section 1441(a).
Similar to the analysis above, a return of basis is not a dividend, profit, income, or gain as contemplated by Section 871(a).  Rather, it is a return of an investment to the investor.  Therefore, withholding under Section 871(a) should not be required for the distribution made by W Corp to shareholders who are nonresident aliens.
The analysis for the distribution made by X Corp. under Section 871(a) is similar to the analysis for Section 1441(a).  Under Section 301(b)(1), a distribution in-kind is generally subject to withholding based on its fair market value.  However, Section 305(a) provides that “gross income does not include the amount of any distribution of the stock of a corporation made by such corporation to its shareholders with respect to its stock.”  Therefore, because gross income (and therefore taxable income) does not include a distribution of stock of a corporation made to its shareholders with respect to its stock, it does not seem to be in the same class of distributions subject to withholding based on its fair market value under Section 871(a).
Please state any assumptions that you feel should be made.
This analysis is based on the assumption that the distributions do not exceed the adjusted basis of the stock.
This analysis is based on the assumption that the distributions arise from U.S. sources.
This analysis is based on the assumption that the shareholders are not considered “related parties” as defined by the Internal Revenue Code and are not 10% shareholders.
 
 
 

Question 4 – Royalties – Milestone Payments
Your client X Co, a non-US Corporation, is in the pharmaceutical industry and they have developed a drug that they think will cure Nile Fever.  They believe that they need to license this product to a larger organization, which will better be able to both further develop the drug and arrange for the various regulatory authorities, such as the Federal Drug Administration (“FDA”) in the US and the equivalent bodies in the European Union (“EU”) and Japan, to grant approval for its commercial use. 
In this regard they are entering into a licensing agreement with Y Inc, a US Corporation.  The terms of the licensing agreement are below.
[remainder of facts omitted]
QUESTIONS
 Will the following payments to be made by Y Inc to X Co be subject to US withholding tax (“WHT”)?
(a)  Non-refundable, non-creditable, upfront license fee of US$2.5M
I. License vs. Sale
Royalty income is sourced to the place where the intangible property is used (Code Secs. 861(a), 862(a)). Thus, if intangible property is used in the United States, it is U.S. source income.  If the intangible property is used outside the United States, it is foreign source income. If the property is used both in the United States and outside the United States, then a reasonable allocation must be made.
However, gain on the sale of intangible assets, such as a patent, are sourced by Section 865(d).  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.
Under the principles of Rev. Rul. 60-226, the consideration received by a creator of a copyright for the transfer of the exclusive right to exploit the copyrighted work throughout the life of the copyright is treated as proceeds from a sale of property.  This is true even if the calculation of the payment is based on a percentage of the receipts from the sale.  The deciding factor was whether the intellectual property is transferred for its remaining life (sale) or for a period less than its remaining life (license).

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 intangible property, sourcing the sale to the location of the seller's residence.
II. Upfront License Fee
The upfront license fee is being paid by Y to X in exchange for worldwide rights to develop, commercialize, market and sell the underlying drug.  The term of the license is “Last to expire of valid and enforceable X Co and jointly owned patent claims that cover NFD, on a country-by-country basis.”  In other words, the license lasts for as long as the patents are valid, i.e. the life of the product.
The license is exclusive, and includes the right to sublicense, to develop and commercialize the intangible property and product. 
The upfront license payment is not contingent on use. 
Based on the liberal rights transferred, it appears the transfer is actually a sale of the intellectual property.  As discussed above, noncontingent payments for sale of intellectual property are sourced to the residence of the seller.  In this case, X is a non-U.S. resident, therefore the gains would be non-U.S. source income.  U.S. withholding tax does not apply to foreign source income, and therefore should not apply to this payment.
(b)  Milestone Fees
In contrast to the up front license payment, the milestone fees are contingent upon the achievement of certain specified events.  The milestone fees are non-refundable.  Milestone payments are due for:  Filing of an IND with the FDA, Completion of Phase I Dose Escalation trial, Initiation of first pivotal trial, Completion of first US/EU Phase II trial in first indication, Completion of first US/EU Phase II trial in second indication, Completion of first US/EU Phase II trial in third indication.
All of these events are solely within the control of Y, and the requirement for payment is contingent upon Y’s performance of these events.  Accordingly, even if the underlying transaction is a sale of intellectual property, because these payments are contingent, they will be sourced according to royalty sourcing principles. 
Royalty income is sourced to the place where the intangible property is used (Code Secs. 861(a), 862(a)).  The milestone payments are in exchange for events that occur inside and outside of the U.S.  Accordingly, the company will need to allocate the milestone fees between U.S.-based events and non-U.S. based events, to determine the appropriate source of income.  Methods for this allocation may include costs of achieving each milestone by jurisdiction, over total costs.  Therefore, the payments allocable to use of the patents in the U.S. would be U.S. Source income.
Section 881(a) applies to corporations to impose a tax of 30% (subject to reduction by treaty) on gross income from U.S. sources that are fixed or determinable, annual or periodic (“FDAP”) income.  FDAP income includes royalty income.  Accordingly, the milestone fees should be U.S. source income, and subject to withholding tax upon payment.
(c)  Royalties
The royalty payment (Y Inc will pay to X Co a 10% royalty on net sales in the United States) is a contingent payment, based on Y’s ability to make sales in the United States.  As a contingent payment, the source of the income will be determined by the source rules applicable to royalty income, as discussed above.  Royalty income is sourced to the place where the intangible property is used (Code Secs. 861(a), 862(a)).  Therefore, the royalty payments will be U.S. source income, and subject to withholding tax, to the extent sales were made in the U.S.  The royalty payments will be non-U.S. source income to the extent the sales were made outside the U.S.
 
 

Question 5 – Trade or business - Ship builder
Your client, X Co, a non-US corporation, is involved in the designing of ships (really big ones).  X Co has entered into a contract to design a ship for a US person, as a part of that arrangement X Co will send "tech" people over to the US for:
(a) 94 days to "help" with design issues and technical problems that arise while the ship is being built; or
(b) 190 days doing the same thing.
Assume further that X Co will NOT be building the ship and that X Co is incorporated in either Singapore or Germany.
Finally, assume X Co will be paid $1M for this, of which $150K is attributable to the "techie" whose entire workload on this project was undertaken in the US.
The techie receives salary of $25K plus expenses while he is in the US.
Question
What are the US income tax consequences of X Co entering into this contract with the US person? 
I.                  Trade or Business
If a foreign person engages in a U.S. trade or business, such net income effectively connected with the U.S. trade or business is subject to tax at the normal graduated rates (Sections 871(b), 882(a)). 
A “U.S. trade or business” is not completely defined by the Internal Revenue Code or Regulations.  However, case law has defined a U.S. trade or business to include activities that are profit oriented, with substantial activities occurring in the U.S., either directly by the taxpayer or through an agent, and regular, substantial, and continuous.[1]
a.               X Co.
Income for providing personal services is sourced to the location where the services are performed (Sections 861(a)).  X Co. has been contracted to perform design services for a U.S. customer.  Apart from $150,000 worth of design services that will be performed in the U.S., these design services will take place at X Co.’s location outside of the U.S.  Other than sending employees to the U.S. for brief visits, as discussed below. X Co. has no other contacts with the U.S. 
 
Therefore, of the $1,000,000 of services performed, all but $150,000 will be foreign source income.  The $150,000 of services income for services performed in the U.S. will potentially be U.S. source income.
No foreign sourced income is effectively connected with a U.S. trade or business unless the taxpayer has a office or other fixed place of business in the U.S. and the income is attributable to that office (Section 864(c)(4)(B)).  Determination of the existence of a U.S. office or fixed place of business depends on the facts and circumstances of the nature of the business and the physical facilities actually required by the business.  The use of another person’s facilities may create a U.S. office or fixed place of business (Reg. 1.864-7(b)(2)), but not if the use is relatively infrequent.
X Co. does not have an office or other fixed place of business in the U.S., and it is unlikely that the temporary visit by the employees performing design and tech services in the U.S. would constitute an office or fixed place of business, since the employees will be here temporarily and infrequently.
 
A U.S. trade or business includes activities that are profit oriented, with substantial activities occurring in the U.S., either directly by the taxpayer or through an agent, and regular, substantial, and continuous (supra).
 
X Co.’s activities are profit oriented, but X Co. does not have substantial activities occurring in the U.S.  X Co. is sending one or two low-level technical and design people to the U.S. to facilitate the design services.  The costs attributable to these activities make up just over 10% of the total cost of the contract.  Therefore, the $150,000 of U.S. source income should not constitute income effectively connected with a U.S. trade or business.
 
The U.S. has a tax treaty with Germany.  Therefore, if X Co. is located in Germany, the tax treaty will apply, and the U.S. trade or business analysis will be replaced with a permanent establishment analysis.  The standard for a permanent establishment is more strict than the standard for a U.S. trade or business.
 
The U.S.-German tax treaty provides 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 U.S.   The U.S.-German tax treaty defines a PE as “a fixed place of business through which the business of an enterprise is wholly or partially conducted.”  A fixed place of business includes an office, factory, mine, and place of management, but not if used solely purchasing, storing, displaying, or delivering goods, collecting information, or any other preparatory or auxiliary character.  Additionally, a dependent agent may create 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.
As discussed above, X Co. does not have a fixed place of business in the U.S. through which the company conducts its activities.  The company has sent one or two employees to the U.S. to perform services.  This should not constitute a fixed place of business.  Further, while the employees are dependent agents of the company, the employees do not have the authority to negotiate or conclude contracts.  Therefore, X Co. should not have a PE in the U.S.
b. Tech Employees
A U.S. trade or business can be created by the performance of personal services in the U.S. (Section 864(b), Reg. 1.864-2(a)).  However, a U.S. trade or business is not created by the performance of personal services in the U.S. if those activities are (a) performed while temporarily present in the U.S., (b) the taxpayer present in the U.S. for no more than 90 days, (c) the total compensation for services while present in the U.S. does not exceed $3,000, and (d) paid by an employer who is a non-resident alien or foreign corporation not engaged in a U.S. trade or business (Section 864(b)).
The employees of X Co. are performing services while temporarily present in the U.S. for more than 90 days.  The total compensation for the services they are performing is $25,000, which is greater than the $3,000 threshold.  Their wages are paid by an employer who is a foreign corporation, and as discussed above, the corporation is not engaged in a U.S. trade or business.  Therefore, the wages earned by the employees will be subject to tax in the U.S.  The employees will have to file a non-resident tax return (i.e., Form 1040-NR), and will be taxed on their net wages based on graduated tax rates.
If the employees are from Germany, the U.S. has a tax treaty with Germany that supersedes the U.S. trade or business rules above.  Under the U.S.-German treaty, salaries for employment of a nonresident in the U.S. are taxable in the U.S. only if the employee is present in the U.S. for more than 183 days in a 12 month period, the remuneration is paid by a nonresident, and the company employing the taxpayer does not have a PE in the U.S. 
If the employees of X Co. Germany are in the U.S. for 94 days, then the U.S.-German treaty will preclude the U.S. from taxing those wages, because as discussed above X Co. does not have a PE in the U.S.  If the employees of X Co. Germany are in the U.S. for 190 days, then the U.S.-German treaty allows the U.S. to tax the wages.  The employees would be able to make use of the foreign tax credit to avoid double taxation.
Actual expenses reimbursed by the employer are not treated as wage income to the employees, as long as they are based on actual expenses incurred, and not a per diem allowance.
II.                Withholding
Income effectively connected with a U.S. trade or business is generally not subject to withholding (Sections 1441(c)(1), 1442(b)).  There is an exception for wages and salaries of the nonresident employees, which is subject to withholding.  The rate of withholding is 39.6% for employees (Rev. Proc. 89-31).
Please state any assumptions that you feel should be made.
This analysis assumes that the design work, except that work that explicitly took place in the U.S., took place in either Germany or Singapore.
This analysis assumes that X Co. has no other contact with the U.S., including an office in the U.S. or other contracts with U.S. customers.
Page 15

[1] Spermacet Whaling & Shipping Co., 281 F2d 646, Amalgamated Dental Co., 6 TC 1009, Pasquel, 12 TCM 1431, 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.

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