International Tax Structuring for Foreign Manufacturer’s U.S. Sales Office.
(1) In the absence of a tax treaty, a foreign corporation is subject to U.S. federal income taxes if it has gross income that is “effectively connected” with the conduct of a U.S. trade or business. In most cases, only U.S. source income will be treated as effectively connected with a U.S. trade or business. However, in certain very limited circumstances, income derived from foreign sources will be treated as effectively connected with a U.S. trade or business under a complex set of rules.
(2) With respect to inventory sales by a foreign manufacturer, such sales will generate U.S. source income and be treated as effectively connected with a U.S. trade or business if the sales are attributable to an office or fixed place of business of the foreign manufacturer in the United States. If the foreign manufacturer does not have an office or fixed place of business in the United States, then the sales of inventory will be sourced to the place where title to the inventory passes.
(3) In determining whether a foreign corporation has an office or fixed place of business in the United States, the office or fixed place of business of its agents may be attributed to the foreign corporation so that the foreign corporation itself will be treated as having an office or fixed place of business in the U.S. Therefore, care must be taken when structuring and documenting the relationship of a foreign corporation and a U.S.-based agent. While the activities of an independent agent should not cause a foreign corporation to be deemed to have an office or fixed place of business in the U.S., the activities of a dependent agent may. Determining whether a U.S. subsidiary or affiliate of a foreign corporation is a dependent or independent agent can often be a difficult and uncertain task. Importantly, however, the activities of a dependent agent will not create an office of fixed place of business for a foreign manufacturer unless the agent (1) has and regularly exercises authority to negotiate and conclude contracts in the name of the foreign corporation, or (2) has a stock of merchandise belonging to the foreign corporation from which orders are regularly filled on the foreign corporation’s behalf.
(4) A U.S. subsidiary with a properly structured and documented relationship with its foreign corporation parent can be considered an independent agent. Therefore, when opening a U.S. sales office, it is advisable for a foreign corporation to establish a U.S. subsidiary corporation rather than a local branch office as the use of a branch would cause the foreign entity itself to have income taxable in the U.S.
(5) A properly structured U.S. subsidiary can keep all income of the foreign manufacturer (but obviously not the income of the U.S. subsidiary) free from U.S. taxes. U.S. tax treaties often allow a foreign manufacturer additional flexibility to conduct certain ancillary activities in the U.S. without becoming subject to U.S. tax. For example, under the current U.S. Model Income Tax Convention, a foreign manufacturer could use facilities in the U.S. to store, display or deliver goods or merchandise without creating a U.S. tax liability for itself. In such a case, however, it would have to file a U.S. tax return claiming the benefits of the tax treaty and most foreign companies prefer to avoid filing a U.S. tax return.
(6) As with any structure designed with tax considerations in mind, it is very important to have all of the entities transact business with each other on an arm’s-length basis, fairly compensating each entity for the services it performs for, or goods it provides to, an affiliate. For example, in the example above, the new U.S. sales subsidiary should have some form of sales agency agreement with its foreign parent entity, the U.S. sales office should receive an arm’s-length fee for its services, and should pay U.S. income taxes on its net income.