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Taxing Foreign Corporations in the Digital Age

Effectively Connected Income and it’s Tax Consequences

Taxing Foreign CorporationsForeign entities that deliver digital goods and services using the internet as a point of distribution may be subject to U.S. income tax. The nature and character of the goods and services will dictate how the income is taxed. In the interest of clarity, the following discussion is limited to effectively connected income.

The explosion of foreign companies using the internet to deliver digital products and services has afforded foreign businesses the opportunity to compete in global markets without the necessity of a traditional bricks and mortar operation. In this regard, the critical question is always this: Does the United States have a right to impose an income tax? It is important to note that jurisdiction to tax a foreign entity requires determining whether a sufficient connection or nexus with the United States exists to justify imposing an income tax. Foreign corporations are subject to U.S. income tax on income that is considered effectively connected income (“ECI”) and associated with conducting a trade or business within the United States 26 U.S.C. § 864(b), 26 U.S.C. § 871(b) and26 U.S.C. § 882(a).

Business Presence in United States Tax Consideration

ECI is based upon the permanent establishment of a presence in the United States. In some cases, the question of permanent establishment is easy. For instance, a foreign company that leases office space and employs its administrative staff in Phoenix will be deemed to have permanently established a U.S. presence. Other cases are less clear, for example, a case where goods and services are digitally delivered to consumers in the United States, while the company’s operation, employees, website and servers are located in one or more countries. Generally, the existence of a website alone is insufficient to establish a permanent establishment within the United States due to the absence of any tangible physical component. In contrast, the location of the server, where the website is hosted is a piece of equipment with a physical location. Thus, the presence of a server in the United States may be sufficient for purposes of permanently establishing a U.S. presence. This is particularly true where a foreign company owns and operates its servers or has physical access to them. For U.S. tax purposes, the delivery of goods and services through a server that is located in the United States but neither owned, leased nor at the disposal of a nonresident does not currently create a permanent establishment in the United States.

Foreign companies will often deliver their products and services via the Cloud using the Software as a Service(“SaaS”) model or by using a CD, portable USB device or by the customer downloading a copy of the software from the company’s website. The SaaS model involves using a third party to host a foreign company’s website and software and to store and process its hardware infrastructure. These solutions are generally delivered to consumers over the internet for a fee. The manner in which these products and services are delivered will affect how the income is characterized for U.S. tax purposes.

Character of Income in US Business Tax Consideration

The amount of a foreign company’s ECI depends, in part, on the source and character of the income.The starting point for evaluating these inbound transactions can be found in the Treasury Software Regulations(the “Regs.”). Under the Regs, the character of payments received in transactions involving computer programs is based on the nature of the rights conveyed. The determination is made without regard to the transaction form adopted by the parties or the terms they apply (26 C.F.R. § 1.861-18(g) (1)). Moreover, the means of the transaction (that is, whether by purchase of physical disc or electronic download) is irrelevant (26 C.F.R. § 1.861-18(g) (2)).

Under the Regs, computer software transactions are classified into four categories:

  • The sale of a copyright right: the right to make copies of the property, the right to prepare derivative property, the right to make public performances, or the right to publicly display the property (26 C.F.R. 1.861-18(c) (1) (i) and 26 C.F.R. § 1.861-18(c) (2) (i)-(iv)).
  • The license of a copyright right: considered a sale or exchange for income tax purposes if under the facts and circumstances, the transferee receives substantially all of the right to the underlying copyright. Where less than substantially all of the rights to the underlying copyright are transferred, the transfer will be treated as a license (26 C.F.R. §1.861-18(f) (1)).
  • The sale of a copyrighted article: transferee receives a copy of a software program but acquires no rights (or a deminimis grant of rights) that accompany a copyright right (26 C.F.R. § 1.861-18(c) (1) (ii)). To qualify for sale treatment, the transferee of the copyrighted article must receive all the “benefits and burdens” of ownership
  • The lease of a copyrighted article: Where all of the benefits and burdens of ownership have not been transferred, the transaction will be treated as a lease generating rental income (26 C.F.R. § 1.861-18(f) (2)).

The Regs, however, do not applyto transactions involving digitized content or services that do not involve the transfer of a computer program. Transactions involving hosted software, such as SaaS, do not include a transfer of a computer program, and, as such, are not subject to the Regs (26 C.F.R. §1.861-18(b) (1)). The question then is: whether hosted software transaction is a property or services transaction? That distinction can be found in 26 U.S.C. §7701(e),which provides that a contract that “purports to be a service contract” can be recast as a lease based upon the existence of the following factors:

  • The customer is not in physical possession of the software.
  • The customer does not control the software application.
  • The customer does not have a significant economic or possessory interest in the software.
  • The provider uses the software to provide services to multiple third parties.

The Section 7701 (e) factors should be carefully examined when considering SaaS services or similar digital transactions. Payments made in exchange for SaaS services are generally characterized as service income because such transactions do not satisfy a number of the Section 7701(e)factors.

In Tidewater Inc. v. U.S.,(565 F.3d 299 (5th Cir. 2009), the U.S. Court of Appeals for the 5th Circuit applied the 26 U.S.C. § 7701(e) factors in holding that income earned by a time charter that supplied a vessel complete with a crew to its customers constituted leasing income.In Xerox Corp. v. U.S., (656 F.2d 659 (Ct. Cl. 1981), the U.S. Court of Claims applying a set of factors predating Section 7701(e) determined that a supply of copying machines was treated as a service.

Source of income in US Business Tax Determination

In addition to the “character” of the income”, the “source” of the income will also drive certain U.S. federal income tax consequences (e.g., application of withholding tax to foreign persons, application of the foreign tax credit limitation formula).

Income earned from the performance of “services” is sourced according to the place of performance. If the services are performed in the United States, the income is U.S. sourced income, and subject to U.S. federal income tax; if the services are performed outside the United States, the income is considered foreign-sourced income and exempt from U.S. tax.

Determining where a digital service is performed, and, thus, the source of the income derived in connection with such service, can be difficult in certain cases. For instance, in Piedras Negras Broad Co. v. Comm’r,the United States Board of Tax Appeals held that the source of a Mexican broadcaster’s income was Mexico since the broadcast originated in Mexico and the facilities and personnel were located in Mexico, not the United States, where its customers were located ((43 BTA 297 (1941) (nonacq. 1941-1 CB 18), aff’d, 127 F.2d 260 (5th Cir. 1942)). Similarly, in  Korfund v. Comm’r,(1 T.C. 1180 (1943), the Tax Court interpretingPiedras Negrasheld that the source of such income was not within the United States, by holding that the source of income is the situs of the income-producing service and that the source of the income was the act of transmission.

In conclusion, tax jurisdiction as well as the character and source of incomeplay a critical role in determining the U.S. federal income tax consequences as well as how the income will be taxed. Accordingly, foreign companies planning to do business within the U.S. would be well advised to consult with an experienced and knowledgeable tax attorney prior to conducting business.

 

 

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Residency Based Taxation Legislation Provides False Hope for U.S. Expats

 Tax billCitizen Based Taxation

The origins of citizen based taxation can be traced back to the Civil War and the government’s struggle to raise revenue for the war effort. The predicate for imposing such a system was based upon the notion that Americans living outside of the United States were shirking their duties to America during a crisis. As a consequence, in 1861 the Government imposed an income tax on expats. This tax that was higher than the rate charged to the Americans who resided in the United States.

The law was subsequently reformed and beginning in 1864, nonresident citizens paid the same rate as citizens residing in the United States. In exchange for equalizing the tax rates, nonresident citizens were now required to pay income tax on their worldwide income.

The rationale for imposing citizen based taxation was predicated upon a sense of duty and community membership, sentiments that carried over from the Civil War. In 1924 the Supreme Court decided that citizen based taxation was constitutional (Cook v. Tait, 265 U.S. 47 (1924).  However, instead of relying on sense of duty and community membership, the Court appeared to rely upon the inherent benefits associated with becoming a U.S. citizen, but failed to detail the benefits. Presumably, these benefits include: the right to return to the United States, the ability to participate in the American economic and social community, and the right to access U.S. Courts for redress and the right to vote.

Over the years, efforts to mitigate the impact of citizen based taxation on non-resident citizens have included the implementation of the foreign tax credit in 1918 and the foreign earned income exclusion in 1926.

Tax Fairness for Americans Abroad

U.S. expats have been lobbying for years seeking to change the current U.S. citizen based taxation system to a residency based system. In December of 2018, Republican Congressman Holding introduced a bill entitled: “Tax Fairness for Americans Abroad Act” (H.R. 7358). This bill proposes a transition from citizen based taxation system to a system that is based upon residency. The bill would amend I.R.C. Section 911 by adding a Section 911A designated as “ALTERNATIVE FOR NON-RESIDENT CITIZENS OF THE UNITED STATES LIVING ABROAD” (Id. at Pg. 2).

With the introduction of this legislation in Congress, many expats, practitioners and other observers are overjoyed at the prospect of ending the citizen based taxation, which taxes U.S. Citizens and its legal residents on their worldwide income. However, I do not believe the change will occur, at least, for the foreseeable future.

Reasons that will hinder the change in the current IRS Tax based system

The proposed amendment provides qualified non-resident citizens of the United States, who elect to be taxed as nonresident citizens, with exclusion for foreign earned income as well as foreign unearned income for U.S. tax purposes. Alternatively, an Individual can elect to continue to be taxed based upon the current citizen based system.

In addition, qualified non-resident citizens would be allowed to exclude unearned income (Gains) associated with the “sale of personal property to the extent such income is attributable to periods during which the individual was a qualified nonresident citizen. Id. at Pg. 3. Similarly, HR 7358 would amend I.R.C. Section 7701(b) by adding a new definition for the term “Nonresident Citizen.” To be considered a non-resident citizen in a given tax year an individual must: (i) be a citizen of the United States; (ii) have a tax home in a foreign country; and (iii) must otherwise be in compliance with the U.S. tax laws for the previous 3 years.

Similarly, the individual must establish that he or she has been a bona fide resident of a foreign country or countries for an uninterrupted period of one year or alternatively meet the physical presence test which requires that an individual be present in one or more foreign countries for a minimum of 330 days during the tax year. The amendment excludes Federal Employees from the definition of nonresident citizen.

It is also important to note that the prospects for passing such legislation are slim based upon the history of citizen based taxation, the Government’s investment in financial reporting, FATCA, Bank Secrecy Act, concurrent FBAR filing requirements and the political climate in DC.

One could also argue that, the proposed bill undermines the integrity of FATCA and other IRS global tax enforcement initiatives designed to ferret out overseas tax cheats.

Perhaps the most significant reason HR 7358 will fail is the upcoming presidential election in 2020. It is highly unlikely that bipartisan support for HR 7358 could be achieved in the foreseeable future, given the current legislative climate in DC. The logic is clear.  The passage of any bill introduced by a Republican would be considered a victory for the President Trump. Consequently, democrats will never get on board.

Furthermore, there are no signs that the congressional stalemate will subside following the presidential election. Quite the contrary. Political commentators predict more of the same, irrespective of who is in the White house and whether the Republicans regain control of the House of Representatives. If Trump is reelected, more investigations will certainly follow. Even if the Republicans somehow are able to regain the majority in the House, there is no certainty that anything will be accomplished. Remember! “Repeal and Replace Obamacare.”

While politicians and expats alike may consider HR 7348 promising, I am reluctant to pop the cork just yet. We will just have to wait and see. Expats who meet the filing threshold will still be required to file FinCEN Form 114 (FBAR) with respect their Foreign Financial Accounts.

 

 

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