INTERNATIONAL TAXATION OUTLINE

Course Overview:
Outbound Transactions: Citizens, residents, Domestic Corporation
Inbound: Non-residents, Foreign Corporations
Safeguards: Foreign Corporation owned by United States persons

I. OUTBOUND TRANSACTIONS:
 Taxed on worldwide income
 Source rules become important subject to §911
 Foreign Tax Credit ameliorates double-taxation: direct, indirect, limitation

INTRODUCTION §§1, 11, 63 and 151 (new act)

PROBLEM SET 1: CLASSIFICATION RULES

Read: Code §§ 2(d); 11 (d); 871(a)(1)(A), (a)(1)(D), (a)(2), and (b);
7701(a)(4) and (5); 7701(a)(30); 7701(b)(1) - (7),

Reg. §§ 1.1-1 (b); 301.7701-1 (a), (b); 301.7701-2(a), (b)(1) - (3), (b)
(8)(i),
(c)(1) - (2)(i); 301.7701-3(a), (b)(1) - (2), (c)(1)(i);
301.7701(b) (2a)-(d)(2) ; 301.7701(b)-3 (a); 301.7701(b)-4a.

Skim: Code §§ 2(d); 11(a),(d); 881(a)(1) and (4); 882(a)(1) and (2).

Reg. §§ 1.1-1(b), (c); 301.7701(b)-3(a), (b)(1), (3) - (4), (6) - (8);

301.7701(b)-4(a), (c)(3)(i), (c)(3)(iv).

General Notes:
Under §7701, individuals belong to one of two categories; (1) United States
citizens and resident aliens, who are domestic persons; and (2) non-resident alien
who are foreign persons. According to Regulations §1.1-1 © “every person born or
naturalized in the United States and subject to its jurisdiction is a citizen.” An
individual who has filed a declaration of intent to become a citizen, who is not
admitted to citizenship through naturalization, is deemed an alien and not a
citizen. All US citizens, even if they are citizens of another jurisdiction are subject
to worldwide income taxation.

Under §7701 (b), an alien individual will be considered a United States resident
with respect to any calendar year if: (1) the individual is a lawful permanent
resident of the United States at any time during the calendar year (the “green card
test”), or (2) the individual meets a “substantial presence test”. In addition to
limited elections are available, which we will not take up.

In all other cases, an individual is classified as a non-resident alien for tax

purposes. If an individual is not described in either of these tests (and does not
make a residency election), he will not be considered a US resident, regardless of
the degree or extent of his physical, economic, or commercial contacts with the
US.

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1.02

The Green Card Test

An individual is a lawful permanent resident of the United States if he holds a

green card at any time during the year and his status as a green card holder at any
time during the year and his status as a green card holder has neither been
revoked nor determined administratively or judicially to have been abandoned.

The Substantial Presence Test

The substantial presence test focuses on the alien individual’s actual physical
presence in the United States. Individual who spends substantial amount of time
in the United States over a period of years have a sufficiently close relationship
with the United States to justify taxing them as residents.

Under the substantial presence test, an alien individual is treated as a resident

alien in a given year if he is present in the United States on at least 31 days of that
year and at least 183 total days during a three-year period, weighted towards the
year in question.

Section 7701 (b) (3) and the Regulations thereunder determine whether the 183
days are met using a composite, weighted measure of the days of physical
presence in the United States over the three-year period including the year in
question and the two preceding years. If an alien’s individual presence equals or
exceeds 183 days using the multipliers set forth in the statute, and equals or
exceeds 31 days during the year in question, the alien individual meets the
substantial presence test and is treated as a US resident, unless the exception
applies.
In the absence of an exception, actual presence of 183 days or more in a year is
incontrovertible evidence of residence.

The 30-day De Minimis Rule

Notwithstanding any prior presence by an alien individual, if an alien individual is

in the United States for 30 days or less in the current calendar year, a de minimis
exception to the substantial presence test applies. Under this 30-day exception, in
an alien individual is physically present within the United States for such a limited
time in the current year, he will be considered a non-resident even if the 185-day
formula would otherwise be satisfied.

The tax home exception

Section 7701 also negates resident status under the substantial presence test
where the facts and circumstances and the individuals physical presence during
the current year indicate that the individual has more significant ties to another
jurisdiction.

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Under the “tax home exemption”, an alien individual is treated as a non-resident
even if he meets the substantial presence test for any current year if the individual
(1) is present within the United States on fewer than 183 days during the current
year; (2) establishes that, for the current year, his “tax home” is in a foreign
country; and (3) has a closer connection to such foreign country than the United
States.

Exempt and Other Special Categories of Alien Individuals

§7701 (b) certain alien individuals and their activities are accorded special
exemptions from resident status. Certain days of presence of these “exempt” and
special aliens are not counted towards the individuals United States residency.
Under §7701 (b) (3), special rules apply to four categories of exempt individuals, as
well as to individuals unable to leave the United States for medical reasons, and
certain individuals commuting to or travelling through the United States. In
general, days spent in the commuting or traveling through the United States will
not be counted for purposes of determining presence under the substantial
presence test.

Exempt Individuals

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Foreign government-related individuals, teachers, trainees, students and
professional athletes competing in charitable sporting events. § 7701 (b) (5) and
Regulation §301.7701 (b)-3 provide detailed definition of the individuals in these
exempt categories. These limitations prevent a timeless pursuit of experience and
knowledge in the United States without contributing to the national revenues.

Medical Conditions

Presence does not arise for any day on which an individual objectively intended to
leave the United States but was unable to leave due to a medical condition or
problem arising when the individual was present in the United States.

Regulation §301.7701 (b)-3 (c) provides that the condition causing the failure to
leave must not be a pre-existing problem or condition known at the time the
individual entered the United States.

Days in Transit
Pursuant to §7701(b)(7)(C) and Regulations §301.7701 (b)-3 (d), days in transit
between the foreign points are excluded as days of presence for the substantial
presence test, presumably because such a traveler must likely cannot utilize his
brief stay in the United States for any purpose sufficiently significant to extend
residency nexus. The exemption is designed to protect individuals who must travel
between airports to change planes or who experience brief US layovers. The
exemption is conditioned on physical presence of less than 24 hours and the
absence of any non-travel activities. Thus, for example, should the individual
attend a business meeting while in transit, the exemption will not apply.

Contiguous Country Commuters

Regular commuters residing in Mexico and Canada are also shielded from resident
status. Under §7701 (b)(7)(B) and Regulation §301.7701 (b)-3, a “regular”
commuter is an individual who commutes to his place of employment or self-
employment in the United States on more than 75% of the workdays during the
working period. Commuting is determined on a daily basis, so overnight or
extended stays will not qualify as commuting for purposes of this exemption.

Residency Commencement and Termination

A resident individual’s period of residency in the United States depend on the test
under which the individual obtained residency status. If an alien individual satisfies
the green card test but does not meet the substantial presence test, the
individual’s “residency starting date” is the first day of his physical presence
during a calendar year as a lawful permanent resident, pursuant to §7701 (b)(2)(A)
and Regulation §301.7701 (b)-4. If an alien individual satisfies the green card test
for the current year but is not physically present in the United States during the
current year, the residency starting date is the first day of the following year.

If the substantial presence test is met, residency generally commences on the first
day the individual is present in the United States. However, §7701 (b)(2)(c)
provides for a diminis rule which disregards nominal presence in some cases for
purposes of the substantial presence test. For example, if an individual during a

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period of actual presence (for example, a house-hunting trip) can establish that he
had a closer connection to a foreign country than to the United States, up to ten
days of presence can be disregarded for purposes of determining the residency
start date.

Under §7701 (b)(2) (a), if an individual meets both the green card and substantial
presence tests, residency commences on the earlier of the residency
commencement dates provided under both tests. Similar rules apply for
determining the alien individual’s residency termination date. Regulation
§301.7701 (b)-4(b) provides the general rule that, for an individual who ceases to
be a resident during a calendar year and is not a resident at any time during the
following calendar year, the residency termination date is the last day of the
calendar year.

Section 7701 (b)(2)(B) and the Regulations thereunder provide that,

notwithstanding the general rule, residency terminates under the green card test
on the first day during the calendar year on which the individual is no longer a
permanent resident, if the individual establishes that, for the remainder of the
calendar year, his tax home was in a foreign country and he maintained a closer
connection to that foreign country than to the United States. An alien individual
who holds a green card may abandon resident alien status (subject to the
substantial presence test) by surrendering the green card (subject to the
substantial presence test) by surrendering the green card to the United States
Citizenship and Immigration Services (USCIS) or a consular officer. The date of
such surrender controls the date of termination of residency, rather than the
subsequent date, if any, on which the United States government processes the
surrendered green card.
According to §301.7701 (b) – 1, abandonment occurs when an individual files an
application for abandonment or submit a letter accompanying his green card
stating his intent to abandon resident status. If, however, the determination of
abandonment of lawful permanent residency is initiated by the USCIS or a
concular officer, the abandonment of lawful permanent residency occurs upon the
issuance of a final administrative or judicial order of abandonment (after the
appeal has been exhausted).

Under the substantial presence test, §7701 (b)(2) provides that an individual’s last
day of physical presence will close the period of residency, provided that after such
date the individual has a closer connection to a foreign country for the balance of
the calendar year and is not a United States resident in the next year. The nominal
presence rules may be used to disregard up to ten days of actual presence.
Although these days are disregarded for purposes of determining residency
commencement and termination dates, they are still considered for determining
whether an individual meets the substantial presence test.

 First Question in Outbound transaction is – is this a United States citizen or

resident?
o If yes, will be taxed on worldwide income under § 61

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 o If no, non-residents will be taxed under separate regime focusing on
source rules; taxes only specific items of income § 871, 881, 882

Entity Classification:
US Domestic Non-Domestic
Individual US Citizens § 61 Non-citizen, non-resident §
2(s)§ 871
Residents (non-citizens) Foreign Corporation § 881, 882, 11 (d)
– foreign corporation should be taxed
in accordance with 881, 882
Domestic Corporations § 11(a)
Partnership (look at nature of partners)

1-1 Determine the entity classification for United States tax purposes of
the following entities:
(a) A Delaware corporation owned entirely by citizens and residents of Japan.
(b) A Limited Company formed in Singapore.
(c) A Gesellschaft mit beschrankter Haftung (GmbH) formed in Germany and
owned by United States persons, with respect to which neither has any
personal liability under German law.
(d)
(e) A Limited Company formed in Ghana and owned entirely by two United
States persons, one of whom is personally liable for the debts and
obligations of the entity under Ghanaian law.
(f) How would your answer to (d) change if the Ghanian company was owned by
a single United States person who was personally liable for the company’s
debts?

Step 1: Is the entity domestic?

 §301.7701-1 definition of person; a corp is not a partnership and a

partnership is not a corporation
 §301.7701-5(a) Entity is domestic if it was created or organized in the
United States
o Still domestic if organized in both US and abroad
o If entity formed abroad, no difference if classified as corp when no $
earned in US

Step 2: Is it a corporation (default or per se)? May it elect treatment?

 Look under the §301.7701-1,2, and 3 regs
o First category of business entities with per se treatment
(automatically a corporation) are listed in -2(b)
 Association
 Incorporated under state law as corp, 301.7701–2 Business
entities (b)(1)
Certain foreign entities listed per se in regs 301-7701-2(b)(8). Default for foreign
301-7701-2(b)(2).

(a) A Delaware Corp owned by Japanese Citizens. Foreign? No. Is this a

corporation? Yes.

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§ 7701(a)(4) Domestic-created or organized in US Federal or under US state law.
May not elect
 If this were an LLC could use check the box regs to choose corp or P
taxation – if taxed as a P, classification is dependent on the partners (so
probably would be foreign); Delaware LLC Corp. is not a per se corporation,
you can elect.
No default rule?

(b) A Public Limited Company formed in Singapore. Foreign? Yes. Is this a

corporation? Yes.
Not created or organized in the United States, § 7701(a)(5)
Yes per se corporation under 301-7701-2(b)(8) as a (public) listed foreign
corporation. May not elect

(c) A Gesellschaft mit beschrankter Haftung (GmbH) formed in Germany and

owned by two United States persons, neither has any personal liability under
German law. Is this foreign? Yes. Is this a corp? Default.

 Individual parties may have income tax from the corporation under the CFC
and PFIC rules
Not on the per se list for corp. Therefore it is eligible to elect tax treatment as a
corporation or partnership under the “Check the Box” regulations in 301.7701-3.
 Default rule: International companies are default treated as corporations
under check the box if there is limited liability for all members

(d) A Limited Company formed in Ghana and owned entirely by two US persons,
one of whom is personally liable for the debts and obligations of the entity under
Ghanaian law. Foreign? Yes. Corp? NO
 Not a per se corp, company may elect treatment under check the box
 By default it will be treated as a partnership because only one party has
limited liability
o Note: Foreign companies have greater flexibility to use check the box
rules in US

(e) Same as (d) except owned by single US person who was personally liable.
Foreign? Yes. Corp? No
Still default will be treated as a disregarded entity (single owner; sole
proprietorship/branch). May elect

Policy Side-Note:
A US entity/citizen/resident is taxable by US on worldwide income regardless of
source, graduated rates

Clients will have the following questions:

 Does the policy provision make sense?
 Someone has already acted and wants to know consequences
 Someone has yet to act and wants to know choices

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Cook v. Tait – US Citizen moved to Mexico. SC says that citizenship confers
benefits no matter where you live, can be taxed as a nonresident on worldwide
income.

Residency Classification for Individuals:

Extent of a foreign citizen’s liability for US tax is predicated on whether a resident
or non-resident of US

Three Tests - §7701(b)

(1) Lawful Permanent Resident – “Green Card Test”
(2) Substantial Presence Test - present in US at least 31 days during the year, and
sum of days prior 2 years equals or exceeds 183 days: Current year 1x, last year
1/3x, 2 years back 1/6x
(3) First-year election to be treated as a United States Resident.

Questions to Answer:
 Is the individual a United States resident?
 If so, when does their residency begin/end?
o Begin: §7701(b)(2)(A) - first day present while lawful permanent resident
o End: §7701(b)(2)(B) - after last day present
o
1-2 Paulina has never been in US prior to move to San Francisco February 1, Year
1. Paulina moved after applied for (and received) a green card from US. She has
lived in San Francisco since that time.

 Paulina is a non-citizen, we must determine whether or not she is a resident

of US

(a) Is Paulina resident alien Year I? Under what test(s) is she be a resident alien?
Residency start date?
 Yes resident under the “green card test” § 7701(b)(6) lawfully accorded
privilege of residing permanently in US and not revoked or abandoned
 Residency begins on Feb 1st because Green card was already received. Prior
to Feb 1, non – resident.

(b) Like (a) instead Paulina moved to San Francisco under a temporary visa on
February 1, Year 1, and she lived there until her application for permanent
residence was approved on November 15, Year 1?

Issue: Here, Paulina satisfies both the substantial presence and green card test.
 Meets substantial presence test under 7701(b)(3). Date is important because
once she becomes a US resident she is taxed on foreign income. Bifurcation
of her tax year.
 Under substantial presence test - start date first day present in qualifying
year
 Rule: Under the regulations, if you meet both the green card test and
substantial presence test your presence state begins as the earlier of the two
dates

§7701 (C) Certain nominal presence disregarded.-

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(i) In general.--For purposes of subparagraphs (A)(iii) and (B), an individual shall
not be treated as present in the United States during any period for which the
individual establishes that he has a closer connection to a foreign country than to
the United States.
(ii) Not more than 10 days disregarded.--Clause (i) shall not apply to more than 10
days on which the individual is present in the United States
 Nominal Presence: May affect the starting date if you can disregard those
days, then the green card may be the earlier of the two dates; Then question
of the first day of counted presence.

(c) How would the answer to (a) change if, instead, Paulina moved to San Francisco
on October 15, Year 1, and her application for permanent residence in the United
States was granted on December 1, Year 1?

 Only Green card test satisfied, residence for tax purposes begins December
1, first day lawful

1-3 Eduardo citizen of Peru, present in US for 90 days during Year 1, 120 days in
Year 2, and 125 days in Year 3. Not a lawful permanent resident during any of
those years and not present in US before Year 1.

Substantial Presence Test: An individual is treated as a resident if he is present

in the United States
(1) On at least 31 days of the current year (non-consecutive); AND
(2) At least 183 weighted average days during the current and two preceding
calendar years. Start date: during the year that individual is resident.

Equation: Total Number of Days Present for Current Year

ADD: 1/3 Number of days present during the first preceding year
ADD: 1/6 Number of days present during the second preceding year.

Note: Actual presence for 183 days or more for the year under review is
incontrovertible evidence of residence, as long as the individual is not exempt
under the statute.

De Minimus Exception: If an individual is physically present within the United

States for 30 days or less during the current year, they will be considered a non-
resident even if they meet the 183-day formula

Tax Home Exception: Where the facts and circumstances indicate that the
individual has more significant ties to another jurisdiction, an individual will be
treated as a non-resident if they are (1) present less than 183 days during the
current year; (2) establish that for current tax year their “Tax home” was in a
foreign country; and (3) have closer connection to the foreign country
 §162(a)(2) Tax Home: located at an individuals regular place of business, or
abode

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  Factors for indicating tax home are in §301.7701(b)-2(d) “more significant
contacts”

Exempt Individuals: §7701(b)(3)(D) accepts “exempt” individuals from the

residency label required under the substantial presence test
 Exempt Individual: foreign government related individual, student, teacher
or trainee, professional athlete in US for charity event
 Sick Person: Individual was unable to leave the United States on such day
because of a medical condition which arose while such individual was
present in the United States

(a) What is Eduardo's residency status in the United States for each of the three
years?
Eduardo fails aggregation prong of the Substantial presence test, as such he is a
non-resident all years.
Year 1 residency status: 90 days aggregate – fails second prong. Non-resident
Year 2: 120 days + 90 * 1/3 = 150 days aggregate. Non-resident
Year 3: 125 days + 120 * 1/3 + 90*1/6 = 125 + 40 + 15 = 180. Non-Resident

(b) How would answer to (a) change if Eduardo was present in the United States
for 190 days in Year 3?
Year 1 and 2 would remain the same
Year 3: 190 + 40 + 15 = 245. Resident under substantial presence for year 3

(c) How would (a) change if present for 360 days in Year 1, 300 days in Year 2, and
30 days in Year 3?
Year 1: Resident for Year 1 regardless because >183 days in Year 1
Year 2: Resident for Year 2 regardless because >183 days in Year 2
Year 3:
 §7701(b)(3)(A)(i) – De minimis exception because now you are in the country
for less than 31 days
o Reg §301.7701(b)-1(c)(4)
 Non-resident for Year 3, despite residency in Year 1 and 2 and fact that
aggregate is > 183

(d) How would (a) change if Eduard was present for 90 days in Year 1, and 180
days in Year 2 and 150 days in Year 3? Assume Eduardo spent the remainder in
Peru where his wife and children still live, where he operates a thriving business,
and where he is registered to vote and licensed to drive, and that Eduardo travels
to the United States in order to sell the widgets produced by his Peruvian
business.
Result: Under (a), Eduard would typically satisfy the residency requirement in
Years 2 and 3. However, under 7701(b)(3)(B) qualifies with a closer connection tax
home exception because the factors weight heavily in Eduardo’s favor that his
actual tax home and lifestyle nexus is that of Peru

NOTE: With weighted average substantial presence ONLY, there is Tax Home
exception; can argue has a closer connection to foreign country. (cannot be present
183 days or more or applied for green card…)

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Connections: List of factors are outlined in §301.7701(b)-2(d) regs, similar to §
162(a)(2) including:

(i) The location of the individual's permanent home;

(ii) The location of the individual's family;
(iii) The location of personal belongings, such as automobiles, furniture, clothing
and jewelry owned by the individual and his or her family;
(iv) The location of social, political, cultural or religious organizations having a
current relationship;
(v) The location where the individual conducts his or her routine personal
banking activities;
(vi) The location where the individual conducts business activities;
(vii) The location of the jurisdiction in which the individual holds a driver's
license;
(viii) The location of the jurisdiction in which the individual votes;
(ix) The country of residence designated by the individual on forms and
documents;

1-4 Geir, a citizen of Ghana, is a student at the University of Arizona and in US on

student visa. Plans to be in US for four years of college, returning home for
summers. If offered a job, Geir may stay.

(a) What is Geir's residency status?

Geir is an exempt individual 7701(b)(5)(D) (4 year limitation) and therefore the

days Geir spends in the United States will not count for purposes of the substantial
presence test, as such, if he is not a green-card nor an elected resident, then he is
a non-resident. Would count in year 4 after graduation.

(b) After four years in the United States, Geir's student visa was set to expire upon
his graduation on May 1. He did not find a job, so he planned to skip
commencement ceremonies and return to Ghana. As Geir was driving to the
Tucson airport on April 28 to catch his flight home, he was distracted by the
beauty of the Tucson countryside and drove into an embankment. Geir recovered
from the accident but only after being immobilized in a body cast until December
28 of the year of his graduation. He flew home on December 31 of that year. What
was his residency status that year?

Geir was a lawfully exempt student until May. After May 1, he would have to
account for the days spent in the United States but for exemption for persons
suffering from medical conditions, which “arose while the individual was present in
the United States.” §7701(b)(3)(D)(ii).

The regs further explain the conditions for exemption of medical condition
(301.7701(b)-3(c)). Because he left within a reasonable period of time after being
totally immobilized (Dec. 31) No days would count for residency status that year,
and he is considered a non-resident because of intend to leave.

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NOTE: Family members are not specifically listed in statutes; but there would be a
good faith argument
* Also if there was no real presence don’t worry about the reasonableness of
departure

1-5. Lidia, a citizen and resident of Bolivia, considered moving to US even though
she had never been to the country. She visited the United States for 15 days in
February of Year 1. The trip convinced her to make the move. In May of Year 1, she
spent 20 days in Atlanta on a house-hunting trip and on September 3, Year 1, she
moved to the United States where she continues to be present and reside
domestically.
(a) What is Lidia's residency status for Year 1?
Lidia has neither applied for a green card, nor will she meet the substantial
presence test for Year 1.
o Total days was 154 (15 + 20 + Sept. 3 – Year End)

(b) May Lidia elect to be treated as a resident for any portion of Year 1? If so,
under what circumstances would she want to make this election?
The rules for election are in 7701(b)(4) and allow a non-resident alien to make a
residency election if:
 Lidia does not meet the green card or substantial presence test,
 Lidia will meet the substantial presence test for the calendar year following
the year of election
 Lidia must remain in US for 31 consecutive days in Year 1 and from the start
of that 31 day period she was present for 75% of the time. Residency
begins when she is here and stays till end of year

Result: Lidia will be able to make an election provided she can meet substantial
presence test in Year 2.
§ 6013(g) allows a limited election for non-resident alien spouses of US residents to
file joint tax returns

Lidia would want to make the election to

 Take advantage of benefits extended in a treaty between the US and a
country in which the resident does not also reside
 Use personal exemptions and other deductions derived within US and not
connected with trade/business, instead of taxed on gross US income
 Lower personal income tax rates than those applied to non-residents
 Ability to claim foreign source losses under §165.
 Become a stockholder in an S Corporation
 Can file a joint return with a resident spouse
 Use preferential rate of interest on sale of real estate
 May qualify for foreign earned income tax credits

NOTE: Foreign individuals and corporations not resident in tax treaty jurisdictions
are subject to US taxation only if they derive income from within the US (i.e.,
United States source income) or if they derive income which is effectively
connected to a US trade or business. Passive income (not portfolio interest)
derived by a non-resident is typically subject to a 30 percent tax rate with no

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allowance of deductions; business income (reduced by attendant deductions) is
subject to tax at the same graduated rates applicable to US citizens and residents.
Incentives for domestic persons to utilize foreign enterprise

(c) If Lidia did not arrive permanently in US until December 8 of Year 1, what is
her residency status? May she elect a different result?
Lidia is a non resident and cannot elect residency status for Year 1 because she
will not meet the 31 consecutive day requirement

(d) If Lidia arrived on September 3, Year 1, but took a vacation in Bolivia for the
entire month of December, Year 1, what is her residency status for Year 1? May she
elect a different result?
Now the issue is whether or not Lidia will be able to meet the 75% of the start date
of the 31 consecutive run. The total number of days to the end of the year
beginning Sept 3, are 27+31+30+31 = 89 days. If Lidia is present only for 65% of
the year (out of 120), does not meet the strict 75% presence requirement
 Can elect to treat 5 of the days absent as “present” 301.7701b-4 regs so she
can have the election.

Example:
Person comes to the US, commits a crime and then is detained – are they a
resident?
 Congress never thought of this – they did not think about jail
 In spite of the statute and regulations, this would be something you would
most likely argue
 If you are taken against your will and brought to U.S. soil - unclear
 Days transit between foreign points (nonbiz, 24 hrs)– excluded §7701(b)7(C)
from subs. presence
 Mexico and Canadian Contiguous Commuters- §7701(b)7(C) to workplace in
US on 75% of days

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PROBLEM SET II: SOURCE RULES
READ: Code §§ 861 (a) (1)-(6); 862(a) (1)-(6); 863(b) (New Act); 864(a);
865(a), (b), (c), (d) and (g).
Reg. §§ 1.861-2(a); 1.861-3(a)(1); 1.861-7(a), (c), (d);

Overview:

As discussed in Unit 1, non-resident aliens and foreign corporations as defined

under §7701 are generally subject to US taxation only on income that is sourced in
the US or is some way connected with business conducted in the US. The rules for
sourcing income as either domestic or foreign are thus crucial for foreign
taxpayers. The source rules are also important for United States persons due to the
pivotal role these rules pay in computing the foreign tax credit.

The principal rules for sourcing are contained in:

§ 861
§ 862
§ 863 (new)

14
§ 865

General rule: source of income is the jurisdiction from which the income is derived.

Similar to classification, source rules are “super” classification, they effect

groupings (in/out/safeguards)
 Important on inbound activity for foreign residents and corporations:
o §871(a)& (b) – For each taxable year, 30% tax on income from sources
within the United States for non-resident
o §864 – income from sources within and without the united states
 Important on outbound activity for citizens, residents and domestic
corporations
o §911 – Citizens or residents of the United States get a foreign earned
income credit.
o Foreign Tax Credit
o §904(a) –limitation on the credit
 Safeguards: §951 with CFC and PFIC; as well as §1241

Purpose of Source Rules: Intended to accurately attribute income to correct

source, foreign or domestic
 Source rules are taking different types of receipts and trying to “center” that
income; as we look at range of relevant factors decide that in this case, THIS
is the rule
 You can have a single transaction that can have different sources for the two
jurisdictions involved because of the U.S. and Foreign Country source rules
each claiming it
 Classifies income in three ways (1) Sourced within US (2) Source outside US
and (3) Mixed Source

Do source rules result in a single transaction

/receipt being centered in one jurisdiction or another?
 Some will be bifurcated between jurisdictions depending on character of
transaction/receipts

Types of Income §861: The following types of income will be treated as sourced
from in the US
 Interest from a domestic corporation or arising from US activities (residence
of the payor)
 Dividend - domestic corp & foreign unless < 25% effectively connected with
US for last 3 years
 Personal Services - Compensation for labor or personal services performed
in US
 Rents and Royalties – from interests in property located (used) in the United
States
 US Real Property - Gains, profits, and income from the disposition
 Personal Property (governed by §865 as well) residence of seller or having a
US tax home
 Inventory - sold or exchanged within US even if purchased outside US

15
Note: Losses not sourced under § 861; they are allocated and apportioned under
Reg §1.861-8 (source rules) to class(es) of gross income to which they relate.
Separate rules for personal property under Reg §1.865-1

STEP 1: What kind of Payment is this?

Identify and then go to the source rule appropriate…

Interest Payments:
§861(a)(1) General Rule: Source of the interest income is controlled by the
residence or place of incorporation of the obligor (i.e. the person who owes the
interest on the loan; person paying the interest).
Interest from United States residents and domestic corporations possess a US
source.
Regs §1.862-2 (a)(2)
- In addition to noncorporate residents and domestic corporations, foreign
partnerships and foreign corporations, that are engaged in trade or business
in the US are also considered to residents of the United States for purposes
of interest sourcing rule. Interest paid by a foreign entity will be considered
US source if the entity is conducting trade or business in the US.
Interest paid by (1) foreign partnership and foreign corporations (2)engaged
in trade or business in the US are US source. They are considered resident
for purpose of interest sourcing rules.

§861(a)(1) (A) interest on deposits on with certain foreign banking branches of

domestic corporations and partnerships will be considered foreign sourced.
Interest income paid by resident obligor to branches of foreign banks are exempt.

§1.861-2(a) (2) (assignment is 1.861 2(a) Foreign corporations and foreign

partnerships are treated as US residents
 Interest is broadly defined – includes disguised forms of interest

§861(a)(1) Two types of interest income are US Source

 Interest from the United States or DC
 Interest from the interest bearing obligations of US non-corporate residents
and domestic corporations (private interest)
o Private Interest: sourced in US if true obligor is US resident or
domestic corporation
o Guarantor on interest payment: Regs §1.862-1 state that true source
is still from obligor

Banking Obligor Exceptions: Interest on deposit with foreign branches of US

corporation or partnership, if the branch is engaged in the banking business, will
be considered foreign source

2-1 Determine the source of each of the following items:

(a) An interest payment of $1,000 made by Ramli, a Malaysian citizen who is
present in the United States for the whole year during which the payment was
made, and whose only gross income for all years consists of interest and dividend
income from investments in Malaysia.

16
Generally, § 861, interest “from the US” is includible in gross income as payments
sourced from US. The regs further discuss that interest from a Resident of the US
includes interest paid by an individual who was a resident of the US at the time of
payment. Ramli satisfies substantial presence test, US source.

(b) $1k interest payment made by Texas Co., a Texas corp, on a general obligation
bond.
Interest - look to the obligor to determine source. This payment made by a
“domestic corporation.” This is a corporation that was organized within the US,
and as such this is a US source under § 861(a)(1).

(c) How would (b) change if the interest is paid not by Texas Co. but by its
Singapore branch on a deposit at that branch? Like Texas Co., the branch is
engaged in the commercial banking business.
Exception Covered in 861(a)(2)(A)(i)– interest paid by foreign banking branch
considered foreign source.

NOTE: Under the rule because it’s a branch and not a subsidiary, the payor is a
domestic corporation, BUT there is a specific exception for the branch banking.

(d) How would the answer to (b) change if Texas Co.’s interest payment is made in
Year 4 and Texas Co. derives both US source income attributable to active conduct
of its business in the US and foreign source income attributable to active conduct
of its business outside US? Texas Co.’s gross income is as follows:

Year U.S. Source Income Foreign Source

Income
1 $500,000 $3,000,000
2 $500,000 $3,000,000
3 $1,000,000 $2,000,000
4 $2,000,000 $2,000,000
Total $4,000,000 $10,000,000
 Congress terminated the active foreign business exception in 2010.
 Because it’s a domestic corp and there is no exception, this is US source

Dividends:

General Rule
§ 861 (a) (2) Dividends are generally sourced according to the situs of the
incorporation of the payor corporation.

Dividend Source Rules:

§316. Dividends Defined. (a) “dividend” means any distribution of property

made by a corporation to its shareholders--
(1) out of its earnings and profits accumulated after February 28, 1913, or
(2) out of its accumulated earnings and profits of the taxable (current) 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.

17
- §301 provides the tax consequences of corporation distributions. Under that
Section, dividends are included in gross income under §301 (c) (1) and are thus
subject to dividend sourcing rules.

General Rule: Focus is on the payor

 Corporations: typically the situs of incorporation unless effectively
connected US business

861(a)(2)(A) – Dividends paid by Domestic Corporation is US Source

Dividends from Foreign Corporation:

Dividends from foreign corporation with a de minimis or no US business nexus are
foreign source.
§861(a)(2)(B): Dividends paid by a foreign corporation may be US source if over a
three-year period, 25% or more of the gross income of the corporation is effectively
connected with a US trade or business.
§861(a)(2)(B): If over three year period preceding the year dividend was declared
less than 25% of gross income of a foreign corporation is effectively connected
with US trade/business any dividend will be deemed foreign source
 If more than 25% just the proportionate amount of dividend will be
considered US source

2-2 Determine the source of each of the following items:

(a) Cash dividend (out of E&p) paid to shareholders by Wash Co, a corporation
organized in Washington.
Step 1: What type of payment is this? Dividend
Step 2: Apply source rule:
Dividend Source Rule: Focus on payor – distribution by a domestic corp is sourced
from US § 861(a)(2)

(b) A cash distribution of $1,000 paid to shareholders in Year 4 by Foreign Co., a

foreign corporation that conducts business in the United States and has the
following items of gross income for Year 1—4:

Year U.S. Source Income Foreign Source

Income
1 $2,000,000 $10,000,000
2 $3,000,000 $10,000,000
3 $5,000,000 $10,000,000
4 $10,000,000 $10,000,000
Total $20,000,000 $40,000,000
Foreign Corporation Dividends: Under these rules, a foreign corp that makes
25% of gross income from US only pays the ratio of gross income – so in this
instance, because the three year period Year 1 – 3 gross income ratio is $10/$40 =
33% then the total US sourced dividend will be $333.
 Begin the year that the distribution was made…
 NOTE nexus is still a foreign corp; but a foreign corp earning income in US
and taxable there

18
(c) How would the answer to (b) change if the dividend was declared in Year 3 but
not paid until Year 4?
* Dependent on when dividend was declared – look at preceding 3 year period.
* Years 1-2 = $5M/$20M. All foreign sourced because only 25% US income, no US
dividend.

Once we move from the interest/dividend and receipt of a single item there are a
multiplicity of factors that need to be involved - Apocalypse Now filming and
income, teaching in Seoul/preparatory work

Personal Services Income:

General rule under §861 is that they follow locale where the services are
performed, regardless of the residency of the payor, place of contract for service,
or place of time and payment for services.
§861(a)(3) – compensation for labor or personal services performed in the US has a
US source.
§1.861-(4)(a)(1) – irrespective of the residence of the payor, the place in which the
contract for services was made, or the place or time of the service.
§861(a)(3) – de minimis exception to the place of performance rule. Up to $3,000 of
certain compensation income earned by foreign persons who are present in the US
for short periods of time is not considered to be sourced in the US.
Exception: If all three prongs are met, will not be considered US Source under §
86
1(a)(3)
 The labor or services are performed by a nonresident alien individual
temporarily present in the United States for a period or periods not
exceeding a total of 90 days during the taxable year,
 Such compensation does not exceed $3,000 in the aggregate, and
 The compensation is for labor or services performed as an employee of or
under a contract with-- a nonresident alien, foreign P, or foreign corp, not
engaged in trade or business within the US
o Purpose: If a foreign person has a trade or business in the US, do not
want to undercut domestic ventures if you allow them to operate in
US with no tax

2-3 Evita is a citizen and resident of Argentina. Evita came to US in Year 1 to sell
clothing on behalf of Patagonia, an Argentine corp. Evita is one of many agents
that Patagonia sent to the US in Year 1. Evita makes $3,000 in commissions on
sales to domestic customers during her five-month stay in the US.
(a) What is the source of Evita’s commissions?
Because Evita does not fit into this exception (fails first and third prong) her
income will be considered sourced in the US – where her services were performed
§ 851(a)(3).

(b) How would the answer to (a) change if Evita was in the United States for only
60 days?
Tricky, depends on facts & circumstances whether foreign corp is engaged in trade
or biz in US

19
2-4 Determine the source of each of the following items:
(a) A fellowship from Duke University awarded to Soledad, a Chilean individual
who is not a citizen or resident of the US. Soledad will use the fellowship to study
the economic development of Madagascar.

General Rule for Unlisted Items: §863(a) provides that items not covered in 861
and 862 will be covered by regulations.
 1.863-1(d) covers scholarships/fellowships – usually follows situs of grantor,
unless used abroad
 General Rule: Fellowship paid by a US institution is US sourced income.

(b) A $100,000 jackpot from the Oregon State Lottery paid to Soledad.
 Prize! Under 1.863-1(d) for prizes you look to the location of the payer – so
this is US Source.
Sale of Inventory Property
Inventory that is purchased and soled to customer that is generally sourced, under
the long-standing title passage rule, according to the jurisdiction in which legal
title passes.
§ 1.861–7: An inventory sale takes place “at the time when, and the place where,
the rights, title, and interest of the seller in the property are transferred to the
Buyer.”

General Source Rule for Inventory: Focus is on jurisdiction where title passes;
i.e. DELIVERY
 § 861(a)(6) income derived from purchase of inventory outside US and sale
inside US (under title of passage rule) is US source
 § 862(a)(6) Purchased within and sold without the United States is foreign
source income

§ 1.861–7 restates the rule of § 861 (a) (6): gains derived from the purchase and
sale of personal property are treated as derived entirely from the property where
the property is sold.

§865 (e)(2) (A)- Exception to Title Passage Rule(title passage rule states that
source if US if title passes in the US, and not US if title passes out of US. The
Exception is only relevant only for title passing outside the US)– Applicable to Sale
of personal property including inventory by non-residents.
If the sales income is attributable to an office or fixed place of business maintained
by seller in the United States, the income is deemed United States source.
In determining whether an office or fixed place of business exists, §865(e)(3)-
factory, store or site through which a foreign person engages in a trade or
business.
§865 (e)(2) (B)-Exception to Override in case of inventory property: the presence
of a domestic office or fixed place of business will not cause the gain to be US
source when such inventory is property is destined for export and a foreign source
“materially participates in the sale.”
§ 1.864–6 (b)(3)(1) participation is material if it involves active participation in
solicitation,

20
 contract negotiations, or other “significant” services related to the sale, but not if
participation merely involves giving final approval, displaying samples, holding and
distributing the sale property, providing a place for title passage, or providing
other related clerical functions.
If title passes in the US, the inventory gain will be considered US source,
regardless of existence of domestic office but if title passes outside of US, the
inventory gain may be resourced to the US under §865 (e)(2)

§ 1.861-7 Exception to Title Passage Rule Anti-abuse provision. When a sale is

arranged primarily to avoid tax, this Regulation provides that “the sale will be
treated as having been consummated at the place where the substance of the sale
occurred” rather than under the title of Passage Rule (again only with respect to
inventory made in the US, and sold Outside).

Note: Title Passage rule governed by UCC usually at delivery of goods. § 1.861–7:
An inventory sale takes place “at the time when, and the place where, the rights,
title, and interest of the seller in the property are transferred to the Buyer.” Except
attributable to an office or fixed place of business maintained in US

Purchase & Sale v. Production & Sale:

 Purchase – no income is allocated to the purchase only the sale is deemed
responsible for generating income, all income derived from the sale has its
source where the sale took place
 Production – income does not stem from sale alone, some is a result of
production activity
 § 864a Produced includes created, fabricated, manufactured, extracted,
processed, cured, or aged

Mixed Source Inventory Income - §863/§ 1.863-3(b)

Production and sale inventory income may be split according to one of three
methods
(1) 50/50 Method: ½ of gross income is allocate to production or manufacturing
activity, other to sales
(2) Independent Factory Price Method: may be elected by a manufacturing
operation that sells goods to independent distributors and its own distributing
branch located in different country than production
 Distributing branch treated as paying same price to manufacturer as other
distributors
 Fictional Payment – COGS = US Source; Actually Receive – Fictional
Payment = Foreign Source
(3)Books and Records: permitted tps who allocate between production and sales by
books of accounting
Notes: Rev Rule 75-263 when both purchased and sold in a country, that situs
controls
Does title passage give wiggle room for foreign/us source? FOB shipping & risk
of loss etc
Inventory sales are an exception from personal property sales under §865. Payor
collects withholding tax

21
Source of income from inventory sales
Current law
Current Section 863(b) provides special rules that source income derived from the
sale of inventory produced within the US and sold outside of the US (or vice versa)
(a Section 863(b) sale) as partly from US sources and partly from foreign sources.
H.R. 1 provision
The bill would amend Section 863(b) to require income from a Section 863 Sale to
be apportioned between US and foreign sources solely on the basis of the
production activities with respect to the inventory sold.
Effective date
Amended Section 863(b) would apply to tax years beginning after 31 December
2017.
Implications
Under current law, the place of sale of inventory for purposes of Section 863(b)(2) is
determined under the “title passage rule.” This rule effectively permits a taxpayer
to elect whether a sale of inventory constitutes a Section 863 Sale — and therefore
whether the associated income is sourced as partly within and partly outside the
US. Amended Section 863(b) would eliminate this bifurcation, and thus would
generally be unfavorable.

2-5 Straw Co. is a domestic corporation that sells drinking straws. Determine the
source of Straw Co.’s income from the sale of its inventory in each of the following
alternative situations:
(a) Straw Co. purchases its inventory from an Ohio manufacturer and sells it to
distributors in Nigeria, with title passing in Nigeria. Foreign Source – title passage
controls

(b) Straw Co. manufactures its own inventory at a factory plant in Ohio and sells it
to distributors in Nigeria, with title passing in Nigeria.
Old answer:
Production & Sales: Most likely for administrative convenience Straw would
employ the 50/50 method to allocate foreign/domestic source income. 1.863-3(c)
(iii) Determination of gross income. The amount of a taxpayer's gross income from
production activity is determined by reducing the amount of gross receipts from
production activity by the cost of goods sold properly attributable to production
activity.
New Answer:

Where manufactured

2-6 $60,000 gain from the sale of an antique automobile located in US and owned
by Soledad, Chilean.
Real Property Interests
Gains from disposition of real property, or an interest in real property, located in
the US is generally sources in the US. If the property is located in the US, it is
foreign sourced.

22
Sales of Personal Property
General Rule on Non-Inventory Property: sourced according to residence of
seller

§865. Rules for Personal Property Sales: depends on residence of seller, unless
fixed US business place
Definition of resident under §865(g)(1)(A): (§
865e2A override)
 a United States citizen or a resident alien and does not have a tax home in a
foreign country, or
 a nonresident alien and has a tax home in the United States, and
 any corp, trust, or estate which is a US person (as defined in section 7701(a)
(30)).

§865 (e)(2) (A)- Exception to Residence of Seller Rule(for non inventory

property, source is the residence of seller. SO if seller is from US, source rule is
US. This exception applies when the residence of the seller is not US. The sale will
still be considered as sourced in the US if the non resident alien has business in
US)– Applicable to Sale of personal property by non-residents.
If the sales income is attributable to an office or fixed place of business maintained
by seller in the United States, the income is deemed United States source.
In determining whether an office or fixed place of business exists, §865(e)(3)-
factory, store or site through which a foreign person engages in a trade or business
Result: Only US source income if Soledad is a US resident or has tax home in the
US.

Intangible Property
§865(d)(1)(A) different treatment than that accorded to income derived from
personal property
Gain from disposition of an intangible asset (other than goodwill) is sourced under
the regular §865 (a) rule (Residence of seller is Source Rule) but only to extent the
payments in consideration of the sale are not contingent on the productivity, use or
disposition of the intangible.
§865(d)(1)(B) provides that sales of intangible assets for contingent consideration
are sourced under royalty source rules of §861(a)(4) (source rule for royalty is
where used)
§865(d) Exception to Rule on Treatment of Intangible Property (rule being:
Intangible property general source rule is residence of seller, exception source rule
is where property is used if payment is contingent on use of property) GOODWILL.
- Source Rule: Sale of Goodwill is sourced in country where it is generated.
Rents & Royalties:
General Rule: §861(a)(4) and §862(a)(4) – Rents and royalties are generally
sourced according to the jurisdiction where the property giving rise to income is
located or used
§1.861-5 rents and royalties derived from the use or right to use property located
in the US are classified as US income. Covers IPR, intangible assets
§1.861-4 US Patents, copyrights, secret processes and formulas, good will, trade-
marks, trade brands, franchises and other like property.
License characterization

23
Revenue Ruling 60-226, 1960 -1 CB 26 – in cases where interests resembling
royalties are retained by copyright proprietor along with other rights in the
transferred interest, the transaction may under some conditions fail to have the
required characteristic of a sale.

§865(d)(1)(B) special sourcing rules:

Income arising from a transaction that is in substance a sale of intangible property
is nonetheless sources according to royalty rule if payment is contingent on the
productivity, disposition, or use of the intangible asset. Income derived from the
transfer is generally sourced according to the jurisdiction in which the property is
used.

Generally sourced in jurisdiction of use of property – i.e. if used in the US = US

source
 S Rohmer (1946) Court held that a US writer who assigned US and
Canadian serial rights to his novel in perpetuity to a domestic corporation,
but retained movie, stage and book rights, Second Circuit held this was a
mere license

Key Issue: Differentiate between royalties and sale

 One of degree: sale is usually where vendor transfers all of rights in bundle
of rights possessed

Simplification through Code:

§865(d)(1)(B) states that if an intangible asset is sold on a contingent payment
basis, sourcing is controlled by §861(a)(4)
 Contingent means: based on productivity, disposition or use.
o Rentals or royalties from property located in US or from any interest
in such property, including rentals or royalties for the use of or
privilege of using in the US patents, copyrights, secret processes and
formulas, goodwill, trade-marks, trade brands, franchises.
 If not contingent, then is a general sale rule which turns on residence of
seller.

Summary: If income from sale of an intangible asset is contingent, then §861

overrides §865 and property will be sourced according to jurisdiction in which the
property is used (even though under §865 sale of personal property turns on
residence of seller)

2-7 Tarek, a citizen and resident of Lebanon, composed a symphony while in

Turkey for two months. He is now considering various offers from music
publishers throughout the world. For each offer described below, determine
whether the proposed transaction will produce United States or foreign source
income.

(a) US publisher offers to pay for the exclusive right to publish and sell the work in
the US. Under the proposed contract, Tarek would receive five percent of the
publisher’s gross revenues from each sale.
 General rule is the nexus of the use; § 865d1B throws us back to 861a4, so
US Source

24
(b) A Kenyan publisher makes the same offer described in (a).
Still US Source – does not matter who is making the offer – it matters where it will
be used.

(c) A US publisher offers to pay Tarek a fixed sum in exchange for all rights to the
composition.
Non-contingent rent/royalty is either treated as a sale or personal service?
 Facts and circumstances lean towards sale – §865 (because sale of personal
property)
o Exception for sale of intangibles – §865 only applies to non-contingent
sales
 Fixed fee likely means sale of personal property, residence of seller, foreign
source

(d) The offers in (a) and (b) were made and accepted before Tarek started
composing the symphony.

Issue: Is this composition for hire personal service or royalty income?

 Royalty income looks at use in US, would be US source but this is unlikely
 Probably service performed/composed in Turkey even for use in US, foreign
source § 861(a)(3)
 §865 Note: Any difference between an exclusive license for 500 years and an
outright sale?

PROBLEM SET III. FOREIGN EARNED INCOME

Read: Code §§ 911(a), (b) (c)(1)-(3 )(d)(1)-(3), (d)(5) – (7), ((f)(1).
Reg. §§ 1.871-2(a); 1.911-2(a)-(d)(2); 1.911-3(a) – (c);
1.911-4(a) – (b)(4),(d) (1)-(3); 1.911-6(a) and (c)(1)

Two Methods to Avoid Double Tax: (1) Exclusion or (2) Deduction

Eligibility for Exclusion:
US Citizen or Resident who has “tax home” in foreign country and meets one of the
following two tests:
 Note: Tax Home under §911 reflects his place of dwelling rather than place
of business
 Cannot have a foreign tax home while maintaining an abode in the US
 § 911d(3) states tax home has same meaning as § 162a(2) “away from home”
requirement
 A person who stays away from his original home for more than a year will
likely be deemed to have established a new tax home for purposes of §911,
regardless of limitations.
(1) Bonafide Residency Test:
 Applies only to US Citizens (and certain Treaty nationals-US Resident Aliens
who are citizens or nationals of a country with which the US has an
applicable income tax treaty in effect under non-discrimination clauses)

25
  Facts and circumstances inquiry about whether taxpayer has established a
lifestyle in the country
o §911 incorporates residency requirements outlined in §1.871-2,
although §911 may require a higher standard to meet residency.
Purpose of travel and buying a renting an abode
o §911(d) is a citizen of the United States and establishes to the
satisfaction of the Secretary that he has been a bonafide resident of a
foreign country “for an uninterrupted period” which includes an
entire taxable year.
o §1.871-2 -determines whether an individual qualifies largely on the
basis of relevant facts and circumstances. Failure to purchase or rent
a home abroad will weigh heavily against the establishment of
bonafide residence unless taxpayer can show, considering the
demands of employment that it would be unreasonable to do so.
 Extended absence from the stated jurisdiction undercuts
residency claims
 § 911d5 cannot make a statement to that country you are a non
resident
Individual who makes such a statement is denied 911 benefits
even if there is prove to the contrary.
 Must meet requirement for the entire taxable year (may reside in more than
one foreign country)
 A fixed time period (in employment contract) does not preclude you from
becoming a resident of a foreign jurisdiction under §1.871-2; too little time
may keep you from qualifying as a resident. Indefinite stay will qualify the
taxpayer; but it also allows for an extended stay, if necessary for
accomplishing the taxpayer’s purpose in going abroad. The purpose cannot
“be promptly accomplished”

(2) US Citizen or Resident Physical Presence Test: §1.911-2(d)

During a period of 12 consecutive months, must be present in a foreign country
330 full days (approximately 11 months)
 Period must end on the day before the corresponding day in the twelfth
succeeding month-
 Does not need to be 330 days of consecutive presence
 Can begin 35 days before arrival or end 35 days after departure
 Does not have to be for business purpose
 Qualifying Day: period of 24 continuous hours beginning at midnight and
ending the following midnight [time spent over international waters does not
count towards 330 day limit]
 In contrast with the bonafide residence test, which requires residence to be
established for a person’s full tax year (usually a calendar year), the 12-
month period for establishing physical presence may begin with any day and
must end on the day before the same calendar year, 12 months later. The
12-month period must be made up of consecutive months but any 12-month
period may be used if the 330 days fall into that period.
 The required presence need not be for business purpose.

§911Citizens or residents of the United States living abroad

26
(a) Exclusion from gross income.--At the election of a qualified individual (separate
for (1) and (2)), exclude from the gross income of such individual, and exempt from
taxation for any taxable year--
(1) the foreign earned income of such individual, and
 Apply sourcing rules from §861, etc.
 Earned Income includes: cash or property, wages, salaries,
professional fees and other amounts received as compensation for
personal services actually rendered
 §911(1)(A) – earned income is “foreign” if it is attributable to the
individual’s services performed in a foreign country or countries
during the individual’s qualifying period of bonafide residence or
presence.
 Deferred Payments: deemed earned in the year of performance
§911(b)(2)(B)
o Unutilized exclusion from deferred income cannot be carried
over to following years – if you defer more than 1 year you lose
it. If income is deferred in excess of one taxable year beyond
the year in which the services were performed, the income no
longer constitutes foreign earned income for purposes of §911
 Income Exclusion: $80,000 per year §911 (b) (2) (D)(i)
(2) The housing cost amount of such individual.
 Definition: all reasonable expenses paid by or on behalf of individual
for housing for taxpayer, spouse, dependents, and includes rent, fair
rental value, utilities and insurance, and salary for housing expense
(does not include interest, taxes, or co-op expenses§911 (c) (3))
 Applies in addition to $80,000 earned income exclusion
 Calculation§911 (c) (1): Housing cost amount is the amount of housing
expenses that falls between the statutory ceiling (cap) and floor
o Floor: 16% x $80,000 = $12,800
o Ceiling: 30% x $80,000 = $24,000
 Individual with housing > ceiling will exclude $11,200
(Difference between ceiling and floor$24,000 -$12,800 =
$11,200)
 Housing Amount x Number of qualifying days / Number days in
taxable year
 Final Excluded Housing Amount: Lesser of housing cost amount or
foreign source income

Foreign Earned Income exclusion is the lesser of (1) FEI reduced by housing cost
amount, or (2) the exclusion amount ($80,000). Reg § 1.911–3d(2) Limitation
 Reg § 1.911–4 Determination of housing cost amount eligible for
exclusion or deduction.
 (d) Housing cost amount exclusion (housing expenses do not include
the cost of purchasing a house, capital improvements, and other
capital expenditures, furniture) (3) Housing cost amount attributable
to employer provided amounts (different if self-employed)
 911(f) –the exclusion comes off the bottom so you get taxed on the
highest brackets

27
Steps for Computing FEI Exclusion:
Step 1: Compute Qualifying Period
 Qualifying Day is a day within the individual meets the tax home
requirement and is either a bonafied resident or meets the presence test
 Normally if you are meeting the test this will be 365; only time it will not be
is during arrival/departure years. Can elect different computation period for
qualifying days each year

Step 2: Compute the Amount of the §911(a)(1) Exclusion:

Number of Qualifying Days in the Taxable Year x $80,000 [Number of days in
Taxable Year (365)]

Step 3: Determine Amount of Foreign Income Received:

 Income source – must be foreign
 Cash v. Accrual:
o Cash: if you render services worth $60K in Year 1 but don’t receive
funds until year 2, then report income in year 2
o Accrual: Report income in year 1 – when he does the work.

Step 4: Determine Amount of Foreign Income Attributable:

Attributable to the year in which the services were performed which give rise to
the income

Step 5: Compute Housing Cost Amount excluded under §911(a)(2)

Step 6: Compute Foreign Earned Income Exclusion

 Available to the lesser of portion of FEI in excess of housing cost amount
excluded under §911(a)(2) or the exclusion limitation.

3-1. Casey, unmarried US citizen, transferred to Belgrade, Serbia, to work for

employer's subsidiary for a four-year period. Arived on December 31, Year 1 and
commenced employment January 1, Year 2. Annual salary $100,000 and her
foreign housing expenses, paid for by her employer, were $3,000 per month.
(a) To what extent can Casey exclude her salary and employer-provided housing
expenses from her Year 2 United States gross income under §911?
Step 1: Qualifying Period
 Qualifying day is a day within the period during which an individual meets
the tax home requirement under either the bona fide residence or physical
presence test.
 It appears that Casey would qualify for the entire period because no facts
point otherwise
Result: Qualifying period = 365
Step 3: Amount of Foreign income received during year
 $100,000 + $36,000 = $136,000
Step 4: Year to which FIE is attributable:
 Casey earned $136,000 in Year 2 as such that amount is attributable for Year
2
Step 6: FIE Computation
 Housing Cost Exclusion - §911(c)

28
 o Floor: 365/365 * 80,000*.16= 12,800
o Ceiling: 365/365 * 80,000*.30 = 24,000
 Excludable housing cost amount is $11,200 [correct answer[
Foreign Earned Income is lesser of (1) FEI reduced by housing cost amount, or (2)
exclusion amount
(1) 100,000+36,000 (3,000 x 12)-11,200 =124,800
(2) 80,000 + 11,200 = $92,000 total foreign earned income exclusion amount

(b) How would the answer to (a) change if her annual salary was $40,000?
The foreign earned income exclusion (including housing) would be
$40,000+36,000 = 76,000
(c) How would the answer to (a) change if Casey's assignment to work in Serbia
was for the period of January 11, Year 2 through December 27, Year 3?
 Can still get entire year with physical presence test qualifying period
 For BRT you most likely would need to be there for over a year
o §1.911-2(a)(2)(i) – have to be an uninterrupted resident for an entire
taxable year.
Now Casey would could have as little as 354 qualifying days, don’t have to prorate
because of § 1.911–3d2

(d) How would the answer to (a) change if Casey paid income tax of $12,000 to
Serbia on her salary? Is there a difference if, under Serbian law, she was not liable
for any tax? If she declared herself a non-resident of Serbia and therefore under
Serbian law was not liable for tax, should the result be different?
 The income tax payment is evidence of residency for the taxable year for
purposes of the Bona Fide residence test. Nothing changes with tax
payment, no foreign tax credits when using § 911
 Exemption from income tax under a treaty or the like will not in itself
prevent a citizen from being a bona fide resident of a foreign country
 If Casey declared herself a non-resident in Serbia then no § 911 exclusion
(§911(b)(5))

3-2. On June 30, Year 1, Douglas, a US citizen employed by an Illinois corporation,

transferred to Guyana to work for the corp’s subsidiary located there. The corp
told Douglas to expect to work at the subsidiary in Guyana for approximately 18
months, with a return to US scheduled for December 31, Year 2. Douglas' yearly
salary is $100,000, and he pays his own foreign housing expenses of $3,000 per
month in Guyana.
(a) To what extent can Douglas exclude some or all of his Year 1 salary and housing
expenses from his United States gross income under §911?
Threshold question before determining qualified residence under either the
physical presence test or bona fide residency test is whether the taxpayer’s “tax
home” is that of the foreign country.
 Cannot have a tax home if your abode is in the united states §911(d)(3)

Tax Home Issue – The Qualifying Individual:

 In order to be qualified individual, and take advantage of exclusion, need a
tax home abroad
o Issue - are you conducting business abroad (situs of the business)

29
NOTES ON PROBLEM:
 Source rules for services is where it was performed
 Because Douglas arrived mid-year need to wait until qualifying 330 days,
then file amended return
Bona Fide Residency Test:
 When contractual terms have a fixed end date, Douglas may be treated as a
non- US resident
Physical Presence Test:
 Must be physically present in a foreign country for 330 full days of 12
consecutive months
Step 1: Qualifying Period
 Can extend 35 days before first day physically present – total qualifying days
= 183 days
Result: Qualifying period 183 + 35 = 219
Step 3: Amount of Foreign income received during year
 $500000 (no employer provided housing assistance)
Step 4: Year to which FIE is attributable:
 Douglas earned $50,000 in Year 1 as such that amount is attributable for
Year 1
Step 6: FIE Computation
 Housing Cost Exclusion - §911(c)
o Floor: 219/365 * 40,000*.16= ______
o Ceiling: 219/365 * 40,000*.30 = ______
 Excludable housing cost amount is $6,720
Foreign Earned Income is lesser of (1) FEI reduced by housing cost amount, or (2)
exclusion amount
(1) 50,000-6720 =43,280 <- this one gets us to excluding entire amount of
income
(2) 48,000 + 6,720 = $54,720 total foreign earned income exclusion amount,
50k income
Self-Provided housing exclusion
 Treated as a deduction in computing adjusted gross income under §911(c)(4)
(A)
 Limited to Excess of Foreign Earned Income less exclusion from foreign
earned income.

(b) How would the answer to (a) change if Douglas invests a portion of his salary in
a Guyanese bank, earning interest of $5,000 per year?
Under 1.911-3, the definition of foreign earned income does not include gains from
investments or passive income made using earned income from providing services
abroad. May not be offset
 This income is foreign sourced, but it is not considered “earned income”

(c) How would the answer to (a) change if, at Douglas's request, his employer pays
$30,000 of his Year 1 and Year 2 salary in Year 3 and Year 4 respectively?
If income is deferred in excess of one taxable year beyond the year in which the
services were performed, the income no longer constitutes “foreign earned
income.” Under §911(b)(1)(B)(iv). If Douglas’ employer pays $30,000 of his salary

30
for Year 1 and 2 in Years 3 and 4 he will forfeit the right to use the §911 exclusion
for those amounts. (gives only 1 extra year)
 Deferred compensation is excluded because the fear is that you claim
residency in the foreign jurisdiction and are negotiated to get paid later, if
they use cash method approach then you receive the exclusion AND not
paying tax on the income in foreign country
Notes:
 §911(c)(4) – Housing expenses paid by self-employed treated as amounts
deductible from AGI
 Still qualify for housing cost in amount of expenditures even if not
specifically compensated

PROBLEM SET 3.5

3.5.02 Limitations

The participation DRD is subject to several limitations. As a threshold matter, only

domestic corporations can claim, individuals and trusts are not entitled to the
deduction.

§951 Only domestic corporation that qualify as “United States Shareholders” can
claim the deduction.
A United States person will be classified as a US shareholder if such person owns
at least 10 percent of the foreign corporation’s stock, measured by either voting
power or value.

Dividend must be from a “specified 10-percent owned” foreign corporation – a

foreign corporation which has at least one US Shareholder (one owning at least 10
% of FC’s stock) that is a domestic corporation.

Dividend is limited to only the “foreign source portion” of the dividend received
under the following formula:

Dividend received by FC x FC’s undistributed Foreign earnings and profits

FC’s total undistributed earnings and profits

§245(c)(3) Earnings and profits will be considered Foreign Source if – these

earnings are not attributable to a US trade or business

§245(A) deduction cannot be claimed unless the recipient domestic corporation

ahs held the foreign corporation’s stock for more than 365 days over the 731 day
period that begins on the date that is 365 days before the date on which the
dividend is paid (or, where the stock is traded, the date on which the stock
becomes ex-dividend with respect to such dividend)
During the 365 period:

31
 (i) Foreign corporation paying the dividend must be a specified 10-percent
owned foreign corporation, and
(ii) The domestic corporation must be a US shareholder with respect to such
foreign corporation
§246(c)(4) the holding period is suspended for any period during which the
taxpayer claiming the participation DRD has substantially diminished its risk of
loss in the stock from various hedging transactions such as options to sell (or short
sales of) the foreign corporation’s stock selling options to purchase the foreign
corporation’s stock or the holding of the positions with respect to substantially
similar or related property.
§245(A)(e) The 245 A deduction is disallowed with respect to hybrid dividends
received by a US Shareholder from one of its controlled foreign corporations. A
hybrid dividend is one in which the controlled foreign corporation making the
payment receives a foreign income tax deduction (

Venezualan FC pays to the Domestic Corporation of 50,000 dividend. (That is

deductable) Such dividends paid was subject to tax in 7,500 in Vanezuela?

What is Domco’s United States Liablity with re

When the foreign corporation pays dividends to a Domco. 245

Tax credit. The ]]\

US corp cannot claim foreign tax credit neither for withholding taxes nor income
paid taxes (245) with respect any dividend for which deduction is allowed.

Conclusion: Deduction for dividends is allowed and tax paid for said deduction
cannot be claimed as tax credit.

(b)
245 A just apply for domestic corporations not individuals.
Dividends must be understood broadly. Broadly any dividends received
notwithstanding that it is received indirectly.

LLC-sole proprietorship.

3-5-3
Holding Period Requirement
Law says that the domestic corporation does not meet the holding period
requirement, no deduction allowed. Shareholder has to hold the stock for more
than 365 days in a period of 731 days (2 years and 1 day) .

32
No deduction allowed.

Such 365 days, you have to start counting backwards from which dividend is paid.

3-5-4
What is the tax liability?

Empire Co.,

Do we have domestic corporation? Yes

Do we have holding period? Yes. Empire held stock for 2018-2020
Empire Co has stock of 600,000 in Irish Co and sold the stock for 2M. Gain-
1,400,000

800,000 income of Irish Co for financial services and it was taxed 120,000.

800,000-120,000 gross income-tax = 680,000 Net accumulated earning this will

be received by US corp, it will be received as dividends and it will be 100%
deductable. DRD

1,400,000 – 680,000 = 720,000.00

Empire Co has Irish Co, Empire Co’s sells Irish Cos stock. Empire Co has stocks for
600,000 (basis of shares)
Irish Co pays $650,000 dividend Empire Co. and immediately

Empire Co sell it for a less amount that bought. Loss is 100,000. Dividend of
650,000.

PROBLEM SET IV – FOREIGN TAX CREDIT

READ: Code §§ 164(a)(3), (b)(3); 275(a)(4); 901(a) – (b), (j) – (k); 903; 904(a).
Reg. §§ 1.901-1(c); 1.901-2(a), (b), (c)(1), and (f).

IV. OUTBOUND – DIRECT FOREIGN TAX CREDITS (UNIT 4)

OUTBOUND

Who are US Persons?

33
 Citizen
Resident
Domestic Corp

World Approach WWI

Exception: 911 Exclusion S *

245 Deduction S*
If you have exclusion/deduction, you may not claim credit.

Double Taxation
Deductions
Credit
Limitation S
Baskets
Reconsideration

Dividend (New Law) – only applies to domestic corporation, not to US citizen

Double Taxation

A. Overview
1. 901(b)(1)  provides credit against taxes actually paid by U.S. citizens and
domestic corporations to foreign countries
a. Purpose is to avoid double taxation
b. Extends a dollar-for-dollar credit for foreign taxes paid against the
domestic taxes imposed on foreign source income
B. Credit Versus Deduction
1. May select either a credit under 901(b)(1) or a deduction under 164(a)(3), and the
election is made on an annual basis (275(a)(4) prevents their simultaneous use)
a. In most cases, 901 credit is more advantageous than the deduction because
a credit reduces tax on a dollar-for-dollar basis while a deduction merely
reduces the amount of income upon which the tax will be levied
C. Creditable Taxes – General Principles
1. 1.901-2(a)  two-pronged test to determine whether a foreign levy is a creditable
tax
a. A foreign levy is an “income tax” for which a credit is allowed if:
1) It is a tax (requires compulsory payment to foreign country under
1.901-2(a)(2)), AND
2) The predominant character is that of an income tax in the U.S.
sense
a) To have predominant character of an income tax in the U.S.
sense must be likely to reach net gain under the realization,
gross receipts, and net income tests 1.901-2(a)(3)
i. Realization test  met if the event that gives rise to
the tax would result in the realization of income
under the standards of the Code

34
 ii. Gross receipts test  a creditable tax may in some
cases be imposed on gross receipts
iii. Net income test  foreign tax must be structured to
reach net income, meaning that the tax must permit
either recovery of actual significant costs (including
capital expenditures) or an allowance that closely
approximates these amounts
D. Payor of a Tax
1. 1.901-2(f)  legal liability under foreign law is the determinative factor for
treatment as payor of a tax, regardless of who actually pays the tax
2. 909  “matching rules” designed to match foreign tax credits to the income to
which they relate
E. Amount of Tax Paid
1. 1.901-2(e)  precludes credit for refundable amounts, subsidies, multiple levies,
and non-compulsory payments

F. Subsidies
1. “Tax payments” made to a foreign government are not creditable if the
government uses the money to provide any direct or indirect benefit to the
taxpayer, to a related party, or to any party to the transaction
G. Multiple Levies
1. 1.903-1(b)(3)  if a foreign country imposes both an excise and an income tax
and the excise tax is creditable against the income tax, the amount of the income
tax for purposes of 901 would not reflect the portion of the income tax sheltered
by the excise tax
H. Economic Benefits
1. 1.901-2(a)(2)(ii)  payments in exchange for specific economic benefits is
bifurcated into its component parts and a credit is available only if the taxpayer
can establish the distinct element of the foreign levy which constitutes a tax
a. These taxpayers are called “dual-capacity taxpayers”
b. A specific economic benefit is one that is not readily available to others
subject to the general tax
I. Soak-up Taxes
1. 1.901-2(a)(3)(ii)  prohibits the use of “soak-up” taxes which are those for
which liability depends upon the availability of the credit against the taxpayer’s
tax obligation to another country
J. Taxes “In Lieu Of” Income Taxes 903
1. Must meet the general definition of a “tax”
2. Must be imposed as a substitute for (and not in addition it) an income tax or series
of income taxes otherwise imposed
3. The foreign jurisdiction’s purpose for imposing the tax, whether administrative or
otherwise, is irrelevant in assessing creditability
4. If a domestic person is subject both to the general tax of a foreign jurisdiction and
also a surtax, the surtax should not qualify as a creditable tax under 903

35
 K. Section 904 Limitation Upon the Amount of Taxes Which May Be Credited
Foreign Source taxable income U.S. tax on
Maximum foreign tax credit = Worldwide taxable income x worldwide income
L. Denial of Credit for Taxes Paid to Certain Countries
1. 901(j)  the foreign tax credit is denied for tax payments to specific countries
a. Intent of the legislation is to deny the tax benefits for activity in these
hostile countries

Majority of individuals cannot take advantage of the §911 exclusion for foreign
sourced earned income derived in the year; however you are still taxed on earnings
in the foreign country.

Issue: What do we do about double taxation?

Foreign Tax Credit:

 Can only receive credit for an income tax in the United States sense §
911(b)
o What constitutes an income tax? What is the comparison?
 Is there an economic benefit conferred from the tax: Refunds,
rebates, etc.
 Mere fact you call something a tax is not sufficient.

If a tax falls short of an income tax, is that all we can do?

 No, you can take the tax as a deduction under §164a3 [not as generous as
the tax credit]

Foreign Income Tax Credits/Deductions:

 §901(b)(1) – credit can be taken against foreign income, war profits and
excess tax profits by US Citizen or domestic corporation
 §164(a)(3) - allows a deduction for same taxes. 275(a)(4) restricts you to one
or the other

Have to choose either the deduction or the credit; make election at time of filing
and you can alternate annually between the credit or deduction – depending on
which is most favorable

§901 Direct Credit:

 Eligibility: primarily available to US residents, citizens and domestic
corporations that paid the tax
 Creditable Taxes: in order for a tax to be included in the credit, must first
determine whether
(1) Foreign levy qualifies as income tax under §901 and is an income
tax in US sense; and
(2) the amount of the tax creditable and identity of the payor of the
tax

“Income Tax” §1.901-2:

 Determination is made for each separate foreign tax

36
  Tax: compulsory payment to a foreign government that is intended as such
[i.e. no fines, penalties, interest royalties] and predominant character is that
of an income tax in U.S. sense

“Predominant Character” of Income Tax:

 Must be designed to reach net gain: Net Gain is dependent upon compliance
with three-pronged test. Most certain to reach some net gain in the normal
circumstances in which it applies
 Cannot be a soak up tax – i.e. one for which liability is dependent upon
availability of US credit

Net Gain: (1) Realization Test 1.901-2(b)(2): met if the event, which is taxable,
would result at the occurrence and there would be realization of income under IRC
Tax triggered by manufacture of product rather than sale-would violate the
realization test since none of these events give rise to realization in §1001
 Exceptions:
o Tax may be credited if it represents a slight (as opposed to
substantial) deviation from US tax concept
o Taxes levied on non-realization events which would result in domestic
realization
o Taxes on transferor processing of readily marketable properties (i.e.
inventory ready for sale/export) serve as a substitute for later
triggering event
(2) Gross Receipts Test1.901-2(b)(3): creditable tax can in hard to value situations
be imposed on gross receipts
(3) Net Income Test1.901-2(b)(4): Tax must permit recover of actual significant
costs including capital expenditures or a surrogate allowance to approximate that
amount [i.e. must permit cost recovery – No VAT]

Creditability of Specific Items of Income:

 Dividends, interest and other Passive Income: withholding taxes on these
items will likely be creditable even if taxation of items is on a gross basis
(even though not meeting net income test)
 Compensation: generally creditable even if imposed on a gross basis

Payor of Tax is the party incurring liability – risk and remedy run against him
Biddle v. Comm.
§ 909 adopts “matching rules” preventing Foreign tax credits until related income
taken into account

§904 Limitation On Credited Taxes

Once the amount of foreign taxes creditable under §§901-903 has been
ascertained, taxpayer must determine §904 limitation
 §904 Credit limitation = US Tax on Worldwide income * (Foreign taxable
income/Worldwide taxable income)
Notes on §904 Limitation:
 Limitation based on foreign source taxable income (excludes any income
exempt from US tax)

37
  Source of Income Rules control – first source income before determining if it
is creditable

4- 1. Todd, a United States citizen, opened a coffee shop in Honduras. During the
year, Todd incurred the following tax liabilities which he paid promptly: (i)
Honduran real property tax; (ii) Honduran value added tax; (iii) Honduran federal
income tax on Todd's business income; (iv) Honduran state income tax;
(v) Honduran withholding tax (at a rate of 25 percent) on dividends; and (vi)
Honduran "social security"

(a) Which of these taxes are creditable under §901 or §903?

Real Property Tax: No, not income tax. §164A allows deductions for foreign real
property taxes
VAT: no FTC, its like a sales tax and doesn’t qualify because it doesn’t take into
account employee expenses etc.
Federal, State: Yes, Income Tax – creditable SS Tax: it should be computed could
go either way because you get some benefit back, special economic benefit need
to argue Wada
Q: There are qualifications for credit. Real Property Tax and Federal and State Tax
are not “income” as defined under double taxation but are excluded as deductions.
You can deduct all sorts of income, but you can only a credit – Foreign Income
Tax, you can have a choice of deduction and credit.

General business tax – deductible

Foreign Income tax – choice of credit or deduct

Dividend Income: §1.901-2(b)(4)(i) allows passive income to be creditable taxes –

 Do not have the same range of deductions in deriving interest, royalty and
dividend income in a passive context
 Just because the tax is withheld does not mean it was paid; still have legal
obligation to pay tax

(b) With respect to the creditable taxes, may Todd credit some and deduct others?
 §275(a)(4) disallows a deduction if the credit is taken - so you must choose
one versus the other; however you can alternate year by year on whsich is
the better tax position – deduction v. credit. Taxpayer may elect his
preferred

4-2. DelCo is a domestic corp. Principal business activity manufacture and sale of
industrial machinery, and its main plant and offices are located in Delaware. DelCo
also has a branch plant located in France where DelCo manufactures and sells its
products in Europe. During the year, DelCo realized $100,000 of taxable income
from its US plant activities, and $75,000 of taxable income from foreign branch
activities. Assume DelCo's US liability is $50,000. The foreign branch paid $40,000
in corp income taxes to France.

Delco has a branch, Part of US, if it were a subsidiary, subsidiary would have been
a separate corporation.

38
(a) Determine if tax in France is Foreign Income Tax, qualified for credit?

(b) What is DelCo's final US tax liability for the year?

 $100K of US taxable income
 $75K in taxable income at foreign branch
What is the maximum foreign tax credit? Limit =

§904 Credit limitation = US Tax on worldwide income * (Foreign source taxable

income/worldwide taxable income)
$50,000 (US Tax) * (75,000/175,000) = $21,429 credit limit – US tax attributable to
foreign income. Allowed to write it off- the fact that France imposed more than the
US did, there is no US tax, because US did not tax US tax attributable to foreign
income.

Total Tax Liability = $50K – 21,430 = $28,572

FTC21-428-18,572 (excess)
As a consequence, 18,571 of foreign taxes paid will not be creditable in the current
year; the taxpayer has “excess credits”. The amount can be carried back one year
and carried forward ten years under §904 (c)

The result is consistent with the United States tax policy of denying credit for taxes
imposed at rates about the United States rate. Here, the French tax rate on the
branch earnings is about 53% - will about the 28.6 percent effective US on Del Co.
worldwide income.

(b) What if the taxes paid to France are $20,000?

21,430 credit. But because you paid only 20,000.

Total Tax Liability = $50K – 20,000 = $30,000 Foreign taxes less than limitation
Excess of Foreign Tax - There would be an “excess limitation” which under §904(c)
could be carried forward ten years/back one year. High tax income in Foreign
Place, carry over

This means that the §904 limitation applies to the French taxes paid in this
example; the taxpayer has an “excess limitation”.

NOTES: Always work out entire available amount of credit – may not get it this
year, but you can carry it backwards and then forwards; usage delayed is still ok.
 You can roll it over but if earning pattern continues, you will have the
carried over amount from the current year, and you will roll it over until you
get to the 10th year and it becomes useless

PROBLEM SET VI: FOREIGN TAX CREDIT - §904 LIMITATION

READ: Code §§ 904(a) – (d)(2), (f)(1) – (3)(B), (5)

VI. THE 904 LIMITATIONS (UNIT 6)

39
Separate Foreign Tax Credit Limitation Basket for Foreign Branch Income

In general, under Section 904, a taxpayer is permitted to claim a foreign tax credit in an amount
equal to the U.S. tax imposed on such taxpayer's foreign source income. This limitation applies
separately to the taxpayer's "general basket" and "passive basket" income.

The Act adds as a new basket "foreign branch income," which is defined as the business profits
of a U.S. person that are attributable to one or more qualified business units in one or more
foreign countries. However, foreign branch income does not include any income that is
otherwise treated as passive basket income.

This provision is effective for taxable years beginning after December 31, 2017

A. 904(a)  The Overall Limitation

1. The FTC cannot exceed the U.S. effective rate of tax on foreign source income
2. The purpose of the limit is to prevent foreign income taxes reducing U.S. tax base
3. The limitation is based on income subject to tax
a. Does not include income which is exempt from U.S. tax
4. Because the limitation is based upon taxable income, it necessarily involves the
allocation of expenses to foreign source income
a. Expenses are generally allocated to the class of income to which they bear
a factual relationship
5. The income sourcing rules control in determining the credit
a. One exception: 904(h)  intended to preserve the domestic source
character (for 904 purposes only) of income derived by a U.S. owned s
foreign corporation (defined as a foreign corporation owned 50% or more
by vote or value by domestic persons)
6. Some taxpayers are exempted from the general 904 limitation
a. 904(k)  individuals whose foreign source income consists entirely of
certain types of passive income are not subject to the 904 limitation if the
amount of creditable foreign taxes paid does not exceed $300
B. The Basket System
1. Two baskets:
a. Passive category income basket
1) 904(d)  passive category income is currently defined generally
as income that is classified as foreign personal holding company
income under 954(c)
a) Includes: interest, dividends, royalties, rents, and similar
items
2) Exclusion  any items that are subject to a higher foreign rate
than the maximum U.S. tax rate that would apply (places in the
general income basket)
b. General category income basket

40
 1) Income that is not included in the passive category income basket
904(d)(2)
C. Special Rules for Capital Gains
1. Applies only with respect to persons who are eligible for a reduced rate on certain
preferred income items under 1(h)
2. Effect is to reduce the overall foreign limitation by excluding from the calculation
a part of the capital gain income
3. Also applies with respect to any 1231 gain taxed to an individual at long-term
capital gains rates
4. 904(b)(2)(B)  “capital gain differential” (the taxpayer’s foreign source income
only includes the amount of “foreign source net capital gain” in excess of “the
rate differential portion”)
a. Foreign source net capital gain is defined in 904(b)(3)(B) as the lesser of
foreign net capital gain or all net capital gain
b. The rate differential portion is determined by finding the difference
between the highest applicable tax rate and the alternative tax rate,
dividing that amount by the highest applicable tax rate, and multiplying
that amount by the net foreign source capital gain amount
c. The rate differential portion is deducted from both foreign source income
and overall income
D. Special Rule for Capital Losses
1. 904(b)(2)(A)  in determining the 904 limitation, foreign source capital gain can
be included only to the extent of foreign source capital gain net income, defined
as the lesser of capital gain net income from foreign sources or capital gain net
income
2. The purpose of this rule is to prevent domestic capital losses from offsetting
foreign capital gain in determining taxable income while the capital gain retains
its foreign source character for purposes of the limitation
E. Recapture of Foreign Losses: 904(f)
1. The confinement of losses to separate baskets
a. 904(f) provides a mechanism for allocating foreign losses first to baskets
in which the taxpayer has foreign income against which the foreign losses
can be offset
2. Allocating foreign losses
a. Under 904(f)(5)(A) losses in one basket can offset domestic source
income only to the extent that the aggregate amount of such losses exceeds
the aggregate amount of foreign income earned in both baskets
b. Works to reduce the numerator of the credit limitation first
3. Recapture rules
a. Allocating income earned in subsequent years to categories that previously
absorbed the foreign loss
b. Foreign source losses offset foreign source income regardless of its basket
label and thereby reduce the 904 numerator and the benefits of the FTC
4. Overall foreign loss

41
 a. If a domestic taxpayer sustains an overall loss from foreign activities
during the year, that loss offsets the taxpayer’s domestic income in the loss
year
1) If the taxpayer in subsequent years earns an overseas profit, 904(f)
(1) requires that foreign source income in an amount equal to that
previously deducted loss to be recharacterized as having been
derived from a domestic source
2) The amount of transformed income is limited to the lesser of the
amount of the previously unrecaptured loss or 50% of foreign
taxable income for that year (a larger percentage may be
recaptured if the taxpayer so elects  might do this if have a
domestic loss)
F. Carryback and Carryover of Excess Taxes Paid 904(c)
1. If foreign taxes paid exceed limitation can carry back one year and forward 10
years under 904(c)

Separate Computations for overall §904(d) Limitation:

Separate credit limitations need to be calculated for passive income and other
general income
(1) Passive Income (limited risk):
 Income classified as foreign personal holding company income under §954
Passive Income Limitation = Foreign Taxable §904(d) Passive Income x US Tax on
Worldwide Income
Worldwide Taxable Passive Income
(2) General Income: All active income

6-1 Jennifer, a United States citizen and resident, operates a pharmacology

consulting business as a sale proprietor. In Year 1, Jennifer realized $100,000 of
taxable income from Colombia, on which she paid Colombian income taxes of
$45,000. Jennifer also realized $150,000 of domestic taxable income.
(a) Assuming a 35 percent rate of tax by the US, compute Jennifer’s foreign tax
credit for Year 1.

Step 1: Calculate Pre-Credit Tax

 Worldwide Income = $250,000, US Tax Rate 35%, Total Tax Liability =
$87,500

Step 2: Calculate Maximum Foreign Tax Credit (under §904)

 §904 Credit limitation = US Tax on Worldwide income * (Foreign taxable
income/Worldwide taxable income)
$87,500 x ($100,000/$250,000) = $35,000 allowed foreign tax credit

Step 3: Apply Credit Limit to Foreign Taxes Paid

Foreign Taxes paid $45,000
Less: Credit Limit ($35,000)
$10,000

“excess credit” situation with a 10,000 credit carryover.

42
Result: Carryforward of excess credit of $10K
 This is high-taxed income and we need low-taxed income from foreign
jurisdictions

(b) What result if, in addition to the above transactions, she derived $50,000 of
Canadian-source interest income subject to a reduced tax rate of five percent. She
paid $2,500 in Canadian income taxes. Assuming a 35 percent rate of tax by the
United States, compute Jennifer's foreign tax credit for Year 1.

Step 1: Calculate Pre-Credit Tax

 Worldwide Income = $300,000, US Tax Rate 35%, Total Tax Liability =
$105,500

Step 2: Calculate Maximum Foreign Tax Credit (under §904)

($150/300) * 105,500 = $52,500

Step 3: Apply Credit Limit to Foreign Taxes Paid

Foreign Taxes paid $47,5000
Less: Credit Limit ($52,500)
($5,000)
This is the result without separate baskets

37,500
Result: Without separate baskets, could plan without high risk to blend low-tax and
high tax income.

Step 4: Apply §904(d) Limitation to Separate Passive and Active Income

Limitation requires separating Passive from Active Income:
 Passive Income Tax = $2,500
 Active Income Tax = $45,000

Passive Limitation Equation: FTI (passive income)/WWI * USTI = $50/$300 * 105K

= $17,500 (maximum credit) but only applied against the passive income tax paid
Final Tax-2,500

The ceiling $17,500. But the credit cannot exceed the actual taxes paid on such
foreign source passive income of $2,500.

Active Income Limitation: $100 (active)/$300 * $105K = $35,000 but only applied
against active income tax paid, Columbia tax 45,000
Results in a Carryforward for the active income of $10,000

6-3. Z Corpo, a domestic corporation, commenced foreign operations in Year 1

by establishing a Brazilian branch, which produced a loss of $40,000, while its
domestic operations generated a $40,000 gain.
Year 1: US $40,000, Brazil ($40,000)
Total worldwide taxable income is $0; there are no foreign income taxes either
 In the first year, there is a foreign loss and no taxable income

43
(a) In Year 2, its Brazilian operations resulted in taxable income of $100,000
with an attendant tax payment of $45,000, while its domestic operations
generated taxable income of $75,000. What is Z’s tax liability for Year 2 if it’s pre-
credit United State tax liability was $61,250?

1. In year 1, there is no liability, the losses are more than the gain.

2. In year two, treat as domestic income the lesser of: amount of loss (40,000)
or 50% of foreign taxable income for that year. (50% of 100,000= 50,000)

Overall Loss Recapture - §904(f):

Any taxpayer who sustains an overall foreign loss must recapture that loss in later
taxable years.
 Re-characterize any subsequently derived foreign income as domestic
source income, limited to the lesser of:
o Amount of previously unrecaptured loss; or
o 50% of foreign taxable income for that year

Overall Foreign Loss: amount by which tp’s gross income from foreign sources is
exceeded by deductions
 Note: If Basket and recapture apply – use recapture rules first

3. 100,000 – 40,000 = 60,000 (because you are try to recover the loss; income
in year 2 minus the loss in year 1)

60,000 (foreign income)

------------------------ x 61,250 (US Tax) = 21,000
100,000 plus 75,000

21000= maximum credit limit

4. Tax liability US $61,250-21,000 = 42,250 since Brazil tax is 45 K but since

limit is 21K
5. carry over – 24,00.

Concern: Loss in Brazil in Year 1 ended up sheltering US Income

 From the US perspective that loss in the prior year had a positive benefit;
perhaps we should adjust for that in figuring out the foreign tax credit in
year 2

904(f)(1)(A) – Taxpayer sustains overall loss for year

 Result: Portion of taxes from taxpayer’s income from without the
United States

Rule: Take foreign loss into account by looking at lesser of:

50% of FTI for Year 2 = $50,000
Overall Foreign Loss = $40K
Lesser of: $40K
 ($100-$40) => $60/$175 X $61,250 = Foreign Tax Limit of $21,000

44
  net foreign income over the two year period is 60

VII. INBOUND – TREATMENT OF FOREIGN-OWNED U.S. INVESTMENT INCOME

(UNIT 7)

A. Overview
1. A non-resident alien is subject to U.S. tax only on specifically defined categories
of income under 871
a. Major category  871(a)(1) includes items generally associated with
passive investment assets, including interest, dividends, and rents but also
other forms of income such as wages, premiums, annuities, and “other
fixed or determinable annual or period gains, profits and income”
commonly referred to as FDAP
b. 871(a)(2)  domestic source income from the sale or exchange of capital
assets, but only if the non-resident individual is present in the U.S. for at
least 183 days during the taxable year
c. Unless otherwise exempt taxed on a gross basis at a flat 30% tax rate (no
deductions or credits)
1) Sometimes referred to as “withholding tax” because in most cases
it is enforced via 1441 and 1442 by imposing an obligation to
withhold on the payor of the income item rather than by collecting
the tax directly from the recipient
2. Foreign corporations are subject to tax on specific domestic source investment
income items described in 881 which generally parallel the investment-related
items listed in 871(a)(1) for individuals
3. Non-resident alien individuals and foreign corporations are also subject to U.S.
tax on a net basis and at the graduated tax rates of 1, 11, and 55, as applicable, on
income that is effectively connected with a U.S. trade or business
B. Income Items Included in 871(a) and 881(a)
1. Income must be derived from U.S. sources and not effectively connected to U.S.
trade or business
a. Passive non-business activities
C. Income from Intangible Property
1. Royalties not listed in the statute but 1.871-7(b) makes clear that these royalties
are so included
2. 871(a)(1)(D)  includes gains from the sale or exchange of intangible assets or
of any interest therein, to the extent such gains are contingent on the productivity,
use, or disposition of the property, from gains from the from the sale or exchange
of all other property are excluded from the scope of 871(a)(1)(D)
3. Patents (special rule)  under 1235, any transfer of a patent or patent right is
considered to be the sale or exchange of a capital asset even if the payments in
consideration for the transfer are contingent on the productivity, use, or
disposition of the transferred property

45
 a. 1.1235-1(d)  payments made pursuant to a 1235 transfer are “payments
of the purchase price and are not the payment of royalties”
b. Would generally be addressed under 871(a)(2) which addresses capital
gain but 865(d)(1)(B) override this rule in the case of contingent gains and
state that such gains are treated as royalty payments for sourcing purposes
c. Non-contingent gain  865(d)(1)(A) causes the gain to be sourced as a
sale of personal property under 865 and potentially subject to tax under
871(a)(2)
d. Contingent gain  sourced under 865(d)(1)(B) and 861(a)(4) and
potentially subject to tax under 871(a)(1)(D)
D. Exception for Most Interest Payments
1. Most U.S. source interest is not in fact taxable to foreign persons due the portfolio
interest exceptions (found in 871(h) and (i) for individuals and 881(d) and (d) for
corporations)
a. Provided such interest is not effectively connected with the payee’s U.S.
trade or business and provided it is not received by a person who owns
10% or more of the stock of the payor, measured by voting power
b. Additional rules for U.S. source interest received by foreign corporations
under 881(c)  exception only applies if the payor or other withholding
agent receives a statement that the beneficial owner of the obligation is not
a U.S. person
E. Exception for Certain Dividends
1. Dividends from U.S. sources typically subject to tax as FDAP under 871(a) with
exceptions provided in 871(i) and 881(d)
a. Transition rule  exists for dividends paid by certain domestic
corporations that meet the active foreign business income test under
former 881(c)(1)
b. Dividends paid by a foreign corporation that are treated as U.S. source
under 861(a)(2)(B) are also exempt from withholding tax under 871 and
881 (less than 25% U.S. income 3-year period rule)  but may not be for
effectively connected trade or business
F. Capital Gains
1. 871(a)(2)  general rule is that non-resident alien individuals are subject to tax
of 30% on net capital gains derived from domestic sources if such individual is
present in the U.S. for 183 days or more during the taxable year
a. In practice, the present requirement will generally result in a determination
that the taxpayer is a U.S. resident under 7701(b) and would be taxed
under 1, including the preferential capital gains rates provided in 1(b)
b. 871(a)(2) is typically imposed only on non-resident alien individuals
whose presence is excluded for purposes of determining residency but
whose presence is counted for purposes of 871(a)(2), such as foreign
government officials, teachers, students, and certain professional athletes
c. The 183 day standard only applies to non-resident alien individuals after it
has been determined that the individual has a U.S. tax home under 865(g),
such that the sale of the property would give rise to U.S. source gain in the

46
 first place (if the taxpayer has no U.S. tax home, the gain will not be U.S.
source under 865 and therefore 871(a)(2) would not apply)
G. Income from Real Property
1. 871(d) (for individuals) and 881(d) (for corporations) permit foreign persons to
elect to treat income derived from U.S. real property as effectively connected
income that would be taxed at the graduated rates rather than 30% gross flat tax
2. 897(a) treats gains and losses derived from sales and other dispositions of U.S.
real property interests as effectively connected income
H. Withholding of 30% Tax at Source
1. Under 1441 and 1442, any foreign or domestic person having “control, receipt,
custody, disposal, or payment” of any item of U.S. source income described in
871 and 881 is responsible for withholding the 30% tax from such payment and
for remitting that tax to the Service
2. Persons required to withhold such tax are themselves liable for the tax (person to
last touch the U.S. FDAP before it is paid to foreign person is the withholding
agent)
3. Payors typically determine a payee’s status on the basis of a withholding
certificate filed with the payor by the payee  Form 8233 (for compensation
income) or Form W-8BEN (for all other FDAP income)
4. A withholding agent must provide a Form 1042-S to each recipient reporting the
amount of tax withheld
5. Partnerships  if domestic partnership with one or more foreign partners, the
partnership becomes the withholding agent and withholding must occur when the
partnership furnishes Forms K-1 reporting the distributive shares of the partners
or, if earlier, upon a distribution of the FDAP income to a foreign partner
I. Insurance Premiums
1. Rev. Rul. 89-91  insurance premiums not subject to the income tax imposed on
premiums by section 881(a)
J. FDAP Expansions
1. Alimony and lottery winnings

47
TAX TREATIES AND BUSINESS INCOME (UNIT 12)

II. INBOUND TRANSACTIONS

 Foreign persons (classification rule first); US only taxes non-citizen under
limited taxing formula
 Return to source rules that applicable to foreign persons on most of the
statutory provisions, it requires a domestic source and if that is absent
then except for a limited category no tax
 US Tax of inbound transactions varies depending upon the country of the
foreign person
o Treaty Countries: modifies the statutory rules [once you determine
someone is Non-US, need to determine if they are subject to treaties]
o Non-treaty Countries are then subject to the statute - Look at
passive/active rules
 Passive income is lightly taxed to encourage investment in US

PROBLEM SET VII: TREATMENT OF FOREIGN OWNED UNITED STATES INVESTMENT

INCOME
Read: Code §§ 871(a), (d), (h), (i); 873(a); 881(a), (c), (d).
Reg. § 1.871-7.

PASSIVE
Looking at Inbound Transactions Enforcement: Use withholding taxes
 §871: Nonresident Alien Individuals
 §881: Foreign Corporations

§871. Tax On Non-Resident Alien Individuals

Passive Income:
§871(a): 30% tax on income not connected with a trade or business received from
sources within US
 Notice that for this subsection, if there is no United States source, then you
can stop
 § 871(a)(2) Taxed on capital gains if present 183 days, no student exceptions

Income from Trade/Business:

§871(b) A nonresident alien individual engaged in trade or business within US shall
be taxable on his taxable income which is effectively connected with the
conduct of a trade or business within the US.
 §864 trade or business - includes performance of personal services,
“Effectively Connected” §864 (c)

§881. Taxation of Foreign Corporations

Subject to tax on certain class of income derived from US sources or activities

Passive Income:
§881(a) imposes a 30% tax on all passive income derived within the United States
on a gross basis

Income from Trade/Business

48
TAX TREATIES AND BUSINESS INCOME (UNIT 12)

§882 imposes tax on effectively connected income derived from US ToB at

graduated corporate rates
 §882(d) foreign corp can elect to treat income from US real property as
effectively connected
 § 871(d) Taxed on net basis with graduated rates. No mandatory
withholding, personal exemption.

7-1. Surya, a citizen and bona fide resident of Nepal, has never been present in
the US. During Year 1, he had no US Trade or Business (871 B) , but he owned a
nu(87mber of assets that produced the following items of income:
 $20,000 dividend on the stock of Delaware Corporation, a corporation
formed in Delaware;
 $5,000 gain on sale of ten shares of stock in UruCo., a corporation formed in
Uruguay;
 $13,000 dividend on the UruCo. stock, of which $5,200 is US source and
$7,800 is foreign source;
 $10,000 in rents from rental property located in the United States;
 $1,000 of foreign-source interest on a loan made to Emily, a citizen and
resident of Bolivia:
 $2,000 of interest on a deposit at a Chicago, Illinois bank; and
 $8,000 in cash from the sale of the United States rights to a patent Surya
created for five percent of the net profits from products produced through
its use.
Surya's potential deductions for the year consisted of depreciation and expenses
with respect to the rental property of $3,000, a $1,000 loss on the sale of five
shares of UruCo. stock, and medical expenses of $4,500. Assume that Surya would
be subject to a 20 percent effective tax rate on his taxable income.

(a) What is Surya’s United States taxable income and his tax liability for Year 1?
Step 1: Is this an inboud/outbound activity? Surya is a nonresident alien so this is
inbound.

Step 2: Is there a trade or business? No. Therefore we are unconcerned about

§864 or §871(b)
 Do not need to worry if you have income effectively connected with a
trade or business which would push you into §871(b)

871- income not connected with trade or business

-income other than capital gains- attributable to appreciation, not
interests, dividends
-income other than dividend

Exception: H (source rules)

Passive income -30%
871 (a) (2) – presence

Two passive income

49
TAX TREATIES AND BUSINESS INCOME (UNIT 12)

US Source

Presence and US source

Step 3: Source Items of Passive Income

 $20,000 dividend on the stock of Delaware Corporation, a corporation
formed in Delaware;
 $20K dividend: US
30% tax (§ 871a),
$5,000 gain on sale of ten shares of stock in UruCo., a corporation formed in
Uruguay;
 $5,000 gain: Foreign (§ 865a)
$13,000 dividend on the UruCo. stock, of which $5,200 is US source and
$7,800 is foreign source
 $5200 US § 871i2(D) US source, exempted from tax
 $7800 Foreign
$10,000 in rents from rental property located in the United States
 10,000 Rent US 30% tax, Foreign interest- foreign source n0
tax.
 $1,000 of foreign-source interest on a loan made to Emily, a citizen and
resident of Bolivia – source rules, residence of payor
 $1,000 Foreign (see rules from previous class)
$2,000 of interest on a deposit at a Chicago, Illinois bank; and
 $2,000 US § 871i2(A) US source but exempt from US tax
$8,000 in cash from the sale of the United States rights to a patent Surya
created for five percent of the net profits from products produced through
its use. (contingent)
 $8000 – 865(d) – sale on contingent basis source by royalty rule – US, 30%
tax

Expenses: Under 873(a) you are only allowed deductions with respect to income
effectively connected with trade or business.
 the tax under §871 is on gross amounts – does not say net amounts

Step 4: Exclude Foreign Sourced Income – they will not be subject to US Tax

Step 5: Search for Additional Exclusions

 Exception for Interest under §871(i)(2)(A) in bank ($2000) (not connected to
a trade or business because we want foreign persons to advance cash to us.
Maybe they wont loan money to US corporation if there is zero tax on
interest. Tax law creates incentives)
 Exception for dividend under §871(i)(2)(D) ($5200) – no tax on 2nd dividend
Tax not to apply in certain dividends-dividends paid by a FC

Step 6: Taxable income = $38,000 x .30 = $11,400

 Remember there is a straight 30% tax on passive income

50
TAX TREATIES AND BUSINESS INCOME (UNIT 12)

(B) What result if Surya elects under § 871(d)? If One Piece of Property- no way
you can argue that this is trade or business. You can deem it to be active income
not passive.
§871(d) Election to treat real property income as income connected with
United States business.--
(1) In general.--A nonresident alien individual who during the taxable year derives
any income--
(A) from real property held for the production of income and located in the
United States, or from any interest in such real property, including (i) gains
from the sale or exchange of such real property or an interest therein, (ii)
rents or royalties from mines, wells, or other natural deposits, and (iii) gains
described in section 631(b) or (c), and
(B) which, but for this subsection, would not be treated as income which is
effectively connected with the conduct of a trade or business within the
United States, may elect for such taxable year to treat all such income as
income which is effectively connected with the conduct of a trade or
business within the United States.

Under §871(d) an individual taxpayer can elect to treat a certain subsection of

investment income as treated under 871(d) and tax that at the (more likely)
preferential rates under §1 and §55.
 Only time you make the election is once you determine that the activity is
insufficient to constitute a trade or business; and rental real estate can then
be treated as a trade or business

Now there are two calculations:

Rental Income: $10,000
 Allowed to take deductions from trade/business income

Calculating TI: $10,000

Less: - $3,000 depreciation expense
Less: -$2,000 personal exemption [don’t need to know exact amount (new law
personal exceptions) No personal exemption (873, mark out no personal
exemption)
$5,000
Grad. Rate 20% = $1,000
Investment Income (Not-Electable): $28,000 X .3 = $8,400
Total Tax Liability: $9,400
NOTE: Only get deductions if you have a trade or business under §873 –§871(a)
does not allow deductions
You can elect. What if we don’t have many deductions and graduated rates go up to
37% while tax on passive income is just 30%

7-2 In Year 1, Shaida, a citizen and resident of Guyana, purchased ten shares of
stock in DelCo, a Delaware Corp, for $7,000. In Year 3, Shaida sold the shares for
$10,000 in cash to an unrelated individual residing in US. To what extent will US
impose income tax ON $3,000 gain in Year 3?

Capital Gains: §871(a)(2). In the case of a nonresident alien individual present in

the US for a period or periods aggregating 183 days or more during the taxable

51
TAX TREATIES AND BUSINESS INCOME (UNIT 12)

year, there is hereby imposed for such year a tax of 30 percent of the amount by
which his gains, derived from sources within the United States, from the sale or
exchange at any time during such year of capital assets exceed his losses, allocable
to sources within US, from the sale or exchange at any time during such year of
capital assets. For purposes of this paragraph, gains and losses shall be taken into
account only if, and to the extent that, they would be recognized and taken into
account if such gains and losses were effectively connected with the conduct of a
trade or business within US, except that such gains and losses shall be determined
without regard to § 1202 and losses shall be determined without the benefits of the
capital loss carryover provided in § 1212.

Before taxed on capital gains: (1) presence and (2) source

(a) Shaida was never physically present in the United States at any time in Year 1,
Year 2, or Year 3.
 Non-resident, non US source, not subject to tax – did not meet the taxing
standard or capital gain

(b) Shaida was not physically present in the United States at any time in Year 1 or
Year 2, but she was physically present in the United States for 200 days in Year 3.
 If in US for more than 183 in year, taxed under §1 because you are
considered a resident alien – so you are kicked out of §871 (only for non-
resident!), and move up to outbound transactions – taxed on worldwide
income!

(c) Same as (b), except that for 100 of the 200 days of presence in US in Year 3,
Shaida was a student residing in the US under a "J Visa," issued under The
Immigration and Nationality Act.
 Note that §871 does not define presence same as §7701; therefore you are
just looking at 183 days; however she has 183 days for purposes of this
statute but she is still a non-resident under §7701b
 She is a nonresident alien with tax home in US under § 865g(1)A(i)(ll). This
is foreign source, § 871 only taxes capital gains derived from sources within
the US, this is foreign source

7- 3 SaudiCo is a corp in Saudi Arabia. Except as otherwise provided, all of

SaudiCo's shares are owned by citizens and residents of Saudi Arabia who have no
connections to US. SaudiCo has investments in US, but it does not conduct a trade
or business within US. For each situation described below, determine whether the
interest received by SaudiCo is subject to US taxation under §881(a).
(a) Interest from a certificate of deposit issued by a California bank:
Step 1: Determine Inbound/Outbound and if Trade/Business
Step 2: Is this Foreign or US sourced?
Foreign Corporation with US Source so look at §881
§881(d) Tax not to apply to certain interest and dividends.--No tax shall be imposed
under paragraph (1) or (3) of subsection (a) on any amount described in section
871(i)(2)(A).
§871(i) Tax not to apply to certain interest and dividends.- No tax imposed
(2) (A) Interest on deposits, if interest is not effectively connected with conduct of
Trade or Business within the US.

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

Result: This is e873xcluded from US taxable income as portfolio interest

(b) Interest from a certificate of deposit issued by the Italian branch of a California
bank.
 Sourced to the residence of obligor – i.e. foreign source 861(a)1A(i)

(c) Interest from a loan from an unrelated domestic corporation.

 US source, not taxed because of § 871h (portfolio debt exception). Tax free if
no US trade or business.

(d) Same as (c), except that the amount of interest payable to SaudiCo is
dependent upon the domestic corporation's net profits each year.
 Taxable under §871(h)(4)(A)(i) – contingent tied to income can be considered
equity (dividend withholding) so not portfolio interest.
 Taxed at 30% gross, no exemption on dividends – effectively a return on
earnings is taxable

(e) Same as (c), except that the amount of interest payable to SaudiCo is
determined with reference to changes in the Dow Jones Industrial Average index.
 Exclusion from exception under § 871h4(C)v(iii), not taxed (portfolio
interest)

(f) Interest from a loan to its wholly-owned United States subsidiary corporation.
 881(c)(3)(C) – Deny preferential treatment to subsidiary
o Related person § 871h3, no portfolio interest exception for 10%
shareholders
o Get a deduction on one end and need tax on the other, US source,
30% gross withholding.

Portfolio Interest:
Allows and encourages investment with no tax – Congress wanted to broaden
investment incentives in US
 General Policy: Anyone who loans and receives interest from a US source
will not be taxed
 881(c) refers back to 871 (h and I for individuals)

§881(c) Repeal of tax on interest of foreign corp received from certain portfolio
debt investments.--
(1) In general.--In the case of any portfolio interest received by a foreign
corporation from sources within the United States, no tax shall be imposed
under paragraph (1) or (3) of subsection (a).
(2) Portfolio interest.--For purposes of this subsection, the term “portfolio interest”
means any interest--
(A) would be subject to tax under subsection (a) but for this subsection, and
(B) is paid on an obligation--
(i) which is in registered form, and
(ii) with respect to which--

53
TAX TREATIES AND BUSINESS INCOME (UNIT 12)

(I) the person who would otherwise be required to deduct and

withhold tax from such interest under section 1442(a) receives
a statement which meets the requirements of section 871(h)(5)
that the beneficial owner of the obligation is not a United States
person, or
(II) the Secretary has determined that such a statement is not
required in order to carry out the purposes of this subsection.

VIII. INBOUND – TREATMENT OF FOREIGN-OWNED U.S. BUSINESS INCOME

(UNIT 8)

A. Overview
1. In contrast to passive investment income taxed at 30% gross, income effectively
connected with the conduct of a trade or business in the U.S. is potentially taxed
on a net income basis at the regular graduated rates
B. Engaged in a Trade or Business in the United States
1. Whether a foreign person is engaged in a trade or business within the U.S. is a
facts and circumstances test
a. As part of the analysis, may draw, in some circumstances, upon the
distinction between activities giving rise to 162 business expenses and
those giving rise to deductions under 212 related to the production of
income

54
TAX TREATIES AND BUSINESS INCOME (UNIT 12)

2. A U.S. trade or business is generally characterized by progression, continuity, or

sustained activity that occurs during some substantial portion of the year
a. If a foreign person’s presence in the U.S. is limited to maintaining an
office for merely ministerial or collection functions, it is probably not a
U.S. trade or business
b. If a foreign person’s domestic activities are directly related or pivotal to
the active pursuit of profit, however, a trade or business probably exists
1) “Core activities” (those activities that are essential to deriving a
profit) must be conducted in the U.S.
a) For example, a foreign person rendering material services
or soliciting sales domestically is probably engaged in a
trade or business

C. Attribution Through Agents

1. No trade or business should typically arise from isolated sales by employees or

minimal operational or export activity in the U.S.  however, extensive sales
activity or domestic marketing conducted through dependent agents (such as
employees) has been found to constitute a trade or business for the principal or
employer
a. To be considered a dependent agent, it is not necessary for the U.S.
person or entity to be related or affiliated with the foreign person, instead,
it is sufficient that the U.S.-based person or entity acts exclusively (or
nearly exclusively) for such foreign person in order to be considered
such foreign person’s dependent agent
b. Less clear when it comes to independent agents  activities of licensees
and lessees are not typically imputed to the foreign licensor or lessor
c.
2. Trade or business activity of a pass-through entity is generally imputed to its
foreign owners under 875(1) in the case of both general and limited partners
a. A partnership is akin to an agent with the partners as principals
3. For corporations  no similar look-through rule for corporations and their
shareholders
a. A foreign person, whether corporate or individual, and regardless of the
level of ownership interest, will not typically be considered to be engaged
in a trade or business by virtue of its ownership of shares in a domestic
corporation that is so engaged
D. Performance of Services as a Trade or Business
1. Aside from a special de minimis rule, 864(b) provides that a foreign person who
performs services within the U.S. at any time within a taxable year is
automatically deemed to be engaged in a domestic trade or business, regardless of
duration, frequency, or other factors
a. Whether or not person performs services as an employee or as an
independent contractor
b. De minimis rule 864(b)(1)  foreign employer and not present in the U.S.
for more than 90 days and compensation does not exceed $3,000 (not

55
TAX TREATIES AND BUSINESS INCOME (UNIT 12)

deemed to be engaged in a domestic trade or business- all three should be

met)
E. Real Property Activity as a Trade or Business

1. Under 871(d) and 881(d) foreign persons may make a “net income election” to
treat income derived from U.S. real property as ECI
a. Does not otherwise cause a person to be engaged in a trade or business
2. 897(a)  treats gains and losses derived from sales and other dispositions of U.S.
real property interests as if that gain or loss were ECI (not a pro-taxpayer rule
because if sourced on the basis of the seller’s residency could avoid tax
altogether)

F. Sales Activity as a Trade or Business

1. It is generally assumed that a domestic trade or business probably exists if a

foreign person maintains a stock of inventory in the U.S. and has a dependent
agent pursuing sales efforts

2. Although less clear-cut, a foreign person will also probably have a domestic trade
or business if it or its dependent agents conduct significant marketing activity and
maintain a stock inventory in the U.S. from which it fills orders

3. If a foreign person ships inventory to a U.S.-based dependent or independent

agent on a

4. consignment basis, such shipments, coupled with the sales efforts of the agent,
will probably constitute a domestic trade or business

G. Purchasing Activity as a Trade or Business

1. Foreign person should not be viewed as being engaged in a U.S. trade or business
simply because it purchases products in the U.S. for sale outside the U.S. (but if
high volume and sophisticated service component together with certain sales
activities, even if such sales are not to U.S. persons, may be U.S. trade or
business)

H. The Force of Attraction Doctrine

1. When this was the rule, all domestic source income was subject to U.S. tax under
regular graduated rates regardless of its connection to a U.S. trade or business
2. Rule has changed so that income must bear an “effective connection” to the
taxpayer’s business before being subject to tax in the U.S. (used to stifle unrelated
passive investment)

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

I. Effectively Connected Income

1. 1.864-3(a)  without a trade or business, a foreign person cannot generally have

ECI

J.
K. Step One: Identification of Gross Effectively Connected Income (Three Principal
Categories Under 864(c)

1. FDAP income as ECI

a. 864(c)(2)  foreign person who conducts a domestic trade or business

and receives domestic source FDAP income items described in 871 and
881 may be required to treat these items as ECI
b. 1.864-4  rules for segregating domestic source passive income from
other domestic source income and establishes two tests for assessing
whether FDAP income items will be treated as ECI:

1) “Asset use” test 1.864-4(c)(2)

a) Applies mainly to determinations involving investment

income that does not directly derive from the business
activity
b) An asset shall be treated as used in, or held for use in, the
conduct of a U.S. trade or business if the asset is:
i. Held for the principal purpose of promoting the
present conduct of the trade or business in the U.S.;
OR
ii. Acquired and held in the ordinary course of the
trade or business conducted in the U.S.; OR
iii. Otherwise held in a direct relationship to the U.S.
trade or business

2) “Business activities” test 1.864-4(c)(3)

a) Applies mainly to passive income that arises directly from
the active conduct of the trade or business
b) Looks to whether the activities of the domestic trade or
business are a material factor in realizing the investment
income

2. All other U.S. source income as ECI

a. Income derived from sales of inventory under 864(c)(3)

b. If a foreign person has a U.S. trade or business, 864(c)(3) treats all of the
person’s U.S. source income, gain, or loss which is not described in 871
and 881 as ECI

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

Exception:

1) 865(e)(2)  if the inventory sale originates from a foreign office

or other fixed place of business which materially participates in the
sale  in that case, if the sale is by a non-resident, the property is
sold for use, disposition, or consumption outside the U.S., and title
passes outside the U.S., the inventory may be deemed foreign
source

3. Effectively connected foreign source income

a. 864(c)(4)  main types of foreign source income that will be treated as

ECI:
1) Certain rents or royalties from intangibles
2) Certain dividends or interest derived in banking, financing, or
trading activities
3) Gains from foreign inventory sales

b. Only treated as ECI if the foreign person maintains a U.S. office or other
fixed place of business and the income is attributable to that other fixed
place of business

1) 1.864-7(a)(2)  whether another fixed place of business exists

depends on the facts and circumstances of each case, with
particular regard to “the nature of the taxpayer’s trade or business
and the physical facilities actually required by the taxpayer in the
ordinary course of the conduct of his trade or business
a) Where management functions occur is not necessarily
determinative
b) Special rules in 864(c)(5)(A)
c)
L. Step Two: Segregating Expenses

1. Once taxpayer ascertains the amount of gross ECI, the next step is to determine
the extent to which deductions against that income is permitted
a. Can only deduct to the extent that the expenses are related to ECI
b. Procedure for the allocation of deductions in 1.861-8
1) Two-tiered method under the regulations:
a) Allocation
i. Threshold determination that focuses on whether an
expense is directly related to a particular class of
gross income
b) Apportionment (if necessary)
i. Necessary only if within a class of gross income
there is both U.S. and foreign source income

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

M. Step Three: Allocation 1.861-8

1. Entails matching deductions to the category of gross income to which those

deductions most factually relate

a. A deduction is definitely related to a class of gross income if it is incurred

as a result of, or incident to, an activity or in connection with property
from which such class of gross income is derived

b. It is entirely possible that a deduction may not bear a definite relationship

to any particular class of gross income and in such a case the deduction is
treated as definitely related and allocable to all of the taxpayer’s gross
income

2. Determine the U.S and foreign source income

a. Allocations must be made even if no gross income has been received or

accrued within the relevant class of gross income
b. Allocation is appropriate even though the deduction to be allocated
exceeds the amount of income in the gross income class

N. Step Four: Apportionment

1. Once a deduction has been allocated to a class of gross income, the source of the
gross income items comprising that class must be determined

a. If the class consists exclusively of foreign source income (the “statutory

grouping”) or exclusively of U.S. source income (the “residual grouping”),
the taxpayer may end its analysis after the allocation process is complete
and the deduction is allocated in its entirely to the income in the statutory
or residual grouping, whichever is appropriate

2. If a class of gross income to which a deduction has been allocated is comprised of

both U.S. and foreign source income, then the deduction must be apportioned
between those two groupings of income
a. “Reflects to a reasonably close extent the factual relationship” between the
deduction and the gross income grouping
3. 1.861-8(e)(2), 1.691-9T through 1.861-13T  interest expense, as a general
rule, is fungible because borrowing money for one activity allows more money to
be devoted to other activities, so deductible interest expense is usually allocated
among all activities

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

PROBLEM SET VIII TREATMENT OF FOREIGN-OWNED UNITED STATES BUSINESS

INCOME
READ: Code §§ 864(b)(1), (c)(1) - (5); 865; 871(b); 873(a) - (b); 875; 882(a),
(c),
Reg. §§ 1.861-4(b)(1), (2); 1.861-8(a)(1) – (4)(b), (c); 1.861-9T(a), (g)
(1)(i); 1.864-2(a) - (b); 1.864-4(a).

ACTIVE RULES
Issue: Is income derived from a trade or business within the United States?
 If we have that, then we move into 882 and 871(b)
Investment (Passive) vs. Trade or Business
 Investment:
o 30% Rate
o US Source
o No deductions
 Trade or Business
o Graduated Rates
o Deductions
o Predominantly US Source
o Trade or Business in US
 Personal Service de minimis exemption
o Almost none fall within this small amount – however the $3K amount
was from 1954

Effectively Connected Rule:

Individual or Corporation will be taxed on their income which is effectively
connected with the trade or business (§882(a) and §871(d))
 Trade or Business: §864(b) includes definition of trade or business; excludes
personal services for foreign corporation, trading securities, etc
 Effectively Connected: §864(c) lists the three principal categories of
effectively connected income
o §864(c)(2) Fixed/determinable income and capital gain/loss from
sources within the US
o §864(c)(3) All other US source income
o §864(c)(4) Certain foreign source income
o Additional “deemed” effectively connected under other code sections.
 Ex: §897 – gains/losses from sale of US real property interests

8-1. Reconsider Problem 7-1 regarding Surya, a citizen and bona fide resident of
Nepal, was never present in US. During Year 1, he owned a number of assets that
produced the following items of income:
 $20,000 dividend on the stock of DelCo., a corporation formed in Delaware;
 $5,000 gain on sale of ten shares of stock in UruCo., a corporation formed in
Uruguay;
 $13,000 dividend on the UruCo, stock, of which $5,200 is United States
source and $7,800 is foreign source;
 $10,000 in rents from rental property located in the United States;
 $1,000 of foreign-source interest on a loan made to Emily, a citizen and
resident of Bolivia;

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

 $2,000 of interest on a deposit at a Chicago, Illinois bank; and

 $8,000 in cash from the sale of the United States rights to a patent Surya
created for five percent of the net profits from products produced through
its use.

Surya's potential deductions for year consisted of depreciation and expenses from
rental property of $3,000, a $1,000 loss on the sale of five shares of UruCo. stock,
and medical expenses of $4,500.

Determining Trade/Business Status:

General rule: this is a facts and circumstances inquiry; trade or business will arise
by degree of activities
 On the ToB Spectrum you can have pure T/B; T/B with Investment; or merely
Investment activity
 §864(b) delineates what is not a trade or business
 Business is generally characterized by progression, continuity, or sustained
activity
o No Trade or Business if purely Administrative: Foreign
corporation which merely collects revenues, or performs other
ministerial functions will not be seen as engaged in a T/B.
o Real Property Income Election (or by degree of activity – so you
are a dealer) under §871(d) or §882(d) for rental income.
o §897 Real Property Dispositions treated as effectively connected
with the conduct of a domestic trade/business
o T/B for Personal Services Foreign person who renders services in
US at any time within taxable year is automatically deemed to be
engaged in a T/B apart from de minimis rule.
 De-minimus: if individual satisfies all three criteria, not be
considered a T/B:
 Physically present for 90 days or less
 Compensation for the services is $3,000 or less; and
 Individual is employed by a foreign person not engaged
in a US T/B or a foreign office of a United States person

(a) The facts of Problem 7-1 assumed that Surya did not have a trade or business in
US. Without that assumption, would Surya be engaged in a domestic ToB with
respect to any of his activities in Year 1?

Result: Surya only engaged in passive activities; received dividends, interest and
rent and as such this is not a trade/business. Probably not a dealer in securities.
Question is on rents on real property, probably one is not enough. Interest on loans
no. Interests on deposits is a question of where that money came from – was it
rental property income? Question of whether it was taken out of business and
never tied to biz operations again. Patents – depends on whether it’s a regular
activity and would want more facts.

(b) Would Surya be engaged in a domestic ToB if either DelCo. or UruCo.

conducted a ToB in US? Does the result depend upon whether Surya is a minority
sh? A significant sh? A majority sh? The sole sh?

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

Does the taxpayer have a trade or business because the enterprise in which it owns
shares is a ToB?
 Doesn’t matter – if they are operating in the US the corps are already being
taxed, doesn’t matter
 Don’t want to discourage investment in US enterprises when we have a
taxing formula that will already tax those corps on income. Separate identity
of subsidiary from owner even if owns 100%.
 No reason to impute ownership status as though they were conducting a ToB
(maybe depending on really high control + ownership then might be an
agent for owners) not a factor here

(c) Would Surya be engaged in a domestic ToB if DelCo. and UruCo. are general Ps
or LLCs (rather than corps) that conducted a ToB in US? Does result depend upon
whether Surya had a minority interest in the entities? A majority interest? What if
both entities are LPs and Surya is the general partner?

When there is a partnership, then the income will be imputed to the owner because
the entity is a “pass through” so there is no separate taxing instrument at the
entity level.
 Rule does not depend upon level of interest; you can own only 1% and still
have to pay tax
 §875 states that this situation is taxable – if the partnership has a US trade
or business then you will be deemed to have a trade or business as well;
regardless of how active or passive you are.
 Does not depend on owners’ status as general or limited partner, still have to
file US tax returns

§ 875. Partnerships; beneficiaries of estates and trusts. For purposes of this

subtitle--
(1) a nonresident alien individual or foreign corp shall be considered as being
engaged in a ToB within the US if the partnership of which such individual or
corpo is a member is so engaged, and
(2) a nonresident alien individual or foreign corp which is a beneficiary of an estate
or trust which is engaged in any ToB within US shall be treated as being engaged
in such trade or business within the US.

(d) Now assume that Surya is engaged in a trade or business in the United States
with respect to the rental property. What is Surya’s federal income tax liability to
the United States? Assume that Surya would be subject to a 20 percent effective
tax rate on his taxable income under §§ 1 and 55.
 Rental income of $10,000 would be taxable at 20% = $2,000 tax liability,
same as Prob 7-1b

8-2. To what extent is each taxpayer described below engaged in a trade or

business within the US?
Trade or Business: Sales Activity
General Assumption: Maintenance by a foreign person of a stock of inventory in
the US + sales efforts of a dependent agent will mean that such person is
engaged in a domestic trade or business

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

 Dependent Agents: An agent is dependent if a united states-based person or

entity acts exclusively or nearly exclusively for such foreign person.
 Independent Agents: unclear if activities of US-based indep agent imputed
to a foreign person
 Consignment arrangements: If a foreign person ships inventory to a US-
based dependent or independent agent on a consignment basis, such
shipments, coupled with sales efforts by the agent will result in
trade/business designation
 Tax Treaties: Must be consulted if applicable.
 Purchasing Activity: foreign person should not be viewed as engaged in US
trade or business simply because it purchases products in US for sale in
foreign jurisdiction – even if it maintains a substantial fleet of trucks and
ships to transport products outside US
 Representative Office Activity: As long as you are not engaged in any activity
for profit, you can have a rep office that gathers/disperses information

(a) X Corp. is organized in Ecuador. X Corp. entered into a contract with DomCo, a
domestic corporation, under which DomCo serves as X Corp.'s exclusive agent in
selling X Corp.'s products in the United States. DomCo receives a commission for
each sale to a United States customer, the contract prohibits DomCo from
selling any competing products in the United States and from acting as the agent
for another in selling any competing products in the United States.
 There is agency imputation of a US trade or business here to the extent that
DomCo is a dependent agent conducting sales efforts in the US on behalf of
X. Exclusivity agreement gives X corp economic leverage, but could be just a
loose sales agreement where exclusive agents are doing a ton of outside
business too. (Dick’s selling light blue wristbands under an exclusivity
agreement with an Ecuador company)

(b) Y Corp. is organized in Panama, has branch office in US. Y Corp.'s products are
sold in US by domestic employees working out of rented office in Tulsa, OK. All
orders from US customers must be approved by Y Corp.'s home office in Panama,
and no domestic employee has the power to bind Y Corp, in any way.
 Agency is engaged – deriving income by activities taking place; seems
similar to a consignment situation. Physical presence with employees in an
office. They are dependent agents even though they can’t bind the company.
It is a branch, probably a US trade or biz

(c) Z Corp. is organized in Belize. Z Corp. purchases goods in the United States for
sale to customers in foreign countries. Z Corp. maintains an office in San Diego,
California, that is staffed by domestic employees who facilitate purchases and
arrange for shipping,
 Representative Office: back office not engaged; even if you are buying
significant quantities of materials within the US and selling outside/ will not
be taxable.

8-3 Fabio, a citizen and resident of Paraguay, is a professional model. Last summer,
Fabio posed in front of the Washington Monument for the cover of a forthcoming
romance novel to be published exclusively in Paraguay by a Paraguayan publisher
that is not engaged in a trade or business within the United States. To what extent

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

is Fabio liable for United States income tax in each of the following alternative
scenarios?

(a) The photo shoot took only a single day and Fabio received total compensation of
$2k from publisher.
 Performance of Service will always be treated as trade or business unless de
minimis rule
 § 864b1 De minimis rule here is satisfied here – so no TB, also § 861(a)3

Revenue Ruling: “Petit Dejeuner Example” gave rise to a trade or business in the
United States
(b) The photo shoot took three days and Fabio received total compensation of
$6,000 from the publisher.
 Now Fabio is outside the de minimis rule – so it is a TB

(c) How would the answers to (a) and (b) change if Fabio received his
compensation under a contract with a US modeling company which performed the
photo shoot on behalf of the Paraguayan publisher?
 Fails third prong of de minimis rule (works for US company) – so it will be a
TB. § 861a3

8-4 ForCo is a foreign corp purchases zippers. It has facilities in the US,
Argentina, and Bolivia.
 The zippers bought in the United States are sold exclusively in the United
States.
 Likewise, the zippers from Argentina are sold exclusively there, and same
for Bolivia.

ForCo generates all of its income from these three countries. ForCo does not have
a United States subsidiary, nor a separate division that oversees operations in the
United States.
 In addition, ForCo purchases wine from a distributor in Argentina and sells
it exclusively therein.
 Year 1, ForCo had $50,000 in general admin expenses related to both US
and non-US operations.
 In addition, ForCo incurred $80,000 in deductible interest expense in Year 1
from its borrowings used to improve the Bolivian facility.
 Additionally, it has $150,000 expense for labor/wages regarding the zippers
and $70,000 expense for labor/wages regarding the wine.
ForCo's sales and gross income from each country in Year 1 were as follows:
Zippers Wine
Gross
Country Asset Bases Sales Gross
Income
Income
United
$50,000 $250,000 $100,000 0
States
Argentina $100,000 $1,500,000 $200,000 $600,000

Bolivia $200,000 $800,000 $300,000 0

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

Assuming the income from the sale of zippers in Argentina and Bolivia is not
effectively connected with ForCo’s US operations, what is ForCo’s taxable income
in Year 1 for US tax purposes?

Issue: Which deductions can ForCo take?

 Conducting business operation solely and exclusively within the United
States
o All the income would have US source and be effectively connected
under 864(c)(3)
 Here there is a US Trade or Business and other activities
Gross Income: US - $100,000
Expenses: $50K General and Admin, $150K Labor-zippers, $70K Labor–wine, $80K
interest-zippe/r Bolivia

General Rule for Expenses:

Step 1: Allocate expenses to Gross Income
Expenses directly allocable to area of gross income:
 Wages would be allocated to Business Income
o If Expenses are allocated to income coming from US and Foreign
Sources-apportion (Step 2)
Expenses related to all income:
 G&A expenses of $50K - Allocate based upon the US v. Overall GI = $4,333
($100/1200)
Interest Expenses (special rule)
 Money is fungible so you have to allocate on a number of standards
 Use asset bases, Reg 1.882-5, 80,000 (50/350) = 11,450 US interest
Step 2: Apportion any income between US and Foreign Source
From Directly Allocable Expenses
 Wine Wages – Foreign
 Zipper Wages – Problem tells us 90k from US, otherwise apportion based on
where performed/used for sales
Net loss of over (5k)
The Foreign Source Spectrum
 Pure Investment
 Pure Investment but election under 871(d)
 Pure Business
o That is “Effectively Connected”
o §864(c)(3) – Catch all for most gain or loss from income within the
United States
 Pure Trade or Business with Secondary Activity
o §864(c)(3) says ALL income
o Regulations – even though wine activity wasn’t related to what you did
in the US it brings in other income, unless it is not US SOURCE
 Pure Trade or Business with Passive Income
o §864(c)(2) – Using assets from the business for a quick return but its
still an asset
 Pure Trade or Business with unrelated non-864(c)(2) passive income

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

o Then some will be taxed as investment (see above) and some will be
taxed ToB
o Reg § 1.864.4 provides two tests for segregating domestic source
passive income:
 “Asset use” test distinguishes holding investment assets from
those used day-to-day in the operation of the business
 “Business Activities” passive income that arises directly from
the conduct of a ToB
 Foreign Source Trade or Business (pg 130)
o §864(c)(4) types of foreign income that might be treated as ECI
 Typically rents, royalties, foreign inventory sales, made US
source under §865(e)(2)
 Source rules for inventory (typically its title passage unless
mere conduit)
 Intended to capture otherwise foreign source income with
economic genesis in US
 Requires there to be a US office or other fixed place of business
(OFPB)
 §897 Deemed Trade or Business Effectively Connected Income
o Not a trade or business, US real property

Non-Resident Foreign Corporation/ Foreigner. If activity has some nexus to US,

that US can tax them. Has to be US Source/Effectively Connected.

PROBLEM SET IX: BRANCH PROFITS TAX AND INVESTMENT IN REAL PROPERTY
Read: Code §§ 884(a)-(d), (f)(1)-(2); 897(a)-(c)(4)(A), (e), (g); 1031(h).
Reg. §§ 1.884-1; 1.897-1(b)(1)-(4); 1.897-1(d)(1)-(2); 1.897-2(a)-(c)(1);
1.897-6T(a)(1)-(3).

26 U.S. CODE § 1031 - EXCHANGE OF REAL PROPERTY HELD FOR

PRODUCTIVE USE OR INVESTMENT

(h)SPECIAL RULES FOR FOREIGN REAL PROPERTY

Real property located in the United States and real property located outside
the United States are not property of a like kind.

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IX. INBOUND – TAXATION OF BRANCH PROFITS AND INVESTMENT IN U.S.

REAL PROPERTY (UNIT 9)

A. Branch Profits Taxes – In General

1. Foreign corporations engaged in a U.S. trade or business are generally subject to
the branch profits tax rules in 884
Designed to impose U.S. tax treatment on foreign corporations doing business
through a U.S. branch that is similar to the tax treatment of foreign corporations
operating through a U.S. subsidiary

In the latter case, the subsidiary is subject to corporate-level tax on worldwide income
plus a tax on dividends repatriated to foreign owners. In the case of a branch, since this is
considered a Non Resident Foreign Corporation, and only the extension of the personality
of the foreign principal, there are no dividends repatriated. It will only be taxed as a
NRFC for income effectively connected with trade or business.

The branch profits tax is then an additional tax intended to simulate the tax on dividends
paid by the subsidiary to the foreign corporation. This is called the branch profits tax. The
branch profits tax is a tax on foreign corporations doing business in the US. This branch
profits tax is imposed on top of the regular corporate income tax on income effectively
connected with a domestic trade or business.

2. The branch profits taxes involve a tripartite regime:

a. First branch profits tax  30% (or a lower treaty rate if applicable) of a
foreign corporation’s “dividend equivalent amount”
1) DEA  generally represents the foreign corporation’s current E&P
from a domestic trade or business as adjusted for net increases and
decreases in U.S. net equity (essentially the amount available for
repatriation)
b. Second branch profits tax  branch interest tax of 30% on interest paid by
a foreign wswcorporation’s domestic trade or business
1) Applies if the recipient of the interest payment is a foreign person
not engage in a domestic trade or business
c. Third branch profits tax  branch excess interest tax of 30% if the
amount of the interest deduction allowed to the foreign corporation against
effectively connected income under 882 exceeds the amount of interest
paid by that corporation’s domestic trade or business
B. Branch Profits Tax on the Dividend Equivalent Amount
1. Purpose  impose 30% tax on the annual effectively connected earnings of a
foreign corporation which are not reinvested in the assets of a domestic trade or
business and are thus considered repatriated to shareholders
2. DEA  under 884(b) equal to the foreign corporation’s current effectively
connected E&P adjusted for increases or decreases in its “U.S. net equity” as
defined in 884(c)

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a. U.S. net equity is determined by reducing, but not below zero, the amount
of money and the adjusted basis of its effectively connected assets (“U.S.
assets”) by its effectively connected liabilities (“U.S. liabilities”)
b. Example:
1) Annual determination of E&P made pursuant to 312
2) Newly formed foreign corporation has $500 effectively connected
E&P from the conduct of domestic trade or business in Year 1, the
Year 1 DEA begins at $500
3) If earnings remain in the U.S. the branch profits tax is avoided
a) If U.S. net equity increases during the year the
corporation’s effectively connected E&P is reduced (but not
below zero) by the amount of this reinvestment in the U.S.
(so would be reduced by $500 and thus no branch profits
tax)
4) If U.S. net equity decreases during the year, it’s effectively
connected E&P are increased by the amount of the reduction
a) So if in Year 2 the corporation withdrew $150 from its
domestic branch and had no effectively connected earnings
for the year, the $150 decrease in U.S. net equity
appropriately increases the DEA and thus a 30% tax would
be imposed on the $150 withdrawal
5) Any increase in the DEA, however, cannot exceed the foreign
corporation’s accumulated effectively connected E&P
a) In the above example if the corporation withdrew $700 it
should not give rise to a DEA of $700 since this would
exceed the corporations domestic earnings of $500
C. Effectively Connected Earnings and Profits
1. 884(d)(1)  effectively connected E&P represents E&P attributable to its
effectively connected income
a. 312 applies for computing E&P
b. In general, all corporate expenditures are allowable as deductions from
E&P, no matter whether they are deductible for income tax purposes
c. Items of income that would otherwise be exempt from tax are included
d. Regular corporate income tax is deducted in computing effectively E&P
e. E&P not reduced by distributions made by the foreign corporation during
that year
D. The Branch Interest Tax
1. 884(f)  30% withholding tax on interest paid by a foreign corporation’s U.S.
trade or business
a. Amount of branch interest subject to tax under 884(f)(1)(A) is generally
capped at the amount of interest apportioned to effectively connected
income under the provisions of 1.882-5
b. No branch interest arises from liabilities incurred in the ordinary course of
the foreign corporation’s foreign business operations
c. No branch interest generally arises from liabilities secured by non-U.S.
assets or from inter-branch liabilities

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E. The Branch Excess Interest Tax

1. 884(f)  30% tax on the amount by which the interest deduction allowed to a
foreign corporation under 882 exceeds the amount of interest paid by that foreign
corporation’s U.S. trade or business
a. The excess is treated as if it were interest paid to that foreign corporation
by a wholly-owned U.S. subsidiary
b. The foreign corporation accounts for and itself pays the tax along with its
U.S. tax return
F. Background on the Taxation of U.S. Real Property
1. Foreign Investment in Real Property Act of 1980 (FIRPTA) 897  enacted to
prevent tax-free dispositions of U.S. real property by foreign investors and to put
domestic and foreign investors on equal tax footing with respect to such property
a. Gain or loss from the disposition of a “U.S. real property interest” by a
foreign investor is treated as if the gain or loss were effectively connected
with a U.S. trade or business
b. Amount of gain or loss determined under 1001 unless one of the 897 non-
recognition exceptions applies to shield it from taxation
c. A non-resident need not satisfy a physical presence test or have a U.S. tax
home to be subject to the tax
G. Section 897: The Big Picture
1. Gain or loss from the disposition of a U.S. real property interest as defined in 897
is considered effectively connected to a domestic trade or business under 871 and
881
a. Absent a special non-recognition exception the gain will be taxed at the
graduated rates in 1 and 55
b. Deductions are allowed under 873 and 882(c)
H. Direct Investment in U.S. Real Property
1. Disposition of a direct investment of property actually and directly owned by the
taxpayer is clearly subject to tax under 897(a)
a. Two critical definitional issues arise for the application of 897:
1) The determination of whether “United States real property interest”
is involved, AND
2) Whether a “disposition” of that interest has occurred
I. United States Real Property Interests
1. 897(c)(1)  generally is defined as any interest in real property (including
interest in a mine, well, or other natural deposit) located in the U.S. and any other
interest (other than an interest solely as a creditor) in any domestic corporation
that is (or was, during certain specified time periods) a U.S. real property holding
corporation
a. Thus includes both direct and indirect investment via outright ownership,
co-ownership, options, and leaseholds
J. Tangible Property
1. U.S. real property interest includes not only land, but also any un-severed natural
products, improvements, and any personal property associated with the use of the
land (also includes leaseholds)

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a. Buildings, permanent structures, and the structural components thereof are

subject to 897
2. “Associated personal property” 897(c)(6) and 1.897-1(b)(4) four categories
(significant expansion of the statute’s reach to include personal property):
a. Property predominantly used in mining, farming, and foresting
b. Property used predominantly in the improvement of real property
c. Property used predominantly in the operation of a lodging facility
d. Property used predominantly in the rental of a furnished office and other
work space
K. Intangible Property
1. Intangibles included under 897  could employ an installment sale and then sell
the obligation to a third party (want to avoid this kind of arbitrage)
2. Installment sales under 453 may also be subject to 897
3. 897(g)  look-through rule under which the disposition of an interest in a pass-
through entity, to the extent that the consideration received by the taxpayer is
attributable to U.S. real property interests held by the entity, is considered to be
received directly by the taxpayer and thus is subject to the rules applicable to
direct investment
L. Dispositions
1. 1.897-1(g)  a disposition of a U.S. real property interest is “any transfer that
would constitute a disposition by the transferor for any purpose of the Code and
regulations”
a. An outright sale, its transfer in satisfaction of a claim, or any other taxable
transfer will constitute a disposition
b. Non-recognition transfers where boot is received
c. With regard to a gift, the relief of a liability in excess of the taxpayer’s
basis
d. Most non-recognition transfers are respected as long as the interest
received in exchange carries the same 897 taint upon its disposition
1) 897(e)  conditions any otherwise available non-recognition
treatment upon the continued application of 897 to the property
received in the non-recognition event
2)
M. Indirect Investment – Interests Held Through Domestic Corporations
1. The interposition of a U.S. corporation between a foreign taxpayer and a U.S. real
property interest will not insulate the foreign investor from the application of 897
2. May even have double taxation in this situation
3. Gain from the sale by a foreign person of shares in a U.S. corporation will be
taxed under 897 if that corporation has at any time within the past five years (or, if
shorter, the taxpayer’s holding period) been a “U.S. real property holding
corporation”
a. Determination predicated upon the extent of the corporation’s investment
in U.S. real property interests
b. Applied regardless of percentage of ownership or whether he disposes of
all or only a portion of his holdings
c.

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N. United States Real Property Holding Corporations

1. 897(c)(2)  Any corporation if the FMV of its U.S. real property interests equals
or exceeds 50% of the value of all its combined foreign and domestic real
property interests and business assets
a. 897(c)(3)  If publicly traded its shares will not constitute an interest in a
real property holding corporation unless the shareholder owns more then 5
percent of the stock
b. Holdings by that domestic corporation in other business entities are taken
into account
c. If the domestic corporation owns a controlling interest of 50% or more of
the value of the stock of another corporation attribute a proportionate
share of the subsidiary’s assets to the parent corporation
1) An all or nothing proposition  if owns less than a controlling
interest then the sole issue is whether the shares in the domestic or
foreign subsidiary constitute a U.S. real property interest (if so,
entire interest considered a real property interest, if not, none of the
interest is so considered)

O. Indirect Investment – Interests Held Through Foreign Corporations

1. No gain or loss recognized under 897 when a foreign taxpayer disposes of shares
in a foreign corporation, thus foreign shareholders in a foreign corporation
holding a U.S. real property interest enjoy greater latitude

P. Distributions by Foreign Corporations

1. Under 311 and 336(a) a foreign corporation that distributes a U.S. real property
interest will recognize gain equal to the full unrealized appreciation in the
distributed property at distribution, however such gain would not ordinarily be
subject to tax absent FIRPTA
a. 897(d)  safeguard that imputes the requisite trade or business and
effective connection status to encompass any such gain
b. Examples:
1) Distributions “with respect to” shareholders stock 301
2) Distributions in redemption of shareholder’s interest 302
Distributions in liquidation where the transferee receives a stepped-up basis

Review of Inbound Transactions:

(1) Statute:
o Passive Income
o Trade or Business – ECI
o Branch Profits
o §897 (real property treated as trade or business)
(2) Treaties:

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§ 884(a) Branch profits tax (a) Imposition of tax.-- there is hereby imposed on
any foreign corporation a tax equal to 30 percent of the dividend equivalent
amount for the taxable year.
 Tax on Foreign Corporations
 Dividend Equivalent Amount: represents foreign corporations’ current E&P
from domestic trade or business adjusted for net increases and decreases in
United States Net Equity

§884(f) Branch Interest Tax: 30% withholding tax on interest paid by a foreign
corp’s domestic ToB.
 Applies if the recipient of interest payment is a foreign person not engaged
in a domestic ToB

Purpose for the policy:

Ex: Foreign Corp forms US subsidiary which carries on Trade or Business and all
income is effectively connected. Assuming Sub makes $100K net income, as money
is earned, under §882, the Sub will pay the §1 rates ~ 35%
 Result: US collects $35,000
After end of year FC decides to wind-up US business; liquidates US sub through
dividend to the Parent
 Source rules for dividend (passive income) – taxed at US again at the 30%
rate

Ex 2: F. Corp. parent forms a foreign subsidiary, which derives $100K ECI in the
United States
 Foreign person with ECI will be taxed at §1 trade or business at 35%
 If all of the foreign subs’ earnings are effectively connected, the dividend
will still have a US source and will be taxed at 30%

Ex 3: F. Corp. uses a branch will still pay taxed at 35% but the payment from the
Foreign corporation to shareholders will not be US source because §861(a)(2)(b)
will only tax if more than 25% is ECI
 If the Foreign corporation has significant foreign earnings they have
prevented the second level of tax – because the dividend income is foreign
sourced
 Foreign source dividend not subject to tax, missed out on second level of tax

9-1v Vietindo is a privately-held corp organized in Vietnam that sells luxury

automobiles in its showroom in NYC to US customers. In all cases, title to cars
passes to customers in US. Vietindo purchased the showroom building two years
ago. Vietindo for Year 1 earned $100,000 of US net income and paid tax of
$35,000 on it. In Year 2, it earned $200,000 net income, paid tax of $70,000, and
repatriated $50,000 to Vietnam. In Year 3, Vietindo earned $300,000 of net
income, paid tax of $105,000, and repatriated $250,000. What is the amount of
the branch profits tax, if any, for Years 1-3?

Dividend Equivalent Amount (DEA): means the foreign corporation's effectively

connected earnings and profits for the taxable year with adjustments up and down
for increases/decreases in U.S. Net Equity

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 Note that this is not the actual dividend – just the equivalent
 If there is a DEA then it is taxed at US rate of 30%
 Note that effectively connected income means that if a foreign corporation is
not conducting a US trade or business at first level there would be no
effectively connected income

Step 1: Compute Effectively Connected E&P for the Year

Year 1:
Net Income (US) $100,000
US Tax ($35,000)

Eff. Conn. E&P $65,000

Step 2: Adjustments for Change in U.S. Net Equity

Two Categories of Adjustments:
(1) Reduction for Increase in US Net Equity
 U.S. Net Equity Close of Year – U.S. Net Equity from Previous Year > $0
 Reduce E&P but not below zero by that amount
(2) Increase for Decrease in U.S. Net Equity

Effectively Connected E&P = $65, Increase in U.S.=$65, DEA = $0

Result: Assets are still within the United States at end of year 1 so there is no
Branch Profits Tax

Year 2:
Net Income: $200,000
Tax: ($70,000)
EC E&P $130,000

Year End Net Equity: $130,000 + $65,000-$50,000= 145,000

 $50,000 was repatriated to Vietnam
 $65,000 accumulated EP from Year 1

Year End NE – Beginning of Year NE:

 $145,000-$65,000 = $80,000 increase (reduces E&P)
 Apply $80,000 as a decrease in the Effectively connected EP of $130,000

Dividend Equivalent Amount (Remainder) = $50,000 X 30% = $15,000

 Note – you can check yourself by determining what left the US during the
year!

Year 3:
Net Income: $300,000
Tax: ($105,000)
EC E&P $195,000

Year End Net Equity: $195 + $145,000-$250,000 = $90,000

Year End NE – Beginning of Year NE:

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$90,000-$145,000 = $55,000 (increases E&P)

Result: $195 + $55 = $250 X 30% = $75K

NOTES:
 There is no threshold on how much ECI is from the United States; which
means that this foreign corporation might actually distribute a dividend to
shareholders - could that be U.S. sourced?
 If this is true then there is a triple tax: ECI (as earned), Branch Profits
(movement in Net Equity)

9-3 FC has $120,000 of interest expense allocable to effectively connected income.

It pays branch interest in the same amounts as problem 9-2. To what extent is the
branch excess interest tax applicable?
Tax Excess ($20,000) at 30% to the foreign corporation.

Excess Interest Tax:

§884(f)(1)(B) – Allocable interest exceeds interest paid
 Remember that expense allocation rules tie closely from what expense to
what source; and with interest you are allocating based on asset ratios
 So you may have a greater allocation than interest actually paid

9-4 Teo, an individual, is a citizen and resident of Argentina who has never been
present in US. Teo owned the following assets: (i) 100 shares of common stock of
domestic X corporation; (ii) 100 shares of common of foreign Y Corp; (iii) rental
real estate located in Modesto, CA (Teo’s activities in this connection do not
constitute engaging in a domestic ToB); and (iv) vacant land located in OR held as
investment property.

§897: Disposition of Investments in U.S. Real Property

 Without this you would tax the gain on §871(a)(2) –where almost no one falls
into the category
 §897(c) definition of real property (basically just interest in property in the
US)
 This item would be passive but the statute forces you to be effectively
connected.

General Rule: Gain or loss of a foreign taxpayer from the disposition of US real
property interest is considered effectively connected to a domestic trade/business
 Absent special non-recognition exception, gain will be taxed at graduated or
capital gain rates for non-resident individuals and §11 for foreign
corporations

United States Real Property Interests:

§897(c)(1) – Any interest in real property located in US, and interest in any US real
property holding corporation
 Includes personal property associated with use of land; includes
improvements – buildings/permanent structures, etc.

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 “Associated Personal Property” expands the statute further to four

categories of tangible property
o Mining/farming/forestry
o Property used to improve real property
o Property used in operation of lodging facility
o Property uses in rental of furnished office and other workspace
 Intangible Property: certain interests treated as personal property to avoid
shielding income

“Disposition” – broader sweep than a mere sale; any effort to sever ownership

Indirect Investment
Gain from the sale of shares in a US corp taxed under §897 if in past five years
been a US Holding Corp
 US Real Property Holding Corporation: Any domestic corporation which fair
market value of US real property equals or > 50% of value of all combined
foreign and domestic real property interest and business assets
o Imputation for (1) Corp owning partnership interest, etc. and (2)
Corporation owning 50%
 Publicly Traded: if corporation publicly traded, shareholder needs to own
more than 5% for USRPH Corp.

(a) Assume that Teo realized a $13,000 gain on the sale of the vacant land in
Oregon. What are the United States income tax consequences, if any, to Teo? §
897c1 real property
Result: Under §897(a) this would be taxed at the normal graduated rates – treated
as effectively connected – possible capital gains treatment (election is only on
income on real property not property gain) Without 897, this would have been
passive income. This would not have been taxed because Foreign Person has to
have residence. If you can buy land, without being in the US.

Only applies if you buy only one piece of land, if more than one piece, it will be
engaged in trade or business (Active).

(b) How would the answer to (a) change if Teo exchanged vacant land in OR for
vacant land in Ireland?
 §1031(h) – U.S. Land for foreign land is not a like-kind exchange; therefore
taxable as in (a) above. Provisions that postpone the tax, if what is getting
back if foreign property. If its exchanged for US Property then postpone
gain.
o §897e and -6T regulations say that this would not be treated as a non-
recognition event

Basic Principle: If you have something that would be recognized if sold to

something that would not be recognized if sold (i.e. out of hands of US) then it will
be taxable.

(c) How would the answer to (a) change if Teo contributed the vacant land in
Oregon to Z Corporation, a domestic corporation, in return for all of its stock?

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 Non-taxable. Ordinarily this would be a non-recognition under §351

Non-recognition-postpone the impostion of tax.

§897(e) Coordination with nonrecognition provisions.--

(1) In general.-- any nonrecognition provision shall apply for purposes of this
section to a transaction only in the case of an exchange of a US real property
interest for an interest the sale of which would be subject to taxation under this
chapter (as long as you have a real property interest you can defer gain)
 As long as you still have a real property interest (stock) you can defer the
gain, qualifies as US real property holding corporation under § 897c2 which
is subject to tax when sold

EVERY time there is a sale of stock by a foreign person you need to ask first:
Assuming corporation is not US real property corp… If you hold land think about
§897; if you hold stock think about US real property interest

(d) Assume the facts in (c) occurred in Year 1. In Year 2, Teo sold the Z stock for a
gain of $20,000. What are the United States income tax consequences to Teo in
Year 2?
 Treated as disposing a piece of real property – taxed as normal capital gain;
this is a US real corporation so §897, FIRPTA applies.

(e) How would the answer to (a) change if Teo contributed the vacant land in
Oregon to Q Corporation, a foreign corporation, in return for all of its stock?
§897(e) – Blocks this; Foreign corporation is not treated as a US Real Property
holding company – it simply looks through to include this as taxable. § 897c4A
applies seeming to make foreign corp a USRPHC, but § 897c(1)(A)(ii) only taxes
domestic corporations

(f) Assume Y Corp owned exclusively real property located in US. If Y Corp sells a
parcel of real property to an unrelated purchaser, what US income tax
consequences, if any, arise? § 897a
 Y is a foreign corporation; does not matter if it is an individual or foreign
corporation – still taxable (except at corporate rates)

(g) How would the answer to (f) change if Y did not sell any of its holdings but Teo
sold all or a portion of his shares in Y?
 Teo sold his shares in foreign corp, not included in the definition of a US
Real property interest

What Happens?
 Still have US real property held by foreign corporation; so when this is sold
tax will arise
 Because assets will be subject to tax when sold; then net value of property is
less because of tax
 Seller of stock is not taxed, purchase price should reduce with knowledge of
inherent tax liability
(h) Assume that Teo buys stock in domestic W Corp, the exclusive holdings of
which are US real property. If Teo sells the stock four years later for a gain of
$5,000, what are the US tax consequences, if any?

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 U.S. real property interest subject to tax under FIRPTA subject to § 897c2
Even if they bought
(i) How would (h) change if Teo purchased and sold a ten-year debenture rather
than stock?
 §897c1A(ii) – does not include interest solely as a creditor (“any interest”)
o Make sure debenture is not actually disguised equity - because you
could see people attempting to cloak debt as equity to avoid §897 tax

(j) How would the result in (h) change if W was publicly traded?
 §897(c)(3) – Exception for publicly traded; will only be taxed if Teo owns
>5% of the corporation classified as a US Real property interest, no change

(k) How would the result in (h) change if W’s real estate holdings comprised only
30 percent of its asset base on the date of sale?
 Now this is below the 50% threshold for US Real Property interest – not
a US holding corp if 5 year taint under §897c1A(ii)(ll)
 §897(c)(2) – If it did at some other time period meet the definition you will
still be taxed as if it was a sale of a US Real Property interest (see further
definition in regs).

Solution:
(l) How would the result in (k) change if Teo sold his stock ten years after its
purchase?
Regs: Shorter of holding period or 5 years before sale; would avoid the US holding
corp classification. Even if it was in the beginning a real property holding
corporation classification.

X. OVERVIEW OF TAX TREATIES (UNIT 10)

A. Overview
1. Purpose is to mitigate the potential for double taxation
2. Provide consistent rules specifically governing which treaty country has the
primary right to tax income items or certain classes of persons
3. Double taxation arises most often when one country asserts taxing authority on
the basis of the residence of the person receiving the income (the home country)
and another on the basis of source of the income (the host country)
4. May introduce complexities because they provide a second source of authority
a. Have the same effect as acts of Congress and possess authority that
overrides the tax treatment otherwise provided by the Code
5. Treaties are generally drawn from model income tax treaties

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B. The Treaty Process

1. The date that ratification instruments are exchanged generally marks the date
upon which the treaty is considered to be “in force”
a. A treaty which is in force is not, however, always “in effect”
b. Treaties may contain prospective or retroactive effective dates

C. Interpretive Resources
1. Protocols  may amend existing and proposed tax treaties and must be duly
enacted via proper ratification procedures
2. Technical Explanations  serve as official guides to the tax treaties
3. Model treaties
4. Letters of understanding
5.
D. Relationship of Tax Treaties to U.S. Federal Law
1. Establishing the directional flow of the income item is therefore an imperative
first step in analyzing how the treaty will apply
2. Treaties and the Code are generally accorded equal weight as 894(a)(1) and
7852(d) acknowledge
3. Courts have adopted a “last in time rule” of construction which provides that the
later enacted provision controls
4.
E. Double Taxation

1. Tax treaties try to ameliorate double taxation in two ways:

a. First, delineates specific types of income and provides precise rules for the
taxation of these items
1) Regarding passive income, the country where the income is
derived generally gives way under the treaty regime to the
recipient’s country of domicile
2) Treaties generally provide that under certain conditions the
recipient of a particular item of income will be taxed at a lesser tax
rate or will be exempt from taxation in the source country
b. Second, treaties establish “competent authority” procedures that afford
taxpayers the opportunity to present disputes

F. Saving Clause

1. The U.S. reserves its right to subject its own citizens, including those permanently
living abroad, to domestic tax on their worldwide income as if the treaty were
not in effect, as provided in Article 1, paragraph 4 of the 2006 Model Tax
Treaty
a. Called a saving clause, presumably because it saves U.S. taxing
jurisdiction over its citizens
b. U.S. citizens are thus generally not permitted to avoid taxation by
establishing foreign residency and claiming U.S. treaty benefits extended
to foreign residents

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G. Treaty Benefit Eligibility

1. In most cases, only a corporation or other person that is a “resident” of one of the
foreign signatory countries may claim the benefits of an income tax treaty
a. Treaties generally define those individuals and entities that qualify as
residents and the 2006 Model Tax Treaty, Article 4 provides a definition
2. Because a person may be a resident of both signatory countries, most treaties
contain a “tiebreaker rule” to place a dual resident in only one country for
purposes of applying the treaty

H. Anti-Treaty Shopping Measures

1. Often found in the “limitation of benefits” clause and operates to restrict treaty
benefits to those individuals and entities legitimately connected to the treaty
countries
a. Prevent citizens of other countries that do not have U.S. tax treaties from
exploiting treaty benefits by selectively conducting their affairs in
favorable treaty countries

I. Non-Discrimination

1. Attempt to ensure that the residents of each signatory country are not
discriminated against in a tax sense by the tax authorities of the other country by
incorporating a “non-discrimination clause”
a. Promises not to tax a foreign person residing in a treaty country at a
higher rate than a U.S. person in the same circumstances, nor to
deprive that person of any deduction or credit available to U.S.
citizens in the same circumstances

J. Competent Authority Procedures

1. “Mutual agreement procedure” provision  designates consultation between
competent authorities to resolve treaty disputes (contained in the 2006 Model Tax
Treat, Article 25)

PROBLEM SET X: OVERVIEW OF TAX TREATIES

§ 894. Income affected by treaty
(a) Treaty provisions.-- (1) Provisions shall be applied with due regard to any treaty
obligation of the US.

Purpose: Ameliorate double taxation in two ways

 Delineate specific types of income and provide precise rules for the taxation
of those items
o Usually recipient’s country of residence controls where tax originates

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

 Establish “competent authority” procedures wher tps can present disputes

regarding provisions.

Treaties & the Code:

Courts have adopted a “last in time” rule so that later enacted provision controls
 Where a treaty and a later-in time enacted code provision conflict, the code
will generally prevail
 However if code section does not plainly show intent to supercede treaty,
treaty may prevail
 §7582 states that they should be considered in tandem
o Note – renegotiating treaties tough; protocols can tweak rather than
rewriting whole.

Treaties: approximately 55 treaties currently negotiated with other countries

 80 countries check the box – 50 or so with treaties

Outbound Considerations (Speak with Foreign Counsel)

 Does foreign country have a statutory override
 Does foreign country have a statutory provision that is a lower rate than the
treaty provision?

Treasury Technical Explanations perform same function of regs in de-mystifying

provisions of a Treaty
 Can look at another treaty with an identical provision and see if there is a
technical explanation

10-1. In what ways do income tax treaties fulfill their articulated objective of
"eliminating double taxation"? What other avenues (besides treaties) are available
for eliminating double taxation'? If unilateral measures are available, to what
extent is a reduced rate under treaty valuable?
 Purpose is to avoid double taxation of individuals; do so by providing sole
means for taxation of individual subject to treaty
 Move from source to residence based taxation
 Gives tp more certainty and relief by allowing appeal to competent authority
 Other avenues are the foreign income exclusion, credit, deduction etc.

10-2. Melinda, a US citizen, retired to Canada on January 1, Year 1. If Melinda

derives $30,000 of dividend income from US sources after her move, what country
or countries might tax income and at what rate(s)?
Eligibility for Treaty Benefits:
 Defined in the treaty – but normally it is limited to “Residents”
 If a person is considered a resident of both countries, then a tie-breaker is
applied

Canada Treaty Tie Breaker – Residency Article IV:

If an individual is resident of both US and Canada, treaty status is determined
under following scheme
 Individual deemed to be a resident of country in which he has a permanent
home; if there is a home in both countries or neither country, the individual

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

is deemed to be a resident of the country to which his personal and

economic (vital interests) are closer
 If cannot determine vital interests, deemed to be resident of country with
habitual abode;
 If no habitual abode or habitual abode in both countries, resident in country
in which a citizen
 If individual is a citizen of both or none, then residency will be determined
by mutual agreement

Step 1: Is Melinda a qualified resident of the Foreign State?

Article IV Resident: means any person that, under the laws of that State, is liable
on tax therein by reason of that persons domicile, residence, citizenship, place of
management, incorp, or other criterion.
Yes - assumption that she is a resident of Canada.
 Melinda’s residence depends on Canadian law – because a “resident of the
Contracting State” means a person who, under the laws of the state is liable
to be taxed therein.

Step 2: Is Melinda a resident of the United States?

 Melinda is a U.S. citizen therefore she is taxed on worldwide income

“Savings Clause” Operates to subject United States citizens living abroad to

continued domestic taxation
 Canada – Article 29(2), Treaty shall not effect taxation of a country’s own
citizens
 Prevents US citizens from shielding themselves in foreign residency to avoid
taxation by US
29 (2) (a) and 29((b)
Tie breaker rules on residency does not apply to US Citizens.

Step 3: Apply Article X – Dividends of Treaty

1. Dividends paid by a company which is a resident of a Contracting State (Us) to a
resident of the other Contracting state may be taxed by that other State (Canada).
 Tax shall not exceed 15% - does not apply because savings clause brings you
outside of treaty

10-3. Hans, a citizen and resident of Canada, works in US each year from January
1 to July 31. During his stay in US, Hans rents an apartment in NYC. Hans owns a
home in Canada, where his spouse and children live all year. Hans is a registered
voter in Canada, and Canada is location of bank accounts, stocks, and automobiles.
Is Hans subject to US taxation on the dividends he receives from his Canadian
stock?

Step 1: Is Hans a qualified resident of Canada? Yes

Step 2: Is Hans a resident of US? Yes because he satisfies substantial presence
test >183 days § 7701b
Step 3: Does the Treaty apply? Yes [regs say treaty overrides statute]

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

 Hans is both a resident of the United States and a resident of Canada. Check
tie breaker rules.
Article IV, Section 2(a) – considered a resident of Canada because
permanent home in Canada
o Then look to personal and economic relations, habitual abode,
citizenship … (possible to have two permanent homes)
Step 4: Not subject to US tax, Article 22(1) articles of income arising in Canada
shall be taxable in Canada

10.4 Eduardo, a citizen and resident of Argentina, forms a wholly-owned

Canadian corporation, which invests in a United States corporation and
receives dividends annually. What result?

Step 1: Who is the Taxpayer?

 The Corporation in Canada
 Look at Article IV Part 1: look at place of management/place of incorporation
so corporation would be a resident of Canada

Step 2: Will this work under the Treaty?
o No – because the treaty includes an anti-treaty shopping clause
o Article 29(a) – Limitation of benefits; if 50 % of ownership of
corporation is Canadians it may be ok – but because only shareholder
is from Argentina, they are trying to accomplish indirectly what they
cannot do indirectly
Even if you are a resident, you have to be a qualifying person, if it’s a
FCThis collapses the transaction so that the corporation is treated as
Argentine – subject to normal 30% tax rate (not reduced rate of
Canadian tax treaty)

XI. TAX TREATIES AND INVESTMENT INCOME (UNIT 11)

A. Overview

1. Taxation on investment income may be reduced or eliminated altogether

pursuant to tax treaties between the U.S. and other countries
2. Treaties generally assign the right to tax investment income to the residence
country and active income to the source country
3. Savings clause in U.S. treaties prevent these agreements from applying to reduce
the taxation of U.S. citizens or residents, or both, the transactions here generally
focus on inbound transactions, that is, the U.S. taxation of U.S. source
investment income earned by foreign persons
a. Generally tax passive income at flat 30% rate under 871 and 881
b. Foreign persons in countries with tax treaties may be entitled to a reduced
rate of tax, since these agreements impose a rate far lower than the
statutory 30% rate for most types of passive income

B. Dividends – Model Tax Treaty Article 10

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

1. Dividends not effectively connected to U.S. trade or business generally taxed at

30%
a. Tax treaties generally reduce the statutory tax rate significantly and the
recent trend has been towards complete exemption of dividends with
respect to certain inter-company dividends paid between companies
resident in contracting states
b. Most treaties reduce the rate to 15% “general rate” for individual
shareholders and for corporate shareholders holding less than 10% of the
company’s shares
1) There is a 5% direct dividend rate for dividends paid to
corporate recipients that own at least 10% of the stock of the
paying corporation, so long as the dividend is not attributable to a
permanent establishment
a) Rev. Rul. 75-118  ruled that a foreign corporation was
entitled to the direct dividend rate under the treaty even
though the company had restructured its subsidiary from
Canada to the U.S. solely to take advantage of the treaty
with the U.S.
2) Reduced rate for dividends applies only if the dividends are not
attributable to the operation of a permanent establishment
a) If attributable to a permanent establishment the provisions
of Article 7 (Business Profits) apply
b)
C. Interest – Model Tax Treaty Article 11
1. Most U.S. source interest is not in fact taxable to foreign persons due to the bank
deposit and portfolio interest exceptions
2. The Model Tax Treaty generally provides that interest received from a U.S. payor
and beneficially owned and derived by a treaty country resident may be subject to
tax of up to 15%, so long as the interest is not attributable to a permanent
establishment
a. If attributable to a permanent establishment, the provisions of Article 7
(Business Profits) apply
3. Majority of treaties do not completely exempt domestic source interest from
taxation but provide a reduced rate typically between 10% and 15%
4. Anti-abuse exceptions:
a. Contingent interest calculated on the basis of profits, cash flow, property
appreciation, and similar items
b. Certain interest payments connected to a real estate mortgage investment
conduit which are typically subject to full source country taxation

D. Royalties – Model Tax Treaty Article 12

1. Royalties derived from the U.S. are generally exempt from tax or subject to a
reduced rate of tax under most tax treaties

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

2. 2006 Model Tax Treaty provides for complete source country exemption of
royalties derived and beneficially owned by a resident of the other contracting
state
a. Royalties derived by a foreign licensor from U.S. sources are exempt
from U.S. taxation
b. Accordingly, so long as the royalties are not attributable to a permanent
establishment, they are also exempt from the flat 30% tax
3. Royalties that are attributable to a permanent establishment are addressed in
Article 7 (Business Profits)

E. Gains from the Disposition of Property – Model Tax Treaty Article 13

1. Under most treaties, gains derived from the transfer of property are generally
table only in the country of the transferor’s residence
a. However, the U.S. retains jurisdiction to tax those gains derived from the
transfer of intangible assets where the amount of the gain is contingent on
the productivity, use, or disposition of the intangible asset

F. Income from Real Property – Model Tax Treaty Articles 6 and 13

1. Most treaties do not provide for a reduction of the statutory rate for income
derived from real property and typically subject to tax in the situs jurisdiction
regardless of whether the income is derived annually (e.g., rental income) or
whether the income is derived from a disposition of the property (e.g., gain from
the sale of property)
G. Residual Income – Model Tax Treaty Article 21
1. Will typically eliminate the U.S. tax on such income, generally granting taxing
authority to the recipient’s home country only
a. Applies so long as the income is not attributable to a permanent
establishment in the U.S.

PROBLEM SET 11: TAX TREATIES AND INVESTMENT INCOME

Read: Relevant portions of United States – Canada Tax Treaty

Inbound Transactions:
I. Statutory Rules
o Active
o Passive
o US Source
o Passive
o Tax applied is 30% on gross [implicitly no deductions allowed]
 Dividends/Interest
o Gains – look at presence test etc. §97
o Real Property – treated as T/B so taxed according to normal rate
schedule

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

II. Treaty Rules

Apply U.S. Regime for Foreign Persons: §871 and §872
o First step would be to source his income
o Determine “If you fall within the Tax Treaty”
 The tax so-charged shall not exceed
 Note that the treaty creates a ceiling but it does not create a
floor.

Result: Look at result under Statute and Under Treaty and choose the lesser of the
two

11-1. Tom, a citizen and bona fide resident of Canada, has never been present in
US. During Year 1, he had no US trade or business, but owned a number of assets
that produced the following items of income:
(a) $20,000 dividend on the stock of DelCo., a corp formed in Delaware. – taxed at
15% under treaty
Dividends. Article X
 Contracting State can impose a tax on its residents for dividends paid by a
company which is a resident of the other Contracting State
 Limitation: Amount of tax that may be imposed on dividend by “other
Contracting State” [i.e. state where company is a resident] if owner of
dividend is resident of Contracting State
o 10% for Companies with beneficial ownership owning 10% or more of
voting stock
o 15% on the gross amount in all other cases [individuals]
 Not parallel with passive income treatment where deductions
are not allowed.
 Dividend Defined: similar to definition in statute
 Beneficial Ownership: requires permanent establishment etc.
o You can have passive income; but there will be a similar determination
if you have business activity so that it moves from passive treatment
in article X to Article VII (Business profits)

II. Source rules are often defined in the treaty/may be different from statute:
Notice that this is not source dependent – although the Dividend is from a US
corporation; does the source rule as defined by the statute carry extreme
significance under the treaty.
 Do the provisions refer back to the US Source rules?
 Article X, 2 is a source rule in the treaty
 Result: Although there is some element of sourcing, the rule is often
provided in the treaty itself – no need to go to the statute.

(b) $5,000 gain on sale of ten shares of stock in UruCo., a corporation formed in
Uruguay;
Gains - Article XIII
Three instances where gains will be taxed:
(1) Gains by resident of CS from alienation of real property from other CS can be
taxed by other CS

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

 “Property” definition in Article XIII(3)(a) for Real Property in US and (b) real
property in Canada
(2) Gains from personal property forming business property
(3) Gains from alienation of any other property

If it’s a Foreign Corporation – only three situations where gain will be recognized
 Real property
 Capital stock
 Interest in partnership

If it’s a Domestic Corporation

 Real property interest within US (does not include capital stock that is not a
resident of US)
 Issue: Is there a United States Real Property Holding Company?

Result: Gain not taxed by the United States

(c) $13,000 dividend on the UruCo. stock, of which $5,200 is US source and $7,800
is foreign source;
 Article X: Not taxed because UruCo. Is not a resident of either country.
Notes:
When we worked through this problem from a source rule point only; we noticed
that dividends from a foreign corporation can have a US source if some of the
earnings (greater than 25%) had a US source
 871(d) – Dividends arising under this provision are not subject to tax
o Branch profits tax
At time source rule was designed, branch profits in 884 was not yet in force
 Branch profits combined with effectively connected will tax as earned and if
removed it will be taxed at 30%
 IF it is ultimately a dividend leaving US it will not be taxed – this would be a
third tax

(d) $10,000 in rents from rental property located in the United States;
Article VI. Income from Real Property
 Income derived by resident of Contracting State (Canada) from real property
in other Contracting State (US) may be taxed by that other State. “May be
taxed in the U.S.”
o Treaty provision clarifies who can tax the income but silent on rate of
tax to be applied
Rule: Where treaty is silent on tax rate to be applied, look to statute

Result: Rental income subject to tax; but it will be taxed according to U.S.
treatment of passive income, which is 30% of the gross amount
 Because there were expenses for the rental property these will not be
allowed – so you would not be able to take the expenses.
 Under US rules would want to elect to treat the income as income from t/b –
get graduated rates

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

(e) $1,000 of foreign-source interest on a loan made to Emily, a citizen and resident
of Bolivia; $2,000 of interest on a deposit at a Chicago, Illinois bank;
Interest – Article XI
 Interest in CS beneficially owned by a resident of the other CS can only be
taxed in that other state
 Result: Taxable in Canada (not US) under Article XI(1)

(f) $8,000 in cash from the sale of US rights to a patent Tom created for five
percent of the net profits from products produced through its use.
Royalties Article XII (3)
 General rule is that both states can tax the income; however certain
royalties which arise in a contracting state owned by a resident of the other
State, can only be taxed in that Other State (treaty provision: contingent
portion0.
 Cap on patent tax of 10% if it is taxable
Result: Under Article XII this is not subject to tax
Notice Themes:
 If we looked at this problem under the statute – go back and look if this is
taxed first
 Article XII pulled this out of Article XIII - gains from patents are handled
here because a royalty

Tom’s potential deduction for the year consisted of depreciation and expenses with
respect to the rental property of $3,000, a $1,000 loss on the sale of five shares of
UruCo. stock, and medical expenses of $4,500. Assume Tom would be subject to a
20 percent effective rate on his taxable income.
(a) What is Tom’s US taxable income and his tax liability for Year 1 assuming none
of his holdings constitutes a permanent establishment under the United States –
Canada treaty?
Income Taxable by US
 Dividends - $20,000 capped at 15%
 Income from Real Property - $10,000 taxed at 30% US statutory rate [unless
elects ToB]

11-2 Shaida is a citizen and resident of Canada. In Year 1, purchased ten shares of
DelCo stock,a Delaware Corp, for $7,000. In Year 3, Shaida sold the shares for
$10,000 cash to an unrelated individual residing in US. To what extent will US
impose tax on $3,000 gain in Year 3 under each of the following scenarios?
(a) Shaida was never physically present in the United States at any time in Year 1,
Year 2, or Year 3.
Gains – Article XIII
 US real property does not include shares of capital stock
 Under Part 4, any other property other than specifically listed is taxably in
the State in which the person selling the property is a resident – i.e. not
taxable by Us because Shaida Canadian resident

Note: If this is a Domestic Corporation you must determine if it is a real

property holding company, and the time period, because it could be dragged in
by §897 or the Treaty

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Capital Gains Provision Notes: Most gains will not be subject to tax
Step 1: Start with the Statute:
Physical Presence Test: For a foreign person have to be present > 183 days
 Then you are a US resident and fall out of §871(a)(2)

If you are there for 200 days/some were exempt – you are not a resident but you
have presence
 Still not taxed because under §865 if tax home not in US, not US source and
therefore its not taxed
Under statute if you are resident of the U.S.
 Then you cannot even look at the treaty – savings clause
 STILL need to determine if you are a resident of Canada and regulations
under §7701(b) says that the Treaty tie-breaker will control
Step 2: Once you figure out it is a foreign person then you head to Article XIII to
answer the question.

(b) Shaida was not physically present in US at any time in Year 1 or Year 2, but she
was physically present in US for 200 days in Year 3. Tie breaker rules make her
Canadian resident under treaty. Look at Gains in Article 13(4) taxable only in
country of residence under treaty – in Canada.

(c) Same as (c), except that for 100 of the 200 days of presence in the United
States in Year 3, Shaida was a student residing in the United States under a
“J Visa,” issued under Immigration and Nationality Act. Now clearly a non resident
– taxable in Canada.

11-3 ForCo is a corp organized in Canada. All of ForCo's shares are owned by
citizens and residents of Canada who have no connections to US. ForCo has a
number of investments in US, but does not have a PE within US. For each
determine whether the interest received by ForCo is subject to US tax under
§881(a).

Interest - Article XI
 Tax rate is 0% [this has been the same in most statutory provisions]
 Except: Portfolio interest rules – does this look like a disguised dividend?
o Exempts withholdings for interest paid on certain obligation held by
foreign persons
(a) § 871a2D not subject to tax
(b) Foreign source, not subject to US tax § 861a1
(c) § 871h not subject to tax, portfolio exception
(d) Tied to earnings, subject to tax under Article XI 6 (b) dividend rate, not to
exceed 15%
(e) Not subject to tax
(f) 30% tax under statue, Article XI does not specify this type of interest, meets
general treaty exception

Answer (e)It is contingent and does not qualify for portfolio interest-???
Still subject to tax but at a lower rate
Contingent Earnings and Portfolio Interest rules

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

 Note that contingencies not tied to earnings are 0%

Look at Article XI (a)
 Treatment gets you $0
 But notice that under (b) if its Canadian gross amount may be taxed not
exceeding rate for dividends – treated as disguised equity

XII. TAX TREATIES AND BUSINESS INCOME (UNIT 12)

A. Overview

Under statutory law, foreign persons are subject to U.S. taxation on all income derived from the
conduct of trade or business in the U.S., while under most treaties, income derived from the
conduct of a trade or business is taxable by the U.S. only if it constitutes “business profits” that
are “attributable to” a “permanent establishment” maintained in the U.S.

Residents of Treaty Countries Residents of Non-Treaty

Countries
Required presence in the Must have a PERMANENT Need only be ENGAGED IN
United States ESTABLISHMENT in the TRADE OR BUSINESS
U.S. to be subject to taxation within the U.S. to be subject to
taxation
What is taxed? BUSINESS PROFITS that are Income EFFECTIVELY
ATTRIBUTABLE TO the CONNECTED with the
permanent establishment conduct of a trade or business
in the U.S.
Rate of tax Graduated rates (1 or 11) Graduated rates (1 or 11)
Deductions allowed? Yes Yes

1. Interpretive steps:

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a. Step One  determine whether a person is carrying on a business in the

U.S. for treaty purposes
b. Step Two  determine whether that business is conducted through a
“permanent establishment”
1) If no  income will not be taxed as business profits (but might be
taxed under another treaty provision)
2) If yes  profits must be appropriately attributed to the permanent
establishment
c. Step Three  deductions must be appropriately allocated to the permanent
establishment

2. Corporate form respected  a foreign person investing in a domestic corporation

that carries on a trade or business will not need to invoke a treaty with respect to
the business profits of the domestic corporation (only when a foreign person is
itself involved in carrying on a domestic business)

B. United States Trade or Business

1. Pretty much the same standard under 864 (regularity and continuity)

C. Permanent Establishment – Model Tax Treaty Article 5

1. Rev. Rul. 58-63  qualitative difference between a trade or business and a

permanent establishment
a. Permanent establishment provision serves as a higher threshold to the
taxation of business profits
b. Instead of triggering U.S. tax upon meeting the more easily satisfied trade
or business standard, a foreign person will be able to avoid triggering U.S.
tax if the activities do not constitute a permanent establishment
2. Treaties generally equate a permanent establishment with a fixed place of
business through which the business of an enterprise is wholly or partly carried on
a. Will possess a permanent establishment in the U.S. if it either maintains
such fixed place of business in the U.S. or if the activities of another
person who maintains such fixed place of business are imputed to the
enterprise
1) “Physical presence test supplemented by an agency rule and
restricted by an activity rule”

3. A permanent establishment may include:

a. Place of management
b. Branch
c. Office
d. Factory
e. Workshop

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

f. Warehouse
g. Place of extraction of natural resources

4. A permanent establishment does not include:

a. Use of facilities or the maintenance of a stock of goods solely for the

purpose of storage, display, or delivery
b. Use of facility for ancillary business purposes
c. Fixed place of business solely for the purpose of purchasing goods or
merchandise, collecting information, or carrying on any other activity of a
preparatory or auxiliary character
d. Website
e. Showroom or demonstration room to display or demonstrate the use of its
products to domestic customers
5. A permanent establishment may indirectly arise by virtue of a foreign person’s
ownership interest in a pass-through entity
a. A permanent establish may be imputed to a foreign partner in a limited or
general partnership if the partnership itself has a U.S. permanent
establishment
b. However, stock ownership, or affiliation with, entities or persons with a
U.S. permanent establishment does not in and of itself appear to be
sufficient grounds to impute a permanent establishment to the owner or
affiliate

D. Duration

1. Permanent establishment should not arise if the use of an office or fixed place of
business is brief or transitory rather than permanent
2. However, conducting significant business operations at a site for abbreviated time
periods has been found to give rise to a permanent establishment

E. Use of Another’s Fixed Place of Business

1. The temporary and transient use of a domestic subsidiary’s office by employees of
a foreign parent corporation should not constitute a permanent establishment (but
may arise if they make frequent and continuous use)

F. Use of Agents

1. Permanent establishment will exist when a foreign person conducts business

through an agent who effectively serves as its U.S. alter-ego

a. Two limitations to this:

1) 2006 Model Tax Treaty Article 5(6)  no permanent

establishment solely because foreign person conducts business in
the U.S. through a broker, general commission agent, or any other

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

independent agent, so long as that agent acts in the ordinary

course of business

2) 2006 Model Tax Treaty Article 5(5)  dependent agent’s

activities are imputed to a foreign principal only if the agent has
and habitually exercises in the U.S. the authority to conclude
contracts in the name of the principal and the agent’s activities
themselves constitute a permanent establishment

2. Independent agent  paid to sell good or merchandise consigned or entrusted to

the agent

3. Dependent agent  one who truly stands in the stead of the principal and may
have the authority to negotiate and conclude contracts or fill orders and must be
exercised with “some frequency over a continuous period of time”

G. Dependent Agents

1. Agents versus purchasers

a. A bona fide purchaser of goods is not an agent of the seller

b. If a domestic entity purchases goods from a foreign manufacturer and
resells the goods on terms and conditions established by the domestic
purchaser then not imputed

2. Agents versus lessees

a. A bona fide lessee of property or equipment is not an agent of the lessor

b. If a domestic entity leases personal property from a foreign lessor then no
permanent establishment
1) But, if foreign person leases from domestic entity may give rise to
a permanent establishment

H. Income from Employment – Model Tax Treaty Article 14

1. “Dependent personal services”  those performed by employees

a. 2006 Model Tax Treaty Article 14(2)  compensation derived by a

foreign individual eligible for treaty benefits is not subject to U.S. income
taxation if the recipient is present in the U.S. for 183 days or less, the
compensation is paid on by or on behalf of a foreign employer, and it is
not borne by a U.S. permanent establishment or fixed base
b. A bona fide employer-employee relationship must exist in order to ensure
treaty exemptions

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

1) If foreign individual establishes a foreign corporation to “employ”

him shortly before coming to U.S., probably no bona fide
employer-employee relationship
2) If corporate employer lacks substance
c. In some situations treaty benefits cannot be extended if the compensation
sought to be excluded is deducted on a U.S. tax return filed by the foreign
employer
d. Some tax treaties limit the amount of income that may be received by a
claimant for dependent services

I. Independent Personal Services (Independent Contractors)

1. Typically subject this kind of income to tax only if the services are performed in the
U.S. and the income is attributable to a domestic fixed base that is regularly
available to the individual for performance of services

a. Fixed base and permanent establishment integrated

b. Canada Treaty  two separate tests for when services will be considered
provided through a permanent establishment:

1) Services provided in one contracting state by an individual on

behalf of an enterprise for 183 days or more during any 12-month
period will be deemed conducted through a permanent
establishment if, during that period, more than 50% of the gross
business revenue of the enterprise is derived from such services

2) Services provided in the other contracting state for 183 days or

more in any 12-month period for the same or a connected project,
for customers resident in that other contracting state, or who
maintain a permanent establishment there, if the services are
provided in respect of that permanent establishment

J. Consequences of Having a Permanent Establishment

1. After having determined that a foreign taxpayer has a permanent establishment in

the U.S., the next step is to ascertain the “business profits” of the taxpayer that
are “attributable to” the permanent establishment

a. Some treaties have a force of attraction rule

b. In the absence of a force of attraction rule, only those business profits that
are attributable to the permanent establishment will be taxed by the U.S.
c. U.S. must generally tax these profits in the same manner as business
profits earned by domestic enterprises (Article 24 anti-discrimination)

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2. Determination of such income follows a three step sequence:

a. Step One  gross income derived by the foreign person attributable to a
permanent establishment must be segregated from any other foreign or
domestic source income which is not attributable to that permanent
establishment
b. Step Two  the foreign person’s expenses related to the permanent
establishment must be segregated
c. Step Three  the expenses must be allocated between income attributable
to the permanent establishment and other income

K. Business Profits – Model Tax Treaty Article 7

1. “Business profits” generally includes income derived from any trade or business,
including the rental of tangible personal property and the performance of services
a. Business profits article generally overrides other treaty articles dealing
with specific types of income
b. If there is a permanent establishment, the business income will be subject
to tax on a net basis even if it is exempt from tax under a separate treaty
article

L. The “Attributable to” Concept

1. Business profits are “attributable to” a permanent establishment if the assets or

activities of the permanent establishment play a meaningful role in generating
those profits

M. Gross Income Attributable to a Permanent Establishment

1. “Attributable to” income encompasses two principal categories of income:

a. Fixed or determinable income and capital gain or loss from sources within
the U.S.
b. Some foreign source income

2. Generally only income from assets used, risks assumed, and activities performed
by, the permanent establishment will be attributable to the permanent
establishment

3. Two tests for segregating passive income from business income:

a. “Asset-use” test  applies to taxpayers such as foreign sellers or

manufacturers dealing with tangible goods in the U.S.
1) Focuses on whether the income is derived from assets used, or held
for use, in the conduct of a U.S. trade or business through a
permanent establishment
a) The factors (with a rebuttable presumption if the foreign
person can demonstrate that the asset is held to carry out

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some future business purpose and not to meet present

business needs):
i. Whether the asset is held for the principal purpose
of promoting the present conduct of a U.S. trade or
business;
ii. Whether the asset is acquired and held in the
ordinary course of the trade or business; and
iii. Whether the asset is otherwise held in some direct
relationship to the trade or business
b. “Material-factor” test  applies to taxpayers such as those conducting
service-intensive businesses or those dealing with the licensing of
intangible assets
1) Focuses on the more overarching measure of the degree of
correlation with the business activities of the foreign person’s U.S.
permanent establishment
a) Generally a U.S. permanent establishment will not be a
material factor in generating income if the core activities
incident to the transaction are conducted abroad

N. Waiver of Business Profits Article Protection

1. A foreign person not maintaining a U.S. permanent establishment may decline to
use an otherwise available tax treaty exemption for business profits
a. May want to do this to create a U.S. net operating loss carryforward
b. May also dislodge income attributable to a permanent establishment to
absorb losses not so attributable

XII. TAX TREATIES AND BUSINESS INCOME (UNIT 12)

O. Overview
3. Under statutory law, foreign persons are subject to U.S. taxation on all income
derived from the conduct of trade or business in the U.S., while under most
treaties, income derived from the conduct of a trade or business is taxable by the
U.S. only if it constitutes “business profits” that are “attributable to” a “permanent
establishment” maintained in the U.S.
Residents of Treaty Countries Residents of Non-Treaty
Countries
Required presence in the Must have a PERMANENT Need only be ENGAGED IN
United States ESTABLISHMENT in the TRADE OR BUSINESS
U.S. to be subject to taxation within the U.S. to be subject to
taxation
What is taxed? BUSINESS PROFITS that are Income EFFECTIVELY
ATTRIBUTABLE TO the CONNECTED with the
permanent establishment conduct of a trade or business

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in the U.S.
Rate of tax Graduated rates (1 or 11) Graduated rates (1 or 11)
Deductions allowed? Yes Yes
4. Interpretive steps:
d. Step One  determine whether a person is carrying on a business in the
U.S. for treaty purposes
e. Step Two  determine whether that business is conducted through a
“permanent establishment”
3) If no  income will not be taxed as business profits (but might be
taxed under another treaty provision)
4) If yes  profits must be appropriately attributed to the permanent
establishment
f. Step Three  deductions must be appropriately allocated to the permanent
establishment
5. Corporate form respected  a foreign person investing in a domestic corporation
that carries on a trade or business will not need to invoke a treaty with respect to
the business profits of the domestic corporation (only when a foreign person is
itself involved in carrying on a domestic business)
P. United States Trade or Business
2. Pretty much the same standard under 864 (regularity and continuity)
Q. Permanent Establishment – Model Tax Treaty Article 5
6. Rev. Rul. 58-63  qualitative difference between a trade or business and a
permanent establishment
c. Permanent establishment provision serves as a higher threshold to the
taxation of business profits
d. Instead of triggering U.S. tax upon meeting the more easily satisfied trade
or business standard, a foreign person will be able to avoid triggering U.S.
tax if the activities do not constitute a permanent establishment
7. Treaties generally equate a permanent establishment with a fixed place of
business through which the business of an enterprise is wholly or partly carried on
b. Will possess a permanent establishment in the U.S. if it either maintains
such fixed place of business in the U.S. or if the activities of another
person who maintains such fixed place of business are imputed to the
enterprise
2) “Physical presence test supplemented by an agency rule and
restricted by an activity rule”

8. A permanent establishment may include:

h. Place of management
i. Branch
j. Office
k. Factory
l. Workshop
m. Warehouse
n. Place of extraction of natural resources

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9. A permanent establishment does not include:

f. Use of facilities or the maintenance of a stock of goods solely for the
purpose of storage, display, or delivery
g. Use of facility for ancillary business purposes
h. Fixed place of business solely for the purpose of purchasing goods or
merchandise, collecting information, or carrying on any other activity of a
preparatory or auxiliary character
i. Website
j. Showroom or demonstration room to display or demonstrate the use of its
products to domestic customers
10. A permanent establishment may indirectly arise by virtue of a foreign person’s
ownership interest in a pass-through entity
c. A permanent establish may be imputed to a foreign partner in a limited or
general partnership if the partnership itself has a U.S. permanent
establishment
d. However, stock ownership, or affiliation with, entities or persons with a
U.S. permanent establishment does not in and of itself appear to be
sufficient grounds to impute a permanent establishment to the owner or
affiliate
R. Duration

3. Permanent establishment should not arise if the use of an office or fixed place of
business is brief or transitory rather than permanent
4. However, conducting significant business operations at a site for abbreviated time
periods has been found to give rise to a permanent establishment

S. Use of Another’s Fixed Place of Business

2. The temporary and transient use of a domestic subsidiary’s office by employees of
a foreign parent corporation should not constitute a permanent establishment (but
may arise if they make frequent and continuous use)

T. Use of Agents

4. Permanent establishment will exist when a foreign person conducts business

through an agent who effectively serves as its U.S. alter-ego

b. Two limitations to this:

3) 2006 Model Tax Treaty Article 5(6)  no permanent

establishment solely because foreign person conducts business in
the U.S. through a broker, general commission agent, or any other
independent agent, so long as that agent acts in the ordinary
course of business

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

4) 2006 Model Tax Treaty Article 5(5)  dependent agent’s

activities are imputed to a foreign principal only if the agent has
and habitually exercises in the U.S. the authority to conclude
contracts in the name of the principal and the agent’s activities
themselves constitute a permanent establishment

5. Independent agent  paid to sell good or merchandise consigned or entrusted to

the agent

6. Dependent agent  one who truly stands in the stead of the principal and may
have the authority to negotiate and conclude contracts or fill orders and must be
exercised with “some frequency over a continuous period of time”

U. Dependent Agents

3. Agents versus purchasers

c. A bona fide purchaser of goods is not an agent of the seller

d. If a domestic entity purchases goods from a foreign manufacturer and
resells the goods on terms and conditions established by the domestic
purchaser then not imputed

4. Agents versus lessees

c. A bona fide lessee of property or equipment is not an agent of the lessor

d. If a domestic entity leases personal property from a foreign lessor then no
permanent establishment
2) But, if foreign person leases from domestic entity may give rise to
a permanent establishment

V. Income from Employment – Model Tax Treaty Article 14

2. “Dependent personal services”  those performed by employees

e. 2006 Model Tax Treaty Article 14(2)  compensation derived by a

foreign individual eligible for treaty benefits is not subject to U.S. income
taxation if the recipient is present in the U.S. for 183 days or less, the
compensation is paid on by or on behalf of a foreign employer, and it is
not borne by a U.S. permanent establishment or fixed base
f. A bona fide employer-employee relationship must exist in order to ensure
treaty exemptions
3) If foreign individual establishes a foreign corporation to “employ”
him shortly before coming to U.S., probably no bona fide
employer-employee relationship
4) If corporate employer lacks substance

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g. In some situations treaty benefits cannot be extended if the compensation

sought to be excluded is deducted on a U.S. tax return filed by the foreign
employer
h. Some tax treaties limit the amount of income that may be received by a
claimant for dependent services

W. Independent Personal Services (Independent Contractors)

2. Typically subject this kind of income to tax only if the services are performed in
the U.S. and the income is attributable to a domestic fixed base that is regularly
available to the individual for performance of services

c. Fixed base and permanent establishment integrated

d. Canada Treaty  two separate tests for when services will be considered
provided through a permanent establishment:

3) Services provided in one contracting state by an individual on

behalf of an enterprise for 183 days or more during any 12-month
period will be deemed conducted through a permanent
establishment if, during that period, more than 50% of the gross
business revenue of the enterprise is derived from such services

4) Services provided in the other contracting state for 183 days or

more in any 12-month period for the same or a connected project,
for customers resident in that other contracting state, or who
maintain a permanent establishment there, if the services are
provided in respect of that permanent establishment

X. Consequences of Having a Permanent Establishment

3. After having determined that a foreign taxpayer has a permanent establishment in

the U.S., the next step is to ascertain the “business profits” of the taxpayer that
are “attributable to” the permanent establishment

d. Some treaties have a force of attraction rule

e. In the absence of a force of attraction rule, only those business profits that
are attributable to the permanent establishment will be taxed by the U.S.
f. U.S. must generally tax these profits in the same manner as business
profits earned by domestic enterprises (Article 24 anti-discrimination)

4. Determination of such income follows a three step sequence:

d. Step One  gross income derived by the foreign person attributable to a
permanent establishment must be segregated from any other foreign or

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domestic source income which is not attributable to that permanent

establishment
e. Step Two  the foreign person’s expenses related to the permanent
establishment must be segregated
f. Step Three  the expenses must be allocated between income attributable
to the permanent establishment and other income

Y. Business Profits – Model Tax Treaty Article 7

2. “Business profits” generally includes income derived from any trade or business,
including the rental of tangible personal property and the performance of services
c. Business profits article generally overrides other treaty articles dealing
with specific types of income
d. If there is a permanent establishment, the business income will be subject
to tax on a net basis even if it is exempt from tax under a separate treaty
article

Z. The “Attributable to” Concept

2. Business profits are “attributable to” a permanent establishment if the assets or

activities of the permanent establishment play a meaningful role in generating
those profits

AA. Gross Income Attributable to a Permanent Establishment

4. “Attributable to” income encompasses two principal categories of income:

c. Fixed or determinable income and capital gain or loss from sources within
the U.S.
d. Some foreign source income

5. Generally only income from assets used, risks assumed, and activities performed
by, the permanent establishment will be attributable to the permanent
establishment

6. Two tests for segregating passive income from business income:

c. “Asset-use” test  applies to taxpayers such as foreign sellers or

manufacturers dealing with tangible goods in the U.S.
2) Focuses on whether the income is derived from assets used, or held
for use, in the conduct of a U.S. trade or business through a
permanent establishment
b) The factors (with a rebuttable presumption if the foreign
person can demonstrate that the asset is held to carry out
some future business purpose and not to meet present
business needs):

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iv. Whether the asset is held for the principal purpose

of promoting the present conduct of a U.S. trade or
business;
v. Whether the asset is acquired and held in the
ordinary course of the trade or business; and
vi. Whether the asset is otherwise held in some direct
relationship to the trade or business
d. “Material-factor” test  applies to taxpayers such as those conducting
service-intensive businesses or those dealing with the licensing of
intangible assets
2) Focuses on the more overarching measure of the degree of
correlation with the business activities of the foreign person’s U.S.
permanent establishment
b) Generally a U.S. permanent establishment will not be a
material factor in generating income if the core activities
incident to the transaction are conducted abroad

BB. Waiver of Business Profits Article Protection

2. A foreign person not maintaining a U.S. permanent establishment may decline to
use an otherwise available tax treaty exemption for business profits
c. May want to do this to create a U.S. net operating loss carryforward
d. May also dislodge income attributable to a permanent establishment to
absorb losses not so attributable

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PROBLEM SET 12: TAX TREATIES AND ACTIVE BUSINESS INCOME

General Rule: Tax treaties provide business income is taxable only if an enterprise possesses a
PE in USs
 Without PE, income is not taxable even if a domestic trade or business exists
 If PE exists, tax is usually only on business profits which are attributable to the PE

Four Questions to Determine

(1) Is the person/business carrying on a business in the United States?
 Same standard as applied under §864 (for deductibility under §162 –regularity and
continuity)
 If no ToB, then exempted from domestic tax on profits without reliance on a treaty
exemption

(2) Is that business conducted through a permanent establishment?
 This is the critical nexus for taxation
(3) What are business profits?
(4) What business profits are attributable to the permanent establishment?
Permanent Establishment:
Treaties generally equate permanent establishment with a fixed place of business
 Should not be brief or transitory period
 Arises through pass through entity ownership – PE may be imputed to foreign partner in
GP or LLC
o Then will be taxed on distributive share of PE business profits, retaining character
Differences from ToB in Statute - treaty requires a physical facility as opposed to just
conducting business
In treaties there are usually three ways to establish PE
(1) Fixed Pace, Certain Activities, Agents

Article V of Canada Treaty

PE: fixed place of business through which business of a resident of a Contracting state is
carried on Includes:
 Place of management, branch, office, factory, workshop, mine/oil/gas well or quarry
 Construction site lasting > 12 months, unless significant business operations,
abbreviated period
 Rev Rul 67-322 operating restaurant during 2 six month periods during world’s fair was a
PE
 Dependent Agent who can conclude contracts in name of the resident

Does Note include:

 Independent agent (paragraph 7)
 Use of facilities for storage, goods are solely maintained for processing by another
 Maintenance of stock/merchandise for storage/display/quick delivery to domestic
customers
 Purchase of goods/merchandise for sale elsewhere, or combination of above

Revenue Ruling 77-45:

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Service took a liberal view of PE- broadly construing preparatory or auxiliary activities
 Canadian corporation contracted to plan and design a manufacturing plant in US
 Most design/services performed in Canada, US building provided without separate
consideration
 Employees sent to inspect work, prepare reports, and perform other duties lasting less
than 1 year
 Holding: Not a PE, insufficient nexus given employees not authorized make major design
decisions

Business Profits Attributable to Permanent Establishment

If a foreign person maintains PE, any business profits attributable to that PE are subject to tax
on a net basis at graduated rates applicable to domestic taxpayers.
 Attributable means assets or activities that play a meaningful role in generating the
profits
o Ensures passive/investment income will retain status and bear treaty rate of 0/15
percent
Active Business Income
I. Statute
Step 1: Is this a United States Trade or Business?
Step 2: Is there a US Source?
o Effectively connected income, then Graduated Rates – on net
Step 3: Apply Statutory Rules
o Deductions, Branch Profits, §884, §897 (deemed active considerations)

II. Treaty
 Business Profits – Article VII
 Independent & Dependent Agents
 Permanent Establishment
o Deductions, Branch Profits, Graduated Rates – on net, §884/§897
o Whether asset held with principal purpose of promoting present conduct of ToB
o Whether acquired and held in ordinary conduct
o Whether held in direct relationship to ToB (3 Factors whether asset tied to PE)

12-1. CanCo was organized under the laws of Canada. Its principal business activity consists of
the worldwide sale or goods purchased in Canada. All of CanCo's office facilities are located in
Canada.

Note: With nothing more, US could not tax CanCo; need US activity that creates a “presence”

(a) If CanCo receives unsolicited orders from US residents, is its income subject to taxation in
US?

PE - Article V: Canco is exempt from income tax in the US because there is no permanent
establishment
Three types of permanent establishments:

(1) Fixed presence, (2) Certain Activities, (3) Agency

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Doesn’t matter if you have business profits – if there is no PE there is no income tax.
o NOTE greater activity may constitute trade or business under the statute but will not be
a permanent establishment in the treaty (so not tax still)
o This also shelters US businesses which may do the same thing in the other country.

(b) How does the answer to (a) change if CanCo sends catalogs to various individuals in US
and advertises on US television, all of which leads to the placement of orders by US residents?
PE Article V, 6(e) – NO permanent establishment even with the increased activity because no
fixed presence either owned or rented.

Notes:
Is it possible to have a trade or business in US and not a PE? Alternatively can we have a PE
and not a TB?
o The PE requirement is more rigorous so more likely you will have a TB under the statute;
however you can possibly have a TB under the statute but not PE under the treaty.

(c) How does (a) change if, respecting sales made in US, orders for CanCo's goods are solicited
by their traveling salespersons operating out of the home office on a commission
basis? Assume purchase orders are sent to the Canadian office where they are accepted by
CanCo and filled from inventory warehoused in Canada. Also assume that CanCo maintains no
inventory, plant, office, or other facilities in US. Yes Trade or Business and No PE
Agents:
Is this an independent or dependent agent?
o Salespersons would probably be a dependent agent - see Article 5, Part 5
o More likely independent agent if authority to conclude contracts and exercises that
Article 5,Part 7

Result: Here because you have to send it back for final approval the real decision (needs to
be a real process of finalization to avoid abuse) is made in Canada, it’s a dependent agent

Strategy: If you have a factual setting where once the agent concludes it always gets approved
and its simply done this way to avoid PE so you may want to look at substance over form
o To avoid taxation would want to document that actual decision-making occurs in Canada
o Independent agents usually represent multiple clients – no permanent establishment
o This is most likely a ToB, individual without treaty taxed on income – but under treaty no
tax!

(d) How does the answer to (c) change if CanCo maintains a branch office located in leased
office space in Chicago, the branch maintains a leased warehouse for storage of
purchased inventory, and US sales staff operates out of the Chicago office, but all orders
had to be accepted in Canada?

Article 5, Par. 6 (a) – No PE if the facilities are used to store inventory, display or deliver
goods/merchandise
 Combination – Agents sitting in an office giving the company a competitive advantage;
here in this situation there are a multitude of activities – but each would have to be
examined to determine whether or not there was a permanent establishment. Probably
yes a PE

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Strategy Note on Business Profits and Permanent Establishment

 Business Profits taxed are only those related to the permanent establishment
 It may be better to have the PE and get higher revenues

(e) Would CanCo have a PE in US if it were a sh in corp conducting ToB through PE in the
United States?

Article 5, Par 8 – Mere fact that you own an interest in a corporation with a PE will not be
imputed to you – because its already being subject to tax in the US

(g) Would the answer to (e) change if CanCo was a significant sh? A majority sh? The sole
shareholder?

 Unless more facts given; it is not considered the foreign enterprises PE through mere
ownership.
 Assuming Domestic Corporation is held by foreign parent but will use the DC to sell
product of the foreign parent – then there is an agency issue where the DC is acting as
the agent for the parent
 RULE: Requires more than mere ownership.

(h) Would the answer to (e) change if CanCo instead invested in a general P or LLCrather than a
corporation?

Rule for Disregarded Entities: If the partnership itself has a PE then this will be attributed to
the partners regardless of their ownership level. In the treaty, this is not defined specifically.
Code § 875 (partner engaged in US trade or biz if P is). Unger Case

However there are a couple of cases that have commented on this:

 If the statutory rule (because partnership is a pass-thru) is that you tax the business
profits from a PE looking at §875 and the principle that because income will flow through
to the partners and its business profits from a PE the tax should be carried on through
and attributed to the partner

(h) X Corp is organized in Canada. X entered into a contract with DomCo, a domestic corp,
under which DomCo serves as X's exclusive agent in selling X's products in US. DomCo
receives a commission for each sale to a US customer. The contract prohibits DomCo from
selling any competing products in the United States and from acting as the agent for another in
selling any competing products in the United States.
Question of independent v dependent agent

Z Corp organized in Canada. Z purchases goods in US for sale to foreign customers. Z

maintains office in San Diego, CA, staffed by domestic employees who facilitate purchases and
arrange shipping.

Article 6 (6)(d) – purchase of merchandise, gathering information is not a trade or business

12-2 George is a Canadian architect representing a client that is constructing a building in San
Francisco, As part of his services. George was on site on six different days during the year.

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 Remember that the magic threshold amount is $3,000 so services would most likely be
instantly subject to tax because its very easy to be a TB - However under the treaty
things may be different

(a) Is George subject to taxation in the United States?

Article XIV – independent personal services was deleted

Canadian treaty basically says that you have to look at independent versus dependent
services.
o Fixed base concept close to PE, silly to have separate articles describing standards (are
the same)
o Canada threw this out – fixed base is still separate in many other treaties
PE Article V, Part 9
 If enterprise provides services in other contracting state, that enterprise is found not to
have PE, it will have PE if services meet certain standards for time spent in the
contracting state (>183 days) and makes 50% of his income from US.

Look at whether George has established PE – which is in Article V, Par 3 and Par 9
o Without par 9 there would be no permanent establishment

(b) Would the answer to (a) change if George was on site for nine consecutive months during
the year?

Because he is present >183 days there is PE + all of income came from the activity (see Par. 9
(a))
Article 3 says if a construction project lasts less than 12 months there is no permanent
establishment
o If it was just construction for less than a year – the Construction company does not have
a PE; however architect is independent that does not tell us whether or not he will fall
into subpart 9

(c) Suppose George is a commissioned salesperson who works for Canadian corp selling
products in US. George spends 130 days in US in pursuit of employment. Is George subject to
taxation in United States?
George is now commissioned & dependent agent; and therefore you look at Article 15 for
employment

Requirements are in Par 2:

No Canada Tax
US can tax only if >$10K; or
Agent was present > 183 days

If the payment is under $10K doesn’t matter and no PE; if you make more than $10K you will
escape the tax if you are there for 183 days and the remuneration is not paid by a resident of
US or a PE

12-3 ForCo is foreign corpo organized in Canada that purchases zippers. It has facilities in
US, Canada, and Brazil. The zippers bought in US are sold exclusively in US. Likewise, the
zippers bought in Canada are sold exclusively there, and same for Brazil. ForCo generates all of
its income from these three countries. ForCo does not have a US subsidiary, nor separate

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division that oversees operations in the US. For Year 1, Forco incurred $50,000 in general
administrative expenses related to both US and non-US operations. In addition, ForCo incurred
$80,000 in deductible interest expense in Year 1 from borrowings used to improve the Brazilian
facility. ForCo's sales and gross income in Year 1 were as follows:
Zippers Wine
Gross Gross
Country Asset Bases Sales
Income Income
United
$50,000 $250,000 $100,000 0
States
Argentina $100,000 $1,500,000 $200,000 $600,000

Bolivia $200,000 $800,000 $300,000 0

Assuming income from purchase and sale of zippers in Canada and Brazil is not attributable to
ForCo’s US operations, what is ForCo’s taxable income in Year 1 for United States
income tax purposes?
Does a PE exist? - Yes therefore taxed on the profits attributable to United States
Deductions
 861-8 regulations
 Article VII, Par 3: Allows to take general and executive/admin expenses
o General Proposition start as 861-8 to determine deductions; tech explain
acknowledges that as we look to allocations under the statute, some not tied as
closely to the business activity
o Look at what it would have deducted if it existed separately on its own.
Final Point:
We have focused in our problems on passive and active; in the treaty context each of those
activities that we discussed in the spectrum would/should be looked at in a treaty context -
business profits.
Need to ask question on this?

No US tax credit for Foreign Individuals.

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XIII. INTRODUCTION TO CONTROLLED FOREIGN CORPORATIONS (UNIT 13)

A. Overview

1. The purpose of subpart F is to accelerate U.S. taxation of certain earnings of foreign corporations
that are controlled by U.S. shareholders
a. Exception to the general rule that U.S. does not impose tax on foreign-source income
earned by foreign persons
b. 951(f)  subpart F subjects certain U.S. shareholders of CFC’s to current taxation on
certain of the CFC’s earnings and investments regardless of whether they are distributed
to the shareholder
B. CFC Defined

1. 957(a)  a CFC is a foreign corporation of which more than 50% of the stock, as measured by
either vote or value, is owned or considered to be owned by “United States shareholders” on any
day during the corporation’s taxable year

C. United States Shareholder Defined

1. 951(b)  a U.S. shareholder is a U.S. person who owns, or is considered to own due to
attribution rules, 10% or more of the foreign corporation’s total combined voting power of all
classes of stock entitled to vote
a. 957(c)  U.S. person is generally defined as provided in 7701(a)(30)
b. 958(a) and (b)  ownership of a CFC determined via shares held directly, indirectly
through other entities, and constrictively by attribution from other shareholders

D. Direct Ownership

1. Substance-over-form approach

2. 1.957-1(b)  mandates a facts-and-circumstances analysis of the voting structure

a. Addresses arrangements taxpayers might use to nominally shift formal voting power
away from U.S. shareholders even though actual control is retained
b. The requisite level of voting power is found in all cases in which U.S. shareholders have
the power to elect, appoint, or replace a majority of the board of directors
3. A foreign corporation is a CFC if the U.S. ownership threshold is met on any day during the
corporation’s taxable year

E. Indirect and Constructive Ownership

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1. Attribution rules provide a safeguard against manipulations

a. 958(a)  stock owned by or for foreign corporations, partnerships, trusts, or estates is
considered proportionately owned by its shareholders, partners, or beneficiaries
b. 958(b)  incorporates the constructive ownership rules of 318, with some modifications,
for purposes of determining whether a person holds a 10% ownership interest

F. Limitations on the Subpart F Regime

1. A foreign corporation is not a CFC so long as no single U.S. shareholder owns 10% or more
of the voting stock, even if more than 50% of its total voting power or value is owned by U.S.
persons

2. A foreign corporation is not a CFC even if a U.S. person owns exactly 50% of its stock, so long
as all other U.S. persons each own less than 10% of the stock and are unrelated

G. Flowchart

1. Is the entity a foreign corporation as defined in 7701?

a. No  not a CFC
b. Yes  did any U.S. person as defined in 7701(a)(30), as modified by 957(c), own any
stock in the corporation on any day of the taxable year?
1) No  not a CFC
2) Yes  did any such U.S. person directly, or indirectly, or constructively own at
least 10% of the stock of the foreign corporation, as measured by vote, on any day
of the year?
a) No  not a CFC
b) Yes  did those shareholders collectively own more than 50% of the
stock of the corporation either by vote or value?
i. If no, not a CFC
ii. If yes, a CFC

PROBLEM SET XIII: CF

C
Read: Code §§ 951(a)(1), (b); 957(a), (c); 958(a) – (b)
Reg. § 1.957-1

Policy behind safeguards is to prevent US citizens from forming foreign corps and trapping
profits abroad

United States Tax System:

 Pure Deferral

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o CFC and the Passive Foreign Investment Company– only if you meet specific
standards
 Pure Imputation [similar to partnership] in some circumstances

Which system are we and which system would you recommend for the future?
 Under the safeguard regime examine whether we are closer to deferral or imputation

CONTROLLED FOREIGN CORPORATIONS

Primary purpose: insulate income from US tax within a foreign corporation – defer tax on that
income
 Otherwise enjoy better tax rate or lower statutory rate and stockpile ordinary income
abroad
 Effectively provides shareholder with an interest free loan from the federal government

Where a CFC exists, all US Shareholders are subject to current taxation on

(1) Proportionate share of CFC subpart F income and previously excluded Subpart F income;
and
(2) Shareholder’s amount of CFCs investment in US property
Controlled Foreign Corporation: More than 50% vote and value owned by US
Shareholders
§ 957. Controlled foreign corporations; United States persons
(a) General rule.- “controlled foreign corporation” means any foreign corp if more than 50
percent of--
(1) the total combined voting power of all classes of stock of such corporation entitled to
vote, or
(2) the total value of the stock of corp, is owned or considered owned by rules of
ownership of section 958(b), by US shareholders on any day during the taxable year of
such foreign corp.

Note: “any foreign corporation” refers to an imputation system

 Safeguard chipped away by requirements > 50% of voting power/value owned by US
Shareholder

CFC: If, for a given taxable year, more than 50% of the vote OR value of stock owned, directly
or indirectly or constructively on any day of the taxable year by a US Sh. Substance over form
test

US Shareholder: Own 10% or more

§951 (b) US shareholder means, with respect to any foreign corp, a US person (defined in
§957(c)) who owns (within meaning of § 958(a)), or is considered owning by applying rules of
ownership of §958(b), 10 percent or more of total combined voting power of all classes of
stock entitled to vote of foreign corp.
 Note that this is the vote only (not OR value)
 Provided they are unrelated – you can have 11 shareholders from the US owning 9%
 BUT once you determine that you have a US sh; must then determine whether they
together hold more than 50% of the vote or value.

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§958(a) attribution rules for ownership

 Stock owned by or for foreign corps and Ps considered proportionately owned by its
shs/partners
 §318 attribution rules apply here as well
 § 958b2 if a P, estate, trust, or corporation owns, directly or indirectly, more than 50
percent of the total combined voting power of all classes of stock entitled to vote of corp,
it shall be considered as owning all stock entitled to vote. (for purposes of determining a
US sh)

Amount of Imputed Income

Income under §958(a) will be included if:
 Corporation was a CFC for 30 uninterrupted days or more during the taxable year
 Sh is US person any time during year and owned at least 10% voting power of all classes
of stock
 US sh owns stock in the foreign corp on last day of taxable year in which CFC was a
corporation
o Even if you get rid of stock, may still get brought in under imputation rule §951

13-1. X Corp is foreign corp with three classes of capital stock outstanding, consisting of 60
shares of Class A stock, 40 shares of Class B stock, and 150 shares of Class C stock. The
owners of a majority of Class A stock are entitled to elect three of the five corp directors,
and the owners of a majority of the Class B stock are entitled to elect other two. The
Class C stock has no voting rights. Dividends are paid on a per share basis and there are
no liquidation preferences.
Y Corp is a foreign corp with one class of stock outstanding, 90 shares. Danielle, a US person,
owns 25 shares of X Corp Class A stock and 45 shares of Y Corp stock for the yea r. Y
Corp owned 15 shares of X Corp Class A stock. Remaining shares of X Corp and Y Corp stock
owned by unrelated foreign persons.

Determine the status of Danielle, X Corp, and Y Corp in Year 1 for purposes of §951.

Step 1: Is this a CFC?

o Is this a foreign corp – i.e. check the box! (if election is made to be treated as US ToB, no
CFC)
o If its not a corporation (passthrough) then you are done with this analysis
o If you check the box to be treated as a disregarded entity – no worries
o Are there United States Shareholders under the statute? – 10% or more of the vote
o Even if there is a US Shareholder, has to total more than 50% of the vote or value

X Corporation – Foreign Corporation

o A – 60 shares voting
o Owners of majority have power to elect 3/5 of directors
o B – 40 shares voting
o Power to elect 2/5 of directors
o C – 150 shares nonvoting
Note that now regardless of who owns it, Class C is non-voting so no US Sh can be found in
those shares
Turn to voting shares…

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 Y Corp – Foreign Corporation

o Note that now you are scrutinizing this corporation as well to determine if they are
CFCs
 90 shares of stock - Danielle owns 45 o/s shares
o Owns 15 shares of o/s stock in X Corporation
Is Y Corporation a CFC?
 This is a foreign corporation
 Danielle is a US Shareholder because she owns 10% or more of the corporation
 Is there a control of the foreign corporation?
o It depends because its more than 50% of the vote OR value – so Danielle could own
more than 50% of the value of the corporation.
 Even only 50% might be more if Danielle can elect majority of director spots
“Based on the facts in front of me, and making the following assumptions this is not a CFC”
Danielle also independently owns 25 shares of X Corp
Focusing On X-Corp
(1) Is there a US Shareholder?
 Total Voting Shares – 100
 Danielle owns at least 25 shares independently – so there is a US Shareholder
o Note that if all of these shares had equal voting rights, you might not have control
for the foreign controlled corporation

(2) Is there something here that suggests that we might have control even though with all of the
voting shares we do not have > 50%
 For voting power you look at ability to vote for the BoD
 Assuming that there are 5 members of the BoD and everything is done by majority rule
(looking at side agreements) a controlling vote is 3 directors.
 Here is where you can look at voting or also value; under the question the majority owner
of A gets to vote 3/5 BoD and therefore control decision making of the enterprise
**Have to Apply Attribution Rules** owns indirectly § 958
 Danielle owns 25 shares + 7.5 shares = 32.5 out of 60 voting shares of A, Sheffield thinks
this is probably a CFC, need more facts
 However, Danielle’s
Note – For this problem try to be familiar with the regs  §1.957-1

13-2. At all times in Year 1, three individuals owned the shares of FC, a French corp. As of
January 1, Year 1, Jacques, a citizen and resident of France, owned 50 shares of FC stock,
while Ken and Lisa, both US citizens and residents, each owned 25 shares of FC stock.
On July 1, Year 1, FC redeemed ten shares held by Jacques.
On July 2, Year 1, American counsel for FC warned of potential US income tax problems
associated with the redemption, Accordingly, on July 4, Year 1, FC redeemed five shares from
each of Ken and Lisa, The holdings of the shareholders remained unchanged for the balance of
Year 1.

Do the July 4, Year 1, redemption transactions avert the United States income tax problems
raised by FC's counsel?
(1) Is this a foreign corporation? Yes
(2) DO we have US Shareholders – Yes
(3) Is there a CFC? No. They only own 50% of voting/value therefore this is a non-CFC
Results: French Corporation redeems 10 shares of stock from Jacque

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 7/1/ Year 1: If Jacque drops ownership Ken and Lisa have more than the 50% necessary
for control
o Rule: The day the redemption took place there was a CFC

FC Corporation was a CFC immediately after the July 1 redemption transaction, because at that
point FC Corporation’s
United States shareholders (Ken and Lisa each owns at least 10% of FC Corporation voting
stock at all times) own more than 50% of the stock in FC Corporation. FC Corporation is still a
CFC for purposes of Year 1 because it was a CFC for at least one day during the year.
But under §951 (a) (1), unless a FC Corporation were a CFC for a consecutive 30 day period
during Year 1, there is no required income inclusion under subpart F. Such was not the case, so
neither US shareholder will be subject to current taxation with regards to FC Corporation’s
activities.

 7/4 Year 1 the FC redeemed 5 shares each from Ken and Lisa, results in a return to non-
CFC status.
 July 4 redemptions restored FC Corporation’s non CFC status, since after the
redemptions, the US Shareholders no longer own more than 505 of at FC corporation
stocl.
Result: For some portion of year tainted enterprise with potentially negative consequences
attached

Step 4: §951 Now that you have a CFC (for any portion of the year) will you be taxed on that
income?
 Even with a CFC not everything is included in gross income.
 For an uninterrupted period of 30 days, it suggests that you might flip in and out of CFC
status, can also adjust your taxable year
Note: If you are not a US Sh; even if you hare a member of a tainted enterprise, not taxed on
that income

§ 951. Amounts included in gross income of United States shareholders

(a) Amounts included.- (1) In general.--If a foreign corp is a controlled foreign corporation for an
uninterrupted period of 30 days or more during any taxable year, every US shareholder who
owns stock on last day, includes in gross income, in his taxable year in in which taxable year of
corp ends—

958 (b) Constructive ownership

Note: In some settings determining whether you own 10% or more you may have enough to
classify the entity as a CFC; however if you are a US Sh you are only imputed for income upon
958(a) ownership

If you are a US Sh in CFC there are only two portions of income for which you will have to pay
taxes
Subpart F income
Certain investments in real property

XIV. CONTROLLED FOREIGN CORPORATIONS – SUBPART F INCOME (UNIT 14)

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A. Overview

1. General rule  if a corporation is a CFC for 30 consecutive days or more during any taxable
year, its U.S. shareholders that hold stock on the last day in the year on which the corporation is
a CFC must include in gross income a “pro rata share” of its “subpart F income” under 951

2. Determining the tax consequences of being a U.S. shareholder of a CFC requires a two-step
analysis:

a. Step One  the CFC’s subpart F income must be identified

b. Step Two  any U.S. shareholder’s pro rata share of such income must be determined

B. Subpart F Income

1. Subpart F income includes under 952:

a. 953  insurance income
b. 954  foreign base company income (main category)
c. 901(j)  bribes and kickbacks
d. 999  certain income of CFCs earned in countries that participate in international
boycotts
2. Foreign base company income defined under 954 as the sum of (reduced by allocable expenses
pursuant to 954(b)(5):
a. Foreign personal holding company income
b. Foreign base company sales income
c. Foreign base company services income
d. Foreign base company oil related income

C. Foreign Personal Holding Company Income

1. Defined in 954(c) and includes:

a. Dividends
b. Interest
c. Royalties
d. Rents and annuities
e. Net gains from certain dispositions of property
2. 954(c)(3)(A)  Dividends and interest from a related corporation are generally excluded from
the definition of FPHCI if the related corporation is incorporated in the same country as the CFC
and a substantial part of that corporation’s trade or business assets are located in that jurisdiction
3. 954(c)(4)  treats the sale of a partnership interest by a CFC as a sale of the proportionate share
of partnership assets attributable to that interest if the CFC owns, directly, indirectly, or by
attribution, at least 25% of a capital or profits interest in the partnership

D. Foreign Base Company Sales Income

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This category was designed to prevent US taxation by setting up foreign subsidiaries as distribution
centers, through which goods would be distributed to other countries and ultimately to customers.

In the absence of subpart F, the use of foreign base companies as conduits for the sale of parent
company’s goods to consumers outside of the base country permitted business profits to be indefinitely
lodged in the foreign sales entity, thereby deferring taxation of profits until they are repatriated to the
domestic owner.

Thus to avoid having foreign base company sales income, a company should avoid setting up a
distribution company in one country to sell products manufactured by a related person in another
country, to costumers located in a third country.
1.
2. 954(a)(2) and (d)  income attributable to the sales of personal property

3. For income to constitute FBCSI four requirements must be met:

a. Purchases or sales must be made to, from, or on behalf of, a person related to the CFC
(any entity or individual owning, directly or indirectly, more than 50% of the CFC’s
stock, and any entity controlled by the CFC or controlled by the same persons as the CFC
b. The transaction must involve personal property
c. The personal property must be manufactured or produced outside of the CFC’s country of
incorporation
d. The purchase or sale must be for use or destination outside the base company’s
jurisdiction
4. Exceptions:
a. Income derived from the sale of goods by the CFC inside the country of its incorporation
is not FBCSI (same country exception)
b. 1.954-3(a)(4)  any sales income earned by a CFC that itself performs manufacturing or
production functions with respect to the products sold, regardless of where those
functions are carried out or where the materials are purchased will not be subpart F
income (requires “substantial transformation of the property”)
1) Additional complication where property sole is comprised of purchased
component parts, two tests:
a) General test of facts and circumstances
i.
ii. If purchased property is used as a component part in the personal
property that is ultimately sold, the integration activity is deemed
to constitute manufacturing if it is substantial in degree
b) Overriding 20% cost of goods sold test
i. No FBCSI arises if 20% or more of the total costs of goods sold is
comprised of direct labor and overhead incurred by the CFC in
converting the purchased item into the finished product

E. Foreign Base Company Services Income

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Foreign base company income also includes “foreign base company services income” under 954 (a) (3).
This category of income was generally included to prevent manufacturers from improperly shifting
offshore the income they derive from certain services performed on their behalf.
The primary concern was that United States persons could shift profits out of the United States tax base
by arranging transactions so that a foreign CFC was the nominal service provider ((for example, it might
be listed as the provider on the contract) while its United States parent company provided most of the
services (for example, by using its employees to provide services described as “supervisory” in nature
but which actually constituted the bulk of the services provided under the contract.”)

1. 954(e)  income derived in connection with the performance of services which are performed
for, or on behalf of, any related person and performed outside the country under the laws of
which the CFC is created or organized
2. FBCSI includes
a. Services paid for or reimbursed by a person related to the CFC
b. Services which a related person is obligated to perform
c. Services which were a condition of a related-party sale of property
d. Services to which a related person gave “substantial assistance”
1) Notice 2007-13  income would only constitute FBCSI if the cost to the CFC of
the assistance furnished by the related U.S. person equals or exceeds 80% of the
total cost to the CFC of performing the services
a) No FBCSI will result so long as more than 20% of the costs incurred by
the CFC in performing the services are attributable to services it performs
directly or through a related CFC

Thus, for example, under the current rules, if a US company enters into a contractual obligation to build a
highway in a foreign country and assigns this contract to a subsidiary located in a country other than in which
the highway is built, the CFC’s service might be deemed to have been performed on behalf of the domestic
parent and give rise to foreign base company service income. The determination would depend on a facts-and-
circumstances based inquiry that would include deciding whether the services provided by the parent company
were a principal element in producing the income from the construction contract.
Under the standard laid down in Notice 2007-13, however, the income would only constitute foreign base
company services income if the cost to the CFC of the assistance furnished by the related United States Person
equals or exceeds 80 % of the total cost to the CFC of performing the services.

Under the standard laid out in Notice 2017-13

F. Allocation of Deductions to Base Company Income: Rules and Limitations

1. Foreign base company income is reduced by “properly allocable” deductions pursuant to 954(b)
(5) (allocated according to 1.861-8 and 1.904-5)
a. Allocated to the gross base company income category to which they directly relate
1) If no such relationship exists then ratably apportioning deductions among all
gross income categories
2) Cannot create a “loss” with respect to a given category of base company income
2. If a CFC’s foreign base company income exceeds 70% of its gross income then under 954(b)(3)
(B) all of the CFC’s gross income is treated as foreign base company income (then all of the
CFC’s deductions may be offset against gross foreign base company income)

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3. 954(b)(5)  interest paid to U.S. shareholders is allocated first to FPHCI that is passive income
within the meaning of 904(d)(2) and any remainder allocated to other subpart F income or non-
subpart F income

G. Special Rules Applicable to Foreign Base Company Income

1. 954(b) provides three special provisions that determine the extent to which foreign base
company income will be included in subpart F income:
a. 954(b)(3)(A)  de minimis rule that says that if the gross foreign base company income
is less than the lesser of 5% of the CFC’s gross income or $1,000,000, the CFC’s foreign
base company income will be deemed to be zero
b. 954(b)(3)(B)  the full inclusion test provides that if the CFC’s gross foreign base
company income exceeds 70% of its total gross income, all of its gross income will be
considered gross foreign base company income
c. 954(b)(4)  a taxpayer may elect to exclude from the subpart F income computation any
item of income subject to an effective tax rate that exceeds 90% of the maximum
domestic corporate tax rate
1)
2) 1.954-1(d)(5)  election must be made by controlling U.S. shareholders and is
3) binding on all of the U.S. shareholders of the CFC
H. Pro Rata Share
1. Only U.S. shareholders who own (directly or indirectly) CFC stock on the last day in a tax year,
on which the foreign corporation was a CFC must include this pro rata share of subpart F income
2. Calculated on the basis of both direct and indirect ownership but not on the basis of constructive
ownership under 951(a)(2)
I. Basis Adjustments
1. 961(a)  a shareholder’s basis for each share of CFC stock or other property is increased by the
amount of income imputed to the shareholder under 951
a. The basis adjustment only applies to “other property” when the U.S. shareholder is only
deemed to own stock through indirect ownership
2. 961(b)  a shareholder’s basis in each share of CFC stock or other property is reduced when
subsequent dividend distributions comprised of previously taxed earnings are actually made
J. Exclusions from Gross Income – Previously Taxed Earnings and Profits
1. 959  in situations where particular E&P have been subjected to imputation, provides that such
2. E&P (and the distributions from them) are thereafter insulated from taxation (also exclusion for
E&P attributable to imputed amounts which have been reinvested by the CFC in U.S. property)
3. 959 invokes the normal ordering rules of 316
a. Distributions are deemed to come first from current E&P to the extent thereof and
thereafter from accumulated E&P
1) Through this priority scheme, previously taxed earnings are deemed distributed to
shareholders first
K. Sale of CFC Stock
1. 1248  upon certain dispositions of CFC stock, this provision recharacterizes a portion of gain,
representing the previously deferred earnings, as a dividend
a. Provides that if the sale of stock or the liquidation of a CFC occurs and if the taxpayer
owned 10% or more of the stock, whether directly, indirectly, or constructively, at any

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time during the five-year period preceding the sale, the portion of the taxpayer’s gain
equal to the E&P attributable to that ownership period will be treated as a dividend
1) The foreign corporation must have been a CFC for some portion of that 10%
ownership period, but not necessarily on the date of the disposition or exchange
2) Most straightforward means to avoid 1248 is to sell stock after the CFC has
ceased to be a CFC for the requisite five year period
3) Only pertains to gain, so any loss recognized would typically be a capital loss
L. Subpart F Income Flowchart
1. Did the CFC earn income?
a. No  no U.S. tax consequences
b. Yes  did the CFC earn any foreign base company income as defined by 954?
1) No  check for other (unusual) items listed in 952 and if none, no U.S. tax
consequences
2) Yes  Is any of the CFC’s income excluded from the definition of FBCI under
954?
a) Yes  this income is excluded from FBCI and therefore not subpart F
income under 952(a) and no U.S. tax consequences as to this income
b) No  Was the CFC a CFC for 30 straight days during the taxable year?
i. No  no current income inclusion of subpart F income
ii. Yes  Did the U.S. shareholder own (as described in 958) the
CFC stock on the last day in the year on which the CFC was a
CFC?
I. No  no current income inclusion of subpart F income
Yes  the U.S. shareholder must include in gross income his pro rata share of the CFC’s subpart F
income

PROBLEM SET IV: SUBPART F INCOME

Read: Code §§ 951; 952(a); 954(a) - (e); 957(a), (c); 958; 959(a); 960(a); 961; 1248(a), (c),
(d).

Constructive ownership rules do not apply for imputing income – direct, proportional
ownership.

Pro-Rata Amount of Subpart F Income:

§951(a) Amount of income shareholder would have received if the CFC had distributed an
amount equal to all of its Subpart F income minus actual distributions to shareholders
 Only include Subpart F income for portion of year in which corporation was a CFC

Calculation:
 Determine CFC’s Subpart F Income
 Apply ratio of number of Days of CFC status per taxable year
 Then determine each taxpayer’s pro-rata share of Sub F income according to portion that
would have been distributed on last day of taxable year
One Class of Stock: pro-rata share determined on per share basis

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Multiple Classes of Stock: Allocated in same manner as distribution rights

SubPart F Income – Definition:
 Income from foreign corp’s insurance of risks outside of its country of
creation/organization
 Foreign base company income
o Foreign Personal Holding Company Income: Targets Passive income from items of
dividend, interest, royalties, rents and annuities
o Foreign base company sales income
o Foreign base company services income
o Oil related income
 Amounts attributable to international boycott participation
 Illegal bribes/kickbacks
 Income from Foreign country subject to foreign tax restrictions

Foreign Base Company Sales Income - §954

In order for income to be FBCSI
 Purchase or sale must be to, from or on behalf of a related party;
o Related party includes all entities/individuals owning directly or indirectly > 50%
of stock
 Transaction must involve personal property;
 Purchase must be for use or destination outside of base company jurisdiction; and
 Personal property must be manufactured, produced, grown, or extracted outside of the
CFCs country of incorporation

De Minimus & Full Inclusion Rule - §954(b)

 If gross foreign base company income and insurance income is less than lesser of 5% of
CFCs gross income or $1,000,000, then de minimis rule shields all gross income from
classification as FBCI
 If total gross FBCI and insurance income > 70% CFCs gross income, all corp gross
income is FBCI

Hypothetical: A and B are unrelated shareholders in X Corp in the Bahamas. They each put in
$50K to the Corporation that engaged in the Tourist industry.
o X corporation makes $200K in fees
A and B are US Shareholders; X is a CFC; do we have to worry about the imputation of income
tax?
o Do we have Subpart F Income?
o Do we have income from investment in US property

§954: Definition of Subpart F Income

(1) Foreign Personal Holding Income
(2) Foreign Base Company Sales Income
(3) Foreign Services Income (do not worry about this for the exam)
(4) Do not need to worry about any other category

In the hypothetical here it does not sound like personal holding company income
 If we stipulate that this is neither foreign base company sales income or PHC income you
may still have a CFC but if you go back to §951 there is nothing to impute
 Only if you are in the tainted categories will you have imputation

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Result: Deferral of income until it is repatriated into the United States

 Note that this was a policy choice to allow certain income to stay abroad

Active v. Passive Income

 This is the heart of the Foreign Personal Holding Company Income
o Step 1: Ascertain whether CFC has PHC Dividends, interest, royalties, rents, and
annuities
 Passive that there is no reason to allow deferral for this type of income
 Individuals don’t defer, we don’t allow individuals through a CFC to do the
same
14-1 A, B, and C are US residents, own 1/3 of Z foreign corp.
(a) 100k interest income, 200k dividnend
Foreign based company income § 954(a)1
$300,000 foreingn based income, each US sh gets pro rata share.
A,B,C each get $100k, increase basis in their stock

(b) Same as (a) but opens travel biz with $7MM in gross income
§ 954b3, Subpart F income includes services income § 954a3. Defined in
§ 954 (e) Foreign base company services income.--
(1) In general.-- means income (whether in the form of compensation, commissions, fees, or
otherwise) derived in connection with the performance of technical, managerial, engineering,
architectural, scientific, skilled, industrial, commercial, or like services which--
(A) are performed for or on behalf of any related person (within the meaning of subsection (d)
(3)), and
(B) are performed outside the country under the laws of which the CFC is created or organized.

Here not performed for a related person, $7MM is not subpart F income. Only $300k is, §
954b3A deminimus applies, none of this is subpart F income
If only 90k in services income, then deminimus no longer applies. Now § 954b3B > 70% of total
income so all income is now subpart F

14-2. Abe, US citizen, and DomCo, a domestic corp wholly-owned by Abe, form Chala Co., a
corp under Peruvian law, on January 1, Year 1, with a contribution of $5,000 each in return for
50 shares of' common stock. Chala Co. purchases equipment in US from DomCo and sells it to
independent parties in Peru and other South American countries. In Year 1, Chala Co. made
$50,000 of net income from sales in other South American countries and $100,000 of net
income from sales in Peru. No foreign income taxes paid
100%
Abe DomCo

50% 50%

Chala Corp (Peru)

A: $5000 Basis in 50%

DomCo: $5000 Basis in 50%

(a) What are the United States income tax consequences for Abe, DomCo, and Chala Co, in Year
1

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(1) Is there a US Shareholder? Yes – Two

(2) Is there a CFC? Yes
(3) What was the income generated by the CFC?
 Receives personal property from DomCo.
o $100K net income from sales in Peru
o $50K net income from sales in other countries
(4) Does this meet the None/All Inclusion test under §954(b)? No.

§954(d)(1) Foreign base company sales income.--

(1) In general.-- means income (whether in the form of profits, commissions, fees, or otherwise)
derived in connection with the purchase of personal property from a related person and its
sale to any person, the sale of personal property to any person on behalf of a related person, the
purchase of personal property from any person and its sale to a related person, or the purchase
of personal property from any person on behalf of a related person where--
(A) the property which is purchased (or in the case of property sold on behalf of a related
person, the property which is sold) is manufactured, produced, grown, or extracted
outside the country under the laws of which the controlled foreign corporation is
created or organized, and
(B) the property is sold for use, consumption, or disposition outside such foreign country,
or, in the case of property purchased on behalf of a related person, is purchased for use,
consumption, or disposition outside such foreign country.

(d)(3) Related Person – possesses >50% of the total voting power but this is subject to the
imputation rules of §958(a) – direct, indirect, constructive ownership. § 318a3(C) Attribution to
corporations.--If 50 percent or more in value of the stock in a corporation is owned, directly or
indirectly, by or for any person, such corp shall be considered as owning the stock owned,
directly or indirectly, by such person.

Results:
 Related person under § 954b(1) referring to § 318a3(C)
 Who has purchased personal property
 Purchased/manufactured/sold outside of the foreign country
o NOTE that this is “foreign base company income” if the property was
manufactured in Peru we would not have an issue here
o Issue here is because the property was manufactured in the US and sold outside
Peru

Income that will be imputed back is $50K but it is pro-rata share. In this instance it is the pro-
rata share of each US Shareholder
o A - $25K, DomCo - $25K. § 951 pro rata share is not determined by constructive
ownership
o They get basis increase in § 961 (only direct)
o 100k sold in Peru is not subpart F income

Notes: Things you can infer – if you are doing this it means that Peru is not going to tax this
transaction
 Underlying assumption: Peru will tax its own income but not the income going to other
countries
Policy: Why is the US unwilling to allow the deferral as it will in so many other cases

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

Manufacturing outside country of CFC organization and sold outside the CFC organization is
that Peru will probably will not tax Columbia
 If Peru was willing to tax it will Congressional rationale fall short?
o §954(b)(4) – High Tax Exception: There is a high tax exception so you are not
effectuating the abuse congress was concerned about

Avoid Tax Through Dividends:

If you don’t want to have the income have corporation give dividends regularly to the extent of
the tainted income you would not be taxed
 DomCo receiving foreign source dividends look at §902 [piggyback of the foreign taxes]
o Get deemed paid credit limitation and it would be fine
o Difference here is that in a CFC situation because we are being imputed currently
we can have an imputation followed by a current distribution so that we get the
deemed paid credit

(b) 20k sales taxes paid in other countries

Need a dividend to distribute foreign tax credits. Can think of income inclusion as a dividend.
Abe doesn’t get § 902 tax credits, only Domco gets FTC. For purposes of subpart F income you
get deductions, including for foreign taxes paid
 §960 – Imputation is akin to forcing an actual distribution that when its imputed do the
§902 transaction – only for corporate shareholders; and obviously have ot have foreign
taxes paid

Abe and Domco only get $15k income now. Need to calculate Domco’s FTC

§ 902 = 20 x (15/130) = $2,308 FTC [15 numerator comes from US deemed income of
Domco)
Not subject to § 904 limitation because paid only 20k tax on 150k income.

(c) § 961, the money has already been taxed so it can come out without tax, but the basis is
decreased (previously taxed income)

(d) How would the answer to (a) change if Damien, an unrelated shareholder, owned eight
percent of the stock of Chala Co. and Abe and DomCo owned 46 percent each?
 Changes pro-rata share, $23k
 Damien is not a US person (8%), therefore would not have current imputation while
others would (See earlier discussion)

(e) Suppose Chala Co. makes the same $150,000 of income for each of Years 1 through 5. On
January 1, Year 6, Abe sells his shares to Martin, an unrelated Peruvian citizen, for $400,000.
What are the United States income tax consequences of the sale to Abe?

Sales of CFC Stock are Recharacterized as Dividends:

§1248 Gain from certain sales or exchanges of stock in certain foreign corporations
(a) General rule.--If--
(1) a United States person sells or exchanges stock in a foreign corporation, and
(2) such person owns, within the meaning of section 958(a), or is considered as owning by
applying the rules of ownership of § 958(b), 10 percent or more of the total combined voting
power of all classes of stock entitled to vote of such foreign corporation at any time during the
5-year period ending on the date of the sale or exchange when such foreign corporation was a

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controlled foreign corporation (as defined in § 957), then the gain recognized on the sale or
exchange of such stock shall be included in the gross income of such person as a
dividend, to the extent of the earnings and profits of the foreign corporation which is
attributable to the stock you own
(d) Exclusions from earnings and profits.--For purposes of this section, the following amounts
shall be excluded, with respect to any United States person, from the earnings and profits of a
foreign corporation:
(1) Amounts included in gross income under section 951.--Earnings and profits of the foreign
corporation attributable to any amount previously included in the gross income of such person
under section 951

A’s Basis: $5,000 + $25K for 5 years (taxable income)= $130,000

Amount Realized: $270K (without §1248 this would be LTCG)

Ordinary income under §1248(d) Exclude EP when it’s been included by a US person. Earned
150k for 5 years = $750k x ½ =
$375K - $125 K= $250K

Result of this the $250K is ordinary income and $20K is LTCG. If Domco sells dividend could
carry up FTC

Is §1248 Bad for US Shareholders?

Under current regime dividends are ordinary income, because it is not a qualified dividend will
not receive preferential dividend rates
 Have different views on desired income characterization depending on corp v. individual
sh.

(f) How would the answer to (c) change if Damien owned eight percent of the stock of Chala
Co., Abe and Domeo owned 46 percent each, and Damien sells his shares?
He is not US shareholder, never included subpart F income, not touched by § 1248 on sale

(a)AMOUNTS INCLUDED
(1)IN GENERALIf a foreigncorporation is a controlled foreign corporation at any time
during any taxable year, every person who is a United States shareholder (as defined in
subsection (b)) of such corporation and who owns (within the meaning of section
958(a)) stock in such corporation on the last day, in such year, on which such
corporation is a controlled foreign corporation shall include in his gross income, for his
taxable year in which or with which such taxable year of the corporation ends—
(A)
his pro rata share (determined under paragraph (2)) of the corporation’s subpart F
income for such year, and
(B)
the amount determined under section 956 with respect to such shareholder for such
year (but only to the extent not excluded from gross income under section 959(a)(2)).
(2)PRO RATA SHARE OF SUBPART F INCOMEThe pro rata share referred to in paragraph (1)
(A)(i) in the case of any United States shareholder is the amount—
(A)

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which would have been distributed with respect to the stock which such shareholder
owns (within the meaning of section 958(a)) in such corporation if on the last day, in its
taxable year, on which the corporation is a controlled foreign corporation it had
distributed pro rata to its shareholders an amount (i) which bears the same ratio to its
subpart F income for the taxable year, as (ii) the part of such year during which the
corporation is a controlled foreign corporation bears to the entire year, reduced by
(B)
the amount of distributions received by any other person during such year as
a dividendwith respect to such stock, but only to the extent of the dividend which would
have been received if the distribution by the corporation had been the amount (i) which
bears the same ratio to the subpart F income of such corporation for the taxable year,
as (ii) the part of such year during which such shareholder did not own (within the
meaning of section 958(a)) such stock bears to the entire year.
For purposes of subparagraph (B), any gain included in the gross income of any person
as a dividend under section 1248 shall be treated as a distribution received by such
person with respect to the stock involved.
(b)UNITED STATES SHAREHOLDER DEFINED
For purposes of this title, the term “United States shareholder” means, with respect to
any foreign corporation, a United States person (as defined in section 957(c)) who owns
(within the meaning of section 958(a)), or is considered as owning by applying the rules
of ownership of section 958(b), 10 percent or more of the total combined voting power
of all classes of stock entitled to vote of such foreign corporation, or 10 percent or more
of the total value of shares of all classes of stock of such foreign corporation.
(c)COORDINATION WITH PASSIVE FOREIGN INVESTMENT COMPANY PROVISIONS
If, but for this subsection, an amount would be included in the gross income of a United
States shareholder for any taxable year both under subsection (a)(1)(A)(i) and under
section 1293 (relating to current taxation of income from certain passive foreign
investment companies), such amount shall be included in the gross income of such
shareholder only under subsection (a)(1)(A).
(a)INCREASE IN BASIS
Under regulations prescribed by the Secretary, the basis of a United States
shareholder’s stock in a controlled foreign corporation, and the basis of property of a
United States shareholder by reason of which he is considered under section 958(a)
(2) as owning stock of a controlled foreign corporation, shall be increased by the amount
required to be included in his gross income under section 951(a) with respect to such
stock or with respect to such property, as the case may be, but only to the extent to
which such amount was included in the gross income of such United States shareholder.

In the case of a United States shareholder who has made an election under section 962
for the taxable year, the increase in basis provided by this subsection shall not exceed
an amount equal to the amount of tax paid under this chapter with respect to the
amounts required to be included in his gross income under section 951(a).
(b)REDUCTION IN BASIS
(1)IN GENERAL

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Under regulations prescribed by the Secretary, the adjusted basis of stock or other
property with respect to which a United States shareholder or a United States person
receives an amount which is excluded from gross income under section 959(a) shall be
reduced by the amount so excluded. In the case of a United States shareholder who has
made an election under section 962 for any prior taxable year, the reduction in basis
provided by this paragraph shall not exceed an amount equal to the amount received
which is excluded from gross income under section 959(a) after the application of
section 962(d).
(2)AMOUNT IN EXCESS OF BASIS
To the extent that an amount excluded from gross income under section 959(a) exceeds
the adjusted basis of the stock or other property with respect to which it is received, the
amount shall be treated as gain from the sale or exchange of property.
(c)BASIS ADJUSTMENTS IN STOCK HELD BY FOREIGN CORPORATIONSUnder regulations
prescribed by the Secretary, if a United States shareholder is treated under section
958(a)(2) as owning stock in a controlled foreign corporation which is owned by another
controlled foreign corporation, then adjustments similar to the adjustments provided by
subsections (a) and (b) shall be made to—
(1)
the basis of such stock, and
(2)
the basis of stock in any other controlled foreign corporation by reason of which the
United States shareholder is considered under section 958(a)(2) as owning the stock
described in paragraph (1),
but only for the purposes of determining the amount included under section 951 in
the gross income of such United States shareholder (or any other United States
shareholder who acquires from any person any portion of the interest of such United
States shareholder by reason of which such shareholder was treated as owning
such stock, but only to the extent of such portion, and subject to such proof of identity
of such interest as the Secretary may prescribe by regulations). The preceding sentence
shall not apply with respect to any stock to which a basis adjustment applies under
subsection (a) or (b).
(d)BASIS IN SPECIFIED 10-PERCENT OWNED FOREIGN CORPORATION REDUCED BY NONTAXED
PORTION OF DIVIDEND FOR PURPOSES OF DETERMINING LOSS
If a domesticcorporation received a dividend from a specified 10-percent owned foreign
corporation (as defined in section 245A) in any taxable year, solely for purposes of
determining loss on any disposition of stock of such foreign corporation in such taxable
year or any subsequent taxable year, the basis of such domestic corporation in such
stock shall be reduced (but not below zero) by the amount of any deduction allowable to
such domestic corporation under section 245A with respect to such stock except to the
extent such basis was reduced under section 1059 by reason of a dividend for which
such a deduction was allowable.

XV. PASSIVE FOREIGN INVESTMENT COMPANIES (UNIT 15)

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

The basic United States tax regime applicable to foreign corporations has a relatively narrow focus, generally
reaching only certain domestic source income and income effectively connected with a United States trade or
business.

As such, domestic investors have found foreign corporations to be an attractive vehicle for deferring or even
completely avoiding United States taxation on foreign earnings. Congress has enacted.

Congress has enacted a litany of statutory mechanisms to prevent what may be considered an excessive amount
of tax-motivated offshore investment, but as we have been seen, these regimes may often be avoided with
excessive tax planning.

For instance, as discussed in Unit 13, because the controlled foreign corporation (CFC) regimes applies only to
United States person owning at least 10% of the voting power of the foreign corporation, these rules can be
avoided by structuring the ownership of the foreign corporation so that no United States person holds the
requisite amount.

Likewise, as discussed in Unit 14, the ordinary income conversion rules of §12 48 applicable to the disposition
of CFC stock may be circumvented by limiting United States ownership.

One way to limit ownership is simply expand the pool of investors- i.e., use a mutual fund model to bring
investors together and dilute any one person’s share of the whole. Foreign investment companies were
established in favorable tax jurisdictions (those imposing little or no taxation on investment earnings) where
shareholders both accumulate untaxed earnings and convert ordinary income items, such as interest and
dividends, to capital gain of the sale on the investment company shares.

In response, Congress enacted the passive income foreign investment company (PFIC). These provisions are
targeted at the deferral benefits accruing to US shareholders who escape the CFC regime by holding less than a
10% stake in a foreign corporation that invests in passive assets. The PFIC rules are secondary to the CFC rules-
if a person is subject to income inclusion under the CFC rules as a US shareholder in a CFC, the PFIC rules will
not apply.

A. Flowchart
1. FC? CFC?
a. U.S. shareholders of CFCs are not subject to PFIC rules under 1297(d)
b. ONLY U.S. shareholders of CFCs excused from PFIC rules
2. PFIC?
a. ≥ 75% of income passive, OR
b. ≥ 50% of assets passive
3. What PFIC regime applies?
a. 1291 (default regime)
b. 1295 QEF election (qualified electing fund)
c. 1296 mark to market
B. Overview

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

A US person or shareholder in a PFIC will not be taxed on income of PFIC (because not FC engaged in
trade or business or a CFC). Generally, will only be taxed when income is distributed as dividends. So
tax on the income of PFIC is deferred, meaning it awaits distribution of dividends.

1. PFIC provisions are targeted at the deferral benefits accruing to U.S. shareholders who escape
the CFC regime by holding less than a 10% stake in a foreign corporation that invests in passive
assets
2. PFIC regime provides two elections that result in current taxing schemes for U.S. shareholders
designed to roughly approximate how the PFIC’s earnings would have been taxed had the assets
been held directly by the shareholders
C. The 1291 Tax and Interest Regime

1. Default tax regime that applies unless the shareholder makes an election to prevent its
application

2. 1291  in general imposes a special shareholder tax and interest charge on deferred income
which is triggered upon the realization of gain from the disposition of PFIC stock and upon the
shareholder’s receipt of certain PFIC distributions attributable to earnings on which the
shareholder enjoyed tax deferral (so-called “excess distributions)

D. The 1295 QEF Election

A US person or shareholder in a PFIC will not be taxed on income of PFIC (because not FC engaged in
trade or business or a CFC). Generally, will only be taxed when income is distributed as dividends. So
tax on the income of PFIC is deferred, meaning it awaits distribution of dividends. The 1295 QEF
Election reverses the deferral benefits.

Under this statutory default regime, shareholders may invest through PFICs and take advantage of
deferral, but they will pay a cost upon exit in the form of back taxes and interest payments.

1. 1295  allows domestic shareholders to elect to have their share of PFIC earnings taxed
currently if certain requirements are met
a. Must elect to treat the PFIC as a “qualifying electing fund” (QEF)
1) In general, the result of QEF status is to create a current year ordinary income and
net capital gain inclusion for U.S. shareholders
2. Lower rate of tax may be imposed on the earnings, both as a result of the segregation of ordinary
income and net capital gain and because the default regime applies the highest taxable rate in
effect

E. The 1296 Mark-to-Market Regime

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1. 1296  may be able to avoid the default regime of 1291 if the stock is marketable on a public
exchange and the shareholder makes the election to recognize income or loss on the PFIC stock
on an annual basis
a. The difference at year-end between the basis of the stock and its FMV constitutes either
income or a deduction
1) Deductions are limited to the extent of prior income inclusions
2) Characterized as ordinary income or loss
3) Basis adjustments to the PFIC stock are provided under 1296(b) for any income
or loss taken into account
F. Classification of a PFIC: The Passive Income and Passive Assets Tests
1. Significantly more difficult to escape PFIC status than to escape status as a CFC
G. Passive Income Test

This so called “tainted” interest includes dividends, interest and interest equivalents, rents,
royalties, annuities, and net gains from certain property, commodities and foreign currency
transaction.
Passive income does not include any income derived from the active conduct of certain
businesses which by their nature generate income from the active conduct of certain
businesses which by their very nature generate income items generally considered passive.
For instance, §1297 (b) provides that interest income derived in the active conduct of a
banking business is not passive income. Or insurance business

1. 1297(a)(1)  a foreign corporation is a PFIC if 75% or more of its gross income for the taxable
year consists of passive income (any income comprising FPHCI under 954(c))
2. Generally does not include any income derived by a foreign corporation from a related party if
the related party generated the income in the active conduct of a business
Passive income does not include income derived by a related company if the passive income was
derived by his active conduct of business.

H. Passive Assets Test

1. 1297(a)(2) and 1297(e)  a foreign corporation is a PFIC if the average annual percentage of
the FMV or adjusted basis of its passive income-producing assets represents at least 50% of the
value or adjusted basis, as applicable, of all of the entity’s assets

a. Determined on a quarterly gross basis

b. Generally applied on the FMV basis
1) 1297(e)  if election made can be applied to the adjusted basis of the assets
(avoids complicated and uncertain valuation issues)

I. Special Look-Through Rule

The PFIC provisions contain a special look-through rule for applying passive income and passive
assets tests.
§1297 is intended to prevent the sheltering of passive-income generating assets in a subsidiary.

1. 1297(c)  provides that for purposes of determining whether a foreign corporation is a PFIC, a
foreign corporation is deemed to own its proportionate share of the assets of a subsidiary of
which it owns directly or indirectly, by value, 25% or more of the subsidiary’s stock

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a. Also deemed to receive its proportionate share of the subsidiary’s income

b. Applies regardless of whether the subsidiary is domestic or foreign
c. If the look-through rule applies then the subsidiary’s underlying assets and income factor
into the foreign parent’s passive asset and income calculations for testing purposes
d. Stock ownership and dividends are not factored in to the parent’s assets and income for
PFIC determination purposes
Because the look-through rule is not meant to penalize PFIC that own stock in, or receive dividends
from, an active subsidiary (again, the main focus is easily mobile capital), stock ownership and
dividends are not factored in to the parent’s assets and income for PFIC determination purposes.

Depending on the investments and activities of a foreign corporation’s subsidiary, the look through
rule may benefit or burden the taxpayer. If the subsidiary has a minimal amount of passive assets
and generates little or no passive income, attributing its assets and income to the foreign parent
may favorably dilute the parent’s overall passive income and investment structure. However, tiered
structures in which a subsidiary has a significant amount of investment in passive assets should be
avoided, since the subsidiary, viewed separately or combined with that subsidiaries, might be
classified as a PFIC.

J. The 1291 Tax and Interest Regime – Excess Distributions and Dispositions
The goal of the PFIC provisions is to eliminate the deferral benefits obtained by United States
investors through the use of foreign investment companies as vehicles for passive investment.
§1291 recoups the tax on income previously subjects to deferral and tacks on a penalizing interest
charge when that income is repatriated from the PFIC.
Why is there interest charge? The subject of PFIC is a US stockholder who is less than 10%, and
normally would only be taxed on dividends received from PFIC. In the meantime, the PFIC earns
passive income and law taxes that. We are trying to tax the passive income earned by PFIC and so
this is tucked in – as interest, when income is realized through certain excess distributions or actual
or deemed disposition of PFIC stock.

1. 1291 recoups the tax on income previously subject to deferral and tacks on a penalizing interest
charge when that income is repatriated from the PFIC
a. When income is realized by U.S. shareholders through certain “excess distributions” of
PFIC income, OR
b. Upon a shareholder’s actual or deemed disposition of PFIC stock

K. Mechanics of 1291
The §1291 deferral tax and interest regime are triggered by an “excess distribution” to a United
States person.

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

1. “Excess distribution” captures income which has effectively been lodged in the PFIC during the
shareholder’s holding period of the stock and direct or indirect disposition of PFIC stock
a. The excess distribution is generally the shareholder’s ratable portion of the excess, if any,
of the amount of PFIC distributions received during the taxable year over 125% of the
average amount of PFIC distributions received by the taxpayer during the three preceding
taxable years (or the shareholder’s holding period, whichever is shorter)
b. The excess distribution on a disposition is the amount of gain, if any, realized on the
transaction (made on a share-by-share basis)

L. The Deferred Tax Amount

1. If either a distribution from a PFIC or the gain from the disposition of PFIC stock is included is
included in the shareholders gross income under §1291 (a), the shareholder will be taxable in the
current year on this amount at ordinary income rates.

2. Deferred tax amount

3. However, the amount of the tax owed by the PFIC shareholder is further increased by a specially
computed tax on the excess distribution allocated to PFIC taxable years within the shareholder’s
holding period (i.e., the deferred tax amount)
a. The deferred tax amount is computed at the highest tax rates that would have applied had
the PFIC income actually been received in those years and also reflect an appropriate
interest charge
1. The deferred tax amount is the sum of:
a. The tax on the excess distribution allocated to each relevant prior PFIC taxable year
computed at the highest applicable tax rate in effect for that year, PLUS
b. Interest on the tax so computed (using the 6621 rates and methods for the computation of
underpayments of tax)
2. Even if the distribution represents a tax-free return of capital under normal taxing rules, it may
still give rise to a tax and interest liability

M. QEF Election

1. 1291 generally steers taxpayers to the QEF election current taxation regime
2. Governed by 1293 (current imputation and taxing regime)
3. If election is made after first year that the person is a shareholder, then 1291 will govern the prior
taxable years

N. Removing the 1291 Taint

1. Two elective statutory devices are available to enable shareholders to cleanse PFIC shares of
their 1291 taint:
a. “Deemed sale” election
b. “Deemed dividend” election

O. The Deemed Sale Election

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TAX TREATIES AND BUSINESS INCOME (UNIT 12)

1. 1.1291-10  enables shareholders to recognize gain with respect to stock in a QEF held on the
first day of the QEF’s first taxable year as such
a. Deemed to have sold the stock on the first day that the QEF election is in effect
b. Hypothetical gain is included in the shareholder’s gross income as ordinary income
c. The gain is treated as a disposition forcing the shareholder to also pay the appropriate
1291 deferred taxes and interest
d. If the stock has minimal appreciation, the deemed sale election is a cost-efficient means
of avoiding the continued application of the 1291 deferral tax and interest regime

P. The Deemed Dividend Election

1. 1291(d)(2)(B)  if the shareholder holds the stock on the first day of a given year, the
shareholder may elect to include in gross income for that year a deemed dividend equal to the
post-1986 earnings and profits attributable to that stock
a. The 1291 taint is stripped from the PFIC stock as the deemed dividend is treated as an
excess distribution to be allocated to the days in the holding period underlying the E&P
(this excess distribution is subject to tax and to the special deferral tax and interest
provisions of 1291)
Q. Requirements for Making the QEF Election

1. QEF subject to current taxation under 1293 if two general requirements are satisfied:
a. The shareholder must make an election on a timely filed tax return for the election year
b. The PFIC must comply with all reporting and other requirements for both determining its
ordinary earnings and net capital gain and for otherwise carrying out the purposes of the
PFIC rules
2. QEF election is irrevocable without permission from the Service
3. The election is shareholder specific and not to subsequent transferees

R. Current 1293 Taxation of U.S. Shareholders Electing QEF Status

1. 1293  requires an electing shareholder to include in gross income its imputed pro rata share of
the PFIC’s current E&P regardless of whether the PFIC actually distributes any earnings
a. Includes in gross income his or her pro rata share of the PFIC’s ordinary earnings and net
capital gain to be taxed to the shareholder as ordinary income and long-term capital gain
2. Any gain realized on the disposition of stock in a QEF will be treated as capital gains

S. Safeguards Against Double Taxation of PFIC Earnings

1. 1293 contains two specific safeguards to prevent double taxation when those earnings are
actually distributed:
a. Any amount distributed by a PFIC is treated as a non-dividend distribution to the extent
the taxpayer establishes that the actual distribution is paid out of E&P previously taxed
under the QEF regime (available to a shareholder if such earnings were previously taxed
to any U.S. person)

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b. Basis adjustments to the shareholder’s PFIC stock investment follow the 1293 inclusions
1) 1293(a)  increased by the amount of inclusion
2) 1293(c)  decreased by any tax-free non-dividend distribution

Problem Set XV: PFICS

Read: Code §§ 954(c); 1291(a) – (d); 1293(a) – (e); 1295; 1296(a) – (e), (k); 1297.
Reg. § 1.1296-1(c) – (d).
Prop. Reg. §§ 1.1291-2(e); 1.1291-4(a), (c) – (e).

Purpose:
CFCs only apply to US persons owning 10% or more of voting power of corporation
 Imputation can be avoided by structuring ownership to avoid the classification
 §1248 Apply to CFC stock disposition but can be circumvented by limiting US ownership
as well

PFICS: enacted to target deferral benefits accruing to US persons who escape CFC regime by
holding less than 10% of voting power
 Imposes a tax on domestic shareholders of foreign corporations who derive passive
income but are beyond scope of other anti-deferral regimes and stock disposition
provisions

Application: PFIC status is applied to any foreign corporation (including CFCs), which satisfies
either passive income or passive assets test
 No ownership requirement – focus is on character of entity and predilection for deferral
(US shs of CFCs are exempt)

Definition in §1297(a)
(a) In general.--For purposes of this part, the term “passive foreign investment company” means
any foreign corporation if--
(1) “Passive Income Test” 75 percent or more of the gross income of such corporation for
the taxable year is passive income, or
(2) “Passive Assets Test” the average % of assets (as determined in accordance with
subsection(e)) held by such corporation during the taxable year which produce passive
income or which are held for the production of passive income is at least 50%.

1297(d) Exception for United States shareholders of controlled foreign corporations.--

(1) In general.--For purposes of this part, a corporation shall not be treated with respect to a
shareholder as a passive foreign investment company during the qualified portion of such
shareholder's holding period with respect to stock in such corporation.
 Will only be taxed on income as either a CFC or PFIC; If you are a US shareholder under
CFC rules then that is how you will be taxed; if you fall outside of the CFC rules, PFIC
will pick up the tax

PFIC Taxing Regimes:

(1) §1291 Tax on Interest: special shareholder tax and interest charge on deferral benefits of
PFIC shareholders
 Triggered when shareholder realizes gain on disposition of PFIC stock and receipt of
PFIC distributions

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(2) §1293 Current Tax:

 Qualifying Elective Fund requires current year ordinary income and net capital gain
inclusion for United States Persons
 If you elect to defer this you are hit with an interest charge

(3) §1296 Mark to Market Regime: IF the stock is marketable, can elect to recognize income
or loss on an annual basis

15-1 All of the single class of stock in Venn Corporation, a Venezuelan corporation, is owned
by Theo (6 percent), Remi (47 percent), and Paloma (47 percent) (all unrelated United States
citizens and residents). Venn’s only asset is an office building in Brazil that is currently leased
to an unrelated Brazilian operating company under a 50-year lease. Venn derives substantial
rental income from the property but does not make distributions to its shareholders.

(a) Are the shareholders subject to the CFC rules and/or the PFIC rules?
(1) Is this a Foreign Corporation?
o §7701 etc.
o If it is a Foreign Corporation, is it doing something in the US (inbound); Is it owned by US
interests and therefore a safeguard issue?

(2) Is there a US shareholder?

o Theo is not a US shareholder (owns less than 10%)
o US shareholders – Remi and Paloma (each own more than 10% voting; and who own
more than 50% of vote and value)
o Result: This is a CFC

(3) Is the CFC deriving tainted income?

o Rental Income: Active or Passive – Passive! §1297b1 refers to § 954c (§ 954c1A passive:
dividends, rents, royalties, annuities)

Treatment of Income under CFC Rules: No distributions to US shareholders so that income is

staying abroad and taking advantage of deferral but there may be some imputation

(4) Is the CFC a PFIC?

Difference between PFIC and CFC
o CFCs are determined based on ownership
o PFICs are determined based on the type of income; concentration of ownership is
irrelevant for actual PFIC classification (it will apply in the next step to determine income
inclusion)

Note: Safeguard regimes will deprive you of full benefits of deferral in one way or another

Two Tests for PFIC:

§ 1297a(1) - Income Test: 75% or more gross income is passive
§ 1297a(2) - Assets Test: Average percent of assets held for year for passive income are more
than 50%

Result: Sole asset is passive office building, this is also a PFIC (under the Income Test), taxed
on excess distributions

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 If you are a US Shareholder subject to CFC rules you will be taxed under those rules;
other parties in the CFC will then be subject to the PFIC rules

(b) How would the answer to (a) change if Remi was a citizen and resident of Brazil?

If Remi was foreign, the corporation would not be a CFC, but the corp would still be a PFIC.
Theo and Paloma now subject to PFIC

Three possible situations:

 Enterprise is a CFC but not a PFIC (US Shareholders/Active Trade/Business)
 Enterprise is a CFC and a PFIC (US Shareholders/Passive Income)
 Enterprise is not a CFC but is a PFIC (No 50% majority of US Shareholders/US person
owners with Passive Income)

15-2 Assume the same general facts from Problem 15-1. In addition, assume the following
facts:
 Theo purchased his Venn stock on January 1, Year 1, from an unrelated seller for $5,000 and
sold all of his stock on December 31, Year 10, to an unrelated purchaser for $15,000.
 No election was ever made under § 1295 or §1296.
o §1295: Allows shareholder to elect to defer tax payment at the cost of an interest
charge
o §1295: Allows election to recognize income on marketable stock/loss on an annual
basis
 The United States tax rate on long-term capital gains at all times relevant to this Problem is
15 percent.
 The highest marginal tax rate under § 1 in each of Years 1-10 was 35 percent, and Theo’s
taxable income placed him in this bracket each year.
 The interest rate under § 6621 for underpayments of tax at all times relevant to this Problem
is seven percent. Ignore the compounding aspect of the determination and round up to the
nearest dollar.

(a) What are the United States income tax consequences of Theo’s ownership of the Venn stock
in Years 1-10 and the gain from his stock sale in Year 10?
AB: $5,000
AR: $15,000
Gain: $10,000 (without PFIC this would be LTCG)

During 10 year period does anything happen to Theo? He gets to seemingly enjoy 10 years of
deferral on taxable income under CFC rules
 Why are we not forcing the current imputation here?
 To extent that you have “Tainted income” and you are a US person under the CFC you wind
up imputing it, but under the PFIC rules we are not
 Under the PFIC there is not a minimum ownership requirement for the domestic
shareholder; so Congress is assuming that you have no control over the governance of the
corporation so it would be unfair to impute income for distribution that you never receive
o In the CFC to avoid imputation you don’t need CFC regime if you have an actual
distribution. But under the CFC rules the theory is that there is enough ownership
centered in US persons that you can control the distribution/taxation

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o But no imputation where someone is a small shareholder they cannot control the
distribution.
 Given the lack of power Congress waited until an event or point in time to play
“catch-up” to treat as if it had been imputed
 To extent that you can make the election you can affirmatively elect and create an
imputation regime (to avoid interest)

Because Theo Made no Election, he is going to be taxed under Regime (1) Special Tax and
Interest §1291
 Tax is on both distributions and dispositions
 If loss on disposition then PFIC rules don’t apply (only gains are affected)

§1291(a) (2) Dispositions.--If the taxpayer disposes of stock in a passive foreign investment
company, then the rules of paragraph (1) shall apply to any gain recognized on such
disposition in the same manner as if such gain were an excess distribution.

Step 1. Determine the Excess distribution amount in in respect of stock in a foreign

passive investment company.

Theo purchases his Venn stock on January 1, Year 1, from an unrelated seller for $5,000 and
sold all of his stock on December 31, Year 10, to an unrelated purchaser for $15,000. Excess
distribution amount is $10,000.

Step 2. The amount of excess distribution shall be allocated ratably to each day in
the taxpayer’s holding period for the stock (subparagraph A).
Holding period – 10 years. Excess distribution allocated ratably. $10,000 divided by 10 years =
$1,000

Step 3. With respect to such excess distribution, the taxpayers gross income for the
current year shall include (as ordinary income only the amounts allocated under
subparagraph A (Step 2) to the current year (for 10th year= $1,000).
So tax ratable amount of 10th year of $1,000 with ordinary income tax rate (28%)= $280

INCREASED BY DEFERRED TAX AMOUNT

Compute first amount
Step 4: Determine the excess distribution allocated to each relevant prior PFIC Taxable
Year. In the example, how much is the ratable excess distribution allocated per year.
Look at years 1-9, $1,000.

Step 5. Apply the highest applicable tax rate in effect for that year.
$1,000 x .35 = 350

(The highest marginal tax rate under $1 in each of years 1-10 was 35%, and Theo’s taxable
income placed him in the 28% bracket each year.)

Compute second amount: interest on additional taxes

Step 6. Compute at the underpayment rate established under $6621.

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(The interest rate under §6621 for underpayments of tax was 7% Ignore the compounding
aspect of the determination and round up at the nearest dollar. We did not compound her. We
only look at principal amount. Add up the amount for current year with previous amounts (350
plus 350 etc) and multiply sum with interest rate .07

Year Tax Interest Amount

1. 350 221 571

2. 350 196 546
3. 350 172 522
4. 350 147 497
5. 350 123 473
6. 350 98 448
7. 350 74 424
8. 350 49 399
9. 350 25 375
TOTAL $3,150 $1,105
$ 4,255

Step 7. Add the tax (first column) and the interest (second column). (350 + 221 = 571)
Answer third column.

Step 8. Get to sum of third column

$4,255

Step 9. Add tax liability for year 10 ($280) plus Deferrred tax amount $4,255)
$4,535

§1291(a)(1) Distributions.--If a United States person receives an excess distribution in respect of

stock in a passive foreign investment company, then--
(A) the amount of the excess distribution shall be allocated ratably to each day in the taxpayer's
holding period for the stock,
(B) with respect to such excess distribution, the taxpayer's gross income for the current year
shall include (as ordinary income) only the amounts allocated under subparagraph (A) to--
(i) the current year, or
(ii) any period in the taxpayer's holding period before the 1st day of the 1st taxable year
of the company which begins after December 31, 1986, and for which it was a passive
foreign investment company, and
(C) tax imposed by this chapter for the current year shall be increased by the deferred tax
amount (determined under subsection (c)).

Deferred Tax Amount: Aggregate increase in tax, plus aggregate increase in interest
 Aggregate increase in taxes = multiply gross income allocated for the year by highest
taxable income

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o Sum of aggregate increase in taxes + aggregate interest

o Taxed at highest rate applicable during the year - i.e. 35% (just assume for our use
that it was always 35

Note the gain is coming back as ordinary income – which is why you are applying the highest
rate of tax of 35%. The entire $10K will be taxed as ordinary income.
 Even though you were able to get the deferral you pay a penalty because normally the
sale of stock would be capital gain
o Penalty one is that the sale of the stock will be treated as ordinary income
o It then has the highest tax rate § 1291c2;
o THEN there is an additional 7% simple interest application to deferred tax
payments – so you will have 9 years of interest accumulating on the tax § 1291c3

Deferred Tax Amount is the increased tax + interest = $4,245 which will be added on to overall
tax liability for the year. Year 10 gain of 1k is taxed at 28%, total tax now is $4,535 (effectively
none of the gain is classified as capital gain – can’t offset with capital losses)

(b) How would the answer to (a) change if Theo made a timely § 1295 election with respect to
the Venn stock in Year 1?
If we make a §1295 election:
 Have to, on an annual basis determine ordinary income and capital gains
 Many PFICs are Mutual Funds and because the United States has no jurisdiction
many will not or cannot do this.
 Must be made by each shareholder, considered “pedigreed” if made at beginning
of first year sh owns the stock

Results under a §1295 Election gives you treatment under §1293:

 §1291 Deferral? Depends on what you can do with your money now versus what
you can do after?
o Under 1291 everything is coming back as ordinary

“Qualified Electing Funds”

 Requires electing shareholder to include imputed pro-rata share of PFICs earnings
in current year income regardless of whether disposition/distribution is made -
both ordinary income and LTCG (i.e. if it is characterized as such for PFIC)

§ 1293. Current taxation of income from qualified electing funds

(a) Inclusion.--
(1) In general.--Every United States person who owns (or is treated under section 1298(a) as
owning) stock of a qualified electing fund at any time during the taxable year of such fund shall
include in gross income--
(A) as ordinary income, such shareholder's pro rata share of the ordinary earnings of
such fund for such year, and
(B) as long-term capital gain, such shareholder's pro rata share of the net capital gain
of such fund for such year.

Result: This will most likely be favorable to the taxpayer; remember that the final sale at $10K
does not tell us the fluctuations in value over the course of the ownership.

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 Each year you are told that the PFIC had certain amount of ordinary income and
capital gain
 Each year ordinary income is taxed at his marginal rate, also gets benefit of capital
gains

(c) How would the answer to (b) change if Theo made the § 1295 election at the beginning of
Year 6? (stock worth 10k on that day)
From year 6 through year 10 can make inclusion; however previous 5 years you will receive
treatment under §1291 when sold.
 When you elect the QEF you can elect on the year that you make the election to
treat the differential as a gain to go back and make the calculation. Can make
deemed sale or deemed dividend election
§1291(d)(2) Election to recognize gain where company becomes qualified electing fund.--
(A) In general.--If--
(i) a passive foreign investment company becomes a qualified electing fund with respect
to the taxpayer for a taxable year which begins after December 31, 1986,
(ii) the taxpayer holds stock in such company on the first day of such taxable year, and
(iii) the taxpayer establishes to the satisfaction of the Secretary the fair market value of
such stock on such first day,
the taxpayer may elect to recognize gain as if he sold such stock on such first day for
such fair market value.

(d) How would the answer to (a) change if Theo in Year 1 made a valid and timely election
under § 1296 with respect to the Venn stock, which was publicly traded, and the stock
appreciated $100 annually?

§1296 (Regime 3) Mark to Market

 Public company with trading market where you have results brought back as
ordinary income each year
 If stock goes up in value you recognize ordinary gain, loss is ordinary also but only
to extent of prior included gain
 Loss is deferrable until you sell it

§ 956 treats loan from subsidiary foreign corp as a dividend

§ 367 outbound rules, made certain inversions taxable
§ 7874 current basic anti-inversion statute. Focuses on how much of new corp is owned by
former US shareholders. If 80% or more, treated as if it was still a US corp. 60% - 80% US
owners then there are limits on US company after transaction (NOLs limited 10 yrs)

Exam Discussion:
 Use code sections; get all the requirements down
 Use policy at end of your answer

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