How the IRS Taxes Australian, Candadian, U.K. and Europeans Companies and Citizens Doing Business In The United States

french tax, french tax planning, job loss.

French businesses are profiting by avoiding the VAT by manufacturing in the U.S.

This blog is for Australian, Canadain, U.K. and Western European companies and citizens planning to have a business in the U.S. or business income from U.S. customers.

The United States is courting U.K., Western European, Canadian and Australian citizens to move their businesses.  The U.S. doesn’t  have a VAT (value-added tax).  The absence of this tax gives a 25% increase in a company’s purchasing power (assuming a VAT of 20%) of inventory, machinery and employees.  Business makes more money due to the additional working capital.   

Labor unions are weak in the U.S. Employee rights are limited compared to the U.K., the EU, and Australia.

This blog explains how citizens (and their companies) from a tax treaty country are taxed in the U.S.

I am using the U.S. Model Income Tax Convention (the “U.S. Model Treaty”) for this blog.  I will highlight the articles that apply to business.  I will make the treaty easy to understand by removing the tax jargon. 

If you would like to discuss a U.S.’s tax treaty, then please call me, Brian Dooley, CPA, MBT at (U.S.) 949-939-3414.

 Next, I will explain the U.S. tax law on doing business in USA.  

Lastly, I will have some questions that I am frequently asked and the answer.

Before we start, I am aware that most cross-border tax planners want to avoid having a permanent establishment.    So, this blog will focus on U.S. tax law about permanent establishments.

Paragraph 1  of Article 7 of the  Treaty provides:

 The business profits of a company of a Country shall be taxable only in that Country unless the company carries on business in another Country through a permanent establishment in the other Country.

The business profits of the company are taxable by the other Country but only to the extent that the income as is attributable to that permanent establishment.

 Article 5 paragraph 1 of the U.S. Model Treaty provides:

“Permanent establishment” is a fixed place (such as a factory, a retail store or an office)  of business through which the company’s business is wholly or partly carried on.

U.S. Model Treaty Article 5 paragraph 5 of the provides:

 Where a person (other than an agent of an independent status)  is acting on behalf of a company  and habitually exercises  “the authority to conclude contracts that are binding on the company,  then the company has a permanent establishment in that Country in respect of any activities that the person undertakes for the company.”

An exception applies if the activities of the person are limited to those mentioned in paragraph 4. In that case, the exercise of the activities through a fixed place of business doesn’t make that fixed place of business a permanent establishment.

 U.S. Model Treaty  Article 5 paragraph 6 of the provides:

 Also, an enterprise does not have a permanent establishment because it has a  business in that Country through a general commission agent, an independent broker, or any other independent agent if such agent is acting in the ordinary course of its activities as independent agents.

 Based on the preceding provisions, the U.S. can tax a foreign corporation on its U.S.  business profits only if:

 {1) the foreign corporation has permanent establishment (“PE”) within the U.S. and
 {2) the profits that are attributable to the PE. 

Even if an agent executes contracts within the U.S. in the name of a foreign corporation, if the agent is of an independent status acting in the ordinary course of its business as an independent agent, then the foreign company will not be deemed to have a PE within the U.S. because of such agency’s activities.

To be an independent agent, the person must be:
 {1) not related by common ownership or family  and
{2) be acting in the ordinary course of its business.

When an agent concludes contracts in the name of a foreign company, to avoid a tax problem, the agent must satisfy the following three conditions to prevent dependent agent status (dependent agent status creates the permanent establishment).

The agent must be:
 {1) legally independent (this includes a alter ego or a nominee);
 (2) economically independent; and
 {3) acting in the ordinary course of its business.[1]

In other words, the actions of a dependent agent are considered the activities of the foreign person or foreign company.

Here is the problem in U.K. and European international tax planning in the United States.

The American courts are biased for the IRS.  I will explain three tax court cases. The fist two the IRS won.  The third case, the IRS lost.

In the court case of Handfield versus IRS Commissioner,[2] a  non-resident Canadian citizen was residing in Canada.  He manufactured picture postal cards in Canada.

The tax court ruled he was engaged in business within the United States through the activities of an agent.  The problem for me is the fact that the agent was an “independent agent.”  Canada has a tax treaty with the U.S. similar to most EU and the UK tax treaty.

The taxpayer managed the business from his office in Canada.  He had hired the American News Company to distribute the postcards to newsstands in the United States.

The cards were sold to the public at bookstores and drugstores.  The taxpayer had one employee, a resident of the United States, to check the vendors of the cards to ensure that the cards were correctly displayed.  The employee could not negotiate contracts.

 The taxpayer argued that the American News Company purchased the cards from him for resale.  He explained that the sale took place in Canada when the cards.  When the cards were shipped to the U.S., he surrendered “all his rights, title, and interest” (this is a tax term) in the cards. At the time of shipment, he argued that the American News Company owned the postcards.

The IRS stated that the arrangement was an agency relationship. Further American News Company was the taxpayer’s exclusive distributor in the United States.  This fact should not create a permanent establishment since American News Company was an independent agent.

 The Handfield court found that the American News Company was the taxpayer’s agent. Next, the court held that the cards were shipped on consignment for sale to the public. 

As you will note, the American News Company was an independent agent with many other customers.  The American court did not care.

The second tax court case is Lewenhaupt v. Commissioner.[3]  Here the issue was whether a nonresident alien individual was engaged in business within the United States because of the activities of an agent. 

The agent had the power to buy, sell, lease, and mortgage real estate for and, in the name of the taxpayer.  The agent managed the taxpayer’s property and other investments in the United States.  The court found the activities of the agency to be “considerable, continuous, and regular.’’  This finding caused the nonresident to be in taxable in America.

A good tax court case for international tax planning with a U.K. company

A nonresident taxpayer was not engaged in business in the court case of Amalgamated Dental Co. v.  IRS Commissioner.  In this court case, a United Kingdom corporation purchased dental supplies from a U.S. dental supply company.

Before years in issue in the case, the dental supply company shipped the merchandise bought by the taxpayer directly to the taxpayer in the U.K.  Next; the taxpayer would send the merchandise to its customers in the U.S. 

But, because of WWII, it became impossible for transatlantic shipments.  

The U.K. company and the U.S. dental supply company agreed that the U.S. company would ship the merchandise directly to the taxpayer’s U.S. customers.  

The U.S. dental supply company did not charge for the additional services of shipping the merchandise.

        The tax court ruled that “gratuitous” services provided to the U.K. company by the dental supply company did not create an agency relationship.  The war directly caused the change in operating methods.  The court found that, considering the long continued relations between the two companies, that the change was not one of principal and agent.   

The third case (and a taxpayer victory) is  Amalgamated Dental versus the IRS.  Here the court concluded that the lack of a formal written contract of agency was critical.  Prior U.S. Supreme Court cases stated that a written agreement with specific terms was required in an agency relationship.

The court saw that what was done was not as an agency, but merely a continuation of the previous arrangement in a not hugely different way.

The tax court ruled that the U.K. corporation did not engage in a U.S. business.

So, here you have it.  From my viewpoint, the U.S. courts are biased for the U.S. Government.    If you want to brainstorm your tax situation, then please call me, Brian Dooley, CPA, MBT at 949-939-3414.

International Tax Planning and Strategy Questions that I am asked about dependent agents:

 (A)      What is the tax law for a nonresident company that sells products in the U.S by way of a commission agent?

For example, a retailer is selling stock on commission for a nonresident affiliated company. When would the U.S.  tax charge nonresident Company?  Before I answer the question, it is important to understand that U.S. tax law is not like U.K. or EU tax law.  The U.S. does not have the concept of a “nonresident company”.  A “resident company” concept as used in the U.K. and the EU is not used in U.S. tax law.  

When a tax treaty exists, the United States may only tax the business profits of the affiliated foreign corporation only if it has PE in the United States.

If the affiliated foreign corporation does a fixed place of business in the U.S., then the tax issue is whether it is deemed to have a U.S.  PE because of the activities of the retailer.  This PE issue is similar to the Handfield postcard tax case.

 If the retailer is an independent agent, the affiliated foreign corporation will not have a PE in the United States.  This is despite the fact that the affiliate foreign corporation:
1.   may be engaged in a U.S.  business and
2.  income is “effectively connected” with that business.

As a result,  the U.S.  is not allowed to tax that income.   However please remember, to be independent, the agent must be both legally and economically independent. 

 (B)  Does the U.s. have any law that taxes a foreign company that has economic activity in the U.S.  by subcontracting (similar to a contract manufacturer).

 For example, a  foreign company insures the warranty risk of a product sold in America by a resident affiliate company. The warranty repair work is carried out by the selling affiliate, on behalf of the non-resident affiliate.  The sales affiliate is paid for the work.  Does the U.S tax the non-resident affiliate’s profits.

 Answer:  The fact that the entities are related does not, by itself, cause U.S. taxation.  The determining factor is the relationship between the parties and if the selling affiliate is an independent agent or a  dependent agent regarding the repair work.   

Additionally, transfer pricing is an issue in determining that amount of taxable income.

First, the prices charged between the affiliates for the repairs made under warranty may be adjusted to increase taxable income.

Next, if the warranty was sold as a part of the price of the product, the allocation of the sales amount allocated to the warranty could affect the amount of taxable income.

   (C) What is the U.S. tax law regarding the making of commercial decisions over assets or business functions the U.S. (as a place of management) while the legal ownership of property or legal responsibility of those functions belongs to a company in a foreign country?

For example,  goods are manufactured in the U.S.  The goods are sold to a related company in a second county. The related company then sells the goods to an unrelated customer resident In U.S.

 The sale is facilitated by a related company “resident” (meaning management and control)  in U.S.  The related company  ‘services’ the customer by demonstrating products and discusses customer needs but is not involved in executing the sales contract.

 The analysis set provided, above, for question An also applies to this issue.

 The transfer pricing rules may apply.  The IRS may require allocation of profits on the initial transfer of the manufactured goods from the manufacturing affiliate and again to the affiliate in the second country, who sells them to the third party customer in the United States.

This not topic is important to the U.K. and European business.  The U.S. has a common law (created by court cases) known as “substance over form”.  The law recharacterizes the taxable event if there is no economic substance to the transaction or no business purpose of the entity in the second country.[4]   You can learn more about the  ”substance over form”  law below, after the footnotes.    

FOOTNOTES                                                                                                           

[1] See also tax court case of  Taisei Fire and Marine Ins. Co. Ltd. v. IRS  Commissioner, 104 T.C. 535 (1995).  To be an agent of independent status, both legal and economic independence are required.

[2] 23 T.C. 633 (1955),

[3] 20 T.C. 151, 163 (1953),

[4]  See  UPS of Am. v Commissioner, T.C. Memo.  1999-268.

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