Author: Santiago Coindreau
Email: smc@ssacpa.com
For a foreign company, doing business in the US can be a very lucrative experience. This, however, could also mean having to pay federal income taxes every year in the US, and potential non-deductible penalties if the income is not reported, or the tax is not paid on time. The IRS code could deem that a foreign company is conducting a taxable trade or business based on its level of business and contracts in the US. This can be avoided by foreign companies that are only planning on having limited activity in the US, and whose country of residency has an income tax treaty with the US. To do so, care must be taken to avoid creating a permanent establishment through a fixed place of business in the US.
To take advantage of this benefit, the foreign company must file a tax return position on a timely filed IRS Form 8833 claiming the treaty benefit. If a permanent establishment has not been created, then none of the income will be taxable, but a protective return will still have to be filed.
U.S. tax treaties define a permanent establishment as a “fixed place of business through which the business of an enterprise is wholly or partly carried on”. The existence of a permanent establishment is determined based on the facts and circumstances of each case, but even if the business of the foreign company is being conducted through a fixed place of business, the company will not be considered to have a permanent establishment if these activities are limited to certain auxiliary and preparatory activities.
Some examples of places of business, which create a permanent establishment, listed on the OECD Model Treaties include the following:
- Place of management
- Branch or office
- Factory
- Workshop
- Mine, oil or gas well, or any other place of extraction of natural resources
Examples of activities that do not create a permanent establishment include the following:
- Use of a facility to store, display or deliver goods or merchandise (E.g. Showroom)
- Maintaining a fixed place of business solely for the purpose of purchasing goods or merchandise, or of collecting information, for the enterprise
- Maintaining a fixed place of business solely for the purpose of advertising, supplying information, scientific research, or for the preparations relating to the placement of loans, or for similar activities which have a preparatory or auxiliary character, for the enterprise.
In the case that a foreign company owns a partnership that has a permanent establishment in the United States, the company, as a partner in such company, is also deemed to have a permanent establishment. Even limited partners, as in the case of Donroy, Ltd v. United States, are considered to have a permanent establishment in these cases.
Having a subsidiary in the US, however, does not automatically create a permanent establishment for its parent as it is considered to be an independent legal entity, but there are ways that it could create a permanent establishment, for example, if both the parent and the subsidiary have the same officers, a permanent establishment could be created by the parent, if the activies of such officers in the US are considered to be on behalf of the parent rather than the subsidiary.
If a foreign company has agents in the United States, they could also create a permanent establishment for the foreign company. For this to happen, two requirements would have to be met:
- The person is not a broker, commission agent, or other agent of independent status, and is conducting acts in the ordinary course of its business on behalf of the foreign company in the United States.
- That person has and habitually exercises in the United States an authority to conclude contracts that are binding on the corporation.
Lastly, it’s important to review the tax rules of any State in which the foreign company is doing business in. Each one of the 50 US States has different rules to determine what constitutes taxable income for State purposes, and the threshold to create a nexus in a State is normally much lower than that of a permanent establishment for federal purposes. The income tax treaties only apply to income taxes at the Federal level, and cannot be used to minimize the State income taxes that might be due.
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