The question of whether a foreign person's income would be treated as income "effectively connected" with a trade or business in the United States ("ECI") often invites significant confusion and challenges. The concept of "U.S. trade or business" is inherently ambiguous and fact dependent, unless a taxpayer can rely on certain statutory safe harbors. Once a foreign taxpayer is deemed engaged in a U.S. trade or business, it can be even more challenging to determine the exact scope of ECI, particularly in light of the potential application of the limited force of attraction rule under Code Sec. 864(c)(3) of the Internal Revenue Code (the "Code").
The origin of the force of attraction rule predates the codification of the ECI regime under Code Sec. 864 and the rule survived in a limited form as we see today. The current force of attraction rule can come into play in certain limited circumstances only, but when it does, it can unexpectedly amplify a foreign person's ECI. Certain U.S. source, ostensibly passive income, can be pulled into a foreign person's ECI even where there is no apparent relationship between such income and such foreign person's U.S. trade or business.
In this article, we will provide an overview of the statutory framework of the ECI rules (including the limited force of attraction rule and related provisions), the history relating to these rules, their interplay with the portfolio interest exemption, the implications of the recent court ruling in YA Global Investments LP ("YA Global")1 on these rules, and the potential application of these rules in the context of certain credit fund structures.
II. Statutory Framework
A foreign taxpayer is generally subject to U.S. taxation on ECI, which is taxed on a net basis at graduated tax rates.2 Although determining whether certain income qualifies as ECI requires a fact-intensive analysis, the framework generally examines (1) first, whether the taxpayer is engaged in a U.S. trade or business, and (2) if the answer to the first question is yes, whether a specific income item is "effectively connected" with such U.S. trade or business.
A. "U.S. Trade or Business" Test
The U.S. trade or business test is governed by Code Sec. 864(b). Code Sec. 864(b) provides that the term "U.S. trade or business" includes the performance of personal services within the United States at any time within the taxable year, but no additional definition is provided in the Code or the Treasury regulations thereunder.3
Instead, case law provides additional color to determine the contours of a U.S. trade or business. Such cases generally hold that regular, substantial, and continuous profit-oriented activities in the United States, whether carried on by the taxpayer directly or through agents, constitute a U.S. trade or business.4 In other words, mere ownership of U.S. real property, "quiescent" receipt of income therefrom, and customary acts incidental to ownership do not give rise to a U.S. trade or business.5 In contrast, if a person "buys and sells real property, collects rents, pays operating expenses, taxes, and mortgage interest, makes alterations and repairs, employs labor, purchases materials, and makes contracts over a period of years," then the foreign owner of U.S. real property will be deemed engaged in a U.S. trade or business.6 For this purpose, if a taxpayer is acting through an agent, the agent's activities are imputed to the taxpayer, regardless of whether the agent is independent or dependent.7
To encourage foreign investors to invest in the United States, however, Code Sec. 864(b)(2) was enacted to provide certain safe harbors related to trading in securities or commodities (collectively, the "Trading Safe Harbor"). If this Trading Safe Harbor applies, the taxpayer trading stock or securities will be deemed not to have a U.S. trade or business by reason of its trading activities, and therefore none of the taxpayer's income, gain, or loss from such trading activities will be treated as ECI.8 If the Trading Safer Harbor does not apply, the taxpayer will have to assess its activities to determine whether it would be treated as engaged in a U.S. trade or business.9
Generally, the Trading Safe Harbor is available if a foreign person's activities are limited to (1) trading in stocks or securities through an independent agent or (2) if the foreign person is not a "dealer," trading in stocks or securities for its own account, whether by the foreign person or through a resident broker or other agent.10 For this purpose, a "security" includes a note, bond, debenture, or other evidence of indebtedness.11 A taxpayer can be treated as a "dealer" if such taxpayer regularly engaged in purchasing and selling securities with a view to making profits from such transactions.12
B. "Effectively Connected" Test
If it is determined that a foreign person is treated as engaged in a U.S. trade or business, the next question is whether, and to what extent, the taxpayer's income would be treated as "effectively connected" with such U.S. trade or business. This "effectively connected" test is governed by Code Sec. 864(c). For this purpose, different tests apply depending on the type and source of income.
1. FDAP Income and Gains
For U.S.-source fixed, determinable, annual, periodic income and U.S.-source capital gains ("FDAP Income and Gains"), such income or gain will be treated as ECI only if either the "asset use" test or the "business activities" test is satisfied (collectively, the "General Rules").13
a) General rules: asset use test and business activities test. The asset use test is satisfied if the income, gain, or loss is derived from assets used, or held for use, in the taxpayer's ordinary course of the trade or business. Certain FDAP Income and Gains may be considered ECI under the asset use test if it is derived from the working capital or inventory of a business.14 For example, bank accounts, securities, and other investments are considered to be used in a U.S. trade or business if they are "held to meet the present needs" of the trade or business, such as working capital or inventory.15 This test involves looking at current and past activities to determine whether the asset, prior to generating the applicable income, was used or held for use in the U.S. trade or business.16 In order to satisfy this test, it is not necessary for the transaction generating such income or gain to have any connection with a U.S. trade or business.17 Rather, it is sufficient to demonstrate that the assets in question were used or held for use in the relevant business.
The business activities test is satisfied if the activities of the trade or business were a "material factor" in realizing the applicable income or gain.18 In other words, if a business activity were a material factor in producing FDAP Income and Gains, such income can be treated as ECI even if the particular property generating such income or gain has not been used or held for use in a U.S. trade or business. This test, contrary to the asset use test, focuses on the transaction itself that generates the applicable income or gain and assesses whether such transaction was connected with the U.S. trade or business activities.19 For example, the business activities test could be satisfied when dividends or interest are derived by a dealer in stocks or securities, capital gains are derived from the investments held by an investment company, or royalty income is derived by a taxpayer engaged in a licensing business.20 Under this test, however, activities relating to the management of an investment portfolio shall not be treated as activities of a U.S. trade or business unless the maintenance of the investments constitutes the principal activity of that trade or business (as in the case of an investment company).21
To view the full article click here
Footnotes
1. 161 TC No. 11, Dec. 62,306 (2023).
2. Code Secs. 871(b) and 882.
3. See generally, Kingson, Taxing Foreign Corporations on U.S. Business Income, 118 Tax Notes 1143 (Mar. 10, 2008).
4. See I. Balanovski, CA-2, 56-2 ustc ¶9832, 236 F2d 298, cert. denied, SCt, 352 US 968, 77 SCt 357, reh'g denied, 352 US 1019 (1957) (partnership had U.S. trade or business, even though its U.S. activities were limited to purchasing and exporting goods for sale abroad); Northumberland Ins. Co., DC-NJ, 82-2 ustc ¶16,383, 521 FSupp 70, 78 (foreign insurance company, which "occupied office space, hired agents and employees, and maintained assets and bank accounts in the United States," had U.S. trade or business, even though it was not "authorized to do business" in United States); J. Pasquel, 12 TCM 1431, Dec. 20,047(M) (1953) (purchase and sale of two ships in threemonth period not trade or business).
5. I. de Amodio, 34 TC 894, Dec. 24,315 (1960), aff'd, CA-3, 62-1 ustc ¶9283, 299 F2d 623 (ownership of U.S. real property, receipt of rentals, and payment of taxes, mortgage principal and interest, and insurance premiums was not U.S. trade or business because activities "beyond the scope of mere ownership of real property, or the receipt of income from real property" were "sporadic rather than 'continuous,'... irregular rather than 'regular,' and ... minimal rather than 'considerable'"); E. Herbert, 30 TC 26, Dec. 22,928 (1958); E.M.L. Neill, 46 BTA 197, Dec. 12,251 (1942) (taxpayer's ownership of U.S. real property and collection of rents was "no more a business activity carried on within the United States than her ownership of stocks or bonds of American companies held for her by an American agent").
6. Taiyo Hawaii Co., 108 TC 27, 611, Dec. 52,114 (1997) (citing A.R.E. Pinchot, Exr., CA-2, 40-2 ustc ¶9592, 113 F2d 718; see also I. de Amodio, 34 TC 894, Dec. 24,315, 1960 WL 1317 (1960) (active management of rental property on a "regular and continuous" basis is a U.S. trade or business), aff'd, CA-3, 62-1 ustc ¶9283, 229 F2d 623; E. Herbert, 30 TC 26, Dec. 22,928, 1958 WL 961 (1958); J.C. Lewenhaupt, 20 TC 151, Dec. 19,606, 1953 WL 256 (1953), aff'd, CA-9, 55-1 ustc ¶9339, 221 F2d 227).
7. See Rev. Rul. 80-225, 1980-2 CB 318 (foreign person may "be engaged in a trade or business in the United States as a result of activities performed on its behalf by an independent agent of the taxpayer in the United States"). See also YA Global Invs., LP, 161 TC No. 11, Dec. 62,306 (2023) (finding that adviser's activities on partnership's behalf were attributed to partnership); A. Zaffaroni, 65 TC 982, Dec. 33,662 (1976) (nonresident aliens had community property income earned in United States by active spouse; held, inactive spouse was engaged in U.S. trade or business by activities of active spouse as "agent or manager of that community").)
8. Code Sec. 864(c)(1)(B).
9. InverWorld, Inc., 71 TCM 3231, 3237-26, Dec. 51,428(M), TC Memo. 1996-301. The court concluded that the Trading Safe Harbor was not available to the taxpayer and therefore conducted an intensive analysis of the facts to determine that the taxpayer was engaged in a U.S. trade or business.
10. Code Secs. 864(b)(2)(A)(i) and 864(b)(2)(A)(ii).
11. 1 Reg. §1.864-2(c)(2)(i).
12. Reg. §1.864-2(c)(2)(iv).
13. Reg. §1.864-4(c).
14. Reg. §1.864-4(c)(2)(ii).
15. Reg. §1.864-4(c)(2)(iv)(a).
16. Robert P. Rothman, Gain from Property Sales as Effectively Connected Income, J. Int'l Tax'n, available at www.akingump.com/a/web/1495/ Rothman-July-2009.pdf.
17. Id.
18. Reg. §1.864-4(c)(3)(ii).
19. Robert P. Rothman, Gain from Property Sales as Effectively Connected Income, J. Int'l Tax'n, available at www.akingump.com/a/web/1495/ Rothman-July-2009.pdf.
20. Reg. §1.864-4(c)(3).
21. Id.
Originally Published by International Tax Journal
Visit us at mayerbrown.com
Mayer Brown is a global services provider comprising associated legal practices that are separate entities, including Mayer Brown LLP (Illinois, USA), Mayer Brown International LLP (England & Wales), Mayer Brown (a Hong Kong partnership) and Tauil & Chequer Advogados (a Brazilian law partnership) and non-legal service providers, which provide consultancy services (collectively, the "Mayer Brown Practices"). The Mayer Brown Practices are established in various jurisdictions and may be a legal person or a partnership. PK Wong & Nair LLC ("PKWN") is the constituent Singapore law practice of our licensed joint law venture in Singapore, Mayer Brown PK Wong & Nair Pte. Ltd. Details of the individual Mayer Brown Practices and PKWN can be found in the Legal Notices section of our website. "Mayer Brown" and the Mayer Brown logo are the trademarks of Mayer Brown.
© Copyright 2024. The Mayer Brown Practices. All rights reserved.
This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.