In a move designed to thwart efforts to have offshore loan originators and purchases of U.S. debt portfolios, such as consumer debt or subprime mortgages, from avoiding effectively connected income per §864(b), the Office of Chief Counsel addressed the question of whether interest income earned by a foreign corporation with respect to loans originated by an agent, whether dependent or independent, operating in the United States is attributable to "the U.S. office" through which the foreign corporation’s banking, financing or similar business activity is carried on, such that the interest income is "effectively connected income"?
The CCO Memorandum concludes that received by a foreign corporation with respect to loans that it originated to U.S. borrowers constitutes income effectively connected with such foreign corporation’s banking, financing or similar business when an agent, whether dependent or independent, performs origination activities described in the facts below on the foreign corporation’s behalf with respect to such loans in the United States.
The underlying facts to the Memorandum are relatively straight forward. A foreign corporation is organized in Country X and all of its issued and outstanding shares are owned by non-U.S. persons. Country X has no income tax convention with the U.S. The foreign corporation Country X does not have a bilateral income tax treaty with the United States. Foreign Corporation makes loans to U.S. persons located within the U.S. The foreign corporation maintains no office or employees in the U.S.
The foreign corporation originates its U.S. loan portfolio through the activities of a U.S. based company, which finds loans on a "considerable, continuous, and regular basis". The origination company is subject to U.S. tax on the fee it receives for finding loans for the foreign corporation. All contracts are executed by representatives of the foreign corporation situated outside of the U.S.
In analyzing the law, the CCO starts with examining whether the foreign corporation is engaged in a trade or business within the U.S. §882. With respect to the rendering of personal services, a "’trade or business within the United States’ includes the performance of personal services within the United States at any time within the taxable year . . . ." §864(b). The term "trade or business within the United States", however, does not include "[t]rading in stocks or securities through a resident broker, commission agent, custodian, or other independent agent." §864(b)(2)(A)(i). But this exception is inapplicable if he taxpayer has an office or other fixed place of business in the United States at any time during the taxable year through which the transactions in stocks or securities are effected. §864(b)(2)(C). Still, the term "trade or business within the United States" does not include "[t]rading in stocks or securities for the taxpayer’s own account, whether by the taxpayer or his employees or through a resident broker, commission agent, custodian, or other independent agent, and whether or not any such employee or agent has discretionary authority to make decisions in effecting the transaction." §864(b)(2)(A)(ii). In contrast, a "dealer" in stocks or securities would not qualify under this safe harbor.
If the safe harbor does not apply, as was apparent in the facts in this case, the determination of whether the foreign corporation is engaged in a trade or business (ETB) is based on all facts and circumstances. Treas. Reg. §1.864-2(e). If so engaged, then only such income which is "effectively connected" (ECI) with the conduct of a U.S. trade or business is subject to tax in the U.S. on a graduated rate (net income) basis.
For U.S. interest income, determining whether the interest is ECI, the factors taken into account include whether: (i) the income is derived from assets used in or held for use in the conduct of such trade or business, the so-called "asset use test"; or (ii) the activities of such trade or business were a material factor in the realization of the income, the so-called "business activities test". §864(c)(2). However, Treas. Reg. § 1.864-4(c)(5) provides a special rule for determining whether income is ECI with a "banking, financing or similar business activity." Specifically, any U.S. source interest received by a foreign corporation during the taxable year in the active conduct of a banking, financing, or similar business in the United States is treated as effectively connected to the conduct of that business "only if the stock or securities giving rise to such income, gain, or loss are attributable to the U.S. office through which such business is carried on" and the securities were acquired in one of the specified manners enumerated in the regulations, which includes making loans to the public. Treas. Reg. §1.864-4(c)(5)(ii). A stock or security is deemed to be attributable to a U.S. office "only if such office actively and materially participates in soliciting, negotiating, or performing other activities required to arrange the acquisition of the stock or security." Treas. Reg.§1.864-4(c)(5)(iii). Treas. Reg. § 1.864-4(c)(5)(iv) provides rules for determining when a stock or security was acquired in the course of making loans to the public. Even when U.S. source income from stocks and securities is not effectively connected with the active conduct of a foreign corporation’s banking, financing or similar business in the United States, such income may be effectively connected with the conduct of another U.S. trade or business under the "asset-use test" or the "business activities test".
In contrast to U.S. source interest, foreign source interest income, i.e., interest paid from a non-U.S. person, generally is not ECI with the conduct of U.S. trade or business. § 864(c)(4)(A). Foreign source interest income of a foreign corporation derived from the active conduct of a banking, financing, or similar business within the United States, however, is treated as effectively connected with the conduct of a United States trade or business "if such person has an office or other fixed place of business within the United States to which such income, gain, or loss is attributable." §864(c)(4)(B). In determining whether a foreign corporation has an office or other fixed place of business, the office or other fixed place of business of an agent will be disregarded unless the agent (i) has the authority to negotiate and conclude contracts in the name of the foreign corporation and regularly exercises such authority and (ii) is not a general commission agent, broker or other independent agent acting the ordinary course of business. §864(c)(5)(A). In addition, a foreign corporation’s income, gain or loss will not be attributable to an office or fixed place of business in the United States unless such office or fixed place of business "is a material factor in the production of such income, gain, or loss" and the office or fixed place of business regularly carries on the type of activities from which such income, gain or loss was derived.§864(c)(5)(B). When determining whether a foreign corporation has an office or other fixed place of business with regard to foreign source income, the office of a dependent agent is generally disregarded unless such agent has the authority to negotiate and conclude contracts in the name of the foreign corporation and regularly exercises that authority. Treas. Reg. § 1.864-7(d)(1)(i).
In the Memorandum, the Office of Chief Counsel concluded that even though the loan origination company in the U.S. did not have the authority to conclude contracts, it was an integral part of its "agent", the foreign corporation’s, lending activities, such as the solicitation of customers, negotiation of terms and performance of credit analysis. The Memorandum cited the Tax Court Memorandum decision in Inverworld, Inc. v.
Comm’r, T.C. Memo. 1996-301 (activities of a U.S. corporation, although nominally an independent contractor and not an agent, attributed as agent to a foreign corporation) and De Amodio v. Comm’r, 34 T.C. 894, 905-06 (1960), aff’d, 299 F.2d 623 (3rd Cir.
1962) (taxpayer engaged in a U.S. business; activities of agent were considerable, continuous and regular, and that those activities, which constituted more than the mere ownership of real property or receipt of income from real property, were attributable to the taxpayer); Lewenhaupt v. Comm’r, 20 T.C. 151 (1953), aff’d, 221 F.2d 227 (9th Cir. 1955) (taxpayer engaged in a U.S. business because taxpayer’s activities through an agent were considerable, continuous and regular despite requiring agent to receive taxpxayer’s approval prior to taking any important action); Handfield v. Comm’r, 23 T.C. 633, 637-38 (1955) (taxpayer engaged in a trade or business in U.S. where agent made substantial sales in the United States on behalf of the taxpayer pursuant to a distribution agreement); Adda v.Comm’r, 10 T.C. 273, 277 (1948) (concluding that the taxpayer engaged in a trade or business within U.S. by activities undertaken by the taxpayer’s agent). Accordingly, the activities with respect to foreign corporation’s loans to U.S. borrowers constitute a trade or business because as the foreign corporation lends money to customers on a considerable, regular and continuous basis with the intention of earning a profit.
Finding the ETB connection, per Treas. Reg. §1.864-2(e), foreign corporation was determined not to fall within the personal securities investment exception under §864(b)(2). The interest income was held to be ECI with such trade or business as it was engaged in a banking business and such interest is attributable to an office in the U.S. Treas. Regs. §§1.864-4(c)(5)(i), (ii). The regulation does not specify or imply that the U.S. office belong to or be attributable to the taxpayer.
The Service is aware that some taxpayers may have taken the position that the interest income is not effectively connected with banking, financing or similar business activity because the income is not attributable to a U.S. office of the foreign corporation and that the office of foreign corporation’s agent is not attributable to the foreign corporation under Treas. Reg. § 1.864-7(d). Because Treas. Reg. § 1.864-4(c)(5) does not provide guidance defining the phrase "the U.S. office," a taxpayer may argue that the definition of the phrase "office or other fixed place of business" provided in Treas.
Reg. § 1.864-7 should apply to interpret the phrase "the U.S. office." Under the taxpayer’s analysis, because origination co. is either an independent agent or does not
have the authority to conclude loans on behalf of foreign corporation, its office is not attributable to the foreign corporation. The CCO rejected this analysis.