The Permanent Establishment of a Foreign Person in the United States Under U.S. Income Tax Convention
It is a generally accepted axiom of international income taxation that a U.S. tax treaty will prevent the taxation of the business profits of a resident of a treaty county, unless the profits in question are attributable to a "permanent establishment" that is maintained by that resident in the United States. See, e.g., U.S. treaties with Canada art. 7(1) ; Japan art. 8(1) ; Netherlands art. 3(1) ; United Kingdom art. 7(1) . Thus, in planning for a foreign person’s inbound investment in the U.S., and based on such foreign person’s status as a resident of a treaty country, the critical terms will be evaluating whether the foreign persons’ activities constitute a "permanent establishment" and the definition of "business profits". As to the latter term, see See, e.g., Japan art. 8(5) (manufacturing, mercantile, insurance, agricultural, fishing, or mining activities); Netherlands art. 3(5) (active conduct of trade or business); United Kingdom art. 7(7) (manufacturing, mercantile, banking, insurance, agricultural, fishing, or mining activities).
Where a permanent establishment is maintained in the U.S. the source country can tax the the business profits of the foreign person but only to the extent that the business profits that are attributable to the permanent establishment. If a taxpayer has a permanent establishment, a U.S. treaty does not exempt the resulting business profits but may limit the U.S. taxation. Typically, the treaty allows U.S. taxes to apply only to the business profits that are "attributable" to the permanent establishment. See, e.g., Canada art 7(1) ; Japan art. 8(1) ; Netherlands art. 3(1) ; United Kingdom art 7(1).
Where U.S. business type activities are conducted through a pass through entity such as a partnership, the character of the income passes through to any foreign partner. Therefore if the partnership maintains a permanent establishment in the U.S., any foreign partner will be treated as so engaged. Rev. Rul. 85-60, 1985-1 CB 187 (U.S. tax applied to foreign beneficiary of foreign trust that was limited partner in partnership with U.S. permanent establishment). Rev. Rul. 91-32, 1991-1 CB 107 (situation 3). See also Donroy, Ltd. v. United States, 301 F2d 200 (9th Cir. 1962), aff'g 196 F. Supp. 54 (ND Calif. 1961); WC Johnston v. Comm'r, 24 TC 920 (1955) (Canadian individual was taxable on his share of income of general partnership with a U.S. permanent establishment); Robert Unger v. Comm'r, P-H TC Memo. ¶ 90,015 (1990), aff’d 936 F.2d 1316 (DC Cir. 1991
While there are various formulations of the term "permanent establishment" under our tax treaties, generally it means a "fixed place of business" through which the business is carried on. See, e.g., Canada art. 5(1) ; Japan art. 9(1) ; Netherlands art. 2(1)(i)(A) ; United Kingdom art. 5(1) . Some examples may be listed in the statute as falling within or outside of the definition. For example, a "branch, office, factory or workshop" may be a permanent establishment. Another term used is "place of management". Generally tax treaties consider a mine, oil and gas well, quarry, or other place of extraction of natural resources as a permanent establishment. It is generally understood that the Service he Service ordinarily will not rule whether a taxpayer has a U.S. permanent establishment.
A treaty may list certain activities that a taxpayer may perform in the United States without being treated as having a U.S. permanent establishment. A list of such exceptions include: (i) facilities used for storage, display, or delivery of goods or merchandise belonging to the foreign person; (ii) storing goods or merchandise belonging to the resident for storage, display, or delivery or for processing by another person; (iii) the purchase of merchandise or collection of information; and (iv) advertising, research activities or similar activities that are preparatory in nature.
A growing concern in this area is when an agent of the foreign person can cause the principal to be treated a maintaining a permanent establishment in the U.S. A principal generally will not be deemed to have a U.S. permanent establishment merely because of carrying on business through a broker, general commission agent, or other independent agent. However, where a principal conducts business in the U.S. through an agent that is not independent and has and habitually exercises its authority to conclude contracts in the name of the principal such can cause the activity to be treated as part of a permanent establishment. See, e.g., Canada art. 5(5) ; Japan art. 9(4); Netherlands art. 2(1)(i)(D); United Kingdom art. 5(4) . For example, in Frank Handfield v. Comm’r, 23 T.C. 633 (1955) a Canadian manufactured postal cards in Canada which were sold in the United States through an agreement with a news company. The Tax Court held that under the agreement, the news company was the petitioner's agent for distributing the cards in the United States. It therefore concluded that the petitioner was engaged in business within the United States and income from sales in this country is subject to income taxes. Taisei Fire & Marine Ins. Co. v. Comm’r, 104 TC 535 (1995), acq. 1995-2 CB 1 .
The foregoing provides an over-simplified view of the permanent establishment concept. If the IRS successfully determines that a foreign person (of a treaty country) does have a permanent establishment in the US, then the foreign person will be subject to full U.S. income tax on the attributable profits. Employees or service providers of the foreign entity may also fall into a US employment tax whole as well with withholding consequences for the employer. It is possible that a branch tax issue may arise if the foreign person is incorporated, subject to treaty rate reduction. These are just a few of the major consequences of a permanent establishment finding.
Therefore, it is critical in planning for a non-U.S. person’s investment in a business operation in the U.S. to carefully analyze whether and to what extent a permanent establishment risk is present.
