How are “Business Profits” Related to the Concept of a Permanent Establishment?
Article 7(1) of both the UN and the OECD Model Conventions provides that the business profits of an enterprise resident in one country cannot be taxed in the other country unless the business is carried on through a permanent establishment in that other country (or source country). The existence of a permanent establishment is thus a threshold for taxation by the source country.
Once a permanent establishment exists in the source country, the source country is generally able to tax the profits attributable to the PE as long as those profits are not taxable under other provisions of the treaty. The determination of the amount of profits attributable to the permanent establishment may be governed by treaty as well as domestic law.
Thus, under U.S. tax treaties, generally if business is carried on through a permanent establishment in one country, the business profits attributable to the permanent establishment can be taxed by that country.
What are Business Profits?
U.S. law distinguishes between the U.S. business income and other U.S. income of a nonresident alien or foreign corporation.
The term “business profits” generally includes, but is not limited to, income derived from manufacturing, mercantile, banking, insurance (or reinsurance), agricultural, fishing or mining activities, the operation of ships or aircraft, the furnishing of services, the rental of tangible personal (movable) property, and the rental or licensing of motion picture films or films or tapes used for radio or television broadcasting or from copyrights thereof.
The term “business profits” also includes any other income which is effectively connected with a permanent establishment which the recipient, being a resident of one of the Contracting States, has in the other Contracting State. The term “business profits” does not include income from the performance of personal services derived by an individual either as an employee or in an independent capacity.
The concept of business profits is also directly tied to the concept of a permanent establishment and the force-of-attraction rule, both of which are discussed below.
How are Profits Attributed to a Permanent Establishment?
In determining the proper attribution of business profits under the Convention to a permanent establishment, under U.S. tax treaties both Contracting States are to attribute to the permanent establishment such profits as it would reasonably be expected to derive if it were an independent entity engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment.
Generally, expenses, wherever incurred, which are reasonably connected with profits attributable to the permanent establishment — including a reasonable allocation of executive and general administrative expenses, research and development expenses, interest, and other expenses incurred for the enterprise as a whole (or the part which includes the permanent establishment) — will be allowed as deductions in determining the business profits of the permanent establishment. However, in determining the amount of the deduction for expenses incurred by a head office, the deduction generally is limited to the expense incurred without including a profit element for the head office.
Generally, no business profits can be attributed to a permanent establishment merely because it purchases goods or merchandise for the enterprise of which it is a part. This is the position of the Treasury and the OECD Model. This rule applies only to an office that performs functions for the enterprise in addition to purchasing. The income attribution issue does not arise if the sole activity of the office is the purchase of goods or merchandise because such activity does not give rise to a permanent establishment under the Permanent Establishment provisions of U.S. treaties.
Generally, where the profits of a permanent establishment include items of income which are dealt with separately in other Articles of the Convention, the provisions of those Articles will not be affected by the provisions of this Article.
How Does the Business Profits Concept Related to the Force of Attraction Rule?
Business profits may be attributable to a permanent establishment that an enterprise of one Contracting State has in the other Contracting State — whether from sources within or without a Contracting State. Thus, items of income described in section 864(c)(4)(B) of the Code which are attributable to a permanent establishment situated in the United States will be subject to tax by the United States.
In some cases, the amount of income “attributable to” a permanent establishment may be greater than the amount of income that would be treated as “effectively connected” to a U.S. trade or business under section 864. For example, a taxpayer that has a significant amount of foreign source royalty income attributable to a U.S. branch may find that it will pay less tax in the United States by applying section 864(c) of the Code, rather than the rules of Article 7, if the foreign source royalties are not derived in the active conduct of a trade or business and thus would not be effectively connected income. But, if it does so, it may not then use Article 7 principles to exempt other income that would be effectively connected to the U.S. trade or business. Conversely, if it uses Article 7 principles to exempt other effectively connected income that is not attributable to its U.S. permanent establishment, then it must include the foreign source royalties in its net taxable income even though such royalties would not constitute effectively connected income.
How is Effectively Connected Income Tax?
A nonresident alien or foreign corporation is subject to a flat 30-percent rate (or lower treaty rate) of tax on certain U.S.-source income if that income is not effectively connected with the conduct of a trade or business within the United States. The regular individual or corporate rates apply to income (from any source) which is effectively connected with the conduct of a trade or business within the United States.
The treatment of income as effectively connected with a U.S. trade or business depends upon whether the source of the income is U.S. or foreign. In general, U.S.-source periodic income (such as interest, dividends, and rents), and U.S.-source capital gains are effectively connected with the conduct of a trade or business within the United States if the asset generating the income is used in, or held for use in, the conduct of the trade or business or if the activities of the trade or business were a material factor in the realization of the income. All other U.S.-source income of a person engaged in a trade or business in the United States is treated as effectively connected with the conduct of a trade or business in the United States (referred to as a “force of attraction” rule).
When is Foreign Source Income Treated as Effectively Connected Income?
Foreign source income generally is treated as effectively connected income only if the foreign person has an office or other fixed place of business in the United States and the income is attributable to that place of business. Only three types of foreign source income are considered to be effectively connected income: rents and royalties for the use of certain intangible property derived from the active conduct of a U.S. business; certain dividends and interest either derived in the active conduct of a banking, financing or similar business in the United States or received by a corporation the principal business of which is trading in stocks or securities for its own account; and certain sales income attributable to a U.S. sales office. Special rules apply in the case of insurance companies.
Any income or gain of a foreign person for any taxable year that is attributable to a transaction in another taxable year is treated as effectively connected with the conduct of a U.S. trade or business if it would have been so treated had it been taken into account in that other taxable year (Code sec. 864(c)(6)). In addition, if any property ceases to be used or held for use in connection with the conduct of a trade or business within the United States, the determination of whether any income or gain attributable to a sale or exchange of that property occurring within ten years after the cessation of the business is effectively connected with the conduct of a trade or business within the United States is made as if the sale or exchange occurred immediately before the cessation of the business. (Code sec. 864(c)(7)).