Practical advice on current issues.
EMPLOYEE BENEFITS & PENSIONS
IRS guidance offers useful reminders about employee discount plans; p. 617.
FOREIGN INCOME & TAXPAYERS
Recent developments under FATCA, U.S. withholding tax, and global information reporting; p. 618
Treaty benefits on FDAP income derived by hybrid entities; p. 620.
PARTNERS & PARTNERSHIPS
How the death of a partner could affect a partnership's year end; p. 624.
Sales-and-use-tax pitfalls in the construction and real estate industries; p. 627.
STATE & LOCAL TAXES
State tax considerations for foreign companies with inbound U.S. investments; p. 630.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP
For additional information about these items, contact Mr. Wagner at 502-420-4567 or firstname.lastname@example.org.
Employee Benefits & Pensions
IRS guidance offers useful reminders about employee discount plans
The IRS recently released Field Attorney Advice 20171202F, which provides guidance on the taxability of an employee discount plan.
Under the discount plan as described (with identifying details redacted), employees could designate a certain number of individuals, including themselves, to receive a discount on services from the employer. Designated individuals could include spouses or domestic partners, family members, and friends of the employee. Individuals eligible for the discount were required to create an account from which they received a discount of a certain percentage off the published rates for the employer's services. The employer claimed the discount was, in most cases, less than the discount offered to the employer's large customers or under certain customer discount programs but did not provide supporting evidence of this to the examining agent.
Sec. 132(a)(2) allows employers to provide a qualified employee discount that is excludable from an employee's taxable income. A qualified employee discount is defined under Sec. 132(c) as a discount with respect to qualified property or services that:
* In the case of property, does not exceed the gross profit percentage of the price at which the property is offered to customers; or
* In the case of services, does not exceed 20% of the price at which the services are offered to customers.
Qualified property does not include real property or property of a type commonly held for investment. Qualified property and services must be offered for sale in the ordinary course of the taxpayer's trade or business in which the employee provides services. For example, employee discounts provided on merchandise only available to employees through a company store will not qualify for exclusion as an employee discount plan.
Qualified employees who can receive tax-free discounts generally include the employee, his or her spouse and dependent children, former employees who retired or left because of disability, and the widow or widower of a deceased employee (Sec. 132(h)).
Regs. Sec. 1.132-3 includes several additional clarifying rules:
* Discounts in excess of the amounts allowed under Sec. 132(a)(2) are includible in the employee's taxable income.
* The qualified employee discount exclusion does not apply to property or services provided by a different employer through a reciprocal agreement to provide discounts to employees of the other employer.
* Property or services may be provided directly or through a third party. For example, an employee of an appliance manufacturer may be allowed a discount when purchasing the appliance through a third-party retailer. However, to qualify for the exclusion, the employee may not receive additional rights, such as an extended warranty, not offered to customers in the employer's ordinary course of business.
* The price at which an employer offers property or services to its customers controls the price used to determine whether an employee discount is excludable. In cases where the employer offers a discounted price to a discrete customer group, and the sales at that discounted price comprise at least 35% of gross sales for a representative period, then in determining the employee discount, the discounted price is considered the price at which the service is being offered to customers.
Although the response from the Office of Chief Counsel (OCC) to the examining agent was heavily redacted, the published portion of the response is consistent with the law and clearly unfavorable to the taxpayer. First, the OCC agreed with the examiner that the discount pertained to services, not property. Second, regarding who is considered an employee, the OCC confirmed that only individuals identified as employees under Sec. 132(h) or the related regulations qualified for the exclusion of an employee discount from taxable income. Any discount received by someone who was outside the definition of a qualified employee was includible in the wages of the employee who designated that individual.
Third, the OCC confirmed that a rate for property or services lower than a published rate may be used to determine whether an employee discount is qualified for exclusion if at least 35% of gross sales to ordinary customers are made at a discounted rate. However, the employer in this case did not provide sufficient evidence regarding standard discounts provided to corporate customers to prove that the employee discount should be based upon the discount rates provided to those customers, instead of its published rates. Therefore, the employer was required to use the published rates to determine the taxable portion of the discount until the employer provided the required customer discount information. The OCC, noting that the employee discount rate was more than 20% of the published rates, stated that the employer must include the excess discount in the employees' gross income as a taxable fringe benefit and withhold and pay employment taxes on that amount.
Discount plans are a common and easy way to provide an incentive to employees for their service. However, as demonstrated, the rules permitting an employer to exclude the employee discount from taxable income are complex and easy to run afoul of, especially when documentation is poor.
Companies offering employee discount plans should review their plans closely in light of this IRS guidance to determine whether they must make adjustments to align with statutory and regulatory requirements. Current payroll applications should be modified to identify any discounts that must be included in employees' taxable income and include the corresponding information on Forms W-2, Wage and Tax Statement, as well as to perform the applicable withholding. If taxpayers do not have a system that can identify any discounts that are includible in taxable income, they should institute a process to do so and thus comply with statutory and regulatory requirements.
From Allen F. Tobin, J.D., New York City, and David J. Holets, CPA, Indianapolis
Foreign Income & Taxpayers
Recent developments under FATCA, U.S. withholding tax, and global information reporting
The Foreign Account Tax Compliance Act (FATCA) has been gradually implemented over the course of several years, starting with its enactment in 2010. FATCA was primarily enacted to combat tax evasion by U.S. persons holding investments in offshore accounts. FATCA withholding became effective in 2014, and the law has come into force over time, using staggered effective dates. Due to the complexity of the legislation, multiple delays and transitional rules regarding effective dates for various aspects of the law have been provided through ongoing IRS guidance.
FATCA levies a 30% withholding tax on U.S.-source payments of fixed or determinable, annual or periodical (FDAP) income unless its prescriptive requirements regarding payee documentation are met. On Dec. 30, 2016, the IRS released additional final FATCA regulations. These additions introduced changes regarding documentation of sponsored entities and the associated registration process on behalf of a sponsoring entity. Beginning in 2019, the withholding tax of 30% will apply to gross proceeds from the sale or other disposition of any property of a type that can produce U.S.-source FDAP income, further expanding the law's reach.
As of this writing, 113 countries had entered into intergovernmental agreements (IGAs) with the United States under FATCA. IGAs are contractual agreements that require countries to facilitate the reporting of information mandated under FATCA by their resident companies, either directly or indirectly, with the U.S. government.
As a group, IGAs do the following:
* Provide an agreed set of definitions and procedural requirements, including the treatment of resident entities, associated duties, and the prerequisites for certain entities to be exempt from registration, under FATCA.
* Set thresholds on the values of accounts that are required to be documented and reported.
* Provide guidance and safe-harbor rules regarding information that is required to be obtained and reviewed by the resident payer.
* In certain instances, extend the deadline for FATCA reporting for resident entities.
Treatment of sponsored entities
Notice 2015-66 delayed the effective date for the requirement of sponsored entities to obtain their own global intermediary identification number (GUN) until Dec. 31, 2016. A sponsored entity is one that has contracted with another entity to perform its FATCA-related duties. The final regulations issued in T.D. 9809 extended the requirement for sponsored entities to obtain their own GUN three months, through March 31, 2017. Because the IRS has not extended the exception beyond March 31, 2017, a withholding agent that does not have the GUN of a sponsored entity must withhold 30% on withholdable payments made after this date. As such, withholding agents should be in the process of updating their withholding certificates for sponsored entities, if they have not already done so.
Reporting on gross proceeds
Under the recendy released final regulations (T.D. 9809), withholdable payments under FATCA will be expanded to include payments of gross proceeds from the sale or other disposition of any property of a type that can produce U.S.-source interest or dividends. Reporting of gross proceeds stemming from any sale or disposition of property subject to FATCA reporting was slated to begin for transactions occurring after Jan. 1, 2017. However, the IRS has delayed the effective date of this requirement until at least Jan. 1, 2019, when withholding on those transactions is currently scheduled to begin for sales of property subject to FATCA occurring after Dec. 31, 2018.
Gross proceeds: Gross proceeds in this context are defined under FATCA as the total amount realized as a result of the sale or other disposition event. To the extent a clearing organization settles sales and purchases of securities between members of an organization on a net basis, the gross proceeds from these sales or dispositions are limited to the net amount paid or credited to that member's account, as allocated from the sale or disposition.
Property: Property subject to gross proceeds reporting includes any type of property that can produce interest or dividends that would be U.S.-source under the Code. This determination is made irrespective of whether interest or dividends were actually paid while the property was held. Furthermore, such "Chapter 4 property" includes contracts producing U.S.-source dividend-equivalent payments, regardless of whether the non-U.S. persons are otherwise subject to federal income tax. Finally, regulated investment company distributions are included in gross proceeds to the extent the payment is attributable to property that produces U.S.-source interest or dividends designated as capital gain dividends.
Foreign passthrough payments:
Notice 2015-66 also provides additional guidance for foreign passthrough payments. Under FATCA, participating foreign financial institutions (FFIs) must agree to withhold at the 30% rate on foreign passthrough payments made to recalcitrant account holders and nonparticipating FFIs. Under current guidance, withholding does not apply to foreign passthrough payments until 2019 at the earliest. The definition of foreign passthrough payments is still being developed and is reserved under the current regulations. In general, however, the scope of foreign passthrough payments is exceptionally broad and, as such, includes all withholdable payments, including other payments attributable to withholdable payments. Although the focus on foreign passthrough payments is primarily on U.S.-source income, it is expected that certain non-U.S.-source income may also be included. It is important to note that one of the primary purposes behind the foreign passthrough payment concept under FATCA is to preclude an FFI from serving as a "blocker" for U.S. persons attempting to avoid U.S. tax via indirect investments in U.S. assets.
Other U.S. withholding tax developments
The final regulations issued in T.D. 9808 provided additional guidance regarding the requirement to specify the limitation-on-benefits (LOB) provision that an entity is relying upon in making a treaty claim for reduced withholding under Chapter 3 of the Code. Specifically, under Temp. Regs. Sec. 1.1441-6T, for withholding certificates issued after Jan. 6, 2017, Form W-8BEN-E, Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities); Form W-8EXP, Certificate of Foreign Government or Other Foreign Organization for United States Tax Withholding and Reporting; and Form W-8IMY, Certificate of Foreign Intermediary, Foreign Flow-Through Entity, or Certain U.S. Branches for United States Tax Withholding and Reporting, must indicate the precise LOB provision within the relevant treaty on which the foreign recipient is relying in making its treaty claim. For withholding certificates provided before Jan. 6, 2017, entities can continue to rely on these certificates through 2018.
Thus, as a practical matter, all withholding agents will be required to collect new withholding certificates from their foreign payees and investors during 2018 to have the requisite LOB documentation in hand to continue to make withholdable payments at less than the 30% standard rate where a treaty applies. The IRS released a revised version of Form W-8BEN-E in April 2016 that provides an expanded Part III, "Claim of Tax Treaty Benefits," as the primary means of complying with this requirement. The IRS released revised versions of Forms W-8EXP and W-8IMY in September 2016 and June 2017, respectively.
The requirement to provide a taxpayer identification number (TIN) to enjoy U.S. tax treaty benefits also remains in flux. Under Regs. Sec. 1.1441-6, a TIN is required to be provided by the foreign recipient to receive a reduced rate of withholding, except in cases of actively traded securities, for which no TIN is required. Current regulations permit a foreign TIN to be provided in instances when a TIN is required, as opposed to a U.S.TIN. Moreover, for 2017, the IRS further relaxed this requirement via temporary regulations for payments to foreign individuals, thereby delaying this requirement until at least Jan. 1, 2018. Nonetheless, under regulations in effect as of this writing, the IRS will require the provision of foreign TINs for payments made after 2017, to eventually share information with taxing authorities in other jurisdictions.
Lastly, the IRS also published new guidance on the qualified intermediary (QI) regime in late December 2016. As a result of the new QI agreement released at that time, all QIs needed to reapply for QI status as of March 31, 2017, to have their new QI agreement effective as of Jan. 1, 2017. Now that the deadline for QI agreement renewals has passed, the focus has returned to nonqualified intermediaries (NQIs), many of which are being pressured by their upstream counterparties to become QIs. Many of these NQIs have traditionally opted to suffer the full 30% withholding tax under Chapter 3 or 4, which is levied on U.S. withholdable payments, rather than disclose the ultimate beneficiaries of those payments.
Whether by design or unintentionally, many NQIs did not comply with the U.S. tax regulations' requirement to issue Forms 1042-S, Foreign Person's U.S. Source Income Subject to Withholding, to their investors and account holders. Due to this implied lack of compliance and potential for those prone to evade tax to employ NQI structures, many upstream counterparties have mandated that those customers obtain QI status as soon as possible or risk cessation of the financial relationship. These upstream counterparties are essentially acting in their own best interests to minimize the associated reputational risk that might arise from continuing relationships with undocumented indirect account holders.
OECD's common reporting standard
In 2013, the G-8 and G-20 commissioned the Organisation for Economic Co-operation and Development (OECD) to create a platform similar to FATCA for the automatic exchange of information. The result was the development of the common reporting standard (CRS), which was initially effective as of 2016 in 50 jurisdictions. Reporting is on a calendar-year basis and is made electronically to the tax authority of the jurisdiction in which the reporting financial institution is based. Of particular note is that traditional "tax haven" jurisdictions such as Bermuda, the British Virgin Islands, the Cayman Islands, and even Panama are participating in the effort.
Unlike the FATCA regime to date, the information exchanges will be truly reciprocal with other jurisdictions and will commence in September 2017 for the early-adopting jurisdictions. As of this writing, more than 100 jurisdictions have signed on to the CRS by executing multilateral competent authority agreements (MCAAs). Unlike FATCA, however, the CRS does not include a withholding tax or penalty component on payments. Rather, the home country of reporting entities will be able to assess penalties on those financial institutions that do not comply, including the revocation of a license to do business. The United States has opted not to participate in the CRS at this time and is continuing with FATCA instead. This position has led to some tax advisers' branding the United States a relative tax haven, given the tendency under FATCA to require less overall reporting than the CRS.
The information required to be reported under the CRS includes name, address, TIN(s), date and place of birth (for individuals), account numbers, and account balances or values, as well as interest, dividends, other income, and gross proceeds, where applicable. In recognition of the administrative costs otherwise created by differing reporting systems, the OECD has chosen a highly standardized approach in designing the CRS. Nonetheless, each signatory jurisdiction can make certain adjustments in its local legislation and system requirements, which has introduced some complexities in the actual implementation of the CRS.
As a result of the CRS, an additional wave of tax compliance is now sweeping the world, much as FATCA and the IRS's offshore initiatives have done for U.S. persons in recent years. The confluence of technology and tax legislation has reached new heights in the current decade, ushering in a new world order in the battle against global tax evasion, which seems to promise ever-greater transparency.
From Randall M. Cathell, CPA, Fort Lauderdale, Fla.
Treaty benefits on FDAP income derived by hybrid entities
The United States is a party to more than 60 income tax treaties with foreign jurisdictions. One of the primary purposes of an income tax treaty is to reduce or eliminate double taxation of income.
U.S. taxpayers are subject to U.S. federal income tax on their worldwide income regardless of whether the income is from the conduct of a trade or business or passive. Foreign taxpayers are subject to U.S. tax under two regimes: income that is effectively connected to a U.S. trade or business, or certain types of passive U.S.-source income considered fixed or determinable, annual or periodical (FDAP). Typically, this includes income from an activity in which the taxpayer does not materially participate, e.g., dividends, interest, rents, annuities, royalties, compensation for personal services, etc.
The Code and regulations impose a 30% gross-basis withholding tax on U.S.-source FDAP income paid to a foreign taxpayer. However, most U.S. income tax treaties reduce or eliminate this withholding tax. Many treaties also contain articles that limit benefits and further define and limit who qualifies for treaty benefits, preventing foreign income recipients from passing income through a country only for the purpose of gaining access to the treaty. Therefore, it is extremely important to analyze the applicable treaty prior to making a payment of U.S.-source FDAP income to a foreign person in a treaty jurisdiction to ensure the recipient qualifies for reduced or lower rates provided by the treaty.
This analysis is even more complicated when U.S.-source FDAP income is paid to a foreign hybrid entity. The purpose of this discussion is (1) to explain the treaty benefit limitations imposed by Sec. 894(c) on U.S.-source FDAP income with respect to hybrid entities, and (2) to provide an overview of procedural requirements of obtaining those treaty benefits.
The check-the-box regulations allow certain entities to elect to be taxed either as a corporation or as a partnership for U.S. tax purposes. Shortly after the check-the-box regulations were enacted, taxpayers began using hybrid entities--entities that are treated as fiscally transparent under U.S. laws and as fiscally nontransparent under the laws of an applicable treaty jurisdiction (or vice versa)--as a means of taking advantage of income tax treaty benefits. For example, if a payment of FDAP income was made to a Cayman Islands corporation, withholding tax would generally apply at a rate of 30% in the United States, since the United States does not have an income tax treaty with the Cayman Islands.
However, if the Cayman Islands corporation was owned by a French corporation, a check-the-box election could be filed in the United States to treat the Cayman Islands company as a fiscally transparent entity for U.S. purposes. As a result, the United States would look through to the French corporation as the beneficial owner of the income and would apply a lower withholding rate under the U.S.-France treaty. Due to the increase in the use of hybrid entities as a means of taking advantage of treaty benefits, the Taxpayer Relief Act of 1997, PL. 105-34, enacted Sec. 894(c) to limit the applicability of treaty benefits to hybrid entities.
The regulations under Sec. 894(c) provide that income tax treaty benefits are allowed on items of U.S.-source FDAP income to the extent that income is derived by a resident of a treaty jurisdiction. Accordingly, to determine the availability of treaty benefits, the first step is to ascertain whether the entity, the interest holder, or both are deriving the U.S.-source FDAP income (the "derived-by" requirement); the second step is to determine whether the entity or the interest holder deriving the U.S.-source FDAP income is a resident of an applicable treaty jurisdiction (the residency requirement).
The derived-by requirement
Regs. Sec. 1.894-l(d)(l) provides two scenarios to determine whether FDAP income is considered to be derived by an entity or by an interest holder: (1) The entity is not fiscally transparent in the jurisdiction where the entity is a resident; and (2) the entity is fiscally transparent in the jurisdiction in which the interest holder is a resident, and the interest holder is not fiscally transparent in the jurisdiction where the interest holder is a resident. Generally, an entity is considered to be fiscally transparent under the laws of the entity's jurisdiction to the extent the entity's interest holder is required to include in its current taxable income its share of the entity's items of income or loss, regardless of whether the entity made any distributions to the interest holder.
In the first scenario provided by Regs. Sec. 1.894-l(d)(l), an entity will be considered to have derived the U.S.-source FDAP income only if the entity is treated as fiscally nontransparent under the laws of the entity's jurisdiction. For example, when a French entity that is classified as a partnership for U.S. income tax purposes but as a corporation for French purposes receives U.S.-source FDAP income, the French entity is considered to have derived the FDAP income, since it is treated as fiscally nontransparent by France. As such, the entity would qualify for reduced withholding rates provided by the U.S.--France income tax treaty, provided all the other treaty requirements are satisfied, including residence, which is discussed below.
In the second scenario provided by Regs. Sec. 1.894-1(d)(1), an interest holder will be considered to have derived the FDAP income only if the entity is considered to be fiscally transparent under the laws of its interest holder's jurisdiction and the interest holder itself is not fiscally transparent under the laws of its jurisdiction. This treatment applies regardless of whether the entity is fiscally transparent under the laws of the entity's jurisdiction. The following examples illustrate this scenario.
Example 1: A German entity is a partial shareholder of a French entity. The United States is a party to income tax treaties with Germany and France. Both Germany and France treat the German entity as fiscally nontransparent and treat the French entity as fiscally transparent. The French entity receives U.S.-source FDAP income.
In Example 1, the German entity is considered to have derived the FDAP income because under the laws of Germany, the French entity is treated as fiscally transparent, while the German entity is treated as fiscally nontransparent. As a result, the German entity is entitled to treaty benefits under the U.S.--Germany treaty. However, if Germany treats the French entity as fiscally nontransparent, the German entity would not be eligible for treaty benefits. In this case, no treaty benefit would be available because neither the entity nor the interest holder is deemed to have derived the income.
Example 2: Assume the same facts as Example 1, except the French entity is treated as fiscally nontransparent under the laws of France but treated as fiscally transparent under the laws of Germany.
In Example 2, both the German entity and the French entity are treated as having derived the U.S.-source FDAP income. The French entity is considered to have derived the U.S.-source FDAP income because it is fiscally nontransparent under the laws of France. The German entity is also considered to have derived the U.S.-source FDAP income because Germany treats the French entity as fiscally transparent and the German entity itself is not fiscally transparent under the laws of Germany. In this scenario, a claim could be made under either the U.S.--Germany treaty or the U.S.--France treaty, assuming all other requirements are met under both treaties.
Conversely, Regs. Sec. 1.894-1(d)(2)(i) denies treaty benefits to a U.S. entity that is treated as fiscally nontransparent for U.S. income tax purposes but that is fiscally transparent under the laws of the interest holder's jurisdiction. Such an entity typically is referred to as a domestic reverse hybrid entity. For example, assume a U.S. entity with a French interest holder is treated as a partnership for French tax purposes but as a corporation for U.S. purposes. If the U.S. entity receives U.S.-source FDAP income, treaty benefits are not available. The rationale for this rule is that the United States retains taxing jurisdiction over items of U.S.-source income paid to its residents consistent with U.S. income tax treaty principles.
The residency requirement
The final step in establishing the availability of treaty benefits is to determine whether the entity or the interest holder deriving the U.S.-source FDAP income is a resident of an applicable treaty jurisdiction. If the entity itself is considered to have derived the FDAP income, the residency of the entity is considered in determining treaty application. However, if the entity is considered to be fiscally transparent under the laws of its jurisdiction, the residency of the entity's interest holders is considered in determining treaty application.
Complexities may arise where an entity's interest holders are residents of multiple jurisdictions, since the treaty analysis would need to be performed separately with respect to each interest holder. Consider the following:
Example 3: A French partnership has the following partners: a German corporation, a Brazilian corporation, and a U.S. corporation, and all three entities are treated as fiscally nontransparent and residents of their respective jurisdictions. All jurisdictions treat the French entity as fiscally transparent. Consequently, all three entities are treated as deriving their respective share of U.S.-source FDAP income.
In Example 3, only the German corporation is eligible for treaty benefits because only the German corporation is a resident of a treaty jurisdiction. The United States does not have a treaty with Brazil and, as such, the Brazilian corporation is subject to the full 30% withholding tax. The U.S. corporation is subject to current U.S. income tax on its share of the income, and withholding would not apply.
Overview of the procedures for obtaining treaty benefits
The 30% gross-basis withholding tax is withheld by the payer of U.S.-source FDAP income. Prior to receiving U.S.-source FDAP income, a foreign payee eligible for a reduced rate of withholding pursuant to the terms of an applicable income tax treaty must provide a valid Form W-8 (e.g., Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals); Form W-8BEN-E, Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities); Form W-8ECI, Certificate of Foreign Person's Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States; Form W-8EXP, Certificate of Foreign Government or Other Foreign Organization for United States Tax Withholding and Reporting, or Form W-8IMY, Certificate of Foreign Intermediary, Foreign Flow-Through Entity, or Certain U.S. Branches for United States Tax Withholding and Reporting) to the payer substantiating its residency and its basis for a reduced rate of withholding.
Form W-8BEN-E contains information necessary to ascertain the entity or the interest holder deriving the FDAP income and determining whether that entity or interest holder is a resident of an applicable treaty jurisdiction. Form W-8IMY must be filed when U.S.-source FDAP income is received by an entity or an interest holder on behalf of another person or as a flowthrough entity. When dealing with hybrid entities, determining the appropriate form to provide and how it should be completed can be especially complex. This is true for the foreign entity that must provide the form but often has very limited knowledge of U.S. tax rules, as well as for the U.S. payer, who has a due-diligence responsibility to determine whether the form is reliable and accurate but may have limited knowledge about the payee.
Example 4: A payment of U.S.-source FDAP income is made to a U.K. entity that has two owners, a U.K. corporation and a French corporation. For U.K. purposes, the U.K. entity and both the U.K. and French owners are treated as fiscally nontransparent. For French tax purposes, the U.K. entity is treated as fiscally transparent.
In Example 4, both the U.K. entity and the French owner are considered to have derived the income. Assuming the U.K. entity meets the requirements of the U.S.--U.K. treaty, it could provide a Form W-8BEN-E to the payer of the income to claim a reduced rate of withholding. However, for the portion of the income derived by the French interest holder, the French entity could make a claim for reduced rates under the U.S.--France income tax treaty, assuming it meets all of the other treaty requirements. In this case, the U.K. entity would provide a Form W-8IMY to the payer to indicate that it is an intermediary and would attach a Form W-8BEN-E from the French entity claiming reduced rates on the portion of income allocable to the French entity. Such a claim may be beneficial in a situation where the French treaty provides a lower rate of withholding than the U.K. treaty.
The payer of the income would use the Form W-8BEN-E provided by the U.K. to determine the withholding on the U.K. portion of the income and would use the Form W-8IMY with the attached Form W-8BEN-E to determine the withholding on the French interest holder's portion of the income. Thus, an entity could provide both a Form W-8BEN-E and a Form W-8IMY with respect to the same payment and claim reduced rates under two different treaties.
Carefully scrutinize treaty benefits
Although check-the-box regulations have simplified the tax classification rules, Sec. 894 has added an extra level of complexity with respect to hybrid entities, i.e., entities that are treated inconsistently by two taxing authorities. The general rationale behind the requirements imposed by Sec. 894 is to ensure that an item of U.S.-source income is taxed currendy either by the United States or by a foreign jurisdiction that is a party to an income tax treaty with the United States. As such, it is extremely important to analyze the applicable treaty prior to making a payment of U.S.-source income to a foreign person to ensure the recipient of the income qualifies for reduced withholding rates under the applicable treaty.
From Kristin N. Kranich, CPA, and Tara Nazifi, J.D., LL.M., San Francisco
Partners & Partnerships
How the death of a partner could affect a partnership's year end
When a partner in a partnership dies, tax practitioners usually have many tax items to think about, including information for the decedent's estate or a new trust for purposes of reporting activity on the partnership's Schedules K-l. Other examples of items typically considered are income allocations for the year of death such as closing of books or pro rata allocations and whether there is a tax opportunity for a Sec. 754 election or corresponding basis step-up.
However, an important tax implication that practitioners often overlook is the impact on a partnership's year end when a partner dies and the partner's estate adopts a fiscal year end. Furthermore, if the decedent's partnership interest was held in a revocable trust before death, and the trustee elects under Sec. 645 for the trust to be included in the estate with a fiscal year end, the partnership year end could be similarly affected.
Partnership tax years must follow a hierarchy of rules when determining the required tax year. Sec. 706(b) dictates the year end of the partnership, using the first day of the year as an annual measurement date. Partnerships must reevaluate their current fiscal year when a partner dies, since the estate may have a different year end than the individual partner. These rules could cause a change in the required partnership year end upon the death of a partner. Furthermore, a partnership tax return may inadvertently be filed late if the change to the year end is not discovered until after the short-year partnership return is due.
The partnership tax return is late: So what?
Assume a partnership has 40 partners. Due to the death of one partner, the partnership year end changes, and the tax practitioner does not realize this until after the short-period due date. As a result, the partnership tax return is filed six months late, without an extension.
Penalties: If a partnership return is not timely filed, the IRS assesses a $195 per month penalty on the partnership multiplied by the number of partners during the partnership's tax year. In this example, the partnership would owe $46,800 in penalties.
Elections: If the partnership desires to make an election under Sec. 754 to step up the basis of the partnership's assets to fair market value at the date of death under Sec. 743(b), an election must be made with a timely filed partnership return. If the partnership does not timely file its return, the opportunity for a basis step-up could be missed, which could prove costly to the partnership and its partners. (The possibility of Sec. 9100 relief in certain circumstances for late Sec. 754 elections is outside of the scope of this discussion, but tax professionals who have missed a deadline for making a Sec. 754 election should investigate it further.)
Other affected filings: Other filings could be negatively affected by a late-filed partnership return, which could be costly to the partnership. One example is Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. If a partnership is required to file this form, it is due with a timely filed partnership return. A late-filed Form 5471 results in substantial penalties, starting with $10,000 for each foreign corporation failing to file timely.
Partnership required year end: The three-tier test
Under Sec. 706(b)(1)(B), the partnership year end is determined as follows (unless a business purpose is established under Sec. 706(b)(1)(C) allowing a different year end):
* Majority interest: The partnership must adopt the tax year of the partner or partners who own more than 50% of the partnership's capital and profits.
* Principal partners: If no single partner, or combination of partners with the same year end, owns more than 50% of the capital and profits, the partnership must adopt the tax year of the principal partners (those owning 5% or more in either profits or capital).
* Least aggregate deferral: If there is no tax year determined under either of the first two tests, then the partnership must adopt the tax year that results in the least aggregate deferral of income, which is the tax year of one or more of the partners in the partnership that will result in the least aggregate deferral to the partners. The aggregate deferral for a particular year is equal to the sum of the products determined by multiplying the month(s) of deferral for each partner that would be generated by that year and each partner's interest in the partnership's profits.
In determining a majority interest, both capital and profits must be considered. However, for determination of the principal partner(s), the test looks at either capital or profits.
The consistency rule of Sec. 706(b)(4) is used for purposes of determining whether the ownership structure meets the majority-interest rule. This rule states that the test date is the first day of the partnership's tax year.
A special de minimis rule provides that if the tax year with the least aggregate deferral produces an aggregate deferral that is less than 0.5 months of the aggregate deferral of the partnership's existing tax year, the existing tax year will be treated as the tax year with the least aggregate deferral. Thus, no change in tax year is necessary or permitted.
If a partnership changes its tax year to comply with the majority-interest rule (because of any changes in the tax years of majority partners), no further change is required for the next two tax years, under Sec. 706(b)(4)(B). However, the partnership has the option to change again if there is another change in the majority interest (such as a distribution of the partnership interest from an estate to individual beneficiaries) before the next two years have passed.
Example 1: An individual partner dies in 2016, and the estate adopts a June 30 estate year end. The estate is the majority interest partner, so the partnership's required year end changes to June 30, 2017.
The partnership is not required to change its year end again for the next two years, even if there is another change to the majority interest year end. If the estate distributes the partnership interest in December 2017 to the individual beneficiary, the partnership has the option to change to a calendar year end for July 1 through Dec. 31, 2018, but it is not mandatory because of this consistency rule. The partnership has the option to retain the June 30 year end for two tax years following the year of change (which would be the years ending June 30, 2018, and June 30, 2019). The partnership would then have to change to a calendar year end for July 1, 2019, through Dec. 31, 2019.
Does the death of a partner cause a technical termination?
Although a partner's death terminates the partnership year for that partner, the partner's death does not automatically cause the closing of the partnership's tax year for the other partners.
Under Sec. 708(b), a partnership shall be considered as terminated if 50% or more of the capital and profits interests are sold or exchanged within a 12-month period; the partnership ceases doing business; or the partnership ceases to have at least two partners. A partner's death and associated transfer to his or her estate is not treated as a sale or exchange for these purposes. Similarly, the transfer of the partnership interest from a living revocable trust to a post-death trust is not a sale or exchange for Sec. 708(b)(1)(B) purposes. Furthermore, even for a partnership with only two partners, one partner's death does not terminate the partnership because his or her estate or other successor in interest immediately becomes a partner for tax purposes.
Certain transfers of the partnership interest after death may cause the partnership to terminate, however.
For example, if a partner's interest in a partnership is transferred to the decedent's heirs to satisfy a pecuniary bequest, this may cause the partnership to technically terminate because, under Sec. 761(e), the distribution of a partnership interest is treated as a sale or exchange of the interest under Sec. 708.
Estate year end
All trusts (other than charitable trusts) must use a calendar year. The executor of an estate is free to select any fiscal year; however, the year must end on the last day of a month and cannot have more than 12 months. By carefully selecting a fiscal year, it is possible to equalize the income tax rates during the various fiscal years or to defer income so it is taxed in a beneficiary's subsequent year.
Under Sec. 645, the executor (if any) of an estate and the trustee of a qualified revocable trust may elect for the trust to be treated and taxed as part of the estate and not as a separate trust. This allows the income and expenses from the trust to be reported by the estate on a combined Form 1041, U.S. Income Tax Return for Estates and Trusts. A qualified revocable trust (QRT) means any trust (or portion thereof) that was treated under Sec. 676 as owned by the decedent, including a revocable trust. Once the Sec. 645 election is made, it is irrevocable under Regs. Sec. 1.645-1(e)(1). As a result of the Sec. 645 election, the trust has the same year end as the estate.
Examples: Majority-interest rule
The following examples illustrate the determination of a partnership's tax year in the year after the death of an individual majority interest holder in three scenarios.
Example 2: Partnership interest owned individually: FLP Investments LLC (FLP) is a family limited partnership owned by individuals and thus has a calendar year end. Grandpa (G) owns 60% of FLP; his children and grandchildren own the remaining units. Because on Jan. 1, 2016, G is the majority interest partner, FLP's 2016 year end is Dec. 31, 2016. Upon G's death in July 2016, the executor of his estate selected a June 30 year end.
On Jan. 1, 2017, G's estate, the majority partner in FLP, has a year end of June 30, and thus the required year end of FLP changes to June 30. FLP would file a short-year return from Jan. 1 through June 30, 2017. The next year is July 1, 2017, through June 30, 2018.
Example 3: Partnership interest owned via revocable trust that does not make a Sec. 645 election with estate: Assume the same facts as in Example 2, except G owns 60% of FLP via his revocable trust instead of individually. The trustee of G's revocable trust (G Rev Trust) elects not to make a Sec. 645 election with G's estate; therefore, the trust files its own return on a calendar year, and the estate would file its own return using the estate's elected June 30 year end.
On Jan 1.2017, because G RevTrust, the majority partner in FLP, continues to have a year end of Dec. 31, FLP will continue to file on a calendar year.
Example 4: Partnership interest owned via revocable trust that makes a Sec. 645 election with estate: Assume the same facts as in Example 2, except G owns 60% of FLP via his revocable trust, but upon G's death in July 2016, the executor of his estate and the trustee of his trust made a Sec. 645 election. Therefore, the combined entity files using the estate's June 30 year end.
The result in Example 4 will be the same as Example 2 in which G owned the partnership interest individually. On Jan. 1, 2017, G Rev Trust, the majority partner in FLP, has a year end of June 30, and thus the required year end of FLP changes to June 30. FLP files a short-year return from Jan. 1, 2017, through June 30, 2017. The next year is July 1, 2017, through June 30, 2018.
Neither G's death nor G's estate and trust making a Sec. 645 election is considered a termination of the partnership since the decedent's estate or revocable trust immediately becomes the partner for tax purposes (Regs. Sec. 1.708-l(b)(l)(i)).
If the partnership year changes, the short-period partnership tax return will only report income during the applicable time period (Jan. 1-June 30) and must not annualize (Regs. Sec. 1.706-l(b) (8)(i)(B)). Thus, the individual partners will be deferring six months' worth of partnership income beginning with their 2017 individual returns but eventually will report a year and a half of income when the partnership reverts to a Dec. 31 year end (following the closing of the estate). The revocable trust will report a year and a half of partnership income on its June 30, 2017, Form 1041 (including 2016 income).
When a partner dies, tax advisers must remember to consider the partner's ownership as it could cause a mandatory year-end change for the partnership. Important issues that must be settled include:
* Confirming whether the partnership interest is held by an individual or grantor trust prior to death (since in both cases the partnership's Schedule K-1 may report the individual as the owner);
* If the interest is held by an individual, asking the executor of the estate what the estate is electing as its fiscal year; or
* If the interest is held by a revocable trust, asking the trustee if he or she will be filing a Sec. 645 election to combine the estate and trust. If yes, determine what fiscal year the trustee will elect.
This is an example of a situation where proactive and solid communication between accountants, estate attorneys, and the executor of the estate is extremely important to avoid costly tax compliance errors.
From Sarah Allen-Anthony, CPA, South Bend, Ind., and Alexandria Hartig, CPA, Tampa, Fla.
Sales-and-use-tax pitfalls in the construction and real estate industries
Being aware of the taxability of the various expenditures associated with a construction project or the management of a building is crucial in preventing a hefty use tax assessment with penalties and interest as is managing the relationship a real estate or construction company has with its vendors and subcontractors. This discussion examines the most common sales-and-use-tax problems that arise for the construction and real estate industries and the preventive measures that companies can take to avoid these issues or handle them in an audit.
Sales and use tax is imposed in all states except Alaska, Delaware, Montana, New Hampshire, and Oregon, and in a few limited cases, transaction-based taxes are imposed in those states as well (e.g., local sales tax in Alaska and hotel room tax in Delaware). In the construction and real estate industries, sales-and-use-tax issues arise every day, whether it is new construction, the renovation or expansion of an existing property, or the ongoing operation of a property or complex.
Companies often deal with hundreds of vendors and subcontractors, many of whom are small businesses that do not always properly identify what they have sold or charge sales tax when they are required to (or do a poor job of indicating they have charged it). Additionally, companies that manage or own new real estate projects may mistakenly believe the contractor will pay the tax when, in fact, the project is actually a repair or maintenance that requires the building owner to pay the sales tax.
How sales tax should be charged and paid in an ideal world
Depending on whether a project is new construction, a capital improvement, a renovation, or ordinary repairs, or the type of work being charged for, sales or use tax has to be paid on most tangible personal property and some services. Exactly who pays the tax and when they pay it depends on the situation.
New construction and capital improvements
In the case of new construction or capital improvements made to real estate, the construction company is generally responsible for paying sales tax on the materials and taxable services used to complete the project. A construction company must collect and remit sales tax on any materials or services in a capital improvement on which the company charges a markup to its customer as well.
Arizona, Hawaii, Mississippi, Nebraska, and New Mexico follow different rules and do not automatically impose tax on the full amounts paid by contractors for taxable materials and services for new buildings and capital improvements; these states may either impose sales tax at special wholesale rates on part of the contract proceeds or give the contractor the option to charge and remit sales tax from its customers.
Repairs and maintenance: In the case of repairs and maintenance, contractors may purchase the materials or services without paying sales taxes under a resale exemption, bill customers for the items, charge sales tax on the invoice, and then remit the sales tax to the state. The sales tax must be a separately identified charge on the invoices; any invoice that says "sales tax included" will have sales tax assessed on the full amount in the event that the contractor or its customer is audited.
Self-assessed use tax: In the event that sales tax should have been charged on an invoice for a repair- or maintenance-related expense or for a taxable item purchased during new construction or capital improvement (e.g., new furniture) but was not, the purchaser should self-assess use tax and pay the state on its own. This often occurs when an out-of-state vendor without a physical presence in the state ships tangible property to the customer, or when vendors do not realize they were required to charge sales tax. In most states, taxable purchases for repairs or maintenance that were not taxed at the time of purchase are self-reported on a monthly, quarterly, or annual sales tax return as "taxable purchases."
As a practical matter, some in-state vendors and contractors may not always collect and remit sales tax from their customers when they are required to do so because they do not want to bother with the added work associated with collecting the sales tax from their customers and remitting it to their state and then filing sales tax returns. Additionally, some vendors or contractors may deliberately omit sales tax charges from their bids on a project when they are competing against other contractors. The fact that the contractor or vendor was required to comply with state sales tax laws and did not do so does not absolve the buyer of the taxable property or services from paying use tax on a taxable purchase. Furthermore, the buyer can be assessed penalties and interest on any use tax that the buyer was required to pay that it did not self-assess.
Of course, it is not always clear when a construction- or real estate-related purchase is taxable at the time of purchase or sale (or at all), given that some areas of construction and work performed on existing real estate lie in a gray area as to whether they are to be considered repairs and maintenance or capital improvements. Additionally, not all states tax the labor charges associated with repairs and maintenance, provided these charges are itemized separately on invoices--something many contractors and vendors fail to do.
Construction- and real estate-related activity not easily categorized as taxable or nontaxable
A good (but not absolute) rule of thumb is if the physical property in question cannot be removed without causing damage to the structure, it is a capital improvement. While some types of work, such as the installation of a new elevator or a new overhead lighting system, are fairly obviously classified as capital improvements, some types of work are subject to frequent disputes over taxability. Model and uniform state tax laws do not have a definition for capital improvement, and the Streamlined Sales and Use Tax Agreement does not address the definition either, but most states have an established definition for capital improvement.
New York Comp. Codes R. & Regs. Tide 20, Section 541.2(g)(1), for example, defines a capital improvement as an addition or alteration to real property that (1) substantially adds to the real property's value or appreciably prolongs its useful life; (2) becomes a part of or is permanently affixed to the real property so that it cannot be removed without causing damage; and (3) is intended to become a permanent installation.
Ohio refers to a capital improvement as "a permanent addition, enlargement, or alteration that, had it been constructed at the same time as the building or structure, would have been considered a part of the building or structure" under Ohio Rev. Code Section 5701.02(D).
Painting: Painting buildings, inside or out, is not always regarded as a simple repair or maintenance activity. Painting new structures, buildings, or additions typically is regarded as a capital improvement, while the painting of existing structures, buildings, or additions is usually identified as routine maintenance. However, for painting done in conjunction with an extensive renovation, an argument can be made either way. If the painting is directly incorporated into the renovation and regarded as an important part of it, then it can be considered a capital improvement. Painting done at the end of a renovation as a sort of cleanup measure, on the other hand, usually is considered taxable maintenance.
Floor covering: Carpet, carpet tile, carpet padding, linoleum and vinyl roll floor covering, linoleum tile, vinyl tile, and other similar items fit the definition of floor covering. When installing floor covering as part of a complete rehabilitation or renovation of a building, the sale of the covering and installation charges generally are regarded as a nontaxable capital improvement. New floors that are installed to permanently cover the subfloor (e.g., board, plywood, concrete, etc.) also are usually considered nontaxable capital improvements. A new floor can be intended to permanently cover the subfloor when it is installed under a variety of different materials and methods (e.g., wall-to-wall carpeting installed with tackless strips, vinyl or linoleum tiles installed with peel-and-stick glue backing, laminate floors installed with planks that lock or glue together, etc.). When replacing part or all of an existing worn floor covering when no major renovation is occurring, the sale and installation can be treated as a taxable repair. Some states also treat the installation of floor covering on walls or ceilings as a nontaxable capital improvement.
Software: Building security systems, electronic management programs, and on-site machines (e.g., ATMs and laundry card dispensers) are considered capital improvements, and all use software to run efficiently and correctly. Generally, the upfront cost of software that is not customized but is part of a capital improvement needs to be separately stated and include charges for sales tax. The same is true for ongoing upgrades and support and maintenance charges. Software that is fully customized for its users generally is treated more like a service and is not taxable in most states.
Reception desks: Building lobbies often have a reception or security desk. While a desk is often thought of as a piece of easily removed furniture and might appear to be taxable personal property, some desks are built into the floor and are intended to be "permanently affixed" to the building structure. Auditors often mistakenly overlook that fact and try to assess tax on the cost of the desk. A desk is considered "permanently affixed" and a nontaxable capital improvement if its removal could damage the floor and if the desk cannot be easily reused elsewhere. This does not mean that a reception desk that is simply bolted to the floor automatically qualifies as a nontaxable capital improvement, as desks are sometimes fastened to the floor for safety reasons and still can be removed with little or no damage and reused elsewhere when necessary.
Taxable items purchased as part of a nontaxable capital improvement: Sometimes, during the course of a capital improvement, a buyer purchases taxable items at the same time as it purchase items for the capital improvement. Although the work done and items used for the capital improvement are not taxable to the purchaser of the improvement, the items purchased along with the capital improvement as part of the job are taxable. For example, a company might be contracted to fully renovate a building lobby by replacing the floors and walls, which are nontaxable capital improvements. The same company might also sell the building owners new furniture for the lobby as part of the contract, and those sales are taxable. Either the building owner must be charged tax on the furniture with the contractor remitting the tax to the state, or the building owner must self-assess the tax and pay it separately.
Work for exempt entities
Contractors and vendors doing projects for not-for-profits, government agencies, and other tax-exempt entities also can face a number of tricky situations related to sales tax. Contractors that perform repair and maintenance work for, or vendors who sell tangible personal property to, tax-exempt entities might not need to charge sales tax on their invoices. However, the contractor should clearly indicate on its invoices that the customer is an exempt entity and retain a copy of the entity's exemption certificate that is readily available for production in the event of an audit. Furthermore, exempt entities that have repair or maintenance work done on facilities that produce unrelated business income for them (e.g., work done at a gift shop or cafeteria in a not-for-profit hospital) are required to pay sales tax on this work in most states.
Contractors doing construction and capital improvements for exempt entities usually pay tax on the materials they buy to do the work, but in some states, they may purchase the materials tax-free "on behalf of "the exempt entities by showing the exemption certificate to the vendors from whom they purchased the materials. Other states will allow the contractor to use the exemption by acting as an agent for the exempt entity, by either ordering the materials and billing the cost directly to the exempt entity or ordering as the exempt entity's agent with title to the materials passing direcdy to the entity at the time of purchase.
Avoiding problems during an audit
Any time a building undergoes a major renovation, addition, or large-scale repairs, auditors will seize the opportunity to perform a full-scale sales-and-use-tax audit in an attempt to assess sales or use tax that should have been paid. If a taxing authority is auditing a construction company, it is important that invoices are well-organized, sales tax payments are well-documented, and the work or items paid for are adequately itemized and described.
The following issues frequently arise in such audits:
Inaccurate descriptions of work done: The terminology used in an invoice is key to an auditor's determination whether to assess tax. If an auditor sees words such as "clean," "maintain," or "repair" on an invoice with no sales tax charged, the work instandy is a target for additional tax to be assessed. Words such as "install," "retrofit," "update," or "rebuild" are probably less likely targets. It is important that contractors and vendors accurately describe the work performed in the invoice and charge sales tax when appropriate.
Lack of clarity on work done and tax charged: Invoices that come from smaller construction and real estate contractors and vendors that do their own billing are a common problem as they typically poorly describe the work done and fail to clearly indicate whether any sales tax was charged. When auditors cannot determine what the charges on the invoices are for and whether sales tax was charged, they often automatically assume a taxable item or service was sold and no sales tax was charged. This will result in an assessment of sales taxes against the contractor.
If the amount of tax being assessed on an invoice is large enough to dispute, the construction or real estate company should require a subcontractor or vendors to make clear descriptions of what was sold and the sales tax charged, if any. Subcontractors and vendors can be motivated to improve the appearance of their invoices if they understand that it will be beneficial to them in case of an audit.
Inadequate breakdown of different work items: While many contractors and vendors have invoices that are legible with the sales tax broken out, they might mistakenly combine taxable and nontaxable items on an invoice. For example, a contractor might charge a single price for the nontaxable sale and installation charges of an on-site ATM along with the taxable upfront cost of the software required to run it. This could result in the appearance of an invoice that has undercharged sales tax, and as a result, most state auditors will assume the entire amount is taxable and assess tax on the balance. To avoid paying the added tax, the purchaser should require its vendors and contractors to itemize each taxable and nontaxable charge on the invoice from the outset. Having an itemized invoice will negate the need to rush to obtain a revised and itemized invoice during an audit.
"Sales tax included": It also is crucial that contractors and vendors be instructed to specifically separate sales tax as a line item on every invoice where sales tax would apply. Any invoice with the words "sales tax included" is an instant red flag for auditors, and they will assess sales tax automatically on the full amount of charges on the invoice. A buyer should immediately return any invoice that includes this phrase to the contractor with a request that it list the sales tax charge separately. The contractor also stands to benefit from correcting the invoice if it is audited for sales tax in the future.
Implementing strict controls on payment and billing practices
Construction companies and their subcontractors, vendors, and real estate customers alike need to be as proactive as possible with billing and payment practices to minimize audit exposure. Failure to do so is a common problem in these industries and can result in a large sales tax assessment, which will be difficult to defend without the intensive task of contacting each vendor and subcontractor to obtain the necessary detail associated with the work done.
Extreme clarity about the nature of the work being performed (particularly in areas where the nature of work being done could be construed as either a repair or a capital improvement), itemizing taxable and nontaxable work, obtaining exemption certificates from exempt customers ahead of time, and separating out sales tax as its own line item on an invoice are all essential to complying with sales-and-use-tax laws and with reducing the possibility of substantial tax, penalties, and interest in an audit. All of these practices result in a smoother operation for the construction and real estate industry, a common target of state sales tax auditors because of the inevitable amount of additional taxes collected.
From Chris A. Johnson, J.D., Oak Brook, III.
State & Local Taxes
State tax considerations for foreign companies with inbound U.S. investments
Most U.S.-based taxpayers are aware that the United States has many state and local taxing jurisdictions. Not only are these taxes imposed at different levels of government (state, county, and city) and special taxing districts, the types of taxes imposed by these jurisdictions are exceedingly diverse (e.g., income, net worth, sales and use, gross receipts, property). As most other countries approach tax administration from a federal or national level, non-U.S. taxpayers generally are surprised by the degree of complexity involved in complying with the U.S. state and local tax regimes.
From a U.S. inbound perspective, most foreign companies rely on bilateral tax treaties for guidance on the federal tax consequences of their U.S. activities. Under most tax treaties, foreign companies are subject to federal tax if their U.S. business activities rise to the level of a "permanent establishment." However, there is a distinction between the standards for federal treaty protection for foreign companies and the standards for state tax nexus that subject a foreign company to tax in a particular state. Understanding the difference between these standards is crucial for foreign companies in managing their state tax risks and liabilities. This distinction is further complicated by the lack of uniformity and guidance provided by states in how treaty-protected foreign companies should be taxed.
Generally, the first step in this type of analysis is to determine whether a state can impose a tax measured by income, gross receipts, or net worth on a foreign company that has no permanent establishment and is otherwise exempt by treaty from federal tax. An inquiry of this nature usually consists of two components: (1) whether the foreign company has sufficient in-state contacts to be subject to a state income, gross-receipts, or net-worth tax; and (2) whether the company would incur a tax liability if it were subject to tax.
Doing business and nexus
Generally, a foreign company's state tax filing obligations depend on whether the company is doing business or has nexus in the state or local jurisdiction imposing the tax. The determination of what constitutes doing business is generally based on the U.S. Constitution's Due Process and Commerce Clauses, which require a sufficient connection or nexus with the taxing state.
Traditionally, nexus required some physical presence in the state (see Quill Corp. v. North Dakota, 504 U.S. 298 (1992)). However, the current trend has many states taking a more expansive view of nexu.s. Commonly referred to as economic nexus, this standard is moving beyond the traditional view of nexus toward a standard in which physical presence is not required as long as there is an economic connection to the state. Under this expanded approach, a foreign company that derives royalties from the licensing of intangible property from a customer in a state that has adopted market-sourcing rules would be taxable in that state, regardless of whether the licensor is physically present in the state.
For instance, a Washington state ruling held a German pharmaceutical company had economic nexus in the state due to its receipt of royalties paid when its products were sold in Washington, even though the business had no physical presence in the state. The ruling also determined that a tax treaty between the United States and Germany implicitly permits states to tax royalties (Wash. Dep't of Rev, App. Div., Det. No. 15-0251, 35 WTD 230 (decided 9/11/15, published 5/31/16)).
For companies performing service activities, states have been fairly consistent in ruling that out-of-state companies should not be able to avoid imposition of state taxes by contracting with in-state third parties to conduct company business instead of sending in company employees. When the instate party performs service activities, its classification as an independent contractor, representative, or agent usually has little consequence on the nexus determination. Under these interpretations, a foreign company using an independent contractor to perform in-state services will be viewed as doing business and having a tax reporting responsibility in most states.
Foreign companies that engage only in sales solicitation of tangible personal property encounter the issue of whether a state will extend the protection afforded under the Interstate Income Tax Act, P.L. 86-272, to non-U.S. entities. P.L. 86-272 prohibits the imposition of state income-based taxes against businesses when their activities are limited to the solicitation of sales of tangible personal property and they fulfill the orders from a location outside of the state. Foreign commerce is not mentioned. As a result, it is generally understood that P.L. 86-272 applies only to interstate commerce.
Nevertheless, states can apply P.L. 86-272 protection by policy or regulation to foreign commerce in the same manner as applied to interstate commerce. Responses to the Bloomberg BNA "2017 Survey of State Tax Departments" indicated that 28 states apply P.L. 86-272 protection to foreign commerce. Responses from 12 states indicated that they do not extend those protections.
Federal tax rules apply a different nexus standard to treaty-protected foreign companies. The United States has bilateral income tax treaties that contain a permanent establishment provision, under which the business profits of a foreign corporation are exempt from federal income tax to the extent that its business activities do not rise to the level of a permanent establishment. U.S. treaty provisions do not apply for state tax purposes; there is some likelihood that a foreign company could have nexus for state tax purposes given the difference between the two standards.
State corporate income tax
State income tax calculations generally adopt federal taxable income as a starting point for determining state taxable income and the corresponding tax liability. Sec. 894 provides an exclusion from income for foreign businesses entitled to treaty benefits. Absent any state modification that specifically disallows the Sec. 894 exemption, federal taxable income will drive the calculation of state taxable income. Because a treaty-protected foreign company will have zero federal taxable income, its state tax computation will likely begin with zero.
In contrast to the previous example, where the state begins with federal taxable income, some states require businesses to compute state taxable income on a pro forma basis "as if" the company had taxable income under the Code. (According to the Bloomberg BNA "2017 Survey of State Tax Departments," responses from 15 states indicated that they do not permit the federal tax treaty exemption for state tax purposes.) In this instance, the foreign company could have state income tax liabilities even though it has no federal taxable income. Furthermore, some states (e.g., California, New Jersey, New York, and Oregon) have enacted laws that would add back a foreign corporation's business income that is "effectively connected" income, regardless of whether it is excluded under an applicable tax treaty.
To the extent that a foreign corporation is subject to state tax, it will need to complete a pro forma federal tax return to prepare state tax returns. Most states would expect a pro forma federal tax return, Form 1120F, U.S. Income Tax Return of a Foreign Corporation, which is based on amounts attributable to U.S. activities. But there are exceptions to this rule, and a state may request pro forma federal returns on a worldwide basis.
Non-U.S. businesses should be aware that it is possible for inbound companies without a federal income tax liability to nonetheless have state income tax filing responsibilities and concomitant liabilities.
A few states have enacted taxes measured by gross receipts or modified gross receipts to replace traditional income taxes. For example, Texas imposes a franchise tax commonly referred to as the Texas Margin Tax. Under this tax methodology, companies are subject to tax on Texas modified gross receipts, which are gross receipts modified by one of four options: (1) cost of goods sold; (2) compensation expense; (3) $1 million; or (4) a 30%-of-gross-receipts deduction.
Similarly, Ohio enacted the Commercial Activity Tax, a gross-receipts tax based on Ohio-situs gross receipts. Also included in this category would be the Washington state business and occupation tax, a business privilege tax measured by Washington-situs sales.
To the extent that a foreign company has Washington or Ohio sales, the economic nexus standard is taken to a new level through the use of a bright-line test. Under this method, a company would have a filing requirement if annual sales exceed a certain threshold. Lastly, the protections under P.L. 86-272 do not apply to gross-receipts taxes.
Nearly half of U.S. states impose a franchise tax based on the company's apportioned net worth. The tax is reported using several scenarios: (1) The net-worth tax is reported on the income tax return and is a component of total tax due; (2) the net-worth tax is reported on the income tax return but is assessed only if the net-worth tax is greater than the income tax; or (3) a separate return is used to report and remit the tax, either to that state's department of revenue or to that state's secretary of state.
Net-worth taxes are measured by amounts reported on the taxpayer's balance sheet. No clear guidance exists regarding whether the balance sheet should be based on a U.S. balance sheet as reported on a Form 1120F or on worldwide amounts. Most states offer little to no guidance on this topic. As with gross-receipts taxes, P.L. 86-272 protection does not apply to net-worth taxes.
Sales and use taxes
Most non-U.S. businesses are familiar with value-added taxes (VAT). VAT is a tax on each transfer of property along with a credit for previous transfers of that same property. Sales and use taxes are imposed only on the end user and are typically imposed at higher rates. Forty-six states impose a sales tax. Furthermore, many county, city, and special taxing jurisdictions also impose sales tax. There are more than 9,000 sales tax jurisdictions in the United States. Generally, sales taxes are imposed on each legal entity, regardless of whether it is separately regarded for income tax purposes. Again, sales taxes do not fall under the P.L. 86-272 protection, and they typically are not protected by income tax treaties.
State-based expertise recommended
In terms of both tax types and jurisdictions, U.S. state and local tax complexity can present traps for unwary foreign businesses with U.S. inbound investment or operations. Thus, any significantly large U.S. inbound companies should consult with U.S.-based state practitioners.
From Daniel P. Sieburg, CPA, and Donald R. Dennis, CPA, Chicago.
Howard Wagner, CPA
Howard Wagner is a director with Crowe Horwath LLP in Louisville, Ky.