If a non-U.S. corporation is selling product to customers in the U.S. or is rendering services in the U.S., there is a strong possibility that it would be considered to be conducting a U.S. trade or business; and the profits derived from such transactions could be subject to U.S. federal corporate income tax under U.S. domestic tax law. However, the income tax treaties that the U.S. maintains with many countries provide that the U.S. can only tax such income if the foreign corporation has a “permanent establishment” (PE) in the U.S.; i.e., some sort of fixed physical location or continual physical presence. So, for non-U.S. corporations that are qualified residents of a country that has an income tax treaty with the U.S., and that does not have a permanent establishment in the U.S., invoking such treaty can provide a path to avoid U.S. federal corporate income tax on any income that is “effectively connected with a U.S. trade or business.”[1]
In order to apply the benefits of a tax treaty and override U.S. domestic law so to avoid U.S. federal corporate income tax on U.S. source trade or business income due to the lack of a PE, Internal Revenue Code §6114 requires that the foreign corporation file a U.S. corporate income tax return and disclose the treaty position. The applicable form that must be filed with the IRS is Form 1120-F, “U.S. Income Tax Return of a Foreign Corporation” with the treaty-position attached. While the Form 1120-F is generally due to be filed on the 15th day of the fourth month following the conclusion of the corporation’s tax year, if no office or place of business is maintained in the U.S., the due date is the 15th day of the sixth month following year-end. Failure to file a return and adequately disclose the treaty position can result in a $10,000 penalty being assessed.
If the penalty isn’t bad enough, Internal Revenue Code §882(c)(2) provides that in order to deduct expenses against U.S. source income, the foreign corporation must file a U.S. corporate income tax return. Expanding on this, the U.S. Treasury and the Internal Revenue Service have promulgated Reg. §1.882-4(a)(3) that requires that such return be filed timely in accordance with the normal due dates, but in no event later than 18 months after the original due date of the return in order to sustain the deductibility of expenses. While the U.S. courts have split on the validity of this regulation, the Internal Revenue Service has continued to abide by it.
U.S. cross-border tax practitioners generally advise their in-bound corporate clients that are residents of a country that has an income tax treaty with the U.S. to file U.S. “treaty-based” returns if they don’t have a PE in the U.S. This not only complies with U.S. tax law, but also starts the running of the “statute of limitations” for assessment of any tax by the IRS; generally, the statute period is three years from the date of filing the U.S. return. Some companies choose not to as, in order to comply with the requirements, a U.S. taxpayer identification number, referred to as the Employer Identification Number, or EIN, has to be obtained. They often express concern that in so doing, they would be on the “radar screen” for the Internal Revenue Service and would have a greater chance of being subject to audit. Besides, if they didn’t have a PE and wouldn’t be subject to U.S. corporate income tax, they could make that point if they were ever contacted, right? This latest case underscores the riskiness of this approach.
Adams Challenge (UK) Ltd v. Commissioner (Dkt. No. 4816-15, Jan. 21, 2021) involved a UK corporation whose primary asset, being a “multipurpose support vessel,” was utilized in the period 2009 to 2011 in the decommissioning of oil & gas wells and removing debris from the U.S. outer continental shelf in the Gulf of Mexico. In so doing, it generated revenue of approximately $45 million. Believing it did not have a PE in the U.S., the UK corporation did not file a U.S. corporate income tax return for 2009 and 2010 but did file a “treaty-based” protective return for 2011 in 2013. The Internal Revenue Service identified Adams Challenge (UK) Ltd. (“Adams”) as a potential non-filer, and in 2014, using available information as to the time the vessel spent in the coastal waters, prepared and subscribed returns for Adams and issued a notice of deficiency, in which the Service disallowed deductions and credits for 2009 and 2010. Adams filed a petition with the U.S. Tax Court in 2015 challenging the IRS’s disallowance of deductions but did not file protective “treaty-based” U.S. corporate income tax returns for those years until 2017.
On January 8, 2020, the Tax Court found that Adams, indeed, did have a PE in the U.S. for 2009 – 2011 and, as a result, was subject to U.S. corporate income taxation on the income that was effectively connected with the conduct of the trade or business by the vessel while in such PE. Adams then argued that the disallowance of the deductions and credits by the IRS in the 2009 and 2010 tax years should not be sustained because the filing deadline under Reg. §1.882-4(a)(3) lacked statutory basis. It further argued that:
(i) Under the “business profits” Article 7 of the U.S.-UK Tax treaty, corporations are entitled to the deduction of expenses; and
(ii) Disallowance of the deductions was inconsistent with the “nondiscrimination provisions” of Article 25 of the U.S.-UK Tax treaty.[2]
On these points, the Tax Court completely sided with the Internal Revenue Service and upheld its denial of the deductions.
In its ruling, the Court side-stepped the issue of the validity of Reg. §1.882-4(a)(3) by indicating that Adams had lost its right to claim deductions even under law that existed prior to the promulgation of the disputed regulation (which was in 1990). Under that law, a foreign corporation is not required to file a “timely” return to preserve its entitlement to deductions and credits; but it is required to file a return by a “terminal date.” Such “terminal date,” according to the Court, is the date on which the Internal Revenue Service exercises its authority under Internal Revenue Code §6020(b) to prepare and subscribe returns on behalf of a delinquent taxpayer. The Service prepared and subscribed returns for Adams for 2009 and 2010 in 2014, three years before Adams attempted to submit “treaty-based protective returns” for these tax periods. In this regard, the Tax Court found that Adams acted too late.
In the most significant part of its ruling, the Court then squarely addressed the two Treaty issues raised by Adams. The court first found no conflict with the statement in Article 7, paragraph 3 of the U.S.-UK Treaty that deductions “shall be allowed” to a UK corporation engaged in a U.S. trade or business, because “this phrase typically means ‘shall be allowed so long as certain conditions are met.” The Court concluded that:
“. . . section 882(c)(2) simply specifies the administrative steps that a UK taxpayer must take in order to report (and ultimately obtain) such deductions: It must (1) file a U.S. tax return and (2) file that return before the IRS prepares a return for it. These administrative requirements are not “absolutely incompatible” with the business profits article of the Treaty. We accordingly conclude that the statute and the Treaty can ‘be read harmoniously, to give effect to each.’ ”
Turning to the nondiscrimination clauses, the Court found that the requirement to file a U.S. tax return to preserve deductions did not discriminate against UK corporations as such requirement is not “more burdensome” than the filing requirements placed on U.S. corporations, and given the elongated filing deadlines, in some cases more lenient than the due dates imposed on U.S. corporations. Further, the Court rejected Adams’ assertion that the requirement to file returns for 2009 and 2010 violated Article 25, paragraph 2, which provides that U.S. taxes should not be “less favorably levied” on UK corporations than on U.S. corporations. While, by denying deductions, Adams was effectively being taxed on its gross income for 2009 and 2010, the Court reasoned that it was completely within the UK corporation’s control whether it would be taxed on gross or net income for those two years, as it was for 2011, a year for which Adams had ‘timely’ filed a return. Adams simply had to follow the U.S. administrative requirements with respect to how its deductions needed to be claimed for 2009.
It is unknown at this point whether Adams will appeal the Tax Court’s ruling. But if they do, given the Tax Court’s reasoning, it is certainly questionable whether such an appeal would be successful.
The Court’s decision does clearly provide a warning to all foreign corporations that may be conducting a trade or business in the United States; if they are a resident of a country that has an income tax treaty with the U.S., they would be well served to timely file protective treaty-based U.S. corporate income tax returns to invoke the benefits of such treaty. In so doing they would not only be complying with U.S. tax law requirements and avoiding a potential penalty, they would also take the issue of denial of deductions against U.S. income off the table. The relatively minor amount of time and expense to prepare and file such returns could be cheap insurance.
For more information on this topic, please contact James Frank, CPA, Partner, at Tronconi Segarra & Associates. He can be reached at jfrank@tsapa.com or (716) 633-1373. www.tsacpa.com
