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By Edward Tanenbaum, Esq.
Alston & Bird LLP, New York, NY
I've had occasion to discuss the tax consequences of consignments in the context of "permanent establishments" any number of times over the past year with both tax colleagues and clients alike, and I sense a little confusion in the area. So, although consignments are not new, I thought that it might make sense to review some of the basics.
The problem is that consignment sales involve aspects of both a "buy-sell" arrangement and an "agency" relationship. They are a little bit like fish and a little bit like fowl. In the cross-border context, the tax consequences of these arrangements can be significant but if properly structured and managed correctly, consignment arrangements can prevent a foreign manufacturer from having a U.S. permanent establishment.
Let's say a foreign manufacturer (assume resident in a country that maintains an income tax treaty with the United States) wishes to sell goods from that foreign country to a U.S. distributor in a classic "buy-sell" arrangement. Typically, such sales should not rise to the level of a U.S. trade or business and would certainly, alone, not involve a permanent establishment. This is the cleanest tax position from the foreign manufacturer's perspective.
However, the distributor may not want to "advance" funds to the manufacturer prior to the distributor locating its own customers and getting paid on its sales of the merchandise. This will often be the case when dealing with expensive products or with products that take a long time to sell. So, the manufacturer and distributor will often agree that the manufacturer will "consign" the goods to the U.S. distributor, with the manufacturer storing or warehousing the inventory either on the premises of the distributor or in a third-party warehouse in the United States. Title to the merchandise remains at all times with the foreign manufacturer. The parties further agree that, as soon as the distributor is able to locate a customer for the product, the distributor will purchase the merchandise from the manufacturer (effecting title passage) and immediately resell it to its customer. This is often referred to as the distributor taking "flash title." The difference between the sale and purchase price is the markup.
So, how is this consignment treated for U.S. income tax purposes and will the foreign manufacturer be deemed to have a permanent establishment in the United States? Well, it depends on whether it's the right kind of consignment and what its terms are.
The issue is further complicated by the fact that parties use the word "consignment" to mean different things. For example, a foreign manufacturer may "consign" the goods to a distributor (pursuant to a contract labeled "consignment agreement") but only intending that the distributor arrange for sales without taking flash title prior to the distributor effecting the sale of the products to the customers. This "consignment" arrangement is tantamount to a warehousing of merchandise coupled with an agency, thereby most certainly creating potential permanent establishment issues. This, in effect, was what happened in Handlfield v. Comr.1
In Handlfield,a Canadian manufacturer placed its merchandise with a U.S. distributor, the latter appointed as the taxpayer's exclusive agent. The court observed that there was no agreement between the parties that the consignee would buy, and take title to, the Canadian manufactured products (so that it wasn't the equivalent of a "buy-sell"); the unsold products could be returned; the manufacturer was responsible for transportation costs and the manufacturer controlled the retail price. The court held that the "arrangement was an agency relationship in the form of a contract of consignment." (The court cited to another case, which stated that a contract of consignment does not impose any obligation on the consignee to purchase property and the consignment arrangement effects no transfer of title of property from the consignor to the consignee. Rather, it merely creates a bailment coupled with an agency.)
On the other hand, although consignment arrangements are more typically thought of in the trade as a transaction involving the taking of flash title, some consignment arrangements may still be regarded as an agency (regardless of title passage) if certain facts exist. For example, if risk of loss of the merchandise remains with the manufacturer, if the manufacturer fixes the resale price, and if merchandise can be returned to the manufacturer, then an agency may exist.2 Conversely, if the terms of the arrangement are indicative of a buy-sell transaction, then an agency situation will not be found.3
The IRS has weighed in on the subject and has identified what it views as critical factors in determining whether a consignment (with flash title passage) would be viewed as a "buy-sell" and not as an agency.
For example, in Rev. Rul. 63-113, 1963-1 C.B. 410, the IRS found, under the U.S. income tax treaty with Canada, that the consignor-consignee relationship was that of buyer and seller, not principal and agent. In that ruling, a Canadian corporation shipped goods to a company in the United States on a "consignment" basis. The Canadian manufacturer retained title to the merchandise and the merchandise was purchased immediately prior to the time that it was sold by the consignee.
The IRS observed that the products were to be delivered to a carrier at the consignor's plant in Canada, to be forwarded by the carrier for and on behalf of, and at the expense and risk of, the U.S. consignee, and that all responsibility for the products was assumed by the consignee, which could move the products to any location it desired without notice to, or consent from, the consignor.
The IRS further noted that title to the goods remained with the consignor until purchased by the consignee immediately prior to its sale of the merchandise, i.e., flash title. Moreover, the consignee was responsible to the consignor for damage, destruction, theft, or loss of the goods prior to the purchase of the goods (but after forwarding to the carrier); the consignee bore the cost of insurance; the consignee was not liable to account to the consignor for the sales proceeds; the consignee was under no obligation to purchase the consigned products; and the consignor had the right to recall any consigned products prior to their purchase by the consignee.
On these facts, the IRS indicated that an agency was not established. Instead, according to the IRS, the relationship was more in the nature of a seller and purchaser, i.e., a buy-sell, not creating a permanent establishment in the United States.
A similar result was indicated in Rev. Rul. 76-322, 1976-2 C.B. 487, involving the Australian income tax treaty and a wholly owned subsidiary in which the IRS again ruled that an agency was not created since the relationship between the parties was really akin to that of a seller and purchaser (because the power that the consignee had in determining when title to the consigned goods passed from the consignor was exercisable only as a purchaser).
So, while there may be different definitions and notions of what a consignment sale is, a consignment sale should typically involve the taking of flash title and, subject to negotiation of the various business issues (which, coincidentally, involve the very issues raised in the IRS rulings), the parties should, to the maximum extent possible, be guided by the factors listed in the IRS published rulings regarding risk of loss, etc., in order to avoid permanent establishment issues. The road map is there; it simply needs to be followed.
This commentary also will appear in the April 2011 issue of BNA's Tax Management International Journal. For more information, in BNA's Tax Management Portfolios, see Katz, Plambeck, and Ring, 908 T.M., U.S. Income Taxation of Foreign Corporations, and Cole, Kawano, and Schlaman, 940 T.M., U.S. Income Tax Treaties — U.S. Competent Authority Functions and Procedures, and in Tax Practice Series, see ¶7130, Foreign Persons — Effectively Connected Income and ¶7160, U.S. Income Tax Treaties.
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