The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
A recent IRS legal memorandum, AM 2009-010, created quite a stir in the tax community. The memorandum determined that a foreign person (FP) who entered into an arrangement with a U.S. person (USP) to originate loans on FP's behalf was engaged in a U.S. business by reason of USP's activities. Stated that boldly, there would not seem to be much surprising about the memorandum's conclusion. If an agency relationship exists, and if the activities of a domestic agent of a foreign corporation rise to the level of a trade or business, they may be imputed to the foreign corporation.1 The memorandum concluded that the activities of USP rose to the level of a business, and that conclusion will not be addressed here.2 The question is whether an agency relationship existed and, if so, what kind of agency.
Commentators rightly criticized the memorandum's analysis on a number of grounds, including its determination that USP's U.S. office could be attributed to FP without regard to longstanding regulations, developed in a slightly different context, that suggest otherwise.3 This commentary questions the validity of the memorandum on a much more fundamental ground, which is simply that the memorandum does not set out facts sufficient at law to support any conclusion at all, and certainly not the conclusion it reached.
There is hardly a legal issue more fact-sensitive, or more slippery, than the issue of agency, yet the IRS memorandum provides virtually none of the facts relevant to that determination. It is possible that the real facts were known to the field and to counsel's office, but did not make their way into the published memorandum and, if so, it is certainly possible that the memorandum's conclusion was well supported by the facts. But the memorandum as released does not even hint at the facts necessary to support its conclusion, and the fact that the memorandum's analysis had to distinguish extant regulations addressing a closely analogous situation, which was quite a stretch at best, suggests that there were key facts missing that ordinarily would support a finding of agency.
What do we know, based on the released text of the memorandum? We know that FP had "no office or employees located in the United States" but that it did have its own employees and its own office outside the United States. We know that it entered into a service agreement with USP pursuant to which USP performed nearly all of the activities necessary to originate loans to U.S. borrowers, including solicitation, negotiation of loan terms, and performing credit analysis. We know that USP performed these activities within the United States from its own U.S. office "on a considerable, continuous, and regular basis" and that FP paid it an arm's-length fee for doing so. We know that USP was "not authorized to conclude contracts on behalf of" FP, and that final approval and execution of the loan documents were done by FP's own employees at its office outside of the United States.
The memorandum is unclear as to whether USP performed the same type of services for others, and whether it was also engaged in the lending business for its own account. The memorandum states that USP "performs all of the origination activities on behalf of" FP. That could mean that all of USP's activities were performed on behalf of this one foreign person (and no other), such that USP would pretty clearly be a dependent agent. Or it could mean that USP did not perform such activities on its own behalf, but may have done so for others. Or it may merely mean that all the pertinent origination activities were performed by USP and not by FP.
We also don't know for sure whether FP was engaged in the loan origination business outside of the United States, or indeed what its business was. Certain statements in the legal analysis portion of the memorandum suggest that FP was, in fact, a loan originator at home. We don't know how many loans USP originated for FP under their agreement.
And, critically, we don't know how much discretion USP had in its dealings with borrowers and with FP. Did FP approve every loan USP offered up, or did it withhold its approval of some loans? Did FP provide USP with a list of loan criteria that, if followed, would ensure FP's approval? Did USP and FP kibbitz and jointly agree on loan terms as they were being negotiated with borrowers? At what point in the solicitation/negotiation/credit analysis process did USP clue FP in on what it was up to? What did USP tell the borrowers about FP – was FP's existence disclosed?4 Were potential borrowers told that their loan terms were subject to the approval of FP, which approval might not be forthcoming? Did USP have a quota? Were USP and FP related? Did they have a prior history of dealing with each other? Who bore the expenses of busted deals? These and other facts are critical to the issue of risk, which is fundamental to any agency analysis.
The memorandum's absence of factual development may be related to its explicit statement that whether USP was an independent or dependent agent was immaterial. The memorandum stated simply, "In similar circumstances, courts have found an agency relationship to exist in fact and have attributed the activities of the U.S. agent to the foreign principal …." This statement is wrong, and not just because there were no "similar facts" presented to which the extant court cases might be compared . The only court case cited for this ex cathedra proposition was InverWorld, discussed below. That case presented unique facts not at all similar to those few facts set out in the memorandum, which facts were critical to the court's holding that the U.S. party to the arrangements was a dependent agent.
So what do the cases tell us?
The case that is probably closest to the IRS's position in the memorandum is Handfield v. Comr.5 Frank Handfield, a Canadian resident, was in the business of manufacturing and selling postcards. He entered into a contract with an unrelated U.S. corporation which distributed his postcards to newstands in the United States. Handfield retained risk of loss and the potential for profit. The cards were fully returnable and Handfield was responsible for shipping the cards to and from the United States. Payments to Handfield were made on the basis of the quantity of postcards sold. On these relatively straightforward facts, the Tax Court found that Handfield did not sell the postcards to the U.S. corporation, but rather that the latter acted as Handfield's agent in the activity of selling postcards to the public in the United States.
The handful of cases involving financial businesses are not sympathetic to the government. Although Inverworld, Inc. v. Comr.6was cited as supportive of the conclusion reached by the IRS in its memorandum, that case turned on the Tax Court's finding that a U.S. subsidiary of the foreign person was a dependent agent. The facts that supported this finding of a dependent agency relationship were voluminous. Inverworld, Ltd. ("LTD") was a foreign investment management and financial services company. It owned all of the stock of Inverworld, Inc. ("INC"), a Delaware corporation. The two companies entered into an agreement whereby INC agreed to invest assets of LTD's clients according to LTD's instructions and to maintain accounting records in exchange for an annual fee.
The court noted that a foreign corporation does not have a U.S. office simply because its subsidiary has one. However, the foreign parent should have its own employees through which it conducts its day-to-day business from its foreign office. The court found that LTD conducted virtually all of its day-to-day activities out of the U.S. office of its U.S. subsidiary. LTD used the address of the U.S. office as its return address on numerous brochures and other documents and maintained its client files in the U.S. office. The court found that this use was not sporadic or infrequent in the context of LTD's overall trade or business. The court found that the day-to-day business was conducted in the United States, where, among other things, LTD's client files were located and investment instructions were received and carried out. The court found that INC had the authority to negotiate and conclude contracts in LTD's name, and that INC regularly exercised this authority.
In contrast, in Taisei Fire and Marine Insurance Co. v. Comr.,7 the Tax Court held that several Japanese insurance companies did not have permanent establishments in the United States, despite granting authority to a U.S. agent to underwrite reinsurance on their behalf, because the facts established that the agent was independent. Although a finding of a permanent establishment under a treaty requires a greater degree of U.S. presence than does a finding of U.S. business nexus generally, and requires a dependent agent, the decision is noteworthy for its weighing of the relevant facts.
The U.S. agent entered into reinsurance contracts through brokers on behalf of the Japanese insurance companies. However, the agent bore its own operating costs. The only "material limitation" on its authority was a "net acceptance limit," a ceiling on the net liability on any one original reinsurance contract that it could accept on behalf of one of its members. The U.S. agent decided independently which businesses to underwrite and which layer of protection to reinsure. It was compensated based on management fees and commissions.
On these facts, the court found that the U.S. agent was both legally and economically independent from its principals. As a legal matter, the agent had complete discretion over the details of its work and was not subject to external control. As for economic independence, the agent had no guarantee of revenue and it was not insulated from risk. It was therefore an agent of independent status whose activities could not be imputed to its principals.
These cases suggest that the primary factors in determining whether a foreign corporation is engaged in a U.S. trade or business through the actions of a U.S. corporation with whom it contracts are whether the U.S. corporation is compensated at arm's length, whether the relationship between the parties is exclusive, the degree of control that the foreign corporation exerts over the U.S. corporation, and which party bears the risk of economic loss.
The IRS memorandum stated that the contract between USP and FP was entered into at arm's length. The memorandum does not tell us whether USP conducted business outside of its dealings with FP; therefore, we do not know whether there was an exclusive relationship between them, indicative of a principal-agent relationship. Nor does the memorandum tell us anything about the degree of control FP exerted over the actions of USP. And most importantly, there are no facts at all bearing on which party bore the risk of economic loss.
This commentary also will appear in the March 2010 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Katz, Plambeck and Ring, 908 T.M., U.S. Income Taxation of Foreign Corporations, and in Tax Practice Series, see ¶7130, Foreign Persons — Effectively Connected Income.
1 See Lewenhaupt v. Comr., 20 T.C. 151 (1953) (foreign individual managing real properties through domestic agent was engaged in a trade or business in the United States).
2 The IRS legal memorandum gives great weight to the fact that USP's activities on behalf of FP were regular and continuous. But this confuses the issue of whether a set of activities rises to the level of a trade or business (where regularity and continuity are key) and where a foreign person can be said to be engaging in those activities in the United States through an agent (which does not turn on regularity or continuity).
3 See, e.g., Zhu et al., "U.S.-Source Interest Income from a Lending Business," 125 Tax Notes 785 (11/16/09); Moldenhauer, "The Foreign Lender Memorandum and the Definition of a U.S. Office," 125 Tax Notes 1200 (12/14/09); Walker, "The Submerged Logic of `Doing Business' and Attribution Diving Below the Surface of the Offshore Lending `GLAM,'" Tax Forum No. 621 (2/1/09) (unpub. monograph)
4 Because FP argued that it was not engaged in a U.S. trade or business, FP would have treated any interest on the U.S. loans as potentially subject to §1441 withholding. We are told that FP did not reside in a treaty country, so to avoid withholding the interest would have had to qualify either as portfolio interest – not generally available to "banks" – or as §892 income, if FP was a foreign government. U.S. borrowers certainly would need to know whether FP qualified for an exemption from withholding tax, but the memorandum sheds no light on this important fact.
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