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By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
The domestic tax treatment of personal service corporations (PSCs), including the use of "loan-out" companies and other forms of incorporated talent, has a long and confusing history. The IRS has tried, usually unsuccessfully, to combat the use of these types of corporations for many years, attacking them under the sham corporation doctrine and under §269, and applying assignment of income or §482 transfer pricing principles. Where the corporation provides an individual's services to only one service recipient, the special rules of §269A can apply.
After the repeal of the General Utilities doctrine in 1986, and as the corporate rate of tax came to equal or exceed the individual rate from time to time, the use of PSCs in the United States has generally died out. Today, most such corporations would be organized as S corporations or LLCs, with pass-through treatment for tax purposes.
However, the use of such corporations outside the United States remains common, in the sports and entertainment industries. Such corporations may be used to defer or even avoid home country tax permanently. They may be used to avoid home country social security taxes, in much the same way that some U.S. individuals seek to use S corporations to avoid paying social security tax on all but a modest amount of compensation income. In many countries, corporate tax rates are well below the rates applicable to individuals, with full or partial integration of corporate and individual taxes. The Organization for Economic Co-operation and Development (OECD) has recognized that the use of such corporations is usually abusive,1 but there seems to have been no real movement to clamp down on their use in most countries.
Both the U.S. and OECD model tax treaties contain a special article addressing the taxation of payments to athletes and artists. These articles, that are found in many treaties, typically allow the State in which services are performed to tax the income therefrom, regardless of whether the individual performer has a permanent establishment or fixed base in such State. Historically, because these articles were limited to individuals, many performers sought to use PSCs as a means of avoiding these applications. It was hoped that the PSC would be subject to the business profits rule of the treaty, requiring a permanent establishment as a condition to source-State tax. This type of planning has been eliminated in most modern treaties.2 However, the special treaty rule for athletes and artists generally does not apply to other individuals who perform personal services (other than as an employee) in a host State, even if they are in the entertainment industry. In such cases, the normal business profits rules apply.3
Any person, U.S. or foreign, making a payment of U.S.-source or effectively connected income to a foreign PSC is a potential U.S. withholding agent. In the absence of a treaty, payments for services performed by an individual on behalf of a PSC while physically present in the United States will be subject to U.S. tax, either as paid to the PSC or, if the IRS is successful in challenging the use of the PSC, to the individual directly.4 Section 864(b) of the Code states that the performance of personal services is engaging in a U.S. trade or business, and thus would give rise to effectively connected income and an obligation to file a U.S. tax return. Withholding at source can be avoided in such cases only if the PSC provides the payer with a properly completed W-8ECI, certifying that it will file a U.S. tax return. In the absence of such a form, the payer would be required to withhold a tax of 30% of the gross amount paid. Even if a treaty applies, where the services are covered by the athletes and artists article, withholding of tax under the special rule will be required.
Where the services are provided by a person other than an artist or athlete, such services are subject to the business profits article of a treaty. The PSC may assert that no withholding is required and that it is not required to deliver a Form W-8ECI or to pay any U.S. tax, on the ground that it lacks a U.S. permanent establishment. This can put the potential U.S. withholding agent in a difficult spot. While the regulations do not require the payer to second guess a properly documented claim of treaty benefits, most payers would be uncomfortable relying on such a claim if they had reason to know that there might in fact be a U.S. permanent establishment to which the services could be attributed. The existence or nonexistence of a permanent establishment is a question of fact that is not always simple to determine. At the least, the payer should insist that the claim of treaty exemption specifically state, on a W-8BEN, that the payee has no U.S. permanent establishment, and secure a covenant from the payee that it will file a treaty-based return under §6114.
Once the payer has properly withheld or received proper exemption certification from the PSC, in theory the payer should not have to concern itself whether the PSC properly withholds and reports on payments it, in turn, makes to the individual service provider. However, it is not uncommon to find that foreign persons are unaware of their obligations to withhold U.S. tax in such cases. The payer may be concerned that the IRS might assert that the true owner of the payment is not the PSC, but the individual owner of the PSC. This might be an issue particularly where the PSC does not properly withhold, or obtain the proper tax treaty documentation, on its payments to the service provider. Accordingly, best practice suggests that the original payer obtain a covenant from the PSC that it will properly withhold U.S. tax (or seek proper exemption forms) on any payments to the individual attributable to days worked in the United States.
The use of a PSC seems less than ideal in the U.S. cross-border context. If the payments for services are ineligible, or are found to be ineligible, for treaty benefits, the PSC will be subject to the branch profits tax, which may be reduced, but typically not wholly exempted, under an applicable treaty. Moreover, because state and local governments are not bound by U.S. tax treaties, the use of a PSC will attract state and local corporate taxes, which may be in addition to taxes on the individual service provider. Although both the branch profits tax and most state and local taxes can be zeroed out by causing the PSC to pay all of its net income to the individual owner as compensation, in most cases this will undermine whatever home country tax planning the individual is trying to accomplish.
Given these uncertainties, the foreign provider of services should consider making a "check-the-box" election to disregard the PSC. (This assumes that the PSC is wholly owned by the service provider, which is almost invariably the case.) The election would have no effect in his or her home country, preserving the ability to engage in any tax planning there. From the U.S. point of view, it would greatly simplify the analysis and eliminate the risk of branch profits tax applying. It would also eliminate the risk of state and local corporate taxes applying, at least in those localities that give effect to a federal check-the-box election. Of course, in this case the individual owner of the PSC will be required to secure a taxpayer identification number and file a U.S. tax return, at least a return claiming treaty benefits. But this will normally be true in any event, if that individual receives any payments from the PSC for services performed in the United States.
This commentary also will appear in the September 2012 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Tello, 915 T.M., Payments Directed Outside the United States-Withholding and Reporting Provisions Under Chapters 3 and 4, and Williamson, 943 T.M., U.S. Income Tax Treaties-Provisions Relating Only to Individuals, and in Tax Practice Series, see ¶7160, U.S. Income Tax Treaties, and ¶7170, U.S. International Withholding and Reporting.
1 OECD Model Convention on Income and on Capital, Commentary on Article 17, ¶ 2.11(c).
2 For further background, see Ruchelman, "Tax Concepts Affecting the Foreign Entertainer or Athlete Performing in the United States," 37 Tax Mgmt. Int'l J. 272, 280 (5/9/08).
3 Historically, if the services were performed directly by an individual, most treaties addressed this case through a separate article for independent personal services, employing a "fixed base" in lieu of a "permanent establishment" construct. However, in recent treaties that article has been eliminated and only the business profits article is applicable. In the balance of this commentary, the term "permanent establishment" will refer to "fixed base" where appropriate.
4 SeeRev. Rul. 74-330, 1972-2 C.B. 278; compare Sargent v. Comr., 929 F.2d 1252 (8th Cir. 1991) (PSC respected), with Leavell v. Comr., 104 T.C. 140 (1995) (PSC disregarded).
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