The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
By Philip D. Morrison, Esq.
Deloitte Tax LLP, Washington, D.C.
A recent private letter ruling (PLR 201024028) appears to endorse, at least in certain circumstances, a method of doing business whereby the U.S. tax on the U.S. marketing and sales income of a U.S. affiliate of a foreign corporation can be quite modest or even zero. While the PLR doesn't rule on all the necessary aspects to achieve such a result, read in context with prior, still-valid authority, it still provides some helpful authority.
The PLR involves foreign corporations selling goods into the U.S. market through a cooperative ("co-op"). If the foreign corporations are such that they can act cooperatively within the meaning of Subchapter T (a subject not discussed by the PLR), their use of a co-op ought to result in little or no corporate-level tax on the co-op's income and a single U.S. withholding tax at a treaty-reduced (in some treaties, zero) rate on profits distributed to the co-op's foreign "patrons."
Typically, foreign corporations that sell their products in the United States will either have a U.S. subsidiary act as a distributor or will sell their products themselves through a branch. In either case, there are two levels of tax on the profits earned in the United States in such a distribution/marketing function—one on the subsidiary's or branch's net income, under §11 (imposed on the sub's income or, via §882, on the effectively connected income (ECI) of the foreign corporation's branch), and one on the dividends (or, in the case of a branch, the dividend equivalent amount) distributed to or enjoyed by the foreign corporation, either through §881 or §884. While interest and royalty payments can reduce the U.S. corporate base in many instances, where a company is not highly leveraged or where the marketing intangibles are developed in the United States, or where the interest or royalty recipient is taxed on its receipt of such items, there may be considerable U.S. tax, at two levels, on U.S. marketing and sales income.
Selling through a co-op, where that is possible, essentially reduces the U.S. tax to a single, low level—the treaty-reduced §881 tax on dividends. As PLR 201024028 explains, if the U.S. corporation doing the marketing/selling operates on a cooperative basis and qualifies under Subchapter T, the "patronage dividends" it distributes to its foreign patrons are, essentially, deductible to the co-op. If the co-op distributes all profits, of course, this makes it, practically speaking, tax-exempt. And if the patrons are treaty-qualified corporate residents, the shareholder level tax on the patronage dividends can be reduced to 5% or even zero, depending on the treaty.
Given that the co-op in PLR 201024028 had foreign corporate patrons, as did the co-ops in other authorities (e.g., Coastal Chemical Corp. v. U.S., 546 F.2d 110 (5th Cir. 1977); Rev. Rul. 66-53, 1966-1 C.B. 206; PLR 8715037; GCM 35846 (June 6, 1974)), it seems clear that a co-op with foreign patrons can qualify under Subchapter T. While the elimination of at least one level of U.S. tax on corporate profits is the clear intent of the co-op tax regime, the elimination or reduction to a combined total of 5% of both shareholder and corporate tax levels for foreign patrons can only be achieved with foreign corporate patrons through a combination of the co-op regime with the treaty reduction (or elimination) of withholding tax on dividends. Nothing in either the co-op provisions or in treaty dividend articles appears to limit the benefits of a co-op in a foreign patron context so the PLR's endorsement of foreign patrons appears correct.
While co-ops are typically thought of as selling or purchasing entities for agricultural commodities, the qualification under Subchapter T is not so restricted. GCM 35846, for example, dealt with a co-op that purchased and sold "lubricating oils and allied products." In Coastal, the co-op purchased fertilizer. Several large businesses that sell non-commodity, non-agricultural products, such as Ace Hardware, are organized as co-ops. Nor, though it may be atypical, do the foreign patrons of the co-op necessarily need to be unrelated (seeDr. P. Phillips v. Comr., 17 T.C. 1002 (1951)), though that is common.
As PLR 201024028 reminds us, however (though, unfortunately, because of redactions, does not discuss the non-legal facts demonstrating this), co-ops must operate for the mutual benefit of their members. This requires that the patrons themselves actually make or otherwise deal with the product sold by the co-op. See Mississippi Valley Portland Cement, 408 F.2d 827 (5th Cir. 1969), cert. denied, 395 U.S. 944 (1969). Profit from the co-op's activities must be returned to patrons based on business done with the co-op, not based on equity invested. Puget Sound Plywood, Inc. v. Comr., 44 T.C. 305 (1965). Each member must have one and only one vote. Id. The co-op must operate at cost. Id.
As a practical matter, the "mutual benefit" requirement appears to mean that each foreign patron that is a member of a foreign-controlled group needs separate, substantive operations, like a manufacturing facility. Alternatively, a foreign conglomerate with separate but related product lines or that operates the same or closely related businesses through multiple affiliates or divisions ought to be able to qualify. Where there is overlap in the U.S. marketing and sales activities of several potential foreign patrons, or where a single organization can perform those functions efficiently for several related patrons, a co-op might fit the bill. Taking a single business and artificially creating separate pieces placed into separate foreign patrons likely does not. This is both critical to satisfying the "mutual benefit" requirement and, unfortunately, not something the PLR gives meaningful guidance on, given the redactions.
Other than reaffirming that foreign corporations may be patrons, PLR 201024028, unfortunately, does not deal with the various international tax issues raised by such a co-op. Other authorities, however, either explicitly or implicitly, provide some answers to the relevant questions. Together with the reaffirmation provided by the recent PLR, these prior authorities provide considerable encouragement regarding the use of foreign patron co-ops for U.S. marketing and sales in the right circumstances.
Rev. Rul. 66-53, above, concludes that patronage dividends distributed to foreign patrons are fixed or determinable annual or periodical income (FDAP), not income effectively connected with a U.S. trade or business. While the revenue ruling might arguably be said to assume that the foreign patrons do not conduct a trade or business in the United States, it is clear from the ruling that the mere act of being a co-op patron does not itself cause a foreign patron to be engaged in a U.S. trade or business; otherwise the ruling would make no sense. Similarly, in Coastal, above, the Fifth Circuit held that patronage dividends received by a Mexican corporation were subject to the 30% withholding tax under §1442. The court found as a matter of fact that the Mexican patron was not engaged in a U.S. trade or business. While the issue of whether the mere receipt of patronage dividends could cause the Mexican patron to be treated as engaged in a U.S. trade or business was not explicitly discussed by the court, the court's finding that the foreign patron was not so engaged and its explicit holding that the dividend was subject to U.S. withholding under §1442 is a clear endorsement of a favorable conclusion on that issue. Otherwise the conclusion regarding withholding tax makes no sense. While the absence of ECI of a U.S. trade or business makes treaty protection under Articles 5 and 7 unnecessary, §894(b) also makes clear that, with respect to income that is not ECI of a U.S. trade or business, the foreign taxpayer will not have a permanent establishment.
While under the authority above patronage dividends are FDAP and subject to withholding tax, there is also authority that they are also subject to treaty reductions of withholding tax on dividends. PLR 8715037 holds that, for purposes of the U.S.-Canada Income Tax Treaty, patronage dividends distributed to foreign patrons are dividends for purposes of the treaty. It further holds that such dividends are, therefore, subject to a reduced rate of withholding of 15% under the treaty. The patrons in that letter ruling were non-corporate so could not take advantage of the then 10% (now 5%) rate for corporate, 10%-or-greater shareholders. While that PLR states as a proviso that the patronage dividends not be effectively connected with a U.S. trade or business of the patrons, it is clear from Rev. Rul. 66-53 and Coastal that merely being patrons of a co-op, without more, does not make the patronage dividends ECI of a U.S. trade or business.
Most treaties define "dividends" similarly to the U.S.-Canada treaty in PLR 8715037. Like the U.S.-Canada treaty, for most U.S. treaties, as well as the U.S. Model Treaty, "dividends" include income not only from shares but also from "other rights, not being debt-claims, participating in profits…."
While a co-op must distribute patronage dividends based on the relative quantity or value of business done with or for the patron, this ought not to disqualify such dividends from being considered income from "other rights, not being debt-claims, participating in profits" for treaty purposes. Section 1388(a) defines the term "patronage dividend" to mean "an amount paid to a person…which is determined by reference to the net earnings of the organization from business done with or for its patrons." (Emphasis added.) While it might be argued (see the Treasury Technical Explanation for the U.S. Model Treaty) that "dividends" should be restricted to cover income only from and based on equity investments, such an argument ought not to prevail given the broad definition in most treaties and §1388's reference to patronage dividends being out of profits. In 1987, clearly, it did not with respect to the taxpayer receiving PLR 8715037.
Finally, any foreign multinational with the requisite business operations to make the use of a U.S. marketing and sales co-op sensible must also consider the possible application of the "economic substance" doctrine as "codified" in §7701(o). Importantly, §7701(o)(1) and (5)(D) provide generally that this new provision only applies when relevant and that the determination of relevance "shall be made in the same manner as if this subsection had never been enacted." It hardly seems sensible that the choice of operating a U.S. corporation on a cooperative basis (that which is necessary for qualification under Subchapter T) would have invoked the application of the economic substance doctrine prior to the enactment of new subsection (o) of §7701. Like an election to be treated under Subchapter S, qualifying a corporation to be treated under Subchapter T is simply a choice to take advantage of a specific, Code-provided treatment for certain corporations. It hardly even rises to a "choice of entity," which itself ought not to invoke the economic substance doctrine.
As noted above, not all (or perhaps even not many) foreign corporations are set up and conduct business in such a manner that a U.S. marketing and sales subsidiary can operate on a cooperative basis and distribute its profits to the foreign owners based on the business they do with it, rather than based on equity invested. In the relatively unusual cases where they can, however, PLR 201024028 and prior, still-valid authority provide that the foreign owners from treaty jurisdictions can either effectively eliminate U.S. tax on marketing and sales income or reduce the total U.S. tax to 5%.
This commentary also will appear in the October 2010 issue of BNA's Tax Management International Journal. For more information, in BNA's Tax Management Portfolios, see Freitag, 744 T.M., Taxation of Cooperatives and Their Patrons , and Katz, Plambeck, and Ring, 908 T.M.,U.S. Income Taxation of Foreign Corporations , and in Tax Practice Series, see ¶5200, Cooperative Organizations, ¶7130, Foreign Persons — Effectively Connected Income, and ¶7160, U.S. Income Tax Treaties.
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