I. Introduction
For a U.S. manufacturer of tangible consumer products that wishes to begin selling its products worldwide through the Internet, the tax considerations generally are the same as those raised by a more traditional marketing program. The use of a website ("website.com") as a marketing and sales tool does not raise novel issues under U.S. tax laws, although some issues under those laws may be resolved differently when sales are conducted through the Internet. The tax considerations are the same whether marketing and sales are conducted through the means of a traditional catalogue or sales force or electronically through the Internet. The United States applies the same basic principles to a U.S. corporation in determining its U.S. tax liability.
Most importantly, the United States taxes a U.S. corporation on the basis of its worldwide income. Of almost equal importance is the highly developed U.S. controlled foreign corporation regime. The application of the rules implementing these two policies means that a U.S. manufacturer generally will not be permitted to defer tax on income on sales income even if the sales activities are conducted outside the United States. The one exception to this general rule is if the sales are conducted through a foreign sales corporation ("FSC").1
What is potentially different, however, when sales activities are conducted through a website, is the tax result in the country in which the website is located. An enterprise that has sales persons located in a foreign country may well be subject to tax on the sales income generated by those sales persons. Their presence may constitute a permanent establishment (in the case of a country with which the United States has in effect an income tax treaty) or such presence may create a trade or business (in the case of a country that does not have in effect an income tax treaty with the United States.) Generally, income derived from catalogue sales is not subject to tax in the jurisdiction in which the customer is located. Income derived from sales solicited through a website most likely will be treated in the same manner as income from catalogue sales in most OECD member states. Depending on the treatment of the website under the foreign country's tax law, the conduct of sales activities through a website may avoid any foreign taxation of the income derived from the website sales. Furthermore, income derived from sales to customers located in jurisdictions different from the one in which the server on which the website is located should not be subject to tax in that other jurisdiction, so long as the website solicitation is the only activity within those jurisdictions.2
Developing OECD policy would not treat a website located on a server in its jurisdiction as constituting a permanent establishment. However, at least one OECD member country, Australia, and one non-member country, India, have indicated that the presence of a website through which business is conducted is sufficient activity to create a permanent establishment in the jurisdiction in which the website is located.
This paper will discuss the various U.S. and certain non-U.S. tax consequences of the three business models: (1) separate incorporation of the Internet sales operations in a foreign corporation; (2) conduct of the Internet sales through a branch of the U.S. manufacturer; and (3) conduct of the Internet sales through a joint venture entity that is not treated as a pass-through entity for U.S. tax purposes.
General U.S. Tax Considerations
From a U.S. tax perspective, putting the website business into a foreign corporation - even if it is located in a low tax jurisdiction - generally will not provide a U.S. tax advantage. This conclusion follows from (1) the fact that the foreign corporation undoubtedly would be treated as a controlled foreign corporation and (2) the sales income attributable to the foreign corporation may well be characterized as subpart F foreign base company sales income, subject to current taxation in the hands of the U.S. shareholders. In addition, if any services are performed by the CFC for customers, that income may be treated as subpart F foreign base company services income, which also is taxed currently to the U.S. shareholders. However, as discussed below, under some circumstances, the income may not be characterized as subpart F base company income and will be eligible for the privilege of deferral.
Further, if a foreign corporation were used to own website.com, transfer pricing issues would arise over the proper amount of commission income to be earned by the foreign corporation if it did not take title to the consumer goods or, if it did take title to the consumer goods, the correct arm's length price for the sale of those consumer goods to the foreign corporation by the U.S. manufacturer. Even if the CFC entered into a contract manufacturing agreement with a third party outside the United States, the issue would nonetheless arise as to whether subpart F income is created under the so-called "branch rule."3 Under the branch rule, a branch is treated as a separate corporation for purposes of determining whether income is to be characterized as foreign base company sales income.
Other tax considerations include the tax cost of transferring to a related foreign corporation any intangibles such as trademarks, tradenames, or marketing intangibles under the "commensurate with income standard" of §482 and potential taxation of the CFC in the foreign jurisdiction. If the CFC is subject to foreign country tax, the U.S. shareholder generally would be eligible for a foreign tax credit under §960 for the foreign taxes paid by the CFC.
Other tax considerations include the tax cost of transferring to a related foreign corporation any intangibles such as trademarks, tradenames, or marketing intangibles under the "commensurate with income standard" of §482 and potential taxation of the CFC in the foreign jurisdiction. If the CFC is subject to foreign country tax, the U.S. shareholder generally would be eligible for a foreign tax credit under §960 for the foreign taxes paid by the CFC.
Not using a separate corporation for the Internet sales in fact may provide a better U.S. tax result because of the split sourcing rule.4 That rule provides a generous allocation of income to the foreign sales when a U.S. company manufactures a product in the United States and sells that product outside the United States. The rule essentially divides any income from the sale outside the United States between U.S. source manufacturing income and foreign source-sales income. The potential effect of this split sourcing rule is to provide a larger foreign tax credit.
Finally, another alternative for Internet sales is a joint venture for the sale of the consumer goods. In that case, if the U.S. manufacturer owns only 50 percent (and no more) of the interests in the joint venture, it would not be a CFC. In that case, U.S. tax on the income earned from the sales by the foreign joint venture (assuming that the joint venture is not a pass-through entity) would be deferred. A manufacturer may not wish to relinquish control of the joint venture, but if good business reasons exist for such a joint venture, a positive tax result through deferral is possible.
A. Deferral Issues - Separate Entity v. Branch
Generally, the U.S. rule is that the earnings of a U.S. owned foreign corporation are permitted deferral from U.S. tax until such time as the earnings are repatriated to the United States. However, the actual ability to defer U.S. tax on foreign earnings is limited under U.S. tax law. Deferral is not available to the foreign earnings of a branch of a U.S. corporation or to the passive and foreign base company income (i.e., highly mobile types of income) of a U.S.-owned foreign corporation.
A branch is not recognized as a separate tax-paying entity. Therefore, the earnings of a branch are taxed on a current basis and the losses of a branch reduce the corporation's taxable income. If losses are anticipated, the use of a branch, therefore, may be advantageous. However, recapture provisions (applicable when a branch is incorporated) that may resource foreign earnings as U.S. source earnings to the extent of foreign losses claimed may diminish this advantage. Of course, the time value of money may impact loss planning and subsequent recapture.
B. Subpart F Issues5
The regime essentially converts a foreign corporation into a pass-through entity for certain types of statutorily identified foreign income,6 thereby subjecting this income to current taxation in the hands of certain U.S. shareholders, triggering U.S. tax consequences before the income is actually repatriated to the United States through a distribution by the foreign corporation.7
The foreign base company sales income and foreign base company services income provisions are designed to prevent the deferral of tax on sales and services income that has been artificially separated, within the related party group, from the manufacturing activities (by means of a subsidiary) in order to obtain a lower rate of tax on the sales or services income. If a CFC either purchases property from a related party and sells the property to any person, or purchases property from any person and sells the property to a related person and the property is manufactured, produced, grown, or extracted outside the CFC's country of incorporation, the income is foreign base company sales income. Additionally, if a CFC purchases property on behalf of a related party for use outside of the CFC's country of incorporation or if a CFC sells property on behalf of a related party for use outside the CFC's country of incorporation, the income also will be characterized as foreign base company sales income.8 However, if the CFC performs enough activities with respect to the property so that it is considered to have "manufactured" or "produced" the property within its country of incorporation, the income derived from the sale of the property will not be characterized foreign base company sales income.9
C. Movement of U.S. Manufacturing Operations Outside United States
If the U.S. manufacturer decides to move its manufacturing operations outside the United States to a wholly-owned foreign corporation, several issues under the subpart F regime should be considered in determining whether the income from the sales of the foreign manufactured consumer goods will be characterized as subpart F income. Generally, as stated above, under the subpart F rules, income derived from sales of property manufactured by a CFC within its country of incorporation or creation is not characterized as subpart F income. The income, therefore, is eligible for deferral until it is repatriated to the United States. However, under some circumstances, the income from such sales may be characterized as subpart F income, as described below.
1. Branch Rule Issues
As described above, the foreign base company sales income branch rule treats a branch that conducts sales or purchase activities outside the CFC's country of incorporation as a separate entity if the effect of the use of a branch is the same as if it were a wholly owned subsidiary earning the income. The effect of the use of the branch is determined by comparing the rates of effective tax on the income in the CFC's jurisdiction and that of the branch.10 Thus, for example, if a manufacturing CFC in a high tax jurisdiction (40 percent rate) establishes a sales branch located in a low tax jurisdiction (10 percent rate), the income from the sales will be treated as foreign base company sales income that is taxable on a current basis to the U.S. shareholders of the CFC. But for the use of the low-tax jurisdiction branch, the sales income would not be treated as foreign base company sales income because of the manufacturing activities of the CFC
In the case of a CFC that manufactures consumer goods to be sold over the Internet, if it locates its website on a server located outside its country of incorporation, the branch rule potentially would apply to characterize the sales income as foreign base company sales income.
The fact pattern raises a number of issues, both under U.S. and non-U.S. tax law. First, for purposes of the "branch rule" does the location of the website on a server located in another country different from that of the CFC create a branch? Second, does the location of the website in its jurisdiction create such nexus that the jurisdiction would assert taxing jurisdiction over the sales income derived from the website? For OECD member countries, as discussed previously, the answer to this second question generally will be "no", unless the CFC owns or leases the server.
The beginning of the inquiry relating to the first issue is to determine the definition of a branch. Neither the Code nor the regulations define the term "branch" in this context11 The regulations under §954(d)(2) 12 assume that a sales office - without any further activities - is a branch. In Ashland Oil, Inc. v. Com'r, 13 the Tax Court considered what the definition of the term should be in the absence of a definition under the Code and regulations. The taxpayer in that case proposed to define the term "branch" as a "division, office, or other unit of business located at a different location from the main office or headquarters" or, alternatively, as an "office" in a different location than the "parent company." Although the Tax Court did not formally adopt either definition, it did state that nothing in the legislative history underlying the branch rule was inconsistent with these definitions. The Tax Court did note, however, that without clarification of the terms "divisions" and "units," the definitional issue was not resolved, rather shifted.
What is important to note are the factors of a "unit of business" in a different location from that of its main office or headquarters. If a website is viewed as a "unit of business" and it is viewed as being located where the server is located, and the server is not located in the same country as the country of incorporation of the CFC, the branch rule could apply.
Under the Internet sales model, a website substitutes functionally for the sales office. Like a sales office, it has physical presence in the jurisdiction based upon its location on a server in that location.14 If the CFC either owns or leases the server, the CFC's presence in the other country is increased. Whether the CFC owns or leases the server, in either instance, the CFC may well have a "branch."
2. Contract Manufacturing
If the CFC engages a "contract manufacturer," i.e., a person that provides manufacturing services, but does not assume the marketing risk of the goods, for purposes of determining whether the CFC has manufactured the goods, may the activities of the contract manufacturer be attributed to the CFC so that the CFC is treated as having manufactured the goods? If the activities of the contract manufacturer may be attributed to the CFC, the CFC may be treated as having manufactured the goods within its country of incorporation. Income from the sale of the goods therefore would not be characterized as foreign base company sales income.
The IRS position is that the activities of a contract manufacturer do not qualify as those of the CFC. In Rev. Rul. 97-48,15 the IRS revoked its former position enunciated in Rev. Rul. 75-716 that the activities of a contract manufacturer could be attributed to a CFC for purposes of determining if the goods sold by it were manufactured by it for purposes of the foreign base company sales income provisions. The stated reason for the reversal of the position in Rev. Rul. 75-7 is the IRS loss in two U.S. Tax Court cases applying the branch rule under §954(d)(2).17 The IRS believes that by adopting the result of the Tax Court cases for the branch rule, it must also adopt that same result for purposes of contract manufacturing. The new position has been vigorously debated by various commentators.18 While most commentators have expressed the view that a legal challenge to Rev. Rul. 97-48 is inevitable, such a challenge has not materialized to date. As a result, the issue is unresolved.
D. Transfer Pricing Issues
1. Transfers of Tangible Property
If the U.S. manufacturer conducts the Internet sales outside the United States through a related foreign corporation, a number of transfer pricing issues arise under §482. An arm's length price must be determined for any commissions if the foreign subsidiary does not take title to the goods but merely receives a percentage of each sale. If the foreign subsidiary is a buy- sell distributor, an arm's length price must be determined for the transfer price between the U.S. manufacturer and its foreign sales subsidiary. Further, if a related contract manufacturer is used, the price of services charged by the contract manufacturer must reflect an arm's length price.
2. Transfers of Intangible Property - Trademarks, Tradenames, Know-How, Marketing Intangibles
If the manufacturing operations are transferred outside the United States to a related party such as a wholly owned subsidiary, an arm's length royalty would be required to be paid for any intangibles that would be transferred. Under §482, the royalty paid under such circumstances must be "commensurate with the income attributable to the intangible." This language means that the royalty payment must be evaluated - and potentially adjusted - each year to ensure that it meets the "commensurate with income" standard. The standard looks to the income derived from the intangible by the licensee and requires that the royalty paid to the licensor reflect that income.
3. Cost Sharing Arrangements
The use of a cost sharing arrangement may avoid the requirement to pay an arm's length royalty to the U.S. parent corporation. A cost sharing agreement is defined as an agreement to share all the costs related to the development of the intangible in a pre-determined ratio in exchange for an equivalent share of the benefits derived from the intangible.19 The benefit is that each cost share participant is treated as a partial owner of the intangible. Thus, the arm's length royalty requirement described above is not applicable to a cost sharing agreement.20
E. Sales by U.S. Manufacturer
1. Application of Split Source Rule
If the U.S. manufacturer conducts its non-U.S. sales operations through the use of a website located outside the United States, the U.S. tax result may be beneficial. This would be particularly true if the U.S. manufacturer were in an excess credit position with respect to the U.S. foreign tax credit.21 Under this structure, the taxpayer simply rents space on a server (as opposed to leasing or owning the server itself) for its website. Generally, income derived from sales of property in another jurisdiction are not subject to tax in that jurisdiction, provided that no actual activities take place in the jurisdiction.
Although any income from sales generated by website.com will be taxed by the United States in the year in which it is earned, the sourcing rule provided under §863(b) for split-source income usually will permit the taxpayer to treat 50 percent of that income as foreign source income. This treatment of the income as foreign-source income is potentially beneficial because it increases the numerator of the foreign tax limitation fraction. This increase in the numerator, in turn, increases the amount of foreign taxes that may be credited against U.S. tax. In this situation, the income will be in the "general" basket for purposes of §904(d). Because it is unlikely that foreign tax will be imposed on the sales income, to the extent that the taxpayer has accrued other foreign taxes that otherwise would not be permitted to be claimed as a credit because of the limitation fraction, it will permit it to "cross-credit" those taxes against the U.S. tax on the foreign Internet sales income that has not been burdened with foreign tax.
2. Sales Through a Foreign Sales Corporation
Although the foreign sales corporation regime will most likely not extend beyond October 1, 2000, prior to that time the FSC regime provided an alternative for selling U.S. goods outside the United States. Under that regime, sales attributed to a FSC were treated as foreign trade income, a portion of which was exempt from U.S. tax. For a U.S. taxpayer that was in an "excess limitation"22 position, the use of a FSC would provide a better U.S. tax result than relying on the foreign source treatment of 50 percent of the sales income as foreign-source income, as explained above.
3. Use of a Hybrid Entity to Protect Against PE Status in Foreign Jurisdiction
If a U.S. manufacturer is concerned about possibly triggering permanent establishment status through its activities in a foreign jurisdiction, it could conduct any such activities through a wholly owned hybrid entity. For U.S. tax purposes, the entity would be treated as a disregarded single member entity under the "check-the-box" regulations23 and as a separate entity for foreign tax purposes. Use of such a hybrid entity would permit the U.S. manufacturer to take advantage of the §863(b) sourcing rule as outlined above, while protecting itself against the possibility of creating a permanent establishment in the other jurisdiction.
4. Sales Through a Joint Venture
A third alternative tax structure for the foreign sales would be to form a joint venture with an unrelated party. If the U.S. manufacturer owns no more than 50 percent of the joint venture, and the joint venture is not treated as a pass-through entity for U.S. tax purposes, the U.S. manufacturer will be able to defer the U.S. tax on the sales income until it is repatriated to the United States. An ownership interest greater than 50 percent would cause the entity to be treated as a controlled foreign corporation with respect to the U.S. manufacturer. The subpart F issues as discussed earlier in the paper would arise as a result.
III. Conclusion
Although the issues presented by sales of tangible goods through a website located outside the United States are similar to those raised by similar sales conducted by a sales force located abroad or through the use of a catalogue, a number of sub-issues do arise that are created by the new Internet technology. Nonetheless, the existing U.S. tax law framework adequately addresses how the income derived from Internet sales should be taxed by the United States.
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1The FSC regime has been declared non-compliant with WTO standards and as a result will be replaced in some form that is yet undetermined to date. A broader replacement regime that permits favorable tax treatment of certain foreign-source income of U.S. persons is anticipated.
2This statement obviously would not be true for sales by a U.S. manufacturer to U.S. customers.
3§954(d)(2). Unless otherwise stated, all section references are to the Internal Revenue Code of 1986, as amended, ("Code") and the regulations thereunder.
4§863(b)
5foreign corporation must be a controlled foreign corporation for the subpart F provisions to apply. A foreign corporation is "controlled" if 10 percent U.S. shareholders own more than 50 percent of the total combined voting power of all classes of stock of the corporation that are entitled to vote or the total value of the stock of the corporation. Special attribution rules apply to determine stock ownership, whether the stock is owned directly, indirectly, or constructively. If the subpart F regime is applicable to a foreign corporation, the 10 percent U.S. shareholders of the foreign corporation are required to include in their gross income for the taxable year the "subpart F" income derived by the foreign corporation from its activities abroad and certain limited categories of U.S.-source income. Income of a CFC that is not subject to the application of the subpart F income provisions generally is income associated with the active conduct of a trade or business with unrelated parties, accorded the privilege of deferral, and not taxed until it is repatriated to the United States taxing jurisdiction.
6Some U.S. income also is characterized as subpart F income.
7Of course, if the corporation has no earnings and profits, a distribution may not be subject to U.S. corporate tax. Under §301(c)(2), if a corporation has no earnings and profits, the distribution will be treated as a return of capital to the extent of basis. A return of capital is not subject to tax under the U.S. taxing system. Distributions in excess of basis are taxed as capital gains under §301(c)(3).
8In the case of a purchase by a CFC on behalf of a related party, the income referred to would be commission income of the CFC for the purchasing services.
9§1.954-3(a)(4). See Bausch & Lomb Inc. v. Com'r, 71 T.C.M. 2031 (1996) (The sunglass assembly operations of a CFC met the "manufacturing" test under §1.954-3(a)(4) and, therefore, the income from the sale of the sunglasses was not subpart F income.)
10§1.954-3(b) and (d)
11The term is not defined in other parts of the Code or regulations either, although the term is used in a number of instances.
12§1.954-3(b)
1395 T.C. 348 ( 1990)
14A website may be factually distinguished from a catalogue that is mailed to a resident of the jurisdiction. The website actually performs its functions in its location by transmitting the order to the home office for delivery. A catalogue, on the other hand, only serves to inform the potential customer what goods may be purchased. In order to actually purchase a product described in the catalogue, a customer must initiate an order through the mail, by telephone, or by fax. None of the means of delivery for the order in this instance would be owned or leased or otherwise be attributed to the manufacturer as the website is.
151997-2 C.B. 89
161975-1 C.B. 244
17Ashland Oil, Inc. v. Com'r, 95 T.C. 348 (1990) and Vetco v. Com'r, 95 T.C. 579 (1990). Both of these cases involved manufacturing activities performed by separate foreign corporations, one wholly owned by the taxpayer and the other an unrelated corporation to the taxpayer. The IRS view is that to not treat the corporations as a branch but to allow attribution for purposes of §954(d)(1) would be inconsistent, although Rev. Rul. 97-48 provides no analysis underlying this conclusion.
18For example, see Dolan, DuPuy & Jackman, "Contract Manufacturing: The Next Round," 27 Tax Mgt. Int'l J. 59 (Feb. 1998)
19§1.482-7(a)
20§1.482-7(b)
21The reference to an "excess credit" position merely means that the taxpayer has paid more foreign taxes than the §904 foreign tax credit limitation fraction permits to be credited against U.S. tax. In other words, the taxpayer has more foreign taxes than limitation, hence "excess credit".
22An "excess limitation" position is the reverse of an excess credit position. In this case, the taxpayer has paid less foreign tax than the foreign tax credit limitation fraction would permit it to credit against U.S. tax.
23§301.7701-3