USA: IRS Chief Counsel Office Publishes Guidance on the Sourcing of Income and Withholding
13 January 2014
Posted by: Authors: Stewart L. Kasner and Sean J. Tevel
Author: Stewart L. Kasner and Sean J. Tevel (Baker & McKenzie)
On October 25, 2013, the IRS Office of Chief Counsel released CCA 201343020 (the "CCA”) addressing the tax treatment of payments made by a US corporation to foreign distributors of a multi-level marketing company. While the advice may not be used as precedent, the guidance in the CCA should benefit taxpayers by providing clarity on the source of those payments and the proper amount (if any) to withhold on such payments made in multi-level distribution chains.
Facts of the CCA
The taxpayer ("Taxpayer") is a US corporation which produces and sells products to US and foreign distributors through a multi-level marketing arrangement. Taxpayer's income from the sale of the products is split between US and foreign sources. The various distributors in the arrangement are independent contractors and are not employees of Taxpayer. In addition to purchasing and reselling products to consumers, distributors ("higher-tier distributors") also sponsor, train and support lower-tier distributors of the products ("lower-tier distributors"). The lower-tier distributors may sponsor additional (further lower-tier) distributors and this creates a sponsorship chain with all distributors in the chain potentially purchasing and reselling products from Taxpayer directly. Lower-tier distributors are only required to follow the rules and guidelines set out by Taxpayer, and not necessarily the rules, guidance or advice of the sponsoring higher-tier distributor. The sponsorship chain allows for higher-tier distributors to earn income in two ways: (1) from the resale of the products it has purchased directly from the Taxpayer; and (2) as earnings attributable to purchases from Taxpayer by lower-tier distributors in the distributor's sponsorship chain. The CCA limits its analysis to the second category of earnings.
Issues Covered in the CCA
The CCA covers the three (3) issues specified below with regard to the payments made by Taxpayer to the higher-tier distributors.
- What is the character and source of the payments made to the foreign (upper-tier) distributors for their role in cultivating their respective (lower-tier) sponsorship chains?
- Under what circumstances must Taxpayer withhold tax under Code Section 1441 (as fixed or determinable annual or periodical income ("FDAPI")) upon making payments to a foreign distributor?
- If Taxpayer is generally required to withhold tax on the FDAPI payments to higher-tier distributors, can this requirement be modified by an income tax treaty?
Character of Payments made to Foreign Distributors
The CCA reaches the conclusion that the payments to foreign distributors should be characterized as compensation for the performance of personal services in recruiting, training and supporting lower-tier distributors in their sponsorship chains.
In support of its conclusion, the CCA relies on the Tax Court's decision British Timken Ltd v. Commissioner, 12 T.C. 880 (1949), acq., 1949-2 C.B. 1. In British Timken Ltd., a UK corporation ("Timken") appointed distributors to handle the sale of goods of a US manufacturer ("USM") in Timken's designated territory. Timken, through its distributors, marketed the products to customers, maintained contact with customers, procured orders and facilitated sales. Eventually, Timken directed its lower-tier distributors and customers to place orders and receive shipments directly from USM. USM could not sell goods directly in Timken's territory without Timken's consent and title to all goods sold passed in the US. Once USM collected the sales price from either Timken's distributors or customers, USM would pay a percentage of the price to Timken. When determining the character and source of the payments from USM to Timken, the Tax Court held that the income earned by Timken was related to its sales activity and not the sale of personal property. Therefore, the Tax Court rejected that the place of sale was determinative of the source of the compensation, and instead held that situs of the sales activity was the source.
The CCA found similarities between the USM payments to Timken and the payments from Taxpayer to higher-tier distributors. Both Timken and the higher-tier distributors received income based upon purchases of the lower-tier distributors, although the income was not from direct sales by them to the lower-tier distributors. Instead, the income was earned as compensation for services rendered that were associated with those sales. In the case presented by the CCA, the earnings were compensation for the recruiting, training and support of the lower-tier distributors in the sponsorship chain.
The CCA further justified the characterization of the earnings as services income by comparing the fact pattern presented to the Tax Court's previous treatment of "finder's fees" as services. See, e.g., Sinclair v. Commissioner, T.C. Memo 1960-113. The CCA also explained that even if the higher-tier distributors only engaged in minimal activities in the sponsoring of the lower-tier distributors, the limited activities should not preclude the services income characterization. See, e.g., Malchin v. Commissioner, T.C. Memo 1981-460.
Source of Payments Made to Foreign Distributors
The source of the income is relevant because a foreign distributor engaged in a US trade or business is subject to US federal income tax on US-source income derived from the performance of those services. The source of a foreign distributor's services income is the location of where the services are performed. Thus, in determining how the services income should be sourced for the upper-tier distributors, the location of the services provided by the upper-tier distributors and not the location of the sales to the lower-tier distributors is the relevant inquiry.
In situations where the distributor is providing services both within and without the US, the CCA cites Treas. Reg. § 1.861-4 for the proposition that the amounts of compensation that are US sourced and foreign sourced respectively is determined based upon the facts of circumstances of the particular case. In many cases, the income can be apportioned based on the amount of time a distributor performs services in the US and outside the US Treas. Reg. § 1.861-4(b)(1),(2). The services of a distributor might be performed over the course of more than one taxable year. In that case, a comparison can be made as to how much time was spent over that entire period on services performed within and without the United States to determine what portion should be treated as US or foreign-sourced. Treas. Reg. § 1.861-4(b)(2)(ii)(F). With respect to the US-sourced portion, consideration should then be given as to whether the distributor was engaged in a US trade or business when the respective services were performed (and not when payment is received) so as to determine whether such US-source income is effectively connected with that trade or business and eligible for an exemption from withholding tax as discussed below.
Withholding upon Payments Made to Foreign Distributors
Section 1441 generally provides that any person making FDAPI payments to a nonresident alien individual ("NRA") must withhold tax on that income at a 30 percent rate, unless specifically exempted. Code Section 1442 provides the companion rule for payments of US-source FDAPI payments to foreign corporations.
An exception from withholding exists for most income that is effectively connected with a trade or business conducted in the US. Generally, a foreign person performing personal services in the US is considered to be engaged in a US trade or business and the income from the performance of such services is considered to be effectively connected to that trade or business. Foreign corporate distributors can meet this exception from withholding by providing US withholding agent with a Form W-8ECI, Certificate of Foreign Person’s Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States, documenting their status as a foreign person. In the case of NRAs, an exemption from withholding on US-source services income is unavailable unless the income is subject to wage withholding under Code Section 3402 (among other exceptions not mentioned in the CCA). The NRA distributors were independent contractors and not employees of Taxpayer. Therefore, they did not qualify for the wage withholding exception and the CCA concluded that US-sourced payments received from Taxpayer (relating to services performed in the United States) were subject to a 30 percent withholding tax.
When withholding tax on payments made to foreign distributors, the US taxpayer must determine the portion of the payment consisting of income from US sources in order to withholding the proper amount. If the taxpayer cannot determine the proper amount to withhold on based upon the available facts, the taxpayer must treat the entire amount as US-sourced and withhold on the entire amount at the 30 percent rate. Treas. Reg. § 1.1441-2(a). A refund of overwithheld tax can be claimed by a return filed by the foreign distributor directly with the IRS. Treas. Reg. § 1.1441-1(b)(8). The CCA referenced Treas. Reg. § 1.1441-3(d)(1), which provides procedures for a withholding agent to set aside the withheld amount in an escrow account until the proper sourcing determination can be made.
Effect of Income Tax Treaties
In cases where Taxpayer must withhold on payments to distributors, the CCA concludes that the amount withheld may be modified by an income tax treaty if the foreign distributor is a resident of a country with which the US has such a treaty in force. With regard to NRAs, the applicable treaty provisions are those that apply to personal services income that does not arise in an employment context. In many treaties, this income would fall under the Independent Personal Services provision or the Business Profits provision. Generally, under these provisions, the income would not be taxable in the US unless the NRA has spent a certain amount of time in the US or the income is attributable to a fixed base or permanent establishment in the U.S. The income could be exempt from withholding if the foreign distributor provides a Form 8233, Exemption From Withholding on Compensation for Independent (and Certain Dependent) Personal Services of a Nonresident Alien Individual, to the US company prior to the time of payment.
With regard to foreign corporate distributors that qualify for treaty benefits, the applicable treaty articles are the Permanent Establishment and Business Profits articles. If the payments from the US company are not attributable to a permanent establishment in the US, the foreign corporate distributor will not be subject to US federal income tax on the income from the services. The income will be exempt from withholding under section 1441 if the distributor provides a properly completed Form W-8BEN to the US taxpayer prior to payment. Treas. Reg. § 1441-4(b)(1)(iv).
This article first appeared on lexology.com.