The Business Profits Article of U.S. Income Tax Treaties
Companies that expand their operations across international borders are faced with a host of tax-related complexities to navigate. These tax considerations include general registration requirements, income taxes, payroll taxes, indirect taxes (i.e., sales taxes, value-added taxes, and other similar taxes), and more. The amount of detail and nuance involved with any number of subtopics within these broad considerations can be overwhelming, and a comprehensive understanding requires a textbook-level explanation.
This article is limited to a brief overview of how the Business Profits article of United States income tax treaties can limit a U.S. resident company’s exposure to income taxes imposed by foreign jurisdictions.
It is important to note that this article discusses general rules that appear in the United States Model Income Tax Convention 2016 (“U.S. Model Treaty”), in which all treaties are based. However, each ratified treaty stands on its own and includes many differences from the model treaty framework. Thus, the applicable treaty must be examined closely in comparison with the general rules discussed in this article. Furthermore, the United States has an extensive network of income tax treaties, but it is far from inclusive of all countries in the world. The IRS provides a list of tax treaties between the United States and its treaty partners here.
For example, pursuant to the U.S. Model Treaty, Article 7, Company A’s (i.e., a U.S. resident business enterprise) business profits attributable to activities conducted within Country X (i.e., a foreign country with which the United States has an income tax treaty) will be taxable only in Country A unless Company A carries on business through a permanent establishment within Country X. Thus, Company A’s liability for Country X’s income tax generally depends on whether Company A’s activities within Country X rise to the level of a permanent establishment.
What Is Considered a Permanent Establishment?
A permanent establishment generally means a fixed place of business through which the business of an enterprise is carried on. This includes an office, a place of management, a factory, a branch, and a workshop. Additionally, if Country A has a person located within Country X that has and habitually exercises an authority to conclude contracts that are binding on Company A, then Company A is deemed to have a permanent establishment within Country X with respect to the activities being conducted by such person. Thus, Company A should structure its operations such that contracts must be approved and concluded by the executive team located within the United States.
A key exception from the term “permanent establishment” relates to inventory handling facilities. A fixed place of business will not constitute a permanent establishment if it’s used solely for the purpose of storage, display, or delivery of goods or merchandise belonging to Company A. This exception also applies to facilities used for the sole purpose of purchasing goods or merchandise, and to facilities used solely for certain preparatory or auxiliary purposes. This exception often allows Company A to engage a third-party warehouse to store its inventory and fulfill orders on its behalf.
Another key exception from the term “permanent establishment” relates to a building site or construction or installation project. Generally, these activities must be carried on for more than 12 months before they constitute a permanent establishment. Thus, short-term construction-related projects can often avoid classification as a permanent establishment.
It’s important to recognize that each individual treaty modifies the U.S. Model Treaty to account for differences in tax bases and circumstances and needs to be carefully analyzed. For example, the treaty with Canada includes a concept of a service-based permanent establishment. Essentially, the treaty doesn’t just look to whether there is a fixed place of business in the country. It also considers whether services are provided leading to situations where a company doesn’t have a fixed place of business but is instead sending employees to work outside the U.S. If so, it would be considered to have a permanent establishment as a result of the services provided by those individuals.
If Company A’s activities rise to the level of a permanent establishment, Company A will be subject to Country X’s income tax, but the treaty may still prove beneficial to Company A in at least two ways. First, only the business profits “attributable to” the permanent establishment are subject to Country X’s income tax. This standard limits the amount of income subject to taxation by Country X to the amount of profit a separate and standalone enterprise would be expected to make with respect to the activities of the permanent establishment. Second, the treaty will help ensure Company A is entitled to a foreign tax credit for the income taxes it eventually pays to Country X.
Understanding the income tax treaty provisions attributable to the international taxation of business profits is critical in determining the global income tax burden associated with the outbound expansion of business operations. Furthermore, application of a tax treaty can impact the decisions a company makes in structuring their outbound business operations. It may be beneficial to forgo the legal formation of a foreign subsidiary and operate as a branch within the foreign country to maximize available treaty benefits.
While this is just one of many international considerations, application of the business profits provision of income tax treaties is often an important early consideration for companies planning to expand into foreign jurisdictions.
If you have any questions about the application of U.S. income tax treaties or other international tax matters, please reach out to your KSM advisor or complete this form.
We're Looking for
At KSM, you’ll be encouraged to find your purpose, exercise your creativity, and drive innovation forward.