February 25, 2015
In Chief Counsel Advice 201501013, IRS has concluded that the lending and underwriting (stock distribution) activities of a foreign partnership (Fund) conducted on its behalf through its U.S. agent (Fund Manager) rose to the level of a U.S. trade or business. According to IRS, these activities do not qualify for the “trading in stocks and securities” exception under Code Sec. 864(b)(2)(A) (the Trading Safe Harbors). Therefore, the foreign corporation that is a partner of Fund (Foreign Feeder) is treated as being engaged in a U.S. trade or business. Background on the U.S. trade or business rules. A foreign corporation that is engaged in U.S. trade or business is subject to U.S. federal income tax on income that is effectively connected with the conduct of a U.S. trade or business. (Code Sec. 882(a)(1)) A foreign corporation is considered to be engaged in a U.S. trade or business if that foreign corporation is a member of a partnership that is engaged in a U.S. trade or business. (Code Sec. 875(1)).
The Code does not include a comprehensive definition of the term “trade or business within the United States.” Instead, the Code provides only that the term “trade or business within the United States” includes the performance of personal services within the U.S. at any time within the tax year, does not include certain de minimis personal service activity, and also does not include, under certain circumstances, “trading in stocks or securities” or trading in commodities. Code Sec. 864(b). There is no other statutory definition of the term. The courts and IRS have adopted a facts and circumstances test to evaluate whether the activities of a foreign person cause that person to be engaged in a U.S. trade or business. Treas. Reg. § 1.864-2(e). For a foreign corporation to be engaged in a U.S. trade or business, the foreign corporation's profit-oriented activities in the U.S. must be “considerable, continuous, and regular,” according to U.S. case law. In other words, the conduct of activities in the U.S. that are ministerial and ancillary to a business conducted outside the U.S. are not sufficient to give rise to a U.S. trade or business.
Under U.S. case law, for purposes of determining whether a foreign person is engaged in a U.S. trade or business, the activities undertaken on behalf of the foreign person by an agent may be considered to be performed by the foreign person, regardless of the degree of control the foreign person exercises over the agent.
Background on the Trading Safe Harbors. The Trading Safe Harbors are two statutory exceptions that exempt certain trading activities conducted by or for a foreign person from being treated as a U.S. trade or business. (Reg. § 1.864-2(c)) The first exception requires that the foreign person not conduct those activities through an agent who has been granted discretionary authority or through a U.S. office of the foreign person. The second exception, however, permits trading through an agent with discretionary authority or through the foreign person's U.S. office, but requires that the foreign person not be a dealer. The Code Sec. 864 regulations define a “dealer in stocks or securities” as “a merchant of stocks or securities, with an established place of business, regularly engaged as a merchant in purchasing stocks or securities and selling them to customers with a view to the gains and profits that may be derived therefrom.” Treas. Reg. § 1.864-2(c)(2)(iv)(a). In this regard, a person that buys and sells, or holds, stocks or securities solely for investment or speculation is not a dealer.
With respect to lending, Treas. Reg. § 1.864-4(c)(5) stipulates that a foreign person is considered engaged in the active conduct of a banking, financing, or similar business within the U.S. when the person “[m]ak[es] personal, mortgage, industrial, or other loans to the public” in the U.S. According to IRS, although this regulation provides rules for determining whether income is effectively connected to a banking, financing, or similar business, these regulations demonstrate that the conduct of that type of business in the U.S. does not qualify as “trading in stocks or securities” for purposes of the Trading Safe Harbors.
Similarly, the Code Section 864 regulations establish that underwriting generally does not constitute trading for purposes of the Trading Safe Harbors. Those regulationss describe a narrow set of circumstances under which a foreign underwriter may qualify for the Trading Safe Harbors. Specifically, a foreign underwriter will not be treated as a dealer, and will not be engaged in a trade or business within the U.S., if the foreign person acts as an underwriter, or as a selling group member, for the purpose of making a distribution of stocks or securities of a domestic issuer only to foreign purchasers of such stocks or securities. Treas. Reg. § 1.864-2(c)(2)(iv)(b)(1) and Treas. Reg. § 1.864-2(c)(2)(iv)(c), Example (1). According to IRS, the limited nature of this exception demonstrates that distributing stocks or securities to U.S. customers exceeds the level of underwriting activity permitted to qualify as “trading in stocks or securities.”
In Year 1, Fund was organized as a U.S. limited partnership. It converted to a Country X limited partnership (foreign partnership) in Year 2. During Year 1 and Year 2, Foreign Feeder, a Country X corporation, was a limited partner in Fund. Country X does not have an income tax treaty with the U.S.
During Year 1 and Year 2, Fund had no employees, but was instead managed exclusively by Fund Manager. Under a management agreement, Fund appointed Fund Manager as Fund's agent and irrevocable attorney-in-fact with full power to buy, sell, and otherwise deal in securities and related contracts for Fund's account. Furthermore, Fund granted Fund Manager the full power and authority to perform every act necessary and proper to be done as fully as Fund might or could do personally. Under such authority, Fund Manager conducted an extensive lending and underwriting (stock distribution) business on behalf of Fund.
In Year 1 and Year 2, Fund (through Fund Manager) actively solicited unrelated borrowers in the U.S. and made multiple loans to those borrowers. Fund made “personal, mortgage, industrial, or other loans to the public” in the U.S. In addition, Fund Manager (on Fund's behalf) also committed extensive time and resources to conduct Fund's underwriting (stock distribution) activities. Through Distribution Agreements, Fund (through Fund Manager) purchased shares from U.S. issuers and sold those shares to purchasers in the U.S. and abroad.
Fund Manager conducted these business activities and otherwise managed Fund primarily through an office in the U.S. No employees of Fund Manager worked exclusively for Fund, and Fund Manager provided similar services for other investment entities.
Taxpayer loses. IRS concluded that the nature and extent of Fund's lending and underwriting activities in the U.S. during Year 1 and Year 2 rose to the level of a U.S. trade or business within the meaning of Code Section 864(b). According to IRS, these activities were: (i) actively conducted, (ii) profit oriented, and (iii) undertaken on a “considerable, continuous, and regular basis.” In this regard, IRS attributed the activities of Fund Manager (its U.S. agent) to Fund, as such activities were performed by Fund Manager on behalf of Fund, for purposes of Code Section 864(b) and Code Section 882.
Second, IRS ruled that Fund's lending and underwriting (stock distribution) activities do not qualify for the Trading Safe Harbors. During the years at issue, Fund had no employees of its own, but conducted its business entirely through the authority granted to Fund Manager. Hence, Fund granted discretionary authority to Fund Manager to conduct a lending and underwriting business in the U.S. on behalf of Fund. Therefore, Fund Manager was not a resident broker, commission agent, custodian, or other independent agent for purposes of the first Trading Safe Harbor during the years at issue. Fund was ineligible for the Second Trading Safe Harbor, because its underwriting activities made it a “dealer in stocks or securities.”
Finally, according to IRS, even if Fund's lending and underwriting activities had qualified for the Trading Safe Harbors, Fund would have been ineligible for the Trading Safe Harbors during Year 1 and Year 2 because Fund: (i) granted discretionary authority to Fund Manager; and (ii) acted as a dealer during Year 1 and Year 2.
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