One tax-efficient way for a non-United States person to invest
in U.S.-based loan activities is to rely on the provisions of an
applicable U.S. income tax treaty which allows the lending business
income to avoid U.S. income taxation so long as the
income-producing loan activities are not attributable to the
non-U.S. investor’s permanent establishment in the United
States. For this purpose, a permanent establishment generally
includes a place of management, a branch, or an office. However,
the non-U.S. investor is also treated as having a permanent
establishment in the United States if a dependent agent has the
authority to conclude contracts on behalf of the non-U.S. investor
and habitually exercises that authority through a permanent
establishment in the United States. However, under most treaties, a
non-U.S. investor is not treated as having a permanent
establishment in the United States by reason of the activities of
an independent agent in the United States that acts in the ordinary
course of its business as an independent agent.
So, in virtually every treaty-based structure, to accommodate a
non-U.S. investor’s investment in a U.S.-based lending
activity, it is essential to confirm that the investment manager
(or similar service provider) engaging in the income-producing
activities in the United States on behalf of the non-U.S. investor
is acting as an independent agent.
The determination of whether a manager is an independent agent
is, of course, not clearly defined by applicable U.S. tax law and
is based on all of the relevant facts and circumstances. Tax
counsel will typically focus on certain specific factors which the
few available authorities suggest are relevant. For example, the
greater the number of non-U.S. investors represented by a manager,
the more likely the manager is acting as an independent agent.
The purpose of this briefing is to focus on one factor that is
often thought to be essential to conclude that the manager is an
independent agent that we believe is based on a misreading of the
Tax Court case where it originated. Specifically, tax counsel
tasked with creating a treaty-based structure may require that the
non-U.S. investor have the right to terminate the agreement with
the manager without cause. The perceived significance of that
factor traces its roots to the decision of the Tax Court in The
Taisei Fire and Marine Insurance Co., Ltd. v. Commissioner,
104 T.C. 535 (1995). In Taisei, the court concluded that
the U.S. service provider (a reinsurance agent) was an independent
agent and one of the facts described in the decision was that the
non-U.S. persons had the right to terminate the U.S. service
provider without cause (with six months’ notice). However, a
close reading of the Taisei decision discloses that the
right to terminate the service provider without cause was not a
significant factor supporting the Tax Court’s favorable
conclusion and, in fact, could have been viewed by the court as an
adverse factor.
In Taisei, the Tax Court concluded that independent
agent status requires both legal independence and economic
independence. Taisei, 104 T.C. at 549–51.
In first addressing the concept of legal independence, the court
saw “comprehensive control” as determinant. Id.
at 551. The IRS pointed to the various restrictions on the
insurance activities which the U.S. service provider was hired to
undertake on behalf of the non-U.S. persons (e.g., limitations on
acceptance and net premiums) as indicative that the service
provider was subject to comprehensive control by the non-U.S.
persons. The Tax Court disagreed and concluded:
As an agent, (the service provider) had complete discretion over
the details of its work. As an entity, (the service provider) was
subject to no external control. In sum, (the service provider) was
legally independent of (the non-U.S. persons).
Id. at 555. Although the argument was not presented to
the court by the IRS, it seems clear that the ability of the
non-U.S. persons to terminate the U.S. service provider without
cause effectively eliminated, or at least seriously undermined, the
U.S. service provider’s control.
In our view, in the case of a treaty-based structure
accommodating a non-U.S. investor’s investment in a U.S.
lending activity, allowing the non-U.S. investor to terminate the
agreement with the U.S.-based manager would be inconsistent with
establishing the legal independence of the manager. Without legal
independence, the manager cannot be an independent agent. See
id. at 549–51.
Although the Tax Court in Taisei did not discuss the
relevance of the non-U.S. persons’ termination right in the
context of determining legal independence, it is recited as a fact
in the separate part of the court’s decision regarding economic
independence. Id. at 555. The court viewed economic
independence as determined by the existence of
“entrepreneurial risk.” See id. at 551, 551.
In concluding that the U.S. service provider bore
entrepreneurial risk, the court focused on the need for the service
provider to procure adequate client income to cover its expenses
and to establish terms and conditions for its services consistent
with the current market, and on the existence of a sufficiently
large pool of potential clients from which the service provider
could draw new clients. See id. at 555–556.
Although the Tax Court at the beginning of its discussion of
economic independence refers to the right of the non-U.S. persons
to terminate the agreement with the U.S. service provider, it does
not rely on that fact in any of its subsequent analysis leading to
the conclusion that the service provider had economic independence.
See id. Rather, the court relied on the facts that the
service provider had to bear its own expenses and the service
provider was not dependent on a limited source of revenues.
In the context of a treaty-based structure accommodating a
non-U.S. investor’s investment in U.S. lending activities, the
manager’s economic independence should be able to be adequately
demonstrated by the manager bearing responsibility for the payment
of its own operating expenses and having a sufficient volume of
business with enough clients to show that reliance on any one
client is not essential to the manager’s continued operations.
This can be demonstrated by the manager’s financial history and
the market conditions for the manager’s loan investment
activities, as the Tax Court did in Taisei. It
should not be necessary to show that any one client is not
essential to the manager by giving to all clients who are not U.S.
persons the right to terminate the manager without cause.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.