U.S. Taxation of Global Commerce in the 21st Century

The technology and information revolutions have facilitated the spread of global commerce to every nation in the world. Consequently, various countries have extended their taxing arms to include business operations of multinational corporations. Japan, Canada and the United Kingdom developed transfer pricing policies geared to tax a portion of the worldwide profits of U.S. multinationals.

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In response, the U.S. has developed a new approach for taxing global commerce by promulgating global dealing regulations that cover international banking operations and the issuance of exploratory papers on the taxation of electronic commerce. Also, various tax bills are aimed at the taxation of foreign income attributable to U.S. activities that is not taxed significantly elsewhere in the world. In an effort to achieve more standardized and reciprocal tax results, the U.S. decided to renegotiate its existing income tax treaties and enter into new ones. In addition, the U.S. has enacted expanded interpretations of what constitutes doing business within its borders. As a result, foreign taxpayers that either purchase or sell goods and services in the U.S. will encounter many pitfalls, which require substantial analysis and planning in order to avoid adverse tax consequences. The most significant aspect of this new approach is the shifting of emphasis from revenue-generating activities to the recognition of all the functions, assets and activities that generate revenue. Under this new approach, non-treaty foreign taxpayers that purchase goods on a regular basis through dependent agents located in the U.S. can be subject to income taxation. Foreign taxpayers must now be aware of what constitutes doing business in the U.S. on a regular basis, through dependent agents.

In InverWorld, Inc. et al. V. Commissioner (71 TCM CCH 3231, reaffirmed 73 TCM CCH 2777), the U.S. Tax Court addressed the major perils facing foreign taxpayers who fail to file U.S. income tax returns by denying their deductions. The Tax Court also described the circumstances under which the activities of an agent give rise to U.S. taxation. Generally, activities that are regular, substantial and continuous are found to constitute doing business through an office in the U.S. As such, effectively connected income can include foreign inventory sales attributable to a U.S. office, unless a foreign office materially participates. A false sense of security existed, based on regulatory exceptions that disregarded dependent agent activities in the U.S. under certain circumstances.

These exceptions applied where the dependent agent did not have, and did not exercise, the authority to conclude contracts in the name of its foreign principal or did not have a stock of goods from which orders were filled. The decision in InverWorld, Inc. concluded that no matter what legal formalities are given to inter-company agreements, economic dependency alone can be sufficient to trigger income recognition of the agent's activities in the U.S. Once income recognition is found to exist, the reallocation of income rules applicable to related taxpayers will apply. It is at that point that transfer pricing rules must be followed. These rules are far from being an exact science and their interpretation often leads to conflict between taxing jurisdictions. Perhaps the solution would be for countries to agree on a predetermined profit allocation percentage, depending on the business activities of the taxpayers.

InverWorld, Inc. also addressed the rules for pricing inter-company services. It upheld the regulations that require arm's length charges for services provided by members of a controlled group. The regulations provide that such charges must be equal to the expenses incurred in rendering services in situations where the services do not constitute an integral part of the parties. A service provider in the U.S. must recognize income in excess of its costs where:

1. either the service provider or the related beneficiary of the services to one or more unrelated parties;
2. the service provider renders services to one or more related parties as one of its principal activities;
3. the service provider is peculiarly capable of rendering the services and such services are a principal element in the operation of the recipient; or
4. the recipient has received benefit of a substantial amount from one or more related parties during the taxable year.

The conclusion to be drawn from InverWorld, Inc. is that foreign taxpayers should not assign too many of the responsibilities and functions of their overall business activities to the U.S. if they wish to avoid U.S. taxation. They should also consider filing Protective U.S. Income Tax Returns to disclose business nexus. Finally, they must maintain contemporaneous inter-company pricing documentation to support their worldwide profit allocations.