TAX COURT RULES ON AGENTS AS PERMANENT ESTABLISHMENTS

By Mark L. Lubin, LLM, Marks & Murase

Foreign corporations and nonresident alien individuals are subject to Federal income tax on two general classes of income: 1) "fixed or determinable annual or periodical" income derived from U.S. sources but not effectively connected with a U.S. trade or business and 2) income from any source that is effectively connected with a U.S. trade or business. In general, the IRC imposes a 30% withholding tax on the former class of income, and it taxes the latter class at the regular graduated U.S. tax rates applicable to U.S. persons.

Income that would otherwise be subject to either of these taxing schemes may be subject to exemption (or, in some instances, to a tax rate reduction) by treaty. A common tax treaty exemption limits Federal income taxation of "industrial or commercial profits" (denoted in some tax treaties as "business profits") of a treaty country resident to amounts that are attributable to a U.S. permanent establishment. Many treaties do not specifically define industrial or commercial profits for purposes of this type of exemption; however, income derived from business activities (as distinguished from investment or personal activities) should generally fall within that classification.

Although treaty definitions vary, tax treaties typically define a permanent establishment as an office or other fixed place of business and further provide that activities of agents can constitute a permanent establishment in certain instances. Where activities of an agent are involved, it generally is necessary to determine whether the agent is "dependent" or "independent" of the taxpayer-principal. Broadly speaking, an independent agent (i.e., a broker, general commission agent, or other agent of "independent status" acting in the ordinary course of business) will not be treated as a principal's permanent establishment, regardless of the degree of discretionary authority it exercises. On the other hand, activities of other (i.e., dependent) agents will generally be treated as a principal's permanent establishment where there are regular exercises of authority to bind the principal in business transactions.

In Taisei Fire and Marine Insurance Co., Ltd., 104 T.C. No. 27 (May 2, 1995), the U.S. Tax Court considered whether a reinsurance underwriting manager (Fortress) that acted as an agent for four Japanese corporations was a dependent or independent agent for purposes of the permanent establishment exemption in the United States-Japan Income Tax Treaty (the Japan Treaty).

Each of the four Japanese taxpayers in the Taisei case was actively engaged in a property and casualty insurance business that involved the assumption of reinsurance risks. The stock of each taxpayer was publicly traded, and there was no stock ownership relationship among the corporations. Each taxpayer provided authority to two or three U.S. agents (including Fortress) to underwrite reinsurance on its behalf and perform certain activities in connection therewith.

Fortress had broad discretionary authority to underwrite and cede reinsurance on behalf of the four taxpayers. Effectively, the taxpayers received premiums with respect to insurance risks accepted by Fortress on their behalf and paid premiums on the risks ceded. The taxpayers also earned commission income on the ceded risks.

For the three taxable years in question, Fortress acted solely on the taxpayers' behalf in underwriting and ceding reinsurance, although it had acted in similar capacities for other reinsurance companies in other periods. Fortress was compensated for its services under compensation schedules set forth in separate written agreements with the taxpayers.

According to the Court, the only material limitations on Fortress's discretionary authority were net acceptance limits, which provided maximum net liability exposures that Fortress could accept on behalf of each taxpayer on any one reinsurance contract. Because Fortress was not limited on how many contracts it could write, however, each taxpayer's potential exposure (and potential net premium income) was, at least in theory, unlimited.

It was uncontroverted that the taxpayers' income at issue constituted industrial or commercial profits, that Fortress had acted on the taxpayers' behalf in the ordinary course of its business, and that Fortress was not a broker or a general commission agent. Thus, the question presented was whether Fortress was another agent of independent status or a dependent agent with respect to the taxpayers.

The Court's Analysis

The Tax Court held that Fortress was an independent agent of the taxpayers, with the result that the income in question was exempt from Federal income tax as business profits not attributable to a U.S. permanent establishment. Had the Court determined otherwise (i.e., that Fortress was a dependent agent), the taxpayers would have been considered as having U.S. permanent establishments by reason of Fortress having regularly exercised authority to bind them in the reinsurance transactions. The following discussion highlights certain aspects and implications of the Court's analysis.

At the outset of the opinion, the Court noted that the Japan Treaty does not define an independent agent. Therefore, the Court set out to determine the treaty parties' shared expectations regarding the meaning of that term. Because the relevant treaty provisions were found to have been modeled after the 1963 O.E.C.D. Draft Model convention (the "1963 O.E.C.D. Draft"), it first looked to the commentaries on the 1963 O.E.C.D. Draft to determine the treaty parties' intent.

A 1963 O.E.C.D. Draft commentary provides that, in order for an agent to be deemed a permanent establishment, it must be dependent, from both legal and economic points of view, upon the enterprise for which it carries on business dealings (i.e., the principal). However, the commissioner argued that the 1963 O.E.C.D. Draft commentary had erroneously phrased the dependent agent standard in conjunctive terms and that legal and economic independence are both required to qualify as an independent agent. The commissioner's position was supported by commentaries to a 1977 O.E.C.D. model convention (which adopted such an approach in construing language similar to that of the 1963 O.E.C.D. Draft and the Japan Treaty).

Although the Court indicated reluctance to interpret the Japan Treaty on the basis of subsequently adopted commentaries (the Japan Treaty was ratified in 1971), it ultimately was persuaded that the 1963 O.E.C.D. Draft was intended to be interpreted consistent with the Commissioner's characterization, despite the apparent plain meaning of the 1963 commentary.

Legal and Economic Independence

The Court then analyzed whether Fortress was legally and economically independent of the four taxpayers. With respect to legal independence, the Court noted that the taxpayers' relationships with Fortress were defined by separate management agreements, that the taxpayers had no interest in Fortress and that no representative of any of the taxpayers was a director, officer, or employee of Fortress. The Court also cited other factors, including the complete discretion that Fortress had in conducting business on the taxpayers' behalf, and it rejected (as unsupported by the facts) an argument that the taxpayers acted in concert as a "pool" to control Fortress. In light of these considerations, and in particular Fortress's complete discretion over the details of its work, Fortress was held legally independent of the taxpayers.

In analyzing economic independence, the Court noted that Fortress was owned entirely by individuals unrelated to the taxpayers and that it was not guaranteed revenue or protected from loss by the taxpayers. The Court rejected an argument by the commissioner that Fortress bore no entrepreneurial risk as a result of its having been compensated in part by management fees and because of the taxpayers' creditworthiness (which, the commissioner had argued, guaranteed Fortress business). Fortress' industry relationships, good reputation, experience, and income level (which exceeded $27 million for the three taxable years in issue) were viewed as indications that Fortress was not economically subservient to the taxpayers.

Because Fortress was determined to have been both legally and economically independent of the taxpayers, it was held an independent agent. Accordingly, as noted above, the taxpayers prevailed in establishing an exemption from Federal income tax on the basis that they did not have U.S. permanent establishments for the taxable years in question.

Much to Be Learned

Given the existence of relatively limited precedential authority concerning what constitutes a permanent establishment, the Taisei decision is significant in several respects. Perhaps most fundamental is the Court's reliance on the O.E.C.D. commentaries in interpreting the Japan Treaty. O.E.C.D. commentaries have been regarded by many in the tax community as a persuasive indication of the intended meaning of treaty provisions similar to those in the O.E.C.D. model treaties, and the Tax Court has lent credence to the view that substantial weight should be accorded those commentaries in appropriate instances. (This would, of course, apply with respect to other treaty provisions in addition to the permanent establishment rules.) Nevertheless, the Taisei decision makes it clear that the Tax Court will not feel constrained by commentaries that it regards as erroneous, and that it may consider subsequent authorities in making that determination.

Although the Tax Court ultimately construed the independent agent test in the manner favored by the commissioner (i.e., that both legal and economic independence are necessary for independent agent status), the four taxpayers in Taisei received substantial income from U.S. activities conducted solely on their behalf by Fortress, free of Federal income tax liability. Thus, the Taisei decision tends to highlight planning opportunities that may be available to foreign taxpayers in insurance and other industries, who may be amenable to conducting U.S. transactions through agents. Because the IRS remains likely to challenge perceived abuses of treaty exemptions, however, arrangements involving agents should be structured carefully. *

Editor:
Lawrence A. Pollack, JD, LLM, CPA
KPMG Peat Marwick LLP

OCTOBER 1995 / THE CPA JOURNAL