A tax efficient way for non-U.S. Residents to invest in US-based credit operations is to rely on the provisions of an applicable U.S. income tax treaty that allows credit business income to evade U.S. income taxation. as long as the income producing credit activities are not attributable to the non-US investor’s permanent establishment in the United States. A permanent establishment usually includes management, a branch or an office. However, the non-US investor will be treated as having a permanent establishment in the United States even if a dependent agent is authorized to enter into contracts on behalf of the non-US investor and that authority habitually has a permanent establishment in the United States States exercises. However, under most agreements, a non-U.S. Investor will not be treated as having an established establishment in the United States because of having an independent agent in the United States acting as an independent agent in the ordinary course of the business.
Therefore, in virtually any contract-based structure, in order for a non-US investor to invest in a US-based lending business, it is essential to certify that the investment manager (or similar service provider) involved in the income-generating activities in the United States acts as an independent agent on behalf of the non-US investor.
Determining whether a manager is an independent agent is of course not clearly defined by applicable US tax law and is based on all relevant facts and circumstances. Tax advisors tend to focus on certain specific factors that the few authorities available believe are relevant. For example, the greater the number of non-US investors represented by a manager, the more likely it is an independent agent of the manager.
The purpose of this briefing is to focus on one factor that is often considered essential to concluding that the manager is an independent agent who we believe is due to a misinterpretation of the tax court process, in which it originated. In particular, a tax advisor tasked with creating a contract-based structure may require the non-US investor to have the right to terminate the contract with the manager without giving any reason. The perceived importance of this factor goes back to the decision of the tax court in The Taisei Fire and Marine Insurance Co., Ltd. v Commissioner, 104 TC 535 (1995). In Taisei, the court concluded that the US service provider (a reinsurance intermediary) was an independent agent and one of the facts described in the decision was that the non-US persons had the right to call the US service provider without disclosure to terminate for reasons (with six months’ notice). However, a close reading of the Taisei decision reveals that the right to terminate the service provider without giving a reason was not a major factor in the positive conclusion of the tax court and could in fact have been viewed by the court as an adverse factor.
In Taisei, the tax court concluded that independent agent status requires both legal and economic independence. Taisei, 104 TC at 549-51.
When first considering the concept of legal independence, the court saw “comprehensive scrutiny” as a crucial factor. ID. at 551. The IRS pointed out the various restrictions on insurance activities that the US service provider was engaged to carry out on behalf of non-US persons (e.g. full control by non-US persons. The tax court disagreed and concluded:
As an agent, [the service provider] had complete discretion over the details of his work. As an instance, [the service provider] was not subject to any external control. In total, [the service provider] was legally independent of [the non-U.S. persons].
ID. at 555. Although the argument has not been submitted to the court by the IRS, it seems clear that the ability of non-US persons to terminate the US service provider for no reason effectively removes, or at least seriously, the control of the US service provider has undermined.
In our view, in the case of a contract-based structure that allows a non-US investor to invest in a US loan, it would allow the non-US investor to terminate the agreement with the US-based manager with the Justification of legal independence incompatible with the manager. Without legal independence, the manager cannot be an independent agent. See ID. at 549-51.
Although the Taisei Tax Court did not discuss the importance of the right of termination of non-U.S. Persons in connection with the determination of legal independence, it is cited as fact in the separate part of the court’s decision on economic independence. ID. at 555. The court considered economic independence to be determined by the existence of “entrepreneurial risk”. See ID. at 551, 551.
In concluding that the US service provider bears an entrepreneurial risk, the court focused on the need for the service provider to raise adequate customer revenue to cover its expenses and to establish fair market conditions for its services, as well as the existence of a sufficiently large pool of potential customers Customers from which the service provider could win new customers. See ID. at 555-556.
Although the tax court at the beginning of its discussion of economic independence refers to the right of non-US persons to terminate the contract with the US service provider, it does not refer to this fact in its subsequent analysis, which leads to the conclusion that the service provider is economically independent. See ID. Rather, the court relied on the fact that the service provider had to bear its own expenses and the service provider was not dependent on a limited source of income.
As part of a contract-based structure that allows a non-US investor to invest in US credit operations, the manager’s economic independence should be adequately demonstrated by the manager being responsible for paying its own operating costs and having sufficient volume of doing business with enough clients to show that dependence on a single client is not essential to the continuation of the manager’s business. This can be evidenced by the manager’s financial history and market conditions for the manager’s credit investment activities, as did the Taisei Finance Court. There should be no need to demonstrate that an individual customer is not material to the manager by giving all non-US customers the right to terminate the manager without giving a reason.
The content of this article is intended to provide general guidance on the subject. Expert advice should be sought regarding your specific circumstances.