The following is intended to provide an introduction into what is considered a “United States Trade or Business” (“USTB”) and why this concept is important to a foreign person with business plans or activities in the U.S. With limited exceptions, there is no clear definition of a USTB in the Internal Revenue Code or in the associated regulations. The concept has evolved over time through the issuance of various official statements and court decisions. This guidance typically addresses specific factual situations and may sometimes appear unclear and contradictory. While there are few “bright line” standards, certain broad principles may be gleaned from the published authorities. In the following paragraphs, we will highlight some of the guideposts which are useful in evaluating the existence of a USTB in certain common commercial scenarios. This said, it is important to bear in mind that ultimately the determination of USTB status depends on an assessment of the specific facts and circumstances in each case.

The Basic Idea Behind the Concept

The key point which characterizes a “trade or business” and differentiates it from a mere passive investment is the word “activity.” Whether a foreign person is involved in a “business” or is simply making a passive investment depends on the degree of activity involved. The “activity” contemplated in this context implies business activities intended to culminate in the realization of profit.

The mere ownership of assets which may produce small or occasional profit in the absence of effort expended by the investor is not a “business” for this purpose. The opinion of a U.S. court explained that the word “business” as used in the context of a USTB implies “busyness.” In plain language, for a foreign person to be engaged in a USTB, the foreign person must be engaged in business activities and not merely “clipping coupons.”

As previously stated, there is no “bright line” or clear objective test which may be applied. In the final analysis, the determination of the existence of a “trade or business” depends on the nature and extent of the activity undertaken. The regularity, substantiality and continuity of the business activity are all persuasive indicators of a USTB, and each discrete factor is accorded significance in itself.

For example, the courts have held that a single athletic or artistic performance or lecture in the U.S. is sufficient to create a USTB.

Some Activities That Do Not Qualify as a USTB

Because there is no bright line indicating the existence of a USTB, it is useful to be aware of certain common activities which have been determined to not in themselves result in a USTB. Some of these are:

  • Advertising in the U.S.
  • Purchasing goods in the U.S. for resale abroad
  • Keeping business records and collecting/depositing payments
  • Ownership of corporate shares
  • Ownership of financial assets with no associated involvement in the business or exposure to liability
  • Ownership of a royalty stream with no involvement in the underlying business producing the royalties
  • Ownership of rental real estate subject to a long-term net lease where there is no day-to-day involvement in the management of the real estate.

When Does Owning Rental Real Estate Qualify as a USTB?

As previously mentioned, the IRS has ruled that a nonresident who owns real estate subject to a long-term lease which shifts responsibility for the major costs associated with the real estate to the lessees (i.e., a “net lease”) is not engaged in a USTB. It doesn’t matter if the real estate holdings are large or small for the purpose of this ruling.

On the other hand, an owner who is involved in the day-to-day operation of the real estate is treated as engaged in a USTB. Even where the owner engages a third-party independent agent to manage the properties, the owner may still be engaged in a USTB.

For example, if the real estate holdings are significant and if it is reasonable to expect that the U.S. real estate operations necessitate the “considerable, regular and continuous” involvement of the owner due to regular real estate sales, refinancings, purchases, etc., a USTB may be found to exist. (See Pinchot v. Commissioner).

How Does Buying and Selling Merchandise in the U.S. Affect USTB Status?

This is the most common situation encountered and the one that involves the greatest potential for controversy. In a “nutshell,’ the following may be reliably concluded

  • Merely purchasing merchandise in the U.S. and selling it abroad is not likely to result in a USTB.
  • Sale of investment assets is not a USTB (e.g., a “one-off sale of a painting, etc.)
  • Sale of passive assets such as financial assets and securities is generally not a USTB
  • The regular and habitual solicitation of orders directly by a foreign person or using a dependent agent for the purpose of selling “inventory” is likely to constitute a USTOB.
  • A USTB may be avoided where the selling activity involves the use of a truly independent agent operating in its own commercial interest and not on behalf of the foreign person.
  • Sales of inventory made from a stock of inventory maintained in the U.S. has been found to result in a USTB.
  • Manufacturing in the U.S. which culminates in the sale of the manufactured merchandise may be expected to result in the creation of a USTB

How Does Performing Services Impact USTB Status?

Sec. 864(b)(1) of the Internal Revenue Code provides that the performance of personal services, whether athletic, artistic, or otherwise is treated as a USTB. The performance of services for a single event is sufficient to create a USTB.

Special Rules for Trading Stocks, Securities, and Commodities

Under Sec. 864(b)(2), trading by a foreign person in the above-mentioned financial assets for his or her own account is not treated as a USTB. This exception applies even if the foreign person is physically present in the U.S. or uses a resident broker or an employee to effectuate the trading activity. The volume of trading performed by the foreign person or on his behalf is irrelevant in applying this exception.

How Partnership or Trust Beneficiary Status Can Create a USTB

If a partnership or trust is engaged in a USTB, a foreign person who is a partner or beneficiary will be deemed to be engaged in that same USTB.

Why Determining USTB Status Matters

If a USTB is determined to exist, the “effectively connected income” (“ECI”) of the USTB is subject to U.S. income tax at the regular rates applicable to individuals and corporations.

In addition, the party deriving the ECI (e.g., a foreign individual or corporation) must file an annual U.S. income tax return. Deductions related to the creation of the ECI may be claimed in connection with the filing of the required tax return.

If a tax return is not filed, otherwise available deductions may be forfeited. This is why where there is uncertainty about the existence of a USTB, it is advisable for the foreign person to file a “protective” pro forma tax return, a precautionary tax return filed to protect the right to claim deductions.

What Is Effectively Connected Income (ECI)?

The rules for determining ECI are complex, but the basic rules are as follows:

  • Any “U.S. source” income of a foreign person engaged in a USTB other than “fixed or determinable” (i.e., passive) income and capital gains is ECI. Common examples of U.S. source income include income from the sale of merchandise where title passes in the U.S., rents, royalties and interest derived from U.S. payors and income from services performed in the U.S.
  • In certain limited cases, foreign source income may be treated as ECI. This will only occur where the foreign person has an office or fixed place of business in the U.S. and the income is attributable to that office.
  • Passive income such as dividends and interest may be treated as ECI if derived from assets used in the USTB or if the activities of the USTB are a material factor in the realization of the income.
  • Gain realized on the sale of a partnership interest will in most cases result in the recognition of some level of ECI subject to U.S. tax.

How Do Tax Treaties Affect USTB Rules?

Where a foreign person is eligible to obtain the benefits of a tax treaty, the threshold for becoming subject to U.S. taxation on his or her business activities is considerably higher, and the rules are more objective in nature.

The main difference is that under a tax treaty, a foreign person will generally not become subject to U.S. taxation unless he/she/it has a “permanent establishment” (PE) in the U.S. A PE ordinarily involves a fixed place of business such as an office or factory, or the employment of agents who possess the power to conclude contracts on behalf of the foreign person.

In view of the many South and Central American countries that do not have a tax treaty with the U.S., the USTB concept remains vitally relevant for individuals and companies from such countries.