By Ji Zhang, Esq., 2012/07/26
When foreign companies work through US subsidiaries to conduct business in the US, it can bring up complicated issues of who should be held responsible for the tax, and at what rate. For example, during years 2004-2007, DeCoro Limited (Parent), a Hong Kong limited liability company, manufactured furniture in China. DeCoro USA Ltd. (Sub) is a North Carolina corporation and a wholly owned subsidiary of Parent. So, the Sub company bought furniture from the Parent company, and sold to customers in the US either through its local employees or independent sales representatives. In re DeCoro USA, Ltd., (2012 Bankr. LEXIS 1608, 109 A.F.T.R. 2d 1811) involves sales of furniture in the US. The key question in this case is which company is the seller and should be held responsible for income tax due from such sales.
Initially, the IRS took the position that the Sub company is a dependent agent of the Parent company, and so the US sales would be attributed to the Parent. The income from these sales effectively connected to US trade or business would be taxed at graduated rates. In February of 2009, the IRS issued an assessment letter against the Parent company for unpaid income taxes due from furniture sales. However, unknown to the IRS and prior to any tax assessments, the Parent company had filed an insolvency proceeding in Hong Kong and the Sub company had filed for bankruptcy relief in the US.
On June 8, 2009, the IRS filed its original proof of claim in bankruptcy court and took an entirely opposite approach from its initial assessment. Instead of seeing the Sub company as a dependent agent, the IRS claimed the US-based subsidiary as an independent distributor of the furniture made by Parent. As such, the Sub would be responsible for any taxes due from the furniture sales to US customers. Apparently, from the IRS perspective, it is much easier to collect taxes from the US Sub company than from the foreign Parent company. To support its position, the IRS included a Distribution Agreement between the Parent and Sub companies which provided that they were “independent parties” and that “neither party will either have nor represent itself to have any authority to bind the other party or act on its behalf.”
Furthermore, the IRS adjusted Sub company’s taxable income pursuant to Sec. 482, because the two organizations did not conduct transactions at arms-length. For example, the Parent company consistently sold furniture to the Sub at a mark-up rate substantially lower than to other uncontrolled parties, resulting in a low profit margin for the subsidiary from its inception. Sec. 482 allows the IRS to allocate income and expense among members of a controlled group to reflect their true income. With respect to the foreign Parent, the IRS deemed that it had received dividend income equal to the difference between an arms-length mark-up and the actual mark-up. Under Section 881, a foreign corporation is taxed at a flat rate of 30% on US source dividend. Because the Sub company failed to withhold this amount, the IRS included it as part of the tax liability against Sub.
The Sub company moved for summary judgment, arguing that several factors clearly showed it is a dependent agent, not an independent distributor:
1) The Sub was required to pay for almost the same price at which it charged to customers, which precluded it from realizing any profits,
2) The Sub did not bear any risk of loss as to bad debts or any unsold furniture,
3) The Parent paid all shipping costs, custom duties, insurance related to sale and delivery of furniture, and
4) Parent excised “a considerable degree of control” over Sub.
The Court denied this summary judgment motion because the evidence failed to show the existence of a fiduciary relationship between the Parent and Sub companies. There was also no evidence of the Sub company’s power to bind the Parent to agreements, and how the companies conducted business with third parties and each other.
The totality of the facts and circumstance must be considered. Given the limited scope of the evidence and the inference that was favorable to the IRS, the Sub company failed to show its dependent agent status. This case is another example of the manipulative nature of US trade or business, and the resulting challenges and uncertainties facing companies when a foreign corporation uses the services of another party to conduct business in the US, thereby raising the specter of agency attribution and the resulting tax liabilities. Because fact-based inquiries are less likely to be decided at summary judgment, taxpayers may feel pressured to settle simply to minimize the cost and uncertainty associated with a long, full-blown trial. Therefore, before engaging in any cross border activities, companies should always consult with a tax adviser to avoid being left at the mercy of the IRS.
These publications do not constitute legal advice. Further information regarding this notice.