CLOUD COMPUTING – WHAT IS IT?

The US Department of Commerce has referred to cloud computing as, “a model for enabling convenient, on-demand network access to a shared pool of configurable computing resources that can be rapidly provisioned and released with minimal management effort or service provider interaction”.[1]  Whatever the definition, the common consensus is that cloud computing entails a sharing of infrastructure with exceptional accessibility and often at a greatly reduced cost.

KEY COMPONENTS OF THE CLOUD

Cloud computing has thrived due to the on-demand nature of the products and services offered.  A user can access a program via the internet, store and manipulate data from anywhere as if they were in their office at their desk.  The various programs in the cloud behave exactly as they would if you were in your local network, and often at a similar speed.

Access to the cloud is, by necessity done via network, or internet.  The ability to pool and share resources and data is one of the key features of the cloud.  A stand-alone system, not connected to other systems isn’t able to share or pool resources, so singular systems are not able to benefit from the cloud.

COST VERSUS BENEFITS ARE COMPELLING

Business use of cloud computing has grown rapidly over the past few years as the ability to increase network speed at very low cost has increased.  By being able to share resources among several departments or locations seamlessly, businesses have used cloud computing to reduce duplication of some infrastructure which greatly reduces cost of investment by business.  Consumers also regularly use cloud computing, often without stopping to consider that they are doing so.  Accessing webmail or on-line banking are examples of cloud computing that have become commonplace in current daily living.

Another benefit of cloud computing is that the services available are easily scalable to meet the needs of the user.  Because of the virtual nature of cloud computing, users can often quickly increase capacity or decrease capacity to meet current requirements.  In traditional IT models, some excess capacity is required to allow for peak usage or permanent growth.  In the cloud, that excess capacity is sold as virtual server capability.  Since users are generally acquiring capability to complete a process, not physical resources, billings are often based on usage.  Therefore, the more you use, the more you pay and vice versa.

SO, WHERE EXACTLY IS THIS CLOUD?

In cloud computing, the sharing that takes place generally uses the most efficient route possible with little consideration of what that route may actually be and where the servers actually reside.  Service providers can offer excess capacity in several locations at once and a user could be accessing computing power in several different parts of the globe simultaneously.  The routing is often designed to maximize data exchange and processing, often with little regard for regulations within the jurisdiction where the data is processed or ultimately resides.

There are four traditional cloud deployment models in current use.  They are;

• Private – a cloud within a single company
• Public – a cloud open to the general public (e.g. gmail)
• Community – a cloud shared by several organizations within a specific community (e.g. a university)
• Hybrid – two or more clouds that interact without merging into a single cloud

US FEDERAL AND STATE IMPLICATIONS

This type of technology can create difficult tax issues for businesses.  For example, an order for goods is input in one country, processed in a second country, validated and approved in a third country, drop shipped from a vendor in a fourth country and the data could reside in a fifth country.  Where does the business have a taxable presence and where does the income generated from the transaction get taxed?  These questions are complex when applied between countries, but they are just as complex when applied between the states.  The income tax laws and nexus guidance of the various states are based on twentieth century ideas that often don’t fit well onto twenty-first century technology.  For a more detailed discussion about nexus, please see our article on our website.

US STATE INCOME TAX ISSUES

One key aspect of US state income taxes is that the income generated by a business is apportioned among the several states where the taxpayer has sufficient business activity to create nexus.  In the case of cloud computing, two questions arise.  Firstly, does having a customer in a remote state accessing your product in the cloud create nexus?  The second question is where to source the income generated from those customers.

A number of states are adopting an economic nexus standard in respect to income taxes.  These economic nexus standards often incorporate a bright-line test for nexus.  As an example, California’s legislation states that if you have more than $50,000 of property or payroll located in the state, or if more than $500,000 of your gross receipts are from California customers, or if any of your California property, payroll or sales is 25% or more of the total of that factor, then you are considered to be doing business in California and you have nexus.  In Washington, the Business and Occupation tax based on gross receipts has a sales threshold of only $250,000 before nexus is created.  In other states, the threshold may be some different amount, so we recommend that you consult with your US tax advisor before getting too far into e-commerce and cloud based services in the US.

If you have exceeded these minimums and have nexus, the second question poses even greater difficulty for most taxpayers.  Sourcing rules for sale of property are different from those used in the sale of a service.  A taxpayer must first understand if they are selling a license to use software or are they providing software as a service (“SAAS”).  Once you have determined this point, you need to understand where you allocate the gross receipts for apportioning the income.  Some of the options are;

• the user’s physical location when they accessed the software,
• the customer’s invoice address,
• the location of the server accessed by the customer,
• the location of your servers (which may be different from the server accessed), or
• your place of commercial domicile.

Since most cloud computing is done by using excess capacity of several servers, and has built in redundancy, your customer could be accessing servers in different locations simultaneously.

As said before, there is often little guidance, although several states are working to deal with emerging issues brought on by internet commerce and cloud computing.  To be certain, the rules are generally different from state to state.  So how do you find your way out of the cloud?

Pursuant to IRS circular 230, this document is to be considered other written advice.  The information in this publication is accurate as of the time of its publication.  State and local taxes are constantly changing and AG Tax assumes no responsibility for changes to tax legislation subsequent to the publication of this document.  Readers are urged to work with their tax advisor to ensure that any tax planning decisions are made in consideration of current tax legislation available.  This document was not written to be used, and it cannot be used, for the purpose of avoiding any federal, state or local tax penalties that may be imposed upon a taxpayer.

Washington has a couple of very unique aspects to the state taxation structure.  Firstly, there is no state level personal income tax.  Secondly, there is no state level corporate net income tax either.  So exactly how does Washington fund the state budget?  The state raises funds through sales taxes and the Washington Business & Occupation (“B&O”) tax.

What’s the Difference Between B&O and Income Tax?

Income taxes are generally based on the net income, after deductions, of the corporation.  The B&O tax is an excise tax and is based on the gross receipts, with a few limited exclusions and deductions, of a corporation.

Most would think a tax on gross receipts is not as desirable as a tax on net income.  To derive net income, a taxpayer has the opportunity to deduct expenses incurred to earn that income, but this is not so with a gross receipts tax.

The State understands that if the tax is too aggressive, they risk having businesses migrate to states with more favorable tax systems.  Accordingly, the State has taken steps to moderate the effect of the tax on businesses.

Why Do Business Under the B&O?

The tax rate for the B&O for most business classifications is less than ½ percent.  For retail and wholesale businesses, the tax rate is 0.471% and for manufacturing businesses the rate is 0.484%.  Services are taxed at 1.5%.  These rates are subject to periodic changes without notice.  A good way of understanding how the Government determines the rate is to think of it this way.  The B&O should provide roughly the same tax burden as most net income taxes.  The range for Income tax rates in the US is between 5% and 10%; with a good estimate of the average around 8%.  In determining an acceptable tax rate, the state appears to have estimated a net income average of 6% of gross sales.  Accordingly, an 8% tax on a 6% net margin is equivalent to a 0.48% tax on the gross margin (gross receipts * 6% net profit margin * 8% tax rate).  The real benefit in the gross receipts tax to the taxpayer is the relative simplicity of the reporting.

The drawback to a tax based on gross receipts is that when the company is in a net loss position, the B&O tax is still applicable and you still have tax to pay.  Additionally, the B&O tax is not a creditable tax for Canadian companies doing business in the US, so there is tax leakage with this system in the cross-border environment.

Another aspect to remember is that several Washington local and municipal governments also apply a B&O tax in addition to the State B&O tax, so there may be more than one return to file.  While this may seem burdensome, there are a number of other cities in states that levy net income taxes that also apply local net income taxes on corporations doing business in the city.

 Is There Planning Opportunity in the B&O?

The B&O is based on gross receipts from sales delivered in Washington or services performed in the State.  The definition of gross receipts isn’t always as clear as one would expect and different business models may yield different results.  The room for error is even greater in a digital marketplace.  A misinterpretation of the rules may result in not paying the proper amount of tax.  We recommend that companies doing business in Washington or doing business with Washington customers consult with a US tax advisor to ensure that they are properly reporting their gross receipts for B&O tax purposes.

Pursuant to IRS circular 230, this document is to be considered other written advice.  The information in this publication is accurate as of the time of its publication.  State and local taxes are constantly changing and AG Tax assumes no responsibility for changes to tax legislation subsequent to the publication of this document.  Readers are urged to work with their tax advisor to ensure that any tax planning decisions are made in consideration of current tax legislation available.  This document was not written to be used, and it cannot be used, for the purpose of avoiding any federal, state or local tax penalties that may be imposed upon a taxpayer.

We often get calls to our office asking what the tax implications are if I want to get into a business in a country.  We thought it would be useful to help explain taxation in a particular country.  One concept that particularly affects the transaction of business between Canada and the United States is Permanent Establishment.

Article VII of the Canada – US Income Tax Convention (1980) (the “Treaty”) provides that the business profits of an individual or corporation resident in one country may only be taxable in the other country to the extent that those business profits are attributable to a Permanent Establishment (“PE”) in that other country.  In other words, if you can set up your business in such a manner as to not create a PE in the other country, you don’t have to pay their tax!  You should still file a treaty based return to protect your rights, but there isn’t any tax to pay.

Since the rules governing PEs are set out in the Treaty, the requirements of PEs are generally the same in both countries. As a consequence this article should be of interest to residents of both Canada and the United States engaged in cross border trade and commerce or services. For clarity, in this article the country that the company or individual is resident in is described as the foreign country and the country where the PE is located is referred to as the source or other country.

It is important to note that Canadian residents may be subject to US state and local taxes that can vary significantly from state to state since the individual States are not necessarily bound by the Treaty. US companies doing business in Canada should note that the Canadian federal government administers taxes on behalf of all provinces except Quebec and generally applies the Treaty to those Provinces income taxes.

 Permanent Establishment Defined

Article V of the Treaty defines a PE as, among other things;

• a place of management,
• a branch,
• an office,
• a factory,
• a workshop,
• a mine, oil or gas well, a quarry or other place of extraction of natural resources,
• a building site, construction or installation project that lasts more than 12 months, and
• a dependent agent who has and habitually exercises the authority to conclude contracts in the source country on behalf of the foreign company.

Depending upon the frequency and nature of the activity, things such as directors or management meetings may create a PE; and signing contracts in the other country will almost always create a PE.

Historically, the definition of a PE has emphasized “bricks and mortar” facilities with a relatively narrow definition given to an agent.  An agent does not, however, generally create a PE by simply assisting a customer or facilitating contracts by acting as an intermediary between the customer and the foreign management.

Determining Whether You Have a Permanent Establishment

The existence of a PE is a based on a ‘facts and circumstances’ test within the criteria of Article V of the Treaty.

A PE could be any premise or facility used by a foreign individual or corporation to carry on the business of the foreign resident whether or not it is used exclusively by the foreign resident nor does the foreign resident require a formal right to use the premises. A place of business may be determined to be a PE even if it exists for only a short time if that is the nature of the business.

Specifically excluded from the definition of a PE are;

• a facility used to store, display or deliver the goods of the foreign person;
• maintenance of a stock of goods for the purpose of storage, display or delivery;
• maintenance of a stock of goods for the purpose of processing by another person;
• purchase of merchandise, or the collection of information for the foreign person;
• advertising, the supply of information or scientific research or similar activities which have a preparatory or auxiliary character for the foreign person; and
• ownership of a subsidiary in the other country.

 Dependent Agent Permanent Establishment

If the foreign business does not meet the criteria for a fixed place of business the source country taxing authority may try to establish the existence of a Dependent Agent PE. If the business of the foreign resident is conducted through a dependent agent that has, and habitually exercises, the authority to conclude contracts on behalf of that foreign person, a PE likely exists. The agent may be either a company or an individual. Furthermore, a dependent agent is not required to be a resident or have a place of business in the source country where the business is carried on.

 Independent Agents

Independent agents operating in the normal course of their own business representing the products or services of the foreign resident generally do not create a PE of the foreign resident. Therefore, having your products sold by an unrelated company should not give rise to a PE, however, if that agent undertakes activities on your behalf (e.g. concludes a contract) a PE may be created.

 New Rule: Permanent Establishments from Services

The fifth protocol to the Treaty that became effective January 1, 2010 introduced an additional definition for a PE. As a result individuals and companies engaged in providing cross border services will be deemed to have a PE in the other country if either of the following tests are met:

• The Single Individual Test for Individuals.

If an individual resident in one country performs services in the other country and the non-resident individual is present in that other country for a period exceeding 183 days in any twelve-month period and, during the period the individual was present in the other country, more than 50% of gross active revenues of the individual were earned in the other country.

• The Enterprise Test for Corporations.

If a company resident in one country performs services in the other country through one or more individuals present in the other country for a period of more than 183 days in any twelve-month period; or

Provides services for a client or customer in the other country for an aggregate of 183 days or more in any twelve-month period with respect of the same project or a connected project.

If an individual or a corporation resident in one country is deemed to have a PE in the other country they must file tax returns and pay taxes in the second country on profits attributed to the PE.

In any case, individuals and corporations engaged in cross border trade will now need to keep detailed records of the border crossings of their management and staff and accurately distribute payroll and other expenses between the two countries.

What’s the Risk?

If a Canadian corporation fails to file a U.S. tax return because it believes its U.S. activities do not constitute a PE, and is later found to have had a PE, it may be denied deductions against income attributed to its U.S. PE. More likely, however, is the US $10,000 penalty per occurrence arising from failure to file the Treaty Based Position Statement with the U.S. return.  US companies operating in Canada are required to report all Canadian-source income to the Canada Revenue Agency whether or not a PE actually exists.

Another position of the IRS is that where a taxpayer has failed to file returns, the statute of limitations has not started and all years of the taxpayer are open for assessment.  Accordingly, the U.S. could require a Canadian company to pay income tax for a year that is closed in Canada or is beyond the ability to carry over unused foreign tax credits and double taxation would result.

Pursuant to IRS circular 230, this document is to be considered other written advice.  The information in this publication is accurate as of the time of its publication.  State and local taxes are constantly changing and AG Tax assumes no responsibility for changes to tax legislation subsequent to the publication of this document.  Readers are urged to work with their tax advisor to ensure that any tax planning decisions are made in consideration of current tax legislation available.  This document was not written to be used, and it cannot be used, for the purpose of avoiding any federal, state or local tax penalties that may be imposed upon a taxpayer. 

Canadian companies looking to sell goods into the Unites States have several choices of structure for their U.S. operations.  These choices can have substantial impact on the amount of taxes paid as well as the complexity and number of the U.S. filings required.

BACKGROUND

The Canada-United States Income Tax Convention (1980), commonly referred to as the Treaty, lays out in some detail the interaction of the tax systems in both countries for individuals and companies working across the border.

In the United States, each state has differing business tax laws that apply to foreign companies.  These different taxes, coupled with the fact that the individual States are not bound by the provisions of the Canada-U.S. Income Tax treaty creates complication for Canadian companies  looking to enter U.S. markets.

Most, but not all, states impose a corporate income tax.  Some states also impose franchise taxes on the value of the company’s equity in addition to the corporate income tax, while other states have tax bases other than income and equity.  The type of corporate structure chosen can have an effect on how each of these taxes may apply to Canadian companies expanding into the U.S.

A number of Canadian companies wonder if they need to go to the trouble of setting up subsidiaries or other entities to do business in the various states in the U.S.  Two common misconceptions are;

• since they will only operate from a Canadian location, there isn’t any risk; and
• a Canadian company will never be caught.

Both of these ideas usually lead down the road to disaster.  If you set up your business correctly right from the beginning, you can generally reduce the amount of tax paid and reduce the amount of risk you face.

HOW ARE THEY GOING TO FIND ME?

This is one of the most common questions asked by companies beginning their journey across the border and it is a valid question.  One way that foreign companies are found out by the various tax authorities in the U.S. is by audit of your U.S. customer.  When your customer is audited, the revenue agent will want to look at a sampling of supplier invoices and your invoice may likely be in the sample group.  Suppliers in the sample group are compared to the list of currently filing taxpayers and if you aren’t on the list of taxpayers, you will likely get a questionnaire asking what you are doing in the U.S. or in the state.

The IRS in the United States has been increasing its focus on reporting from non-resident institutions and companies in the past few years.  One need only to look at the Swiss bank

There are a few states where the Departments of Revenue have asked the federal government for all customs documentation pertaining to goods imported into the US where the final destination is in their particular state.  A state revenue agent then cross references the shipper to the tax rolls and in the case where a shipper isn’t a taxpayer, the shipper gets a questionnaire asking what they are doing in the state.

WATCH OUT FOR TRAPS

Keep in mind that these questionnaires are intended to determine who should be filing, not who shouldn’t be filing and the questions are worded accordingly.  To quote an agent from one of the Departments of Revenue of a large and populous eastern state, “our Unit is here to figure out who is taxable, not who is not!  If you want someone to determine that you are not taxable, you’ll need to find a different Unit.”  A simple misinterpretation of the jargon used on the questionnaire can inadvertently cause a tax presence for a Canadian company that may be difficult to correct.

One of the favorite questions is, “when did you begin selling your products in the state”.  For most people, the answer would be when they made their first sale to an in-state customer.  Often overlooked is the distinction between a sale in the state and a sale into the state.

If it is determined that you have a U.S. federal or state tax exposure, you will be required to register, file and pay back taxes, including substantial penalties and interest.  Once you have been identified and contacted, the ability to ask for relief of those penalties and interest is gone, so you should review your current situation with your U.S. tax advisor.

For a discussion of state tax nexus, please see the Nexus article on our website.

WHAT ARE THE PENALTIES?

There are substantial penalties for non-compliance with taxes and tax filings which range in size based on severity of the offence.

Some states require the inclusion of certain federal forms which carry substantial penalties for non-filing or late filing.  As an example the Treaty Based Return Disclosure Form (#8833) carries a penalty of USD $10,000 for failure to timely file.[1]

In addition to piggy-backing on federal penalty provisions, states have the opportunity to add additional penalties which can range to over 50% of outstanding amounts.  The states can also decide on whether to allow relief for any penalties and interest independent of any determination made at the federal level or in any other state.  California requires that a taxpayer include copies of certain federal forms and mirrors the federal penalty for California purposes.  Effectively, the penalty for not filing certain forms with your federal and California returns can climb to USD $20,000 per occurrence.

WHAT CAN BE DONE?

Canadian companies that properly structure their ventures into the U.S. can effectively reduce tax payable, both federally and in the various states.  By properly structuring the organizational chart along with ensuring that the duties of employees and agents in the U.S. is controlled, companies can ensure that they do not create a U.S. Permanent Establishment so that they may take advantage of the Treaty to source their income to Canada and reduce their U.S. federal taxable income to zero.  Additionally, by using the right structure, Canadian companies are able to take a dollar for dollar credit for U.S. taxes paid instead of a deduction from income.

Many states, while not actively adhering to the treaty, nonetheless do so by default.  These states rely on taxable income reported on the federal tax return as filed with the IRS as the starting point for computing state taxable income.  If the Treaty is used to reduce federal taxable income to zero, then the computation of state taxable income also begins at zero.  There are, however, several states that require a foreign corporation to recompute their U.S. taxable income as if there were no treaty to find the starting point for determining state taxable income.

The use of different subsidiary structures for your U.S. business can reduce or restrict legal liability in addition to tax liabilities.  In certain circumstances, a Canadian subsidiary responsible for all sales to the U.S. may provide relief from U.S. federal tax and greatly reduce U.S. state income tax.  We remind readers of this article that no single tax plan is suitable for all situations.  Making sure that you have the most effective structure possible is highly dependent upon your individual situation and what you want the plan to accomplish.

Pursuant to IRS circular 230, this document is to be considered other written advice.  The information in this publication is accurate as of the time of its publication.  State and local taxes are constantly changing and AG Tax assumes no responsibility for changes to tax legislation subsequent to the publication of this document.  Readers are urged to work with their tax advisor to ensure that any tax planning decisions are made in consideration of current tax legislation available.  This document was not written to be used, and it cannot be used, for the purpose of avoiding any federal, state or local tax penalties that may be imposed upon a taxpayer.

In the current economic environment, state governments are trying to expand the reach of sales taxes as they apply to internet sales of goods and services and other online transactions.  There is a natural tension created when the various States are looking to increase tax revenues by characterizing where the sale occurs and the taxpayers are looking to minimize tax costs.

HISTORY

Sales taxes in the United States are generally borne by the final retail purchaser or consumer of goods and certain services; and should create little incremental cost to the businesses that provide those goods and services if efficiently administered.  If, however, the business doesn’t apply the sales tax rules properly, any shortfall may become a liability of the business with no opportunity to recover the tax from its customer.  An additional income tax may be a percentage of the bottom line and may put a serious dent in the net income of the company, but sales taxes are a significant percentage of gross income and may completely wipe out all of the company’s profit.

As an example, a few years back a small company in British Columbia set up a system to push data and ad copy to their customers all over North America.  The service were exempt from U.S. sales taxes in almost all of the states and providing data services from Canada shouldn’t have been sufficient presence to create a tax collection responsibility.  The company, however, leased dedicated data terminals to their customers as part of the plan.  The terminal created a tax presence and the lease payments were taxable.  The company missed this seemingly minor detail and the resulting sales tax bill from three years of operations bankrupted the company!

SALES TAX OBLIGATION

One of the underlying principles of U.S. sales and use taxation is that for a vendor to be subject to the requirements to collect and remit the tax to the state; that vendor must first have sufficient nexus with the state so as to be subject to the State’s tax obligations.  Please see our article that deals with U.S. tax nexus for more detailed information about this subject.

WHAT TO COLLECT

There are a few basic questions that vendors ask when trying to figure out how much U.S.  sales tax to collect on a sale, if any at all.  The questions are;

1. Is what I’m selling taxable?
2. Is the person I’m selling to exempt or required to pay?
3. What rate of tax should I apply?

These questions become more complicated when dealing in the realm of e-commerce and internet sales.

INTERNET SALES

In addition to the previous three questions, companies conducting sales via the web need to first figure out where they are making those sales.  The place of physical delivery occurs generally determines which jurisdiction gets to tax the transaction, but again, only if the vendor has nexus.  Consider a company that may be headquartered in Canada, with their website hosted on a server in second country, purchasing goods from a supplier in a third country, then having the supplier send the goods directly to the U.S. customer with title passing in transit.   Where did the sale take place?  Did it happen in the U.S., in Canada or in the country where the server processed the order and payment?  Generally, if the company has nexus in the place where the goods were delivered, they will collect and remit that state’s sales tax.  But, what if they don’t have nexus?  Where the seller doesn’t have nexus, there is no obligation for the vendor to collect and remit the tax.  We understand that the purchaser is required to self-assess and pay the appropriate tax to the state, but that rarely happens.  The end result is that in- state retailers are put at a distinct disadvantage and the states are always looking for creative ways to re-level the playing field.

One way the states are looking to level the playing field is to assert economic nexus on out-of-state vendors.  The principle of economic nexus is that the out-of-state vendor has sufficiently directed their activity to the state to create Due Process nexus.  Further, once beyond a bright-line threshold, the company’s economic presence is deemed to be substantial, which satisfies the Commerce Clause.  So, states have come up with a system to create an obligation for out-of-state vendors despite prior case law.  The states are arguing that the prior case law is outdated in the modern economy, and to date, the Supreme Court has not accepted any new cases in this area.

DIGITAL GOODS

Digital goods pose a second layer of complexity.  Since there is no physical delivery of digital property, the question of where and at what rate the tax should be applied is even less clear.  States are currently grappling with the question of whether the tax should be applied where the vendor makes the digital goods available for download, where the transaction is processed, or where the purchaser makes use of the downloaded digital goods.  The rising opinion is to locate the sale where the purchaser makes use of the digital goods, but there is no unanimous consensus.  Since no state wants to forgo tax revenue, the potential for double taxation is significant.

CLOUD COMPUTING

With the advent of cloud computing and mere use of hosted applications, the sales tax questions become even more difficult to answer because there is no actual download of the goods or applications.  The customer often is merely making use of the program hosted at some remote location.  In this digital arena, many states are contending with the question of what is the true nature of the transaction.  Was there a sale of an intangible digital good or the sale of a computing service?  Nobody knows for sure yet where this will end up, but the debate will get interesting and the states will find new and creative ways to try to tax as many transactions as possible.

Pursuant to IRS circular 230, this document is to be considered other written advice.  The information in this publication is accurate as of the time of its publication.  State and local taxes are constantly changing and AG Tax assumes no responsibility for changes to tax legislation subsequent to the publication of this document.  Readers are urged to work with their tax advisor to ensure that any tax planning decisions are made in consideration of current tax legislation available.  This document was not written to be used, and it cannot be used, for the purpose of avoiding any federal, state or local tax penalties that may be imposed upon a taxpayer.

I remember several years ago working with a fellow who had made several trips to almost every state in  the U.S. to visit clients, install equipment and provide other services to his customers.  I told him, quite sadly, that he had nexus all over the place.  He looked at his arms with a horrified expression and asked if could be cured?  We both almost fell off our chairs laughing at his joke, but the underlying question was a very good one.  What is nexus, is it a good thing or a bad thing, and what can be done about it?

NEXUS – DEFINED

Nexus is a concept developed by the various states in the U.S. to determine whether a taxpayer is, a taxpayer.  It is loosely similar to the federal concept of permanent establishment.  Where the comparison ends is in the definition of the two terms.  Permanent establishment is fairly well defined in treaties and the Internal Revenue Code.  There are some very important concepts in tax that are very poorly defined.  The definition of income for tax purposes is “income from whatever source”.  The definition of nexus is more nebulous in that this concept has been defined mostly by jurisprudence.

In short, nexus is a closeness or connection between the taxing jurisdiction and the person that the jurisdiction is seeking to impose its tax obligations upon.  Not helpful, but it’s a start.

Nexus has different thresholds that depend upon the type of tax, the state and sometimes even the industry under consideration.

Generally, both the Due Process Clause of the United States Constitution and the Commerce Clause require that a taxpayer have some minimum connection with, or presence in the state before taxes can be imposed.

NEXUS – MINIMUM STANDARD

The Supreme Court ruled in Millar Brothers Co. v. Maryland that the Due Process Clause requires some “definite link, some minimum connection, between a state and the person, property, or transaction it seeks to tax.”[1] Generally a residence within the state, the doing of business or the hiring of employees within the state, or the owning of property within the state would all qualify as such a connection.

The Court further ruled in Quill Corporation v. North Dakota that while the Due Process Clause required some minimal connection the Commerce Clause imposed a different and higher standard.  In this instance, Quill had some minimal amount of property present in North Dakota, however, the Court determined that, “… contrary to the State’s argument, a mail-order house may have the “minimum contacts” with a taxing State as required by the Due Process Clause and yet lack the “substantial nexus” with the State required by the Commerce Clause. These requirements are not identical and are animated by different constitutional concerns and policies. Due process concerns the fundamental fairness of governmental activity, and the touchstone of due process nexus analysis is often identified as “notice” or “fair warning.” In contrast, the Commerce Clause and its nexus requirement are informed by structural concerns about the effects of state regulation on the national economy.”[2]

In other words, while a company may have enough presence to satisfy the Due Process Clause, the Commerce Clause, and in particular, the Dormant Commerce Clause requires that the presence is substantial before sales or use tax nexus is found.

Many states, when looking at other types of taxes are quick to remind that Quill and its supporting cases are applicable only to sales tax and not to other tax types.

NEXUS – THE INCOME TAX APPROACH

The Supreme Court’s found in the Northwestern States Portland Cement case, that an out of state seller could be required to pay income tax for having employees solicit orders for sales and maintaining a leased office in the state.[3]  The Court wasn’t clear whether nexus was created by the presence of a leased office, the activity of the employees or some combination of the two.  In response to the questions raised, Congress acted to assist business by passing Public Law 86-272 (PL 86-272) in 1959.  This federal law allowed that, no state or political subdivision thereof, shall have the power to impose a net income tax on the income derived by such person from interstate commerce if the only business activities of such person are the solicitation of orders for the sale of tangible personal property, which orders are sent outside the State for approval or rejection, and if approved, are filled by shipment or delivery from a point outside the State.”[4]

There are a few terms of art in the legislation that warrant further scrutiny.  The law is clear that it only applies to net income based taxes.  Therefore, taxes on capital, gross receipts or other tax bases that are not net income are not covered by this law.  Accordingly, Ohio’s Commercial Activity Tax and Washington’s Business and Occupation Tax are not restricted by PL 86-272.

The law is also very clear that it applies only to orders for the sale of tangible personal property.  Taxpayers making sales of intangible property or services, whether in addition to sales of tangible personal property or not, are not covered by this law.  In recent years, legislation has been introduced in both Congress and the Senate to extend the protection of PL 86-272 to intangible property and services, however, none of the efforts to date to expand the law have been successful.

Another point is that the law specifically applies, by its terms, to interstate commerce and not necessarily to foreign commerce.  Interstate commerce is generally thought of to include business done between the 50 states and the Commonwealth of Puerto Rico.  Therefore, shipments originating outside of the United States may not be included as “in furtherance of interstate commerce”, and the activity of soliciting orders for those sales is not a protected activity pursuant to PL 86-272.  California is one of the more predominant states to hold the position that companies who fill orders by shipment from a point outside the U.S. (e.g. direct shipment from an offshore factory) are acting in furtherance of international commerce and are outside the protections of the law.

SO IS NEXUS A BAD THING?

Having nexus in a state is not necessarily a bad thing.  In the U.S., state income and franchise taxes generally require taxpayers to apportion their tax base among the several states where they are doing business.  Underlying the apportionment principle is that you must be doing business, or have nexus, in more than one state to have the right to apportion some amount of income to that state.  If you only have nexus in one place, it is hard to argue that your income should be apportioned to other locations.

Having nexus in a state will create a filing requirement in that state which will increase the compliance and administrative burden on taxpayers.  This is generally the first thought when looking at whether expanded nexus is good or bad and since the expansion means an increase in burden and associated costs, nexus is often viewed as a bad thing.

If, however, by creating nexus in another state, you can apportion income from your current state to another state that has a lower tax rate state, then nexus may not be a bad thing.  The analysis will depend upon the incremental costs of operating in, and complying with that second state’s rules compared to the incremental benefits gained.  Those benefits can be cost savings and can also be intangible benefits such as better presence in a local market or other rights that residence in a state ma confer.

You should work with your U.S. tax advisor to determine whether you have created nexus in a state, whether you want to create nexus in a state, or whether you want to structure your business in that state to take advantage of the protections offered or other methods for not creating nexus in a state.

Pursuant to IRS circular 230, this document is to be considered other written advice.  The information in this publication is accurate as of the time of its publication.  State and local taxes are constantly changing and AG Tax assumes no responsibility for changes to tax legislation subsequent to the publication of this document.  Readers are urged to work with their tax advisor to ensure that any tax planning decisions are made in consideration of current tax legislation available.  This document was not written to be used, and it cannot be used, for the purpose of avoiding any federal, state or local tax penalties that may be imposed upon a taxpayer.

What is a Section 1031 Exchange?

Under Internal Revenue Code Section 1031 no gain or loss is recognized on business or investment property exchanged solely for business or investment property of a like-kind. Properties of the same nature or character are considered to be like-kind even if they differ in grade or quality. Real properties are generally of like-kind whether or not the properties are improved or unimproved where the exchange is made by someone who is not a dealer in real estate. Real property and personal property can both qualify as exchange properties under Section 1031 but real property can never be like kind to personal property. Real property located outside of the US is not like-kind to real property within the United States.
If other property of a not like-kind (e.g. assumption of debt, money, or other valuable consideration) is received as part of a 1031 exchange, a taxable gain is created in the year of the exchange on the value of the other property, other consideration, or money received. A property can be exchanged for a property of lesser value triggering a taxable gain on the difference in value. There can be both deferred and recognized gain on the same transaction. A loss on a 1031 exchange is not recognized.
Section 1031 does not apply to exchanges of inventory, stock in trade or other property held primarily for sale, stocks, bonds, notes, other securities or evidence of indebtedness, interests in a partnership, certificates of trust, or other beneficial interests.

Different Structures of a Real Property 1031 Exchange

Any taxpayer entity including individuals, corporations, partnerships, and trusts may set up an exchange of business or investment properties under Section 1031. A Section 1031 exchange requires an exchange of properties used for investment or business purposes. A simultaneous swap of a qualified property for another is the simplest example but deferred exchanges are allowed that permit the disposal of property and the subsequent acquisition of another like-kind replacement property. Multiple properties can be involved in 1031 exchanges.
A Section 1031 deferred exchange must be distinguishable from a simple sale of a property and the use of the sales proceeds to buy another property. To defer the recognition of gain under Section 1031 the property that is disposed of and the acquisition of another property should be mutually dependent parts of an integrated transaction that constitutes an exchange of property.
Generally an exchange facilitator under an exchange agreement pursuant to rules provided in the Income Tax Regulations is used to facilitate a deferred exchange. You cannot act as your own facilitator nor may your real estate agent, investment banker, mortgage or investment broker, accountant, attorney, employee or anyone else who has acted in the capacity of an agent for you within the last two years. A seller has 45 days after the sale of a relinquished property to identify potential replacement properties. Replacement properties must be clearly described in writing including the legal description, street address or other distinguishable name, signed by the seller, and delivered to a person involved in the exchange such as the person that sold the replacement property or the qualified intermediary or facilitator. Title to the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property must be substantially the same as the property identified within the 45-day limit.
A reverse exchange is more complex than a deferred exchange. A reverse exchange involves acquiring a replacement property through an exchange accommodation titleholder who can hold the title for a maximum of 180 days. During this period the purchaser sells or otherwise disposes of his relinquished property to close the exchange.
These limits cannot be extended for any ordinary circumstance or hardship. The single exception is a national emergency declared by the President of the US. Failure to meet time limits will result in the entire gain being taxable.

What property qualifies for a Like-Kind Exchange?

Generally, both the relinquished property you sell and the replacement property you buy must meet certain requirements. Section 1031 requires that the properties be held for use in a trade or business or for investment. Property used primarily for personal use is excluded from like-kind exchange treatment pursuant to Sec 1031(h)(2). For instance, you cannot exchange your residence or a vacation home for a rental property and defer the recognition of gain under Section 1031. You should be aware that receiving cash or other proceeds before a 1031 exchange is completed could also disqualify the transaction and make any gain immediately taxable. If cash or other proceeds that are not like-kind property are received at the conclusion of the exchange, the transaction may still qualify as a like-kind exchange. Gain, in this case would only be taxable on the amount of the proceeds that are not like-kind property. To avoid premature receipt of cash or other proceeds of a Section 1031 exchange a qualified intermediary or other exchange facilitator could hold those proceeds until the exchange is complete

How do you compute the basis in the new property?
When the replacement property is ultimately sold and is not as part of another exchange the original deferred gain plus any additional gain realized since the purchase of that replacement property will be recognized and become subject to tax. You are required to calculate and keep track of your basis in the newly acquired property. The basis of property acquired in a Section 1031 exchange is the basis of the property given up reduced by any money received and increased by any gain recognized at the time of the exchange plus other acquisition and disposal costs. This transfer of basis from the relinquished to the replacement property preserves the deferred gain for later recognition. The resulting depreciable basis is generally lower than what would otherwise be available if the replacement property were acquired in a taxable transaction.
It is important that you adjust and track basis correctly to comply with Section 1031 regulations. Gain is deferred but not forgiven in a like-kind exchange. You must report a Section 1031 exchange to the IRS on Form 8824 (Like-Kind Exchanges) which is filed with your tax return for the year in which the exchange occurred. If you do not specifically follow the rules for like-kind exchanges, the transaction may be considered to be taxable in the year of the exchange and penalties and interest may result on any underpayment of tax in the year of the exchange.

We Can Help

The international tax specialists at AG Tax will assist you to calculate the new basis of your replacement property and file any forms and tax returns required by the IRS. You should also be aware that you may be required to include the gains from 1031 transactions on your Canadian tax returns. AG Tax cross border specialists can assist you with your immediate and ongoing tax and accounting matters at reasonable cost. Contact Peter Aylett or Edward Shawchuk at 604-538-8735 for a free consultation.

Precautionary Notice

To the best of our knowledge and ability the information in this article was current and accurate at the time it was published. However, laws, regulations, and administrative rulings issued by governments are constantly evolving and being revised. Readers are cautioned that it is incumbent upon them to check with the competent authorities to ensure that they have acted upon the latest available information. This article is intended only to provide an overview of the regulations regarding Section 1031 exchanges. Individuals should consult a tax professional for information regarding a specific tax problem.
Pursuant to IRC Circular 230, this document is considered other written advice. This document was not intended or written to be used, and cannot be used, for the purpose of avoiding US federal, state or local tax penalties.

The truth is that nobody knows for sure if and when US real estate prices might recover or to what level they may recover.  Will home prices eventually recover to pre-collapse levels or will prices continue to decline? This article neither recommends investing in US properties nor does it attempt to dissuade anyone contemplating such a purchase. Each individual and situation is unique and what may prove to be serendipity to one individual may prove to be disadvantageous to another.  We do, however, advocate that anyone contemplating such a purchase seek professional advice regarding the legal, residential and tax ramifications of purchasing US properties. AG Tax has prepared a number of articles that may assist you to reach your decision. Once again we stress that our intention is to provide information to consider while making your decision depending on your own individual circumstances – we offer no general advice on the appropriateness of such a purchase or investment.  If you wish to make an appointment with one of our international tax specialists we will review your individual situation with your and provide comment on how purchasing a US property might affect you and outline the some of the risks and advantages of such a move. If you have decided to purchase a United States property we recommend that you read our article entitled “Guidelines for Purchasing US properties”.

Seek legal advice

We recommend that anyone seeking to purchase a foreclosed home in the United States seek the advice of a real estate attorney with experience in US foreclosures. If you require assistance in obtaining the services of an attorney you should contact your local bar association for references.

Study the local market before you make a decision

Many individuals and commercial organizations are advertising what they claim to be “once in a lifetime” opportunities in the US foreclosure market. In certain markets home prices are half of what they were at the height of the market. Potential purchasers should carefully study the market trends in the specific market they are interested in and fully acquaint themselves with not just the number of foreclosures presently on the market but also with the number piling up in the courts and the local statistics on delinquent mortgages. Many analysts have speculated that United States banks and mortgage institutions are attempting to manage the incoming supply of current sales in order to prevent further price declines. Mortgage lenders may be managing the number of foreclosures even as delinquencies rise. In the short term this action may tend to stabilize prices by restricting the number of properties that are placed on the market.  The flip side is that the market will continue to see sales of foreclosed properties for a much longer period of time.

A long-term supply of foreclosed properties may provide continued downward pressure on US home prices or at least inhibit significant price increases. Even if the prices of these foreclosed homes appear to be extremely low when compared to the Canadian market it may be a long time before there is any significant appreciation in value. In fact, the Wall Street Journal has recently reported that the home prices continued to decline through the first quarter of 2011 in 27 major US markets. According to the 2011 State of the Nation’s Housing Report by the Harvard University Joint Center for Housing Studies there are at the present time over 2 million delinquent mortgages in the US with another 2.2 million stuck in the foreclosure pipeline. Even if there is not another foreclosure, 4.2 million homes must still be cleared before real estate markets are stabilized. In some US markets the existing inventory of homes for sale is equal to 40 months of home sales. Many analysts predict that there may not be a significant turn-around in the US housing market over the next 3 to 5 years.[1]

In studying foreclosure prices in the selected market in which you are interested you should also study the prices of non-foreclosed property. Just as a rising tide raises all boats distressed pricing affects all home sales. Foreclosures may not be your only opportunity to purchase property at a favorable rate. Many homeowners may have to sell their homes and will have to take whatever price the market dictates. While a bank or mortgage institution may be able to hold a foreclosed property until the market stabilizes or improves a homeowner may be forced to sell in a short period of time. In a market where there are more homes for sale than purchasers, as in the case of most US markets, homeowners can be very motivated and realistic. Their home is worth what they are able to sell it for – no more or no less. Another consideration is that many homeowners have taken the opportunity to move up in their market area. They have purchased another home in the area at a favorable price and are anxious to sell their existing home so that they are able to close.

Make sure that the seller is able to deliver the title

Any potential purchaser of a foreclosed home should be cautious and undertake careful investigation to ensure that the lending institution involved is actually able to deliver clear and unencumbered title to the home you intend to purchase. You are urged to obtain the services of an experienced attorney in real estate foreclosures if you intend to purchase a foreclosed property.

Precautionary Notice

To the best of our knowledge and ability the information in this article was current and accurate at the time it was published. However, laws, regulations, and administrative rulings issued by governments are constantly evolving and being revised. Readers are cautioned that it is incumbent upon them to check with the competent authorities to ensure that they have acted upon the latest available information. This article is intended only to provide an overview of the potential problems that may exist when purchasing a US property that has been foreclosed. Individuals should consult a tax professional for information regarding specific cases.

Pursuant to IRC Circular 230, this document is considered other written advice.  This document was not intended or written to be used, and cannot be used, for the purpose of avoiding US federal, state or local tax penalties.

Some time ago you may have decided to leave Canada and settle in another country. Your intention was to leave Canada permanently and not return. Since Canada taxes Canadian residents on their worldwide income you did not want to be in a tax situation where you were required to pay income taxes to two different countries. You notified the Canada Revenue Agency that you were permanently giving up your Canadian residency. You severed all your ties to Canada to the satisfaction of the CRA and filed all the required documents. You diligently settled your departure taxes before you left and you have since paid Canadian income taxes on any Canadian source income that you may have had according to the rules applicable to nonresidents.

You wish to Return to Canada

But circumstances change over time. Perhaps the dream job that you emigrated to take didn’t work out or maybe the political situation in your new country is so unstable that you fear for your family’s safety. The reason doesn’t particularly matter; the fact is that you wish to return to Canada. Unlike the United States that requires you to renounce your citizenship to escape US taxes on your worldwide income, Canada requires only that you sever your Canadian residency and become a tax resident of another country. Unlike the United States where once you have renounced your citizenship for tax reasons you can never permanently re-enter the US (although you may apply for a visitor’s visa), Canada welcomes back her citizens with open arms.

Seek Legal Advise

If you have given up your Canadian residency and now wish to return to Canada you should consult an experienced immigration lawyer. We recommend that you contact the bar association in the province or territory where you intend to locate for a list of recommended immigration lawyers.

However, if you were not a Canadian citizen but a were a legal resident when you left Canada you may not be able to re-establish your Canadian residency. Remember that you intended to permanently give up your Canadian residency when you left. Also there is a difference in the Canada Revenue Agency definition of a tax resident and Citizenship and Immigration Canada’s definition of a legal resident. Non-citizens who have severed their Canadian residency but now wish to return to Canada should consult an experienced immigration attorney.

Unwinding a Deemed Disposition

In any case, as a Canadian citizen you have decided to return to Canada. Well, you’re in luck – you get to unwind the departure tax that you were assessed at the time you emigrated. You could even end up with a tax refund – or maybe not. When you immigrate to Canada, you are generally deemed to have disposed of and to have immediately reacquired at fair market value the worldwide properties that you own on the date you re-entered Canada. If you had previously elected to defer payment of the tax owing on the income from the deemed disposition of property at the time you emigrated, you may now have to pay the deferred tax.

If you emigrated after October 1, 1996, and you have re-established Canadian residency you can elect to adjust the deemed dispositions of property that you still own that was deemed sold when you emigrated. This is referred to as an election to “unwind” a previous deemed disposition. If you make this election, the amount of the gain from the deemed disposition that you reported on your return for the year you emigrated can be reduced by the least of:

• The amount of the gain reported on your return for the year you departed;
• The fair market value (FMV) of the property on the date you immigrated;
• Any other amount to a maximum of the least of the above-noted amounts.

The election to unwind may result in the reduction or elimination of the tax owing on the deemed disposition of property at the time of emigration. If you make this election and had previously elected to defer payment of the tax owing on the income from the deemed disposition, some or all of the security you may have furnished may be returned to you.

You must submit the request to unwind in writing on or before your filing-due date for the year you immigrate and become resident. You must include a copy of this written request with your income tax return for the year you returned to Canada along with a list of all the properties you own and the fair market value of each property to which this election applies. This will establish the base that the Canada Revenue Agency will use for any future calculation of gains or losses from the disposition of property owned at the time you re-entered Canada.  Valuable property such as jewelry and artworks should be properly appraised to avoid future problems. Your income will be prorated in the year of re-entry but you may be entitled to full benefits from other programs.

Precautionary Notice

To the best of our knowledge and ability the information in this article was current and accurate at the time it was published. However, laws, regulations, and administrative rulings issued by governments are constantly evolving and being revised. Readers are cautioned that it is incumbent upon them to check with the competent authorities to ensure that they have acted upon the latest available information.

Many US citizens or US residents living or working in Canada and many Canadians living in the US have invested in Canadian Mutual Funds. A significant number of these investors may not realize that foreign mutual funds are classified as Passive Foreign Investment Companies. If they were not aware that they unwittingly held an interest in a PFIC they probably were not aware that the IRS has established a strict tax and reporting regime governing taxation of their Canadian (or other foreign) mutual funds.  As a consequence many US taxpayers holding Canadian have failed to meet the required US tax and reporting obligations.

US taxpayers holding an interest in a PFIC must file a Schedule B with their US income tax returns and a Form 8621 to report certain elections and transactions within their Canadian or other foreign mutual funds. If the total value of foreign accounts, including mutual funds, held and controlled by a US taxpayer exceeds $10,000 at any time during a taxation year, a Form 90-22-1 (FBAR) must be separately filed with the US Treasury Department.

Definition of a Passive Foreign Investment Company

Under the United States Internal Revenue Code a foreign company that meets either of the following tests is considered to be a Passive Foreign Investment Company:

1. 75% or more of its gross income for a taxable year is passive income (the income test); or
2. 50% or more of assets held during the taxable year produce passive income, or are held for the production of passive income (the asset test).

Passive income includes interest, dividends, royalties, annuities, rents, income equivalent to interest, net gains from commodity transactions, net foreign currency gains, payments in lieu of dividends, income from notional contracts, and income earned from certain personal service contracts.  Generally the fair market value of a foreign company’s assets (based on the value of the corporation’s assets at the end of each quarter) is used to apply the Asset Test.

In applying these tests to a foreign corporation it is necessary to look-through subsidiary corporations that the tested corporation holds an interest in. If a foreign corporation owns, directly or indirectly, 25% or more of a subsidiary, the corporation’s share of the earnings and assets of the subsidiary must be included when determining if the corporation is a Passive Foreign Investment Company.

The IRS does not classify as Passive Foreign Investment Companies foreign corporations such as bona fide banks, financial institutions, insurance companies, and security traders that can establish that passive income was earned in the conduct of an active business by the corporation. PFIC status applies separately for each US person owning shares, and also separately with respect to shares acquired at different times. PFIC status does not, in and of itself, have any impact on the foreign corporation or foreign shareholders.

A Passive Foreign Investment Company is a corporation by definition and in most cases a trust or partnership would not be a Passive Foreign Investment Company (notwithstanding that the IRS might argue that a foreign trust or foreign partnership had the characteristics of a corporation).  A partnership that does not own shares in a PFIC is not a Passive Foreign Investment Company even if all of its income is from passive investments. The same is true with respect to any trust or estate that does not own any shares of a Passive Foreign Investment Company. Partnerships and trusts, however, are taxed under other sections of the Internal Revenue Code that require earned income to flow through to individual taxpayers regardless of whether or not such earnings are distributed.

What Happens if a Corporation is Classified as a Passive Foreign Investment Company

In 1986 Congress added PFIC rules to the Internal Revenue Code due to concerns that U.S. taxpayers investing in passive assets indirectly through a foreign investment company had an inappropriate tax advantages when compared to direct investments in those same assets. The purpose of the PFIC rules was to eliminate this advantage. PFICs include foreign-based mutual funds and pooled investment vehicles that have at least one U.S. shareholder. Most US investors in PFICs must pay income tax on all distributions and appreciated share values, regardless of whether capital gains tax rates would normally apply. PFICs are subject to the complicated and strict tax guidelines set out in Sections 1291 through 1297 of the Internal Revenue Code. These strict guidelines are set up to discourage ownership of PFICs and particularly foreign mutual funds by U.S. investors. In fact, the rules are clearly intended to deter US investors from using a foreign corporation as an investment fund.

When assessing the severity of the tax regime established by Congress for PFIC holdings it is important to compare the tax treatment of for shareholders of ordinary corporations. Corporate shareholders are normally taxed on the corporation’s income when dividends are declared and only taxed at the taxpayer’s ordinary rate. Furthermore, shareholders are normally only taxed on accumulated value gains when the shares are sold or otherwise deemed disposed by the IRS. It is important to note that gains in the value of shares in an ordinary corporation are generally taxed at significantly reduced capital gains rates. It is also important to note that Congress has addressed other areas where US taxpayers have obtained inappropriate tax advantages through the utilization of foreign corporations in offshore tax havens. Two specific areas are Controlled Foreign Corporation and Foreign Personal Holding Company legislation. In essence Congress has re-characterized the income from such corporations as flow-through income to the individual shareholders subject to US taxes in the current year.

The Tax and Interest Regime (Excess Revenue Regime) for Taxing PFICs

A US taxpayer holding an interest in a PFIC is subject to taxation under tax and interest regime set out in Section 1291 of the Internal Revenue Code. This tax and interest regime includes a look-back procedure to allocate distributed income by a PFIC in excess of 125% of the three year moving average to the taxpayer’s entire holding period. Income allocated to the current year is reported on the taxpayer’s tax return as other income and taxed at the taxpayer’s ordinary rate. The portion of the distribution that is allocated to each prior year, however, is taxed at the taxpayer’s highest possible rate and the amount calculated is deemed to have been payable in the year of allocation. The statutory interest rate for unpaid taxes is then applied to the to each prior year that the taxpayer has held the PFIC.

The sum of the tax and interest payable for each year that the taxpayer has held the PFIC is added to the taxpayer’s current tax liability without setoff for an otherwise reported loss or loss carry forward. If the taxpayer has held the PFIC for an extended period of time it is possible for the PFIC tax liability to exceed the amount distributed. The legislation passed by Congress, however, limits the tax payable to 100% of the distribution received. For more detailed information on this subject please refer to our article entitled “Excess Distribution Tax Regime for Taxing Passive Foreign Investment Companies”.