Summary:
The Debtor was a North Carolina corporation, wholly owned by DeCoro Limited (“Ltd.”), a Hong Kong limited liability company, which shipped furniture manufactured in China to the United States. The the furniture sales in the United States were procured by the Debtor. In 2008 or 2009, the IRS began an examination to determine whether the Debtor or Ltd. were liable for taxes in the United States. The determination hinged on whether the Debtor was a “dependent agent” of Ltd., in which case Ltd. would be liable for the taxes, or if the Debtor was an “independent distributor”, in which case the Debtor would be liable for the taxes. The IRS issued an audit letter finding that taxes would be assessed against Ltd., but prior to an actual assessment, Ltd. filed an insolvency proceeding in Hong Kong and the Debtor filed this bankruptcy.
The IRS filed (with multiple amendments) a Proof of Claim in the Debtor’s bankruptcy in the amount of $13,011260.56, indicating that this consisted of Corporate Income tax and Foreign taxes for 2004-2008. The corporate income taxes were assessed as the IRS had found that the “mark-up” between the Debtor and Ltd. of 3.32% was well below the mark-up rate of independent distributors. The IRS apparently then determined what an "arms-length"mark-up rate would be and used that figure in arriving at the income tax liability of the Debtor based on the furniture sales that were made in the United States during the years in question. The foreign tax assessed followed from the difference between the actual and the hypothetical arms-length mark-up rates, which the IRS considered a dividend payable from the Debtor to the Ltd. Since the Debtor failed to withhold this 30% tax, it was assessed against the Debtor.
The Debtor, however, contended that the the furniture sales in the United States should be treated
as having been made by Ltd , who would then be liable for the income taxes due from such sales. Under § 882(a)(1) of the IRC, a foreign corporation engaged in a trade or business within the United States may be taxed "on its taxable income which is effectively connected with the conduct of a trade or business within the United States." § 882(a)(1) has two requirements;
(1) The foreign corporation must be engaged in trade or business within the United States; and
(2) The taxable income that is "effectively connected" with such trade or business.
The dispute depended on whether Ltd. was engaged in business in the United States, with the Debtor arguing that it was acting as an agent of the Ltd., which was then actually the entity engaged in business in the United State. The IRS, however, argued that the Debtor was an independent distributor.
As to the second requirement of § 882(a)(1), the parties also disagreed as to which the income must be “effectively connected” with trade or business within the United States. § 864(c)(3) determines the income “effectively connected” with the trade or business for source “within” the United States and § 864(c)(3) applies to income sources from “without” the United States. The bankruptcy court held that “the key which of the [these] provisions is applicable is to ascertain the source of the income at issue, i.e., whether the source of the income is within or without the United States.” From this the court turned to § 861(a)(6), which provides that "income derived from the purchase of inventory property . without the United States . . and its sale or exchange within the United States" is treated as income from sources within the United States.”
In determining whether the Debtor was acting as an agent or an independent distributor for Ltd., the bankruptcy court considered the following factors:
(1) a contract between the parties which may be express or implied;
(2) the power of the agent to bind its principal;
(3) the existence of a fiduciary relationship between the parties; and
(4) the right of the principal to control the conduct of the agent with respect to matters entrusted to the agent.
AS the bankruptcy court was reviewing this in response to a Motion for Summary Judgment by the Debtor, it examined the extensive factual evidence concerning the relationship between the Debtor and Ltd. by construing the facts in the light most favorable to the IRS. Given the totality of the evidence, the bankruptcy court denied the Summary Judgment.
Commentary:
It would appear that the IRS and the Debtor switched the positions each held at the time of the audit and then during the bankruptcy. Not knowing anything about Hong Kong insolvency laws, it can only be hazarded that the IRS expected a higher priority treatment in a U.S. bankruptcy court.
For a copy of the opinion, please see:
DeCoro USA, Limited- Tax Liability Between Subsidiary and Foreign Corporate Parent.pdf
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