Does Your Non-US Company Operate in the US? Avoid This Costly Tax Trap

May 10, 2022

At a glance

  • Key takeaway: The high-profile Adams Challenge ruling has changed the tax playing field for non-US-based organizations that do business in the US.
  • Impact on your business: Based on the US Tax Court’s interpretation of a permanent establishment in this case, many other non-US-based businesses could be subject to US federal income tax when they thought otherwise.
  • Next steps: It’s paramount to enlist the help of an experienced international tax professional who has a deep, nuanced understanding of the tax rules in the countries where you do business.

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The full story:

Opportunities abound for businesses in international markets. From promoting your products to new customers to exploring the cultural nuances of a new landscape, international expansion can give your business the next-level boost it needs to grow into the future.

But doing business internationally also means you need to account for new laws, regulations and provisions. If you fail to practice due diligence and develop a full understanding of your business’s tax liability across international borders, you could be putting your product line — and your bottom line — at risk.

A cautionary tale: the Adams Challenge case

Historically, the matter of applying US tax rules (or the US tax code) to non-US companies that perform work in the United States, but do not have a permanent establishment (PE), has been unsettled.

This is the predicament with a high-profile case that has drawn attention in the US Tax Court: Adams Challenge (UK) Ltd. v. Commissioner, 154 T.C. No. 3.

Adams Challenge (UK) Limited (Adams Challenge) is a company incorporated under the laws of the United Kingdom. It chartered a vessel to perform oil and gas work and debris clean-up in the Gulf of Mexico for a US firm. The terms of the charter stated that Adams Challenge would provide a crew to man the vessel while performing this work. Since Adams Challenge is a UK resident, it is subject to special rules under the US─UK tax treaty. Pursuant to Article 5 of the tax treaty, a UK enterprise is not subject to federal income tax unless it does business in the US through a PE.

According to the treaty rules, income from the operation of ships in international waters is only taxable in the owner’s home state. However, an exception to this rule is that any income earned by the resident of one foreign country who does business in the other country through a PE can be taxed by the latter.

From the charter established with the US firm that contracted the work, Adams Challenge earned about $45 million from 2009–2011; the company did not file timely tax returns for those years. Adams Challenge assumed that most of the earnings from the charter were considered exempt from federal income tax under the assumption it had not created a PE. In January 2021, the Court disagreed with this assertion, concluding that Adams Challenge was subject to US federal income tax because it had, in fact, created a PE with its actions.

Upon this determination, the IRS assessed interest, penalties and tax of about $24 million to Adams Challenge, based on the roughly $45 million in income it had earned from the work it performed. (OUCH!)

What does this case mean for other international businesses?

The Adams Challenge ruling has major implications for non-US-based organizations that do business in the US. Based on the Court’s interpretation of a PE in this case, many other businesses could be subject to US federal income tax, such as foreign companies with installation projects in the US, foreign representatives who make sales or exhibit merchandise at trade shows in various states, and independent contractors. Not only do businesses need to be mindful of federal income tax guidelines, but they also need to pay attention to US state and local tax rules, which are all uniquely complex.

The true question is, how can foreign businesses avoid making the mistakes that Adams Challenge made? Though preparation and due diligence varies greatly based on your business’s individual situation, any business that is unsure about whether it is subject to federal income tax should file a protective tax return.

Essentially, this type of return lists the name of the taxpayer, does not show income and is supplemented with a written letter explaining the taxpayer has a “good-faith belief” that it has no US-source income. By filing a protective tax return, the non-US company maintains the ability to pay tax on its net income (instead of gross receipts) if the IRS decides to audit the business.

The bottom line

International tax rules are complicated, and this won’t be the last time we see a case like this one, especially as the business landscape becomes more globalized and interconnected. If you plan to do business abroad, it is essential to enlist the help of a qualified, knowledgeable and experienced international tax professional who has a deep, nuanced understanding of the tax rules in the countries where you do business. At Aprio, we are proud to have a robust international tax practice, led by a team of accountants and advisors who understand how new laws and provisions can impact your business. Since 1993, we have provided global tax, assurance and advisory services and currently advise more than 150 multinational corporations in their US-based operations and expansion projects. We are here to provide the third-party expertise your business needs to not only avoid risks, but to thrive in new areas of the world.

If you want to learn more about the Adams Challenge ruling or find out how Aprio’s International Tax team can help you navigate a similar situation, contact me, Kristin Maeckel, CPA, or submit an inquiry to our Aprio team.

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