Rev. Rul. 81-78

ISSUE

Is a Polish corporation that has a permanent establishment in the United States, through which it carries on the business of the manufacture and sale of a product, taxable on the income earned by it from the sale of another product through unrelated business activities that do not constitute a separate permanent establishment in the United States?

FACTS

The taxpayer, a corporation organized under the laws of the Polish People's Republic, has a permanent establishment in the United States, within the meaning of Article 6 of the United States-Poland Income Tax Convention (the "Convention"), 1977-1 C.B. 416, 419, through which it is engaged in the business of manufacturing and selling product a. The taxpayer sells product a both in the United States and abroad. The taxpayer has no other permanent establishment in the United States.

However, the taxpayer also manufactures product b in its home office in Poland from which it also sells this product through an independent contractor in the United States and abroad. The manufacture and sale of product b are wholly independent of the taxpayer's operations through the permanent establishment in the United States and such permanent establishment does not in any way participate in the manufacture or sale of product b. The sale of product b in the United States does not constitute a separate permanent establishment in the United States within the meaning of Article 6 of the Convention. Under the provisions of the Convention, the taxpayer is taxed by the United States on the profits from the manufacture and sale of product a, that is, on the profits attributable to the business carried on in the United States through the permanent establishment.

LAW AND ANALYSIS

Section 894(a) of the Internal Revenue Code provides that income, to the extent required by any treaty obligation of the United States, shall be exempt from taxation under subtitle A.

Article 8(1) of the Convention provides that if an enterprise of one contracting State, in this case Poland, carries on business in the other contracting State, in this case the United States, through a permanent establishment situated therein, only the business profits attributable to the permanent establishment may be taxed by such other State (emphasis added).

The concept of taxing profits attributable to a permanent establishment in the United States in the context of a tax treaty such as the subject Convention is analogous to the concept of taxing income effectively connected with conduct of a trade or business embodied in section 864(c) of the Code. The "effectively connected" principle was introduced into the Code by section 102 of the Foreign Investors Tax Act of 1966, Pub. L. 89-809, 1966-2 C.B. 656, 662, for purposes of the differentiation in tax treatment between business and nonbusiness (investment) income. Progressive or corporate rates were imposed on the former and a flat 30-percent rate was imposed on the latter.

Prior to the introduction of this principle, United States source income of foreign persons or entities was taxed under what is referred to as the "force of attraction" principle. Under this principle, all United States source income was treated by the Code as taxable at progressive or corporate rates if the foreign person or entity was engaged in trade or business in the United States. See S. Rep. No. 1707, 89th Cong., 2nd Sess. 1, 17, 1966-2 C.B. 1059, 1070-71. A limited form of this "force of attraction" principle has been retained in section 864(c)(3) of the Code. This section and the regulations thereunder provide that any United States source income of a foreign taxpayer that is not fixed or determinable within the meaning of section 871(a)(1) shall be treated as effectively connected with the conduct of a taxpayer's trade or business within the United States. The question arises, therefore, whether the "attributable to" principle of taxation applied in the context of the Polish Convention should be interpreted similarly to its analogue, the "effectively connected" principle applied in the Code.

The Code specifically retains a limited or residual "force of attraction" principle as discussed above without any indication that it shall apply to any tax treaties. There is no indication of the application of this residual principle, specifically or otherwise, in the subject Convention. In fact, the report of the Senate Foreign Relations Committee in recommending the ratification of the Convention states that the most significant feature of the Convention is the adoption of the "effectively connected" concept contained in most recent United States treaties, which replaces the "force of attraction" principle incorporated in earlier United States treaties. S. Ex. Rep. No. 94-15, 94th Cong., 1st Sess. 1 at 3 (1975), 1977-1 C.B. 425.

Although there are many areas in which the "attributable to" and "effectively connected" principles overlap, these principles are only analogous. They are not synonymous. The "attributable to" principle is limited in its scope, which does not encompass the residual "force of attraction" principle present in section 864(c)(3) of the Code. The Technical Explanation of the Convention prepared by the Department of the Treasury in discussing Article 8 of the Convention states, "While this Convention does not contain an explicit definition of the term 'effectively connected,' that term has substantially the same meaning as in section 864(c)(2) of the Code." 1977-1 C.B. 427 at 431 (emphasis added). The reference to paragraph (c)(2) rather than (c)(3) is significant.

In the context of a substantially similar provision regarding the taxation of industrial or commercial profits (Article III) in the United States-Federal Republic of Germany Income Tax Convention, 1955-1 C.B. 635, as amended by the Protocol of December 27, 1965, 1966-1 C.B. 360, the Joint Committee Staff Memorandum, 1966-1 C.B. 547, 548, accompanying the Protocol states:

The . . . protocol limits the existing [Convention] by allowing the other country to tax only those industrial and commercial profits that are . . . attributable to the permanent establishment. . . . Therefore, unless the income is essentially a part of or closely related to the permanent establishment, it will not be taxed by the source country.

This statement makes clear the abandonment of the "force of attraction" principle in the context of the "attributable to" language in Article III of the German Convention and thus provides support for the same interpretation of the "attributable to" language in Article 8 of the more recent Polish Convention.

HOLDING

Under the facts described above, a Polish corporation that has a permanent establishment in the United States through which it carries on the business of the manufacture and sale of product a is not taxable on the United States source income earned by it from the sale of product b through unrelated business activities that do not constitute a separate permanent establishment in the United States.