FOREIGN CORPORATION MUST TREAT INCOME AND CAPITAL GAIN FROM U.S. SHOPPING CENTER CONSISTENTLY UNDER EITHER CODE OR TREATY.

Index Nos.: 9114.03-00

Refer Reply to: CC:C:R:3:7

February 12, 1985

Whether the gain realized by Taxpayer from a 1978 sale of a shopping center located in the United States which Taxpayer purchased in 1976, is exempt from United States taxation pursuant to the provisions of Article VIII of the Convention.

FACTS

Taxpayer is a Country B corporation. Between 1975 and 1980, Taxpayer had held and derived income from real property in the United States in its own account and through joint ventures. In 1976, Taxpayer purchased a shopping center in the United States for X dollars. The shopping center was managed by an independent agent and between 1976 and 1978 the income therefrom was reported on a net basis on the federal income tax returns filed by the Taxpayer pursuant to section 882(a) of the Internal Revenue Code. Taxpayer claimed to be engaged in a United States trade or business. At no time was an election made pursuant to Article XIIIA of the Convention or pursuant to section 882(d) of the Code. Both Taxpayer and the * * * have agreed that Taxpayer did not have a "permanent establishment," as that term is defined in the Convention, in the United States during 1978. In 1978 Taxpayer sold the shopping center, realizing a gain of Y dollars. This gain was reported on Taxpayer's 1978 federal income tax return as exempt income pursuant to the provisions of Article VIII of the Convention.

It is the District Director's position that since the shopping center is not a capital asset as defined in section 1221 of the Code, the exemption from United States taxation provided for in Article VIII of the Convention would not be applicable. It is the Taxpayer's position that Article VIII of the Convention applies to assets receiving capital gain treatment under section 1231 as well as assets directly meeting the definitional requirements of a capital asset pursuant to section 1221.

It is also the Taxpayer's position that the Taxpayer may report the shopping center rental income on a net income basis pursuant to section 882(a) of the Code, in addition to exempting from United States taxation the gain from the sale or exchange of the shopping center in accordance with Article VIII of the Convention. The Taxpayer's position is that Rev. Rul. 84-17, 1984 - 1 C.B. 308, is contradictory to treaty obligations of the United States as well as specific Code sections affirming that obligation, and in any event is inapplicable to the present case.

LAW

Section 882(a) of the Code provides that a foreign corporation engaged in a trade or business within the United States during the taxable year shall be taxable as provided in section 11 or 1201(a) on its taxable income that is effectively connected with the conduct of a trade or business within the United States.

Section 1221(2) of the Code excludes from the definition of the term "capital asset" property which is used by the taxpayer in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business.

Former section 1231(a) of the Code provides, in part, that if, during the taxable year, the recognized gains on sales or exchanges of property used in the trade or business exceed the recognized losses from such sales or exchanges, such gains and losses shall be considered as gains and losses from sales or exchanges of capital assets held for more than one year. Section 1231(a) further provides that if such gains do not exceed such losses, such gains and losses shall not be considered as gains and losses from sales or exchanges of capital assets.

Former section 1231(a)(1) provides, in part, that in determining under section 1231(a) whether gains exceed losses, the gains described therein shall be included only if and to the extent taken into account in computing gross income.

Former section 1231(b)(1) of the Code provides, in part, that for purposes of section 1231, the term "property used in the trade or business" means property used in the trade or business, of a character which is subject to the allowance for depreciation provided in section 167, held for more than one year, and real property used in the trade or business held for more than one year, which is not property of a kind which would properly be includible in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.

Section 894(a) of the Code provides that income of any kind, to the extent required by any treaty obligation of the United States, shall not be included in gross income and shall be exempt from taxation.

Article VIII of the Convention provides that gains derived in one of the contracting States from the sale or exchange of capital assets by a resident or a corporation or other entity of the other contracting State shall be exempt from taxation in the former State, provided such resident or corporation or other entity has no permanent establishment in the former State.

Article XI of the Convention provides, in part, that the rate of income tax imposed by one of the contracting States, in respect of income (other than earned income) derived from sources therein, upon corporations organized under the laws of the other contracting State, and not having a permanent establishment in the former State, shall not exceed fifteen percent for each taxable year.

Rev. Rul. 84-17 dealt with the issue of whether a taxpayer could elect the provisions of the United States -- Polish People's Republic Income Tax Convention (Polish Convention) with respect to the taxability of business gain that is in part attributable to a permanent establishment and in part not attributable to a permanent establishment, while in the same taxable year elect the provisions of the Code with respect to a nonattributable business loss.

In Rev. Rul. 84-17, the taxpayer, a Polish corporation, markets three entirely different products in the United States through separate and unrelated business activities. Product A is manufactured and marketed by a business which has a permanent establishment in the United States and is therefore taxable by the United States pursuant to Article 8(1) of the Polish Convention. Products B and C are manufactured in Poland and sold in the United States by separate independent contractors.

The businesses which manufacture and sell products B and C are not taxable by the United States under the Polish Convention since the activity does not constitute a permanent establishment in the United States. However, the gain or loss from the sale of products B and C in the United States is effectively connected with the conduct of a trade or business in the United States within the meaning of sections 882(a) and 864(c)(3) of the Code.

In the tax year at issue, the taxpayer had a gain from the sale of products A and B, and a loss from the sale of product C. The taxpayer claimed the provisions of the Polish Convention with respect to products A and B which resulted in United States taxation of gain from product A because of its permanent establishment in the United States, and the exemption of product B gain because of the lack of a permanent establishment. The taxpayer claimed the provisions of the Code and not the Polish Convention for the loss on the sales of product C because the taxpayer wished to offset this loss against his United States recognized gain from Product A, while at the same time exempting his gain from product B under the Polish Convention.

Rev. Rul. 84-17 held that the product C nonattributable loss cannot be used to offset the product A gain attributable to the United States permanent establishment because the provisions of the Polish Convention had been claimed with respect to products A and B gain. The rationale was that the intent of the Polish Convention of only taxing Polish business profits which are attributable to a trade or business conducted by such business in the United States would be thwarted if nonattributable losses could be used to offset gain attributable to a permanent establishment in the United States. In addition, such an offset would require the inconsistent treatment during the same taxable year of nonattributable gain and loss, i.e. nonattributable gain exempt under the Polish Convention and nonattributable loss being deductible under the Code. Rev. Rul. 84-17 further held that if, for the taxable year, the taxpayer desires to use the provisions of the Code with respect to the taxability of the product C loss, the provisions of the Code must be used with respect to the taxability of the gain from products A and B.

RATIONALE

In 1978 the Taxpayer has claimed to be engaged in the active trade or business of investing, leasing out and disposing of real estate in the United States. Therefore, section 882(a) of the Code applies to the Taxpayer permitting the Taxpayer business deductions from rental gross income for the year 1978.

The Taxpayer seeks to exempt from taxation the gain on the 1978 sale of the shopping center pursuant to Article VIII of the Convention. Article VIII of the Convention requires the sale or exchange of a capital asset by a corporation which does not have a permanent establishment in the United States.

The term "capital assets" contained in Article VIII of the Convention is not defined in the Convention. Section 519.110 of the regulations promulgated pursuant to the Convention (T.D. 5206, C.B. 1943, 526), refers to section 117 of the Internal Revenue Code of 1939 for those types of assets which constitute capital assets. Section 117(a)(1)(B) of the Internal Revenue Code of 1939 contained an exclusion from the definition of capital assets under the 1939 Code substantially similar to the exclusion contained in section 1221(2) of the 1954 Code.

Since both Taxpayer and the * * * are in agreement that the shopping center sold by Taxpayer in 1978 is property described in section 1221(2) of the Code, it accordingly does not qualify as a capital asset. However, this office is of the opinion that focusing on whether or not there has been a sale or exchange of a capital asset as defined in section 1221 of the Code too narrowly limits the scope of Article VIII of the Convention.

It has been represented that the shopping center is "property used in the trade or business" as defined in section 1231(b) of the Code. Since, as has been represented for the year 1978, the Taxpayer's recognized gains on sales or exchanges of property used in the Taxpayer's trade or business (including the gain from the shopping center) exceed the recognized losses from such sales or exchanges, pursuant to 1231(a) such gains and losses are considered as gains and losses from sales or exchanges of capital assets held for more than one year.

Therefore, pursuant to section 1231(a) of the Code, the gain on the sale of the shopping center is considered to be a gain from the sale or exchange of a capital asset held for more than one year. This capital asset treatment under section 1231(a) of the Code is sufficient to qualify the shopping center as a capital asset under Article VIII of the Convention.

This interpretation of the term "capital asset" is consistent with the holding and rationale of Rev. Rul. 58-247, 1958 - 1 C.B. 623. Rev. Rul. 58-247 held that a lump sum distribution from a section 401(a) employee trust, not otherwise meeting the definition of a capital asset, is considered a gain from the sale or exchange of a capital asset under section 402(a)(2) of the Code and is exempt from taxation in the United States pursuant to Article VIII of the Convention.

Article XI of the Convention generally provides for an income tax not in excess of 15 percent in respect of income (other than earned income) derived from sources within the United States by Country B corporations not having a permanent establishment in the United States. Section 519.112 of the regulations promulgated pursuant to the Convention provides, in part, that the 15 percent limit on the rate of income tax specifically applies to amounts received from sources within the United States as rents by corporations organized under the laws of Country B.

Although regulation section 519.112 speaks in terms of "foreign corporations not engaged in trade or business in the United States and not having an office or place of business therein," regulation section 519.112 has not been amended pursuant to the revision of Article XI of the Convention by the supplementary convention effective January 1, 1951. The supplementary convention replaces the aforementioned language with the words "not having a permanent establishment in the former State." Therefore, Article XI is applicable to the Taxpayer because the Taxpayer is a Country B corporation receiving rental income from the United States and the Taxpayer does not have a permanent establishment in the United States.

It has been represented that neither the gain from the sale of the shopping center nor the rental income derived from the shopping center are attributable to a permanent establishment in the United States. Rev. Rul. 84-17 requires the consistent treatment during the same taxable year of nonattributable gain and loss.

Following the holding and rationale of Rev. Rul. 84-17, Rev. Rul. 84-17 would require the consistent treatment during the same taxable year of nonattributable income derived from a single source, i.e. nonattributable rental income derived from the shopping center and nonattributable gain from the sale of the shopping center. In accordance with Rev. Rul. 84-17, the Taxpayer must use either the Convention or the Code, but not both, in determining the taxability of the rental income and gain from the sale of the shopping center.

CONCLUSION

Article VIII of the Convention is applicable to the gain from the sale of the shopping center. However, the Taxpayer must treat the gain from the sale of the shopping center consistently with the rental income derived from the shopping center. Since in the year the shopping center was sold the Taxpayer used section 882(a) of the Code to report the rental income on a net basis instead of using Article XI of the Convention, the Taxpayer must use the Code to determine the taxability of the gain on the sale of the shopping center and may not avail itself of Article VIII of the Convention.

No opinion was requested and none is expressed as to whether or not Taxpayer had a "permanent establishment" as defined in the Convention in 1978.

A copy of this Technical Advice Memorandum is to be given to the Taxpayer. Section 6110(j)(3) of the Code provides that it may not be cited or used as precedent.