Rev. Rul. 84-17

ISSUE

Whether a taxpayer can elect the provisions of the United States-Polish People's Republic Income Tax Convention (the Convention), 1977-1 C.B. 416, with respect to the taxability of business gain that is in part attributable to a permanent establishment and in part not attributable thereto, while in the same taxable year elect the provisions of the Internal Revenue Code with respect to a nonattributable business loss under the circumstances described below.

FACTS

In Rev. Rul. 81-78, 1981-1 C.B. 604, a Polish corporation (the taxpayer) markets two entirely different products in the United States through separate and unrelated business activities. One business activity, the manufacturing and marketing of product a both in the United States and abroad, constitutes a permanent establishment in the United States within the meaning of Article 6 of the Convention. The profits attributable to the activity of the permanent establishment are taxable by the United States under Article 8(1) of the Convention. The profits attributable to the second business activity, the manufacturing of the product b in Poland and the sale of the product through an independent contractor in the United States and abroad, are not taxable under the Convention by the United States since the activity does not constitute a permanent establishment in the United States.

Assume that the facts of Rev. Rul. 81-78 apply in the subsequent taxable year. In addition to the manufacture and sale of products a and b , the taxpayer manufactures product c in its home office in Poland and sells the product through another independent contractor in the United States. The manufacture and sale of product c are wholly independent of the taxpayer's operations through the permanent establishment in the United States and from the sale of product b in the United States through an independent contractor. In the taxable year in question, the taxpayer has gain from the manufacture and sale of product a through the permanent establishment, gain on the sale of product b , and a loss from the sale of product c in the United States. The gain or loss from the sale of products b and c in the United States is not attributable to a permanent establishment in the United States, but, like the income from the sale of product a , 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 Internal Revenue Code.

The taxpayer claimed the provisions of the Convention with respect to the gain-producing activities, involving products a and b , so that the gain from the permanent establishment was subject to United States income taxation and the gain from the sale of product b was exempt from United States income taxation. The taxpayer claimed the provisions of the Code with respect to the loss producing activity so that the loss from the sale of product c was used to offset the product a gain from the permanent establishment in determining the taxpayer's United States income tax liability.

LAW AND ANALYSIS

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 864(c)(3) of the Code provides that all income, gain, or loss from sources within the United States (other than income, gain, or loss to which section 864(c)(2) applies) shall be treated as effectively connected with the conduct of a trade or business within the United States.

Section 894(a) of the 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 5(2)(a) of the Convention prevents the United States from construing the Convention to restrict in any manner any deduction allowed by the laws of the United States in the determination of the tax that the United States imposes.

The Technical Explanation of the Convention, 1977-1 C.B. 427, states that the rule of Article 5(2)(a) reflects the principle that a convention should not increase the tax burden on residents of the Contracting States.

Article 8(1) of the Convention provides that the profits of an enterprise of a Contracting State, in this case Poland, will be taxable only by Poland unless the enterprise carries on business in the other Contracting State, in this case the United States, through a permanent establishment situated therein; if the enterprise carries on business as aforesaid, only the profits of the enterprise that are attributable to the permanent establishment may be taxed by the United States.

The provisions of the Convention dealing with business profits indicate an intent to subject Polish businesses to United States income taxation only on profits attributable to a permanent establishment in the United States. All nonattributable profits are to be taxed only by Poland. This intent is further evidenced by a statement in the report of the Senate Foreign Relations Committee describing the general objectives of the Convention. The Committee stated that ordinarily business income is not taxable in the source country, in this case the United States, unless the taxpayer has a fixed place of business there; if there is only a temporary or minimal presence in the source country, the conventions typically provide for taxation exclusively by the residence country, in this case Poland. S.Ex.Rep. No. 94-15, 94th Cong., 1st Sess. 1 at 7-8 (1975), 1977-1 C.B. 425.

The intent under the Convention-that the United States will only tax business profits of a Polish enterprise that are attributable to a trade or business conducted by such enterprise in the United States-would be thwarted if losses not attributable to a permanent establishment in the United States are offset against gain attributable to a permanent establishment in the United States. Further, such an offset would require the inconsistent treatment (during a taxable year) of nonattributable gain and loss-such gain being exempt under the Convention and such loss being deductible under the Code. Accordingly, 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 Convention have been claimed with respect to the product a and product b gain.

However, Article 5(2)(a) allows the taxpayer the option to use the provisions of the Code to determine the tax liability with respect to the sales activities for products a, b , and c if this results in a lower tax liability than that obtained using the provisions of the Convention with respect to all of those sales activities. If the Code provisions are used, the effectively connected product c loss can be used to offset the effectively connected gain from products a and b in determining the taxpayer's United States income tax liability.

HOLDING

The taxpayer must use the provisions of the Convention with respect to the taxability of the product c nonattributable loss for the taxable year in question because those provisions are used with respect to the taxability of the gain from products a and b .

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 also be used with respect to the taxability of the gain from products a and b .

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 81-78 is amplified.