TAXATION OF ARTISTS AND SPORTSMEN. University of Geneva, Faculty of Law Geneva, October 11-12, 2007 REPORT OF THE UNITED STATES

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1 TAXATION OF ARTISTS AND SPORTSMEN University of Geneva, Faculty of Law Geneva, October 11-12, 2007 REPORT OF THE UNITED STATES By Michael G. Pfeifer Caplin & Drysdale, Chartered Washington, DC Michael G. Pfeifer

2 TAXATION OF ARTISTS AND SPORTSMEN Geneva, October 11-12, 2007 Report of the United States By Michael G. Pfeifer Caplin & Drysdale, Chartered Washington, DC I. Taxation of Residents 1. Jurisdiction to Tax (residence rules) a. Income Tax U.S. citizens and resident aliens generally pay income tax on their net worldwide income and gains at normal U.S. graduated tax rates (including the current 15% rate applicable to qualified dividends and long-term capital gains). An alien individual will be treated as a resident of the U.S. for any taxable year only if he is a "lawful permanent resident" of the U.S. at any time during the year or spends sufficient time in the U.S. to meet a "substantial presence test." An alien is a "lawful permanent resident" of the U.S. if he has obtained a visa giving him immigrant status (i.e., a "green card") under U.S. immigration laws, and such status has not been revoked or administratively or judicially determined to have been abandoned. An alien having a green card generally will be considered a U.S. resident from the first day he enters the U.S. with such status (the "residency starting date"). The "substantial presence test" measures the weighted average of days an alien is physically present in the U.S. over a three calendar year period. For purposes of the calculation, an individual generally will be treated as present in the U.S. for an entire day if physically present at any time during the day (i.e., partial days, including days of arrival and departure, are counted). However, there are statutory exceptions to this rule for workers commuting from Canada and Mexico and persons in international transit between two points outside the U.S. who are present in the U.S. for less than 24 hours. The substantial presence formula counts days present in the current year at full value, days present in the immediately preceding year at 1/3 value, and days present in the second preceding year at 1/6 value. If an alien is present in the U.S. for more than 31 days in the current year and the weighted average for the three year period totals 183 days or more, he generally will be treated as a resident alien of the U.S. as of the first day in the current year he is physically present in the U.S. Under the formula, an alien present in the U.S. for 121 days 2

3 or less each year will not become a U.S. resident alien for income tax purposes; an alien present for 122 days or more each year will become a resident alien. There are several statutory exceptions to the substantial presence test. The first applies to aliens who are present in the U.S. less than 183 days in the current year (but who would equal or exceed that total under the three-year weighted average rule) and who can establish that they have a "tax home" in a foreign country with which they have a "closer connection" than they do with the U.S. For this purpose, an individual's "tax home" generally is considered to be located at his principal place of business or, if he is not engaged in business, at his principal place of abode and must be in existence for the entire year. The "closer connection" test requires that an alien demonstrate that he has maintained more significant personal and economic contacts with the foreign country in which he maintains a tax home than with the U.S. Factors considered include, e.g., the location of an alien's permanent home, family, personal belongings, licenses (e.g., driver's license), and social, political, economic, cultural and religious affiliations. In limited circumstances, an alien whose tax home changes during the year can demonstrate a closer connection to two foreign countries. Note that an alien who has applied for a "green card" or taken certain other steps to adjust his immigration status may not avail himself of the "closer connection" exception. The other principal statutory exceptions to the substantial presence test are for aliens unable to leave the U.S. because of a medical condition which first arose while present in the U.S. and "exempt individuals," including foreign government-related individuals, teachers or trainees, students, and certain professional athletes temporarily present to compete in a charitable sporting event. Subject to certain time limits (in the case of teachers, trainees, and students), the days of U.S. presence of these individuals (including, in the case of most "exempt individuals," members of their immediate families) are disregarded. In determining the residency starting date (or residency termination date) under the substantial presence test, up to ten days of physical presence (which are not contiguous with the starting or termination date, as determined) may be disregarded if an alien shows that, during such period, he had a "closer connection" to a foreign country than to the U.S. Note that this nominal presence exception applies only for purposes of determining residency starting and termination dates, not whether the substantial presence test has been satisfied. An alien's U.S. tax residence will normally cease on the last day of a year on which he satisfies the "lawful permanent resident" and "substantial presence" tests. In the case of a green card holder, this generally will be the date he surrenders the visa (or becomes a resident of a foreign country having a tax treaty with the U.S. with sufficient contacts to be considered a resident of such foreign country under the applicable treaty tie-breaker test.) In the case of a substantial presence alien, it usually will be the last day of physical presence in the U.S. An alien will not be considered a U.S. resident for the portion of the calendar year following these events so long as he has a closer connection to a foreign country than to the U.S. throughout such period and does not again become a resident alien of the U.S. at any time in the next calendar year. 3

4 Finally, the residence rules contain an anti-abuse provision intended to limit the ability of aliens to make frequent changes of residence for tax avoidance purposes. Under this provision, if an alien, who has been a U.S. tax resident for three consecutive calendar years, ceases such residence and then resumes U.S. tax residence before the end of the third calendar year following cessation, he will be taxed on U.S. source income (as determined under the tax expatriation rules) arising during the nonresident period as if he had retained U.S. residence throughout the period. However, note that such an individual may claim the benefit of tax treaties that may have been applicable during his U.S. nonresident period. b. Transfer Taxes The U.S. imposes a gift tax on transfers of property by gift. The gift tax is imposed on the donor of property, although the Internal Revenue Service ( IRS ) can collect the tax from the donee if the donor is unable or refuses to pay. The gift tax applies to U.S. citizens and residents (i.e., domiciliaries) without regard to the location of the gifted property. In addition to the gift tax, a generation-skipping transfer ( GST ) tax is imposed on a donor who transfers property by gift to an individual who (i) in the case of a relative, is two or more generations below the donor (subject to the pre-deceased parent exception described below), or (ii) in the case of a non-relative, is 37½ years or more younger than the donor. The GST tax also applies to a distribution from a trust, the termination of a life estate, and similar events where the distributee/remainderman is two or more generations below or 37½ years younger than the person who originally transferred property to the trust or created the life estate. The pre-deceased parent exception generally excludes from GST tax a transfer to a lineal descendant of the donor who is two generations below the donor if such donee s parent is deceased. The U.S. imposes an estate tax upon the transfer of a decedent s taxable estate at death. The taxable estate is the decedent s gross estate less applicable deductions. For U.S. citizens and residents, the gross estate includes the decedent s worldwide assets at the time of death. In addition to property owned outright by the decedent at death, the gross estate will also include: (i) the proceeds of life insurance policies on the life of the decedent if such policy was owned by the decedent or the proceeds were payable to his estate; (ii) property over which the decedent has a general power of appointment (i.e., decedent has the power to appoint the property to himself, his creditors, his estate, or the creditors of his estate); (iii) property transferred by decedent during life over which he retained certain powers; (iv) gift tax on transfers that were made within three years of the decedent s death; (v) the decedent s interest in jointly-owned property; and (vi) income earned by the decedent before death but paid after his death (called income in respect of a decedent or IRD ). (In addition to being includable in the decedent s estate, the estate must also pay income tax on IRD that it receives. However, an income tax deduction will be allowed for any estate tax that is attributable to the IRD items.) For transfer tax purposes, a resident is a person who is domiciled in the U.S. Domicile is acquired by living in a particular jurisdiction with no present intention of leaving and making one s home someplace else. Thus, residence for U.S. transfer tax purposes is 4

5 determined subjectively and is entirely different from residence for U.S. income tax purposes, which is determined objectively based upon either an individual s visa status or the number of days that a person spends in the U.S. over a three-year testing period. 2. Definition of Artist/Sportsman Under U.S. statutory law, there generally are no special provisions pertaining to the taxation of earnings from the performance of personal services as an artiste/entertainer or sportsman and, therefore, there generally are no special definitions of these terms under domestic law. This is to be contrasted with the situation under tax treaties, discussed at III below. 3. Special rules for Artists/Sportsmen In the case of a U.S. citizen or resident, compensation for the performance of personal services in any capacity, however paid and from whatever source derived, constitutes gross income and is generally currently taxable at graduated rates applicable to ordinary income absent an express provision affecting the time or manner of taxation (e.g., compensation deferred in a qualified retirement plan). The only special rules for entertainers and athletes generally are found in the antideferral rules discussed under the next heading. 4. CFC/ rent-a-star company rules The principal domestic anti-deferral rules that affect the taxation of entertainers and athletes are found in the personal holding company rules. A personal holding company ( PFC ) is generally any U.S. domestic corporation that is controlled, directly or indirectly, by five or fewer individuals and has, as 60% or more of its certain items of income referred to as personal holding company income ( PHCI ). PHCI generally includes items of passive income (e.g., dividends, interest and certain rents and royalties not received in the active conduct of a rental or licensing business). Of particular importance to performing artists and athletes is income from personal service contracts, which is services income paid under contracts where the individual who is to perform the services either is identified in the contract or some person other than the corporation has the right to designate such person by name or description, and the person who is to perform services owns 25% or more of the stock of the corporation, directly or indirectly. If a company is a PHC for any year, in addition to its regular corporate income tax liability, it must pay a personal holding company tax equal to 15% of its undistributed personal holding company income, which is generally its undistributed net taxable income with certain adjustments. A PHC gets a deduction for dividends actually distributed or deemed distributed at year-end. In addition, there is a provision allowing deductions for deficiency dividends that is intended to reduce the PHC penalty where a corporation inadvertently becomes a PHC. 5

6 The PHC tax is really a throw-back to the times when the tax rates applicable to individuals were much higher than those applicable to corporations. The tax was a means of ensuring that certain high earning individuals couldn t allow after-tax earnings to accumulate at the lower corporate tax rates. In a world in which the individual and corporate tax rates don t vary by much, the PHC tax doesn t have much impact, especially where most dividends are taxed to individuals at a 15% rate. Today, U.S. performers are more likely to earn their fees and other income through limited liability companies, or possibly corporations electing to be taxed as S corporations, so that U.S. federal income tax is levied only at one level. For entertainers and athletes who earn substantial income from non-u.s. sources, there is an incentive to try to earn the funds through a foreign corporation established in a jurisdiction having low or no taxes, where the benefit from deferring the taxation of income could be significant. However, the U.S. has long had anti-deferral regimes to counter this strategy. From 1937 through 2004, the U.S. had rules regarding foreign personal holding companies ( FPHC ), which were similar in design and operation to the rules applicable to PHC s. However, since an FPHC wasn t itself a U.S. taxpayer in most cases, rather than imposing a penalty tax on undistributed net earnings, the FPHC rules provided that such a company s undistributed taxable income with some adjustments was directly taxable to U.S. shareholders as a dividend, whether or not actually distributed. Concurrent with the repeal of the FPHC rules in 2004, the personal service contract provision of the FPHC rules were engrafted on the foreign personal holding company income ( FPHCI ) definition for purposes of the controlled foreign corporation ( CFC ; first enacted in 1962) and passive foreign investment company ( PFIC ; first enacted in 1986) anti-deferral regimes. Thus, the U.S. IRS has ample provisions to counter the attempts of U.S. entertainers and athletes to defer taxation of their offshore performance and royalty income. Because the U.S. generally allows an individual a credit against U.S. federal taxes for foreign taxes paid on non-u.s. source income (up to the effective U.S. federal tax rate on such income, with a one-year carryback and 10-year carryover of excess foreign tax credits; see below), where a foreign jurisdiction imposes taxes on the earnings of a U.S. entertainer or athlete, the general taxpayer strategy is to structure so that the foreign taxes will be considered borne by the individual performer directly and to try to limit the effective foreign tax rate to not more than the individual s maximum U.S. federal tax rate. 5. Tax exemption or Tax credit Under domestic law, the U.S. generally employs a tax credit mechanism rather than an exemption or territorial regime to avoid double taxation. Thus, it generally affords a taxpayer a credit against U.S. federal tax for any similar foreign income taxes that are paid. However, the U.S. generally will not allow a credit for foreign taxes (income or transfer taxes) incurred with respect to U.S. source income or U.S. situs property. Under an applicable double tax treaty a potential for double taxation is sometimes but not always resolved by a resourcing provision in the treaty. Absent a treaty, such a double tax situation is rarely resolved 6

7 favorably. Even tax treaties cannot always resolve character and timing differences between the laws of countries with competing claims on income or property. The U.S. does allow a limited exclusion from gross income for the foreign earned income of U.S. citizens or residents earned while they are bona fide residents of a foreign country (or countries) for a period including an entire taxable year or, during any consecutive 12 month period, are present in a foreign country (or countries) on at least 330 full days during such period. An individual qualifying for this provision can exclude up to $80,000 of foreign earned income (indexed for years after 2005; 2007 exclusion of $85,700) as well as certain excess foreign housing costs. 6. International allocation of income/expenses For U.S. citizens and residents, the rules generally used for allocating and apportioning income and expenses arising from an international business are those prescribed for use in connection with the foreign tax credit. These generally employ a two-step process: (a) allocate an expense to the class of gross income (e.g., services income, royalty income, etc.) to which it is definitely related; and (b) apportion expenses between statutory and residual groupings (e.g., U.S. source vs. non-u.s. source) using an apportionment basis that generally reflects the underlying factual relationship between the expense and the class of gross income. If a taxpayer allocates a deduction to a class of gross income that includes income in more than one statutory or residual grouping, he must determine a reasonable method to attribute the deduction between or among the income groupings. If an expense can be directly allocated to a type of income, it is directly allocable to such income category and is then apportioned between U.S. and foreign source income on some reasonable basis. If an expense cannot be directly allocated to a particular type of income but is identified as generating all categories of income, the expense is first apportioned to a class of gross income and then apportioned between U.S. and foreign source income. II. Taxation of Nonresidents 1. Jurisdiction to tax (source rules) a. Income Tax In general, nonresident aliens only pay income tax at a flat 30% rate (which may be reduced by an applicable tax treaty) on certain items of gross U.S. source income (generally passive items, including, e.g., dividends, interest and royalties, but not including most capital gains) and at the normal graduated rates on net income from whatever source (including capital gains) which is effectively connected with the conduct of a trade or business in the U.S. The source of income is generally determined under a series of complex and specific rules contained in the U.S. Internal Revenue Code ( Code ). These rules, which can sometimes be varied under applicable income tax treaties, broadly are as follows: 7

8 (1) Income from the performance of services generally is sourced by reference to where the services are performed. (2) Interest paid by U.S. residents generally is U.S. source, other than interest on bank or similar deposits or interest paid on portfolio debt instruments. (3) Dividends paid by U.S. domestic corporations are U.S. source; dividends paid by foreign corporations generally are treated as U.S. source only if more than 75% of the foreign corporation s gross income for a 3-year testing period are effectively connected with a U.S. trade or business. (4) Rents and royalties generally are sourced by reference to the location of the property or where the rights representing the property are used. (5) Gains from the sale or exchange of real property generally are sourced where the real property is located. (6) Gains from the sale of inventory property generally are sourced by reference to where the property is sold. (7) Gains from the sale of other personal property generally are sourced by reference to the residence of the seller. A nonresident alien who formerly was a U.S. citizen or a long-term resident (i.e., a former green card holder taxed as a U.S. resident in 8 of the 15 taxable years preceding residence termination) and who equals or exceeds certain average net income tax ($124,000, indexed post-2004; for 2007 expatriations, $136,000) or net worth ($2 million) thresholds remains subject to tax on U.S. source income at rates applicable to U.S. citizens and residents for 10 years following the year in which he relinquished citizenship or terminated residency. In addition, a former U.S. citizen or long-term resident alien subject to these rules will be taxable on worldwide income in any of the 10 post-expatriation years in which he is present in the U.S. on more than 30 (or, in limited cases, 60) days. b. Transfer Taxes Nonresident aliens generally are subject to gift and estate taxes on real or personal property considered to be situated in the U.S. However, except in the case of a nonresident alien subject to the expatriation tax provisions, they are not subject to gift tax on transfers of intangible property wherever situated. In addition, a nonresident alien who would not be subject to gift or estate tax on a transfer will not be subject to GST tax on the transfer. For these purposes, the situs of various types of property are generally as follows (although these rules may be modified by an applicable estate or gift tax treaty): (1) The situs of real property and tangible personal property (except certain artworks on loan for exhibition) is generally the jurisdiction where the property is physically located. 8

9 (2) Deposits in a U.S. bank are not treated as having a U.S. situs. (This rule applies to deposits in the U.S. with a U.S. bank, withdrawal accounts at a U.S. savings and loan association, amounts held by U.S. insurance companies under an agreement to pay interest, and deposits with a foreign branch of a U.S. commercial bank). (3) Stock issued by U.S. corporation has a U.S. situs. (4) Assets connected with a U.S. trade or business have a U.S. situs. (5) Although there are certain exceptions, debt obligations of a U.S. person or U.S. government entity generally have a U.S. situs. (6) Proceeds from a life insurance policy on the life of a nonresident alien are deemed not to have a U.S. situs. However, a life insurance policy that a nonresident alien owns on the life of another will have a U.S. situs if issued by a U.S. insurance company. (7) Intangible personal property will have a U.S. situs if the written evidence of the property is not treated as the property itself, and the property is issued by or enforceable against a U.S. resident, corporation, or government unit. 2. Tax at source The payment of certain categories of gross income to nonresident alien taxpayers generally is subject to the imposition of a withholding tax at the statutory rate of 30% (which may be reduced by an applicable tax treaty). This type of income is referred to as fixed or determinable annual or periodical gains, profits and income or FDAPI. It generally includes items of passive income, such as interest, dividends, rents, royalties and annuities, but it also includes wages, compensations, remunerations and emoluments. Income that is considered effectively connected with a U.S. trade or business, including wages for the performance of personal services as an employee, is not subject to the withholding tax on payments of gross income. Such wages generally are subject to employment withholding tax rules at normal graduated rates applicable to wages paid to a U.S. citizen or resident. However, amounts paid to a nonresident alien as compensation for services performed as an independent contractor are subject to the statutory 30% withholding tax regime applicable to FDAPI, unless reduced by treaty. In certain cases, foreign entertainers whose gross receipts would otherwise be subject to the 30% withholding tax, but who will ultimately be liable to pay tax at normal graduated rates on their net taxable income, may enter into an arrangement with the IRS (referred to as a central withholding agreement ) that allows them to pay withholding tax on their receipts at a rate that will approximate the ultimate tax liability on net income that will be due. 9

10 3. Deduction of expenses (including allocation of income) A nonresident alien generally is allowed deductions only if, and to the extent that, the deductions are connected to income effectively connected to a U.S. trade or business. The proper allocation and apportionment of deductions is made according to the rules set out at section I.6 above for U.S. citizens and residents. Excepted from this rule are deductions for casualty or theft losses incurred in the U.S., charitable contributions (but generally only for gifts to U.S. charities or for use in the U.S.) and one personal exemption. Note that a nonresident alien generally is entitled to deductions and credits only if he timely files a true and accurate return of his income effectively connected to a U.S. trade or business. If the IRS commences an examination of a nonresident alien who has not filed a return, the individual generally will be precluded from thereafter claiming otherwise available deductions and credits. 4. Characterization of income (performance vs. sponsoring/merchandise, etc.) In the case of a nonresident alien, income from the performance of personal services in any capacity performed in the U.S. is generally treated as income from a trade or business taxable at graduated rates applicable to ordinary income, except where the taxpayer is present in the U.S. in the year of performance for 90 days or less and the compensation does not exceed $3,000. Thus, salary, wages, bonuses, prizes, awards and even scholarships received in connection with the performance of personal services in the U.S. generally will be treated as income effectively connected with a U.S. trade or business. This includes income received and benefits conferred in connection with personal appearances, promotions and endorsements, even where an entertainer or athlete is not contractually bound to provide any specific services to the provider of a benefit (e.g., the rent- free use of an automobile while competing in a sporting event can be viewed as an implied endorsement of the product). To be contrasted with income arising from the performance of personal services is sponsorship and merchandising income typically received by entertainers and athletes for allowing their name and/or likeness to be used in connection with the sale of a product or service. Whether or not such use is based on a registrable property right (e.g., a copyright), such income is generally treated as akin to a royalty or performance right that is not based on the actual performance of any services by the entertainer or athlete but only on their reputation, which gives the name/likeness its value. Thus, it generally constitutes FDAPI and, under the Code, is taxable in gross at a 30% statutory rate (unless reduced or eliminated by an applicable tax treaty) and is collected by means of withholding at source. In some cases, the transfer of an indefinite and exclusive right to use an entertainer or athlete s name or likeness in a geographic territory might be treated as a sale giving rise to a capital gain that is exempt from U.S. tax. However, where the income from any such sale of property is contingent on the utilization of the property, which is frequently the case, the payment will be treated as a royalty or licensing fee taxable at the fixed 30% rate on gross and collected by means of withholding at source. 10

11 5. Treatment of payments to third parties Where an entertainer or athlete receives a direct payment of U.S. source income, the payment will generally be treated either as a payment for services or for the use of a property right and will be taxed accordingly. However, where the payment for an entertainer or athlete s personal services is made to a third party that ostensibly is unrelated to the entertainer or athlete, except by way of an employer-employee relationship, any portion of the payment not considered attributable to the entertainer/athlete s personal services might avoid tax altogether, if the third party is a non-u.s. person that is not considered to be engaged in a U.S. trade or business and the payment is not considered to be U.S. source FDAPI. This is the classic paradigm of the use of the so-called loan-out companies. In a pair of revenue rulings issued by the IRS in 1974, Rev. Rul and Rev. Rul , 3 commonly referred to as the lend-a-star rulings, the IRS analyzed a number of situations in which a U.K. entertainer was, in form, employed by a foreign corporation that contracted with either another foreign corporation or with a U.S. person (including a U.S. corporation) to loan out the entertainer s services to be performed in the U.S. In some cases the entertainer owned the shares of the company employing him and loaning out his services; in other cases, the shares of the loan-out company were nominally held by unrelated persons. The income tax treaty involved in all cases was the 1945 U.S.-U.K. income tax convention, which did not contain a special provision regarding artistes and entertainers. The tax planning generally was intended to exempt the entertainer s income from U.S. tax under the dependent employment provision of the treaty and to also exempt the loan-out company s profits from U.S. tax under the industrial and commercial profits provision of the treaty on the basis that the company had no U.S. permanent establishment. In both rulings, the IRS examined factors pertaining to the existence of an employeremployee relationship, such as who controls the manner and timing of the employee s performances; who furnishes the place and materials for his performance; who bears the customary risk of the performance; and the duration and financial terms of the purported employer-employee relationship. Of these factors, the IRS stated that the right to control the performance of the entertainer s services was the most important factor. The IRS determined that in many such cases, a foreign entertainer really performs as an independent contractor with the loan-out company acting as, at most, the entertainer s agent. Thus, the entertainer s compensation is, in the first instance, subject to U.S. tax at the statutory 30% rate, collected by means of withholding, and he is subject to tax on his net income at the normal graduated tax rates. The residual fees, if any, retained by the loan-out company are exempt from U.S. tax under the treaty, since the company had no U.S. permanent establishment. In some cases, the IRS determined that the entertainer should be treated as an employee of the U.S. company or person sponsoring the performance, with U.S. tax being collected by means of wage withholding, and the performer ultimately paying U.S. tax on his net income at normal graduated tax rates C.B C.B

12 In both rulings, the IRS also suggested that it could apply judicial doctrines, such as assignment of income, in appropriate cases and might also consider whether any of the corporations involved in the complex structuring might be shams. In both rulings, the IRS concluded by stating that, where the relationship of a foreign entertainer and the U.S. and/or foreign companies involved in providing his performances is not readily ascertainable, a U.S. payor should withhold tax from payments to the foreign entertainer or loan-out company at the statutory 30% rate. The IRS invited the entertainer and the foreign or U.S. companies involved to apply for an advance ruling as to the U.S. tax consequences of such loan-out structures. Following the issuance of the lend-a-star rulings, U.S. representatives of foreign entertainers and athletes began to approach the IRS to determine whether there was any way to avoid the imposition of a 30% withholding tax on gross receipts arising from an entertainer s performance. Because a tax on gross profits generally substantially exceeds the tax that would ultimately be owed by the performer on the net income attributable to a performance, and, such tax, if imposed at the box office (as occasionally threatened by the IRS), would be very disruptive to the smooth functioning of, e.g., a concert tour, taxpayer representatives were desperate to enter into some arrangement with the IRS to reduce the effective rate of withholding tax in such cases. Although not originally sanctioned by any provision of the Code or regulations, the IRS acceded and started to enter into central withholding agreements ( CWA ) with performers and their agents in the late 1970 s. CWA s generally involve considerable negotiations and the preparation of detailed projections of income and expenses; copies of all contracts; prompt accounting at year-end by a firm acceptable to the IRS; and, in the case of disagreement with the IRS, payment of any amounts due on demand by way of withholding. It is also necessary that there be a substantial U.S. payor that accepts responsibility to operate the withholding regime and make payments, as necessary. The process was ultimately approved officially in Rev. Proc All potential withholding agents and the covered aliens (i.e., the performers) must agree to perform all provisions of the CWA, including the filing of appropriate withholding information returns on Forms 1042 and 1042S and, in the case of the performers, the filing of a sailing permit on Form 1040C. III. Impact of Double Tax Treaties 1. In General Under U.S. law, treaty obligations of the U.S. and U.S. domestic statutes generally have equal legal authority. Where there is an apparent conflict between the two, courts generally try to construe the provisions of a treaty and domestic law so that both are given effect. In particular, courts will look to the legislative history of a statute to determine whether Congress intended that a legislative provision override the provisions of a treaty. Frequently, but not always, Congress will make its intentions clear in this respect in its legislative reports C.B

13 However, where the provisions of a treaty and domestic law cannot be reconciled, whichever of the treaty and statutory provision that was enacted or became effective later in time generally prevails. With respect to tax treaties, a taxpayer for whom a U.S. tax treaty is or may be applicable has the right to elect to compute and pay his U.S. tax liability in accordance with the treaty if it produces a more beneficial result than would arise under the provisions of the Code. However, a taxpayer may not choose to apply some provisions of a treaty where they are of benefit in a certain matter and, at the same time, also apply provisions of domestic tax law that are more beneficial than the treaty with regard to other matters also encompassed by the treaty. Thus, a taxpayer generally must elect to apply the treaty or the Code; he cannot cherry pick provisions of the treaty or domestic law to obtain the optimum tax result. At the same time, a taxpayer electing to use the provisions of an applicable tax treaty may also have obligations under the Code as to matters not addressed in the treaty. For example, a U.S. lawful permanent resident (i.e., green card holder) who is eligible to tiebreak his residence to a foreign country under the provisions of a tax treaty is entitled to compute his U.S. tax liability as a nonresident of the U.S. if it results in a lower overall tax burden. However, for all other U.S. tax purposes, he remains a U.S. person and must comply with his other U.S. tax obligations, such as filing information returns with respect to certain interests in, e.g., foreign corporations, partnerships or trusts. Finally, it should be noted that, just because a taxpayer has recourse to the provisions of an applicable bilateral income tax treaty, it doesn t follow that the treaty will always provide complete relief to the taxpayer. Treaty partners are given fairly wide latitude to interpret the provisions of a tax treaty in terms of their domestic law provisions. Indeed, the general clauses of most treaties provide that terms not expressly defined in the treaty are to be construed either under domestic law or the law of the party seeking to impose tax. In all events, occasionally there are issues of income characterization or other matters about which the treaty partners don t agree and which may not be resolved through the mutual agreement procedure conducted by the respective competent authorities. Such was the case in a matter involving the well-known French composer and conductor, Pierre Boulez, regarding the characterization of income that he earned in the U.S. during the early 1970 s in connection with musical performances with two distinguished U.S. orchestras to which his services were loaned out by his putative employer, a U.K. company. The IRS brought a claim against Boulez under the Lend-a-Star rulings to the effect that the amounts paid to the U.K. loan-out company were, in fact, payments to him for his services and were subject to 30% withholding tax in the first instance and taxable at graduated rates. At the same time, Germany, where Boulez then resided, claimed that the payments were royalties, free of U.S. tax under the U.S.-Germany income tax convention and fully subject to tax in Germany. Thus, Boulez was subject to tax both in the source country, on what it considered were payments for services, and in his residence country, on what it considered were royalty payments. The respective competent authorities engaged in a mutual agreement procedure but 13

14 were unable to reach agreement on the character of the payments and the resulting taxation thereof. Fortunately for Boulez, the U.S. apparently gave up its claim to save him from true economic double taxation. 2. Income Tax Treaties Although many provisions of U.S. income tax treaties may have general application to the interests that foreign entertainers and athletes may have in the U.S. (e.g., provisions pertaining to the receipt of interest, dividends, royalties and capital gains), the provisions of greatest relevance that will be discussed below are those pertaining to the determination of a taxpayer s residence for treaty purposes and the special provision pertaining to entertainers and sportsmen (or, more traditionally, artistes and athletes ). a. Residence for Treaty Purposes All modern U.S. income tax treaties have provisions defining residence for purposes of the treaty. These are found in Article 4 of the 2006 U.S. Model Income Tax Convention ( 2006 U.S. Model ) and the same article of most U.S. bilateral income tax treaties. The article generally is based on the residence article found in the 2005 OECD Model Income Tax Convention ( 2005 OECD Model ) and its predecessor model conventions. Thus, if a taxpayer is a tax resident under the domestic law of the U.S. and the treaty partner, his residence for all treaty purposes generally is determined by looking, sequentially, to (i) the place of his permanent home, (ii) his centre of vital interests, (iii) his place of habitual abode, and (iv) his nationality. If a clear determination cannot be made from looking the foregoing factors, then his residence for all treaty purposes will be determined by mutual agreement of the competent authorities of the U.S. and its treaty partner. What is important to understand for foreign entertainers and athletes who perform frequently in the U.S. and, therefore, are physically present in the U.S. for substantial periods of time is how the residence provision of an applicable tax treaty works with the U.S. statutory residence rules, discussed at section I.1.a above. As was stated there, if an alien is present in the U.S. for a sufficient number of days over a three year period to become a U.S. tax resident under the substantial presence test, if he is present in the U.S. in the current reporting year for less than 183 days, he might still closer connect his residence to a foreign country in which he maintains a tax home. If he does so, then he will not be treated as a U.S. resident for the current year under the Code, despite the fact that he otherwise satisfies the substantial presence test. Note that under this Code test, the alien can closer connect his residence to any foreign country in which he has a tax home; a tax treaty is not required. What happens in the case of an entertainer or athlete who both meets the substantial presence test and is present in the U.S. in the current year for 183 days or more? Can he still avoid being taxed as a U.S. resident on his worldwide income and gains? He can if he is also a tax resident of a country with which the U.S. has an income tax treaty and can tie-break his residence to the foreign country under the provisions of the treaty s residence article. This 14

15 position might even be maintained for several years, if the alien performer or athlete has a strong basis to demonstrate that, e.g., he has a permanent home only in the foreign country and not also in the U.S. (where, e.g., he constantly stays in hotels or other short-term accommodations) or clearly has his centre of vital interests (e.g., family, financial accounts, etc.) in the foreign country. b. Entertainers and Sportsmen Provision An entertainers and sportsmen provision (also referred to as artistes and athletes, artistes and sportsmen, etc.; it will be referred to herein as the Artistes Clause ) first appeared in the 1963 OECD Draft Income Tax Convention ( 1963 OECD Draft ). It was a single paragraph and provided essentially that, notwithstanding the industrial and commercial (i.e., business) profits and dependent/independent personal services provisions of the draft treaty, income derived by a resident of a home country from services performed as an artiste or athlete in the host (or source ) country could be taxed in the source country. Paragraph 2 of the Artistes Clause, the far more troublesome provision pertaining to the source country taxation of income in respect of an entertainer s performances that accrues to third persons, first appeared in the 1977 OECD Model Income Tax Convention ( 1977 OECD Model ). An Artistes Clause began to appear in U.S. income tax treaties negotiated in the mid- to late-1970s, likely as a response to the tax treaty dilemma posed for the IRS by the various loan-out scenarios dealt with in the Lend-a-Star rulings. It now appears in virtually all U.S. income tax treaties. The treaty article, and especially its Paragraph 2, provides yet another weapon in the IRS s arsenal against abusive tax avoidance in the structuring of big money transactions involving foreign entertainers and athletes. Paragraph 1 of the Artistes Clause makes clear by the use of its non-exclusive examples that the provision is intended only to apply to income from the services of performing entertainers and athletes. The 1996 U.S. Model Income Tax Convention ( 1996 U.S. Model ), the 2006 U.S. Model and the 2005 OECD Model all refer to income derived by an entertainer, such as a theater, motion picture, radio or television artiste, or a musician, or as a sportsman, from his personal activities as such. The U.S. Treasury Department s Technical Explanation to the 1996 U.S. Model ( 1996 Technical Explanation ) states that others involved in a performance or athletic event, such as producers, directors, technicians, managers, coaches, etc. are not subject to the Artistes Clause but remain subject to the normal provisions pertaining to business profits and personal services. Thus, the income derived from such other persons generally will not be taxed in the source country if the individuals satisfy certain conditions. The 1996 Technical Explanation doesn t elaborate further on the categories of performing artistes who are within the Artistes Clause, but it is likely that the IRS would apply it to all participants in public performances intended for entertainment purposes, including, e.g., models at fashion shows and participants in high-stakes poker games, chess tournaments, 15

16 etc. Whether the U.S. would go as far as the Commentary to the 2005 OECD Model, which states that even income received by participants in political, social, religious or charitable events where an entertainment character is present might be included, is unknown. The 1996 Technical Explanation states that, in determining whether income falls within the Artiste Clause, the controlling factor is whether the income is predominantly attributable to the performance or other activities or property rights of the entertainer/athlete. Endorsement fees for an event or sponsorship fees paid for the right of a business to attach its name to an event are clearly within the clause. In a similar manner, the 1996 Technical Explanation indicates that, where an entertainer or athlete fulfills a dual role as a performer and, e.g., an executive producer or coach, it is the predominant character of the individual s activities that should control the characterization of the income. Where an individual performs more than negligible services in both capacities, there should be an apportionment between performance-related compensation and other compensation. Note that both the 1996 and 2006 U.S. Models contain a gross income threshold for taxation of $20,000 for a taxable year in Paragraph 1. Reimbursed expenses or expenses borne on behalf of a performer are included, and if income derived by an entertainer/athlete, including expenses, exceed the threshold, then the entire amount will be taxable. By comparison, the current 2005 OECD Model contains no similar income threshold and would tax the first $1 of income derived. As indicated above, Paragraph 2 of the Artiste Clause seeks to address the potential abuses that arise in the situations analyzed in the Lend-a-Star rulings. The 1996 Technical Explanation states that Paragraph 2 seeks to prevent the potential abuses of loan-out companies while at the same time protecting a performer s right to tax treaty benefits where there is a bona fide employer-employee relationship. Thus, if substantial income ostensibly accrues to persons other than the performer, but the performer or related persons participate, directly or indirectly, in the profits of such other person, then the source country can tax such income, either to the performer, if appropriate (e.g., under an assignment of income or other judicial doctrine), or, if appropriate, to such other person, without affording them the benefits of the treaty intended for personal services or business income. In this regard, note that the 1996 Technical Explanation states that a direct or indirect participation in the profits accruing to another person may include the receipt or accrual of deferred remuneration, bonuses, fees, dividends and other income or distributions, whenever and wherever accrued, paid, or otherwise realized. Note further that, if the loan-out company is not a resident of a treaty jurisdiction, then it will be taxed under applicable provisions of the Code and not under the provisions of the treaty, including the Artiste Clause. Finally, note that the 2006 U.S. Model has significantly modified the language of Paragraph 2 of the Artiste Clause. In the 1996 U.S. Model, the provision stated that income accruing to another person can be taxed in the source country, unless it is established that 16

17 neither the entertainer or sportsman nor persons related thereto participate directly or indirectly in the profits of that other person in any manner.... In other words, Paragraph 2 was couched in the language of an anti-abuse provision. The 2006 U.S. Model changes the foregoing proviso to unless the contract pursuant to which the personal activities are performed allows that other person to designate the individual who is to perform the personal services. This would appear to make the income fall within the category of income from a personal services contract of a PHC or CFC, as previously discussed at section I.4 above. Exactly how this provision would help resolve the IRS s dilemma in the case of abusive loanout company structures, as the language of the 1996 U.S. Model does, is unclear. There is as yet no new Treasury Department Technical Explanation to shed any light on the matter. In a May 8, 2007 comparison of the 1996 and 2006 U.S. Models prepared by the staff of the Congressional Joint Committee on Taxation, the difference was noted but no explanation of the new provision was offered. By comparison, Paragraph 2 of the 2005 OECD Model s Artiste Clause merely states that income accruing to another person may be taxed in the source country; there is no limitation to abusive structures. The Commentary to the 2005 OECD Model notes that some countries (e.g., the U.S.) look through loan-out company structures and impose tax on the performer under domestic law. Other countries, having no such provisions of domestic law, can simply tax the income to the other party under the OECD provision without establishing the participation of the performer or related persons Michael G. Pfeifer 17