CCA 1343020: foreign distributor earnings are compensation for services, sourced by service location

Plain-English summary

Chief Counsel Advice addresses payments made by a multi-level marketing company to foreign distributors based on purchases by distributors lower in their sponsorship chains. It concludes that the payments are compensation for recruiting, training, and supporting those lower-tier distributors, not proceeds from product sales. The source of the income depends on where the higher-tier distributor performs those services, and the company must generally withhold on U.S.-source amounts unless an applicable exception or treaty rule applies. For foreign individuals, the advice discusses Form 8233, while foreign corporations may use Form W-8ECI or Form W-8BEN depending on the circumstances.

Ruling snapshot

• Question: How should earnings paid to foreign distributors be characterized, sourced, and handled for withholding?
• Outcome: Advice given
• Key authorities: IRC §§ 861-864, 871, 881-882, 1441-1442, 3402; Treas. Reg. §§ 1.861-4, 1.1441-2, 1.1441-3, 1.1441-4

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       memorandum
       Number: 201343020
       Release Date: 10/25/2013
       CC:INTL:B06
       PRESP-100596-12

UILC: 1441.02-03

date: August 23, 2013

 to:   David W. Horton, Director, International Individual Compliance
       Office of Deputy Commissioner International, LBI

from: Anne Shelburne, Senior Counsel, Branch 6
Office of the Associate Chief Counsel (International)

subject: ------------------------------------------------------------------

       This non-taxpayer specific Chief Counsel Advice responds to your request for
       assistance in determining the character and source of certain payments made to foreign
       distributors by a multi-level marketing company (Taxpayer) and the withholding tax
       responsibilities of such Taxpayer. This advice may not be used or cited as precedent.

       ISSUES

           1. What is the character and source of payments made by Taxpayer to a
              nonresident alien individual distributor or foreign corporate distributor
              (collectively, foreign distributor) to reward the foreign distributor for cultivating a
              multi-level chain of distributors that result in sales of Taxpayer’s products?1
           2. Under what circumstances is Taxpayer required to withhold tax under section
              14412 when it pays Earnings to a foreign distributor?
           3. If Taxpayer is required to withhold tax when it pays Earnings to a foreign
              distributor, can that requirement be modified by an income tax treaty?




       1
         These payments are typically calculated on the basis of a percentage of the purchases made by
       distributors below the distributor earning the payment. Such payments are hereinafter referred to as
       “Earnings.”
       2
         Unless otherwise specified, references herein to “section” or “the Code” are to the Internal Revenue
       Code of 1986, as amended.

PRESP-100596-12 2

CONCLUSIONS

1. Earnings of a foreign distributor based on purchases of Taxpayer products by
   lower-tier distributors in the foreign distributor’s sponsorship chain constitute
   income from performance of personal services by the foreign distributor. The
   source of Earnings derived from performance of personal services is based on
   where the services of the foreign distributor are performed subject to limited
   exceptions not relevant here, such that income attributable to services performed
   in the United States is U.S. source income.
2. Taxpayer is required to withhold tax on Earnings of a nonresident alien individual
   that constitute compensation for the performance of services within the United
   States. Taxpayer is required to withhold tax on Earnings of a foreign corporation
   that constitute compensation for the performance of services within the United
   States unless the foreign corporation provides Taxpayer with a completed Form
   W-8ECI.
3. If the foreign distributor is a resident of a foreign country that has an income tax
   treaty in force with the United States and does not have a fixed base or
   permanent establishment in the United States to which Earnings are attributable,
   Taxpayer will not be required to withhold tax if the foreign distributor provides a
   completed Form 8233 or Form W-8BEN to Taxpayer prior to the payment.

FACTS

Taxpayer, a U.S. corporation, produces and sells products to U.S. and foreign
distributors, with some sales income sourced within the United States, and some sales
income sourced outside the United States, under applicable rules. Taxpayer sells its
products to the ultimate customers through a multi-level marketing arrangement, using
distributors who are treated as independent contractors for U.S. federal income tax
purposes. For purposes of this advice, we assume that the distributors are not
employees or agents of Taxpayer or other distributors in the multi-level marketing
arrangement.

A distributor’s income depends on several criteria, including the amount of products the
distributor purchases from Taxpayer and resells, and the success of the distributor in
sponsoring, training, and supporting other distributors (“lower-tier distributors”). These
lower-tier distributors may sponsor additional distributors, creating a sponsorship chain,
with all distributors in the chain potentially purchasing additional products from
Taxpayer. Product sales to all distributors in the sponsorship chain are made directly by
Taxpayer. The distributors may re-sell the products or keep the products for personal
use. A distributor sponsors a potential lower-tier distributor, who may be a resident of
the sponsor’s country or of another country, by supplying that person with an application
to become a distributor of Taxpayer’s products. If Taxpayer accepts the applicant as a
distributor, the sponsor (“higher-tier distributor”) is responsible for training the lower-tier
distributor on Taxpayer’s products, sales and marketing plans, recruitment guidelines,
PRESP-100596-12 3

and other rules, regulations, and guidelines for distributors. The higher-tier distributor
is encouraged to, among other things, assist the lower-tier distributor with setting sales
and recruiting goals and is encouraged to provide support and useful tools and insights
that will motivate and help the lower-tier distributor achieve sales and sponsorship
goals. Some higher-tier distributors meet, email, or participate in conference calls with
lower-tier distributors to motivate them to recruit, sponsor, and sell.

If the lower-tier distributor (“lower-tier distributor 1”) sponsors another distributor (“lower-
tier distributor 2”), lower-tier distributor 2 becomes a part of both the lower-tier distributor
1’s sponsorship chain and the higher-tier distributor’s sponsorship chain. There is no
limit on the number of lower-tier distributors who can become part of a sponsorship
chain. A lower-tier distributor’s success in recruiting and sponsorship activities is an
important factor in the success of its sponsor’s business.

Each distributor in the chain independently purchases products from Taxpayer and
carries on its sales and recruiting activities. A lower-tier distributor is not required to
follow the advice of its sponsor and does not have to follow any rules or guidelines
established by the sponsor. The distributor is only required to follow the rules and
guidelines set out by Taxpayer.

A distributor may earn income in two ways:

1. A distributor may buy products directly from Taxpayer and sell those products to
   the ultimate customers. The distributor earns the difference between the price
   the distributor pays for the products and the price paid by the ultimate customers
   to the distributor. Advice has not been requested with regard to this income.

2. In addition, a distributor may receive Earnings based on purchases of products
   from Taxpayer by lower-tier distributors in the distributor’s sponsorship chain.

This advice only addresses the income described in 2, above.

LAW AND ANALYSIS

Generally, under the Code, a foreign person may be subject to U.S. tax depending on
the character and source of the foreign person’s income. A foreign individual is subject
to U.S. tax under section 871(a)(1) at a flat rate of 30 percent on income that is not
effectively connected with the conduct of a trade or business within the United States
and which constitutes fixed or determinable, annual or periodical gains, profits or
income (FDAP). Nonresident alien individuals with income effectively connected with
the conduct of a trade or business within the United States are taxed under section
871(b) at graduated U.S. tax rates. Foreign corporations are subject to similar rules
contained in sections 881(a) and 882(a). The United States requires the withholding of
income taxes by the payor from certain payments made to foreign persons under
sections 1441 and 1442.
PRESP-100596-12 4

1. Character of Earnings

Considering the facts presented above, the Earnings are properly characterized as
compensation for performance of a foreign distributor’s personal services in recruiting,
training, and supporting lower-tier distributors in the foreign distributor’s sponsorship
chain, and not income from sales of products. This conclusion is supported by the Tax
Court’s decision in British Timken Ltd. v. Commissioner, 12 T.C. 880 (1949), acq., 1949-
2 C.B. 1,. Although the types of services provided by the foreign distributors of
Taxpayer in this case differ somewhat from those provided in British Timken, that case
supports the proposition that the Earnings should not be treated as income from the
sale of Taxpayer’s products to lower-tier distributors in the distributor’s sponsorship
chain.

In British Timken, a U.K. corporation (“Timken”) established a sales force by appointing
distributors to handle the sales of goods of a U.S. manufacturer (“USM”) in Timken’s
territory. Timken, through its distributors, sent consulting engineers to potential
customers to induce them to incorporate the goods into product designs, maintained
contact with customers, procured orders, and set prices and conditions of sale. Initially,
Timken took possession of the goods and reshipped them to its customers. Eventually,
it directed its lower-tier distributors and customers to place orders and receive
shipments directly from USM. However, USM could not sell its goods to Timken’s
distributors or customers without Timken’s consent, since Timken had an exclusive right
to sell in those territories. Title to the goods passed in the United States, with USM
collecting the sales price from either Timken’s distributors or customers and passing on
a percentage of the sales price to Timken.

At issue was the character and source of the payments made by USM to Timken. The
court determined that Timken’s income from its sales activities was not derived from the
sale of personal property and, thus, rejected the place of sale as determinative of the
source of Timken’s income. The court said:

  Although a manufacturer’s profits may be the direct result of the production and
  sale of its products, it does not follow that such sales constitute the source of the
  income of many persons associated with the sales such as its salesmen, buyers,
  agents, and officers whose earnings are attributable to other considerations such
  as their sales ability or technical knowledge. This is true even though the
  compensation received may be measured by the amount of sales. It is the situs
  of the activity or property which constitutes the source of the compensation paid
  and not the situs of the sales by which it is measured that is of critical
  importance.

12 T.C. at 887.
PRESP-100596-12 5

Like the taxpayer in British Timken, in this case the higher-tier foreign distributors do not
take title to or beneficial ownership of products at any point. Instead, here lower-tier
distributors purchase products directly from Taxpayer, and Taxpayer pays the foreign
distributors an amount determined as a percentage of the lower-tier distributor’s
purchases from Taxpayer. Also, as in British Timken, although the compensation is
measured by the amount of product sales to lower-tier distributors, such compensation
is not derived from the sale of products to the distributors. Instead, the compensation is
paid for other activities associated with the sale. In this case, the activities that warrant
payment of Earnings are the recruiting, training, and supporting of the lower-tier
distributors in the sponsorship chain.

The conclusion that the payments made by Taxpayer to a foreign distributor are
characterized as income from performance of services is also consistent with
precedents holding that payment of a finder’s fee is compensation for services
performed. In Sinclair v Commissioner, T.C. Memo 1960-113, the Court addressed the
character of a payment made by one party (“Sinclair”) for arranging an opportunity for
another party (“Abbott”). The court found Sinclair suggested to Abbott that she knew a
man who had the production rights to a story, and that she might be able to obtain the
rights for Abbott to produce the play. Sinclair successfully obtained the rights for Abbott
to produce the play. The court found that Sinclair asked for some compensation in the
form of a finder’s fee, and ultimately found that a payment made by Abbott was a
finder’s fee for services rendered by Sinclair to Abbott. Thus, in Sinclair, the Tax Court
ruled that a payment made for an introduction and certain information constituted a
payment for services rendered. Sinclair supports the conclusion that the foreign
distributors’ Earnings should be characterized as services income because of the
similarity of the activities generating the income; in each case they involve finding,
sponsoring, and ultimately uniting buyers and sellers.

Nor is it relevant if only minimal activities are undertaken by the higher-tier distributors
to sponsor the lower-tier distributors. In Malchin v Commissioner, T.C. Memo 1981-
460, the Court determined that compensation paid to the taxpayer for information, which
led to a merger, constituted a payment for services even where “petitioner’s involvement
in the merger apparently consisted merely of keeping his ears open, remembering a
prior conversation, and making two telephone calls.” T.C. Memo 1981-460 at 12.

Similarly, this characterization is not affected by the fact that some of the compensation
may, depending on the specific circumstances, be contingent or deferred -- contingent
because the amount a distributor receives in a later year will not be known in the year
the services are performed, and deferred because a distributor will receive a payment in
a later year based on services performed in an earlier year. Accordingly, contingent
and deferred compensation retains its character as compensation for services in the
year such payment is actually received. See section 864(c)(6).
PRESP-100596-12 6

2. U.S. trade or business

If, within a particular taxable year, a foreign distributor performs services within the
United States, the foreign distributor is engaged in a trade or business within the United
States for that year. Section 864(b). Under section 864(c)(6), the determination of
whether deferred compensation is taxable to a foreign distributor, who performed
services within the United States, is made as if such income were taken into account in
the earlier year in which the services were performed, without regard to whether the
distributor is engaged in a trade or business in the United States in the year the
distributor receives the deferred compensation.

3. Source of income

A foreign distributor engaged in a U.S. trade or business is subject to U.S. tax on U.S.
source income derived from performance of services. Earnings attributable to services
performed by the foreign distributor within the United States are from sources within the
United States, while Earnings attributable to services performed by the foreign
distributor outside the United States are from sources without the United States. See
sections 861(a)(3), 862(a)(3), and 863(b)(1). If services are performed both within and
without the United States, the amount of compensation attributable to personal services
performed within the United States or outside the United States is determined on the
basis that most correctly reflects the proper source of the income under the facts and
circumstances of the particular case. Treas. Reg. § 1.861-4. In many cases, the facts
and circumstances will be such that it will be acceptable to apportion income between
U.S. and foreign sources on a time basis, with income attributable to the amount of time
a taxpayer performs services in the United States sourced as U.S. source income.
Treas. Reg. § 1.861-4(b)(1) and (2).

In this case, although the amount of Earnings paid to a foreign distributor is determined
by product purchases made by lower-tier distributors in the foreign distributor’s
sponsorship chain, the Earnings may compensate the foreign distributor for services
performed over a number of years. The contingent and deferred compensation, though
paid in a later year, may compensate the foreign distributor for recruitment, training, and
supporting services performed over a multi-year period. The regulations address the
sourcing of income in multi-year compensation cases in Treas. Reg. §1.861-
4(b)(2)(ii)(F). The regulations provide that the source of multi-year compensation is
determined generally on a time basis, over the period to which such compensation is
attributable. The regulations define multi-year compensation to mean compensation
that is included in income in one taxable year but is attributable to a period that includes
two or more taxable years. The determination of the period to which such
compensation is attributable is based on the facts and circumstances of a particular
case. Thus, in this case, if apportionment of compensation paid to a foreign distributor
between U.S. and foreign sources is made on a time basis, it may require determination
of the number of days the foreign distributor spent in the United States recruiting,
training, or supporting lower-tier distributors. Generally, if determining on a time basis
PRESP-100596-12 7

how much of a payment to a foreign distributor is U.S. source income, the regulations
indicate that such amount is the amount that bears the same relationship to the total
multi-year compensation as the number of days that the services were performed in the
United States to the total number of days such services were performed both within and
without the United States over the multi-year period. A unit of time less than a day may
be appropriate for purposes of this calculation.

Finally, in this case, the source of a foreign distributor’s income turns on the location of
the personal services performed by that foreign distributor. Thus, determination of the
source of income in this case is based on location of the activity of the higher-tier
foreign distributor in recruiting, training, and supporting the lower-tier distributors in the
sponsorship chain, and not on the location of the activity of lower-tier distributors. See
Miller v. Commissioner, T.C. Memo 1997-134.

4. Withholding of tax at source

Section 1441(a) generally states that any person making a payment of FDAP to a
nonresident alien, to the extent such item constitutes gross income from sources within
the United States, is required to withhold from such item a tax equal to 30 percent
thereof, unless such rate is reduced by an applicable exception. See Treas. Reg. §
1.1441-2(a). Section 1442 contains the companion rule for payments of FDAP to
foreign corporations. Income from the performance of services within the United States
is FDAP that would be subject to withholding unless specifically exempted.

Treas. Reg. § 1.1441-4 provides an exception from withholding for most income that is
effectively connected with a trade or business in the United States. Income from the
performance of personal services in the United States generally constitutes income
effectively connected with a trade or business in the United States. Earnings paid to a
corporate distributor for services performed in the United States is exempt from
withholding tax under this exception if the distributor provides Taxpayer with a Form
W-8ECI (“Certificate of Foreign Person’s Claim That Income Is Effectively Connected
With the Conduct of a Trade or Business in the United States”), documenting its status
as a foreign person.

However, this exception from withholding tax on effectively connected income generally
does not extend to compensation of an individual for the performance of personal
services unless that income is subject to wage withholding under section 3402 or
certain other exceptions that are not applicable here. Because the distributors are not
employees of Taxpayer, Earnings paid to the foreign distributors constitute income from
personal services that are not payments to employees taxable under section 3402.
Accordingly, the Earnings are subject to withholding under section 1441 to the extent
they are paid to an individual distributor for services performed within the United States.
Consequently, for Earnings paid to an individual distributor, Taxpayer must determine
the portion of the payment constituting income from sources within the United States
and withhold on that portion. To avoid over-withholding, Taxpayer should determine,
PRESP-100596-12 8

prior to the time of payment, the source of the income based on facts relevant to the
place where the foreign distributor performed the recruiting, training, and supporting of
the lower-tier distributors, the activities for which it is being compensated during the
year or years in issue. This may require an allocation of time spent performing those
services within and without the United States by the individual higher-tier foreign
distributor, and, if multi-year compensation is at issue, may require that determination to
be made over a multi-year period.

If, when Taxpayer makes a payment of the Earnings to the foreign distributor, it is
unable to determine the amount that is subject to withholding because it does not have
sufficient facts to determine the source of the Earnings, Taxpayer must withhold on the
entire amount of the Earnings to ensure that a sufficient amount is withheld. Treas.
Reg. § 1.1441-3(d)(1). Therefore, Taxpayer may be required to treat the entire payment
as U.S. source income and withhold up to the maximum 30 percent rate, subject to any
reduction under a treaty or the Code. See also Treas. Reg. § 1.1441-2(a) (providing
that for purposes of determining amounts subject to withholding, when the source of an
amount is unknown at the time of payment, the amount shall be treated as from sources
within the United States). Alternately, the regulations provide procedures for a
withholding agent to set aside the withholding tax in an escrow account until the
sourcing determination can be made. Treas. Reg. § 1.1441-3(d)(1). No provision of the
Code or regulations exempts a withholding agent from withholding on a payment simply
because the source of that income cannot be determined. Thus, if Taxpayer wishes to
avoid over-withholding on Earnings paid to its foreign individual distributors, it must
determine the portion of the payment constituting U.S. source income prior to the time
of payment.

5. Application of income tax treaties

The tax treatment of Earnings paid to a foreign distributor may be modified by an
income tax treaty if the foreign distributor is a resident of a foreign country with which
the United States has an income tax treaty in force.

In the case of distributors who are nonresident alien individuals, the applicable treaty
provisions are those that apply to personal services income that does not arise in an
employment context. In many U.S. income tax treaties currently in force, the applicable
article would be the Independent Personal Services article, which generally focuses on
whether a service provider who is a resident of one Contracting State is physically
present in the other Contracting State for a specified number of days or has a “fixed
base” available to them in that State to which the income is attributable. Some of the
newer U.S. income tax treaties have eliminated the Independent Personal Services
article because no practical distinction can be made between a "fixed base" (as used in
the Independent Personal Services article) and a "permanent establishment" (as used
in the Permanent Establishment and Business Profits articles). A permanent
establishment generally is a fixed place of business, although in certain circumstances a
taxpayer without a fixed place of business may nevertheless have a permanent
PRESP-100596-12 9

establishment because of the activities of a dependent agent. In these newer treaties,
income from the performance of activities of an independent character generally would
be taxable under the Business Profits article, but only to the extent attributable to a
permanent establishment in the other Contracting State.

Nonresident alien individuals who are residents of a treaty country and do not have a
fixed base or permanent establishment in the United States to which their Earnings are
attributable are not subject to U.S. income tax with respect to their Earnings. The
Earnings in such case will be exempt from withholding under section 1441 if the
distributor provides a properly completed Form 8233 (Exemption From Withholding on
Compensation for Independent (and Certain Dependent) Personal Services of a
Nonresident Alien Individual) to Taxpayer prior to payment. Treas. Reg. § 1.1441-
4(b)(1)(iv) and (2).

In the case of distributors that are foreign corporations, the applicable treaty articles are
the Permanent Establishment and Business Profits articles. Corporate distributors that
are residents of a treaty country, satisfy any applicable Limitation on Benefits article,
and do not have a permanent establishment in the United States to which their Earnings
are attributable are not subject to U.S. income tax with respect to their Earnings. The
Earnings will be exempt from withholding under section 1441 if the distributor provides a
properly completed Form W-8BEN (Certificate of Foreign Status of Beneficial Owner for
United States Tax Withholding) to Taxpayer prior to payment. Treas. Reg. § 1.1441-
4(b)(1)(iv) and (2).

Please call Anne Shelburne at --------------------or Angela Holland at -------------------- if
you have any further questions.