When is a U.S. Subsidiary a Permanent Establishment?
A recent US Supreme Court decision in an environmental case may offer guidance on the question whether a subsidiary will be deemed to be a permanent establishment of its parent corporation.
The 1992 model tax convention on income and on capital of the Organization for Economic Cooperation and Development (OECD), as revised in 1997 provides that:
[t]he fact that a company which is a resident of a Contracting State controls or is controlled by a company which is a resident of the other Contracting State, or which carries on business in that other State (whether through a permanent establishment or otherwise), shall not of itself constitute either company a permanent establishment of the other.(3)
This concept, which is based on the well-established principle that a subsidiary constitutes an "independent legal entity"(4) for tax purposes,(5) has been incorporated in many international income tax conventions, including the 1980 Canada-US treaty.(6)
Despite the general acceptance of the concept, however, a number of countries have attempted recently to bring foreign parent corporations within their taxing jurisdiction by characterizing the local subsidiaries of these corporations as deemed permanent establishments.(7) The aggressive positions of these countries raise again a perennial question: how close can the relationship between parent and subsidiary corporations become before the subsidiary will be deemed to be a permanent establishment of the parent corporation?(8)
A recent decision of the US Supreme Court in an environmental case may shed some light on the manner in which the Internal Revenue Service and the US courts will answer this question.(9) In Bestfoods, the Supreme Court considered the extent to which a parent corporation may be held liable under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980, as amended ("CERCLA"), for cleanup costs relating to a polluting facility owned by its subsidiary. Before the rationale of the Supreme Court is discussed, however, some background concerning the decisions of the lower courts is necessary.
The district court in Bestfoods concluded that a parent corporation could be held liable for cleanup costs under CERCLA in one of two ways: either directly, if the parent corporation acted as the "operator" of a polluting facility owned by its subsidiary; or indirectly, if the court pierces the corporate veil and disregards the separate existence of the subsidiary. The district court found that a parent corporation could be held directly liable for cleanup costs as an operator if the parent corporation "actually operated the business of its subsidiary" and did not restrict its involvement with its subsidiary to activities "merely consistent with their investment relationship."(10)
The district court interpreted this standard to mean that a parent corporation could be held liable for cleanup costs under CERCLA if the parent corporation had "exerted power or influence over its subsidiary by actively participating in and exercising control over the subsidiary's business during a period of disposal of hazardous waste."(11) In applying this test to the facts before it, the court held the parent corporation liable under CERCLA for cleanup costs relating to the polluting facility owned by its subsidiary. In reaching its decision, the court "found it particularly telling" that the parent corporation selected the subsidiary's board of directors and "populated its executive ranks with [parent] officials, and that a [parent] official ... played a significant role in shaping [the subsidiary's] environmental compliance policy."(12) Because the district court found the parent corporation to be directly liable for the cleanup costs as an "operator" of the facility, it did not consider the question whether the corporate veil could be pierced and the separate existence of the subsidiary disregarded.
Sixth Circuit Court of Appeals
The Sixth Circuit Court of Appeals reversed the decision of the district court.(13) In doing so, it "remarked on the possibility that a parent company might be held directly liable as an operator of a facility owned by its subsidiary"(14) if the parent corporation independently operated the facility in the subsidiary's stead or if the parent corporation operated the facility as a joint venturer with the subsidiary. The Sixth Circuit found the standard for direct liability developed by the district court to be "unworkable."(15) explaining instead that
where a parent corporation is sought to be held liable as an operator ... based upon the extent of its control of its subsidiary which owns the facility, the parent will be liable only when the requirements necessary to pierce the corporate veil are met. In other words, ... whether the parent will be liable as an operator depends upon whether the degree to which it controls its subsidiary and the extent and manner of its involvement with the facility, amount to the abuse of the corporate form that will warrant piercing the corporate veil and disregarding the separate corporate entities of the parent and subsidiary.(16)
In applying this test to the facts before it, the Sixth Circuit held that the parent corporation was not liable under CERCLA for the cleanup costs. Although the parent corporation took "an active interest in the affairs of its subsidiary," its actions
[did] "not indicate such a degree of control that the separate personalities of the two corporations ceased to exist and that [the parent corporation] utilized the corporate form to perpetrate the kind of fraud or other culpable conduct required before a court can pierce the veil."(17)
Because several other circuit courts of appeal had reached contrary decisions on the same issue (i.e., holding that a parent corporation could be held indirectly liable for cleanup costs regardless of whether the corporate veil could be pierced), the Supreme Court granted certiorari in Bestfoods in order to resolve the conflict.(18) The Supreme Court agreed with the Sixth Circuit that a parent corporation could be held indirectly liable for cleanup costs only where the corporate veil could be pierced under state law.(19) The Supreme Court then went on to address the knottier issue of when a parent corporation could be held directly liable for cleanup costs as an operator of a facility owned by its subsidiary.
The Supreme Court found that, for the purposes of CERCLA, "[t]he question is not whether the parent operates the subsidiary, but rather whether it operates the facility, and that operation is evidenced by participation in the activities of the facilities, not the subsidiary.'"(20) Accordingly, the Supreme Court criticized the district court's analysis of the direct liability issue. The lower court had rested its analysis on the parent corporation's relationship with the subsidiary, not on its relationship with the facility, and had premised its finding of direct liability on little more than the parent corporation's 100% ownership of the subsidiary and the parent's active participation in, and at times majority control over, the subsidiary's board of directors.(21) The Supreme Court also criticized the district court for failing "to recognize that 'it is entirely appropriate for directors of a parent corporation to serve as directors of its subsidiary, and that fact alone may not serve to expose the parent corporation to liability for its subsidiary's acts.'"(22) The Supreme Court went on to state that "it cannot be enough to establish liability here that dual officers and directors made policy decisions and supervised activities at the facility."(23) Furthermore, the government would bear the burden of establishing liability based on the fact that common officers and directors made policy decisions and supervised activities at the facility. This would require the government to show that, "despite the general presumption to the contrary, the officers and directors were acting in their capacities as [parent] officers and directors, and not as [subsidiary] officers and directors, when they committed those acts."(24)
According to the Supreme Court, the Sixth Circuit had "stopped short when it confined its examples of direct parental operation to exclusive or joint ventures."(25) There were, in the Supreme Court's view, two additional situations in which a parent corporation could be held directly liable for cleanup costs because it was "operating" a facility owned by its subsidiary. In the first situation, the actions of common officers and directors, who would usually be presumed to be wearing their "'subsidiary hats'"(26) when acting on behalf of the subsidiary, "might depart so far from the norms of parental influence exercised through dual officeholding as to serve the parent, even when ostensibly acting on behalf of the subsidiary in operating the facility."(27) In the second situation, "an agent of the parent with no hat to wear but the parent's hat might manage or direct activities at the facility."(28) The Supreme Court found "some evidence" that the parent corporation in Bestfoods "engaged in just this type and degree of activity" at the polluting facility owned by its subsidiary.(29) Accordingly, the Supreme Court reversed and remanded the case for further proceedings to develop the facts relating to this issue.
Although the Supreme Court's decision in Bestfoods nominally concerns the liability of a parent corporation under CERCLA for environmental cleanup costs incurred at a polluting facility owned by a subsidiary, it may offer guidance in two respects on the question whether a subsidiary will be deemed to be a permanent establishment of its parent corporation.
First, the Supreme Court's decision in Bestfoods reaffirms certain principles that would appear, absent the aggressive positions taken recently by some countries on the deemed permanent establishment issue, to be self-evident.
For example, the Supreme Court in Bestfoods held that a parent corporation will not be directly liable for the acts of its subsidiary unless the corporate veil may be pierced. In the Supreme Court's view, "the corporate veil may be pierced and the shareholder held liable for the corporation's conduct when, inter alia, the corporate form would otherwise be misused to accomplish certain wrongful purposes, most notably fraud, on the shareholder's behalf."(30) This standard for disregarding the separate existence of the subsidiary is rather high. For tax purposes, this holding could be read to mean that a subsidiary will be disregarded and a parent corporation will be deemed to have a permanent establishment only when the subsidiary is a sham corporation.
The Supreme Court also acknowledged that a parent corporation may be held directly liable for actions at a polluting facility owned by a subsidiary when the parent corporation operated the facility in the subsidiary's stead or in a joint venture with the subsidiary. It seems appropriate that activities engaged in by a parent corporation directly with or on behalf of its subsidiary would give rise to a permanent establishment. Nevertheless, the Supreme Court went on to indicate that a parent corporation could also be held directly liable for cleanup costs in other circumstances. However, neither of the situations posited by the Supreme Court appears to offer substantive guidance with respect to either a parent corporation's direct liability under CERCLA or the treatment of a subsidiary as a permanent establishment.
In the first situation, the Supreme Court stated that a parent corporation could be held directly liable for cleanup costs under CERCLA when common directors or officers "depart so far from the norms of parental influence exercised through dual officeholding as to serve the parent, even when ostensibly acting on behalf of the subsidiary in operating the facility."(31) This example merely restates the proposition that, under certain egregious circumstances, the government may rebut the presumption that common directors or officers are wearing their "subsidiary hats" when acting on behalf of the subsidiary. In the situation, the Supreme Court stated that a parent corporation could be held directly liable for cleanup costs under CERCLA when "an agent of the parent with no hat to wear but the parent's hat" ... manages or directs activities at the subsidiary's facility.(32) This example appears to be no more than a caution sign for the reckless; direct liability may generally be avoided in this situation by ensuring that all directors and officers of the parent corporation who have dealings with the subsidiary are also directors or officers of the subsidiary.
Second, and more important, the Supreme Court's decision in Bestfoods may provide tax advisers with some comfort in structuring a closer relationship between a foreign parent corporation and its US subsidiary.
The Supreme Court stated that it is appropriate for parent and subsidiary corporations to have common directors and officers. In fact, the Supreme Court quoted a treatise for the proposition that "it is 'normal' for a parent and subsidiary to 'have identical directors and officers.'"(33) This acknowledgment of business reality is contrary to the advice given by many tax advisers, who usually advise clients to establish separate boards of directors for parent and subsidiary corporation, and to hire separate officers for subsidiaries in order to undercut any argument by a taxing authority that the subsidiary is a dependent agent or alter ego of the parent corporation. In light of the decision in Bestfoods, it may be appropriate for tax advisers to reconsider the extent to which the establishment of separate boards of directors and the hiring of separate officers are actually necessary or desirable.
The Supreme Court also stated that common directors and officers are presumed to be wearing their "subsidiary hats," rather than their "parent corporation hats," when acting on behalf of the subsidiary. The Supreme Court further implied that the government would bear the burden of proving that the common officers or directors were wearing their "parent corporation hats" when acting on behalf of the subsidiary. These statements buttress the Supreme Court's acknowledgment that it is "normal" for parent and subsidiary corporations to have common directors and officers, and may ease the minds of some tax advisers in considering whether a US subsidiary needs a separate board of directors and separate officers.
Tax advisers involved in structuring the relationship between a foreign parent corporation and its US subsidiary may find that the United States, after Bestfoods, now provides some solace amid the clamour of the great permanent establishment debate.(34)
2. The assistance of my associate, Anthony C. Infanti, in the preparation of this article is gratefully acknowledged.
3. Organisation for Economic Co-operation and Development, Model Tax Convention on Income and on Capital (Paris: OECD) (looseleaf) (herein referred to as "the revised OECD model treaty"), article 5(7). See also United States, Treasury Department, United States Model Income Tax Convention of September 20, 1996, article 5(7); and the 1980 United National Model Double Taxation Convention Between Developed and Developing Countries, UN publication no. ST/ESA/102, article 5(8).
4. Revised 1992 OECD model treaty, commentary on article 5, at paragraph 40.
5. The commentary to the revised OECD model treaty further explains, ibid., that "[e]ven the fact that the trade or business carried on by the subsidiary company is managed by the parent company [will] not constitute the subsidiary company a permanent establishment of the parent company." The commentary does observe, however, that a subsidiary may constitute a permanent establishment of its parent corporation under the same circumstances that an unrelated corporation would constitute a permanent establishment of the parent corporation (that is, if the subsidiary does not qualify as an agent of independent status and if the subsidiary has and habitually exercises an authority to conclude contracts in the name of the parent corporation). See ibid., at paragraph 41.
6. The Convention Between the United States of America and Canada with Respect to Taxes on Income and on Capital, signed at Washington, DC on September 26, 1980, as amended by the protocols signed on June 14, 1983, March 28, 1984, March 17, 1995, and July 29, 1997 (herein referred to as "the Canada-US treaty"). See the Canada-US treaty at article V(8) (containing language identical to that of article 5(7) of the revised OECD model treaty, save for the omission of the words "of itself").
7. See, for example, Piergiorgio Vanlente, "Italian Permanent Establishments and the Philip Morris Case" (February 23, 1998), 16 Tax Notes International 573-74 (summarizing a recent decision by the Milan Tax Court concerning whether Philip Morris Inc. had a permanent establishment in Italy by virtue of services performed by its Italian subsidiary; this decision was "the first in a series of expected rulings" in the "numerous assessments" made by the Italian tax authorities against Philip Morris Inc., many of which involve the issue whether Philip Morris Inc. had a permanent establishment in Italy); Robert A. Baskerville & Woo Taik Kim, Business Operations in the Republic of Korea, Tax Management Foreign Income Portfolio 970-2d (Washington, DC: Bureau of National Affairs, 1998) A-17 (explaining that, despite the inclusion of a provision analogous to article 5(7) of the revised OECD model treaty in most Korean tax treaties, "the trend of enforcement by the [Korean tax authority] has been to disregard corporate boundaries where the activities of a subsidiary company appear to exceed the scope of activities 'usually conducted' by a subsidiary, and where the subsidiary does not have 'substance'"); and J.Y. Lee and R.M. Donaldson, "Latest Developments in PE Disputes Involving Agents in Korea" (September 4, 1995), 11 Tax Notes International 627-33, at 632 (describing developments in the "great Korean PE debate" and concluding that, "[u]ntil a clear ruling, court decision, or intergovernment agreement is reached, the [Korean tax authority] will continue to be able to apply its own aggressive interpretation in discovering that Korean branches and subsidiaries of foreign companies are actually PEs").
8. For example, from a US perspective, the application of article V(8) of the Canada-US treaty is uncertain because none of the US authorities that usually provide interpretations of recently concluded income tax conventions elaborates on the concept that a subsidiary will not be deemed to be a permanent establishment of its parent corporation merely by virtue of the parent's control over the subsidiary. See United States, Treasury Department, Technical Explanation of the Convention Between the United States of America and Canada with respect to Taxes on Income and on Capital, April 26, 1984; United States, Report of the Senate Committee on Foreign Relations Accompanying the 1980 U.S. Canada Income Tax Treaty and 1983 and 1984 Protocols, S. Exec. Rep. No. 98-22, 98th Cong., 2d Sess. (1984); and United States, Joint Committee on Taxation, Explanation of Proposed Income Tax Treaty (and Proposed Protocols) Between the United States and Canada, JCS-20-84 (Washington, DC: US Government Printing Service, April 25, 1984).
9. See United States v. Bestfoods, 66 USLW 4439 (US 1998).
10. CPC Intern. Inc. v. Aerojet-General Corp., 777 F. Supp. 549, at 573 (W.D. Mich. 1991).
12. Bestfoods, supra footnote 7, at 4441.
13. See US v. Cordova Chemical Co. of Michigan, 113 F.3d 572 (6th Cir. 1997).
14. Bestfoods, supra footnote 7, at 4441.
15. Cordova, supra footnote 11, at 581.
16. Ibid., at 580.
17. Ibid., at 581.
18. Bestfoods, supra footnote 7, at 4441 and footnote 8.
19. Ibid., at 4442.
20. Ibid., at 4444, quoting Lynda J. Oswald, "Bifurcation of the Owner and Operator Analysis under CERCLA: Finding Order in the Chaos of Pervasive Control" (Spring 1994), 72 Washington University Law Quarterly 223-85, at 269.
21. Bestfoods, supra footnote 7, at 4444.
22. Ibid., quoting American Protein Corp. v. AB Volvo, 844 F.2d 56, at 57 (2d Cir. 1988), cert. denied, 488 US 852 (1988).
23. Bestfoods, supra footnote 7, at 4444.
26. Ibid., quoting Phillip I. Blumberg, Law of Corporate Groups: Procedural Problems in the Law of Parent and Subsidiary Corporations (Boston: Little Brown, 1983), section 1.02.1, at 12.
27. Bestfoods, supra footnote 7, at 4445.
30. Ibid., at 4442.
31. Ibid., at 4445.
33. Ibid., at 4444, quoting Harry G. Henn and John R. Alexander, Laws of Corporations and Other Business Enterprises, 3d ed. (St. Paul, Miknn.: West Publishing, 1983), 347.