Fundamental Issues in U.S. Taxation of Foreign Entertainers and Athletes

The first of these two exceptions is the “closer connection” test and is available to individuals who have a closer connection to a foreign country in which the alien's tax home is located. To qualify for this exception and thus not be treated as a resident alien, the individual must be present in the United States on fewer than 183 days during the current year. See, I.R.C. '7701(b)(3)(B). This is another example of how important it is to accurately count days in the United States, not just mechanically but taking into account the web of exceptions. The closer connection exception is extremely useful for aliens who spend a substantial amount of time in the United States each year, enough to trigger the substantial presence test, but not more than 182 days in the year in question.

To analyze whether an individual has a closer connection to a country other than the United States requires going through the same kind of exercise that one generally goes through in other kinds of residency determinations, i.e., looking at the individual's connections to either, both, or neither country. Pertinent factors, and there are many, include the location of the individual's home(s), where the kids go to school, the location of prized and other personal possessions, the location of gyms, churches, doctors, etc. Residency determinations can require digging deeply into the client's personal life.

Treaty Tiebreak Exception

The second exception is the treaty tiebreak exception. Even if an individual would otherwise be treated as a resident under the substantial presence test, he or she will be treated as a nonresident alien if a tax treaty says the individual is a nonresident alien or, more precisely, if he or she is treated as a resident of our treaty partner under the treaty.

Here's a good way to think about this.

Occasionally two different countries will each claim an individual as their resident. There is no international law that prevents this. It frequently arises when a national of one country spends lots of time in another, whether for work, pleasure or as a result of actual immigration. Tax treaties, which are essentially contracts between countries, generally have provisions that are triggered when both countries treat a person as a resident. These provisions permit only one of the countries to treat the individual as a resident, notwithstanding internal laws that conclude otherwise. They are colloquially referred to as “tiebreak” provisions, or “treaty tiebreakers.”

(Note that the same issue can arise within the United States when two different states each claim the same person as a resident. This can happen when the laws of two states, such as California and New York, apply different tests to determine whether an individual is a resident. Unfortunately, there are no treaties between the states that provide tiebreakers, and the law of the land is that it is not unconstitutional for an individual to be tax resident in two different states.)

The United States has tax treaties with numerous trading partners, and the bulk of them follow the same methodology for determining which country gets to treat the individual as a resident, thus breaking the tie.

The first test usually asks whether the individual has a permanent home available to him or her in one, both, or neither of the countries. If the individual has such a home in one but not the other, that country wins and the inquiry ends. If instead the individual has a permanent home available in both countries or in neither, the test is inconclusive and we move to the second test.

The second test usually asks where the individual's “center of vital interests” is located, i.e. , the country with which his personal and economic relations are closer. This requires a general inquiry and comparison of connections to the two countries, analogous to the “closer connection” test described above. It may be very difficult to determine whether an individual's center of vital interests is in one country or another. For example, an individual who is single with no children may lack the natural location anchors that families with children have (such as, for example, schools).

The vast majority of cases seem to be resolved by the permanent home or the center of vital interests tests. But if those tests are inconclusive, treaties typically next look at whether the individual has a habitual abode in one country but not the other; if this doesn't resolve the issue, then an individual is a resident in the country in which he or she is a national. If the individual is a national of neither or both, then the countries have to try to come to an agreement under a so-called competent authority procedure.

There are many issues that arise in applying the treaty tiebreaker provisions, but a discussion of any more will pull us too far astray from our main focus.

U.S. Source Income

If a foreign individual is not treated as a U.S. resident for tax purposes, she will nevertheless be taxed in the United States on her U.S. source income. This is a particularly important consideration for foreign entertainers and athletes, some of whom remain clear tax residents of their home countries while earning income from U.S. sources.

There are numerous items that can constitute U.S. source income. The most common include compensation for services rendered in the United States: income from the rental or sale of U.S. real estate; dividends from U.S. corporations; income from membership or partnership interests in limited liability companies or partnerships that are themselves doing business in the United States; and certain royalties.

Source-of-income is an enormous topic, so this piece will discuss the two types that tend to be the most important for nonresident athletes and entertainers: compensation for services rendered in the United States, and royalties.

Compensation for Services Rendered in U.S.

Compensation for services rendered in the United States is sourced to the United States. This is another seemingly straightforward principle that has spawned much controversy and uncertainty.

In the clearest cases there is no uncertainty. A Czech tennis player who earns $1 million by winning the U.S. Open has U.S. source income and pays tax on it here. A Canadian singer who is paid $1 million for giving a concert in the United States has U.S. source income and pays tax on it here.

But suppose that a top French business consultant is engaged by a French company to advise it on commencing operations in the United States. The business consultant spends two weeks in a New York hotel doing her analysis, for which she is paid $1 million, and then returns to France.

Her $1 million fee is sourced to the United States because that's where the services are rendered. But because of a tax treaty, her fee is exempt from U.S. tax.

Article 14 of the tax treaty between the United States and France exempts from U.S. tax any compensation paid to a French resident for independent contractor services rendered in the United States unless she has a “fixed base regularly available” to her in the United States for the purpose of performing her activities. A hotel room available to her for two weeks would likely not be a “fixed base” under the treaty. Article 15 of the treaty provides for a similar, but not identical, exemption for employees.

So why is the consultant who works for two weeks in the United States exempt from U.S. tax, while the athlete or musician who works for a similarly-short period of time is not exempt? That is because the treaty between the United States and France contains a common article ' in this case titled “Artistes and Sportsmen” (Article 17), but elsewhere titled “Artists and Athletes” or “Artists and Entertainers” (with or without an “e” plunked near the end of “Artists”) ' that provides for the taxation of entertainers, musicians and athletes providing services as such, notwithstanding Articles 14 and 15 (re: independent contractors and employees).

Except in very rare cases where a tax treaty with the United States is so old that it predates the onset of Artists and Athletes clauses (such as the treaty with Hungary), athletes, entertainers and musicians are rarely eligible for an exemption. Providing services through a foreign loan-out corporation does not circumvent the problem, as was shown in the in terrorem lend-a-star rulings of 1974 (See, Rev. Rul. 74-330 and Rev. Rul. 74-331).

Compensation for Services Partly Within and Partly Without the U.S.

In many situations, services are rendered both inside and outside the United States. Determining how much compensation is attributable to services rendered inside the United States is extremely important in determining overall tax liability, particularly for entertainers, musicians and athletes who, because of treaty overrides, are unlikely to enjoy an exemption. This can be a challenging exercise with significant financial consequences.

In some cases it may be straightforward. A foreign backup musician who is paid a flat $10,000 per concert, eight of which are performed in the United States, will have $80,000 of income.

But some cases are more complicated. Suppose, for example, a Canadian nonresident alien hockey player plays for the New York Rangers. Regular season games and playoff games are played both in the United States and in Canada. Training camp is in Canada, and he spends the off-season in Canada staying in shape for the season.

What days are counted in determining the hockey player's U.S. source income? Just the actual games? Training camp? The off-season?

This fact situation was addressed in Stemkowski v. Commissioner, 690 F.2d 40 (2nd Cir. 1982). The Second Circuit concluded that to determine how much compensation was allocable to the United States, training camp and regular season and playoff games counted, but offseason days did not count.

The contract required Stemkowski to show up for games and training camp, but it had no requirements for the offseason. Stemkowski argued that offseason days should be covered because his contract required that he show up in shape for the start of training camp. However, the appeals court concluded that this was merely a condition of employment.

Compensation for Services, Or Payment for Something Else?

Proper characterization of income can have material bottom-line economic consequences. In particular, whether a payment is compensation for services or is instead a royalty for the use of property can mean the difference between paying tax in the United States or not, although this is not always the case.

We already know from the discussion above that compensation received by foreign athletes from competing in the United States is generally subject to U.S. tax. This concept has an important corollary: payments to athletes for other types of services rendered in the United States (for example, shooting a commercial) should not automatically be taxed here. Instead, they should be analyzed under the treaty rules applicable to service providers generally, which usually exempt compensation unless, broadly speaking, that compensation is paid from a U.S. permanent establishment or a fixed base.

Royalties paid to nonresidents are frequently exempt from tax in the United States ( see , for example, Article 12 of the treaty between the United States and the United Kingdom). But labels can be misleading. The term “royalties” is used in entertainment and sports in a much broader context than it is used in the tax world. Just because a payment is labeled a royalty does not mean that it will be taxed (or exempted from tax) as a royalty.

For example, consider the case of the famous composer and conductor Pierre Boulez. Boulez, who was a nonresident alien and was under contract with CBS Records. Under the contract, Boulez would make recordings that would be owned by CBS Records ' what we recognize as a work for hire. The contract provided that he would receive royalties based on a percentage of the receipts from sales of the records.

Seizing on the fact that the contract described his remuneration as “royalties,” Boulez argued that the payments were exempt from U.S. tax under the treaty with Germany, his home country, which exempted royalties from U.S. tax.

But even though the contract called his remuneration “royalties,” Boulez did not own any property that was being licensed. The property was owned by CBS Records. The Tax Court concluded that the contract was for personal services and the exemption did not apply. Boulez v. Commissioner, 83 T.C. 584 (1984). CBS's ownership of the underlying rights was a key determinative factor. (Note: Under U.S. copyright law, post-1977 recordings aren't listed as a work-for-hire category.)

Application of the principles in Boulez has come to the fore in complicated fashion in a couple of relatively recent, but unrelated, cases involving the world-famous golfers Retief Goosen and Sergio Garcia. They illustrate the difficulties in determining what is compensation for services and what is not.

The broad ideas in the two cases are the same. A company that makes golf equipment and clothing pays a nonresident alien golfer substantial sums of money to allow the company to use the golfer's name and likeness in its marketing campaigns. In return, the golfer is required to wear and use the company's products and to perform some incidental services. The golfer plays tournaments around the world, including some in the United States. How should the golfer's income from the endorsement contract be classified? Is the income royalties, compensation for services, or both?

The more recent case involved Sergio Garcia. See, Garcia v. Commissioner, 140 T.C. 141 (2013). While one might expect that by now everyone would have a good idea how these endorsement deals should be structured and analyzed, this case highlights the fact that there are still many issues that have become needlessly confused.

Sergio Garcia entered into a contract with TaylorMade to be the brand's “Global Icon.” TaylorMade had endorsement deals with many golfers, but Garcia was its only “Global Icon,” and thus was the centerpiece of TaylorMade's worldwide branding efforts.

Garcia was a top golfer at the time, but he was not the best. He made his deal with TaylorMade in 2002, the year after he finished at #6 in the world. At the end of 2002, he finished at #4. He was neither Michael Jordan nor Roger Federer. But his personality and image apparently more than compensated for the fact that he was not #1, which explains why his endorsement income was disproportionate to his on-course achievements. Think Anna Kournikova.

In his deal with TaylorMade, Garcia was required to use TaylorMade golf products (clubs, balls, gloves, etc.) and wear its golf clothes. He was also obligated to make some personal appearances.

This endorsement deal was all about Garcia's name and image. The core of the marketing plan was for the world to see, on TV, in print and otherwise, the TaylorMade brand on the body of Sergio Garcia. The personal services were merely incidental to the branding.

Which is why it is mind-boggling that the IRS argued, in its original notice of deficiency, that 100% of the payments made by TaylorMade were compensation for Garcia's personal services. 100% . The IRS at trial took a baby step back from this position to argue instead that the “vast majority” of the payments were compensation for services.

As absurd as the IRS's litigating position was in this case, it shouldn't hurt a golfer who is a resident of a country with which we have a double tax treaty, as was the case with Garcia. He was originally from Spain, but at all times in question was a resident of Switzerland, with whom we have a tax treaty. The treaty with Switzerland contains fairly typical clauses, including Artistes and Sportsmen (Article 17) and Independent Personal Services (Article 14).

Endorsement services should not be subject to the Artistes and Sportsmen clause, and instead should be exempt from U.S. tax (unless there is a fixed base or a permanent establishment, which there rarely is for endorsers). Article 17 allows for the United States to tax income derived by a nonresident alien athlete “from his personal activities as such” exercised in the United States. Endorsing is not golfing, so any income allocated to personal endorsement services should be tax-free under the treaty. The IRS doesn't see it this way, though.

This all should have been good news for Garcia, but inexplicably his counsel conceded on more than one occasion that all of his income from services rendered in the United States was taxable in the United States. By the time the Garcia camp realized the error and claimed the treaty exemption for the first time in their post-trial opening brief, it was too late, according to the Tax Court, because the IRS had not been given the opportunity to address the issue at trial.

Garcia and the IRS fought over how much was properly allocated to services vs. royalties. The details are not pertinent to this discussion, except for some observations they generate.

First, the original endorsement contract did not attempt to allocate payments between services and royalties. This was certainly not helpful to Garcia's cause. A later amendment did have an allocation, but neither the IRS nor the Tax Court was persuaded because a TaylorMade executive testified that the company was indifferent as to the allocation.

Second, as the Tax Court concluded, under the treaty with Switzerland the royalties were exempt from U.S. tax. The IRS wrongly argued that the royalties were: 1) compensation for personal services; and 2) covered by the Artistes and Sportsmen provision of the treaty. Both arguments are ridiculous and the Tax Court reached the right conclusion.

But look at what this all means. Sergio Garcia's royalties were determined to be exempt from U.S. tax. And his personal service endorsement income might have been exempt from U.S. tax had his counsel not conceded the issue. So Garcia should have paid no U.S. tax on his endorsement earnings.

More broadly, isn't this really entirely about royalties and not at all about personal services? TaylorMade doesn't care about the services. It only cares about the value of the brand. The services are relevant only to the extent that they increase that value. In other words, the better argument seems to be that no allocation should be made to services. And for Garcia, because he resided in a treaty country, the royalties would not have been subject to U.S. tax.

This argument would not be welcomed by Retief Goosen. A foreign golfer with generally a better ranking than Sergio Garcia, Goosen was another TaylorMade endorser who faced tax issues similar to Garcia. See, Goosen v. Commissioner, 136 T.C. 547 (2011). In that case, Goosen lost on the royalties issue because the right to receive his royalties was held by a Lichtenstein entity. The United States does not have a tax treaty with Lichtenstein. Thus, U.S. royalties paid to a Lichtenstein entity are subject to 30% withholding. Had the royalties been paid to Goosen directly, they likely would have been exempt from U.S. tax because Goosen was a resident of the United Kingdom, with which the United States has a favorable income tax treaty. It thus seems that with some advance thought and planning Goosen could have fared much better.

Bob Jason is a Principal with Nigro Karlin Segal Feldstein & Bolno, LLC. This piece is intended as a broad introduction to key fundamental income tax issues presented when a foreign entertainer or athlete comes to the United States, rather than as a comprehensive analysis of the topic. Copyright ' 2016 Robert M. Jason. All rights reserved.