by Jeffrey L. Rubinger and Nadia E. Kruler
Since the 1930s, companies have used endorsements by high-profile athletes to increase their sales. As a result, top professional athletes routinely secure multi-million dollar endorsement deals for lending their names or images to products. In fact, the practice has become so competitive that more than 20 percent of the top 100 world’s highest paid athletes have endorsement deals that significantly exceed their salaries and winnings.1 These athletes primarily include professional golfers, tennis players, race car drivers, and track and field stars.
In a recent Tax Court case, Garcia v. Commissioner, 140 T.C. No. 6 (2013), the court reallocated the compensation received by professional golfer Sergio Garcia pursuant to an endorsement contract 65 percent to royalty income and 35 percent to personal services income. In doing so, the Tax Court rejected the allocation agreed to by the parties under the endorsement contract, which provided that 85 percent of the income was to be allocated to royalties and the remaining 15 percent to services. The allocation was critical because the Tax Court held that the royalties were exempt from U.S. withholding tax under the U.S.-Switzerland income tax treaty, while the compensation for services was taxable in the United States at graduated U.S. tax rates.2
In 2011, the Tax Court in Goosen v. Commissioner, 136 T.C. No. 27 (2011), held that income received under an endorsement contract by professional golfer Retief Goosen was properly allocated 50 percent to royalty income and 50 percent to services income. The Tax Court also held that a portion of the royalty income from “on-course” endorsement contracts was U.S.-source income effectively connected with a U.S. trade or business and, thus, subject to U.S. federal income tax at graduated tax rates. In addition, the Tax Court determined that the U.S.-source royalties from “off-course” endorsement contracts were subject to a 30 percent U.S. withholding tax because the taxpayer was not eligible for the benefits of the U.S.-U.K. Income Tax Treaty.
These cases illustrate that the most important factors the IRS and courts will consider in determining the appropriate tax treatment of income earned by a non-U.S. athlete under an endorsement contract are 1) the character of the income (i.e., services, royalties, or some other category); 2) the allocation of the income between the respective categories; and 3) the source of any royalty income. The character of the endorsement income depends on what the sponsor is actually paying for. If the endorsement contract indicates the sponsor is paying the taxpayer to make promotional appearances or to film commercials, for example, it is clear that a portion of the income should be classified as services. If the athlete is simply required to wear the sponsor’s logo, and the endorsement income is unrelated to the athlete’s performance in tournaments or other events, then a portion of the income should be classified as royalties.
Once the character of the income is determined, the income is allocated among the different income categories. As noted above, it is generally more advantageous for a non-U.S. taxpayer to allocate as much income as possible to royalties, as long as the taxpayer is eligible for the benefits of a U.S. income tax treaty that reduces or exempts the withholding tax on royalties. However, as illustrated in the Goosen and Garcia cases, in order to support an allocation that is weighted more heavily toward royalties, it is important to show that the athlete is being compensated primarily for the use of his or her name, reputation, and image, as opposed to tournament performance, ranking, or number of promotional appearances. Finally, to determine the source of any royalty income earned by the taxpayer, it is necessary to examine factors such as where the taxpayer’s name and likeness are used, and where the products that the taxpayer is endorsing are sold.
Relevance to U.S. Athletes with Non-U.S. Endorsement Contracts
Given the number of high-profile, non-U.S. athletes that have signed lucrative endorsement contracts with U.S. companies and who are performing in the United States, the Garcia and Goosen cases are crucial in analyzing how the IRS and courts will attempt to allocate the endorsement income between royalties, services, or some other category of income, if relevant under an applicable U.S. income tax treaty. As discussed in this article, however, these cases also may be helpful in minimizing the worldwide income tax liability of professional U.S. athletes who have endorsement contracts with non-U.S. companies and who make appearances outside the United States.
It is becoming more common for professional U.S. athletes, NBA basketball players in particular, to sign multi-million dollar endorsement contracts with non-U.S. shoe companies in countries such as China.3 The issue in such situations is whether it is possible for a U.S. athlete to defer paying U.S. federal income tax on any of the non-U.S. source income earned under such an endorsement contract.4
For example, assume a professional U.S. basketball player is considering signing a multi-million dollar endorsement contract with a Chinese shoe company. Instead of signing the contract directly, the taxpayer forms a controlled foreign corporation (CFC), which in turn enters into an endorsement contract with the Chinese shoe company. Under the endorsement contract, the CFC agrees to cause the athlete to use exclusively the company’s shoes while participating in athletic and sports-related activities in public. The endorsement contract also provides that the CFC agrees to cause the athlete to make a certain number of appearances in China each year in connection with the promotion, advertisement, and sale of the shoes.5 Also assume that the U.S. athlete sells his non-U.S. rights (including the right to use his name, image, signature, photograph, and likeness) to the CFC, which in turn licenses those rights to the Chinese shoe company.6
Under these facts, the issue is whether the U.S. athlete will be subject to current U.S. federal income tax on the non-U.S. source endorsement income earned by the CFC7 or whether the athlete will be able to defer paying U.S. federal income tax until the CFC distributes such income to him or her as a dividend.8 The analysis depends primarily on whether the income earned by the CFC is characterized as “Subpart F” income. In addition, if the CFC is organized in a jurisdiction that has a comprehensive income tax treaty with the United States, it also may be necessary to analyze the artistes and sportsmen provision of such treaty to determine whether the non-U.S. source endorsement income is subject to current U.S. federal income tax.9
CFC Rules, in General
U.S. taxpayers generally are taxed on their worldwide income. To mitigate the potential double taxation that may result from such a system, a foreign tax credit is allowed for income taxes paid to foreign countries to reduce or eliminate the U.S. tax liability imposed on foreign-source income, subject to certain limitations.10
U.S. shareholders of foreign corporations are generally not subject to tax on the earnings of such corporations until the earnings are repatriated to the shareholders in the form of a dividend. Certain anti-deferral regimes, however, most notably the CFC provisions, may cause the U.S. person to be taxed currently with respect to certain categories of passive or highly mobile income (known as Subpart F income) earned by a CFC, regardless of whether any distributions are made.11
One of the primary categories of Subpart F income consists of foreign personal holding company income (FPHCI).12 FPHCI includes most forms of passive income, including royalties.13 FPHCI also includes a category of income known as “personal service contract” income. In general, personal service contract income is income received by a CFC under a written or oral contract to provide personal services, provided two conditions are met:
(1) Some person other than the CFC has the right to designate the performer of the services, or the contract designates the performer.
(2) The designated performer or any performer who could be designated under the contract directly, indirectly, or constructively owns 25 percent or more in value of the outstanding stock of the corporation at any time during the tax year in which the foreign corporation receives the income.14
Therefore, in order for any services income received by a CFC not to be considered personal service contract income, the service agreement must specify that the CFC providing the services has the right to designate the service provider. Although all parties may know who the service provider will be, this knowledge should not be specified in the service agreement itself, leaving the right to select the service provider to the CFC alone.
Another relevant category of Subpart F income is foreign base company services income (FBCSI). In general, FBCSI is any income (whether in the form of compensation, commissions, fees, or otherwise) derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, or like services which 1) are performed for or on behalf of any related person, and 2) are performed outside the country under the laws of which the CFC is created or organized.15
For purposes of this provision, “services which are performed for, or on behalf of, a related person” include services performed by a CFC for an unrelated person in a situation in which “substantial assistance” contributing to the performance of such services has been furnished by a related person or persons.16 The IRS has stated the purpose of the substantial assistance rules is to treat the following as FBCSI: income received by a CFC from rendering services to an unrelated person if in rendering those services a related person substantially contributes to the CFC’s performance of such services “in a manner that suggests that the CFC, rather than the related party, entered into the contract to obtain a lower rate of tax on the service income.”17
In the example above, if the U.S. athlete forms a CFC in a low-tax jurisdiction that does not have a treaty with the U.S., such as the Cayman Islands, and a portion of the endorsement income paid by the Chinese shoe company is characterized as non-U.S. source royalties (e.g., the U.S. taxpayer’s non-U.S. image rights have significant value compared to his worldwide image rights), that income likely would be considered FPHCI and, therefore, subject to current U.S. federal income tax.18
If the endorsement income is characterized as services income (e.g., if the income is related to personal appearances in China), the result would be similar. The services received by the CFC would be treated as FBCSI because they were not performed in the country of incorporation of the CFC and the U.S. athlete would be providing substantial assistance that contributes to the performance of the services. Thus, even if the personal service contract gave the CFC the right to designate the provider of the services and did not specifically name the U.S. athlete in the contract, it may not be possible to avoid the FBCSI provisions without some creative tax planning (e.g., forming the CFC in the jurisdiction where the services are performed and moving the management and control of such company to a lower-tax jurisdiction).
In addition to dealing with the Subpart F rules, if the CFC is formed in a jurisdiction that has a comprehensive income tax treaty with the United States, it is necessary to analyze the artistes and sportsmen provision of that treaty to determine whether the non-U.S. source endorsement income is subject to current U.S. federal income tax in the hands of the U.S. athlete. Many U.S. income tax treaties have a provision in the artistes and sportsmen article that provides
Income in respect of activities exercised by a…sportsman in his capacity as such which accrues not to the…sportsman himself but to another person may, notwithstanding the provisions of Article 7 (Business Profits) or 14 (Income from Employment) of this Convention, be taxed in the Contracting State in which the activities of…sportsman are exercised, unless that other person establishes that neither the…sportsman nor persons related thereto participate directly or indirectly in the profits of that other person in any manner, including the receipt of deferred remuneration, bonuses, fees, dividends, partnership distributions, or other distributions.19
Other U.S. income tax treaties contain a less draconian provision that states that the anti-abuse rule does not apply if the person accruing the income (i.e., the CFC) has the right to designate the individual who is to exercise the personal activities involved in the event.20
Under the facts of the example, this provision should not apply because the income in question would not be derived from U.S. sources.21 Therefore, the applicable U.S. income tax treaty would have no relevance as no U.S. income tax treaty benefits are being claimed.22
Using Maltese Corporation to Create High-tax Exception to Subpart F Income
In the event that none of the above exceptions apply, it may still be possible to circumvent the Subpart F rules by taking advantage of the high-tax exception to Subpart F income. This may be accomplished by using a CFC that is a tax resident of Malta. I.R.C. §954(b)(4) provides that a U.S. shareholder of a CFC may exclude from foreign base company income (which includes FPHCI and FBCSI) an item of income earned by a CFC if the taxpayer can show that the income was subject to an effective foreign income tax rate greater than 90 percent of the maximum tax rate specified in I.R.C. §11.23 The maximum rate of tax specified in I.R.C. §11 is currently 35 percent.24 Therefore, in order for the high-tax exception to apply, the income earned by the CFC must be subject to an effective foreign tax rate of at least 31.5 percent.
For purposes of this provision, the effective tax rate equals 1) the foreign income taxes paid, accrued, or deemed accrued with respect to the net item of income, divided by 2) the net item of FBC income (increased by the income taxes on the item).25 The amount of foreign income taxes paid, accrued, or deemed accrued with respect to an item of income is generally the amount a taxpayer would be deemed to have paid under I.R.C. §960 if the item of income were included in gross income under Subpart F.26 In the case of an individual, this amount is determined as if an election under I.R.C. §962 has been made to treat the individual as a corporation for the purposes of I.R.C. §960.27
The regulations under I.R.C. §954(b)(4) specifically provide that the amount of foreign income taxes paid, accrued, or deemed accrued with respect to an item of income will not be affected by a subsequent reduction in foreign income taxes attributable to a distribution to shareholder of all or part of such income.28 Further, a regulation dealing with the “high-tax kick out” exception under the foreign tax credit rules of I.R.C. §904 specifies that if the effective foreign tax rate imposed on a foreign corporation is reduced under foreign law upon the distribution of that income, the rules of I.R.C. §954(b)(4) are applied without regard to the possibility of a subsequent foreign tax reduction.29
An example in the I.R.C. §904(d) regulations illustrates this concept: S, a CFC, is a wholly owned subsidiary of P, a domestic corporation. P and S are calendar year taxpayers. In 1987, S’s only earnings consist of $200 of passive income that is FPCHI earned in foreign country X. Under country X’s tax system, the corporate tax on particular earnings is reduced on distribution of those earnings and no withholding tax is imposed. In 1987, S pays $100 of foreign tax. P elects to apply the I.R.C. §954(b)(4) high-tax exception to S’s passive income that is Subpart F income. In 1988, S distributes $150 to P. The distribution is a dividend to P because S has $150 of accumulated earnings and profits (the $100 of earnings in 1987 and the $50 refund in 1988). The example concludes that the $200 of FPHCI will be eligible for the I.R.C. §954(b)(4) high-tax exception to Subpart F income, even though the effective foreign tax rate is reduced from 50 percent to 25 percent (which is less than the 31.5 percent generally needed to qualify) as a result of the $50 tax refund received in 1988.30
Similarly, if a U.S. athlete’s non-US endorsement income were earned through a CFC that is tax resident in Malta, the high-tax exception could apply to exclude the income from Subpart F income. Malta’s corporate income tax rate is generally 35 percent. However, under Malta’s “imputation system,” the corporate income tax paid by the company is refunded to the shareholders upon distribution of dividends. The amount of the refund depends on the type of income earned by the company.
When the Maltese company in question earns active income, the shareholders are entitled to claim refunds of 6/7 of the Maltese corporate income tax paid. This results in an effective corporate income tax rate of 5 percent. If, on the other hand, dividends are paid by Maltese companies out of profits earned from passive interest and royalties, the shareholders are entitled to claim a refund of 5/7 of the Maltese corporate income tax paid. This results in an effective corporate income tax of 10 percent on these types of passive income.31 The refunds are payable within 14 days from the last day of the month in which the request is made to the Maltese tax authorities.
Therefore, if a Maltese CFC earns non-U.S. source endorsement income, a portion, which is characterized as services income, should be excluded from Subpart F income (regardless of the FBCSI or personal service contract provisions) since the income initially will be subject to corporate income tax in Malta at a 35 percent rate. The same analysis applies if a portion of the endorsement income is characterized as royalties (under the FPHCI provisions). Based on the regulations above, this result should not be affected by a subsequent reduction in the effective corporate income tax paid in Malta as a result of the distribution of the earnings of the Maltese company. Accordingly, if successful, this structure would allow a U.S. athlete to defer from U.S. federal income tax the non-U.S. source portion of the endorsement income without incurring much in the way of foreign income taxes.32
For U.S. professional athletes that have signed multi-million dollar endorsement contracts with non-U.S. companies, any planning to defer (and eventually repatriate at preferential qualified dividend rates) foreign-source income will involve structuring around the CFC rules. One possible solution may be taking advantage of Malta’s unique tax regime and the high-tax exception to Subpart F income.
1 See Badenhausen, Mayweather Tops List of the World’s 100 Highest-Paid Athletes, Forbes, June 18, 2012.
2 All references made to the Internal Revenue Code shall mean the Internal Revenue Code of 1986, as amended.
3 For example, NBA basketball star Dwayne Wade from the Miami Heat recently signed a multi-year endorsement contract with Chinese shoe company Li-Ning. See Wade and Li-Ning Make an Apparel Deal, New York Times, October 11, 2012.
4 It would be more difficult to defer from U.S. tax on U.S.-source income (especially income that is classified as services) earned under such an endorsement contract.
5 In Leavell v. Commissioner, 104 T.C. 140 (1985), the Tax Court held that compensation paid by a professional basketball team to a corporation formed by a player was attributable to the player individually despite the terms of the player contract between the team and the corporation because the team controlled the manner and means of the player’s performance. It should be noted, however, that the IRS did not challenge the viability of the corporation for purposes other than the taxpayer’s basketball services (i.e., the IRS did not challenge whether the corporation was the taxpayer’s employer for purposes of his personal appearances and endorsements).
6 To defer the payment of U.S. federal income tax, the non-U.S. image rights could be sold for a promissory note payable over a period of years.
7 Any U.S. source income earned by the CFC will either be subject to U.S. withholding tax (if the income is characterized as royalties and treaty benefits are not available) or cause the CFC to be engaged in a U.S. trade or business (if the income is characterized as services income). See I.R.C. §864(b).
8 And if structured correctly, repatriated as a qualified dividend taxed at a maximum U.S. federal income tax rate of 20 percent under I.R.C. §1(h)(11) (plus the additional 3.8 percent Medicare tax under I.R.C. §1411). The U.S. athlete would also need to receive some reasonable amount of salary from the CFC.
9 The structure potentially also can be challenged under I.R.C. §269A, I.R.C. §482, the assignment of income doctrine, the sham transaction doctrine, or under agency principles. In addition, this type of “loan out” arrangement may be challenged under Rev. Rul. 74-330, 1974-2 C.B. 278, on the theory that there is no true employer-employee relationship.
10 I.R.C. §904.
11 In general, a CFC is a foreign corporation that is more than 50 percent (by vote or value) owned (directly, indirectly, or constructively) by 10 percent U.S. shareholders. I.R.C. §957(a).
12 See I.R.C. §954(c).
13 An exception exists for royalties that are derived in the active conduct of a trade or business and received from an unrelated person. I.R.C. §954(c)(2)(A); Treas. Reg. §1.954-2(d)(1).
14 I.R.C. §954(c)(1)(h); Treas. Reg. §1.553-1.
15 I.R.C. §954(e).
16 Treas. Reg. §1.954-4(b)(1)(iv).
17 Notice 2007-13, 2007-5 IRB 410.
18 This is assumed that the active royalty exception is not applicable under Treas. Reg. §1.954-2(d)(1).
19 See U.S.-Ireland Income Tax Treaty, art. 17.
20 See U.S.-Malta Income Tax Treaty, art. 16.
21 Furthermore, the services are not being performed in the CFC’s country of incorporation.
22 Query whether the income tax treaty (if one exists) between the jurisdiction where the CFC is organized and the jurisdiction where the services are performed could result in current taxation in the jurisdiction in which the services are performed, even if no treaty benefits are being claimed.
23 I.R.C. §954(b)(4); Treas. Reg. §1.954-1(d)(1)(ii).
24 I.R.C. §11(b)(1)(D).
25 Treas. Reg. §1.954-1(d)(2).
26 Treas. Reg. §1.954-1(d)(3)(i).
28 Treas. Reg. §1.954-1(d)(3)(i). This provision applies to income other than passive FPHCI.
29 Treas. Reg. §1.904-4(c)(7)(iii).
30 Treas. Reg. §1.904-4(c)(8), Ex. 7.
31 It should be noted that the refund is reduced to two-thirds of the corporate income tax paid if the dividend is paid out of profits from which the company has claimed treaty benefits pursuant to an income tax treaty with Malta.
32 The income is deferred from U.S. tax because the distribution (and the tax refund) would be paid to a second Maltese company (i.e., a Maltese holding company). A check-the-box election would be made to treat the Maltese operating company as a branch of the Maltese holding company. The distribution and the tax refund would be exempt from Maltese corporate income tax when received by the Maltese holding company and would not trigger Subpart F income. The Maltese holding company eventually would pay a dividend to the U.S. shareholder, which should be eligible for qualified dividend rates.
Jeffrey L. Rubinger is a tax partner at Bilzin Sumberg in Miami and heads its international tax practice. He received his J.D. from the University of Florida School of Law and an LL.M. in taxation from New York University School of Law. He is admitted to the Florida and New York bars.
Nadia E. Kruler is a tax associate at Bilzin Sumberg in Miami. She received her J.D. from Hofstra University School of Law and an LL.M. in taxation from the University of Miami School of Law. She is admitted to The Florida Bar.
A version of this article was previously published in The Journal of Taxation.
This column is submitted on behalf of the Tax Law Section, Joel David Maser, chair, Michael D. Miller and Benjamin Jablow, editors.