By Lowell D. Yoder, Esq.
McDermott Will & Emery LLP, Chicago, IL
The IRS issued a private letter ruling, PLR 201201016, that ruled that gain from the sale of a finance business, most of which was attributable to goodwill and going concern value, was not foreign personal holding company income (FPHCI) because the assets of the finance business were used, or held for use, in a trade or business. The IRS also ruled that the gain was qualifying income for purposes of the 70% test for eligibility for the financing income exception.
Under the facts of the ruling, a U.S. group indirectly owned all of the stock of CFC1, a corporation organized under the laws of country C. CFC1 owned 100% of the stock of a foreign entity (F-DE) organized under the laws of country D. F-DE was a disregarded entity for U.S. tax purposes. CFC1 sold its interests in F-DE to an unrelated buyer.
Financing Income Exception
CFC1 was an eligible controlled foreign corporation (CFC) within the meaning of §954(h), and F-DE was a qualified business unit (QBU)1 within the meaning of §954(h)(5)(D). Substantially all of F-DE's income qualified for the active financing exception under §954(h)(3).
As background, §954(h)(1) provides an exception from FPHCI for income derived by an eligible CFC in the active conduct of a banking, financing, or securities business. A CFC is an "eligible CFC" if it meets the following two requirements: (1) the CFC is predominantly engaged in the active conduct of a banking or financing business (e.g., loans, leases, factoring); and (2) the CFC conducts substantial activity with respect to such business.
The predominantly-engaged-in test is satisfied for a financing business if a CFC derives more than 70% of its gross income from its financing business with unrelated foreign customers. The substantial activity requirement is a facts-and-circumstances test. The CFC must conduct material activities related to its financing business and must conduct substantially all of the activities that give rise to its financing income.
Gross income of a CFC that is taken into account for purposes of satisfying the 70% test is gross income derived from the conduct of a lending or finance business. The Code defines the phrase "lending or finance business" to mean the business of:
Therefore, gross income-e.g., interest, factoring income, rents, service fees-derived by a CFC from directly engaging in the above activities with unrelated persons will be counted toward satisfaction of the 70% test. The character of the income earned is not relevant.
For purposes of determining a CFC's eligible status, the income and activities of the entire CFC are taken into account, including the income and activities of its QBUs and activities performed outside the CFC's or a QBU's home country. Activities of employees of related persons generally are not considered, unless certain conditions are satisfied, e.g., they are performed in the CFC's or QBU's home country.
An eligible CFC's active financing income is "qualified financing income," excluded from FPHCI, if all of the following three requirements are met:
Qualified financing income is determined separately for the CFC and each of its separate QBUs.
F-DE-a QBU of CFC1-employed a number of individuals and engaged in the active conduct of a lending or finance business. F-DE entered into numerous lending and financing transactions with unrelated customers located primarily in country D (its country of organization). Substantially all of the income of F-DE for prior years qualified for the active financing exception. (F-DE earned a small amount of passive income which qualified for the de minimis exception.)
Sale of F-DE Business
CFC1 sold all of its equity interests in F-DE to an unrelated buyer in exchange for cash. Because F-DE was a disregarded entity, the transaction was treated as a sale by CFC1 of the assets of F-DE.3
CFC1 represented that the vast majority of the gain from the sale of the assets was attributable to goodwill or going concern value (as defined in Regs. §1.1060-1(b)(2)(ii)) used, or held for use, in CFC1's trade or business. Most of the remaining gain was attributable to receivables resulting from loans made by F-DE to its customers during the ordinary course of its lending or finance business.
Certain assets of F-DE consisted of receivables and other financial assets that produced, before the sales transaction, income that was FPHCI (but which was excluded from foreign base company income under the de minimis exception). These passive assets comprised a small percentage of all of F-DE's assets.
FPHCI includes certain gain derived from the sale of property.4 Generally, such gain includes gain from the sale of property that gives rise to dividends, interest, rents, and royalties.5 In addition, this FPHCI category includes gain from the sale of "property that does not give rise to any income," which the regulations state generally includes all rights and interests in such property.6
This FPHCI category for certain gain derived from the sale of property does not include gain derived from the sale of property used, or held for use, in the CFC's trade or business. This exception can apply to tangible personal property, real property, and intangible property.7 For this purpose, "intangible property" includes goodwill and going concern value.8
The regulations do not elaborate on the meaning of "used or held for use" in the CFC's business. The legislative history states that this FPHCI category "is not intended to apply to gain on the sale of land, buildings, or equipment used by the seller in an active trade or business of the seller at the time of the sale."9 On the other hand, the legislative history indicates that gain from the sale of a painting would be FPHCI if, prior to disposition, the painting was merely displayed in the corporate offices or held in storage.10
The ruling concludes generally that gain realized by CFC1 from the sale of the assets of F-DE is not FPHCI because such assets were used, or held for use, in a trade or business of CFC1. A significant portion of the gain was attributable to goodwill and going concern value that was used, or held for use, in a trade or business. Other assets included loans to customers made in the ordinary course of its business.11 Only the amount of gain realized by CFC1 from the sale of the F-DE's passive assets resulted in FPHCI (which amount was not significant).12
If the gain realized by CFC1 attributable to the sale of the F-DE assets was considered non-qualifying income for purposes of §954(h)(2)(B)(i), CFC1 would fail to satisfy the 70% gross income test, thereby failing to qualify for the active financing exception under §954(h). In the absence of the transaction, CFC1 was expected to be an eligible CFC for the relevant taxable year.
The IRS ruled that, for purposes of applying §954(h) to CFC1, the gain realized by CFC1 on the sale of the F-DE non-passive assets would be treated as qualifying lending or finance income described in §954(h)(2)(B)(i). Thus, CFC1 should qualify for the active financing exception for the year of sale. Gain on the sale of the small percentage of passive assets would not qualify for this purpose, but the amount of such gain should not cause CFC1 to fail the 70% test.
The ruling reconfirms that the sale of an interest in a disregarded entity will be analyzed as a sale by the parent of the assets of such entity for purposes of applying the Subpart F rules (§§951-965). It also confirms that the FPHCI exception for assets used, or held for use, in a trade or business applies to assets used in a finance business that qualifies under §954(h). An important aspect of the ruling is that such gain is "good" income for purposes of the eligibility test for the financing exception.
This commentary also will appear in the February 2013 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Yoder, 927 T.M., CFCs-Foreign Personal Holding Company Income, and in Tax Practice Series, see ¶7150, U.S. Persons-Worldwide Taxation.
2 §954(h)(4)(A) - (E).
3 Regs. §301.7701-2(a); Dover Corp. & Subs. v. Comr., 122 T.C. 324 (2004).
5 Regs. §1.954-2(e)(2).
6 Regs. §1.954-2(e)(3).
7 Gain from the sale of inventory also is excluded from this category of FPHCI. §954(c)(1)(B) (last sentence); Regs. §1.954-2(e)(1)(ii)(A).
8 Regs. §1.954-2(e)(3)(iv) and (vi).
9 Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, 100th Cong., 1st Sess. (5/4/87), at p. 974.
10 S. Rep. No. 313, 99th Cong., 2d Sess. (5/29/86), at p. 367.
11 See also §954(c)(1)(B)(i) (exception for gain from sale of property that gives rise to dividends, interest, rents, or royalties that are not FPHCI under §954(h)); cf. Regs. §1.954-2(e)(2)(ii) (gain on the sale of debt instruments generally is FPHCI).
12 The fact that the FPHCI generated by the passive assets was excluded from Subpart F income under the de minimis exception did not allow the gain on the sale of such assets to qualify for an exception.