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By Lowell D. Yoder, Esq.
McDermott Will & Emery, Chicago, IL
A recent IRS Chief Counsel Memorandum (CCM)1 adopts a new approach for applying the tax rate disparity test ("TRD test") under the Subpart F branch regulations. While the rationale for the computational approach is understandable, the rule is not obvious from the language in the regulations.
Under the facts, a controlled foreign corporation organized under the laws of Country B ("CFC-B") purchases raw materials from unrelated suppliers and uses them to manufacture a product ("Product X") in Country B. Product X is sold to unrelated customers.
CFC-B wholly owns an entity located in Country A that has elected to be disregarded for U.S. tax purposes ("DE-A"). DE-A performs sales activities in connection with the sale of Product X, and receives a commission from CFC-B. Product X is sold for use outside Country A and Country B. DE-A does not engage in any manufacturing activities.
Under the general rule of §954(d)(1), CFC-B's income from the sale of Product X would not be foreign base company sales income (FBCSI) for three independent reasons. First, income from the sale of Product X is not FBCSI because CFC-B does not purchase property from, or sell property to, related persons. Second, the definition of FBCSI does not apply because Product X is manufactured in CFC-B's country of organization. Third, CFC-B's income from the sale of Product X is not FBCSI because CFC-B manufactures Product X. Thus, it is clear, and the CCM accepts, that the sales income derived by CFC-B is not FBSCI under §954(d)(1).2
While the general FBCSI definition does not apply to CFC-B's sales income, §954(d)(2) contains a branch rule that can cause a portion of CFC-B's income to be FBCSI. As relevant to the facts in the CCM, the branch rule applies where a controlled foreign corporation (CFC) manufactures products in its home country and sells the products through a branch located outside of the CFC's country of organization, and the branch's sales income is subject to a relatively low tax rate.3 If the branch rule applies, then the general FBCSI rule is reapplied to the sales income of DE-A by treating it as a separate CFC from CFC-B and as earning income from selling Product X on behalf of CFC-B.4
Under the facts of the CCM, CFC-B manufactures products in Country B, and sells the products through DE-A located in Country A. Thus, the CCM concludes that CFC-B has a foreign branch that earns income from engaging in selling activities.5
The branch rule will apply to DE-A only if the TRD test is met. This test is met if the income derived by DE-A from selling activities is taxed at an effective tax rate ("actual ETR") that is both less than 90% of, and at least five percentage points less than, the effective tax rate that would apply to such income if the sales had occurred in Country B, the country where Product X is manufactured (the "hypothetical ETR").6 The purpose of the TRD test is to limit the application of the branch rule to situations where income that is "shifted" away from the home country to a purchasing or selling branch is taxed at a materially lower rate than if the income were subject to tax in the home country where the goods are manufactured.
The CCM uses the following income and tax assumptions. Both Country A and Country B have a 20% statutory tax rate. DE-A derives 100 euros of gross commission income in connection with the sale of Product X. Country A permits DE-A to exclude half of the gross income from the income tax base (50 euros) because the products are both manufactured outside Country A and sold to customers outside Country A. DE-A incurs selling expenses of 30 euros, leaving taxable income of 20 euros. Applying Country A's 20% tax rate, DE-A pays 4 eurosof tax. Country B does not subject DE-A's income to tax until distributed to CFC-B.
When determining whether the TRD test is met for the sales income derived by DE-A, one approach is to compare the statutory tax rate in Country A with the statutory tax rate in Country B. This is the most straightforward approach, and the examples that apply the TRD test in the regulations merely refer to the tax rates in the relevant countries.7 Under this approach, the TRD test would not be met—and the branch rule would not apply—because the statutory tax rate in both Country A and Country B is 20%. The CCM states, however, that the TRD test is not applied based on statutory tax rates, rejecting this approach.
Another approach for applying the TRD disparity test is to calculate the actual ETR on the sales income derived in the branch by using the income tax base in DE-A's country for the denominator. Under the facts, the computation would again yield a 20% ETR [i.e., €4 ÷ (€100 - €50 - €30)]. Thus, under this second computational approach the TRD test would not be met, and the branch rule would not apply. The CCM also rejects this approach, stating that using the income tax base in the branch's country is improper.
A third approach is to calculate the actual ETR for sales income earned in Country A (the branch's country) by using the income tax base in the country of manufacture (the CFC's home country) for the denominator, i.e., the same income tax base used for calculating the hypothetical ETR. This approach is adopted by the IRS in the CCM.
The CCM states that for the comparison to be meaningful, an appropriate common tax base must be used to calculate the actual ETR and hypothetical ETR. According to the CCM, computing the actual ETR and hypothetical ETR with respect to dissimilar tax bases would be contrary to the legislative purpose of §954(d) and would ignore the incentive to shift income from a manufacturing jurisdiction to a sales jurisdiction that grants exclusions and deductions to derive a smaller tax base. The CCM concludes that the most appropriate method for computing the actual ETR and hypothetical ETR is to use the hypothetical sales income tax base in the manufacturing jurisdiction as the common denominator.
The CCM assumes that Country B would include in its income tax base the full €100 commission derived by DE-A less the 30 euros of selling expenses (i.e., there would be no 50 euros exclusion from gross income as provided by Country A). Thus, the denominator for calculating the actual ETR would be 70 euros (not 20 euros, the income tax base in Country A). Since DE-A pays 4 euros of tax, the actual ETR for sales income derived by DE-A for purposes of the TRD test would be 5.71%.
In determining the hypothetical ETR—i.e., the ETR if DE-A's sales income were subject to tax in Country B, the home country—Country B's 20% statutory tax rate is applied to the same 70 euros of net income. The Country B tax would be 14 euros, or a 20% hypothetical ETR. Comparing that rate to the 5.71% actual ETR, the TRD test would be satisfied, and the branch rule would apply.
The CCM points out that the next step is to determine how much of DE-A's income is FBCSI. For this purpose, DE-A would be treated as a separate CFC organized in Country A that earns its income from selling products on behalf of CFC-B.8 While not stated in the CCM, DE-A's income from selling Product X would be FBCSI because the products are both manufactured and sold for use outside of Country A, and DE-A does not manufacture Product X.9
The approach adopted by the CCM is not expressly provided in the Code or regulations, and does not seem to have been previously discussed by the IRS in any published guidance. Prior informal guidance appears to indicate that the denominator for purposes of calculating the actual ETR is the income tax base in the country where the sales branch is located (the second approach above).
For example, PLR 200945036 addressed the application of the TRD test to branches of a CFC that derived income from selling products manufactured by the CFC. The ruling states that, for purposes of calculating the actual ETR, the sales income and the effective rates of tax applied thereto are determined solely under the tax law principles of the branch's country and taking into account such country's Advance Pricing Agreement. As discussed above, under this approach the TRD test would not be met under the facts in the CCM. 10
A question not expressly addressed in the CCM is whether the computation of the income tax base for purposes of the hypothetical ETR takes into account the CFC's actual facts. Under the CCM's approach, the income tax base for computing the actual ETR on sales income derived by DE-A would also be used for computing the hypothetical ETR on such income, determined under the laws of CFC-B's country. For the branch rule to serve its intended purpose, as articulated in the CCM, this determination of the income tax base must take into account any special rulings and regimes in the home country as applied to the actual facts as if the income were earned in the home country.11
To illustrate, assume the 100 euros derived by DE-A in Country A were instead all earned by CFC-B in country B from carrying on the sales activities in Country B. Further assume that under the tax laws of Country B, 50 euros would be excluded from gross income because all of the customers of Product X are located outside of Country B. Country B would also allow as a deduction the 30 euros of expenses, for an income tax base of 20 euros (the same as the income tax base in Country A). Under these facts, the TRD test is not met, because the effective tax rate in the branch country (20%, or 4 euros/20 euros) and the home country (20%, or 4 euros/20 euros) would be the same. The 50 euros-deduction should be taken into account in calculating the hypothetical ETR even if Country B would have included the entire 100 euros in gross income if instead the sales of Product X had been to Country B customers. Consistent with the rationale of the CCM, since under the facts Product X is sold to non-Country B customers, there would be no tax reduction in earning the income in Country A, and thus no incentive to shift income from the manufacturing jurisdiction to a sales jurisdiction. Therefore, the branch rule should not apply.12
In summary, the recent CCM provides that the denominator for calculating the actual ETR for income derived by a sales branch must be the same as the denominator for calculating the hypothetical ETR in the home country (or country of manufacture), and the denominator is the income tax base determined under the laws of the home country (or country of manufacture). The policy rationale behind this new approach is understandable, but the technical basis for it is not obvious from reading the regulations. Consistent with the rationale for this approach, the income tax base for calculating the actual ETR and hypothetical ETR should be determined by treating the actual sales operations as if they were carried on in the home country (or country of manufacture), taking into account any reductions in income that would apply when the products are sold to foreign customers.
This commentary also will appear in the July 2015 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Yoder, 928 T.M., CFCs -- Foreign Base Company Income (Other than FPHCI), and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.
Copyright©2015 by The Bureau of National Affairs, Inc.
4 The branch rule would not apply to cause income of the home office of CFC-B to be FBCSI. In addition, the branch rule would not apply to any income of DE-A that is not derived from purchasing or selling activities (e.g., income derived by DE-A from maintenance services, loaning funds, or licensing intellectual property). See Reg. §1.954-3(b)(1)(i)(a), §1.954-3(b)(2)(ii). See also Yoder, Limits on the Application of the Subpart F Branch Rules, 38 Tax Mgmt. Int'l J. 366 (June 12, 2009); Yoder, Final Subpart F Branch Regulations, 38 Int'l Tax J. 3 (March-April 2012).
5 For the purchase or sales branch rule to apply, it is necessary for a CFC to have a foreign "branch" that carries on "purchasing or selling" activities. §954(d)(2); Reg. §1.954-3(b)(1)(i)(a), §1.954-3(b)(1)(i)(b); Ashland Oil, Inc. v. Commissioner, 95 T.C. 348 (1990); Vetco, Inc. v. Commissioner, 95 T.C. 579 (1990).
9 The CCM states in footnote 19 that the net income of DE-A for purposes of computing the amount of FBCSI must be determined under U.S. tax principles (which might be a different tax base than for foreign tax purposes).
10 See also PLR 200942034 ("For purposes of determining the effective tax rate to which the sales income derived by Corporation B is subject under Treas. Reg. §1.954-3(b)(1)(ii)(c), the effective rate of tax is determined by applying local law."); Yoder, Local Law Governs Manufacturing Branch Determinations, 36 Int'l Tax J. 3 (July-Aug. 2010).
11 See Reg. §1.954-3(b)(4) Ex. 8 (takes into account lower incentive rate for manufacturing and related sales income in computing the hypothetical ETR); PLR 200942034 (takes into account deductions for interest on net equity in computing the hypothetical ETR).
12 This conclusion may require additional guidance. The regulations provide that, when calculating the hypothetical ETR, the branch's sales income is treated as if derived from "sources within" the home country or the country of manufacture. To be consistent with the rationale and conclusion of the CCM, the IRS should clarify that this language is applied in a manner consistent with how the law would apply to the actual facts, including the location of the customers. For a discussion of this point, see Attorneys Seek Greater Clarity for Proposed Contract Manufacturing Rules, 2008 TNT 148-22 (July 30, 2008) (comment letter submitted by Yoder, Noren, and Lyon on the TRD test). See also Yoder, Final and Temporary Subpart F Contract Manufacturing Regulations, 35 Int'l Tax J. 3 (Mar.-Apr. 2009).
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