Subpart F “Loopholes” Described in the President's FY 2017 Budget

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Lowell D.  Yoder,  Esq.

By Lowell D. Yoder, Esq. McDermott Will & Emery LLP Chicago, Illinois

The Obama Administration's FY 2017 Budget includes proposals to close Subpart F “loopholes.” The planning ideas described are available to taxpayers under current law and Congress has not expressed any interest in enacting these proposals.

As background, “United States shareholders” (U.S. shareholders) of a controlled foreign corporation (CFC) must include in gross income the Subpart F income of the CFC. Subpart F income includes certain insurance income, passive income, sales income, services income, and oil-related income. In addition, the amount of certain investments in “United States property” (U.S. property) held by a CFC is included in the gross income of the U.S. shareholders.

30-Day Rule

A U.S. shareholder includes in its gross income any Subpart F income or investments in U.S. property of a foreign corporation only if the foreign corporation was a CFC for an uninterrupted period of 30 days or more during its taxable year. A foreign corporation is a CFC if U.S. shareholders own, directly or indirectly, more than 50% of the corporation's stock (by vote or value).

The 30-day rule would prevent Subpart F from applying when U.S. shareholders acquire a foreign corporation from a foreign owner during the last month of the foreign corporation's taxable year. Subpart F also would not apply if U.S. shareholders sell a CFC to a foreign owner during the first month of the CFC's taxable year.

No inclusions would result under Subpart F for the first taxable year of a newly formed CFC that is in existence for less than 30 days. In addition, there would be no deemed inclusion under Subpart F from a CFC that is liquidated during the first 30 days of its taxable year.

For example, assume an operating CFC owns certain intangible property which it has licensed to related CFCs. The CFC desires to sell the intangible property to another member of the group. The CFC might sell its intangible property during the first 30 days of its taxable year and then elect to become a disregarded entity owned by a foreign holding company. Since the foreign corporation selling the intangibles would be a CFC for less than 30 days of the taxable year, any Subpart F income would not be included in the income of the U.S. shareholder.

The FY 2017 Budget would eliminate the rule that a foreign corporation be a CFC for an uninterrupted period of 30 days in order for a U.S. shareholder to be required to include in its gross income Subpart F income earned by the CFC. Accordingly, U.S. shareholders would be required to include in income any Subpart F income for a taxable year if a foreign corporation is a CFC on any day of its taxable year.

Toll Manufacturing

The President's FY 2017 Budget would expand the definition of foreign base company sales income (FBCSI) to include certain income earned by a CFC from selling products that a related person manufactures on its behalf, i.e., a “toll” manufacturer.

Toll manufacturing is a common global supply chain structure. The structure targeted by the proposal is a CFC that operates as a principal, purchases raw materials and components from unrelated suppliers, and consigns them to a related company to manufacture finished products. The CFC then sells the finished products to unrelated customers. Since the CFC principal neither purchases property from a related person, nor sells the finished products to a related person, its sales income is not FBCSI.

In its description of the Administration's proposal, the Treasury acknowledges that, “[i]n order for the foreign base company sales income rules of subpart F to apply, a CFC generally must engage in both a purchase and subsequent sale of personal property where such property is either purchased from, or sold to, a related person.” The Treasury further notes that “[u]nder current law, taxpayers take the position that a CFC can avoid foreign base company sales income by structuring the related party transaction by which the CFC obtains the property that the CFC sells to customers as the provision of a manufacturing service to the CFC rather than as a purchase of the property by the CFC.”

The Administration's proposal would expand the category of FBCSI to include income derived by a CFC from the sale of property manufactured on its behalf by a related person. Apparently, the CFC would be treated as purchasing the products it sells from a related person, i.e., the toll manufacturer. Under this construct, the transaction would effectively be recast from a services arrangement with the related manufacturer to a buy-sell arrangement.

Income would not be FBCSI under the new provision where the products are manufactured in a CFC's country of organization, or sold for use in a CFC's country of organization. In addition, the proposal would not apply to income from a CFC's sale of products that it manufactures. For example, sales income earned by a CFC principal that substantially contributes to the physical manufacture of the property by a related toll manufacturer would not be FBCSI.

Digital Income

The President's FY 2017 Budget proposes a new category of Subpart F income that would apply to certain “digital income,” and would be labeled “foreign base company digital income.” This category generally would include income from selling or licensing digital products or providing digital services where the CFC uses intangible property developed by a related party to produce the digital income.

Subpart F currently contains different rules for determining whether an item of income from digital products falls within the definition of Subpart F income, depending on the type of income earned. Digital income that is sales income is not Subpart F income if the products sold are not purchased from or sold to related persons, or the products are sold for use in the CFC's country of organization. Income from providing digital services generally is not Subpart F income if the services are provided to unrelated parties, or are performed in the CFC's country of organization. Income from licensing or leasing a digital product to unrelated persons is not foreign personal holding company income provided the CFC actively markets the property, or materially contributes to the development of the property.

The Obama administration expressed concern that taxpayers may be able to choose different transactional forms for economically similar transactions involving digital goods and services (leases, sales, or services), and thereby avoid the application of the existing Subpart F rules. The FY 2016 Green Book provides the following example: “[A] transaction involving a transfer of a computer program (i.e., a copyrighted article) could be characterized as a sale or lease of the computer program, depending on the facts and circumstances concerning the benefits and burdens of ownership with respect to the computer program. A computer program hosted on a server also might be used in a transaction characterized as the provision of a service to a user who accesses the server from a remote location.”

The FY 2015 Green Book explains, “In this regard, the subpart F rules, which are generally intended to require current U.S. taxation of passive and highly mobile income, have not kept pace with advances in technology. This shortcoming enables CFCs to shift income related to digital goods and services to low-tax jurisdictions, in many cases eroding the U.S. tax base. For example, a CFC may be able to conduct business with remotely-located customers through the ‘cloud’ using intangible property acquired from a related party and without conducting any substantial business activities of its own.”

The new rule would apply in cases where the CFC uses intangible property developed by a related party to produce the income (including intangible property developed pursuant to a cost sharing arrangement). Foreign base company digital income would not include digital income if the CFC, though its own employees, made a substantial contribution to the development of the property or services that gave rise to the income (e.g., a computer program). An exception also would be provided where the CFC earned income directly from customers located in the CFC's country of organization that used or consumed the digital copyrighted article or digital service in such country.

The Subpart F “loopholes” described in the President's 2017 Budget are current law. Therefore, Subpart F planning involving the 30-day rule, toll manufacturing arrangements, and digital income are currently available, and the proposals are not in any legislation under consideration by Congress.

PANEL OF CONTRIBUTORS Thomas S. Bissell, CPA Celebration, Florida David Ernick, Esq.PricewaterhouseCoopers LLPWashington, D.C. Edward Tanenbaum, Esq.Alston & Bird LLPNew York, New York Robert E. Ward, Esq. Ward Chisholm, P.C. Bethesda, Maryland Kimberly S. Blanchard, Esq.Weil, Gotshal & Manges LLPNew York, New York Gary D. Sprague, Esq. Baker & McKenzie LLPPalo Alto, California James J. Tobin, Esq.Ernst & Young LLPNew York, New York Lowell D. Yoder, Esq.McDermott Will & Emery LLPChicago, Illinois This section features brief commentary written on a rotating basis by leading international tax practitioners. Advance versions of most items are published in the “BNA Insights” section of Bloomberg BNA Tax and Accounting Center on the Web.