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By Lowell D. Yoder, Esq.
McDermott Will & Emery LLP, Chicago, IL
Sales income derived by a controlled foreign corporation (CFC) that does not purchase property from, nor sell property to, a related person generally is not Subpart F income. Under certain circumstances, however, a sales branch rule can apply to treat a portion of the sales income as Subpart F income (i.e., foreign base company sales income, "FBCSI"). After discussing the application of the general FBCSI rule to distributor principals, this column describes certain rules that govern the application of the sales branch rule.
General FBCSI Rules
In order for sales income to be Subpart F income under the general FBCSI rule, a CFC must either purchase property from related persons or sell property to related persons (or purchase or sell property on behalf of a related person).1 For example, income derived by a Swiss CFC from selling products purchased from a related German CFC for use outside Switzerland could be FBCSI. On the other hand, income derived by the Swiss CFC from selling to unrelated customers throughout Europe products purchased from an unrelated French manufacturer generally would not constitute FBCSI.
Sales income does not become FBCSI merely because a related person provides purchasing assistance to the CFC. For example, a Swiss CFC may hire a related Chinese corporation to locate products manufactured by unrelated Chinese manufacturers and negotiate terms of supply agreements. If the Swiss CFC purchases the products from the Chinese manufacturers, the fact that it pays a service fee for purchasing services to the Chinese related corporation does not result in a related-party transaction for the principal within the definition of FBCSI.
Furthermore, sales income is not treated as FBCSI as a result of a related person assisting with selling the products. For example, a Dutch CFC may hire a related German commissionaire to solicit sales and sell products to unrelated German customers, with title passing to the customers directly from the Dutch CFC. Again, this related-party services relationship is not one that triggers the application of the FBCSI rules to the principal.
A CFC may hire a related party to manufacture products on its behalf. For example, a CFC purchases raw materials and components from unrelated persons, and consigns them to a related person to manufacture finished products. The CFC then sells the finished products to unrelated persons. The CFC's income is not FBCSI because it neither purchased property from related persons nor sold property to related persons.
The statute and regulations require either a purchase of property from, or sale of property to, a related person (or on behalf of a related person) for the general FBCSI rule to apply to income derived by a CFC from selling products. A CFC functioning as a distributor principal will not be treated as receiving FBCSI merely by reason of paying a service fee to a related person to assist with purchasing, selling, or manufacturing activities. Accordingly, a CFC receiving such related-person assistance does not derive FBCSI when it does not purchase property from related persons nor sell property to related persons (subject to the branch rule).
Sales Branch Rule
If a CFC conducts purchasing or selling activities in a branch outside of its country of organization, and a tax rate disparity test is met, a branch rule can apply to treat the branch's income as FBCSI. If the branch rule applies, then the branch and the remainder of the CFC are treated as separate CFCs for purposes of applying the FBCSI rules to the income derived by the branch.2
The sales branch rule does not apply if a CFC conducts its purchasing and selling activities in the country where the CFC is organized. For example, where a Swiss CFC performs all of its purchasing and selling activities in Switzerland and derives all of its income in Switzerland, the purchase or sales branch rule is not implicated. This is the result even if the sales income is subject to a low tax rate.
The sales branch rule also does not apply if income is derived in a branch outside of Switzerland but all purchasing and selling activities are performed in Switzerland. For example, it does not apply to a foreign finance branch or to a branch engaged in providing administrative services.3 In addition, the sales branch rule would not apply to income derived from exploiting intellectual property in a foreign branch where no purchasing or selling activities are performed by the CFC in the branch's country.
The sales branch rule potentially applies only when the CFC through its own employees engages in purchasing or selling activities in a foreign branch. A CFC that hires a related or unrelated corporation to perform purchasing or selling services in a country different from where the CFC is organized is not considered to have a branch in such country as a result of receiving such services.4
In the event a CFC conducts purchasing or selling activities in a foreign branch, the sales branch rule applies only if there is a tax rate disparity (TRD) with the home office. The TRD test is met where the branch's income derived from purchasing or selling activities is taxed at an effective tax rate (ETR) that is less than 90% of, and at least five percentage points less than, the ETR that would apply to such income in the CFC's country of organization.5 The purchasing or selling branch rule is intended to apply only where a CFC reduces its taxes in a higher tax home country by deriving income in a lower tax branch from conducting purchasing or selling activities.6
For example, the sales branch rule should not apply to a Swiss CFC subject to a 10% tax rate in Switzerland selling products through a U.K. branch that is subject to a 27% tax rate (i.e., the branch is subject to a higher tax rate than the home office).7 In addition, the sales branch rule would never apply where a Bermuda CFC is the owner of a purchasing or selling branch because Bermuda does not have an income tax, and therefore the TRD test could never be satisfied.
The income of the home office is not subject to the sales branch rule. The FBCSI general rule is reapplied under the sales branch rule only to the income of the branch. For example, where a Dutch CFC sells products through an Irish branch, only the income of the Irish branch would be potentially FBCSI under the sales branch rule.
If the branch rule applies, the branch is generally considered as purchasing or selling products on behalf of a related person. The temporary regulations appropriately provide that purchasing or selling activities performed through a branch will not be treated as performed "on behalf of" the remainder where the remainder does not engage in any purchasing, manufacturing, or selling activities.8 Under these circumstances, the branch rule would not operate to create a related-party transaction. For example, the sales branch rule would not result in FBCSI where the branch purchases products from unrelated persons and sells the products to unrelated persons, and all purchasing and selling activities are performed in the branch.9 Accordingly, a principal distributor may operate as a branch of a CFC without being subject to the FBCSI rules.
Under certain circumstances, a distributor principal may engage in purchasing or selling activities in more than one branch with respect to the same product. The branch rules apply separately to each branch. Accordingly, the TRD test should be applied to each branch on a separate basis by comparing the tax rate on income in the branch to the home office tax rate.10 Also, if the TRD test is met for one branch but not the other branch, the sales branch rule may potentially apply to income of the one branch, but not to income of the other branch. When reapplying the branch rule to a branch that meets the TRD test, a branch-to-branch transaction should not give rise to a related-party transaction, because the sales branch rule deems a related-party transaction to exist only when purchasing or selling activities occur in the home office and in the branch.11
Under certain circumstances where a distributor principal hires a contract manufacturer to produce products on its behalf, the CFC might be considered to be manufacturing the products sold under the substantial contribution definition of "manufacturing."12 If a CFC is considered as manufacturing the products sold in a foreign branch, the sales branch rule does not apply.13 Nevertheless, the manufacturing branch rule might apply.14
Applying the sales branch rule as described above is critical to maintain the integrity of the statutory language and legislative intent, as demonstrated by how that rule has been consistently applied for almost 50 years since it was enacted. Temporary branch regulations, which focus on the manufacturing branch rule, are expected to be finalized this year.15 It is essential that the final regulations do not inappropriately attempt to expand the sales branch rule beyond the language of §954(d)(2).
This commentary also will appear in the April 2011 issue of BNA's Tax Management International Journal. For more information, in BNA's 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.
5 The determination of tax rates is based on local law. Regs. §1.954-3(b)(2)(i)(e). SeeRegs. §1.954-3(b)(1)(ii)(b) (the above determinations take into account actual tax treatment "by statute, treaty obligation or otherwise…."); PLR 200942034, PLR 200945036, PLR 201002024. See also Yoder, "Local Law Governs Manufacturing Branch Determinations," 36 Int'l Tax J. 3 (July-August 2010).
8 Regs. §1.954-3T(b)(2)(i)(b) and (ii)(b). SeePreamble to Proposed Regulations, 73 Fed. Reg. at 10721 ("Section 1.954-3(b)(2)(i)(b) and (ii)(b) are intended to apply only to purchasing or selling by a branch with respect to personal property manufactured, purchased, or sold by `the remainder of' the CFC…").
11 There is confusing language in temporary branch regulations which may suggest that FBCSI could result under the sales branch rule by treating a branch as the remainder of another branch. Regs. §1.954-3T(b)(2)(i)(b)(2) and (ii)(b)(2). This language has no basis in the Code and the sales branch rule has never been applied in this manner. The intent of the sales branch rule is that it apply only when income is shifted away from the country where the CFC is organized to a low-tax purchasing or selling branch.
13 Regs. §1.954-3T(b)(1)(ii)(c)(1); T.D. 9438, 73 Fed. Reg. at 79342. The regulations apply the manufacturing branch rule even where the CFC does not rely on the manufacturing exception, e.g., where there is no related-person transaction. See Yoder, "Final and Temporary Subpart F Contract Manufacturing Regulations," 35 Int'l Tax J. 3 (March-April 2009).
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