FAA 20132702F — Do You Have an 'Active Trade or Business'?

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By Edward Tanenbaum, Esq.  

Alston & Bird LLP, New York, NY

The terms "trade or business" and "active trade or business" pop
up throughout the Internal Revenue Code (Code) with different
definitions as the context may require (and sometimes with precious
little definition).

In heavily redacted FAA 20132702F, the IRS had occasion to deal
with these terms in the context of a controlled foreign corporation
(CFC) and, in particular, with respect to the §954(c)(2)(A) "active
leasing exception" to "foreign personal holding company income"
(FPHC) as an item of Subpart F income.

A very similar concept is also relevant in the context of the
Limitation on Benefits article of our tax treaties.  One of
the categories available to demonstrate treaty eligibility under
that article is the "active conduct of a trade or business"
category. Many treaties, or their protocols, have instructed that,
in determining whether a trade or business exists and whether it's
active, one looks to §367(a)(3) and the regulations
thereunder.  Those regulations, in turn, state that when
dealing with a business that produces rents or royalties one looks
to the Subpart F regulations, in particular Regs. §1.954-2(d)(1)
(the "active licensing exception").

While the "active leasing exception" (dealing with rents) is
slightly different from the "active licensing exception" (dealing
with royalties), the subcategories relating to "active marketing"
contained in each one are, for the most part, parallel.

The FAA deals with the "active marketing" subcategory in the
context of rentals. It provides a good analysis of what taxpayers
must do to qualify for and substantiate that exception from Subpart
F income and the same lessons can be learned for treaty purposes as

In the FAA, the taxpayer, a CFC, transferred software to
customers under perpetual, non-exclusive, and transferable
licenses. Under a license agreement, a customer paid a one-time fee
for each user and annual maintenance and support fees based on the
total number of users. After one year, a customer could terminate
the agreement and the maintenance and support fees, provided the
customer certified in writing that it no longer used the software.
The taxpayer had seven customers during the years at issue.

During some of the years at issue, the taxpayer had two
employees, a financial controller ("accounting manager") and a
software media production assistant ("production assistant"), as
well as three directors, one of whom (the "executive director") the
FAA treated as an employee based on his duties. During other years
at issue, the taxpayer did not employ the production
assistant.  The employees' backgrounds were in accounting,
finance, and technology, and their job functions were largely
administrative, e.g., bookkeeping, tracking payments, ordering the
"software keys" to transfer to customers, and filing tax returns.
While there was some indication that the executive director
assisted with marketing and worked with an affiliate company to
promote sales, the employees did not track time spent on specific
activities. The maintenance and support services provided to
customers under the license agreements were contracted out to
affiliates of the CFC.

The FAA first concludes that income under the CFC's license
agreements is rental income from the lease of copyrighted articles
under Regs. §1.861-18. The taxpayer agreed with this
characterization, which reflects that neither: (1) copyright rights
in the software; nor (2) benefits and burdens of owning the
software are transferred under the agreements. Unless an exception
applies, rents generally constitute FPHCI, which is taxable to
"United States shareholders" of a CFC, as defined under the

Under §954(c)(2)(A), rents derived in the active conduct of a
trade or business and received from unrelated persons are excluded
from the definition of FPHCI under the "active leasing exception".
The regulations further provide that rents are considered derived
in an active business if the CFC leases one of four types of
property, only one of which (involving "active marketing") is
relevant to the taxpayer in the FAA. The "active marketing"
subcategory applies if property is leased as a result of a CFC
lessor's marketing function and the lessor, through its own
officers and employees in a foreign country, maintains and operates
an organization in that country that: (1) is regularly engaged in
the business of marketing (or marketing and servicing) the leased
property; and (2) is substantial in relation to the amount of rents
from leasing the property. The exception also extends to leases
acquired by the CFC if the CFC performs active and substantial
management, operational, and remarketing functions with respect to
the leased property.

The IRS found little evidence that the taxpayer regularly
engaged in a marketing business. The taxpayer did not employ anyone
with marketing expertise, compensate employees for marketing
activity or success, or document the time its personnel spent on
marketing.  In contrast, related entities produced nearly all
of the press releases for the parent's website and had even won
international marketing awards. The agreement between the taxpayer
and its parent company indicated that the taxpayer was not a
marketing company, and the taxpayer had signed only one of its
customers in the years at issue. The IRS concluded that the
taxpayer mainly collected passive rents, especially considering
that a "huge" proportion of its income was funneled to the parent
company. Consequently, the taxpayer's rents constituted FPHCI
because no active business was conducted.

The lesson to learn is that CFCs deriving rental income and
hoping to qualify for the active leasing/marketing exceptions to
FPHCI treatment must be able to substantiate their qualification
for the exceptions, including having employees with marketing
expertise and job functions and documenting specific marketing
activities and time spent on marketing. The CFC should operate a
real and substantial leasing business and not appear as a "passive
financial intermediary" that simply collects rents.

This commentary also will appear in the December 2013 issue
of the
 Tax Management International Journal.
 For more information, in the Tax Management Portfolios,
see Yoder, Lyon and Noren, 6220 T.M.
, CFCs - Foreign Personal
Holding Company Income,  and in Tax Practice Series, see
¶7150, U.S. Persons - Worldwide Taxation.


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