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By Lowell D. Yoder, Esq. McDermott Will & Emery LLP Chicago, Illinois
Subpart F income can include income derived by a controlled foreign corporation (CFC) from selling products or from performing services. Such income is Subpart F income, however, only if it falls within the definition of foreign base company sales income or foreign base company services income, respectively.
Before applying the definitions of foreign base company income to a particular item of income, the character of the item of income must be determined. The Subpart F regulations provide that an item of income is characterized based on the substance of the transaction. If a single transaction gives rise to more than one type of income, the items must be analyzed separately, or if not separately determinable, the income must be characterized based on the predominant character of the transaction.
This commentary discusses IRS Field Attorney Advice (FAA) 20153301F which addressed the character of “referral fees” earned by a CFC for purposes of applying the definitions of Subpart F income. While such fees generally would be characterized as services income, the FAA recharacterized the fees as sales income under a unique rule of Subpart F. If the fees were treated as service income, apparently most of the income would not be foreign base company services income because most of the services were performed in the CFC's country of organization. On the other hand, by recharacterizing the fees as sales income, the FAA states that all of the income is foreign base company sales income.
Under the facts of the FAA, a CFC (CFC1) purchased products from suppliers and resold the products to customers. A related CFC (CFC2) provided assistance to CFC1, for which it received fees.
CFC1 identified suppliers and negotiated prices with suppliers, arranged delivery of the products to the customers, and received the signed documents showing that the products met the specifications and were delivered to the customers. CFC1 also made the sale to the customers, invoiced the customers, collected the payments, and recorded the sales revenue.
CFC2 developed and maintained relationships with customers. It solicited orders and negotiated with customers regarding product specifications, coordinated a centralized credit function on terms of the sale, tracked customer purchases from affiliates, and managed exposures with respect to customers. CFC2 also responded to shortages and issues with quality, handled billing disputes and negotiated claims for settlements with customers, managed credit risks, tracked outstanding invoices, and provided customers with information on price trends, market dynamics, and other factors impacting product or supply prices. For these services, CFC2 received a fee ranging from 10% to 50% of the gross margin associated with the transaction, depending on the product.
As a matter of dictionary definitions and general tax law principles, it is indisputable that the fees received by CFC2 from CFC1 were in substance services income. CFC2 received the fees for performing certain functions for CFC1. CFC2 did not own any inventory and did not derive any revenue from selling products that it purchased. Commissions and fees earned for assisting another entity sell products have uniformly been determined to constitute services income.
However, when applying the foreign base company income definitions, further analysis is required. Subpart F contains a unique recharacterization rule that treats certain fees and commissions as sales income for purposes of §954, even though such amounts would be treated as services income for other purposes of the Code. In relevant part, §954(d)(1) requires analysis under the foreign base company sales income rules of “income (whether in the form of profits, commissions, fees, or otherwise) derived in connection with…the purchase of personal property from a related person and its sale to any person, [or] the sale of personal property to any person on behalf of a related person….” The language of the Code requires that, for fees or commissions derived by a CFC to be analyzed as sales income, the CFC must “sell property” to a customer on behalf of a related person.
The legislative history to Subpart F explains that Congress intended for commission or fee income to be analyzed as sales income when a CFC sells property, not in its own name, but in the name of a related person. The Senate report states that Subpart F sales income “is income from the purchase and sale of personal property if the property is either purchased from a related person or sold to a related person” or income from “ similar cases where the controlled foreign corporation does not take title to the property but acts on a fee or commission basis.” The Senate Report further states, “The sales income with which your committee is primarily concerned is income of a selling subsidiary ( whether acting as principal or agent).”
Therefore, the touchstone for recharacterizing commissions or fees as sales income for Subpart F purposes is that a CFC engages in the activities it would engage in if it were actually selling a product (e.g., soliciting orders from customers, negotiating the price and other terms of sales agreements, and entering into sales contracts), only on behalf of another person. The only difference is that the CFC does not take title to the property.
Unfortunately, the FAA does not provide an analysis of the operative language of the Code. It does not set forth a legal framework for determining when fees or commissions for services should be recharacterized as sales income under the unique rule of §954(d).
Moreover, the FAA incorrectly states the basic prerequisite for the unique recharacterization rule to apply:
All of the income from the intercompany referral fee is foreign base company sales income. Commissions derived in connection with the sale of personal property to any person on behalf of a related person are foreign base company sales income provided the locational requirements are also satisfied. The referral fee in the instant case is a commission that was derived in connection with the purchase and sale of personal property ___ by the Supply Broker [CFC1] to a person (third party customers) on behalf of a related person (the Customer Broker) [CFC2]. The ___ which was sold on behalf of the Customer Broker [CFC2] was ___ and ___ outside the country in which the CFC employing the Customer Broker [employee of CFC2] was created or organized, and was also sold for use and/or consumption outside of that [CFC2's] country. Therefore, the intercompany referral fee income is foreign base company sales income.
The above quote concludes that the recharacterization rule treats the services income derived by CFC2 as sales income based on a construct that CFC1 purchased and sold the products on behalf of CFC2. That is not what the language of the Code and regulations require. CFC1 actually purchased and sold the property and derived the sales income. The recharacterization rule concerns whether CFC2's fee income should be recharacterized as sales income, and for that unique rule to apply it must be determined that CFC2 sold the property on behalf of CFC1.
Therefore, the analysis leading to the conclusion in the above quote that CFC2's fee income should be analyzed as sales income is fundamentally flawed. The further discussion in the FAA which purports to support recharacterizing the fee income earned by CFC2 as sales income is also without basis in the law or any reasoned analysis.
The FAA states that no portion of the fees earned by CFC2 should be characterized as services income and the entire amount of the fees should be recharacterized as sales income because: (1) the taxpayer has not substantiated that a portion of the referral fee was for post-sale functions; (2) the fee was derived in connection with the purchase and sale of personal property to a person on behalf of a related person; and (3) the requirements for the intercompany referral fee to be considered as foreign base company services income were not satisfied.
First, there is nothing in the Code or regulations that requires recharacterizing service fees as sales income if the services are provided prior to the sale of a product. For example, if a CFC provided only credit analysis with respect to prospective customers and received a fee, such fee would not be analyzed as sales income. There is no legal authority requiring a taxpayer to substantiate that fees are received for post-sale services to avoid recharacterizing them as sales income for purposes of §954(d), and the FAA cites no authority.
With respect to the second statement, as discussed above, the FAA misreads the necessary requirement for recharacterizing CFC2's services income. The Code and regulations require a conclusion that CFC2 sold property on behalf of CFC1. The FAA's conclusion that CFC1 — which actually purchased and sold the property — sold property on behalf of CFC2 does not provide any basis for recharacterizing CFC2's referral fees as sales income.
The third statement given to support recharacterizing the fees as sales income is wholly meritless. There is no such rule that says services income is recharacterized as sales income unless it falls within the definition of foreign base company services income. The referral fee income would clearly be subject to analysis under the foreign base company services income rule.
Other assertions in the FAA are also incorrect. In concluding that the fees are sales income, it states that “[t]here is no objective evidence that the referral fee was paid for anything more than [CFC2's] referral of customers to [CFC1].” This activity alone is not sufficient to treat the fees as sales income for purposes of §954(d). As stated above, it must be shown that CFC2 sold the products on behalf of CFC1, performing the same functions as if it had actually sold the property but without taking title (i.e., soliciting, negotiating, and entering the sales contract). No facts are presented to support that CFC2 performed these activities.
The FAA also appears to suggest that any services income derived “in connection with” the purchase and sale of products by a related CFC is analyzed as sales income under the unique recharacterization rule of Subpart F. The FAA states that post-sale functions were incident to the sales function, and “[b]ut for the sale, there would be no post-sale activities.” To the extent these statements suggest that any services rendered by one CFC to another CFC must be recharacterized as sales income if they have a connection with the purchase and sale of property by the other CFC is without basis in the law.
First, as discussed above, a prerequisite for services income derived by a CFC to be analyzed as sales income is that the CFC sells products on behalf of a related person. Reading the “in connection with” language of the Code in isolation is an improper reading. In other words, the “in connection with” language is relevant only after it is first determined that CFC2 earned the fees from selling property on behalf of CFC1. Only fees or commissions derived by a CFC in connection with its selling products on behalf of a related CFC are subject to analysis as foreign base company sales income.
Second, the regulations are abundantly clear that income derived from certain services rendered in connection with the sale of property by a related person is not analyzed as sales income. For example, a CFC that earns income from installing or maintaining industrial machines sold by a related person, or adjusting or maintaining electric office machines sold by a related person, is analyzed as services income rather than as sales income.
TAM 8509004 goes further to conclude that income from certain services rendered to provide assistance in connection with selling a product should not be analyzed as sales income. The IRS National Office concluded that a CFC did not perform “sales or selling activities” for purposes of §954(d) where the CFC's staff supervised independent sales agents, performed market research, and prepared demand forecasts. The CFC contracted out selling activities to related and unrelated parties. The IRS concluded that the CFC home office's supervision, market research, and demand forecast activities were in the nature of services, rather than sales.
Therefore, the IRS's determinations in the FAA that services income was earned in connection with, or incident to, a sale of property by a related person, and that the services income would not have been earned but for the sale by the related person, do not suffice to establish that the commissions should be recharacterized as sales income. As described above, the Code and regulations require that a CFC derive the commissions from selling property itself on behalf of a related person as a selling agent.
The FAA also asserts that the referral fee should be analyzed as sales income because the fee is computed based on the gross margins of CFC1 (which in turn were determined entirely based on sales income rather than services). In addition, the FAA seeks to further support its position that the fees were predominantly sales income on the basis that CFC2 received referral fees “solely as a result of successful sales activities with no contingency for the completion or efficacy of the purported non-sale.”
While these facts may be relevant to the analysis, they in no way alone require treating fees or commissions as sales income. How service fees are calculated does not establish that a CFC functioned as an agent selling products on behalf of a related person. Without that determination, the fees must be analyzed as services income, regardless of the basis for calculating the fees.
Much of the discussion in the FAA concerns whether the fees were earned for services provided by CFC2 to CFC1 for pre-sale or post-sale functions. The taxpayer apparently adopted the position that the portion of the fees for pre-sale functions could be recharacterized as sales income and the portion of the fees for post-sale functions could be analyzed as services income. The FAA does not clearly reject that the referral fee might be bifurcated between pre- and post-sale functions and that fees for post-sale functions might not be recharacterized as sales income. The IRS questioned, however, whether certain services should be considered as pre-sale or post-sale functions, whether any portion of the fees should be considered as received by CFC2 for some of the described post-sale functions, and whether the taxpayer's determination of the amount allocated to post-sale functions was too high.
In the end, the FAA determined that the referral fees were predominantly paid for CFC2's referral of customers to CFC1. Even if the fees were in part for post-sale functions, the FAA concluded that there was no factual basis to segregate the fees between pre- and post-sale functions. Therefore, the FAA states that the predominant character of the fees is sales income, and should be analyzed under §954(d). But, as discussed above, the facts provided in the FAA do not support recharacterizing CFC2's services income as derived predominantly from the sale of products on behalf of CFC1.
In sum, FAA 20153301F recharacterized fees for services as sales income under the unique rule of §954(d)(1), but the IRS's analysis is untethered from the governing statute and regulations and as such is fundamentally flawed.
|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.|
Copyright © 2016 Tax Management Inc. All Rights Reserved.
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