By Lowell D. Yoder, Esq.
McDermott Will & Emery LLP, Chicago, IL
Businesses providing services are a major sector of our current economy, and many U.S.-based service providers operate on a global basis. Conducting operations outside the United States through principal structures can provide commercial and tax efficiencies. Careful planning, however, is required to minimize current U.S. taxation-under the Subpart F rules-of services income derived by foreign subsidiaries.
The delivery of services to customers throughout the world has increasingly become centrally managed, but performed from multiple locations. It is common for a member of the global group (the principal) to enter into services contracts with customers and oversee the provision of the services, while customers are serviced from multiple countries by affiliated subcontractors, each providing its own particular expertise. Low-cost labor sources make it important to subcontract out some of the services, and know-how is commonly developed in centers of excellence and provided to affiliated services entities at other locations. Technological advances, the relative ease of commuting, and a general relaxation of regulatory restrictions have also diminished the importance of geographic location. More and more services are being provided over the internet, utilizing employees and servers in remote locations.
A U.S.-based group may operate outside the United States through more than one foreign principal (e.g., in different regions), which may be organized in countries that impose a low tax rate on the services income. In addition to functioning as the master services provider to customers in its region, a foreign principal generally owns or licenses the relevant intangible property and takes on the major risks of the business.
Foreign principal structures that provide services from multiple locations can be subject to current U.S. taxation under Subpart F. Section 954(e) provides that income of a controlled foreign corporation (CFC) is Subpart F foreign base company services income if the services are performed for, or on behalf of, a related person and are performed outside of the CFC's country of organization.1 On the other hand, if the services are performed for unrelated persons, and not "on behalf of a related person," the income derived by the CFC is not Subpart F income, regardless of where the services are performed. If services are performed for, or on behalf of, a related person, the services income will not be Subpart F income if the services are performed in the CFC's country of organization.2
The regulations broadly define when a CFC is considered to be performing services "on behalf of" a related person.
One rule provides that a CFC that performs services for an unrelated person is deemed to perform such services on behalf of a related person when a related person furnishes the CFC with substantial assistance contributing to the performance of such services. Pursuant to a Notice updating the rules in the regulations, a CFC is considered as receiving substantial assistance only if the costs of the services received from related U.S. persons equals or exceeds 80% of the total costs to the CFC of providing the services.3 The IRS apparently applies this test taking into account all costs, including support services, financing, and royalties.4 Note that any payments made to related foreign persons would not result in the application of the substantial assistance rule.
A second "on-behalf-of" rule in the regulations, that has not been updated since 1964, provides that if a related person-U.S. or foreign-guarantees the provision of the services and any related person performs any of the guaranteed services or performs significant related services, the CFC is considered as providing the services on behalf of a related person.5 This is an arcane rule and a trap for the unwary.
With these rules in mind, consideration may be given to using a disregarded entity structure to limit the application of Subpart F to income derived by a foreign services principal. For example, a Luxembourg holding company ("Lux HoldCo") may own a Singapore principal (with a beneficial tax ruling), an Indian subcontractor, and a Japanese service provider. All three operating entities are electively disregarded for U.S. tax purposes.6 The Japanese company contracts with a local Japanese customer to provide services. The Singapore principal oversees the provision of the services, owns or licenses the intangible property rights, and assumes the major risks with respect to the services business, and its employees perform important services for the customer. The Singapore principal contracts with the Indian company to provide some of the services, and the Japanese company assists in fulfilling the services contract. The Indian company receives a fee equal to its costs plus a mark-up, and the Japanese company pays the Singapore principal a fee from the amounts collected from the Japanese customer such that the Japanese company earns a cost-plus amount for its services.
Because the entities involved in providing the services to the unrelated Japanese customer are disregarded for U.S. tax purposes, Lux HoldCo is the only CFC. All of the above intercompany transactions are disregarded, and Lux HoldCo is considered as receiving service fees from unrelated parties. Therefore, Lux HoldCo's income should not be Subpart F income (subject to the "on-behalf-of" rule).7
To conclude that Subpart F does not apply, an annual determination would need to be made that the cost of any assistance received from U.S. related persons is less than 80% of the total costs to the CFC of providing the services. (Total costs would include amounts paid to foreign related subcontractors and unrelated subcontractors.) In addition, while Lux HoldCo can guarantee the performance of the services without the application of Subpart F, a guarantee by a separate related company (e.g., the U.S. parent) would cause Lux HoldCo's services income to be Subpart F income if any related company contributes to the performance of the services or performs significant related services.
In the event there is concern with the possible application of the substantial assistance or guarantee rules to the disregarded principal structure, a regarded principal structure might be considered. No election would be made to disregard the three operating companies, and therefore they would be separate CFCs. The Singapore principal would contract directly with the unrelated Japanese customer, and pay the Indian and Japanese affiliates service fees (cost plus) for their services performed for the customer. Generally, the services income derived by the Singapore principal should not be Subpart F income because it is contracting directly with a third party and receiving assistance from foreign affiliates. Under this structure, even if the Singapore principal were considered as providing the services on behalf of a related person under the substantial assistance or guarantee rules, its services income should not be Subpart F income to the extent the services are performed in Singapore. In addition, income derived by the Indian and Japanese CFCs should not be Subpart F income to the extent they perform the services in their respective countries.
Under certain circumstances it may not be commercially desirable for a principal to be the party interacting directly with local customers. Rather, the local affiliate may be the preferred contracting party. In such case, consideration may be given to implementing a services commissionaire arrangement. The concept of such an arrangement, applied to the above principal structure, is that the Japanese company would contract with the customer on behalf of the principal and manage the customer relationship, possibly not disclosing the Singapore company as the principal. The Japanese company would collect and remit the fees to the Singapore principal, less an amount that leaves the Japanese company a fee for its services determined on a cost-plus basis. The relationship between the Singapore principal and the Japanese company can be contractually established in a manner such that the Singapore principal is considered as providing the services directly to the unrelated customer for U.S. tax purposes, resulting in the same Subpart F consequences as if the Singapore principal had contracted directly with the Japanese customer.8
In sum, foreign principal services structures can be used to achieve business and tax efficiencies, such as centralizing the provision of global services and subjecting the entrepreneurial profits to a low tax rate in the principal's country. Nevertheless, careful planning is required to minimize current U.S. taxation of services income under Subpart F. Treasury is strongly urged to update the Subpart F services rules to permit U.S. companies to operate in a manner best suited to the provision of services in today's global business environment. Of immediate need is a modification of the guarantee rule in the regulations to accommodate common operating structures where the customer desires a parent guarantee and some of the services are provided to the customer by several affiliates.
This commentary also will appear in the March 2012 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.
1 A person is related to a CFC if it controls the CFC, is controlled by the CFC, or is controlled by the same persons that control the CFC (control requires greater than 50% ownership). §954(d)(3); Regs. §1.954-1(f).
2 See also §954(e) (last sentence provides an exception for services income that qualifies for the active banking or financing exception under §954(h)).
3 Notice 2007-13, 2007-5 I.R.B. 410. The Notice appropriately significantly curtailed the scope of the substantial assistance rules in the regulations, which took into account services provided by a related foreign person and contained a subjective test. Regs. §1.954-1(b)(1)(iv). See Yoder, "Notice 2007-13: The New Substantial Assistance Rule," 36 Tax Mgmt. Int'l J. 230 (5/11/07).
4 Because the cost-sharing regulations consider cost-sharing payments as the "payor's costs of developing intangibles," cost-sharing payments made by a CFC to a U.S. related person should not be considered as costs of services provided by a U.S. related person for purposes of the substantial assistance test. Regs. §1.482-7(j)(3)(i).
5 Regs. §1.954-4(b)(2)(i). This rule is not in the Code.
6 Regs. §301.7701-2.
7 Unlike the foreign base company sales income rules, there is no branch rule for purposes of the foreign base company services income rules. Cf. §954(d)(2).
8 The arrangement must be carefully structured to minimize the risk of the Singapore principal having a Japanese permanent establishment.
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