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By Lowell D. Yoder, Esq.
McDermott Will & Emery LLP, Chicago, IL
A recent private letter ruling ("2012 ruling") held that gain derived by a controlled foreign corporation (CFC) from the sale of carbon credits would not be foreign personal holding company income (FPHCI) as defined in §954(c), and therefore not Subpart F income.1 While not explicitly stated in the ruling, it follows that the IRS concluded that the gain would qualify either as active business income or as gain from property used or held for use in a trade or business.
The CFC was organized under the laws of a foreign country ("country X"). It owned and operated commercial timber plantations located in country X. The CFC harvested the timber and sold the logs for domestic use and for export.
The CFC was required to participate in country X's emissions trading program, which is a regulatory program intended to reduce net greenhouse gas emissions to comply with the Kyoto Protocol. Forests remove carbon dioxide, which is released back into the environment when trees are harvested. Participants in the program must surrender carbon credits to country X if there is a deforestation without appropriate replanting. A party receives from country X a one-time allocation of carbon credits at no cost, and if the party does not have sufficient credits, it must buy credits. A party with excess carbon credits can sell them.
The CFC had a general policy of replanting forest land after it harvested timber, in which case it did not need the credits. However, there were instances in which the CFC needed to relinquish carbon credits under the program. This could occur if there were an unexpected infestation of insects that damaged the replanted trees such that the minimum growth standards set forth in the program were not met. The CFC would need the carbon credits to pay the corresponding emissions liability.
Carbon credits are held in accounts at a central registry, which tracks the ownership, surrender, and sale of carbon credits. The CFC planned to open an account with the central registry through which it would sell any of its allocated carbon credits that it ultimately determined it would not use.
In analyzing whether gain recognized by the CFC on the sale of the allocated carbon credits would be FPHCI, the ruling addressed two FPHCI categories: (1) gain from certain property transactions; and (2) gain from commodities transactions. The ruling describes the general rules and business exceptions for each category.2
The first category, in relevant part, defines FPHCI as including the excess of gains over losses from the sale of property "which does not give rise to any income."3 The regulations provide that that property includes all rights and interests in certain property, including forwards, futures, and options.4 Gain from the sale of the carbon credits would appear to fall within this FPHCI category. However, the ruling went on to state that property "which does not give rise to any income" does not include property used or held for use in the CFC's trade or business. This exception can apply to tangible personal property, real property, and intangible property.5
The regulations do not elaborate on the meaning of "used or held for use" in the CFC's trade or business. The legislative history states that this FPHCI category "is not intended to apply to gain on the sale of land, buildings, or equipment used by the seller in an active trade or business of the seller at the time of the sale."6 On the other hand, the legislative history indicates that gain from the sale of a painting would be FPHCI if, prior to disposition, the painting was merely displayed in the corporate offices or held in storage.7
Without analysis, the ruling held that gain from the sale of the carbon credits would not be FPHCI within the meaning of §954(c). This indicates that the IRS concluded that the carbon credits were used or held for use in the CFC's trade or business. This conclusion is supported by the fact that the receipt and holding of the carbon credits were directly related to the business conducted by the CFC. They were part of a regulatory program of country X which applied to the CFC as a result of engaging in the business of growing and harvesting timber. Also, it was possible that the CFC would be required to use some or all of the carbon credits under the country's regulatory program.
A prior ruling ("2008 ruling") similarly held that gain from the sale of surplus CO2 allowances did not constitute FPHCI under this category.8 The ruling initially concluded that the allowances constituted intangible property. It found that the allowances permitted a holder to engage in business activity otherwise unlawful without penalty. The allowances were held to offset emissions resulting from the operation of the CFC's business. Accordingly, the allowances were considered as held for use in the CFC's trade or business, and gain on the sale of the allowances qualified for the exception.
The 2012 ruling next describes the FPHCI category for the excess of gains over losses from transactions in any commodity, including futures, forwards, and similar transactions. The regulations define the term "commodity" to include tangible personal property of a kind that is actively traded or with respect to which contractual interests are actively traded.9
Gain from the sale of carbon credits also might be considered as falling within the FPHCI category for commodities gains. However, the reference in the regulations to "tangible property" may not apply to the carbon credits. The IRS in the 2008 ruling stated that whether CO22 allowances should be considered as commodities is an issue under consideration, and expressly declined to address whether income from the sale of those allowances fell within the definition of commodities. While the 2012 ruling describes the provisions that apply to commodities, it states that no inference is intended as to whether the carbon credits are properly considered as commodities or another type of property for purposes of the FPHCI rules.
The 2012 ruling states that an exception applies to active business gains and losses from the sale of commodities, but only if substantially all of the CFC's commodities are properly described in §1221(a)(1), (2), or (8).10 Those paragraphs apply to inventory, property used in the CFC's trade or business, and supplies used or consumed by the CFC in its business. The ruling also describes an example addressing a bona fide hedging transaction involving aviation fuel forward purchase contracts, which concludes that gain or loss from such contracts is not FPHCI.
The 2012 ruling appears to stand for the proposition that if the gains from the sale of the carbon credits fall within the commodities category, they will qualify as active business gains. Accordingly, they will not constitute FPHCI.
The 2012 ruling refers to the FPHCI coordination rules that apply when an item of gain or loss falls within the definition of more than one FPHCI category. It points out that the commodities category takes priority over the general property gains category.11
Under the coordination rules, an item falling within the general definition of more than one FPHCI category will be classified as income falling within the first category for which it satisfies the general definition. While not mentioned in the ruling, if an item of income falling within more than one of the FPHCI categories qualifies for an exception contained in the definition of the category with priority, the income is not reclassified under the next FPHCI category that it falls within, but rather is excluded from FPHCI. Thus, if the item would not qualify for an exception in the second category, it nevertheless escapes classification as FPHCI if it qualifies for an exception under the first FPHCI category.
By discussing both the category for commodities and the category for property gains, the ruling indicates that, regardless of the classification, gain from the sale of the carbon credits will not be FPHCI. Thus, if the gain is commodities gain, it qualifies for the active trade or business exception. In such case, it would not be necessary to also apply the FPHCI category for property gains. But, if the gain is not considered as commodities gain, then the category for property gains would apply. However, the gain would not be FPHCI under this category by application of the exception for property used or held for use in a trade or business.12
In addition to a sound basis in the rules, this ruling is the proper result from a policy perspective. The income arises from an allocation of valuable rights from a foreign country as a result of the particular type of business the CFC conducts in such country. The carbon credit program is part of a government regulatory regime-applicable to the CFC's business-that is designed to address environmental issues. Finally, the possession of the carbon credits is necessary for the CFC to conduct its business in its country of operation.13
This commentary also will appear in the December 2012 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Yoder, 927 T.M., CFCs - Foreign Personal Holding Company Income, and in Tax Practice Series, see ¶7150 U.S. Persons - Worldwide Taxation.
2 The ruling also held that the CFC would not realize any income when it received the carbon credits from the government of country X and would have a basis of zero in the credits, citing, among other authorities, Rev. Rul. 92-16, 1992-1 C.B. 15.
10 §954(c)(1)(C)(ii). See also Regs. §1.954-2(f)(2)(iii). The taxpayer represented that, without taking into account carbon credits, the CFC did not hold any commodities and would not hold any commodities during a year in which it held carbon credits.
12 There is a second set of priority rules that applies to the four categories of foreign base company income. Regs. §1.954-1(e)(4)(ii). These provide that FPHCI takes priority. In addition, if an item that initially is classified as FHPCI qualifies for an exception, it must be tested under the next category of foreign base company income in which it is defined. In relevant part, gains from the sale of carbon credits might be considered as income from the sale of personal property to be tested under §954(d). The ruling does not address the application of this category. It appears that the carbon credits likely would be sold to unrelated purchasers, in which case the gain should not be foreign base company sales income. (The sale of the CO22 allowances to unrelated purchasers is expressly stated in the 2008 ruling.) Alternatively, since the carbon credits were not purchased, the CFC might not be considered as purchasing and selling property, as required by §954(d).
13 Since the exception to the FPHCI category for gain from the sale of certain property requires that the property be "used or held for use" in the CFC's trade or business (i.e., a facts and circumstances inquiry), it is important to document that this requirement is satisfied under the particular circumstances.
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