By Lowell D. Yoder, Esq.
McDermott Will & Emery LLP, Chicago, IL
The IRS recently issued a private letter ruling addressing the application of Subpart F to income derived by a controlled foreign corporation (CFC) from factoring receivables.1The receivables arose from sales or services transactions, and all or a portion of each receivable had not been included in the CFC's income. The ruling concluded that gain recognized by the CFC on the sale of the receivables was not Subpart F income.
Under the facts of the ruling, a CFC organized in Country B (CFC-B) derives income from the sale of products and associated services. CFC-B enters into contracts with customers that provide for payment based on contractually based milestones. Final payment is due when title passes to the buyer. Upon reaching a milestone, CFC-B sends an invoice to the customer creating a Type L receivable, which is paid by the customer at a later date.
CFC-B recognizes revenue on the accrual method for both GAAP and tax purposes. CFC-B further elected to defer recognition of advance payments under Rev. Proc. 2004-34.2 As a result, CFC-B's revenue recognition for U.S. tax purposes is largely independent of its contractually based milestones or when the Type L receivables arise. Whenever CFC-B's Type L receivables arise before revenue is recognized for U.S. tax purposes, they have a zero basis.
The taxpayer represented that the transactions from which the Type L receivables arise would not produce foreign base company sales income nor foreign base company services income.3 Thus, income recognized by CFC-B with respect to the receivables in accordance with the timing rule of Rev. Proc. 2004-34 would not be Subpart F income.
In order to accelerate the receipt of cash, CFC-B factors its receivables. The receivables generally are sold to a related party and may result in the acceleration of income to CFC-B.4 The receivables factored do not bear interest by their terms and interest would not be imputed under §483 or §1274. Also, the factoring transaction is properly treated for U.S. income tax purposes as a sale of the Type L receivables and not a borrowing. Finally, the factoring transaction does not result in the acceleration of income for U.S. financial reporting, local country reporting, and local tax purposes.
The issue addressed in the ruling was whether §954(c)(1)(B) applied to the income resulting from the sale of the Type L receivables. That provision includes within the definition of Subpart F foreign personal holding company income (FPHCI) gains over losses from the sale or exchange of certain types of property. It applies to property that gives rise to passive income and property that does not give rise to any income. Section 954(c)(1)(B) expressly does not apply to income from the sale of inventory.
The PLR points out that the category for gains over losses from the sale or exchange of property "which does not give rise to any income" is a broad category. The regulations define this category to include "all rights and interests in property (whether or not a capital asset) including, for example, forwards, futures and options."5 Nevertheless, the PLR concluded that this provision did not apply to the gain from the sale of the receivables.
The PLR applies judicial authorities to characterize the income derived by CFC-B from factoring the receivables based on the nature of the activities giving rise to the receivables. The ruling holds that any income CFC-B recognizes as a result of factoring the Type L receivables is a substitute for the income it would have collected under the relevant contracts. Therefore, it should retain the same character for purposes of Subpart F. Since the underlying activities giving rise to the receivables would generate sales and services income that is not Subpart F income, the factoring income should not be Subpart F income.
The conclusion that the factoring income does not arise from the sale or exchange of property within the meaning of §954(c)(1)(B) is based on cases that held that certain gain would be characterized as ordinary income when such gain was realized as a substitute for ordinary income that would have otherwise been recognized in the future. The PLR bases its holding on Comr. v. P.G. Lake, Inc.6 and its progeny. In P.G. Lake, the Supreme Court addressed five consolidated cases that raised the issue of whether the gain realized in connection with a disposition of mineral rights was taxable as long-term capital gain or as ordinary income subject to depletion. The Court first noted that the purpose for the long-term capital gain tax regime was "to relieve the taxpayer from…excessive tax burdens on gains resulting from a conversion of capital investments, and to remove the deterrent effect of those burdens on such conversions."7 The Court further noted that "[t]he lump sum consideration seems essentially a substitute for what would otherwise be received at a future time as ordinary income." In reaching its conclusion, the Court looked to cases that treat a person assigning to another person the right to future income as taxable on the income,8 and ultimately concluded that the "consideration was paid for the right to receive future income, not for an increase in the value of the income-producing property." As a result, the gain realized on the sale of the mineral rights was taxable as ordinary income subject to depletion.
Further support for the "substitute-for-ordinary-income" doctrine defined by the Supreme Court in P.G. Lake is found in two other cases cited in the PLR. In Prebola v. Comr.,9 the Second Circuit addressed the manner in which a lump-sum payment received in exchange for the right to receive future annual lottery payments should be taxed. Citing a long line of cases that follow P.G. Lake, the Second Circuit noted that "the Supreme Court and the courts of appeals have held that where lump-sum payments are received in exchange `for what would otherwise be received at a future time as ordinary income,' the payments should be treated as ordinary income."10 Accordingly, the Second Circuit held that the lump-sum payment was taxable as ordinary income. In another case addressing the sale of a stream of future lottery payments, Watkins v. Comr.,11 the Tenth Circuit stated that the "basic lesson" of the substitute-for-ordinary-income line of cases following P.G. Lake is that "when a party exchanges for a lump sum the right to receive in the future ordinary income already earned or obtained, the amount received serves as a substitute for the ordinary income the party had the right to receive over time" and the lump sum is ordinary income for U.S. income tax purposes.
The PLR provides an entirely appropriate result. The character of gain derived from factoring zero basis receivables should be analyzed in a manner consistent with the treatment of the income if the receivable had been held and income recognized in accordance with Rev. Proc. 2004-34. If the income would be sales or services income that is not within the definition of foreign base company sales or services income, then the gain should be treated similarly for Subpart F purposes.
The PLR does not mention a provision in the regulations that treats gain from the sale or exchange of a debt instrument as falling within the definition of §954(c)(1)(B).12 The same reasoning discussed above supports not applying this provision of the regulations to CFC-B's gain resulting from factoring the receivables.
The focus of the inquiry concerning the Subpart F character of CFC-B's gain from factoring the receivables is based on the original transaction. The facts surrounding the factoring transaction are not relevant for that purpose. For example, under certain circumstances, a transaction with a related person can result in income falling within the definition of foreign base company sales income or foreign base company services income. The fact a related person purchases the receivables from CFC-B should not cause the original transaction to be treated as a related person transaction.
The issue addressed in the PLR should be distinguished from the Subpart F rules that treat "factoring income" as Subpart F income. The definition of "income equivalent to interest" expressly includes "factoring income."13 For this purpose, factoring income is defined as any income derived from the acquisition and collection or disposition of a factored receivable, including any discount income and service fees. A factored receivable is defined as including any account receivable or evidence of indebtedness arising out of the disposition of property or the performance of services by any person, if such account receivable or evidence of indebtedness is acquired by a person other than the person who disposed of the property or provided the services that gave rise to the receivable. This rule does not apply to the facts herein because CFC-B sold the property or provided the services that gave rise to the receivable.
Section 864 treats "related person factoring income" as interest for purposes of the FPHCI rules.14 This provision applies to income earned from trade or service receivables acquired from a related person and loans to a person for the purpose of financing purchases of inventory or services from a person related to the CFC. Income includes stated interest, discount, or service fees. This provision also should not apply to the facts addressed in the PLR because CFC-B sold the property or provided the services giving rise to the Type L receivables.
The PLR states that the ruling does not address the proceeds of factoring any receivable to the extent the receivable has already been taken into account, and the associated income recognized, for U.S. tax purposes. In addition, the ruling expressly states that it has no effect on the treatment of any income that CFC-B may recognize in excess of the amount that CFC-B would have recognized from a full collection of all amounts due under the contract. It states that any such excess is to be calculated in CFC-B's functional currency, as of the date(s) on which CFC-B recognizes income, and with appropriate adjustments for previously recognized income relating to the same contract. Presumably, such additional amounts would be treated based on their underlying character.15
In sum, the PLR concludes that any accelerated income recognized by CFC-B upon factoring the Type L receivables is a substitute for the income it would have collected under the relevant contracts and should retain the same character under common law principles. Therefore, the gain is not Subpart F income because the income that CFC-B would have recognized if it had retained the receivables would not have been Subpart F income.
This commentary also will appear in the January 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 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 PLR 201131023.
2 2004-1 C.B. 991. Advance payments received with respect to the sale of inventory or provision of services can generally be deferred to the next succeeding taxable year to the extent the advance payments are not recognized in revenues by the taxpayer in its applicable financial statement in the taxable year of receipt.
3 §954(d) and (e).
4 In the past, the receivables were factored by CFC-B to a disregarded entity owned by CFC-B, and thus did not accelerate income.
5 Regs. §1.954-2(e)(3).
6 356 U.S. 260 (1958).
7 Id. at 265 (quoting Burnet v. Hormel, 287 U.S. 103, 106 (1932)).
8 See, e.g., Helvering v. Clifford, 309 U.S. 331 (1940) (trust income assigned by husband to wife was taxable to the husband); Harrison v. Schaffner, 312 U.S. 579 (1941) (trust income assigned by mother to children was taxable to the mother); Helvering v. Horst, 311 U.S. 112 (1940) (assignment of interest coupons by father to son was taxable to the father).
9 482 F.3d 610, 611 (2d Cir. 2007).
10 Id. (quoting P.G. Lake, 356 U.S. at 265, and citing U.S. v. Midland-Ross Corp., 381 U.S. 54, 57-58 (treating gain on sale of non-interest-bearing notes as equivalent to interest and thus as ordinary income), Hort v. Comr., 313 U.S. 28, 31 (1941) (lump sum paid for cancellation of rental payments owed under 15-year lease treated as ordinary income), Comr. v. Ferrer, 304 F.2d 125, 131 (right to receive percentage of film proceeds treated as ordinary income), Holt v. Comr., 303 F.2d 687, 690-91 (9th Cir. 1962) (lump sum received in exchange for future movie proceeds deemed ordinary income), and Dyer v. Comr., 294 F.2d 123, 126 (10th Cir. 1961) (lump sum received for mineral leasehold payments held to be ordinary income)), but see McAllister v. Comr., 157 F.2d 235 (2d Cir. 1946) (in a case decided before P.G. Lake, holding that a widow could treat as capital gain the lump-sum payment she received when she was forced to sell her rights to future payments from a life estate in a trust).
11 447 F.3d 1269, 1272 (10th Cir. 2006).
12 Regs. §1.954-2(e)(2)(ii). As mentioned above, the receivables factored do not bear interest by their terms and interest would not be imputed under §483 or §1274.
13 §954(c)(1)(E); Regs. §1.954-2(h)(4).
14 Regs. §1.864-8T.
15 For rules coordinating the different categories of Subpart F income and FPHCI, see Regs. §§1.954-1(e) and -2(a)(2).
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