The Interplay Between Subpart F and the Effectively Connected Income Rules

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Lowell D.  Yoder, Esq.

By Lowell D. Yoder, Esq. McDermott Will & Emery LLP Chicago, Illinois

Subpart F income earned by a controlled foreign corporation (CFC) is included currently in the gross income of its U.S. shareholders. Subpart F income includes certain insurance income, passive income, certain sales income, certain services income, and oil-related income.

This commentary discusses an exclusion from Subpart F income that applies to U.S.-source income effectively connected with the conduct of a trade or business in the United States. It also describes an exception to the effectively connected income rules for foreign-source Subpart F income.

U.S.-Source ECI Exclusion from Subpart F

Section 952(b) provides that the definition of Subpart F income does not include any item of income from sources within the United States that is effectively connected with the conduct of a trade or business within the United States. A CFC that derives such income generally would be subject to direct U.S. taxation on its net amount of effectively connected income.

The existence of a U.S. trade or business generally requires “considerable, continuous and regular” profit-seeking activities (carried out directly or through agents). If a CFC is engaged in a trade or business in the United States, all of its U.S.-source business income generally is treated as effectively connected with its U.S. trade or business. This rule applies whether or not the income has any connection with the trade or business conducted in the United States, and thus is referred to as the “limited force of attraction” rule.

U.S.-source passive income (e.g., dividends, interest, capital gains) is treated as effectively connected with a U.S. trade or business only if it arises from business assets located in the United States or is associated with activities occurring in the United States. If not effectively connected with a U.S. trade or business, U.S.-source passive income generally is subject to a 30% withholding tax on the gross amount.

As an illustration, income derived by a CFC from the performance of services within the United States generally is considered as U.S.-source income that is effectively connected with a U.S. trade or business, and the net amount is subject to direct U.S. taxation. Accordingly, even if such income fell within the definition of foreign base company services income, it would be excluded from the CFC's Subpart F income.

As another illustration, income from the sale of inventory to U.S. customers where title passes in the United States generally is U.S.-source income, and therefore would be effectively connected with any U.S. trade or business of the CFC. If title passes outside the United States, income from sales of inventory to U.S. customers nevertheless will be U.S.-source if the sale is attributable to an office or fixed place of business maintained by the CFC in the United States, and therefore such income will be effectively connected with the CFC's U.S. trade or business. U.S.-source effectively connected sales income would not be Subpart F income, even if it fell within the definition of foreign base company sales income.

The Subpart F exclusion does not apply to any U.S.-source effectively connected income that is exempt from taxation (or is subject to a reduced rate of taxation) pursuant to a treaty obligation of the United States. For example, if a CFC qualifies for the benefits of an income tax treaty, any U.S.-source income that is effectively connected with a U.S. trade or business solely by reason of the limited force of attraction rule would not be subject to U.S. taxation because the income would not be attributed to a U.S. permanent establishment. Therefore, such income would not qualify for the Subpart F exclusion for effectively connected income.

In addition, the IRS has ruled that this exclusion does not apply to income that would be treated as effectively connected income but for a statutory exemption. The IRS held that shipping income that was not effectively connected income by reason of the reciprocal shipping exemption under §883(a)(1) was includible in Subpart F income.

U.S.-source passive income that is not effectively connected with the conduct of a trade or business within the United States does not qualify for this exclusion from Subpart F income, even if the income is subject to U.S. withholding tax. For example, U.S.-source interest income received by a CFC that is subject to a 30% withholding tax would also generally be Subpart F income.

Foreign-Source Subpart F Income Exception to ECI

As a general rule, income earned by a foreign corporation from sources without the United States under general sourcing principles is not treated as effectively connected with the conduct of a trade or business within the United States. However, certain income that is foreign-source under general principles and is derived by a foreign corporation in the active conduct of a trade or business in the United States can be treated as effectively connected with a U.S. trade or business. This rule can apply to rents or royalties for the use of intangible property, for example, if such income is attributable to an office or other fixed place of business of the foreign corporation in the United States.

Section 864(c)(4)(D)(ii) provides that no income from sources without the United States shall be treated as effectively connected with a trade or business within the United States if it is Subpart F income within the meaning of §952(a). This exception, however, does not apply to the extent an item falling within the general definition of Subpart F income qualifies for an exception.

For example, a CFC may derive royalty income that is foreign-source income effectively connected with the conduct of a U.S. trade or business. If the royalty income is Subpart F income includible in the income of the U.S. shareholders, it will not be treated as effectively connected with the conduct of a U.S. trade or business, and therefore the CFC will not be subject to direct U.S. taxation on the royalty income. On the other hand, if such income qualifies for the active trade or business exception to Subpart F income, it would not qualify for the Subpart F exception to effectively connected income.

Summary

Subpart F income generally does not include U.S.-source income that is effectively connected with the conduct of a trade or business in the United States. This exception does not apply to other U.S.-source income nor does it apply to foreign-source income, even if such income is subject to U.S. taxation. Nevertheless, foreign-source Subpart F income generally is not subject to direct U.S. taxation as effectively connected with the conduct of a U.S. trade or business.

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
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