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Lowell D. Yoder discusses how the courts have rebuffed the IRS's attempts to expand the scope of the definition of Subpart F sales income, on the basis of policy considerations, to apply to certain low-tax structures.
By Lowell D. Yoder, Esq.
Lowell D. Yoder, Esq., is with McDermott Will & Emery in Chicago.
As a general rule, sales and services income is not income for purposes of Subpart F of the U.S. Internal Revenue Code. Therefore, income derived by a controlled foreign corporation (CFC) from selling products or performing services outside the United States generally is not currently subject to U.S. taxation.
The code provides specific requirements for sales and services income to be Subpart F income. Only if sales income falls within the definition of foreign base company sales income (FBCSI), or services income falls within the definition of foreign base company services income, will such income be Subpart F income.
Sales income is FBCSI only if the transacted property is either purchased from or sold to a related person. And even if there is a related-person purchase or sale, the income is not FBCSI if the property is not manufactured outside the CFC's country of organization, or is not sold for use outside such country. Section 954(d)(1); Reg. Section 1.954-3(a). (Certain commissions or fees derived by a CFC for purchasing or selling property on behalf of a related person can also fall within the definition of FBCSI, where the property is both manufactured outside the CFC's country of organization and sold for use outside such country.) In addition, the regulations provide a manufacturing exception for property physically manufactured by a CFC, or where a CFC substantially contributes to the manufacture of the property produced on its behalf by a contract manufacturer. Reg. Section 1.954-3(a)(4). If a CFC operates through one or more branches, under certain circumstances a portion of the CFC's sales income can be FBCSI that otherwise falls outside the general definition of FBCSI or qualifies for the manufacturing exception. Section 954(d)(2); Reg. Section 1.954-3(b).
Services income is foreign base company services income only if the services are performed for or on behalf of a related person. Even where the services are performed for a related person, only income attributable to activities performed outside the CFC's country of organization is Subpart F income. Section 954(e); Reg. Section 1.954-4.
These definitions of Subpart F sales and services income have remained essentially unchanged since Subpart F was enacted in 1962. Over the last 60 years, tax planners have developed structures that achieve low foreign taxes on sales and services income earned by a CFC without current taxation under Subpart F. In response, the IRS in litigation has attempted to expand the scope of the definition of Subpart F sales income to apply to certain low-tax structures on the basis of policy considerations. The IRS has lost every case.
Two cases decided in the 1990s involved CFCs that hired contract manufacturers to manufacture the products they sold. The CFCs were in low-tax countries and the contract manufacturers were in high-tax countries. The CFCs' income did not fall within the definition of FBCSI because they did not purchase property from, or sell property to, related parties. The IRS attempted to create a related-party transaction, arguing that policy considerations required a broad interpretation of the definition of FBCSI. The Tax Court rejected the IRS argument in both cases.
In Ashland Oil Inc. v. Commissioner, 95 T.C. 348 (1990), a U.S. corporation organized in Liberia a wholly owned subsidiary, which purchased and sold marine chemical products. In order to establish a source of supply for those products, the Liberian CFC entered into a manufacturing, license, and supply agreement with an unrelated Belgian corporation. Under the agreement, the CFC purchased finished products from the unrelated Belgian corporation. The CFC then sold the products to unrelated customers. Although the CFC was organized in Liberia “in large part to save income taxes,” the Tax Court held that the income derived by the CFC was not FBCSI.
The IRS acknowledged that the purchase transactions were made with an unrelated supplier and did not dispute that the sales transactions were made with unrelated customers, and therefore the income fell outside the general definition of FBCSI. However, the IRS argued that, based on general policy statements in the legislative history, the branch rule contained in Section 954(d)(2) should apply to create a deemed related-person transaction, thereby causing the Liberian CFC's income to be FBCSI.
The IRS referred to the legislative history as describing that the FBCSI rules are intended to end tax deferral in certain situations where the income from sales activities is separated from manufacturing activities of a related person and is thereby subject to a lower rate of tax. Based on the legislative history, the IRS contended that the branch rule should apply in any situation where sales income is subject to a significantly lower rate of tax than manufacturing income.
The IRS argued that the definition of “branch or similar establishment” should be broadly defined to include a contract manufacturer, which would cause the CFC's income to be FBCSI under the manufacturing branch rule. The Tax Court rejected the IRS's argument, finding (among other things) that a separate corporation, such as the Belgian corporation, could not be treated as a branch to create a related-party transaction. The Tax Court determined that Congress did not grant Treasury specific regulatory authority to define “branch or similar establishment.” The Tax Court rejected the Service's argument that the branch rule should be viewed as a broad “loophole closing” provision, to be applied whenever an arrangement separates the manufacturing and sales functions so as to avoid or limit tax on the sales income. Therefore, the branch rule was not applicable, and the CFC's income was not FBCSI, despite the fact that the CFC's sales income was subject to a low rate of tax.
In Vetco, Inc. v. Commissioner, 95 T.C. 579 (1990), the Tax Court similarly rejected the IRS's attempt to broadly define the term “branch” for purposes of applying the Section 954(d)(2) branch rule to create FBCSI. In that case, Vetco International A.G. (VIAG), a Swiss CFC, entered into a contract manufacturing arrangement with its wholly owned U.K. subsidiary, Vetco Offshore, Ltd. (VOL). Under the arrangement, VOL assembled oil and gas drilling equipment from parts and designs provided by VIAG. The assembly activities took place in Aberdeen, Scotland. At all relevant times, title to the materials was held by VIAG, which bore the full risk of loss. VIAG did not have any employees, but contracted with various affiliates to handle certain functions, such as purchasing raw materials and components. VOL earned a fixed fee for its manufacturing services. VIAG sold the finished products to unrelated purchasers.
The IRS argued that although VOL was a subsidiary of VIAG, it was really no different from a branch within the meaning of Section 954(d)(2). The IRS contended that the taxpayer used VIAG and VOL to avoid U.S. tax by splitting their sales and manufacturing operations in order to take advantage of Switzerland's lower tax rate. The Service urged the court to look past petitioner's “contractual wizardry” and to apply the branch rule as a loophole-closing device.
The Tax Court rejected the IRS's argument and agreed with the taxpayer, who argued that a subsidiary by definition could not be a branch under Section 954(d)(2). The court noted that “branches or similar establishments” could be established in a foreign country without the stock ownership required of a separately incorporated subsidiary. Accordingly, the branch rule was intended to prevent CFCs from avoiding Section 954(d)(1) because there would be no transaction with a related person within the meaning of Section 954(d)(3). In examining the structure of Section 954(d) and its legislative history, the court concluded that only specified related-person transactions give rise to FBCSI. As in Ashland, the Tax Court determined that FBCSI is not attributable to a CFC merely because its sales income is realized in a low-tax jurisdiction. Rather, FBCSI arises only if a CFC engages in “certain triggering transactions.” Vetco at 590–91.
The court again rejected the loophole-closing argument, finding that the legislative history did not support a broad interpretation of the term “branch,” and that the provision lacked the “broad language necessary to support [the IRS's] position.” Vetco at 594. It stated that the term “branch” for purposes of Section 954(d) must be interpreted according to its ordinary usage to mean a physical location where activities are conducted separate from the main office. (The IRS will follow Ashland and Vetco. Rev. Rul. 97-48, 1997-2 C.B. 89. See also Yoder, President's Budget Would Apply Subpart F to Toll Manufacturing Arrangements, 43 Tax Mgmt. Int'l J. 496 (Aug. 8, 2014), discussing the Obama administration's fiscal year 2015 budget proposal—which was never enacted—to “expand” Section 954(d)(1) to apply to the type of structure addressed in Vetco.) Therefore, as VIAG did not purchase property from, or sell property to, related persons, its income fell outside the definition of FBCSI.
A subsequent case also held that income from the sale of products was not FBCSI because the requisite related-party transaction did not exist. In Brown Group, Inc. v. Commissioner , 77 F.3d 217 (8th Cir. 1996), rev'g 104 T.C. 105, 111 (1995), a U.S. taxpayer (Brown Group International) owned 100 percent of a Cayman Islands corporation, which in turn owned 88 percent of the interests in a partnership formed under the laws of the Cayman Islands.
During 1985 and 1986, the Cayman partnership acted as a purchasing agent for Brown Group International with respect to footwear manufactured in Brazil. Brown Group International sold the footwear primarily for use in the United States. For its purchasing services, the Cayman partnership received a 10 percent commission from Brown Group International based on the purchase price of the footwear. This commission income was treated as sales income for purposes of Section 954(d).
The Cayman CFC partner of the Cayman partnership reported a distributive share of the sales income. The government argued that the CFC partner's distributive share of sales income was FBCSI by treating the sales income as involving a related-person transaction. The Eighth Circuit Court of Appeals rejected the government's argument and held for the taxpayer.
The court first concluded that it was a well-established principle that income is to be characterized at the partnership level, and that such income retains its character when included in the income of the partners. Under an entity approach, the Eighth Circuit found that the sales income was not FBCSI at the partnership level. The basis for this conclusion was that the partnership had not derived such income from a related person as defined in Section 954(d)(3), because the then-existing definition of a related person did not include a partnership controlled by a CFC. (The statute was subsequently amended to include within the definition of a related person a partnership controlled by a CFC. Section 954(d)(3).) Because the income was not FBCSI to the Cayman partnership, the Cayman CFC's distributive share was not FBCSI.
While rejecting the IRS's position in Brown Group on the basis of the code and regulations, the Eighth Circuit acknowledged that policy considerations evidenced by subsequent legislation supported the IRS's position: “Although our holding may result in a tax windfall to the Brown Group due to the particularized definition of ‘related person’ under the pre-1987 version of section 954(d)(3) of the Internal Revenue Code, such a tax loophole is not ours to close but must rather be closed or cured by Congress.” 77 F.3d at 222. (Treasury later amended the Section 954 regulations to provide that Subpart F income includes a CFC's distributive share of any item of gross income of a partnership to the extent such income would have been Subpart F income if received directly by the CFC partner. T.D. 9008, 67 Fed. Reg. 48,020 (July 23, 2002).)
Thus, even in a case in which the language of the code made it possible to use CFC-controlled partnerships to completely avoid the FBCSI rules, the court found that it was constrained to follow the code rather than substituting policy judgment for the statutory language enacted by Congress. (The Eighth Circuit recounted that the IRS contended that the Tax Court opinion “was ‘unnecessarily broad and can reasonably be interpreted in a manner that effectively repeals virtually all of the subpart F provisions of the Code.’” 77 F.3d at 219.) As in Ashland and Vetco, the court followed the “plain language of the statute” (77 F.3d at 221), though it arguably exposed “an unjustified loophole in the tax laws.” ( See Brown Group, above, 104 T.C. at 139 (Jacobs, J., dissenting), quoting MCA Inc. v. United States, 685 F.2d 1099, 1105 (9th Cir. 1982): “If the omission of income received from controlled partnerships has indeed created an unjustified loophole in the tax laws, the remedy lies in new legislation, not in judicial improvisation.”)
In two other FBCSI cases, the Tax Court broadly interpreted the definition of manufacturing in favor of the taxpayer. In Dave Fischbein Manufacturing Co. v. Commissioner, 59 T.C. 338 (1972), acq. 1973-2 C.B. 2, a CFC purchased from its parent the housing, handle, and most of the component parts for a bag-closing machine, and in a six-hour, 58-step process completed the assembly. The IRS argued that the operations were not substantial enough to constitute manufacturing. The court found that assembly operations performed by the CFC were substantial in nature and generally considered to constitute manufacturing. Therefore, the Tax Court rejected the IRS's argument, and held that the CFC's sales income qualified for the manufacturing exception.
Similarly, the Tax Court, in Bausch & Lomb, Inc. v. Commissioner , 71 T.C.M. 2031 (1996 ), held that sunglass assembly operations performed by two CFCs in Hong Kong and Ireland constituted manufacturing, and therefore the low-taxed income was not FBCSI. The Tax Court rejected the IRS's argument that the assembly operations were not significant enough to constitute manufacturing for purposes of qualifying for the Subpart F manufacturing exception.
In a relatively recent case filed in Tax Court, The Cooper Companies Inc. v. Commissioner , T.C. No. 14816-11 (settlement order entered Feb. 2, 2012), the government argued that the Subpart F branch rule should apply to result in Subpart F income. This case involved a U.K. CFC that sold products manufactured in the United Kingdom. The U.K. CFC wholly owned a Barbados entity that was disregarded for U.S. tax purposes. The Barbados disregarded entity had three employees who performed clerical, administrative, high-level oversight and compliance tasks for the U.K. CFC.
The IRS asserted that the Subpart F branch rule applied to the Barbados disregarded entity, and proposed a $53 million Subpart F income adjustment. The IRS argued that the activities carried on in the Barbados branch had “substantially the same effect as if the Barbados branch were a wholly owned subsidiary of the [U.K.] corporation deriving such income,” and thus that the branch's income constituted FBCSI of the U.K. CFC.
The taxpayer argued that the branch rule cannot apply because the Barbados branch did not engage in “purchasing or selling activities” as required by the regulations. The Barbados employees performed only administrative, oversight, and clerical activities, while other entities carried on the purchasing and selling activities. See Reg. Section 1.954-3(b)(1)(i)(a) (the purchasing or selling branch rule applies only if a “controlled foreign corporation carries on purchasing or selling activities by or through a branch or similar establishment located outside the country under the laws of which such corporation is created or organized and the use of the branch or similar establishment for such [purchasing or selling] activities has substantially the same tax effect as if the branch were a wholly owned subsidiary of such controlled foreign corporation….” (emphases added))
The IRS settled the case prior to trial with the taxpayer agreeing to a tax deficiency of only $50,000. T.C. No. 14816-11 (settlement order entered Feb. 2, 2012).
In sum, the IRS has never won a single litigated case arguing for FBCSI (and has never litigated a foreign base company services income case). Courts have consistently rejected the government's arguments to expansively apply the definition of Subpart F sales income in order to carry out asserted congressional intent. While the courts have acknowledged that the policies informed the rules, they have not permitted the policies to eclipse the plain language of the code, even where the taxpayer engaged in tax planning that took advantage of the rules and arguably frustrated the policies underlying the rules.
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