By Philip D. Morrison, Esq.
Deloitte Tax LLP, Washington, DC
A private letter ruling released in mid-January (PLR 201002024, "the PLR") provides both explicit and implicit guidance on, or clarification of, several issues related to the branch rules of §954(d)(2) and the regulations thereunder. Given the importance and complexity of these rules and the recent promulgation of temporary regulations—which, while extremely helpful, still leave (or raise) some questions—such guidance is welcome. The PLR is especially welcome because it concludes favorably to the taxpayer (or implies a favorable conclusion) on at least some of the issues. With respect to some of these points, it would be even better if the IRS would issue a revenue ruling on which taxpayers could rely without requesting their own private ruling.
An issue that is clarified (or, more accurately, made simpler to understand) deals with the rule of Regs. §1.954-3T(b)(2)(ii)(a). In the PLR, each of three commonly owned disregarded entities (DEs) owns and operates a facility in a separate country (I'll call them "fab plants") that fabricates items (presumably the processed silicon wafers that are turned into computer chips, given the lingo). The products manufactured by the fab plants are inputs to a separate process, which yields the ultimate end-product for sale to customers. That process is the assembly, testing, and packaging process (which activities themselves constitute "manufacturing" according to the PLR) which is performed at a facility (I'll call it an "ATP plant") owned and operated by yet another commonly-owned DE in a fourth country. Each of the manufacturing operations, properly viewed as branches of the owner of the DEs, apparently independently satisfies Regs. §1.954-3(a)(4)(i).
The finished products are sold by three more DE/branches operating in three separate countries, only one of which is the same country as any of the countries where the manufacturing DEs operate. There are tax rate disparities between one of the sales branches and each of the fab plant locations as well as between a second sales branch and one of the fab plant locations. Those tax rate disparities cause each sales branch to be treated as a "remainder" selling on behalf of the fab plant "manufacturing branches" with which they have tax rate disparities. The PLR makes clear, however, that the activities at the ATP plant, so long as it has no tax rate disparity with the sales branch, and so long as it itself is not also a sales branch(as is the case in the PLR), can be combined with the sales branches for purposes of Regs. §1.954-3T(b)(2)(ii)(e) to qualify those "remainders," when treated as separate corporations under the branch rules, as themselves meeting the manufacturing exception. Because the ATP plant independently satisfies the manufacturing exception within the meaning of Regs. §1.954-3(a)(4)(i), had no sales activities, and had no tax rate disparity with any sales branch, its manufacturing qualified the sales branches as meeting the manufacturing exception so as to avoid creating foreign base company sales income (FBCSI).
While it is very nice to have a complex example of the rule of Regs. §1.954-3T(b)(2)(ii)(a) explained in a straightforward manner as in the PLR, it is nevertheless confusing why the IRS did not apply the rule of Regs. §1.954-3T(b)(1)(ii)(c)(3)(ii), penultimate sentence, to avoid having any tax rate disparity (and any need to apply the rule of Regs. §1.954-3T(b)(2)(ii)(a)) in the first place. Regs. §1.954-3T(b)(1)(ii)(c)(3)(ii) applies where, inter alia, a CFC uses more than one manufacturing branch to manufacture the same item of personal property. Presumably, given the broad definition of "property" in the amended Regs. §1.954-3(a)(1)(i) (see Morrison, "The Atomic Theory of Subpart F", 37 Tax Mgmt. Int'l. J. 337 (6/13/08)), the wafers produced by the fab plants and the chips that exit from the ATP plant are the same property. Given that there are two manufacturing branches that manufacture the same item of personal property, it seems clear to this author that Regs. §1.954-3T(b)(1)(ii)(c)(3)(ii) should apply. If it doesn't, it would have been most helpful had the PLR explained why not. If Regs. §1.954-3T(b)(1)(ii)(c)(3)(ii) is applied to the facts of the PLR, the location of manufacturing for purposes of the manufacturing branch rules is the manufacturing branch with the lowesteffective tax rate. Under the PLR's facts, that would be the ATP plant, which is subject to an effective tax rate of 0%. Given that the manufacturing branch cannot, therefore, have an effective tax rate five percentage points higher than the remainder or any sales branch, there is no need to apply Regs. §1.954-3T(b)(2)(ii)(a).
Another issue is implicitly decided in a taxpayer-favorable fashion. That issue deals with the effect of foreign tax law rulings on the tax rate disparity test. In the facts section of the PLR, it is stated that the operations of one of the DEs ("Country 4 branch") that carries on selling activity (that also houses the group's corporate officers) "is subject to a 0% income tax" "[u]nder an agreement with the Country 4 government." (Country 4 is the location of the DE's headquarters, although not the country under whose laws it is organized.) Likewise, "[u]nder an agreement with Country 7, [the ATP plant] is subject to an effective income tax rate of 0%." There is no description as to the breadth or scope of the agreement each branch has with the relevant foreign government, providing for a zero rate. It might be inferred that those rates applied to any income earned by the branches but it is certainly not clear, and there is no recitation of whether the taxpayer so represented or the IRS so found in an analysis not described in the PLR. It is certainly possible that the rulings were not explicit with respect to the tax rate applicable to income other than that earned by sales and HQ activities (in one case) and manufacturing activities (in the other case). There is no analysis of what scrutiny the IRS gave the foreign government "agreements" or the possible taxpayer representations about them; no discussion as to what impact they might have on the type of income that the tax rate disparity test hypothetically allocates to them. Nevertheless, both "agreements" are relied upon by the IRS in concluding whether or not there is a tax rate disparity among branches and, critically, between the ATP location and the sales income of the Country 4 branch. This implies, perhaps, a somewhat more relaxed analysis of the breadth and scope of a foreign ruling than the preamble to the latest round of regulations might otherwise suggest. If correct, this is good news for taxpayers.
A third issue, and really the heart of the PLR, deals with whether a partnership or its CFC partner is the correct entity with respect to which one applies the branch rule determinations (and, implicitly, the "same country" analysis). The PLR concludes that a partnership and its country of organization are relevant and the country of organization of the CFC partner is not.
The common owner of the DEs mentioned above is not a CFC; it's an entity in which a CFC is one of three unrelated members, and which elected partnership classification for U.S. tax purposes. It is "located" in (presumably organized under the laws of) a country ("Country 3") that does not correspond to either the CFC's "location," or to that of any of the manufacturing facilities or DEs, or the selling activities carried on by the DEs. Under one of two fact scenarios addressed by the PLR, the U.S. shareholder of the CFC partner sells items made in fab plants to the DE owned by the partnership with the Country 4 branch—the one with the Country 4 tax holiday mentioned above. Country 4 branch then sells these items to the ATP plant of a sister DE in Country 7, which, after final processing, sells them back to the Country 4 branch for resale to customers or resale to other sister DEs with sales operations in other countries.
The PLR notes that the CFC will have FBCSI, absent an exception, because Country 3 partnership purchases personal property from a person related to the CFC (CFC's U.S. shareholder) and sells to customers. However, the PLR explains, the CFC partner's distributive share of Country 3 partnership's income from such sales can qualify for the manufacturing exception to FBCSI. In making this determination, Regs. §1.954-3(a)(6) requires that only the activities of, and property owned by, Country 3 partnership be taken into account. Because the ATP plant is considered to manufacture (and, as the activity of a DE owned by the partnership, is an activity of the partnership), the partnership meets the manufacturing exception. All of these conclusions derive from fairly straightforward applications of the regulations.
With the application of the branch rules, however, the PLR begins to break new ground. For the manufacturing branch rule to apply, of course, manufacturing activities carried on by a CFC must be carried on by a branch operating in a different country than the CFC. Unfortunately, it's not so clear when the manufacturing activities aren't carried on by the CFC, but rather by a partnership. In that case, there is no explicit guidance to answer the question, "Different country than what?" One logical approach would be to compare the branch's country to the country of organization of the CFC partner. The PLR, however, apparently extrapolating from Regs. §1.954-3(a)(6), looks to whether the manufacturing branch operates in a country outside the country of organization of the partnership. Because the ATP plant operates in a country different than the country under the laws of which Country 3 partnership is organized, the PLR says that it must test whether, because of a tax rate disparity, the manufacturing branch rule causes the Country 4 branch's sales income to be FBCSI.
In applying the tax rate disparity test on the facts in the PLR, the results are unsurprising, notwithstanding the use of the partnership's country of organization as a reference point for whether the manufacturing branch rule may apply in the first place. This is because the "remainder" of the partnership consists of selling branches (there are no activities in the partnership itself, only those conducted through DEs and, in the Country 4 branch case, a branch of a DE). In making the comparison, then, the PLR compares the tax rates of each of the selling branches to the rate their income would be subject to (under the tax rate disparity test's hypothetical facts) were it earned in Country 7 (where the ATP plant operates). As noted above, Country 7's tax rate on the hypothetical income is zero (presumably the Country 7 government's "agreement" to tax the DE that operates the ATP plant at a zero rate extends to any income, including sales income, that such DE might earn). There is, therefore, no tax rate disparity with respect to any of the sales branches. Thus, the manufacturing branch rule does not apply to treat the Country 7 operation as a separate corporation from the remainder of Country 3 partnership. With no manufacturing branch problem, the CFC partner's distributive share of the income earned by Country 3 partnership is not FBCSI. It is also noteworthy that, on the PLR's facts, it wouldn't have mattered whether the tax rate comparison was triggered because of the country of organization of the partnership or the CFC—each is different than Country 7, the location of the ATP plant. Still, the analysis is clear that the IRS believes the "location" (presumably, the country of organization) of the partnership is relevant and the CFC partner's location is not.
While, on the facts of the PLR, this analysis produces a taxpayer-favorable result, there may be structures where the use of the partnership's country of organization as the point of comparison could produce unfavorable results. Taxpayers who thought using a CFC partner as the point of comparison was appropriate should, therefore, review their structures to see if, under the PLR, they might have FBCSI where previously they thought they had none. The PLR, of course, is not useful as precedent according to §6110 nor is it necessarily a correct interpretation of the Code and regulations. Relying on it, as either a sword or a shield, could be problematic in other fact patterns. Still, it is helpful in providing a bit of guidance regarding the IRS's views in a complex and difficult area.
This commentary also will appear in the April 2010 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 Income.
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