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By Lowell D. Yoder, Esq.
McDermott Will & Emery, Chicago, IL
Income derived by a controlled foreign corporation (CFC) from performing services for an unrelated customer generally is not Subpart F income.1 However, if U.S. related persons furnish substantial assistance contributing to the performance of the services, under regulations the CFC will be deemed to perform the services for a related person.2 In such case, the services income would be Subpart F income to the extent attributable to services performed outside the CFC's country of organization.3
Assume a company organized in Ireland wholly owns entities in Germany and in the United Kingdom. The Irish entity is a CFC, and the German and U.K. entities are disregarded for U.S. tax purposes.4 The three entities perform software-related services for unrelated customers in Europe.5 Income earned by the Irish CFC (directly and through its disregarded entities) from providing the software services should not be Subpart F income, even if one entity provides support services to another entity because such transactions are disregarded for U.S. tax purposes. If, however, U.S. related persons furnish substantial assistance contributing to the performance of the services for the unrelated customers, then under regulations the income will be Subpart F income to the extent attributable to services performed outside Ireland.6
The test for determining whether a CFC receives substantial assistance from related U.S. persons is set forth in Notice 2007-13.7 A CFC is considered as receiving substantial assistance if the cost of the assistance furnished directly or indirectly by related U.S. persons equals or exceeds 80% of the total costs to the CFC of performing the services.8
Assume in the above example that the costs of providing the software services to an unrelated customer are $1 million. The Irish CFC and its two subsidiaries collectively incur $400,000 of the costs directly, pay $300,000 to the U.S. parent for assistance and $200,000 to related foreign persons in regarded transactions, and pay $100,000 to unrelated U.S. and foreign persons. Since the cost of assistance furnished by related U.S. persons is only 30% of the total costs of performing the services ($300,000/$1,000,000), the CFC is not considered as receiving substantial assistance.
For purposes of calculating the 80%-cost test, the Notice refers to the definition of "assistance" contained in the regulations. The regulations define two categories of relevant assistance: (1) direction, supervision, services, and know-how; and (2) financial assistance (other than contributions to capital), equipment, material, or supplies.9
The regulations provide that assistance in the first category furnished to a CFC is not taken into account unless the assistance so furnished assists the CFC directly in the performance of the services.10 The Notice does not expressly state this limitation. The examples in the Notice illustrate the application of the 80%-cost test where assistance is provided by a related U.S. person that contributes to the performance of the essential services by the CFC, e.g., supervisory, technical, and design services. Limiting the first category to include only assistance that directly contributes to the performance of the services for the customer is the appropriate standard (e.g., generally not treat as assistance the costs of marketing and selling the services to prospective customers).11
The regulations further provide that items in the second category—financial assistance, equipment, material, or supplies—are considered assistance only in the amount by which the consideration actually paid by the CFC is less than an arm's-length charge. The Notice again does not expressly state this limitation, and might be interpreted as counting all such costs even if the CFC pays an arm's-length price. Nevertheless, such a major departure from the underlying regulations would seem odd since it is nowhere mentioned in the Notice.12 There also is no apparent policy purpose served by expanding the concept of assistance in financial or tangible form to include situations in which arm's-length compensation has been provided.
Like the regulations, the Notice states that assistance for purposes of the substantial assistance rule is not limited to the above-identified items. The Notice does not provide any guidance concerning other types of assistance beyond the items expressly mentioned in the regulations, and in the over 50 years since the regulations were issued no expanded application has been indicated.
The Notice does not generally address the treatment of costs of developing or obtaining access to intangible property. Like the regulations, the Notice only mentions "know-how" as constituting assistance, and there has been no guidance indicating that the substantial assistance rule takes into account costs of other intangibles. Thus, it would be appropriate to exclude the costs of intangibles (other than know-how) from assistance for purposes of the 80% test.
However, at least on one occasion, the government has suggested in public comments that payments made by a CFC to a related U.S. person to obtain or develop intangibles may be counted as costs of assistance.13 Such payments may take the form of royalties, consideration for the purchase of intangible property, fees for research and development services, or cost-sharing payments pursuant to a cost-sharing arrangement.
In contrast, commentators have expressed the view that costs for intangibles should not be counted as assistance in the 80%-cost calculation. In addition to pointing out that neither the regulations nor the Notice mentions costs of intangibles as relevant assistance, they note that the intangibles may not directly assist in the performance of the specific services under a contract (e.g., costs of intangibles relied on to generate services income, such as a trade name, trademark, or service mark) and the putative assistance in this form may not be contemporaneous with the performance of the services (e.g., a payment relating to the development of intangible property that may not be ready for commercialization for some time, if ever).14 In cost-sharing arrangements, cost-sharing payments relate to the development of new intangible property, and at any rate are generally treated as intangible development costs of the paying participant and not as assistance received from a related person.15
Neither the Notice nor the regulations provide rules for allocating costs in calculating the substantial assistance 80%-cost test. Directly related costs likely should be allocated to the particular services contract, and it would seem reasonable to apply the expense allocation rules in the §861 regulations for purposes of allocating and apportioning expenses that are not directly related (to the extent such expenses are properly counted).
If expenditures relate to more than one year, it would seem appropriate to allocate them to the years to which they relate, and not take them into account entirely in the year incurred. For example, if a taxpayer takes into account costs of equipment purchased from a related U.S. person (arguably such costs are not counted as assistance if an arm's-length price is paid), the straight-line method of depreciation or amortization over the asset's useful life might be used to reflect costs for a particular year. This properly matches costs with the income generated from incurring the costs.
The cost of assistance received from a related CFC generally is not counted as a cost of assistance for purposes of calculating the 80%-cost test. The Notice provides that assistance furnished indirectly by a related U.S. person is taken into account, and an example illustrates this as follows: CFC1 pays a fee to CFC2 for assistance, and CFC2 pays a fee to a U.S. related person to provide a portion of that assistance. The U.S. related person is treated as indirectly furnishing the assistance to CFC1 (through CFC2), and thus the cost of the U.S. related person's assistance is taken into account in calculating the 80%-cost test.16
The Notice does not illustrate a situation where a CFC hires a U.S. related person, which in turn hires another CFC to provide indirect assistance to the first CFC. Consistent with the above indirect assistance rule—which looks through an intermediary to determine which person ultimately provides the assistance—it would be appropriate to exclude amounts the CFC pays to a U.S. related person to the extent the U.S. related person pays an amount to another related CFC to provide the assistance.17 It would also be appropriate to apply a similar approach to the cost of third-party services paid by a U.S. related person to assist the CFC with the performance of its services.18 In such situations the U.S. related person is not providing the assistance to the CFC, and thus such payments are outside the scope and purpose of the substantial assistance rule.19
In sum, the best reading of the Notice is that only costs of assistance furnished by U.S. related persons that directly assists the CFC in performing the contracted-for services should be taken into account as assistance in calculating the 80%-cost test. This carries out the purpose of the Notice to apply the substantial assistance rule "in cases where the related United States person or persons provides so much assistance to the CFC that the CFC cannot be said to be providing services on its own account and acting as an independent entity." Furthermore, the better position is that costs of intangibles should not be counted, as well as costs of equipment and financial support for which an arm's-length amount is paid. Because of the lack of clarity on certain computational inputs, it is advisable to calculate the 80%-cost test under various cost inclusion scenarios and take steps to reduce the risk of the substantial assistance rule applying.
This commentary also appears in the April 2016 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 Taxation.
3 The language of the Code and regulations might be read as literally requiring that each item of services income be separately analyzed to determine whether it falls within the definition of "foreign base company services income," although aggregation of similar arrangements should be appropriate. For a detailed analysis of the application of the foreign base company services income rules, see Yoder and Noren, The Archaic Subpart F Services Rules: Ill-Fitting and Disruptive for Modern Services Businesses, 94 TAXES 29 (March 2016).
6 In addition, a CFC that performs services for unrelated customers may be deemed to perform the services for related persons if a related person guarantees performance of the services, or a related person is (or was) obligated to perform the same services that end up being performed by the CFC (e.g., related person agrees to build a superhighway, and the CFC builds it instead). Reg. §1.954-4(b). See Yoder, Applying the Subpart F Services Rules to Regarded Entity Structures, 41 Int'l Tax J. 3 (Nov.–Dec. 2015); Yoder, Applying the Subpart F Services Rules to Disregarded Entity Structures, 41 Int'l Tax J. 3 (Sept.-Oct. 2015).
7 2007-1 C.B. 410. This Notice announced new regulations and may be relied on until the regulations are issued. It substantially limits the much broader substantial assistance rules contained in regulations. Reg. §1.954-4(b)(1)(iv). See Yoder, Notice 2007-13: The New Substantial Assistance Rule, 36 Tax Mgmt. Int'l J. 230 (May 11, 2007).
11 Under the regulations, assistance generally is not considered as directly assisting the CFC in the performance of the services unless the assistance provides the CFC with "essential facilities necessary to its performance of such services and without which such services cannot be performed." T.D. 6981, 1968-2 C.B. 314.
13 See Lisa M. Nadal, Cost of Intangibles Included in Subpart F Calculation Hicks Says, 2007 TNT 14-8 (Jan. 22, 2007) (reporting remarks of Hal Hicks, then International Tax Counsel for the U.S. Treasury Department, to the effect that "intangibles should be included in the pool of costs used to determine what constitutes `substantial assistance'" under Notice 2007-13).
14 See Rollinson, O'Connor, Gordon, and Kilthau, Notice 2007-13 and the Substantial Assistance Rules—A Good Start, But More Clarification Required, 19 J. of Int'l Tax'n 18 (January 2008); Hoerner, Yan, and Galin, PCT Payments Should Not be Included in the Numerator of the 80% Cost Test for Purposes of the Substantial Assistance Rule, 42 Tax Mgmt. Int'l J. 547 (Sept. 13, 2013).
15 See Reg. §1.482-7(j)(3) (cost-sharing payments "generally will be considered the payor's costs of developing intangibles…."). See Morrison, Cost Sharing Intangibles in a Services Business—A Foreign Base Company Services Income Issue That Shouldn't Be, 32 Tax Mgmt. Int'l J. 422 (Aug. 8, 2003).
16 Employees, officers, or directors of a CFC who are concurrently employees, officers, or directors of a related U.S. person will be considered as employees, officers, or directors solely of the related U.S. person.
17 See Rollinson, et al., above, at 25 ("When a related U.S. person is acting merely as a middle person in the transaction and is not directly providing the assistance to a CFC, the CFC's costs to the related U.S. person should not be included in the application of the cost test as long as contemporaneous documentation can verify that a related CFC is the direct provider of the assistance.").
18 To the extent that a U.S. related person is entitled to an arm's-length mark-up on the third-party services (e.g., reflecting value added by the U.S. related person in supervising the third party), it would be appropriate to treat that mark-up as a cost of assistance received from a U.S. related person.
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