Subpart F: Revised Active Rents and Royalties Exception

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Lowell D.  Yoder, Esq.

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

Rental and royalty income received by a controlled foreign corporation (CFC) from unrelated persons that is derived in the active conduct of a trade or business is not Subpart F income. Revised temporary regulations now provide that only activities of a CFC's own employees can be taken into account for all active business tests and, in particular, that cost sharing arrangements cannot be relied on to satisfy the active business tests. One favorable clarification provides that activities can be conducted in multiple countries for purposes of satisfying the active marketing test.

Section 954(c)(1)(A) generally defines Subpart F foreign personal holding company income (FPHCI) as including rents and royalties. An exception is provided for rents or royalties received from unrelated persons derived in the active conduct of a trade or business.

Rents are considered derived in the active conduct of a trade or business if a CFC manufactures or produces the leased property, or the CFC acquires the property and adds substantial value thereto, and the CFC is regularly engaged in the manufacturing or producing, or acquiring and adding substantial value to, property of such kind. This exception also applies if the CFC derives the rents from leasing real property with respect to which the CFC, through its own officers or employees, regularly performs active and substantial management and operational functions while the property is leased. Finally, leased property is considered used in an active trade or business if the CFC lessor, through its own employees, operates an organization that regularly engages in marketing, or marketing and servicing, the leased property and such organization is substantial in relation to the amount of rents derived from leasing the property. Under a safe harbor, an organization is considered substantial in relation to the amount of rents received if the active leasing expenses equal or exceed 25% of the adjusted leasing profits.

Royalties are considered derived in the active conduct of a trade or business if a CFC developed, created, or produced the intangible property, or acquired the intangible property and added substantial value thereto (e.g., customization of software), and the CFC is regularly engaged in developing, creating, or producing, or acquiring and adding substantial value to, property of such kind. In addition, the active business test is satisfied if the CFC licensor, through its own employees, operates an organization that regularly engages in marketing, or marketing and servicing, the intangible property and such organization is substantial in relation to the amount of royalties derived from licensing the intangible property. Under a safe harbor, an organization is considered substantial in relation to the amount of royalties received if the active licensing expenses equal or exceed 25% of the adjusted licensing profits.

Active Developer Test

As discussed above, a CFC is considered to be actively engaging in the conduct of a trade or business with respect to property it leases or licenses if it regularly engages in the business of manufacturing, developing, creating, or producing such property, or regularly engages in the acquisition and addition of substantial value to such property. The prior regulations did not expressly require that only activities of the employees of the CFC be taken into account for purposes of satisfying these tests. Therefore, a position could have been taken that activities of a contract manufacturer or developer could be attributed to a CFC principal causing the CFC to be considered actively manufacturing or developing the leased or licensed property. In addition, intangible property developed pursuant to a cost sharing arrangement might have been treated as developed by a CFC-participant, thus enabling the CFC-participant to qualify for the active licensing exception.

The revised regulations provide that only employees of the CFC may be considered in determining whether the CFC regularly engages in the business of manufacturing, developing, creating, or producing property it leases or licenses, or regularly engages in the acquisition and addition of substantial value to such property. Language was added to those active tests for both rents and royalties, requiring that the activities be performed “though [the CFC's] own officers or staff of employees.”

The regulations add a provision for cost sharing arrangements. The new provision states that, for purposes of satisfying the above active tests, cost sharing transaction (CST) payments and platform contribution transaction (PCT) payments do not result in a CFC's officers or employees being treated as undertaking the activities of the controlled participant to which the payments are made. The CFC's own employee activities pursuant to a cost sharing arrangement would continue to be considered.

Active Marketer Test

The prior regulations provided that the active marketing test is satisfied if the CFC operates an organization that regularly engages in marketing and servicing the leased or licensed property and such organization is substantial in relation to the amount of rents or royalties derived from leasing or licensing the property. Those regulations contained language stating that only activities of the CFC's own employees could be taken into account for this purpose. The revised temporary regulations make it clear that activities of another participant to a cost sharing arrangement are not taken into account for purposes of meeting this active test.

Under a safe harbor, an organization is considered substantial in relation to the amount of rents or royalties received if the active leasing or licensing expenses equal or exceed 25% of the adjusted leasing or licensing profits, respectively. The prior regulations stated that expenses of agents or independent contractors could not be taken into account. The revised regulations provide that deductions for CST payments and PCT payments are also not counted as active leasing or licensing expenses for purposes of meeting the safe harbor.

On a positive note, there was uncertainty under the prior regulations concerning whether only employee activities in one country could be taken into account for purposes of satisfying the active marketing test. The prior regulations contained language stating that the active marketing test is satisfied if the CFC, through its own employees, operates an organization in a foreign country that regularly engages in marketing, or marketing and servicing, the leased or licensed property and such organization is substantial in relation to the amount of rents or royalties derived from leasing or licensing the property. The revised temporary regulations make it clear that activities of the CFC's employees may be performed in any country, by providing that the CFC must operate an organization “in a foreign country or countries.” For example, if a CFC has disregarded entities located in different countries, employees of those disregarded entities are counted for purposes of satisfying the active marketing test.

In summary, the revised temporary regulations now require that only activities of a CFC's own employees can be taken into account for purposes of satisfying the active tests for rents and royalties, but activities of employees in all countries are considered. Activities of employees of other participants to a cost sharing arrangement cannot be taken into account, and CST and PCT payments cannot be counted for purposes of the active marketing safe harbor.

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 This section features brief commentary written on a rotating basis by leading international tax practitioners. Advance versions of most items are published in the “BNA Insights” section of Bloomberg BNA Tax and Accounting Center on the Web.

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