By Lowell D. Yoder, Esq.
McDermott Will & Emery, Chicago, IL
multinationals engage in a significant portion of
their global business outside the United States. The business often
is conducted in multiple entities organized in countries where
operations are carried out or where assets used in the business are
owned. Such operations may include research and development,
manufacturing, sales, services, and financing.
carrying out certain business operations, property owned by a
foreign subsidiary may be leased or licensed to unrelated persons
or to related persons for use in the business of the lessee or
royalty income earned by a controlled foreign
corporation (CFC) that has a specified connection to the conduct of
a business is not Subpart F income. Similarly, gain on the sale of
property that gives rise to business-related rental or royalty
income generally is not Subpart F income. However, gain on the sale
of property leased or licensed to a related person is Subpart F
income, even if the property is used in an active business.
commentary discusses the Subpart F, foreign personal
holding company income (FPHCI) rules that apply to gain on the sale
of property that is leased or licensed. Since those rules
cross-reference to the Subpart F rules that apply to rental and
royalty income, the commentary first provides an overview of the
application of Subpart F to that income.
Subpart F: Rentaland Royalty Income
954(c)(1)(A) generally defines FPHCI as including rental
and royalty income.1 As mentioned
above, however, rents and royalties derived in connection with
business operations generally are not FPHCI. Different rules apply
depending on whether the rents or royalties are received by a CFC
from unrelated or related persons.2
Rental income received from
unrelated persons as
part of the active conduct of a trade or business by the CFC is not
FPHCI. Rent will be considered as derived in the active conduct of
a trade or business if the CFC manufactured or produced the leased
property, or the CFC acquired the property and added substantial
value thereto. 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 as used
in an active trade or business if the CFC lessor, through its own
employees, operates an organization in a foreign country that
regularly engages in marketing and servicing the leased property
and such organization is substantial in relation to the amount of
rents derived from leasing the property.3
Similarly, royalty income received
unrelated persons as part of the active conduct of a
trade or business by the CFC is not FPHCI. Royalties are
considered as derived in the conduct of an active trade or business
if the CFC developed, created, or produced the intangible property,
or acquired the intangible property and added substantial value
thereto. In addition, the active business test is satisfied if the
CFC licensor, through its own employees, operates an organization
in a foreign country that regularly engages in marketing and
servicing the intangible property and such organization is
substantial in relation to the amount of royalties derived from
licensing the intangible property.4
Rents and royalties received by a CFC
related CFC where the related CFC uses the property
in its trade or business generally are not FPHCI under the
look-through rule of §954(c)(6).5 Rental or royalty
income is FPHCI, however, to the extent the rental or royalty
expense reduces Subpart F income of the CFC lessee or licensee.6
Rents and royalties derived from leasing or licensing property
to a disregarded entity are not FPHCI (whether or not the property
is used in such entity's trade or business) because such payments
are disregarded for U.S. tax purposes.7
For example, a Luxembourg CFC may own tangible or intangible
property that it leases or licenses, respectively, to a wholly
owned German entity that by election is disregarded for U.S. tax
purposes. The German entity uses the property in its business of
manufacturing and selling products. The rental or royalty payments
made by the German entity to the Luxembourg CFC are disregarded for
U.S. tax purposes. Rather than generating rental or royalty
income, the income earned with respect to the ownership of that
property is embedded in manufacturing, sales, or services income
derived by the Luxembourg CFC (which includes the German
Subpart F: Gain on the Sale of Leased or
A CFC at some point may sell property
that it leases or
licenses. Section 954(c)(1)(B) generally provides that FPHCI
includes gains in excess of losses from the sale of: (1) property
that gives rise to certain types of passive income (which includes
rental and royalty income); and (2) "property that does not give
rise to income."9 Therefore, gain on the
sale of leased or licensed property generally constitutes
Nevertheless, FPHCI does not
include gain on the sale of
property that is leased or licensed to unrelated persons where the
rental or royalty income qualifies for the active trade or business
exception described above. This exception applies whether the
property is sold to a related person or to an unrelated
In contrast, no exception is provided for gain on the sale of
property leased or licensed by a CFC to a related person. That gain
is FPHCI even if the rents or royalties are excluded from the CFC's
FPHCI under the look-through rule (or the same country of use
exception). Moreover, no exception applies even if the CFC
manufactured or developed the property or used the property in the
active conduct of a leasing or licensing business. The lack of any
exception to FPHCI is inconsistent with the policy of generally
excluding income arising with respect to leased or licensed
property that is used in a business.
Gain on the sale of property
leased or licensed to a disregarded
entity can be FPHCI if it is considered as property that "does not
give rise to any income." The regulations broadly define that
phrase to potentially include all property that does not give rise
to periodic income (e.g., a piece of art work) or property that
itself does not directly generate current income (e.g., machines
used in a manufacturing business).11 Nevertheless,
the regulations provide that this category of FPHCI does not
include gain on the sale of property used in the CFC's trade or
exception is available for tangible personal property, real estate,
and intangible property.
Accordingly, gain on the sale of property used by a CFC in its
manufacturing, sales, or services business generally is not FPHCI,
whether sold to a related or unrelated person. The gain is not
FPHCI even if the CFC derives Subpart F sales or services income
from using the property.13 Thus, this
exception is available to a CFC that sells property leased or
licensed to a disregarded entity. Therefore, gain on the sale
of the property leased or licensed by the Luxembourg CFC to its
German disregarded entity in the above example would not be
In sum, gain on the sale of
property leased or licensed to
unrelated persons in the active conduct of a trade or business is
not FPHCI. 15 In
addition, gain on the sale of property leased or licensed to a
disregarded entity for use in a trade or business is not
FPHCI. 16 But, gain on
the sale of property leased or licensed to a related person is
FPHCI, and there is no exception. In the last situation,
consideration may be given to using a disregarded entity
This commentary also will
appear in the June 2014 issue of
the Tax Management International Journal. For
more information, in the Tax Management Portfolios, see Yoder,
Lyon, and Noren, 6220 T.M., CFCs - Foreign Personal Holding
Company Income, and in Tax Practice Series, see ¶7150,
U.S. Persons - Worldwide Taxation.
2 A person is related to a CFC if such
controlled by the CFC or is controlled by the same persons that
control the CFC. For this purpose, control means, with respect to a
corporation, the direct or indirect ownership of more than 50% (by
vote or value) of the stock of such corporation. §954(d)(3).
3 §954(c)(2)(A); Reg. §1.954-2(b)(6), Reg.
§1.954-2(c). Under a safe harbor, an organization in a foreign
country is considered as substantial in relation to the amount of
rents received if the active leasing expenses equal or exceed 25%
of the adjusted leasing profits.
4 §954(c)(2)(A); Reg. §1.954-2(b)(6),
§1.954-2(d). Under a safe harbor, an organization in a foreign
country is considered as substantial in relation to the amount of
royalties received if the active licensing expenses equal or exceed
25% of the adjusted licensing profits.
5 Section 954(c)(6) has expired for
after Dec. 31, 2013, but is expected to be extended.
See Description of the Chairman's Mark of the
"Expiring Provisions Improvement Reform and Efficiency (EXPIRE)
Act," JCX-26-14 (Apr. 1, 2014).
6 See Notice 2007-9, 2007-5
See also §954(c)(3)(A); Reg. §1.954-2(b)(5) (similar
exception for rents or royalties received by a CFC from a related
corporation for use of the property in the country where the CFC is
12 This is consistent with the legislative
which states that this rule "is not intended to apply to gain on
the sale of land, buildings, or equipment used by the seller in an
active trade or business of the seller at the time of the sale."
H.R. Rep. No. 841, 99th Cong. 2d Sess., II-615 (1986).
13 See Yoder
and Lyon, "Intangible
Property Used Outside the United States: Active vs. Passive
Treatment of Royalties and Gain," 5 J. of Tax'n of Global
Trans. 39 (Winter 2006); Yoder, "Subpart F: Gain From the
Sale of Intangible Property," 39 Int'l Tax J. 3
14 If a CFC derived rents or royalty income from
leasing or licensing property to a related CFC for a period of time
and later an election was made to disregard the lessee or licensee,
consideration should be given to the change-in-use rule. Reg.
15 See also §954(c)(1)(B)(i)
not include gain on the sale of property that gives rise to income
that is not FPHCI under §954(h)); Yoder, "Gain from the Sale of a
Finance Business Treated Favorably for Subpart F Purposes," 42
Tax Mgmt. Int'l J. 102 (Feb. 8, 2013).
16 Gain that is not FPHCI may also
need to be
tested under the foreign base company sales income rules. Reg.
§1.954-1(e)(4)(ii). See §954(d); Reg.
§1.954-3(a)(1)(i) (exception to definition of foreign base company
sales income for certain property sold as part of discontinuing a
CFC's trade or business).
17 Other tax consequences of a disregarded entity
structure should be considered. See Yoder, "Code Sec.
954(c)(6) and the Same Country Rules for Sales and Services
Income," 6 J. of Tax'n of Global Transactions 3 (Fall
2006); Yoder, "Living Without Code Sec. 954(c)(6)," 37 Int'l
Tax J. 3 (Jan.-Feb. 2011).
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