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By Lowell D. Yoder, Esq.
McDermott Will & Emery LLP, Chicago, IL
Income derived by a controlled foreign corporation (CFC) of a U.S. corporation from the purchase and sale of products generally is not subject to U.S. taxation. However, such income is subject to current U.S. taxation under "Subpart F"1 if the income falls within the definition of foreign base company sales income (FBCSI).2
Sales income derived in many foreign supply chain distribution structures is not FBCSI. Generally, the FBCSI rules do not apply where a CFC purchases property from an unrelated person and sells the property to an unrelated person. For this purpose, purchases from or sales to disregarded entities are not considered as related-party transactions, and paying service fees to related persons for purchasing or selling assistance does not trigger the application of the FBCSI rules. Under certain circumstances - where purchasing or selling activities are carried on in a branch of the CFC - a special rule can apply to treat the branch's income as FBCSI, but such rule does not apply if the branch's income is subject to tax at a rate that is not materially lower than the tax rate in the home country.
General definition of FBCSI. In order for income from the purchase and sale of property to be Subpart F income under the general FBCSI rule, a CFC must either purchase the property from a related person or sell the property to a related person.3 Included in this definition is income derived by a CFC (in the form of commissions or fees) from the purchase or sale of property on behalf of a related person.
For example, income derived by a Swiss CFC from selling products purchased from a related U.S. company, or purchased from a related German company, generally is FBCSI. In addition, income derived by an Irish CFC from selling products to a related U.S. company or related Italian CFC that the Irish CFC purchased from unrelated suppliers generally is FBCSI.
Nevertheless, such income should not be FBCSI if the products are either manufactured in the CFC's country of organization, or sold for use in such country.4 For example, the Irish CFC's sales income should not be FBCSI if the products sold were manufactured in Ireland.5
Unrelated purchase and unrelated sale. Income derived by a CFC from selling products to unrelated persons that were purchased from unrelated persons generally falls outside the definition of FBCSI. For example, income earned by the Swiss CFC or the Irish CFC from selling products to unrelated customers throughout Europe that were purchased from an unrelated U.S. or French manufacturer generally should not constitute FBCSI. It does not matter where the products are manufactured or where the customers are located, as long as the products are purchased from unrelated persons and sold to unrelated persons (subject to the branch rule discussed below).
No purchase. Income derived by a CFC from the sale of products it did not purchase also generally should not be FBCSI. The definition of FBCSI requires that the CFC purchase and resell property.6 For example, income from a sale by a CFC of computer software that it develops pursuant to a cost-sharing arrangement generally should not be FBCSI, even if the other cost-sharing participant is a related person.
Related person assistance. Sales income does not become FBCSI merely because a related person provides purchasing assistance to the CFC. For example, a Hong Kong CFC may hire a related Chinese corporation to locate products manufactured by unrelated Chinese manufacturers and negotiate terms of supply agreements. If the Hong Kong CFC purchases the products directly from the Chinese manufacturers, the fact that it pays a service fee for procurement services to the Chinese related corporation does not result in a related-person transaction for the Hong Kong CFC for purposes of the FBCSI rules.7
In addition, sales income is not treated as FBCSI as a result of a related person's assisting with selling the products. For example, a Dutch CFC may hire a related German commissionaire to solicit sales and sell products to unrelated German customers, with title passing to the customers directly from the Dutch CFC. Again, this related-party services relationship is not one that triggers the application of the FBCSI rules to the sales income earned by the Dutch principal.8
A CFC may hire a related person to manufacture products on its behalf. For example, a CFC purchases raw materials and components from unrelated persons, and consigns them to a related person to manufacture finished products. The CFC then sells the finished products to unrelated persons. The CFC's income should not be FBCSI because it neither purchased property from related persons nor sold property to related persons.9
Thus, the FBCSI rules should not apply to a CFC functioning as a distributor principal merely by reason of the CFC paying a service fee to related persons to assist with purchasing, selling, or manufacturing activities. Accordingly, a CFC receiving such related person assistance does not derive FBCSI when it does not purchase property from related persons nor sell property to related persons (subject to the branch rule).
Disregarded entities. A purchase from, or sale to, a disregarded entity is not a related-person transaction for purposes of the FBCSI rules because such transactions are ignored for tax purposes.10 For example, an Irish CFC functioning as a master distributor may sell products to its U.K. subsidiary for resale to unrelated U.K. customers. An election is made to disregard the U.K. entity, and thus the sale from the Irish CFC to the U.K. entity is not a related-party sale. The same result would follow if the Irish and U.K. entities were owned by the same foreign parent and elections were made to disregard both entities.
A similar analysis applies to purchases of products from disregarded related entities. For example, a Hong Kong CFC could own a Chinese procurement subsidiary that elects to be disregarded. A purchase of products by the Hong Kong master distributor from the Chinese disregarded subsidiary should not give rise to a related-person transaction.
Sales branch rule. A CFC that does not purchase products from related persons nor sell products to related persons can, nevertheless, be subject to the FBCSI rules if it engages in purchasing or selling activities in a branch outside of its country of organization. Under these circumstances, income of the branch (but not income of the home office) can be FBCSI if a tax rate disparity test is met.11
The sales branch rule potentially applies only when the CFC through its own employees engages in purchasing or selling activities in a foreign branch. A CFC that hires a related or unrelated corporation to perform purchasing or selling services in a country different from where the CFC is organized is not considered to have a branch in such country as a result of receiving such services.12
In the event a CFC conducts purchasing or selling activities in a foreign branch, the sales branch rule applies only if there is a tax rate disparity (TRD) with the home office. The TRD test is met where the branch's income derived from purchasing or selling activities is taxed at an effective tax rate that is both less than 90% of, and at least five percentage points less than, the effective tax rate that would apply to such income in the CFC's country of organization.13 The purchasing or selling branch rule is intended to apply only where a CFC reduces its taxes in a higher tax home country by deriving income in a lower tax branch from conducting purchasing or selling activities in the branch.14
Assume the facts above where an Irish CFC is selling products through a U.K. disregarded entity. The sales branch rule potentially applies because the CFC is engaging in selling activities in a foreign branch. Nevertheless, if the home office in Ireland is subject to a 12.5% tax rate and the U.K. branch is subject to a 22% tax rate, the sales branch rule should not apply (because the branch is subject to a higher tax rate than the home office).
A similar analysis applies to the Hong Kong CFC in the example above which engages in purchasing activities in a branch in China (i.e., the disregarded entity). Again, the sales branch rule should not apply if the home office in Hong Kong is subject to a 16.5% tax rate and the Chinese branch is subject to a 25% tax rate.
If a parent company organized in a low tax rate country conducts purchasing and selling activities in branches, the sales branch rule should not apply. For example, the sales branch rule should be inapplicable where a Bermuda CFC is the owner of a purchasing or selling disregarded entity because Bermuda does not have an income tax, and therefore the TRD test could not be satisfied.15
When the TRD test is met and the branch rule applies, the branch is generally considered as a separate CFC that purchases or sells products on behalf of a related person. Absent an exception, the branch's income would be FBCSI. Nevertheless, the income derived by the home office should not be FBCSI.
If the income derived by the branch is from selling products for use in the country where it is located, then its income should qualify for the same-country-of-sale exception (e.g., the U.K. branch's sales income would not be FBCSI to the extent the products are sold for use in the United Kingdom). In addition, if the products are manufactured in the branch's country, then the income should qualify for the same-country-of-manufacture exception (e.g., the Chinese branch's purchasing income should not be FBCSI to the extent the products are manufactured in China).16
The sales branch rule should not result in FBCSI where a CFC that engages in purchasing and selling transactions with unrelated persons becomes a disregarded entity of a holding company. The regulations provide that purchasing or selling activities performed through a branch will not be treated as performed "on behalf of" the remainder where the remainder does not engage in any purchasing, manufacturing, or selling activities.17 Under these circumstances, the branch rule would not operate to create a related-party transaction (even if the income of the branch is subject to a low tax rate). For example, the sales branch rule should not result in FBCSI where the branch purchases products from unrelated persons and sells the products to unrelated persons, and all purchasing and selling activities are performed in the branch.18 This should be the conclusion even if the branch pays a royalty to the home office for the use of intellectual property.
Under certain circumstances a CFC may engage in purchasing or selling activities in more than one branch. The branch rule applies separately to each branch. Accordingly, the TRD test should be applied to each branch on a separate basis by comparing the tax rate on income derived by the branch to the home office tax rate.19 Also, if the TRD test is met for one branch but not the other branch, the sales branch rule may potentially apply to income of the branch meeting the TRD test, but should not apply to income of the other branch.
A distributor principal may engage in purchasing or selling activities in more than one branch with respect to the same product. When reapplying the branch rule to a branch that meets the TRD test, a branch-to-branch transaction should not give rise to a related-party transaction, because the sales branch rule deems a related-party transaction only when purchasing or selling activities occur in the home office and in a branch.20
Under certain circumstances where a distributor principal hires a contract manufacturer to produce products on its behalf, the CFC might be considered as manufacturing the products sold under the substantial contribution definition of manufacturing.21 If a CFC is considered as manufacturing the products sold in a foreign branch, the sales branch rule does not apply.22 Nevertheless, more analysis would be required to determine whether the manufacturing branch rule might apply.23
In summary, many distribution supply chain structures are outside the scope of the FBCSI rules because the property is purchased from and sold to unrelated persons. A taxpayer, nevertheless, must carefully navigate the branch rules, which are complex and sometimes unclear in their application.
This commentary also will appear in the June 2013 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.
2 FBCSI is included in the gross income of the U.S. shareholders of the foreign subsidiary. §951(a). See also §882 (a foreign corporation is subject to direct U.S. taxation on sales income that is effectively connected with the conduct of a U.S. trade or business).
7 If the income derived by the Chinese CFC is considered as purchasing income within the meaning of §954(d), it should not be FBCSI to the extent the products are manufactured in China. See also §954(e) (income derived from providing services to related persons is not foreign base company services income if the services are performed in the CFC's country of organization).
8 If the income derived by the German CFC is considered as selling income within the meaning of §954(d), it should not be FBCSI to the extent the products are sold for use in Germany. See also §954(e) (income derived from providing services to related persons is not foreign base company services income if the services are performed in the CFC's country of organization).
13 The determination of tax rates is based on local law. Regs. §1.954-3(b)(2)(i)(e). See Regs. §1.954-3(b)(1)(ii)(b) (the above determinations take into account actual tax treatment "by statute, treaty obligation or otherwise…."); PLR 200942034; PLR 200945036; PLR 201002024. See also Yoder, "Local Law Governs Manufacturing Branch Determinations," 36 Int'l Tax J. 3 (July-August 2010).
17 Regs. §1.954-3(b)(2)(i)(b) and (ii)(b). See Preamble to Proposed Regulations, 73 Fed. Reg. at 10721 ("Section 1.954-3(b)(2)(i)(b) and (ii)(b) are intended to apply only to purchasing or selling by a branch with respect to personal property manufactured, purchased, or sold by `the remainder of' the CFC…").
18 Regs. §1.954-3(b)(2)(i)(b) and (ii)(b), (b)(4), Ex. 3; REG-124590-07, 73 Fed. Reg. at 10721 (2/28/08). See Yoder, "Limits on the Application of the Subpart F Branch Rules," 38 Tax Mgmt. Int'l J. 366 (6/12/09).
20 There is confusing language in temporary branch regulations which may suggest that FBCSI could result under the sales branch rule by treating a branch as the remainder of another branch. Regs. §1.954-3(b)(2)(i)(b)(2) and (ii)(b)(2). This language has no basis in the Code and the sales branch rule has never been applied in this manner. The intent of the sales branch rule is that it apply only when income is shifted away from the country where the CFC is organized to a low-tax purchasing or selling branch.
22 Regs. §1.954-3(b)(1)(ii)(c)(1); T.D. 9438, 73 Fed. Reg. at 79342. The regulations apply the manufacturing branch rule even where the CFC does not rely on the manufacturing exception, e.g., where there is no related-person transaction. See Yoder, "Final and Temporary Subpart F Contract Manufacturing Regulations," 35 Int'l Tax J. 3 (March-April 2009).
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