2. Discussed in this Module Policy Overview of “Subpart F” (§§ 951-964) How Subpart F Accelerates U.S. tax on a CFC’s earnings Branch Rules Foreign Personal Holding Company Income Look-through Rules Non-Dividend Repatriation Planning for Distributions of PTI 2
11. “Tainted” Income U.S. tax arises only if a CFC earns “tainted” income but only to the extent of earnings & profit Personal holding company income (inherently passive items) dividends, interest, rents, royalties etc. Exceptions: Look Through and same country exception through January 1, 2010 Foreign Base Company Income Section 956 income (earnings invested in U.S. property) 6
12. “Tainted” Income Such subpart F income is taxable as a dividend and a foreign tax credit is available. Upon a subsequent distribution the dividend is not taxed but it is treated as previously taxed income. 7
14. 9 Base Company Income has four categories FBCI FPHCI FBCSvI FBCSI FBC oil related income
15. Additional §951 inclusion under Subpart F not discussed in the Module Foreign base company oil related income Insurance income Bribe income Boycott income Income from blacklisted countries Withdrawals from investments in less developed countries Section 956 – (will be discussed later) 10
16. A simple explanation FBCSI represents income from certain related party transactions where the products acquired or sold do not have a economic and legal connection to the CFC’s country of incorporation because they were not manufactured or consumed in the CFC’s country of incorporation. 11
17. Base Company Sales IncomeDefined in §954(d)(1) The purchase from a related person and sale to any person, The purchase from any person and sale to, a related person, and the purchase from any person or sale to any person on behalf of a related person. 12
18. In case of property sold on behalf of a related person, the property which is sold) is manufactured, produced, grown, or extracted outside the country under the laws of which the controlled foreign corporation is created or organized and; the property is sold for use, consumption, or disposition outside such foreign country, or, in the case of property purchased on behalf of a related person, is purchased for use, consumption, or disposition outside such foreign country. 13
19. Base Company Sales Income The “foreign base company sales income” referred to means income from the purchase and sale of property, without any appreciable value being added to the product by the selling corporation. 14
20. Policy Overview U.S. Mfg. Example- Separation of selling in manufacturing from to achieve a lower tax liability 100% Lower Tax No Mfg Country Y Buyer Country X 15
24. How Subpart F Operates U.S. Sales Outside Luxembourg constitute FBS Income 100% Luxembourg (Mfg.) Sells Product UK Buyer Luxembourg Sales Office 19
25. How Subpart F Operates U.S. “Base Company Sales Income” 100% Luxembourg (Mfg.) Sells Product UK Buyer Luxembourg Sales Office 20
26. Exceptions to the FBCSI If product is purchased and sold to unrelated party Product is manufactured in the home country of incorporation of the CFC Product that is manufactured by the CFC (954(d)(1) (Substantial Transformation Test) Product sold for use and consumption in the CFC country of incorporation (same country exception) 21 Product that is manufactured by the CFC (Proposed Reg. 1.954-3(a)(4)(iv)(b)) (Substantial Contribution Test) Issued December 24, 2008
27. Product that is manufactured by the CFC (Substantial Contribution Test) The CFC satisfies the test if all the facts and circumstances clearly demonstrate that the CFC made a substantial contribution through the activities of its employees to the manufacture of the Property. See Proposed Reg. 1.954-3(a)(4)(iv)(a) 22 through the activities of its employees
28. Old Regulations - Test 1“Substantial Transformation” If purchased personal property is substantially transformed prior to sale, the property sold will be treated as having been manufactured, produced, or constructed by the selling corporation. 23
29. Old Regulations - Test 2Provides when a CFC is considered Manufacturing If the activities of the CFC are “substantial in nature” and are considered to constitute manufacturing” “substantial in nature” – safe harbor test provided where conversion costs account for 20% of the cost of goods sold. 24
30. Old Regulations Substantial Transformation Of Property Examples in Treasury Regulation 1.954-3(a)(4)(ii) The transformation of wood pulp to paper The transformation of steel rods to screws and bolts The transformation of fish into canned fish 25
35. Under the New RegulationsHow is the Substantial Contribution Test is Applied ? 28 US P Property is delivered to a contract manufacturer under terms of agreement CFC 2 Country X CFC 1 Country X Property is purchased from a related party Unrelated CM Country Y
36. How is the Substantial Contribution Test is Applied ?Continued… 29 CFC1 owns intellectual property used in manufacturing process CFC 1 retains the right to control raw materials, work in process, finished goods and right to oversee and direct activities or processes but does not exercise through its employees, its powers to control the raw materials, WIP, FG and does not exercise powers of oversight and direction. CFC 1does not through its employees direct the use or development of the intellectual property CFC 1 Country X Unrelated CM Country Y CM performs substantial transformation, assembly and conversion outside of Country X
37. How is the Substantial Contribution Test is Applied ? 30 CFC 1 Country X Finally CFC 1 sells the finished product outside Country X Buyers Country T RESULTS nosubstantial contribution to manufacturing
38. CFC 1 does not satisfy the substantial contribution test because it does not make a substantial contribution through the activities of its employees to the manufacture of the product. Mere contractual rights to control materials and to direct the manufacturing activities or process pursuant to which the property is manufactured, along with ownership of intellectual property are not sufficient to satisfy the test. 31 Explanation of Results
39. Change the Facts - Example Assume the same facts except for the following: CFC 1 through its employees, engages in designing the product, participating in quality control and maintain control over manufacturing and related logistics. Moreover, employees of CFC 1 exercise the right to oversee and direct the activities of CM in the manufacture of product. 32
40. Result Under the facts and circumstances of the business, CFC 1 would satisfy the test because it makes a substantial contribution through the activities of its employees to the manufacture of product. 33
41. Another ExampleContract Manufacture 34 CFC 1 Country X CM Country Y CM provides its own materials and physically performs the substantial transformation, outside CFC 1 home country of incorporation Buyers Country T
42. Additional Information Employees of CFC 1 select the materials that will be used to manufacture CFC 1 does not own the materials or work-in-process during the manufacturing process. However, CFC 1 through its employees, exercises oversight and direction of the manufacturing process and provides quality control. CFC 1 manages the manufacturing costs and capacities with respect to the product by managing the risk of loss and engaging in planning and production scheduling. 35
43. Question 36 CFC 1 Country X CM Country Y Buyers Country T Is there a subpart F pickup here?
44. Result If the manufacturing activities undertaken with respect to product occur through the activities of its employees prior to sale then CFC 1 would qualify for the manufacturing exception because it makes a substantial contribution through the activities of its employees to the manufacture of product. 37
47. FBCSvI Policy Overview Performing services “For, or on behalf of” Substantial Assistance Test 40
48. Policy Overview U.S. Sells Items that Require Service Contracts Low Tax Country Y Buyer Country X Services the Product as a condition of the sale 41
49. Policy Purpose for BCSvI Deny tax deferral where the service subsidiary is separated from the manufacturing activity or related corporation and organized in a country to obtain a lower tax rate from service income Exception Same Country Exception Unrelated Person 42
50. FBCSvI §954(e)(1) Income (whether in the form of compensation, commissions, fees, or otherwise) derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial or like services which CFC performs for or on behalf of a related person (954(e)(1)(A) ) Outside the country of incorporation (954(e)(1)(B) ) 43
51. “For, or on behalf of” Services must be performed “for, or on behalf of,” a related person to constitute foreign base company services income. The regulations identify four situations where a CFC is to perform services for, or on behalf of, a related person when the services are not directly provided to a related person, but the related person is involved with the services transaction 44
52. “For, or on behalf of”Treas. Reg. § § 1.954-4(b)(1)(i) thru (iv) The receives a financial benefit from, a related person for performing services CFC performs services which a related person was obligated to perform CFC performs services for the property sold by a related person and that performance constitutes a condition of the sale The CFC receives substantial assistance from a related person by performing the CFC's services 45
53. Substantial Assistance TestTreas. Reg. 1.954-4(b)(2)(ii) If substantial assistance furnished by a related person then, the CFC is deemed to have provided services (i.e. supervision, know-how, financial assistance and equipment, material, or supplies). Test of substantial - If assistance is a principal element in producing the income 46
54. Measuring “if assistance is the “Principal Element” The cost to the controlled foreign corporation of the assistance furnished equals or exceeds 50% or more of the total cost to of the services performed by such corporation. 47
55. Example – Substantial Assistance §1.954-4(b)(3) 48 US B Manufactures and sells machines to C B Pays A to do installation and maintenance CFC A CFC B CFC C
56. Exceptions to FBCSvI An exception to the definition of foreign base company services income is provided for income derived by a CFC in connection with certain services related to sales of property which is produced, manufactured, grown or extracted by the CFC. See I.R.C. §954(e)(2); Treas. Reg. §1.954-4(d). 49
59. Congressional Concerns Companies may circumvent anti-deferral by using a branch company Separation of the sales and manufacturing functions inappropriately Causes profits to end up in a lower tax jurisdiction 52
60. General Rule - §954(d)(2) Branch rule is implicated where a CFC carries on purchasing or selling activities by or through a branch outside the CFC’s country of incorporation and using that branch has substantially the same tax effect as if the branch were a wholly owned subsidiary. Branch is then treated as a separate corporation in determining FBCSI. 53
61. General Rule - §954(d)(2) The December Regulations treat the branch rules as mutually exclusive: If the manufacturing branch rules apply the sales branch rules does not apply (i.e. no overlap) Note- There are different rules for sales and manufacturing branches 54
64. Sales Test Branch rule applies to sales/purchase branch when the tax rate imposed by the country where the branch is located is less than 90% of and at least 5 percentage points below the ETR if it had the income otherwise been earned in the country where the CFC is located MFG Country Y Sales Country X 57
65. Sales Test Compare the actual tax rate on income in country X to a hypothetical tax that would apply if those sales were earned in country Y Apply the rate disparity test MFG Country Y Tax determinations shall be made by taking into account only the income, war profits, excess profits, or similar tax laws (or the absence of such laws) of the countries involved. Treas. Reg. §1.954-3(b)(2)(i)(e) Sales Country X Test looks up 58
66. Mfg.Test The test is REVERSEDfor the Mfg branch Branch Rule applies if the tax rate in the country in which the CFC is organized is less than 90% of and at least five percentage points below, what it would be if the income was earned where the manufacturing branch is located. Sales Country Y MFG Country X 59 Test looks down
67.
68. Hypothetical tax is determined under foreign lawSales Country Y Test looks down MFG Country X 60
69. Manufacturing branches are tested separately Manufacturing branches are tested separately if the CFC manufactures “different” products in separate branches or hybrid entities. “Different”=“Distinct” 61 . Branch B Branch A Example Branches A&B are tested separately if they are making distinct products. NOTE:One branch cannot taint another Results
70. Testing Separately Country A sells to related and unrelated parties and does not make substantial contributions to the manufacturing through its employees. Country A does not tax Country B and C branches 62 . Sells Televisions Country A 10% Country B 12.5% UK 28% Manufactures flat screens (LCD’s) for TV’s Manufactures Television Chassis
71. Results 63 . Sells Televisions The Analysis starts with the Country B. The tax rate is not 5 percentage points below the tax rate in Country B that would apply if the LCD’s were sold in the Country B Test looks down Country A 10% Country B 12.5% Country C 28% Manufactures flat screens (LCD’s) for TV’s Manufactures Television Chassis
72. Results - Continued 64 . Sells Televisions Next, analyze the Country C. The Country A rate is low taxed when compared with Country C if the Chassis were sold through the Country C branch. Therefore, the branch rules apply to the chassis but not to the LCD’s. Test looks down Country A 10% Country B 12.5% Country C 28% Manufactures Flat screens for TV’s Manufactures Television Chassis
73. Discussion The branch rules do not automatically mean that the income is FBCSI but that the parent company and the branches are treated as separate CFC’s. The income from Country B is not tainted and therefore excluded however, the income from Country C is included and currently taxable assuming no exception applies. 65
74. Two tests…but six procedural steps Identify the sales and purchasing locations Determine the ETR in the locations Identify what locations the sales or purchasing should be compared with to determine whether low-tax jurisdiction exists Determine how the sales and purchasing would have been taxed in the manufacturing or the country of incorporation (if relevant) Apply the tax rate disparity test (mechanical test) Determine the otherwise FBCSI 66
75. Discussion - The Substantial Contribution Test Under the December Regulations, if the substantial contribution test is met then, it is the same as physical manufacturing. So if only one location satisfies the substantial contribution test then that location represents the manufacturing location for purposes of applying the branch rules. 67 . Did not meet the substantial contribution test so tax rate disparity test is applied against B Test 2 looks down A Sales B Mfg C Mfg Test 1 looks
76. Trying to locate the tested manufacturing branch when more than one location satisfies the manufacturing test 68 . Sells Televisions If more than one location independently satisfies the manufacturing test on the same item of property then, the location with the lowest ETR is the manufacturing location Country 10% Country 18% Country 21% Manufactures Television Chassis Manufactures Television Chassis
77. 69 . Sells Product Country A 10% Country B 12.5% Country C 28% Ships Product to unrelated CM Substantial Contribution made through its employees to Product of CM Contract Manufacturer Country D
78. 70 . Result The branch rule does NOT apply... Substantial transformation test is met by country C branch AND, the new substantial contribution test is met by Country B branch. Therefore, the branch rule uses only the 12.5% rate for the tax rate disparity test. Country A 10% Country B 12.5% Country C 28% Contract Manufacturer Country D
79. What happens if no single location satisfies the manufacturing test when substantial contribution is present? 71 Assume substantial contribution made to mfg through its employees by CFC 1 identify the sales location that should be tested CFC 1 Sales CM Final Product CM Components Identify purchasing locations.
80. Group various locations together (i.e. all locations that are not treated as “high-tax” are grouped together and all locations that are treated as “low-tax” are grouped together) 72 CFC 1 Sales CM Final Product CM Components
81. Determine which grouping that provides the “demonstrably greater” contribution to manufacturing and test that grouping first. 73 CFC 1 Sales CM Final Product CM Components
82. This example assumes the low tax jurisdictions provides the “demonstrably greater” contribution to the manufacture than the “high-tax” jurisdictions. 74 CFC 1 Sales CM Final Product CM Components
83. Perform tax rate disparity test on low tax jurisdictions 75 CFC 1 Sales CM Final Product CM Components
84. After you do the tax rate disparity test how much income is FBCSI? What if you have included in some of the low tax groupings locations that do not purchase or sell. Is this included as FBCSI? The branch rule is intended to tax sales and purchasing income that has been separated from the manufacturing process. However, the December Regulations are not quite clear on this issue. 76 Question?
85. Debrief Step 1 – identify the tested sales and purchasing locations. Step 2 – group various locations together (i.e. all locations that are not treated as “high-tax” are grouped together and all locations that are treated as “low-tax” are grouped together) Step 3 – determine which grouping provides the demonstrated greater contribution to manufacturing Step 4 – perform tax rate disparity test on that grouping first Step 5 – Include FBCSI as subpart F 77
86. International Tax Planning Issues to Consider Suppose a CFC purchases manufactured product from an unrelated party and sells to an unrelated party? Assume also that the CFC makes a substantial contribution through its employees to the manufacture of the final product. Is there FBCSI? Do the branch rules apply? 78
89. FPHCI Includes… FPHC income is that portion of income that includes: dividends, interest, royalties, rents, and annuities the excess of gains over losses from the sale or exchange of property on certain property where a deemed dividend occurs other items: f(x) currency gains, interest equivalents, commodity transactions (list is not all inclusive) 81
90. Exceptions to FPHCI Temporary provision granting look-through rules beginning after December 31, 2005 and before January 1, 2010. Applies to dividends, interest, rents and royalties to the extent not allocable to subpart F income Exception provided for rents and royalties from a related corporation received for the privilege of using property within the country where the CFC is organized (same country exception) Active Trade or Business Exception for rents and royalties (Treas. Reg. §1.954-2(b), (c) and (d)) Export Financing (banks only) 82
91.
92. Payor ─ is organized under laws of same country as CFC
93. Payor ─ uses substantial part of assets in trade or business in country of incorporation (50% test)83
94. How to Apply the Same Country Exception Rents and royalties ─ if CFC is incorporated where the property is used, payor is related and the royalty is for the privilege of using the property within the country of the laws of the CFC Exception – rents allocated to insurance income or FBCI 84
95. How to Apply the Same Country Exception Portfolio interest is not excluded Interest allocable to payor’s foreign base company income is not excludable Dividends must be paid out of E&P earned when the amounts were owed to the owner of the stock 85
96. Example ─ same-country exception rule GmbH 1 acquires GmbH 2 and GmbH 2 dividends up GmbH 1 RESULT Same country exception will not apply to pre-acquisition earnings & profit GmbH 2 86
97. Alternate Scenario of Same-Country Exception GmbH forms a Holding company to acquire GmbH Sub GmbH P RESULT GmbH Holding Same country exception should apply to pre-acquisition earnings & profit because GmbH held stock when GmbH Holding earned its E&P GmbH S 87
98. Process for Inclusion of “Subpart F income” (§954) ─ Determine income included as Subpart F (§954(b)(5)) ─ Allocate and Apportion Expenses (§954(b)(3);(4)) ─ Either full inclusion; de minimis exception or high tax exception (§952)(c)) ─ Is there an E&P limitation? 88
99. Full Inclusion Rule §954(b)(3)(B) If the sum of the foreign base company income and the gross insurance income for the taxable year exceeds 70% gross income, the entire gross income for the taxable year shall be treated as foreign base company income or insurance income (whichever is appropriate). 89
100. Exception For Certain Income Subject To High Foreign Taxes (“High Tax Exception”) income that was subjected to an effective rate of by a foreign country greater than 90 percent of the maximum U.S. rate of tax will not be considered FBC income. This exception does not apply to Oil related income. Shareholders must elect to exclude income under the high-tax exception (Treas. Reg. §1.954-1(d)(1)(i)). 90
102. Introduction Generally when a loan is made by a subsidiary CFC corporation to its parent or to another affiliate it is not considered a taxable event. However, Code Section 956, provides an exception, by treating an amount loaned by a controlled foreign corporation (CFC) to a related U.S. person as a deemed dividend to the CFC's U.S. shareholders. 92
103. Example 93 US Parent §956 is implicated to the extent of Earnings and Profit (unless an exception applies) S.A. GmbH
104. Non-Dividend Repatriation §956 Applies to U.S. shareholders of CFC Attempts to tax dividend equivalents Hypothetical deemed distribution Even if U.S. taxpayer had no “tainted” income, if the CFC makes a loan to the U.S. parent or invests in certain types of U.S. property, the U.S. taxpayer is taxed on the amount of that investment 94
105. Tax Court in Ludwig v. Comr. In Ludwig, the court rejected the Service's argument that a U.S. shareholder's pledge of CFC stock as collateral for a loan caused the CFC to be a “guarantor” of the loan and therefore subject to §956. The government argued that “[t]he purpose of section 956 of the Code is to terminate the tax deferment privilege with respect to the earnings of controlled foreign corporations when such earnings are directly or indirectly repatriated.” 95
106. The Treasury provides two exceptions to §956 Notice 88-108 provides “30/60” day exception These are obligations the CFC collects within 30 days as long as the CFC does not have loans outstanding during the year for 60 or more days Notice 2008-91 provides “60/180” day exception expanded the exception to obligations collected within 60 days as along as the CFC does not have loans outstanding to a related person during the year for 180 days or more 96
107. There is a General legal Advice Memorandum (“GLAM”) on Notice 2008-91 GLAM 2009-13 provides guidance with regard to multiple obligations of one or more CFC’s Provides insight in the governments' views on the application of §956 If taxpayer relies on “60/180” there is no requirement for a formal election Done on a CFC by CFC basis Applies for 2009, 2009 and 2010 97
108. GLAM Notes The GLAM points out that the CFC is deemed to have acquired property as of the date it acquires an adjusted basis in US property. This would include obligations on the date the loan was made or guaranteed. Counting days for obligations – date of issuance is excluded and the date of repayment is included. Counting days for purposes of §951-964 the holding period of the asset is determined by excluding the day the asset was acquired and including the day the asset was disposed. 98
109. What about a loan made on December 31st ? GLAM indicates (unless an exception applies) that §956 would apply to the loan for 2008 even though the date of issuance is not counted as a day in the holding period. 99
110. What about a series of loans? GLAM states that a series of loans must be executed independently or else periods of disinvestments will be ignored. GLAM holds that if it is determined a series of obligations constitutes successive rollovers of a single obligation then the disinvestment period will be ignored for the 60 and 180 day requirements. 100
119. Debrief Generally, in order for income to be considered foreign base company sales income, the property purchased must be manufactured or produced outside the country in which the CFC is organized and must also be sold for use outside that country. Sec. 954(d)(1)(A) and (B). 102
121. PTI distributions excluded from income I.R.C.§ 959 excludes from income distributions of E&P which were previously included into income (includes actual and deemed distributions) Section 959(d) generally provides that a distribution from PTI is NOT a dividend. Result upon distribution is that the CFC’s E&P and tax pools are immediately reduced to preclude the USSH from inappropriately gaining a 902 credit 104
122. Exception to non-dividend treatment A distribution of PTI through a chain of ownership. Section 960(a)(3) provides that, for purposes of calculating a U.S. corporate Shareholder's §902 credit for taxes paid on PTI as it is distributed through a chain of ownership to a U.S. Shareholder a distribution of PTI is counted as a dividend when ultimately received by the corporate U.S. Shareholder (where no credit was previously given under 960) 105
123. Planning for Distributionsunder the “Ordering Rules” A distributions is first deemed to made from earnings that were previously taxed and included into income as investments in U.S. property (I.R.C. §956) A distribution is next deemed to be made out of earnings that were currently or previously required to be included into income under §951(a)(1)(A). 106
124. Planning for Distributionsunder the “Ordering Rules” Finally, distributions that occur in excess of the CFC’s PTI are attributable to the remaining untaxed and undistributed E&P…first out of current then, accumulated E&P … 107
125. Planning for Distributions using a chain of corporations GmbH 2 invested 150 in U.S. property. The U.S. P must include 150 into income (I.R.C. §951(a)(1)(B)) U.S. P GmbH 1 US property GmbH 2 108
126. Planning for Distributions using a chain of corporationsAdditional Facts During the tax year GmbH dividends 150 to GmbH 1. The U.S. P does not have to include this into income under §951(a) due to the §959(b) exclusionary rule U.S. P GmbH 1 US property GmbH 2 109
127. Planning for Distributions using a chain of corporationsAdditional Facts Suppose GmbH subsequently invests in US property in the next year without the occurrence of a distribution, U.S. P would have to include into income because US p received the exclusion in the prior year U.S. P GmbH 1 US property GmbH 2 The exclusionary rule contemplates an actual distribution that must occur 110
128. Debrief Distributions of PTI are not considered a dividend (§959(d)) Distributions of PTI reduce E&P Exception is provided (§960 (a)(3)) 111
130. Disclaimers 113 The informal comments and the information presented in these slides should not be construed as constituting tax advice applicable to any specific taxpayer because each taxpayer’s facts are different. To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice mentioned in the presentation or contained in these slides is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transactions or matters addressed herein.
131. Contact Information 114 Seth Primosch Senior Accountant ParenteBeard, LLC 1650 Market Street, Suite 4500 Philadelphia PA 19103 seth.primosch@parentebeard.com Edward Umling CPA, LLM Senior Manager Urish Popeck LLC 3 Gateway Center, Suite 2400 Pittsburgh, PA 15222 Tel: 1 412 391-1994 eumling@urishpopeck.com
Editor's Notes
List is not all inclusive
AMENDMENTS2008 - Subsec. (c)(6)(C). Pub. L. 110-343 (Housing and Economic Recovery Act), Div. C, Sec. 304(a), amended subpar. (C) by substituting “January 1, 2010” for “January 1, 2009”.Subsec. (h)(9). Pub. L. 110-343, Div. C, Sec. 303(b), amended par. (9) by substituting “January 1, 2010” for “January 1, 2009”.
Subpart F income is defined as including foreign base company income. 103 The definition of foreign base company income (“FBCI”) is set forth in §954foreign base company income falls into 4 categories: foreign personal holding company income, foreign base company sales income and foreign base company services income.Section 954(g) includes income from processing transporting or distributing oil or gas if the activities are located in foreign countries other than the country in which the oil or gas is extracted
The internal revenue service defines FBCSI as income from certain related party transactions where the products do not have a connection to the CFC’s country of incorporation because they were not manufactured or consumed in the CFC’s country of incorporation.
in
The income of the subsidiary separated from the manufacturing from selling activities specifically to obtain a lower tax rate
Example of a direct sell would show a tax liability of 245 on sales of 800
If we were to interpose a subsidiary in another lower tax jurisdiction that lower tax jurisdiction in our example would incur 46 as a tax liability and the US side would incur 35
Foreign base company sales income does not include income from sales of property manufactured in the CFC's country of organization, nor does it include income from property sold for use in such country, regardless of related person involvement with the transactions. 112 Finally, income derived by a CFC from the sale of property manufactured by the CFC falls outside the definition of foreign base company sales income (subject to a special branch rule). 113
The manufacturing exception is explicitly stated in the regulations. Section 1.954-3(a)(4)(i) provides: Foreign base company sales income does not include income of a controlled foreign corporation derived in connection with the sale of personal property manufactured, produced, or constructed by such corporation in whole or in part from personal property which it has purchased. A foreign corporation will be considered, for purposes of this subparagraph, to have manufactured, produced, or constructed personal property which it sells if the property sold is in effect not the property which it purchased. The apparent tension between these two sentences epitomizes much of the dispute between taxpayers andthe Service. The first sentence suggests that manufacturing activities must be done ‘‘by such corporation [CFC]’’; whereas the second sentence suggests that purchasing and selling different items of personal property (regardless of the CFC’s activities) is sufficient.
1.954-3(a)(4)(iv)(a) In General. If an item of personal property would be considered manufactured, produced, or constructed (under the principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) prior to sale by the controlled foreign corporation had all of the manufacturing, producing, and constructing activities undertaken with respect to that property prior to sale been undertaken by the controlled foreign corporation through the activities of its employees, then this paragraph (a)(4)(iv) applies. If this paragraph (a)(4)(iv) applies and if the facts and circumstances evince that the controlled foreign corporation makes a substantial contribution through the activities of its employees to the manufacture, production, or construction of the personal property sold, then the personal property sold by the controlled foreign corporation is manufactured, produced, or constructed by such controlled foreign corporation.
Conversion costs = direct labor and factory overhead
Example 1Controlled foreign corporation A, incorporated under the laws of foreign country X, operates a paper factory in foreign country Y. Corporation A purchases from a related person wood pulp grown in country Y. Corporation A, by a series of processes, converts the wood pulp to paper which it sells for use in foreign country Z. The transformation of wood pulp to paper constitutes the manufacture or production of property for purposes of this subparagraph.Example 2Controlled foreign corporation B, incorporated under the laws of foreign country X, purchases steel rods from a related person which produces the steel in foreign country Y. Corporation B operates a machining plant in country X in which it utilizes the purchased steel rods to make screws and bolts. The transformation of steel rods to screws and bolts constitutes the manufacture or production of property for purposes of this subparagraph.Example 3Controlled foreign corporation C, incorporated under the laws of foreign country X, purchases tuna fish from unrelated persons who own fishing boats which catch such fish on the high seas. Corporation C receives such fish in country X in the condition in which taken from the fishing boats and in such country processes, cans, and sells the fish to related person D, incorporated under the laws of foreign country Y, for consumption in foreign country Z. The transformation of such fish into canned fish constitutes the manufacture or production of property for purposes of this subparagraph.
1.954-3(a)(4)(iv)(a) In General. If an item of personal property would be considered manufactured, produced, or constructed (under the principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) prior to sale by the controlled foreign corporation had all of the manufacturing, producing, and constructing activities undertaken with respect to that property prior to sale been undertaken by the controlled foreign corporation through the activities of its employees, then this paragraph (a)(4)(iv) applies. If this paragraph (a)(4)(iv) applies and if the facts and circumstances evince that the controlled foreign corporation makes a substantial contribution through the activities of its employees to the manufacture, production, or construction of the personal property sold, then the personal property sold by the controlled foreign corporation is manufactured, produced, or constructed by such controlled foreign corporation.
1.954-3(a)(4)(iv)(c) Application Of Substantial Contribution Test.When considering whether a controlled foreign corporation makes a substantial contribution to the manufacture, production, or construction of the personal property, the performance of any activity in paragraph (a)(4)(iv)(b) of this section will be taken into account. The performance or lack of performance of any particular activity in paragraph (a)(4)(iv)(b) of this section, or of a particular number of activities in (a)(4)(iv)( b) of this section, is not determinative. The weight accorded to the performance of any quantum of any activity (whether or not specified in paragraph (a)(4)(iv)(b) of this section) will vary with the facts and circumstances of the particular business. See paragraph (a)(4)(iv)(d) Examples 8, 10 and 11 of this section. In determining whether the activities of the controlled foreign corporation constitute a substantial contribution, there is no minimum performance threshold before an activity can be considered. The fact that other persons make a substantial contribution to the manufacture, production, or construction of the personal property prior to sale does not preclude the controlled foreign corporation from making a substantial contribution to the manufacture, construction, or production of that property through the activities of its employees. See paragraph (a)(4)(iv)(d) Example 9 of this section.
Takes from Example 1 Treas. Reg. 1.954-3(a)(4)(iv)(d)
Example 1. No substantial contribution to manufacturing.(i) Facts. FS, a controlled foreign corporation, purchases raw materials from a related person. The raw materials are manufactured (under the principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) into Product X by CM, an unrelated corporation, pursuant to a contract manufacturing arrangement. CM physically performs the substantial transformation, assembly, or conversion outside of FS's country of organization. Product X is sold by FS for use outside of FS's country of organization. Under the terms of the contract, FS retains the right to control the raw materials, work-in-process, and finished goods, and the right to oversee and direct the activities or process pursuant to which Product X is manufactured by CM. FS owns the intellectual property used in the manufacturing process. However, FS does not exercise, through its employees, its powers to control the raw materials, work-in-process, or finished goods, and FS does not exercise its powers of oversight and direction. Likewise, FS does not, through its employees, develop or direct the use or development of the intellectual property for the purpose of manufacturing Product X.(ii) Result. If the manufacturing activities undertaken with respect to Product X prior to sale had been undertaken by FS through the activities of its employees, FS would have satisfied the manufacturing exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this section with respect to Product X. Therefore, this paragraph (a)(4)(iv) applies. FS does not satisfy the test under this paragraph (a)(4)(iv) because it does not make a substantial contribution through the activities of its employees to the manufacture of Product X. Mere contractual rights to control materials, contractual rights to oversee and direct the manufacturing activities or process pursuant to which the property is manufactured, and ownership of intellectual property are not sufficient to satisfy this paragraph (a)(4)(iv). Therefore, under the facts and circumstances of the business, FS is not considered to have manufactured Product X under paragraph (a)(4)(i) of this section.
Example 3. Raw materials procured by contract manufacturer. Facts. FS, a controlled foreign corporation, enters into a contract with CM to manufacture (under the principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) Product X. CM physically performs the substantial transformation, assembly, or conversion required to manufacture Product X outside of FS's country of organization. Product X is sold by FS to a related person for use outside of FS's country of organization. Employees of FS select the materials that will be used to manufacture Product X. FS does not own the materials or work-in-process during the manufacturing process. FS, through its employees, exercises oversight and direction of the manufacturing process and provides quality control. FS manages the manufacturing costs and capacities with respect to Product X by managing the risk of loss and engaging in demand planning and production scheduling.(ii) Result. If the manufacturing activities undertaken with respect to Product X prior to sale had been undertaken by FS through the activities of its employees, FS would have satisfied the manufacturing exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this section with respect to Product X. Therefore, this paragraph (a)(4)(iv) applies. Under the facts and circumstances of the business, FS satisfies the test under this paragraph (a)(4)(iv) because it makes a substantial contribution through the activities of its employees to the manufacture of Product X. Therefore, FS is considered to have manufactured Product X under paragraph (a)(4)(i) of this section.
Example 3. Raw materials procured by contract manufacturer. Facts. FS, a controlled foreign corporation, enters into a contract with CM to manufacture (under the principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) Product X. CM physically performs the substantial transformation, assembly, or conversion required to manufacture Product X outside of FS's country of organization. Product X is sold by FS to a related person for use outside of FS's country of organization. Employees of FS select the materials that will be used to manufacture Product X. FS does not own the materials or work-in-process during the manufacturing process. FS, through its employees, exercises oversight and direction of the manufacturing process and provides quality control. FS manages the manufacturing costs and capacities with respect to Product X by managing the risk of loss and engaging in demand planning and production scheduling.(ii) Result. If the manufacturing activities undertaken with respect to Product X prior to sale had been undertaken by FS through the activities of its employees, FS would have satisfied the manufacturing exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this section with respect to Product X. Therefore, this paragraph (a)(4)(iv) applies. Under the facts and circumstances of the business, FS satisfies the test under this paragraph (a)(4)(iv) because it makes a substantial contribution through the activities of its employees to the manufacture of Product X. Therefore, FS is considered to have manufactured Product X under paragraph (a)(4)(i) of this section.
Employees of FS select the materials that will be used to manufacture Product X. FS does not own the materials or work-in-process during the manufacturing process. FS, through its employees, exercises oversight and direction of the manufacturing process and provides quality control. FS manages the manufacturing costs and capacities with respect to Product X by managing the risk of loss and engaging in demand planning and production scheduling.(ii) Result. If the manufacturing activities undertaken with respect to Product X prior to sale had been undertaken by FS through the activities of its employees, FS would have satisfied the manufacturing exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this section with respect to Product X. Therefore, this paragraph (a)(4)(iv) applies. Under the facts and circumstances of the business, FS satisfies the test under this paragraph (a)(4)(iv) because it makes a substantial contribution through the activities of its employees to the manufacture of Product X. Therefore, FS is considered to have manufactured Product X under paragraph (a)(4)(i) of this section.
“foreign base company services income” means income (whether in the form of compensation, commissions, fees, or otherwise) derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, or like services which
Under the first situation contained in the regulations, services will be considered as performed for, or on behalf of, a related person if the CFC is paid by a related person for performing the services. 723 For purposes of this rule, a CFC will be viewed as paid by a related person if it is paid directly, reimbursed, released from an obligation to a related person, or otherwise receives substantial financial benefit from a related person. This rule applies whether the services are performed directly for a related person, or are performed for an unrelated person.723Regs. §1.954-4(b)(1)(i).The regulations provide the following example illustrating the application of this rule when a CFC performs services for an unrelated person.Example: CFC is paid by a related person for the installation and maintenance of industrial machines which the related person manufactures and sells to a customer. The installation and maintenance services performed by CFC for the unrelated person are treated as performed for, or on behalf of, a related person because the CFC is paid by a related person for performing the services. 724724Regs. §1.954-4(b)(3), Ex. 1.Such income will be foreign base company services income if the services are performed outside of the CFC's country of incorporation.c. Related Person Obligated to Perform Services(1) General RuleServices performed by a CFC which a related person is (or has been) obligated to perform generally will be considered as services performed for, or on behalf of, a related person. 725 This rule applies whether or not the services are provided with respect to property sold by the related person. 726725Regs. §1.954-4(b)(1)(ii).726 Id.This provision may apply, for example, where a person related to the CFC enters a contract to provide services to an unrelated person, and assigns the contract to the CFC. This provision may also apply where a related person in the past was obligated to perform the services, and was released from such obligation before the CFC enters an agreement to provide the services. An exception to this general rule applies in certain situations where the related person participates in the transaction merely as a guarantor of the CFC's performance of the services.The application of this provision is illustrated in the regulations by the following example.Example: M Corporation is obligated under a contract with an unrelated person to construct a superhighway in a foreign country. M Corporation later assigns the entire contract to its wholly owned subsidiary, CFC, and the unrelated person releases M Corporation from any obligation under the contract. CFC's services rendered in connection with the construction of the superhighway under the contract are considered to be performed for, or on behalf of, a related person because a related person had been obligated to perform such services. 727727Regs. §1.954-4(b)(3), Ex. 5.This provision also would apply where a CFC acts as a subcontractor for a related person who is the general contractor on a project.(2) Exception for Related Person Guaranty of PerformanceIf certain conditions are satisfied, a CFC will not be considered to have performed services which a related person is, or has been, obligated to perform pursuant to a services contract under the above rule where the related person's obligation arose in connection with its guarantee of the performance of the services by the CFC. This exception will not apply if the related person has any other obligations under the arrangement, or performs any of the guaranteed services.For purposes of this exception, a related person will be considered to guarantee performance of the services by a CFC if the related person guarantees performance of such services by a separate contract of guarantee. 728 A related person guarantee also exists when the related person enters into a services contract solely for purposes of guaranteeing performance of such services and immediately thereafter assigns the entire contract to the CFC for execution. 729728Regs. §1.954-4(b)(2)(i).729 Id.For this exception to apply, the circumstances of the guarantee must meet the following requirements:• The related person's sole obligation with respect to the contract is to guarantee performance of the services;• The CFC is fully obligated to perform the services under the contract; and• The related person (or any other person related to the CFC) does not in fact:• pay for performance of, or perform, any of the guaranteed services, or• pay for performance of, or perform, any significant services related to the guaranteed services (e.g., if the CFC defaults). 730730 Id.If the related person giving the guarantee (or any other person related to the CFC) does in fact pay for performance of, or perform, any of the guaranteed services or any significant services related to such services, the services performed by the CFC will be deemed services rendered by the CFC which a related person is, or has been, obligated to perform.The regulations provide an example of the application of this exception to a situation involving a related person separately guaranteeing performance by the CFC.Example: CFC procures and enters into a contract with an unrelated person to construct a superhighway and CFC is capable of performing the contract, but the unrelated person enters into the contract on the condition that a related person agrees to perform, or to pay for performance, if CFC fails to perform under the contract. CFC completes its performance under the contract and no related person pays for, or performs, any services called for by the contract or any significant services related to such services. The CFC's services are not performed for, or on behalf of, a related person. 731731Regs. §1.954-4(b)(3), Ex. 4.Therefore, the services income earned by the CFC is not foreign base company services income, even if performed outside of the CFC's country of organization.The regulations provide the following example of the application of this exception to a situation where the related person enters into a service contract for the sole purpose of guaranteeing the CFC's performance of services.Example: M Corporation enters into a contract with an unrelated person to construct a superhighway in a foreign country. M Corporation immediately assigns the contract to its wholly owned subsidiary, CFC. M Corporation is not released by the unrelated person upon the assignment of the contract to CFC. The sole purpose of having M Corporation on the contract, however, is to have it guaranty performance of the contract by CFC. CFC is capable of performing the construction contract. No related person pays for, or performs, any services called for by the contract or any significant services related to such services. The construction of the superhighway by CFC is not considered the performance of services for, or on behalf of, related person. 732732Regs. §1.954-4(b)(3), Ex. 6.On the other hand, guarantees will be considered as giving rise to income for services performed for, or on behalf of, a related person where the related person performs significant services related to the services the performance of which it has guaranteed. This is illustrated by the following example from the regulations.Example: Assuming the same facts as in the previous example, if M Corporation, preparatory to entering the superhighway construction contract, prepares plans and specifications which enable the submission of bids, then M Corporation will have performed significant services related to services which it has guaranteed. Therefore, CFC's construction services under the superhighway construction contract will be considered performed for, or on behalf of, a related person. 733733Regs. §1.954-4(b)(3), Ex. 7.This exception for related person guarantees also apparently would not apply if in connection with its guarantor obligation the related person agrees to finance the customer's payments for the CFC's services.As described below, under the fourth definitional category a CFC will be viewed as performing services for, or on behalf of, a related person if the related person provides substantial assistance to the CFC. The regulations clarify that the standards for determining the application of the exception for services involving related person guarantees is different from the substantial assistance standard. 734 Therefore, if a related person, with respect to guaranteed services, pays for or performs the guaranteed services, or performs any significant services related to such services, this exception will not apply even though the payment or performance by the related person does not rise to the level of being considered substantial assistance to the CFC under the fourth category. 735 On the other hand, if a related person guarantee does not fall within this rule, it must still be tested under the substantial assistance rule, because the two rules are applied independently.734Regs. §1.954-4(b)(2).735 The Technical Memorandum attached to Treasury Decision 6981, 1968 TM Lexis 11, specifically addresses this point:Proposed subparagraph (2)(i) of the accompanying proposed Treasury decision has been amended to make clear that, if the related person (or any other person related to the controlled foreign corporation) does in fact pay for performance of, or perform, any of the guaranteed services or any significant services related to such services, the services performed by the controlled foreign corporation pursuant to the contract will be services performed for, or on behalf of, a related person within the meaning of subparagraph (1)(ii) even though the payment or performance by the related person, or by any other person related to the controlled foreign corporation, is not considered to be substantial assistance for purposes of subparagraph (1)(iv).d. Services Are a Condition or Material Term of a Related Person Property SaleUnder the third specific case in the regulations, services will be considered as performed for, or on behalf of, a related person if a CFC performs the services for an unrelated person with respect to property sold by a related person and the performance of such services constitutes a condition or material term of such sale. 736 The regulations provide the following two examples illustrating the application of this rule.736Regs. §1.954-4(b)(1)(iii). As discussed above, the regulations state that the four categories are not exhaustive. It is likely under the rationale of this category that the Service might find that a CFC performs services for or on behalf of a related person when the underlying related person transaction is other than a sale of property; e.g., services provided pursuant to a lease of property by a related person.Example: Domestic corporation M manufacturers an industrial machine that requires special installation. M sells the machine for a basic price if the sales contract contains no provision for the machine's installation. If, however, the customer agrees to employ and pay CFC (a wholly-owned subsidiary of M) a specified installation charge, M sells the machine at a price less than the basic price. The CFC's installation services furnished to the customers who purchased the machine at a price below the basic price (on the condition that they agreed to employ and pay CFC a specified installation charge) are performed for, or on behalf of, the related person. 737737Regs. §1.954-4(b)(3), Ex. 8.Example: A related person provides a warranty on a machine sold to a customer conditioned upon installation and maintenance of the machine by a factory-authorized service agency and CFC is the only authorized service agency. CFC's services income from installation and maintenance work performed on the machines is from services performed for, or on behalf of, a related person. 738738Regs. §1.954-4(b)(3), Ex. 9.Not all income received for the performance of services for an unrelated person with respect to property purchased from a person related to the CFC is considered as income from services performed for, or on behalf of, a related person. Where a related person is not involved in the purchaser's selection of a service provider, income received by a CFC for providing such services is not considered as received for services performed for, or on behalf of, a related person. The regulations provide an example illustrating this situation.Example: A company manufactures and sells machines without any provision for, or understanding as to, maintenance of the machines. The machines require constant maintenance that can be performed by the manufacturer, the manufacturer's CFC, or certain other unrelated persons throughout the world. The customer selects CFC to perform maintenance services. CFC's services are not performed for, or on behalf of, a related person. 739739Regs. §1.954-4(b)(3), Ex. 10.e. Substantial Assistance Furnished by Related Person(1) General RuleThe fourth situation in the regulations where services performed by a CFC for an unrelated person will be considered as performed for, or on behalf of, a related person is where a related person (or related persons) assists the CFC in the performance of the services. 740 Specifically, if a related person (or persons) furnishes substantial assistance to a CFC contributing to the performance of services by the CFC, then the CFC's services will be considered as performed for, or on behalf of, a related person. 741 As a result, income derived by a CFC for such services will constitute foreign base company services income if performed by the CFC outside of the CFC's country of organization. 742740Regs. §1.954-4(b)(1)(iv); see also Regs. §1.954-4(b)(2)(iii) (special rule for applying this rule to services income derived by partnerships, discussed at XII, F, below).741 This rule seems to turn the foreign base company services income rules on their head by focusing on the nature of the services furnished by a related person to a CFC. In this case, the regulation takes a broad “substance over form” approach by essentially suggesting that the CFC must be performing services for, or on behalf of, a related person if the CFC requires substantial assistance from a related person in order to perform the underlying services. See Holleman, “U.S. Taxation of Foreign Income: The Overseas Construction Industry,” 23 Tax L. Rev. 155, 179 (1968) (“It is difficult to understand how the CFC as a recipient is then performing services for or on behalf of a related person.”). See also Saltzman, “Undistributed Income Subject to ‘Taint’ of Subpart F is Spelled Out by Final Regs,” 21 J. of Tax'n 110, 112 (8/64).742 See ALR, at p. 272 (“These rules appear designed to prevent an enterprise from reducing the U.S. tax base by ‘hiving off’ a service activity into a controlled foreign corporation that is not in fact economically capable of performing the services itself but is a mere appendage of the U.S. parent or other related party.”).In Notice 2007-13, 2007-5 I.R.B. 410, the IRS stated its intent to revise the regulations that impose the substantial assistance rule. The regulations, when revised, will considerably narrow the focus of the rule by providing that only substantial assistance by related U.S. persons (as defined in §957(c)) will give rise to foreign base company services income. The determination of whether the assistance is “substantial” will be made under an objective test that requires that the cost of the assistance provided by the related U.S. person equals or exceeds 80% of the total cost to the CFC of providing the services. The Notice states that the amended regulations will be effective for taxable years of foreign corporations beginning on or after January 1, 2007, and for taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end. The Notice may be relied upon until the regulations are issued.
Assistance furnished by a related person or persons to a controlled foreign corporation in the form of direction, supervision, services, or know-how shall not be considered substantial unless either (1) the assistance so furnished provides the controlled foreign corporation with skills which are a principal element in producing the income from the performance of such services by such corporation or (2) the cost to the controlled foreign corporation of the assistance so furnished equals 50 percent or more of the total cost to the controlled foreign corporation of performing the services performed by such corporation. The term “cost”, as used in this subdivision (b), shall be determined after taking into account adjustments, if any, made under section 482.Financial assistance (other than contributions to capital), equipment, material, or supplies furnished by a related person to a controlled foreign corporation shall be considered assistance only in that amount by which the consideration actually paid by the controlled foreign corporation for the purchase or use of such item is less than the arm's length charge for such purchase or use.
Controlled foreign corporation A is paid by related corporation B for doing the installation and maintenance of industrial machines which B Corporation manufactures and sells to C Corporation. Such installation and maintenance services by A Corporation are performed for, or on behalf of, B Corporation for purposes of section 954(e).
Foreign base company services income does not include-- 1.954-4(d)(1) Income derived in connection with the performance of services by a controlled foreign corporation if1.954-4(d)(1)(i) The services directly relate to the sale or exchange of personal property by the controlled foreign corporation,1.954-4(d)(1)(ii) The property sold or exchanged was manufactured, produced, grown, or extracted by such controlled foreign corporation, and1.954-4(d)(1)(iii) The services were performed before the sale or exchange of such property by the controlled foreign corporation
For purposes of determining foreign base company sales income in situations in which the carrying on of activities by a controlled foreign corporation through a branch or similar establishment outside the country of incorporation of the controlled foreign corporation has substantially the same effect as if such branch or similar establishment were a wholly owned subsidiary corporation deriving such income, under regulations prescribed by the Secretary the income attributable to the carrying on of such activities of such branch or similar establishment shall be treated as income derived by a wholly owned subsidiary of the controlled foreign corporation and shall constitute foreign base company sales income of the controlled foreign corporation.
Without going into detail, the hyper technical branch rules apply if a controlled foreign corporation (CFC) engages in manufacturing or sales activities outside its country of incorporation through a branch: at stake under the branch rules is whether the CFC will have foreign base company sales income (FBCSI) subject to immediate U.S. tax under Subpart F. Whether there will be FBCSI or not depends on whether conducting such operations through a branch is considered, when viewed through the prism of the branch rules, as having substantially the same effect as if such operations were conducted through a wholly owned subsidiary of the CFC.
For purposes of determining foreign base company sales income in situations in which the carrying on of activities by a controlled foreign corporation through a branch or similar establishment outside the country of incorporation of the controlled foreign corporation has substantially the same effect as if such branch or similar establishment were a wholly owned subsidiary corporation deriving such income, under regulations prescribed by the Secretary the income attributable to the carrying on of such activities of such branch or similar establishment shall be treated as income derived by a wholly owned subsidiary of the controlled foreign corporation and shall constitute foreign base company sales income of the controlled foreign corporation.
This slide only mentions two steps in the process and assumes the practitioner is familiar with the other stepsIdentify the sales and purchasing locationsDetermine the ETR in the locations aboveIdentify what locations the sales or purchasing should be compared with to determine whether low-tax jurisdiction existsDetermine how the sales and purchasing would have been taxed in the manufacturing or the country of incorporation if relevantApply the tax rate disparity test (mechanical test)Determine the otherwise FBCSI
If the effective tax rate test is mettreat the manufacturing branch as a separate CFCApply the general rule to sales income to determine whether sales income is FBC sales income“Related party sales” requirement is deemed met.This slide only mentions two steps in the process and assumes the practitioner is familiar with the other stepsIdentify the sales and purchasing locationsDetermine the ETR in the locations aboveIdentify what locations the sales or purchasing should be compared with to determine whether low-tax jurisdiction existsDetermine how the sales and purchasing would have been taxed in the manufacturing or the country of incorporation if relevantApply the tax rate disparity test (mechanical test)Determine the otherwise FBCSI
Analysis starts with the UK. Although the tax rate in Luxembourg is lower it is not 5 percentage points below the tax rate in the UK that would apply if the Chassis were sold in the UK
Determine the ETR in the locations
1.954-3T(b)(1)(ii)(c)(3)(ii) Manufacture, Production, Or Construction In One Or More Locations.If only one branch (or similar establishment), or only the remainder of a controlled foreign corporation, independently satisfies §1.954-3(a)(4)(i) with respect to an item of personal property, then that branch (or similar establishment) or the remainder of the controlled foreign corporation will be the location of manufacture, production, or construction of that property for purposes of applying §1.954-3(b)(1)(i)(b) or (b)(1)(ii)(b) to the income from the sale of that property. See paragraph (b)(1)(ii)(c)(3)(v) Example 1 of this section. If more than one branch (or similar establishment), or one or more branches (or similar establishments) and the remainder of the controlled foreign corporation, each independently satisfy §1.954-3(a)(4)(i) with respect to an item of personal property, then the location of manufacture, production, or construction of that property for purposes of applying §1.954-3(b)(1)(i)(b) or (b)(1)(ii)(b) will be the location of that branch (or similar establishment) or the jurisdiction under the laws of which the remainder of the controlled foreign corporation is organized that satisfies §1.954-3(a)(4)(i) and that would, after applying § 1.954-3(b)(1)(ii)(b) to such branch (or similar establishment) or §1.954-3(b)(1)(i)(b) to the remainder of the controlled foreign corporation, impose the lowest effective rate of tax on the income allocated to such branch or the remainder of the controlled foreign corporation under such section (that is, either §1.954-3(b)(1)(i)(b) or (b)(1)(ii)(b)). See paragraph (b)(1)(ii)(c)(3)(v) Example 2 of this section.
Although the ETR is low in country A it is not 5% percentage points below the 12.5% in Country B that would apply if the product was sold in Country B
Step 1 – identify the tested sales and purchasing locations.Step 2 – group various locations together (i.e. all locations that are not treated as “high-tax” are grouped together and all locations that are treated as “low-tax” are grouped together)Step 2 – perform tax rate disparity test
The term demonstrably greater means- sufficiently large so that it can be demonstrated quantified measured and proved. In other words, the contribution does not have to be significantly or materially greater but the differential cannot be too small.Step 1 – identify the tested sales and purchasing locations.Step 2 – group various locations together (i.e. all locations that are not treated as “high-tax” are grouped together and all locations that are treated as “low-tax” are grouped together)Step 2 – perform tax rate disparity test
Step 1 – identify the tested sales and purchasing locations.Step 2 – group various locations together (i.e. all locations that are not treated as “high-tax” are grouped together and all locations that are treated as “low-tax” are grouped together)Step 2 – perform tax rate disparity test on low tax jurisdictions first
Step 1 – identify the tested sales and purchasing locations.Step 2 – group various locations together (i.e. all locations that are not treated as “high-tax” are grouped together and all locations that are treated as “low-tax” are grouped together)Step 2 – perform tax rate disparity test on low tax jurisdictions first
The IRS has confirmed that a CFC performing activities that substantially contribute in branches outside its country of incorporation may have FBCSI even though there is no related party transaction. But see NOTICE 2007-13, 2007-5 I.R.B. 410 (1/29/2007)
FPHCI does not include rents or royalties that are derived in the active conduct of a trade or business and received from person that is NOT a related person see 954(d)(3)Rental example: A CFC is regularly engaged in the production of office machines which it sells or leases to others and services. The rental income of the from these leases is derived in the active conduct of a trade or business.Active royalties: Royalties will be considered to be derived in the active conduct of a trade or business is such royalties are derived by the CFC the licensor from licensingproperty that the licensor has developed, created or produced or has acquired and added substantial value but only so long as the licensor is regularly engaged in such activity Property that is licensed as a result of the performance of marketing functions by such licensor if the licensor is regularly engaged in the business of marketing and that business is substantial in relation to the amount of royalties derived from the licensing of such property.
a. Basic RequirementsThe Code and regulations provide an exception for certain dividends received from a related corporation. Specifically, FPHCI does not include dividends received by a CFC from a payor corporation that satisfies all of the following three requirements:• The payor is a corporation that is a related person to the CFC;• The payor is created or organized under the laws of the same foreign country as the CFC; and• A substantial part of the payor's assets is used in a trade or business located in the payor's country of incorporation (which also is the CFC's country of incorporation). 192Foreign personal holding company income received by a controlled foreign corporation does not include dividends or interest if the payor--1.954-2(b)(4)(i)(A)(1) Is a corporation that is a related person with respect to the controlled foreign corporation, as defined in section 954(d)(3);1.954-2(b)(4)(i)(A)(2) Is created or organized under the laws of the same foreign country (the country of incorporation) as is the controlled foreign corporation; and1.954-2(b)(4)(i)(A)(3) Uses a substantial part of its assets in a trade or business in its country of incorporation, as determined under this paragraph (b)(4).Dividends are excluded from foreign personal holding company income under this paragraph (b)(4) only to the extent that they are paid out of earnings and profits that are earned or accumulated during a period in which--1.954-2(b)(4)(ii)(A)(1) The stock on which dividends are paid with respect to which the exclusion is claimed was owned by the recipient controlled foreign corporation directly, or indirectly through a chain of one or more subsidiaries each of which meets the requirements of paragraph (b)(4)(i)(A) of this section; and1.954-2(b)(4)(ii)(A)(2) Each of the requirements of paragraph (b)(4)(i)(A) of this section is satisfied or, to the extent earned or accumulated during a taxable year of the related foreign corporation ending on or before December 31, 1962, during a period in which the payor was a related corporation as to the controlled foreign corporation and the other requirements of paragraph (b)(4)(i)(A) of this section were substantially satisfied.
Tangible property is considered located in the country in which it is physically located…Inventory and dealer property is considered located in the jurisdiction where the payor conducts all of its activities in connection with such propertyIntangible property is considered located only if the payor conducts all of its activities in connection with the use or exploitation of the property in that country during the entire quarter (i.e. the country in which the expenses associated with these activities are incurred)A substantial part of the assets of the payor will be considered to be used in a trade or business located in the payor’s country of incorporation for a taxable year only of the average value (valued on a quarterly basis) of the payor’s assets for such year that are used in the trade or business exceeds 50% of the average value of all assets of the payro including assets not used in the trade or business
Tangible property is considered located in the country in which it is physically located…Inventory and dealer property is considered located in the jurisdiction where the payor conducts all of its activities in connection with such propertyIntangible property is considered located only if the payor conducts all of its activities in connection with the use or exploitation of the property in that country during the entire quarter (i.e. the country in which the expenses associated with these activities are incurred)A substantial part of the assets of the payor will be considered to be used in a trade or business located in the payor’s country of incorporation for a taxable year only of the average value (valued on a quarterly basis) of the payor’s assets for such year that are used in the trade or business exceeds 50% of the average value of all assets of the payro including assets not used in the trade or business
De minimis rule – 954(b)(3) Subpart F includes both foreign base company income and insurance income (952(a)Under the deminimisule, no part of the CFC’s gross income is treated as subpart F income for the year if less than both 1M and 5% of total gross income (954(b)(3)(A)
What happens when this occurs?? It creates a separate category of adjusted FBC income for purposes of allocating and apportioning deductions know as the full inclusion FBCIEven after you apply the full inclusion test the high-tax exception can never-the-less apply and result in less that 100% of the gross income of the CFC from being classified as FBC income.
For example, with a U.S. maximum corporate tax rate of 35%, an item of foreign base company income subject to a foreign tax rate in excess of 31.5% would qualify for this exception.
Section 956 modifies the general rules that apply to corporations and their shareholders to treat certain investments by a CFC into the United States (U.S. property investments) as a deemed repatriation of earnings. Nevertheless, only specified investments into the United States are subject to this special rule, and there are numerous exceptions. Unfortunately, the court does not indicate that it is aware of the limited scope of §956, but seems to suggest by its general reference to “repatriation” without limitation that Congress intended to subject to current taxation any funds of a CFC brought back to the United States.For example, a CFC may use its earnings to purchase a machine or other property from its U.S. parent, and ship the property to a foreign destination. The CFC clearly does not have an investment in U.S. property because it does not own a tangible asset located in the United States. Furthermore, §956 provides an exception when a CFC purchases inventory that is located in the United States where the inventory is for export. Even though CFC funds cross the border into the United States and are received by a related U.S. person, and might be considered a “repatriation” of the CFC's earnings to the United States, it is indisputable that such transactions are not subject to §956. It is not the transfer of funds by the CFC into the United States that causes §956 to apply, but whether the particular property is within the limited definition of U.S. property. 24
3 While Notice 88-108 literally applies to year-end obligations, GLAM 2007-0016, reprinted in BNA TaxCore (10/9/07),confirmed that the 30/60 day exception applies to obligations outstanding at the end of a quarter. See Yoder, “IRS Applies Section 956 Thirty-Day Exception to Quarters,” 36 Tax Mgmt. Int'l J. 664 (12/14/07).Section 956 modifies the general rules that apply to corporations and their shareholders to treat certain investments by a CFC into the United States (U.S. property investments) as a deemed repatriation of earnings. Nevertheless, only specified investments into the United States are subject to this special rule, and there are numerous exceptions. Unfortunately, the court does not indicate that it is aware of the limited scope of §956, but seems to suggest by its general reference to “repatriation” without limitation that Congress intended to subject to current taxation any funds of a CFC brought back to the United States.For example, a CFC may use its earnings to purchase a machine or other property from its U.S. parent, and ship the property to a foreign destination. The CFC clearly does not have an investment in U.S. property because it does not own a tangible asset located in the United States. Furthermore, §956 provides an exception when a CFC purchases inventory that is located in the United States where the inventory is for export. Even though CFC funds cross the border into the United States and are received by a related U.S. person, and might be considered a “repatriation” of the CFC's earnings to the United States, it is indisputable that such transactions are not subject to §956. It is not the transfer of funds by the CFC into the United States that causes §956 to apply, but whether the particular property is within the limited definition of U.S. property. 24
951(a)(1)(B), 956 The amount of loan included in income is limited to the earnings and profits of the CFC that have not been previously taxed956(d) Pledges And GuaranteesFor purposes of subsection (a), a controlled foreign corporation shall, under regulations prescribed by the Secretary, be considered as holding an obligation of a United States person if such controlled foreign corporation is a pledgor or guarantor of such obligations. 1
Stated another way Congress enacted subpar F to eliminate the tax deferral advantage of doing business through controlled foreign corporations, by taxing currently to the United States shareholders all income that is deemed earned by those sharholders
The 60/180 day exception is generally available for the first three taxable years of a foreign corporation ending after october 3, 2008 but beginning before January 1, 2011
The sales income with which your committee is primarily concerned is income of a selling subsidiary (whether acting as a principal or agent) which has been separated from manufacturing activities of a related corporation merely to obtain a lower rate of tax for the sales income.As a result, this provision is restricted to sales of property to a related person or purchases of property from a related person. * * * [H. Rept. No. 1447, supra, 1962-3 C.B. at 466.]
This could also apply to PFIC earnings which were subjected to current taxation under the passive Foreign Investment Company provisions Section 1293(c)
a distribution of PTI is counted as a dividend when ultimately received by the corporate U.S. Shareholder. Thus, that corporate shareholder should receive a credit for any additional taxes imposed as PTI is distributed through a chain of ownership
Taxes Paid By Foreign Corporation And Not Previously Deemed Paid By Domestic CorporationAny portion of a distribution from a foreign corporation received by a domestic corporation which is excluded from gross income under section 959(a) shall be treated by the domestic corporation as a dividend, solely for purposes of taking into account under section 902 any income, war profits, or excess profits taxes paid to any foreign country or to any possession of the United States, on or with respect to the accumulated profits of such foreign corporation from which such distribution is made, which were not deemed paid by the domestic corporation under paragraph (1) for any prior taxable year.
Seth PrimoschSenior Accountant | TaxParenteBeard, LLCOne Liberty Place | 1650 Market Street, Suite 4500 | Philadelphia, PA 19103T: 215.972.2523 | F: 215.563.4925 | E:seth.primosch@parentebeard.com
