Practical Issues in Subpart F and Section 956

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Beryl Smith
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1 USA Branch of the International Fiscal Association New York Region Summer Meeting Wednesday, July 16, 2014 Practical Issues in Subpart F and Section 956 Nicole Hinton Partner PricewaterhouseCoopers Colleen O Neill Partner Ernst & Young LLP Marjorie Rollinson Deputy Associate Chief Counsel (International- Technical) Office of Associate Chief Counsel International, Internal Revenue Service Gretchen Sierra Partner Deloitte

2 Agenda Foreign base company sales and services income Background Character overlap Procurement income Recent guidance Branch rule riddles Section 956 Investment in US property Recent guidance Quarter definition 2

3 Foreign Base Company Sales and Services Income 3

4 Foreign Base Company Sales Income Foreign base company sales income ( FBCSI ) is defined in 954(d)(1) (branch rule found in 954(d)(2) The term FBCSI means income derived in connection with the purchase of personal property from: a related person and its sale to any person, the sale of personal property to any person on behalf of a related person; the purchase of personal property from any person and its sale to a related person; or the purchase of personal property from any person on behalf of a related person; Where the following are satisfied: a) the property which is purchased, sold on behalf of a related person, is manufactured, produced, grown, or extracted outside the country under the laws of which the CFC ( CFC ) is created or organized, and b) 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. 4

5 Foreign Base Company Sales Income FBCSI excludes: Property manufactured, produced, constructed, grown, or extracted within the country, and Property sold for use, consumption, or disposition within the country which the CFC is created or organized The so called contract manufacturing regulations allow for manufacturing by a CFC where there is substantial contribution by the CFC s employees to the manufacturing process, even though the CFC does not physically manufacture the property 5

6 Foreign Base Company Services Income Foreign base company services income is defined in 954(e) The term foreign base company services income means income derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, or like services which: a) are performed for or on behalf of any related person, and b) are performed outside the country under the laws of which the CFC is created or organized. The term foreign base company services income shall not apply to income derived in connection with the performance of services which are directly related to a) the sale or exchange by the CFC of property manufactured, produced, grown, or extracted by it and which are performed before the time of the sale or exchange, or b) an offer or effort to sell or exchange such property. 6

7 Sales and Services Overlap Where foreign base company income satisfies the definition of both foreign base company sales income and services income, income shall be characterized in accordance with the substance of the transaction, and not in accordance with the designation applied by the parties to the transaction There is no explicit coordination rule governing the application of the foreign base company sales income provision with the foreign base company services income rule. Technically both rules could apply to the same income; however, the income would only be picked up once even if it classified as Subpart F under both categories. See Treas. Reg (e)(4). To test income, it must first be characterized as sales or services. Sometimes this is difficult to do as a result of the overlapping of the provisions, rendering the test difficult to work through. To the extent the income from a single transaction is separable, each type of income should be analyzed separately (Treas. Reg (e)(2)) To the extent the income is not separable, it must be classified in accordance with the predominant character of the particular integrated arrangement (see Treas. Reg (e)(3) and Rev Rul ) If predominant character is both sales and services, must the income be tested under each provision? 7

8 Procurement income best practices Plan for both sales and services income, for example Structure payments as disregarded within CFC benefitting from such procurement activities CFC incorporated in country of physical manufacturing performs procurement activities in same country If impractical to plan for both If a CFC can meet the requirements of the substantial contribution exception, then a buy / sell arrangement may be preferred as predominant character is likely sales If a CFC can not meet substantial contribution, then avoid buy / sell arrangements and activities such as final choice of vendor, final contract negotiations, and order placement, and focus instead on: Prequalification of a vendor from a quality perspective Evaluation of vendor s compliance with the company policies Ongoing services related to quality control and compliance Consider requesting guidance 8

9 Recent Guidance Issues to Consider PLR & PLR Substantial contribution may be satisfied without taking title Taxpayer assertions regarding activities qualifying for substantial contribution Taxpayer representation on consistency of treatment as FBCSI, regardless of whether such income could also be considered services CCA Character of income as sales or services in the WHT context 9

10 Recent Guidance - PLR Issue: Are the payments received by FDE for the procurement related activities excluded from FBSCI because FDE makes a substantial contribution through the activities of its employees to the manufacture, production or construction of the Products? US Taxpayer Products F Sub (Country X) Foreign Subsidiaries Products Vendors Payment Payment FDE Procurement activities 10

11 Recent Guidance - PLR Background Facts: Taxpayer and certain of its foreign subsidiaries purchase products from unrelated foreign vendors Products are manufactured outside the US and sold to customers both inside and outside the US Taxpayer, its foreign subsidiaries and FDE have entered into a buying agency agreement under which FDE performs various procurement related activities FDE is responsible for ensuring the Products purchased from the vendors meet the Taxpayers standard of design, image, quality, vendor compliance and brand. FDE is paid a commission based on a percentage of the price of ordered merchandise received by the buyer for the procurement related activities FDE performs. Representations: FDE makes a substantial contribution through its employees to the manufacturing production or construction of products FDE income is treated as foreign base company sales income within the meaning of section 954(d) Outcome: The income from the payments received by FDE for the performance of procurement related activities in connection with Products are excluded from FBCSI on the basis that FDE s activities are considered to satisfy the substantial contribution requirements 11

12 Recent Guidance - PLR Issue: Are the payments received by Branch for the sale of Products excluded from foreign base company sales income because Branch makes a substantial contribution through the activities of its employees to the manufacture, production or construction of the Products? US Taxpayer Dealers (Country T) FSub-2 (Country T) Partners Products Payment FSub-3 (Country T) Ptship (Country V) Note: Branch does not take or pass legal title to Products sold in Country T Branch (Country V) 12

13 Recent Guidance - PLR Background Facts: Taxpayer, through its subsidiaries, manufactures Products and other additional products, in Country T. FSub-2 remits a payment to Branch equal to a percentage of the proceeds from the sale of the Products to Country T. This amount can vary to compensate Branch for its role in manufacturing, marketing and selling activities with respect to the Products. Branch never takes legal title of the materials, work in process or finished goods for Products. Representations: Branch makes a substantial contribution to the manufacture, production or construction of Products sold in Country T Branch s income from the payments received from Fsub-2 is derived from branch s contribution to the manufacture and sale of Products in Country T FDE income is treated as foreign base company sales income within the meaning of section 954(d) Outcome: The income from the payments received by Branch are excluded from foreign base company sales income because Branch makes a substantial contribution through the activities of its employees to the manufacture, production or construction of Products. 13

14 Recent Guidance - CCA Issue: What is the character of income received by Distributor? Products Distributor (Foreign) Training Products Taxpayer (US) Products Lower-Tier Distributor 1 Products Customers Products Training Lower-Tier Distributor 2 Products 14

15 Recent Guidance - CCA Background Facts: Taxpayer is a US corporation which produces and sells products to US and foreign distributors. Distributors income is based on the amount of products the distributor purchases from Taxpayer and resells and the success of the distributor in sponsoring, training, and supporting other distributors. Outcome: Distributors income based on purchases by lower-tier distributors in their sponsorship chains represents compensation for Distributors services of recruiting, sponsoring and training lower-tier distributors not income from the sale of Taxpayer s products. The CCA relied on the decision in British Timken Ltd v. Commissioner, 12 T.C. 880 (1949). The source of services income is where the services are performed. If a foreign distributor performs services both inside and outside of the United States, income for the services must be reasonably split between U.S. and foreign sources based on the facts. 15

16 Branch Rule Background 954(d)(2) provides the so-called branch rule which applies to treat a branch or similar establishment of a CFC as a separate CFC, to which FBCSI rules apply where: The CFC engages in purchasing, selling, or manufacturing activities in a foreign branch; and The carrying on of such activities has substantially the same effect as if such branch or similar establishment were a wholly owned subsidiary corporation deriving such income. The tax rate disparity test is used to determine whether the activities of the branch have substantially the same tax effect as if it were a wholly owned subsidiary The tax rate disparity test is satisfied if the purchase or sales income is subject to tax at an effective tax rate that is less than 90% of, and at least 5 percentage points lower than, the rate at which the income would be taxed in the home office or manufacturing location (the hypothetical ETR ). 16

17 Tax Rate Disparity Test Calculation Step 1: Determine amount of income to be allocated to the sales branch or remainder of the CFC Step 2: Determine actual tax imposed on the branch s or remainder of CFC s income Apply foreign statutes, treaties, and relevant rules Step 3: Calculate the actual ETR on the income allocated to the sales branch or remainder (Step 2/ Step 1) Step 4: Calculate the Hypothetical ETR- the ETR that would apply to the Step 1 income if it were earned by a CFC incorporated in the manufacturing branch s or head office s jurisdiction taking into account the following assumptions: All of the CFC s income is treated as derived by the CFC from sources within its country of organization; All of the income is treated as derived by the CFC from doing business through a PE in its country of organization; All of the income is treated as being received by the CFC in its country of organization; All of the income is treated as being allocable to the CFC s PE in its country of organization, and The CFC is treated as if it were managed and controlled in its country of incorporation Step 5: Compare the Hypothetical ETR to the actual ETR 17

18 Tax Rate Disparity Test Guidance- PLR Issues: Should interest expense incurred by DE B with respect to its note from Corp A be taken into account when determining DE B s ETR on its sales income? If Manufacture DEs are permitted a deemed interest on net equity deduction, should this deemed deduction be taken into account in determining DE B s Hypothetical ETR? Outcome: DE B should determine its ETR by applying local law, including an allocation or apportionment of DE B s interest expense between its income categories, in accordance with Country 2 law. DE B s Hypothetical ETR should be computed considering deductions imposed under Country 1 local law, including interest on net equity See also PLR Interest payments Sell Product X Manufacture DEs Country 1 Manufacturing Branches US Parent Corp A DE B PLR (Simplified) Country 2 Unrelated Customers 18

19 Riddle 1: Hypo ETR - how far does the fiction go? What if statutory tax rate is different for a branch vs. a corporation? Example: Taiwan Corporate Income Tax Rate: 17% Retained Earnings Tax ( RET )- 10% surtax on undistributed earnings of a corporation RET does not apply to a branch USP Singapore Sales Taiwan Manufacturing ETR 17% Hypothetical ETR? 19

20 Riddle 2: Hypo ETR - how far does the fiction go? What if manufacturing branch only taxes domestic source income? Example: Bermuda sales CFC with a HK manufacturing branch Bermuda s sales income should be viewed as if earned by a HK CFC Is HK s territorial system taken into account or is all sales income hypothetically taxed at the HK statutory rate? USP Bermuda Sales Hong Kong Manufacture ETR 0% Hypothetical ETR? 20

21 Riddle 3: ETR - how is it calculated? Actual ETR is based on how income is taxed in the year in which it is earned Example: Irish principal with a German Sales Branch Assume German Sales Branch has an NOL which fully offsets German Sales Branch income German Sales Branch has 0% ETR in the year in which income is earned resulting in tax rate disparity Where rate disparity is failed, what is the amount of the inclusion? USP Ireland Principal Germany Sales Hypothetical ETR 12.5% Actual ETR 0% 21

22 Riddle 4: Treatment of substanceless remainders? Assume rate disparity failed. USP Does this not result in FBSCI because DRE1 buys/sells from unrelated or because there is no on behalf of transaction? After amendment in 2008, Example 3 states that CFC does not have FBSCI because it is purchasing and selling from unrelated persons. Unrelated Vendor No activity Sale CFC DRE1 Sale Unrelated Customer However, amendments to the branch rules in 2008 also intended to address Example 3 provides that there is an on behalf of transaction with respect to purchasing and/or selling activities through a branch only if they are with respect to personal property also purchased and/or sold through the remainder. Thus, the regulations indicate there is no on behalf of transaction in this case. 22

23 Section Investment in US Property 23

24 Section 956: Multiple Inclusions & CFC Guarantees/Pledges Issue: Does this arrangement result in three sec. 956 inclusions? BANK Pledge of more than 2/3 of FC2 Stock $50 Loan Guarantee of Loan FC1 USCo FC3 Facts FC1 pledges more than 67% of the FC2 stock as security for the $50 bank loan. FC2 is bound by negative covenants restricting its ability to sell assets or incur liabilities, other than in the ordinary course of business. FC3 guarantees the bank loan. See FSA FC2 24

25 Section 956: Guarantee of CFC Loan by USP Issue: Could FC1 s obligation be recharacterized as a guarantee of USCo s obligation to the Bank? Guarantee USCo Facts Bank lends to FC1. USCo guarantees the bank loan. Under the terms of the guarantee, the Bank may demand payment directly from USCo without seeking payment from FC1. Bank Loan FC1 FC3 FC2 25

26 Recent Guidance - CCA Issue: Does the anti-abuse rule apply in relation to the Section 956 inclusion amount? Parent Co (US) CFC 2 CFC 1 USCo Loan Ptnship Loan DEI 26

27 Recent Guidance - CCA Background Facts: The foreign partnership made a loan to CFC 1. CFC 1 made a loan to USCo as a 956 loan. The loan from CFC 1 to USCo remained outstanding for a period of time, to create an inclusion under Section 956, and the taxpayer included an amount into income on its federal income tax return. As CFC1 had earnings and profits less than the loan amount, the Section 956 amount was limited. The taxpayer contended that the anti-abuse rule did not apply to treat each CFC partner as owning an amount of the 956 loan because the loan facilitated, rather than avoided, a Section 956 inclusion with respect to CFC 1. Conclusion: The IRS concluded that under the anti-abuse rule of Treas. Reg. Section T(b)(4) the US corporation must include in gross income the full amount of a loan from a CFC rather than only the portion corresponding to the CFC 1 s earnings and profits. It was noted that had the Partnership directly loaned the money to the taxpayer, a greater inclusion under Section 956 would have resulted. The CCA also noted the rule in Treas. Reg. Sec (a)(3) that the CFC partners of a partnership that holds U.S. property are considered to own a proportional amount of such U.S. property. 27

28 Section Quarter Definition Under the General Rule contained in Section 956(a) the amount determined to be included in the taxpayer s taxable income may include under section 956(a)(1)(A): 956(a)(1)(A) - such shareholder's pro rata share of the average of the amounts of United States property held (directly or indirectly) by the CFC as of the close of each quarter of such taxable year, over The term quarter is not a defined term Issue to consider what does the term quarter mean? 28

29 Section 956 Examples - Quarterly Measurement Example 1 Short year w/ 4 investment & 4 Testing Quarters Example 2 Short year w/ 2 investment & 2 Testing Quarters First Day of Tax Year 1/1 1/1 1/1 Last day of tax year 12/31 12/31 12/31 CFC Year End 7/10 7/10 7/10 Days in Short Year # of Quarters in Tax Year Days per quarter 48 ~90 ~90 Applicable earnings of CFC 1,000 1,000 1,000 US tax basis in investment in US property 1,000 1,000 1,000 Example 3 Short year w 2 investment & 4 Testing Quarters * Consider whether the last 10 days is also a quarter for this purpose Quarter End Basis in US Property Quarter End* Basis in US Property Quarter End* 2/17 1,000 3/31 1,000 3/31 1,000 4/6 1,000 6/30 1,000 6/30 1,000 5/23 1,000 9/30-9/30-7/10 1,000 12/31-12/31 - Average 1,000 1, Basis in US Property 29

IRS rules on application of manufacturing exception where sales activities did not include taking of title

1 July 2013 IRS rules on application of manufacturing exception where sales activities did not include taking of title Executive summary In a private letter ruling (PLR 201325005), the Internal Revenue