US IRS issues FAA F recharacterizing intercompany referral fee income and reallocating intercompany referral fee expenses

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1 26 August 2015 International Tax Alert EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Services/Tax/International- Tax/Tax-alert-library#date US IRS issues FAA F recharacterizing intercompany referral fee income and reallocating intercompany referral fee expenses In FAA F, issued 14 August 2015, the IRS concluded that the taxpayer did not properly characterize portions of the intercompany referral fee income generated by its foreign subsidiaries as foreign base company sales income, and thus subpart F income. The IRS cited the lack of objective evidence supporting the bifurcation of the referral fee income amongst sales activities and post-sale services. Further, the IRS indicated that where post-sale functions are incident to the sales function, compensation for such post-sale functions should be considered sales income, not services income. The IRS also concluded that the taxpayer did not properly allocate intercompany referral fee expenses when it allocated such expenses across all of the classes of income of the foreign subsidiaries. Instead, the taxpayer should have allocated the intercompany referral fee expenses solely to non-subpart F sales income. Background The US parent of a consolidated group (Taxpayer) wholly owns various foreign subsidiaries, each of which is a controlled foreign corporation (CFC) as defined in section 957(a). Taxpayer uses a network of employee-brokers to refer business internally that involves the payment of intercompany referral fees between various CFCs, which are often times located in different jurisdictions. Each Customer Broker is a salesperson that is responsible for developing and maintaining the business relationship with the customer, including (i) negotiating with the customer regarding the customer s product specifications, (ii) coordinating with the Taxpayer s centralized credit function on the

2 terms of the sale, (iii) tracking the customer s purchases from Taxpayer affiliates, and (iv) managing exposures with respect to the customer. The Customer Broker arranges for the customer to receive its product through a Supply Broker that may be employed by a different CFC than the Customer Broker. Each Supply Broker is responsible for (i) identifying and negotiating the price with direct supplier of the product, (ii) arranging the delivery of the product to the customer, (iii) receiving the signed documents showing that the product meeting the customer s specifications was delivered to the customer, and (iv) invoicing the customer. The Supply Broker makes the sale to the customer, records the sales revenue, and pays the Customer Broker a percentage of the gross sales margin associated with the referred transaction (the Referral Fee Income). Taxpayer and its CFCs did not enter into written contracts regarding the intercompany referral fees. Instead, the business arrangement is based on verbal agreements between the parties. Taxpayer s Position Taxpayer characterizes a portion of its Referral Fee Income as income derived in connection with the performance of services on behalf of a related party. The remaining portion of the Referral Fee Income is characterized as sales income for Subpart F purposes. 1 For the services performed within each respective CFC s country of incorporation, Taxpayer claims that Referral Fee Income treated as services income is not foreign based company services income (FBCSvI) as defined in section 954(e)(1)(B). Accordingly, such income is not subpart F income. Taxpayer claims the Customer Broker received Referral Fee Income for the two types of services: Performing sales functions, including functions performed by a typical, unrelated sales broker, such as the solicitation of the sales. Performing post-sale services, including (i) responding to shortages, issues with quality, and damages resulting from delays in delivery; (ii) handling billing disputes and negotiating claims settlements with customers; (iii) managing credit risk exposure by tracking a customer s overall purchase volume, pattern, and collecting formal and informal information about a customer s credit risk; (iv) tracking outstanding invoices and taking necessary actions to collect payment on behalf of the Taxpayer CFC; and (v) keeping the customer up to the date on current price trends, market dynamics, and other factors impacting product supply and prices. In characterizing its intercompany referral fee income, Taxpayer contends that if the service is provided to the seller and is necessary for the sale to occur, it should be considered a sales function, and compensation for it should be sales income. On the other hand, if the sale can be made whether or not the service is provided to the seller (e.g., if the service is provided only after the sale), compensation for that service should not be considered sales income because it constitutes compensation for a service that is distinct from the sales process. Taxpayer argues that the Referral Fee Income received with respect to the services related to the performance of sales functions is derived in connection with the sale of property, and therefore constitutes sales income for Subpart F purposes. Conversely, Taxpayer argues that the portion of the Referral Fee Income attributable to the performance of post-sale services compensate the CFCs for services that are not necessary to consummate sales, and therefore constitutes services income. To substantiate its split between sales and services income, Taxpayer engaged an unrelated party to draft a memorandum that provided benchmarking data. For purposes of the sales function, the unrelated party utilized information regarding the fees charged by uncontrolled third parties acting as sales brokers for sales by unrelated third parties. Because Taxpayer did not require its CFCs to enter into written agreements memorializing the terms of the intercompany referral fee transactions, the IRS stated that it could not determine if the alleged post-sale functions were contracted for. When asked to substantiate that the post-sale functions were actually provided by the Customer Broker to the Supply Broker CFC, Taxpayer cited to documentation relied on in preparation of a transfer pricing study. That documentation includes interview notes from interviews. 2 International Tax Alert

3 Taxpayer also provided a sample sales agreement by and between Taxpayer, certain of its CFCs, and a third party customer. While the sales agreement includes provisions relating to quality and damages, billing disputes, credit terms, and invoicing (i.e. the first four post-sale functions that the Customer Broker allegedly performs for the Supply Broker CFC), the sales agreement does not specify the Taxpayer entity responsible for providing these alleged post-sale services. Further, the sales agreement does not include a provision regarding the keeping of customers up to date on current price trends, market dynamics, and other factors, and the sales agreement does not reference the intercompany referral fee. Taxpayer claimed that the majority of the Referral Fee Income that it characterized as services income was not FBCSvI because the postsale functions were performed in the country in which the CFC employing the Customer Broker was organized or created. On the second issue, with respect to the referral fees expenses paid by the each of the Supply Brokers to the Customer Brokers (the Referral Fee Expenses), Taxpayer allocated them to all categories of income of each Supply Broker. Taxpayer stated that each CFC that pays intercompany referral fees has the following three categories of income: (i) income from sales to its own customers (as the employer of the Supply Broker and the Customer Broker), (ii) income from the sales to customers on referral from other CFCs (as the employer of the Supply Broker), and (iii) Referral Fee Income received from referral of customers to other CFCs (as the employer of the Customer Broker). Taxpayer contended that these three categories of income are derived from a single activity: the purchase of product from unrelated suppliers, and its sale to customers. Taxpayer then contended that each CFC s deductions incurred in with respect to that sale activity, including Referral Fee Expenses, were related to each of the three categories of income. After allocating them, Taxpayer apportioned the Referral Fee Expenses of each CFC between the CFC s statutory and residual groupings of gross income by comparing the amounts of gross income in the grouping to the gross income in the class. Taxpayer argues that using gross income as a measure of comparison reflects, to a reasonably close extent, the factual relationship between the deduction and the gross income in the relevant groupings because the benefit of being a member of the Taxpayer group (which necessitates the payment of intercompany referral fees) is realized by earning income in all of the groupings of gross income in the class. Consequently, Taxpayer reduced its subpart F income by allocating and apportioning some of the Referral Fee Expenses to its foreign base company sales income (FBCSI), FBCSvI, and foreign personal holding company income (FPHCI). Intercompany Referral Fee As defined in Section 952(a)(2), the term subpart F income includes FBCSI and FBCSvI. Under Section 954(d)(1), FBCSI includes commissions 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, or the purchase of personal property from any person on behalf of a related person, where (i) the property which is purchased or 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 (ii) 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. Under Section 954(e)(1), FBCSvI includes compensation, commissions, fees, or other income derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, or like services which are performed for or on behalf of any related person, and performed outside the CFC s country of the incorporation. In determining whether Taxpayer appropriately characterized its income, the IRS concluded that no portion of the Referral Fee Income should be characterized as services income because (i) Taxpayer did not substantiate that a portion International Tax Alert 3

4 of the intercompany referral fee was paid for post-sale functions, (ii) the intercompany referral fee was derived in connection with the purchase and sale of personal property to a person on behalf of a related person, and (iii) the requirements for the Referral Fee Income to be considered FBCSvI were not satisfied. In short, this is a dispute grounded in just what are the facts; and, not a dispute grounded in the law. The IRS determined that Taxpayer did not substantiate that the intercompany referral fee paid by the CFC employing the Supply Broker to the CFC employing the Customer Broker was for post-sale services performed by the Customer Broker. The IRS noted that there is no written agreement between the CFCs Customer Brokers and Supply Brokers regarding the intercompany referral fee, the sales agreement did not specifically establish that any portion of the intercompany referral fee income relates to post-sale functions, and the service agreement did not designate a specific CFC that is responsible for providing the post-sale functions. Although transfer pricing documentation and interview notes were produced, they did not specify the portion of the intercompany referral fee that should be related to post-sale functions. The IRS found that there is no objective evidence indicating whether the intercompany referral fee was paid for anything more than referring the customer. Consequently, the IRS stated that the referral fee is a commission that is derived in connection with the purchase and sale of personal property (the product) by the Supply Broker to a person (the third party customer) on behalf of a related person (the Customer Broker). Further, the product being sold on behalf of the Customer Broker was sold outside of the country in which the CFC employing the Customer Broker was created or organized, and it was sold for use and/or consumption outside of that country. Accordingly, the Referral Fee Income was FBCSI. The IRS indicated that its conclusion was supported by the fact that the intercompany referral fee is calculated based on the gross margin of the seller, which is defined as the difference between net sales and costs of goods sold. Thus, the intercompany referral fee had nothing to do with compensation for services. There was also no contingency for the completion or efficacy of the purported non-sales services. The IRS noted that if the Customer Broker were earning a fee predominantly for non-sales services, it is doubtful that the fee for such services would be tied to the supposedly less significant sales services. Even assuming that the postsale functions were contracted, performed by the Customer Broker, and compensated for, the IRS still indicated that each of the alleged post-sale functions were part of the sales process. Further, the IRS provided that it is not clear that the alleged post-sale functions were performed by the Customer Broker, and that there was no evidence that the Supply Broker made efforts to confirm that the functions were performed. The IRS rejected five alleged post-sale functions that Taxpayer claimed its CFCs performed. The first alleged post-sale function involved responding to (i) product shortages, (ii) issues with quality, and (iii) damages resulting from delays in product delivery. The IRS found that responding to shortages and responding to quality issues would occur before the sale is consummated, and thus would not be a post-sale function. Further, the IRS noted that the service agreement provided customers with the right to inspect and reject the product within ten days of delivery. Thus, issues with quality and damages resulting from delays in delivery occur before the sale is complete, and thus cannot relate to post-sale functions. Beyond that, the IRS noted that Taxpayer did not substantiate that the Customer Broker even performed these functions. The second alleged post-sale function was handling billing disputes and negotiating claim settlement with customers. The IRS noted that collections are generally considered to be related to sales. While the IRS acknowledged that it is possible that disputes and settlement negotiations could take place after a sale has been completed, it noted that Taxpayer did not prove that the CFC employing the Customer Broker is responsible for handling such activities, especially given that fact that a transfer pricing 4 International Tax Alert

5 report indicated that these activities are performed in whole or in part by the legal department in the United States. The third alleged post-sale function was the managing of credit risk exposure by tracking a customer s overall purchase volume, pattern, and collecting formal and informal information about the customer s credit risk. However, the IRS noted that such functions occur before the sales take place because sales would not occur if the customer s credit is unsatisfactory. Therefore, the IRS contended that this is a sales-related activity. Similar fact-based arguments were made regarding the remaining services performed. The IRS further noted that the intercompany referral fee cannot be bifurcated between sales and alleged post-sale functions because there is no agreement memorializing either the amount of the fee or whether the fee was in fact paid for services. The memorandum that Taxpayer obtained relied on employees best estimates of the portion of their time spent on various activities as the basis for bifurcating the referral fee. Moreover, there was no indication that the alleged service income was accounted for separately from the sales income. The IRS also debunked Taxpayer s reliance on Treas. Reg. Section (e)(3) for the proposition that the Referral Fee Income could be separately determined. The IRS found that Taxpayer erroneously presumed (i) that subtracting the benchmarked fees for the sales function from the estimated referral fee was a reasonable method for calculating services income, and (ii) that the Customer Brokers only spend time on two sets of functions, sales and post-sales. Taxpayer conceded that general relationship management and business development activities were equally important functions, but no portion of the Referral Fee Income was allocated these functions (which the IRS stated would be sales related activities). The IRS contended that the examples cited by the taxpayer (i.e., examples 1, 8, and 10 of Treas. Reg. Section (b)(3)) clearly delineates between sales and service functions by separately stating the amount of the fee related to services. Conversely, Taxpayer did not separately state the amount of the service fee, or make it contingent on the successful completion of the service functions. Even assuming the referral fee could be bifurcated, the IRS felt that Taxpayer s memorandum did not take into account the assistance that the Customer Brokers received from related entities in carrying out the alleged postsale functions. Thus, Taxpayer s bifurcation was subjective and unsupportable. Intercompany Referral Fee Expense Under Section 954(b)(5), FBCSvI and FBCSI should be reduced by certain deductions as prescribed by the regulations under Section 954, which reference the regulations under section 861 for allocating and apportioning expenses. Pursuant to rules of Treas. Reg. Section , taxpayers must allocate deductions International Tax Alert to a class of gross income to which the deductions are definitely related, and then, if necessary, apportion the deductions within the class of gross income between statutory groupings of gross income and the residual grouping. Under Treas. Reg. Section (b)(1), a deduction should be considered definitely related to a class of gross income and therefore allocable to such class if it is incurred as a result of, or incident to, an activity or in connection with property from which such class of gross income is derived. The IRS noted that each Taxpayer CFC has four categories of income to which deductions may be allocated: (i) income from sales to its own customers (as the employer of both the Supply Broker and the Customer Broker), (ii) income from sales to customers on referral from other Taxpayer affiliates (as the employer of the Supply Broker), (iii) intercompany referral fee income from referrals of customers to other Taxpayer affiliates (as the employer of the Customer Broker), and (iv) foreign personal holding company income. The taxpayer took the position that the Referral Fee Expenses is definitely related to all of its categories of income, and therefore, the expense should be allocated across all its categories of income. The IRS disagreed, providing that the intercompany referral fees only relate to income from sales to customers on referral from other Taxpayer affiliates (as the employer of the Supply Broker) but for this income derived from a referral, the Referral 5

6 Fee Expense would not exist. The IRS noted that the definite relationship of the Referral Fee Expense to the income from sales to customers on referral is borne out by the fact that the gross margin of these sales is the basis for calculating the intercompany referral fee. Since the amount of the expense is based on the gross margin of the sale, and not on the amount of services provided or other sales, there is a direct relationship between these sales and the expense. Accordingly, the IRS concluded that the Referral Fee Expense is properly allocable only to income from sales to customers on referral from other Taxpayer affiliates (as employer of the Supply Broker). Because this income generated by the CFC employing the Supply Broker is non-subpart F income, the Referral Fee Expenses should not have reduced Taxpayer s subpart F income. Implications This FAA reflects certain IRS views regarding FBCSI and FBCSvI when earning related party commissions. First, the commission income must be tested as either FBCSI or FBCSvI, but not both. Second, consistent with PLR and PLR , FBCSI has been interpreted broadly and seemingly includes nearly any type of related party sales or purchase commission even though the IRS has not explained how the statutory requirement that the fee be earned in connection with purchases be made on behalf of a related party is satisfied. The FAA implies that solicitation of orders is sufficient in this regard. The IRS does not reject the notion of bifurcating between sales-related and other services in theory, nor does it reject the notion that postsale services should not be treated as sales-related services. Indeed, the definition of FBCSvI specifically excludes certain pre-sale services in Section 954(e)(2)(A), implying that post-sale services are included. The IRS position is based on the lack of substantiation for the Taxpayer s bifurcation. The FAA provides a lengthy analysis of the taxpayer s lack of adequate documentation, and concludes that the demarcation between sales and services income has not been clearly delineated. Taxpayers should be aware that functional analysis and interview notes related to functions may not be sufficient support for bifurcating between sales and services income for purposes of calculating subpart F income. The FAA focused on the importance of intercompany agreements that clearly identify responsible parties and establish methods for the allocation of fees. Taxpayers should reach out to international tax advisors to explore additional methods of bolstering their documentation of intercompany activities. The FAA also noted that certain postsale services (performing collection activity and providing market data) were conducted by the US parent rather than the CFCs. However, this discussion does not account for the fact that the CFC s Customer Brokers ostensibly bore responsibility for these services and, in that case, the US parent would have been performing these services under contract for the Customer Broker. If the CFC employing Customer Brokers chooses to hire an affiliate to provide those services, that does not mean the CFC in question fails to provide post-sale services to customers; the CFCs simply must provide arm s length compensation to that affiliate. With respect to expense allocation, the FAA merely follows the finding on the nature of the payment. Because the IRS believed the payment was 100% for sales generation, it allocated the expense 100% to the related gross income earns (and not apportioning it across all categories of gross income). If, factually, the payment is for other services as well, then a different allocation / apportionment answer may result. Endnotes 1. Note that the Customer Broker does not take title or risk of loss with respect to the property sold and thus earns services (not sales) income from an overall US federal income tax perspective. The sales versus services determination is relevant for Subpart F purposes only because certain services income is brought within the scope of foreign base company sales income. 6 International Tax Alert

7 For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, International Tax Services, New York Steve Jackson Ernst & Young LLP, International Tax Services, San Francisco Stephen Bates Ernst & Young LLP, International Tax Services, Chicago Joe Ryan Ernst & Young LLP, International Tax Services, Washington, DC Min Yu International Tax Services Global ITS, Alex Postma, Tokyo ITS Director, Americas, Jeffrey Michalak, Detroit National Director of ITS Technical Services, Jose Murillo, Washington Member Firm Contacts, Ernst & Young LLP (US) Northeast Johnny Lindroos, McLean, VA Financial Services Phil Green, New York Central Mark Muktar, Detroit Southeast Scott Shell, Charlotte, NC Southwest Amy Ritchie, Austin West Beth Carr, San Jose, CA Canada - Ernst & Young LLP (Canada) Albert Anelli, Montreal Kost Forer Gabbay & Kasierer (Israel) Sharon Shulman, Tel Aviv Mancera, S.C. (Mexico) Koen Van t Hek, Mexico City Central America - Ernst & Young, S.A. Rafael Sayagues, San José South America - Ernst & Young Serviços Tributários S.S. Gil F. Mendes, São Paulo International Tax Alert 7

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