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IRS issues guidance to its examiners on subpart F audits

IRS has released three new international practice units (IPUs) providing guidance to IRS agents on the audit of certain structures and transactions that may generate subpart F income. Noting that the subpart F and transfer pricing rules are “not mutually exclusive,” IRS directs its examiners to request the following additional resources: organizational charts, steps of transactions, contracts/agreements containing the critical facts of the transactions, product flow and transaction flowcharts, transfer pricing information, and/or value added tax (VAT) returns, among other things.

Background. In general, U.S. shareholders of a foreign corporation are not subject to U.S. taxation on the income of the foreign corporation until an actual dividend is remitted by the foreign corporation to the U.S. shareholders. However, the U.S. shareholders of a controlled foreign corporation (CFC) must include in gross income their pro rata share of the CFC’s subpart F income (a subpart F inclusion). (Code Sec. 951)

For this purpose, whether or not a U.S. person (as defined under Code Sec. 957(c) and Code Sec. 7701(a)(3)) meets the requirements of a U.S. shareholder with respect to a foreign corporation, and whether the foreign corporation meets the requirements of a CFC, are both based on defined thresholds of ownership. (See Code Sec. 951(b), Code Sec. 957(a), and Code Sec. 958.)

Subpart F includes foreign base company income, among other things. (Code Sec. 952) Foreign base company income includes foreign base company sales income (FBCSI) and foreign personal holding company income (FPHCI), among other things. (Code Sec. 954(a), Code Sec. 954(c) , and Code Sec. 954(d))

FBCSI generally arises from the sale of tangible personal property under certain conditions. The three conditions are:

1. The property is manufactured or produced outside the country where the CFC is created or organized (i.e., place of manufacturing);
2. The property is sold for use, consumption, or disposition outside the country where the CFC is created or organized (i.e., place of consumption); and
3. The transaction involves a related person (i.e., parties to the transaction).

For this purpose, a CFC and another corporation are related persons if one controls the other, or if both are controlled by the same person or persons, within the meaning of Code Sec. 954(d)(3).

Under the “same country sales exception,” FBCSI does not include income derived by a CFC in connection with the purchase and sale of property, if the property is sold for use, consumption, or disposition in the country where the CFC is created or organized. (Code Sec. 954(d)(1)(B) and Reg. § 1.954-3(a)(3)(i))

In addition, under the “same country manufacturing exception,” FBCSI does not include income derived by a CFC in connection with the purchase and sale of property, if the property is manufactured, produced, grown, or extracted in the country where the CFC is created or organized. (Code Sec. 954(d)(1)(A) and Reg. § 1.954-3(a)(2)) In some cases, a CFC may have to determine whether its in-country activities constitute manufacturing.

In general, FPHCI includes passive income, such as dividends, interest, rents, and royalties. The FPHCI rules generally aim to eliminate the deferral of U.S. tax on income from passive types of investments, e.g., where the foreign corporation is merely passively receiving investment income rather than earning active business income.

The same country exception from FPHCI provides, in relevant part, that FPHCI doesn’t include dividends and interest received from a related person (as defined under Code Sec. 954(d)(3)) that (i) is a corporation created or organized in the same country as the CFC, and (ii) uses a substantial part of its assets in a trade or business in that same country. The same country exception doesn’t apply to interest to the extent it reduces the payor’s subpart F income or creates or increases a deficit in E&P that reduces the subpart F income of the payor or another CFC.

Further, the same country exception doesn’t apply to dividends attributable to E&P that accrued while the recipient did not hold the stock of the payor (either directly, or indirectly). In addition to the above inquiries, the examiner should determine whether the dividend is attributable to E&P accrued while the recipient CFC held stock in the payor CFC

For tax years of CFCs beginning before Jan. 1, 2015, the look-through rule states that dividends, interest, rents, and royalties received or accrued from a CFC that is a related person will not be treated as FPHCI to the extent attributable or properly allocable to income of the related CFC that is neither subpart F income nor ECI. In addition, the look-through rule will not apply to the extent the interest, rent, or royalty creates or increases a deficit in E&P that reduces (or may reduce) the subpart F income of the payor or another CFC.

RIA observation: The look-through rule is one of about 50 “extender” provisions currently being considered for a 2-year, retroactive extension. Although these provisions expire every year or two years, they are generally routinely renewed.

New IPUs. On July 17, 2015, IRS posted the following three new IPUs to its website:

  • CFC purchase from related party with same-country sales (DPL/9412.01_01(2015);
  • CFC sale to related party with same country unrelated party manufacturing (DPL/9412.01_03(2015); and
  • Receipt of dividends or interest from a related CFC (DPL/9412.03_04(2015).

In these new IPUs, IRS agents are instructed to first review the taxpayer’s audited financial statements to determine the effective tax rate (ETR) and the total amount of “permanently reinvested offshore income” (commonly referred to as “permanently reinvested earnings under APB 23”) for the years at issue.

The taxpayer’s ETR would then be compared to other companies in the same industry. Examples are provided of jurisdictions with tax rates lower than the U.S. 35% rate, including the cautionary statement that profits may be “moved” or shifted to lower-taxed jurisdictions.

CFC purchase from related party with same country sales. A CFC may have FBCSI, as a result of buying property from a related person and selling that property to anyone—that is, related and unrelated parties.

The IPU (DPL/9412.01_01(2015)) dealing with this topic examines a scenario where a CFC purchases property from its U.S. parent corporation (a related party) and resells such property to related-party CFCs and unrelated parties, with no additional modifications to the property that was purchased and resold. It addresses whether the income from the resale qualifies for the same country sales exception.

To identify the related-party transactions that may give rise to FBCSI, IRS directs its agents to the applicable Code, regulations, and the following resources:

  • Form 5471 (Information Return of U.S. Persons With Respect to Certain Foreign Corporations), Schedule M (Transactions Between Controlled Foreign Corporation and Shareholders or Other Related Persons), where related-party transactions are reported;
  • Organizational charts, including relevant contracts/agreements, to establish whether related-party transactions took place;
  • Transfer pricing studies that provide detail regarding the related-party transactions; and
  • Any subpart F or “supply chain” functional analysis that may have been undertaken.

To verify the place of use, consumption, or disposition under the same country sales exception, IRS directs its agents to request schedules of sales by destination and copies of local country VAT returns. According to IRS, VAT returns “will be useful in determining where purchased property is acquired from (i.e., if the property is acquired from outside the country, then most likely, it was manufactured outside the country) or sold to.” In addition, the IRS agents are instructed to consider conducting taxpayer interviews.

Finally, IRS agents are instructed to consult with the Transfer Pricing Practice (TPP) or Income Shifting Issue Practice Networks (IPN) regarding any potential transfer pricing issues.

CFC sale to related party with same country unrelated party manufacturing. The IPU (DPL/9412.01_03(2015)) dealing with this topic examines scenarios in which CFCs purchase property from an unrelated vendor and resells the property to its U.S. parent corporation (a related party), with no additional modifications to the property that was purchased and resold. It addresses whether the income from the resale qualifies for the same country manufacturing exception. The U.S. parent corporation ultimately sells the property to unrelated U.S. customers.

To identify the related-party transactions that may give rise to FBCSI and to verify the place of use, consumption, or disposition under the same country sales exception, IRS again directs its agents to the resources discussed above.

To substantiate whether property is physically manufactured in the same country where the CFC is created or organized, IRS agents are instructed to request documentation from the taxpayer to substantiate whether the property is manufactured within such country. Furthermore, if the IRS examiner has reason to doubt that the property was manufactured in said country, he/she “should use professional judgement to determine what, if any, additional exam resources should be expended to verify this.”

As a caveat, the IPU (DPL/9412.01_03(2015)) notes that what constitutes manufacturing and other detailed rules are not addressed.

Receipt of dividends or interest from a related CFC. A CFC receiving dividend and interest income from a related CFC would generally be characterized as FPHCI, potentially resulting in a current Subpart F inclusion to the U.S. parent. However, the income may be excluded from FPHCI under the look-through rule or same country exception if the CFCs meet certain requirements.

This IPU (DPL/9412.01_04(2015)) covers the same country exception and look-through rules for FPHCI (specifically dividends and interest). The examiner is instructed to determine whether the dividend and interest income that the CFC received would normally constitute FPHCI and whether the current amount of unrepatriated offshore E&P may limited this amount.

The examiner should carefully review all of the criteria for the same country exception from FPHCI. And, the examiner should determine whether the payor CFC is a corporation created or organized in the same country as the CFC; whether the payor CFC is a related person with respect to the CFC; whether the payor CFC uses a substantial portion of its assets in a trade or business in the same country where the CFC is created or organized; and whether the interest payment reduces the payor CFC’s subpart F income or creates/increases a deficit in E&P that reduces (or may reduce) the subpart F income of the payor CFC or another CFC.

The examiner should determine whether interest is allocable or apportionable to subpart F income or ECI, in which case the income would not be excluded from FPHCI under the look-through rule. The examiner should determine CFC whether the payor CFC is a related person with respect to the recipient CFC; whether the interest income is attributable to subpart F income or ECI of the payor; whether the interest income creates or increases a deficit in E&P that reduces the subpart F income of the payor CFC or another CFC.

In addition to actual cash dividends, the following are also eligible for the exception: (a) amounts treated as dividends as a result of a Code Sec. 302 or Code Sec. 304 redemptions; (b) gain on sale of a related CFC recharacterized as a dividend under Code Sec. 964(e); (c) gain recognized in certain reorganizations recharacterized as a boot dividend under Code Sec. 356(a)(2). All E&P amounts under Reg. § 1.367(b)-3(b)(3)(i) (inbound reorganization of a lower-tier CFC) are not eligible for the exception.

Under the anti-abuse rule, Notice 2007-9 lists four types of transactions that will not qualify for the look-through rule from FPHCI: (1) amounts that reduce the US tax base, including factoring income; (2) avoidance of Code Sec. 956; (3) use of options or similar interests; and (4) change of character of income through the use of a conduit entity. The IPU notes that the examiner should consult with counsel before applying these anti-abuse provisions.

References: For foreign base company sales income, see FTC 2d/FIN ¶  O-2481  et seq.; United States Tax Reporter ¶  9544.03.

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