Interaction of the Subpart F Dual-Character Property and Majority-Use Rules

By Hui Yu, J.D., LL.M., Washington, D.C.

Editor: Annette B. Smith, CPA

Foreign Income & Taxpayers

When a controlled foreign corporation (CFC) sells property used in its active business, any gain generally is not treated as subpart F income includible in its U.S. shareholders’ taxable income. However, if the property sold has given rise to both active and passive income, the gain must be bifurcated between subpart F and non–subpart F income. A further complication occurs if the property gave rise to purely active income for several years and then to both active and passive income prior to its disposition.

Subpart F Gains

Sec. 954(c)(1) generally defines foreign personal holding company income (FPHCI), one type of subpart F income, to include the excess of gains over losses from the sale of property giving rise to rents or royalties, other than rents and royalties derived in an active trade or business from an unrelated person (the active rent/royalty exception).

Dual-Character Property Rule

A piece of property may be used simultaneously to generate (1) service income or active rent/royalty income from unrelated customers (hence non-FPHCI) and (2) rent/royalty income from related parties that does not qualify for the active rent/royalty exception (hence FPHCI). Such property is referred to as “dual character property” by Regs. Sec. 1.954-2(e)(1)(iv).

Under the dual-character property rule, the sale of such property gives rise to gain or loss that is partly included in, and partly excluded from, FPHCI. Gain from the sale of dual-character property must be bifurcated under the method that most reasonably reflects the relative uses of the property. Regs. Sec. 1.954-2(e)(1)(iv) provides that reasonable methods may include comparisons of gross income generated or the physical division of the property. For example, if a CFC owns an office building, uses 60% of the space for its offices (generating active income in its trade or business), and rents out the other 40% (generating rental income not in its active trade or business), then 40% of the gain on the sale of the building would be included in FPHCI based on physical division.

Majority-Use Rule

Property is not dual-character property merely because the CFC used the property at one time for one purpose and later used it for another. Under such circumstances, the entire gain or loss is either included in or excluded from FPHCI, generally depending on the predominant use of the property during the period the CFC held it before the disposition.

The majority-use rule of Regs. Sec. 1.954-2(a)(3)(i) provides that the determinant use of a piece of property is that to which it was put for more than one-half of the CFC’s holding period. For example, during years 1 and 2, the CFC derived rents as investment income from a building, which were included in FPHCI. At the start of year 3, the CFC changed the use of the building by terminating all leases and using it in an active business and then sold the building at the beginning of year 4. Because the CFC did not use the building in its active business for more than one-half of its holding period, it should be treated as property giving rise to rents, and all gain from the sale should be included in the CFC’s FPHCI.

Interaction of the Two Rules: Possible Approaches

It is common for a business to use property for mixed purposes and for the mixture to change over time. For example, in year 8, the CFC decides to sell an asset that had generated only non-FPHCI for years 1–6. At the beginning of year 7, the structure of the business had changed, and 40% of the CFC’s income from the asset was FPHCI until the sale of the asset at the end of year 8. Does the dual-character property rule or the majority-use rule apply, or do both apply? No IRS guidance has addressed the interaction of the two rules.

One possible approach would be to treat the two rules as mutually exclusive. Under this approach, in the case of the above asset, which has a dual character for some period prior to disposition, the dual-character property rule applies, and gain from sale of the asset would be bifurcated between FPHCI and non-FPHCI based on a reasonable allocation method. This approach would yield a worse result for a taxpayer that uses an asset for mixed purposes for a relatively small part of its holding period compared with a taxpayer that uses an asset to generate entirely nonactive income for the same fraction of the holding period. Such a result would seem contrary to the policy behind these rules.

A second possible approach would be to apply the dual-character property rule first. Because the asset in the example has a dual character in the year of sale, it is treated as two separate properties—active property and nonactive property—and each bifurcated piece then is tested under the majority-use rule. Because in this example the nonactive property was used to generate active income for six out of eight years, its predominant use is active, and it would be treated as active. An issue with this approach arises when the dual character was present in earlier years of the CFC’s holding period but not in the year of sale. To address that problem, the year in which the percentage of nonactive income was greatest or an average over the years of mixed use might be used to determine the bifurcation.

A third approach would be to apply the majority-use rule first to determine whether the asset was used predominantly to generate active income, nonactive income, or a mixture. The dual-character property rule would apply only if the predominant use was mixed—i.e., the property is dual-character for more than half of the holding period. Because the asset in the above example was used to generate active income for six years and both active and nonactive income for two years, the predominant use is active, and the asset would be treated as active property. A problem with this approach arises when no single type of use occurred for more than half of the holding period—e.g., the property generates active income for three years, both active and nonactive income for four years, and nonactive income for three years. To resolve that issue, the plurality of the years might be used to determine which rule applies.


Annette Smith is a partner with PwC, Washington National Tax Services, in Washington, D.C.

For additional information about these items, contact Ms. Smith at 202-414-1048 or

Unless otherwise noted, contributors are members of or associated with PwC.

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