Potential U.S. Tax Consequences of Using Foreign Sales or Manufacturing Branches

Editor: Alan Wong, CPA

Foreign Income & Taxpayers

The IRS late last year released final regulations under T.D. 9563 finalizing previously issued proposed regulations on the rules for foreign base company sales income (FBCSI) under Sec. 954(a)(2) and Regs. Sec. 1.954-3(b). The final regulations adopt with only minor changes proposed regulations issued in 2008 that addressed circumstances where a controlled foreign corporation (CFC) carries on purchasing or selling activities by or through more than one branch or similar establishment located outside the country under whose laws the corporation is created or organized (Regs. Sec. 1.954-3(b)(1)(i)). The regulations also address circumstances where a CFC carries on manufacturing, producing, constructing, growing, or extracting activities by or through a branch or similar establishment located outside the country under whose laws the corporation is created or organized (Regs. Sec. 1.954-3(b)(1)(ii)).

Background

Generally, U.S. shareholders of a CFC are currently taxed on their pro rata share of the CFC’s subpart F income (Sec. 951(a)(1)(A)(i)). A CFC is a foreign corporation that is more than 50% owned by one or more U.S. shareholders. Subpart F income includes FBCSI.

FBCSI is defined under Sec. 954(d)(1) as income derived by a CFC in connection with (1) the purchase of personal property from a related person (as defined under Sec. 954(d)(3)) and its sale to any person; (2) the sale of personal property to any person on behalf of a related person; (3) the purchase of personal property from any person and its sale to a related person; or (4) the purchase of personal property from any person on behalf of a related person where the property is manufactured, produced, grown, extracted, or sold for use, consumption, or disposition outside the country where the CFC was created or organized (Secs. 954(d)(1)(A) and (B)). If the property sold by a CFC is actually manufactured or deemed to be manufactured by the CFC, the CFC does not generate FBCSI (the manufacturing exception) (Regs. Sec. 1.954-3(a)(4)). Further, if the CFC sells property for use solely inside the country where the CFC is organized, the CFC does not generate FBCSI (the same-country exception).

Complications arise when a CFC employs a branch or branches to perform sales or manufacturing activities for the CFC outside the country where the CFC was created or organized.

The Branch Rule

For purposes of determining FBCSI, if a CFC operates a foreign branch outside the CFC’s country of incorporation, income attributable to the branch’s activities can be treated as if it were derived by a wholly owned subsidiary of the CFC (the branch rule) (Sec. 954(d)(2)). The branch rule applies if the CFC conducts any of the activities discussed above through a foreign branch, but only if the activity of the branch is considered to have “substantially the same tax effect” as if the branch were a subsidiary of the CFC (Regs. Sec. 1.954-3(b)(1)(i)(a)). The regulations require the application of a tax-rate-disparity test (Regs. Secs. 1.954-3(b)(1)(i)(b) and (ii)(b)) to determine whether the branch activity has substantially the same tax effect as if the branch were a subsidiary of the CFC.

The tax-rate-disparity test compares the effective tax rate in the country where the sales are executed with the effective tax rate where the property is deemed to be manufactured (i.e., where the manufacturing branch or branches are located). If the effective tax rate in the country where the sales are executed is less than 90% of, and at least five percentage points less than, the effective tax rate in the country where the manufacturing branch is located, then the manufacturing branch is treated as a separate, wholly owned subsidiary of the CFC.

As a result, the manufacturing branch is deemed to have sold products it produced to the CFC. Thus, subsequent sales of the products by the CFC for use or consumption outside the country where the CFC is organized generate FBCSI. If the tax-rate-disparity test is satisfied, the CFC is deemed to have conducted the activities of the manufacturing branch and, thus, the sale of products by the CFC does not result in FBCSI because the manufacturing branch is not treated as an entity separate from the CFC.

The same test applies where the CFC is the manufacturer and operates a branch or branches that sell the products for use or consumption outside the CFC’s jurisdiction. The key to applying the tax-rate-disparity test is to remember that the effective tax rate of the country where the sales are executed is always compared with the effective tax rate where the products were manufactured.

The following examples are based upon those in the FBCSI regulations.

Example 1. Sales branch: A U.S. corporation owns 100% of the shares of a foreign subsidiary in France (French CFC). The French CFC manufactures a product it sells to non-French customers through a branch operation in Ireland. The effective tax rate on the income of the French CFC is 34%. The effective tax rate on the income of the Irish branch is 12.5%.

This structure, which results in a significant reduction in the CFC’s foreign taxes, does not meet the tax-rate-disparity test (12.5% is less than 90% of, and at least five percentage points less than, 34%); therefore, the Irish branch is treated as a subsidiary of the French CFC. As a subsidiary, the Irish branch is deemed to have purchased the property it sells from the French CFC. It does not qualify for the manufacturing exception or the same-country exception discussed above because the branch does not manufacture the property it sells and it sells the property for use or consumption outside Ireland. Thus, any income of the branch from its sales activities is FBCSI, and the U.S. shareholders of the French CFC are currently taxed on the sales income of the Irish branch.

Example 2. Manufacturing branch: A U.S. corporation owns 100% of the shares of a foreign subsidiary in Ireland (Irish CFC). The Irish CFC sells products to non-Irish customers manufactured through a branch located in France. The same tax-rate-disparity test is applied by comparing the effective tax rate in the country where the sales were made and the effective tax rate in the country where the manufacturing activity occurred.

Again, because the effective tax rate in Ireland (12.5%) is less than 90% of, and at least five percentage points less than, the effective tax rate in France (34%), the French branch is considered a subsidiary of the Irish CFC. By isolating the manufacturing activity into a French subsidiary, the Irish CFC is deemed to have purchased the property it sells from the French subsidiary. It does not qualify for either the manufacturing exception or the same-country exception because the Irish CFC does not manufacture the property it sells and it sells the property for use or consumption outside Ireland. Thus, any income of the Irish CFC from its sales activities is FBCSI, and the U.S. shareholders of the French CFC are currently taxed on the sales income of the Irish branch.

More Than One Sales and/or Manufacturing Branch

Where a CFC uses more than one sales or purchase branch in addition to its manufacturing branch, the tax-rate-disparity test is applied separately to the income from each such branch (Regs. Sec. 1.954-3(b)(1)(ii)(c)(1)).

Example 3: A U.S. corporation owns 100% of a foreign subsidiary in France (French CFC). The French CFC operates three branches. Branch A, in Sweden, manufactures product X. Branch B, in Norway, sells product X to customers for use outside Norway. Branch C, in Denmark, sells product X to customers for use outside Denmark. The French CFC does not conduct any manufacturing or selling activities apart from the activities of its three foreign branches. The effective tax rate in France is 34%. The effective tax rate in Sweden is 26.3%. The effective tax rate in Norway is 28%. The effective tax rate in Denmark is 25%.

The use of branch B in Norway and branch C in Denmark does not create FBCSI because the effective tax rates (28% and 25%, respectively) on the income earned from their sales activities are not less than 90% of, and not five percentage points less than, the effective tax rate of the manufacturing branch in Sweden (26.3%).

Similarly, if a CFC operates more than one manufacturing branch, the tax-rate-disparity test is applied separately to each (Regs. Sec. 1.954-3(b)(1)(ii)(c)(2)).

Example 4: A U.S. corporation owns 100% of a foreign subsidiary in Ireland (Irish CFC). The Irish CFC operates two branches, branch A and branch B, in Sweden and Chile, respectively, that manufacture separate items of property (product X and product Y, respectively). The Irish CFC engages in activities in Ireland to sell product X and product Y for use outside Ireland. The effective tax rate in Ireland is 12.5%. The effective tax rate in Sweden is 26.3%. The effective tax rate in Chile is 17%.

Because the effective tax rate on the Irish CFC’s income from the sale of product X (12.5%) is less than 90% of, and at least five percentage points less than, the effective tax rate that applies to such income in Sweden (26.3%), branch A is considered a separate subsidiary of the Irish CFC. The Irish CFC is deemed to have purchased the property it sells from the Swedish subsidiary. It does not qualify for either the manufacturing exception or the same-country exception because the Irish CFC does not manufacture the property it sells and it sells the property for use or consumption outside Ireland. Thus, all the sales income of the Irish CFC with respect to the sale of product X is FBCSI, and the U.S. shareholders of the Irish CFC are currently taxed on that sales income.

Although the effective tax rate on the Irish CFC’s income from the sale of product Y is less than 90% of the effective tax rate that would apply to such income in Chile (12.5% ÷ 17% = 73.5%), it is not five percentage points less. Therefore, branch B is not considered a separate subsidiary of the Irish CFC, and no FBCSI arises from the Irish CFC’s sale of product Y to customers outside Ireland.

Regs. Sec. 1.954-3(b)(1)(ii)(c)(3) provides rules to determine the location of manufacture, production, or construction (the location of manufacture) of personal property for purposes of applying the tax-rate-disparity test where more than one manufacturing branch or one or more manufacturing branches and the remainder of the CFC each engage in manufacturing, producing, or constructing activities with respect to the same item of personal property.

The regulations apply where (1) one or more branches of a CFC or the CFC itself independently satisfies the manufacturing exception; or (2) none of the branches of the CFC independently satisfies the manufacturing exception, but the CFC as a whole makes a “substantial contribution” to the manufacture of the property within the definition of the manufacturing exception. The location of tested activities is where the CFC’s employees perform such activities; or in the case of intellectual property (IP), it is where the employees develop or direct the use or development of the IP.

For purposes of the examples, various assumptions have been made regarding qualification for the manufacturing exception to the FBCSI rules. A detailed discussion of the manufacturing-exception rules is not provided in this item.

One or More Branches Satisfy the Manufacturing Exception

In some cases, only one of multiple manufacturing branches might satisfy the manufacturing exception.

Example 5: The Irish CFC operates three branches. Branches A, B, and C are in Sweden, Norway, and Denmark, respectively. Branches A, B, and C each perform different activities with respect to the manufacture of product X. Branch A, through employees of the Irish CFC in Sweden, designs product X. Branch B, through employees of the Irish CFC in Norway, provides quality control, oversight, and direction. Branch C, through employees of the Irish CFC in Denmark, manufactures product X using designs developed by branch A and under the oversight of the quality-control personnel of branch B.

The activities of branch C independently satisfy the manufacturing exception. The activities of branches A and B do not independently satisfy the manufacturing exception. Employees of the Irish CFC in Ireland purchase the raw materials used in the manufacture of product X from a related person and control the work-in-process and finished goods through the manufacturing process. Employees of the Irish CFC in Ireland also manage the manufacturing costs and capacities related to product X. Further, employees of the Irish CFC in Ireland oversee coordination among the branches. The activities of the Irish CFC performed in Ireland do not independently satisfy the manufacturing exception. Employees of the Irish CFC in Ireland sell product X to customers for use outside Ireland.

Under the regulations, Denmark is the location of manufacture for purposes of applying the tax-rate-disparity test because only the activities of branch C independently satisfy the manufacturing exception. Because the effective tax rate on the sale of product X is only 12.5% (sales are made from the Irish CFC), it is both less than 90% of, and at least five percentage points less than, the effective tax rate that applies to such income in Denmark (25%). Thus, branch C is considered a separate subsidiary of the Irish CFC, and the income from the sale of product X results in FBCSI, unless the remainder of the Irish CFC’s activities qualify for the manufacturing exception.

To determine whether the remainder of the Irish CFC’s activities qualify for the manufacturing exception, the activities of the Irish CFC include the activities of branch A or B, respectively, if each of those branches would not be treated as a separate corporation after the separate application of the tax-rate-disparity test to each branch. Because both branches A and B are considered separate corporations after the application of the tax-rate-disparity test, their activities are not considered to determine whether the remainder of the Irish CFC’s activities qualify for the manufacturing exception, which measures whether a substantial contribution has been made to the production of personal property. If the manufacturing exception cannot be satisfied, the income from the sale of product X is considered FBCSI.

Example 6: Assume the same facts as Example 5, except that, in addition to designing product X, branch A also performs other manufacturing activities, including those ascribed to the Irish CFC, and that those activities, when combined, independently satisfy the manufacturing exception. Further assume that branch A is in Bulgaria, where the effective tax rate is 10%.

Under this example, both branches A and C satisfy the manufacturing exception. Therefore, the tax-rate-disparity test is applied by comparing the effective tax rate in Ireland with the lower effective tax rate between the two branches. Because the rate in Bulgaria is 10%, the tax-rate-disparity test is satisfied, and neither branch A nor C is considered a separate corporation. Thus the income from the sales of product X is not FBCSI. The effective tax rate of branch B in Norway is not considered because branch B does not independently satisfy the manufacturing exception.

No Branch Satisfies the Manufacturing Exception

Where no branch satisfies the manufacturing exception but the CFC as a whole makes a substantial contribution to the production of the personal property sold by the CFC or a sales branch, the location of manufacture is the “tested manufacturing location,” unless the “tested sales location” provides a greater contribution to the manufacturing process.

The tested manufacturing location is the location of any branch or the remainder of the CFC that contributes to the manufacturing process that, after applying the tax-rate-disparity test, is treated as a separate corporation and imposes the lowest effective tax rate on the income allocated to such branch or to the remainder of the CFC. The tested sales location is the location of the purchasing or selling activity or the remainder of the CFC through which the selling activities are performed.

The contribution of the sales or purchasing branch is deemed to include the activities of any branch or the remainder of the CFC that is not treated as a corporation separate from the tested sales location after applying the tax-rate-disparity test. The contribution of the manufacturing location is deemed to include the activities of any branch or the remainder of the CFC that is treated as a separate corporation from the tested sales location after the application of the tax-rate-disparity test.

Whether the tested manufacturing location or the tested sales location makes a greater contribution to the manufacturing process is determined by the facts-and-circumstances test under the substantial-contribution test.

The above examples demonstrate the basics of the FBCSI rules. The regulations cover additional scenarios as well; however, the rules all apply the basic principles outlined in the above examples.

EditorNotes

Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York City.

For additional information about these items, contact Mr. Wong at 212-697-6900, ext. 986 or awong@hrrllp.com.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.