Taxpayer avoids Sec. 954(d)(1) Scylla but not Sec. 954(d)(2) Charybdis

By James A. Beavers, CPA, CGMA, J.D., LL.M.

The Tax Court held that the sales income earned by a taxpayer's Luxembourg subsidiary from sales of products made by a Mexican branch of the subsidiary was foreign base company sales income (FBCSI) of the taxpayer and taxable as Subpart F income.


Whirlpool Financial Corp. (Whirlpool), a Delaware corporation with its principal place of business in Michigan, filed a federal consolidated return with its domestic subsidiaries in 2009. Through its domestic and foreign subsidiaries, Whirlpool manufactures and distributes major household appliances, including refrigerators and washing machines, in the United States and abroad. Whirlpool International Holdings S.a.r.l. (WIH) is a wholly owned subsidiary of Whirlpool, organized under the laws of Luxembourg. Before Dec. 31, 2010, WIH was known as Maytag Corp.

During 2007-2009 Whirlpool restructured its Mexican manufacturing operations, largely for tax reasons. It organized a new entity in Luxembourg (WL), which was a controlled foreign corporation (CFC). Through a branch in Mexico (WIN), WL took over (at least nominally) the manufacturing operations of a subsidiary of Whirlpool Mexico, a Mexican CFC. WL then sold the finished products to Whirlpool and Whirlpool Mexico, which distributed the products for sale to consumers. WL, which had one part-time employee, added no appreciable value to, but earned substantial income from, these sales transactions.

On audit, the IRS determined that the sales income derived by WL constituted FBCSI under Sec. 954(d) and was thus taxable to Whirlpool as Subpart F income under Sec. 951(a). Thus, it increased Whirlpool's taxable income for 2009 by approximately $50 million and decreased the company's consolidated net operating loss (NOL) carryback deduction. The reduction in available NOL carrybacks generated deficiencies for Whirlpool for 2005 and Maytag for 2000.

Whirlpool challenged the IRS's determination in Tax Court. In Tax Court, it filed a motion for partial summary judgment, contending that WL's sales income was not FBCSI under Sec. 954(d)(1) because the appliances it sold were substantially transformed by its Mexican branch from the component parts and raw materials it had purchased. The IRS opposed that motion, contending that genuine disputes of material fact existed as to whether WL actually manufactured the products. Whirlpool and the IRS filed cross-motions for partial summary judgment on the question of whether the sales income was FBCSI under Sec. 954(d)(2), the so-called branch rule.

The Tax Court's decision

The Tax Court held that regardless of whether WL was treated as the manufacturer of the products it sold, WIN was treated as its subsidiary, and under Sec. 954(d)(2), the sales income earned by WL constituted FBCSI taxable to Whirlpool as Subpart F income. The Tax Court analyzed Whirlpool's situation under the terms of Sec. 954(d)(2) itself and Regs. Sec. 1.954-3(b), which was promulgated to govern the application of Sec. 954(d)(2).

Under a territorial tax system, a CFC often would pay no tax to its home country on income sourced through a branch outside its home country, creating the possibility that the U.S. parent could achieve indefinite deferral of both U.S. and foreign tax under Sec. 954(d)(1). Congress therefore backstopped Sec. 954(d)(1) with the "branch rule" in Sec. 954(d)(2).

The statute: Sec. 954(d)(2) states:

For purposes of determining foreign base company sales income in situations in which the carrying on of activities by a controlled foreign corporation through a branch or similar establishment outside the country of incorporation of the controlled foreign corporation has substantially the same effect as if such branch or similar establishment were a wholly owned subsidiary corporation deriving such income, under regulations prescribed by the Secretary the income attributable to the carrying on of such activities of such branch or similar establishment shall be treated as income derived by a wholly owned subsidiary of the controlled foreign corporation and shall constitute foreign base company sales income of the controlled foreign corporation.

The first part of Sec. 954(d)(2) provides two preconditions for application of the branch rule: (1) the CFC must be carrying on activities "through a branch or similar establishment" outside its country of incorporation, and (2) the conduct of activities in this manner must have "substantially the same effect" as if the branch were a wholly owned subsidiary of the CFC.

Regarding the first requirement, the court explained that "branch" is just a term describing the conduct of a trade or business by a corporation directly, rather than through a separate entity. Because WIN was a disregarded entity owned by WL, the court concluded WIN was a branch of the CFC. Furthermore, the court found that this conclusion was supported by the fact that WL represented WIN as a branch to Luxembourg tax authorities. Since WIN was in a country outside Luxembourg, the first requirement was met.

Moving to the second requirement, the Tax Court found that where a CFC was chartered in a country that employed a territorial tax system, the CFC's conduct of business through a branch outside of the CFC's home country and earning only income sourced there could have "substantially the same effect" as if that income were earned by a subsidiary under U.S. tax rules. In either case, the court stated, the income typically would not be currently taxable to its ultimate owner (the branch's home office or the subsidiary's parent).

Here, WL's home country was Luxembourg, which in 2009 employed a territorial tax system. Under the Mexican tax regime, WIN was taxed on its manufacturing income, but WL was treated as a foreign principal that had no permanent establishment in Mexico, so it paid no Mexican tax on its sales income. Thus, by carrying on its activities through WIN, WL avoided any current taxation of its sales income, achieving "substantially the same effect" — deferral of tax on its sales income — that it would have achieved under U.S. tax rules if WIN were a wholly owned subsidiary deriving such income.

The statute's preconditions having been met for WL, the treatment in the second part of Sec. 954(d)(2) applied to its income. Accordingly, under the statute, the Tax Court held that WL's sales income is FBCSI that must be included in Whirlpool's income under Subpart F.

The regulations: Regs. Sec. 1.954-3(b) governs application of the branch rule. The regulations create parallel sets of rules for "sales or purchase branches" and "manufacturing branches." Where (as was the case with WL and WIN) a CFC carries on manufacturing activities through a branch outside the CFC's country of incorporation, the CFC and its branch will be treated as separate corporations for purposes of determining FBCSI if "the use of the branch . . . for such activities with respect to personal property . . . sold by or through the remainder of the . . . [CFC] has substantially the same tax effect as if the branch . . . were a wholly owned subsidiary" of the CFC.

To determine whether the tax effect is "substantially the same," the regulations dictate a two-part analysis. The first part requires the allocation of income between the branch and "the remainder" of the CFC.

The second part requires the comparison of the actual and hypothetical effective rates of tax applicable to the sales income allocated to the remainder to see if it was taxed during 2009 at an appreciably lower rate than the effective rate of the country in which the branch was located would have taxed the income. Per the regulations, it is taxed at an appreciably lower rate if the allocated income by statute, treaty obligation, or otherwise is taxed in the year when earned at an effective rate of tax that is less than 90% of, and at least 5 percentage points less than, the effective rate of tax of the branch country.

The Tax Court found in the first part of the analysis that WIN was allocated all the manufacturing income from the products it made, and WL, the remainder, was allocated all the sales income from the products. It also found that WL paid a 0% tax rate on its income and would have paid the general Mexican corporate tax rate of 28% under the assumptions included in the regulations. The court therefore found that WL's use of a branch in Mexico had substantially the same tax effect as if the branch were a wholly owned subsidiary corporation. Consequently, the court treated WL and WIN as separate corporations for determining whether the sales income was FBCSI.

Under the regulations, to determine whether income is FBCSI where the CFC and the branch are treated as separate corporations, the branch is treated as a wholly owned subsidiary of the CFC, deemed to be incorporated in the country in which it is located. The CFC's selling activities with respect to the personal property manufactured by the branch are treated as performed on behalf of the branch. Therefore, for WL and WIN, under Sec. 954(d)(2), WIN was deemed to be a wholly owned subsidiary of WL, and WL was deemed to have sold the products manufactured by WIN to Whirlpool and Whirlpool Mexico on behalf of its deemed Mexican subsidiary, WIN. Under this scenario, the Tax Court concluded the sales income derived by WL constituted FBCSI under Sec. 954(d) and was taxable to Whirlpool as Subpart F income under Sec. 951(a).


As the Tax Court noted, Whirlpool's tax restructuring of its Mexican operations did not change its manufacturing activities there in any way; it was done solely to send the sales income from the Mexican operations to WL, which was not taxed on that income in Mexico or Luxembourg. If WL had conducted its manufacturing operations in Mexico through a separate entity, its sales income would plainly have been FBCSI under Sec. 954(d)(1). According to the Tax Court, Sec. 954(d)(2) was enacted in order to prevent exactly this sort of activity.

Whirlpool Financial Corp., 154 T.C. No. 9 (2020)

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