You will not find these international tax plans on the web. They are the secrets of big business. Written in early 2000, these “loopholes” continue to remain viable for small business.
This study was never meant to be made public, and you will not find this on the internet, except on this blog.
This study has international tax planning secrets that are not shared at tax seminars.
The Treasury study exposes global tax planning strategies that defeat the IRS. These international tax plans will save you taxes. The study has example after example of tried and true foreign tax plans that will give you planning ideas for your business.
The report is on this blog below in blue ink. If you would like the official U.S. Government PDF report, then please email me at [email protected]
It explains in easy to read terms (because it was written for Congressmen & women), the many legal ways business avoid taxes. The booklet will give you a blueprint for your international tax planning.
If you plan to have a business in a foreign country to export product, this report will give you new international tax planning methods.
Cloud computer tax planning: I was interested in the terminology used. In 2000, the term “cloud computer” or “in the cloud” did not exist. Because of the cloud, saving taxes offshore is easier than ever before. E-commerce in the cloud is different from the E-commerce in 2000. It is cheaper and better, which is why I wrote my easy to read book, International Taxation in America for the Entrepreneur.
This is the only official document where cloud computer tax planning is discussed. If you search the booklet for the term e-commerce, you find the discussion.
More information on cloud computer tax planning is found on this link or my easy to read book, International Taxation in America for the Entrepreneur, on this link. The Kindle edition is on sale for $9.50.
The Deferral of Income Earned Through U.S. Controlled Foreign Corporations
AVOIDING THE RULES OF SUBPART F (Author note: if you avoid the rules of Subpart F, your foreign income is not taxable. You report this income on form 5471.)
Previous chapters have discussed the principal factors that influenced the enactment of subpart F. These were, principally, preventing tax haven abuse, taxing passive income currently, promoting equity among taxpayers, promoting economic efficiency and avoiding undue harm to competitiveness.
The purpose of this chapter is to examine generally the effectiveness of the specific rules of subpart F in meeting these goals. Subpart F attempts to achieve its goals through specific rules that are intended to tax passive income on a current basis and to prevent the deflection of income to low-tax jurisdictions and other special tax regimes. This chapter considers two illustrative categories of transactions that avoid the application of those specific rules.
II. Illustrations of Techniques to Avoid Subpart F A. Hybrid Entity Techniques
The rules of subpart F are largely premised on the assumption that for non-tax reasons business will be carried on in corporate form (e.g., to limit liability). Even if this assumption still holds true in the foreign context, it is no longer true in the United States. As a result, subpart F can be avoided by planning techniques that exploit both the corporate focus of the subpart F related party rules and the failure of subpart F to address directly inter-branch passive income payments.
These tax avoidance techniques generally involve the use of hybrid entities. A hybrid entity is an entity that is classified differently for U.S. tax purposes than it is classified for foreign tax purposes.1
For example, the foreign personal holding company income (FPHCI) rules that relate to the receipt of passive income, such as interest, do not expressly deal with payments between “branches” of a single corporation, even if for foreign law purposes the CFC and branch are respected as two separate entities.
The foreign base company sales income (FBCSI) rules, by contrast, treat a branch of a single corporation as a separate entity in certain circumstances in order to prevent the deflection of income to a low-tax jurisdiction. This disparity in treatment between the FPHCI rules and the FBCSI rules can lead to seemingly inconsistent results.
For example, if sales income is shifted from one CFC to a related CFC in a different jurisdiction,
Footnote 1 Generally, an entity taxed as a corporation in a foreign jurisdiction but treated as a partnership or disregarded entity for U.S. tax purposes is referred to as a “hybrid.” An entity taxed as a partnership or other passthrough in a foreign jurisdiction but treated as a corporation for U.S. tax purposes is referred to as a “reverse hybrid.”
subpart F income (i.e., FBCSI) may arise. Similarly, if sales income is shifted from one CFC to its branch in a different jurisdiction, FBCSI may also arise, because the branch may be treated as a separate corporation under the FBCSI rules. If income is shifted through interest payments from one CFC to a related CFC in a different jurisdiction, subpart F income (i.e., FPHCI) may arise.
If, however, income is shifted through interest payments from one CFC to its hybrid branch in a different jurisdiction, subpart F income currently will not arise.2 Given the outcome in the first three situations, the final result seems anomalous.
The examples below illustrate how hybrid entities have been used to deflect income from a high-tax jurisdiction to a low-tax jurisdiction and exploit the same country exceptions to the FPHCI rules.
1. Use of Hybrids to Deflect Income from High-Tax Jurisdictions to Low-Tax Jurisdictions
A number of hybrid arrangements involve related party payments the purpose of which is to deflect income from a high-tax jurisdiction to a low-tax jurisdiction while avoiding subpart F. For example, assume a U.S. person wholly owns an operating CFC (“CFC1”) in Country A, a high-tax jurisdiction. To deflect operating income from Country A (where it would be subject to a high tax) to Country B, a low-tax jurisdiction, the U.S. person could cause CFC1 to establish an entity (“BR1”) in Country B that would be treated as a corporation in Country A but would be disregarded for U.S. tax purposes.
The U.S. person would then cause BR1 to make a loan to CFC1. Because Country A would treat BR1 as a corporation, the interest payments from CFC1 to BR1 would be deductible in Country A and, therefore, would reduce the amount of CFC1 operating income that otherwise would be subject to the high tax imposed by Country A.
Because Country B is a low-tax jurisdiction, the interest payments received by BR1 from CFC1 would be subject to little or no tax in Country B.
Finally, because the United States would treat BR1 as a disregarded entity for U.S. tax purposes, the taxpayer would take the position that the interest payment between CFC1 and BR1 should be disregarded for U.S. tax purposes, and thus should not be subpart F income.
Accordingly, by exploiting the difference in the U.S. tax treatment of corporations and disregarded entities, as well as differences in entity classification among different jurisdictions, the U.S. person takes the position that it is able to deflect operating income from a high-tax jurisdiction to a low-tax jurisdiction while avoiding the application of the subpart F rules.
2. Use of Hybrids to Shelter Income From Current Tax in All Jurisdictions
Hybrid arrangements also have been used to shelter income from taxation in any jurisdiction. This can be accomplished without the need to deflect the income to a tax haven or other low-tax jurisdiction. For example, assume a U.S. person owns an operating CFC (“CFC1”)
Footnote 2 Proposed regulations under section 954 would tax certain hybrid transactions described in this section. However, such regulations will not have effect until after July 1, 2005, at the earliest. See 64 Fed. Reg. 37727 (July 13, 1999).
in Country A, a high-tax jurisdiction. To shelter CFC1’s operating income from country A tax and to avoid subpart F, the U.S. person could establish a reverse hybrid in Country A (“FP1”) (i.e., an entity that would be treated as a partnership in Country A and a corporation in the United States).
FP1 must be engaged in a trade or business located in Country A. The U.S. person could then contribute cash to FP1, and cause FP1 to make a loan to CFC1. CFC1 should get a deduction in Country A for the interest paid to FP1 thereby reducing the amount of CFC1 operating income that otherwise would be subject to high Country A tax.
Because, for purposes of Country A tax, FP1 is a transparent entity, no entity level tax would be imposed on FP1 on the interest paid to it. Instead, Country A would treat the interest paid to FP1 as actually paid to the U.S. shareholder. Assuming Country A has an income tax treaty with the United States (and that the interest paid to FP1 would qualify for treaty benefits3), this interest likely would be subject to little or no withholding taxes in Country A.
Finally, because the United States would treat FP1 as a Country A corporation, the interest payment between CFC1 and FP1 would not be subpart F income, pursuant to the same country exception in section 954(c)(3)(A)(i).4
A U.S. person could achieve the same result by using other deductible payments such as royalties.5 Thus, by exploiting (1) the difference in the tax treatment of corporations and partnerships, (2) differences in entity classification among jurisdictions, and (3) the same country exceptions to the FPHCI rules in section 954(c)(3)(A), a U.S. person is able to use hybrid structures to shelter foreign source income from current tax in any jurisdiction.
B. Manufacturing Exception to FBCSI
As previously noted, FBCSI is income of a CFC from the sale of personal property that is purchased from, or on behalf of, or sold to, or on behalf of, a related person where the property is both manufactured and sold for use outside the CFC’s country of incorporation. If the CFC manufactures the property that it sells, the sales income generally will not be subject to the FBCSI rules. The FBCSI rules are intended to prevent the deflection of income from the jurisdiction in which the goods are manufactured to a low-tax jurisdiction.
Thus, when the manufacturing is carried on by related corporations, the FBCSI rules often will apply. Further, the FBCSI provisions contain a branch rule, which provides that, even when both the manufacturing and sales activities are conducted by the CFC, the FBCSI rules may apply if the sales and manufacturing activities are conducted in separate tax jurisdictions and the effective rate of tax imposed on the
Footnote 3 If the principles of the recent OECD report on partnerships were applied, this might not be the case. See The Application of the OECD Model Tax Convention to Partnerships (1999).
Footnote 4 I.R.C. § 954(c)(3)(A)(i) exempts from FPHCI dividends and interest received from a related corporation organized under the laws of the same country as the recipient, provided that the related payor corporation has a substantial part of its assets used in a trade or business in the same foreign country.
Footnote 5 I.R.C. § 954(c)(3)(A)(ii) provides a similar exemption from the FPHCI rules for rents and royalties received from a related corporation for the use of property within the country in which the recipient is organized.
sales income is significantly lower than the rate that would be imposed on such income if the sales income were subject to tax in the jurisdiction where the manufacturing activities occurred.
One weakness of the FBCSI rules is that they may not apply to some types of transactions through which income from the sale of goods manufactured in a high-tax jurisdiction can be diverted to a low-tax jurisdiction, such as certain transactions in which there are no purchases or sales involving related persons. These transactions are illustrated below.
1. Contract Manufacturing
The first technique relies on the focus in the FBCSI rules on the owner of the property being sold. Thus, if at all stages in the acquisition, production, and disposition of the property from or to unrelated persons, only one CFC holds title to the property (although others may be involved in manufacturing the property to be sold), then the FBCSI rules will never apply. This is because there will have been no sale to, from, or on behalf of a related person.
Assume CFC2, a contract manufacturer, is related to CFC1, the selling CFC. CFC1 holds title to raw materials that are being processed by CFC2, and CFC1 pays CFC2 for processing them. CFC2 is incorporated and has its operations in a high-tax jurisdiction, while CFC1 is incorporated and has its operations in a low-tax jurisdiction.
The processing takes place outside of CFC1’s country of incorporation. CFC1 purchases the raw materials from an unrelated party and sells the finished goods to an unrelated party outside CFC1’s country of incorporation.
If CFC1 had instead sold raw materials to CFC2 and then repurchased the manufactured goods from CFC2, or if CFC1 had purchased finished goods from CFC2, CFC1’s resulting sales income would have been FBCSI.
However, in this case, the taxpayer takes the position that subpart F does not apply to CFC1 because there has been no sale to, from or on behalf of a related person. This is despite the fact that the group of related corporations has managed to reduce income in a high-tax jurisdiction by splitting off the sales profit into CFC1 and reducing the manufacturer’s profit in CFC2 (for example, to a small mark-up over costs).
Thus, the sales profits have been diverted within the group to an entity (CFC1) in a low-tax jurisdiction, in the manner that the FBCSI rules were intended to prevent.6 The taxpayer might also take the position that the amounts paid to CFC2 are not foreign base company services income because the goods are manufactured (and hence the manufacturing services are performed) in the country where CFC2 is incorporated.
2. Commissionaire Arrangements
Another technique to avoid subpart F involves so-called “commissionaire” arrangements. In these arrangements, a subsidiary earns commission income for arranging the sales of goods, rather than taking title to the goods and selling them for a profit.
Footnote 6 This example is based on the facts of Vetco v. Commissioner, 95 T.C. 579 (1990).
Assume CFC1 (often called the “principal”), incorporated and operating in Country A, a low-tax jurisdiction, owns CFC2 in Country B and CFC3 in Country C. CFC2 manufactures a product in Country B, a high-tax jurisdiction, from raw materials the supply of which is arranged by CFC1. CFC1 at all times keeps title to the raw materials. CFC3 “arranges” the sale of the product in Country C, another high-tax jurisdiction. CFC2 and CFC3 are both compensated for their costs plus a small mark-up. In this way, most of the profit is kept by CFC1 in the low-tax jurisdiction.
As discussed above, the use of the contract manufacturer (CFC2) in this structure allows CFC1 to reduce CFC2’s manufacturing profit to a small mark-up over cost and to shift much of the profit to CFC1.
The use of the commissionaire (CFC3) allows for an additional shifting of income to CFC1, thereby enabling CFC1 to keep more profit than it would in a buy-sell arrangement (i.e., an arrangement in which CFC3 took title before selling the goods and, thus, arguably, as an economic matter, was entitled to additional profits to reflect the risk of loss, etc.).
Author note: This is a great international tax planning idea.
In such a case, the taxpayer might assert that: (a) the sales revenue received by CFC1 is not FBCSI because the income arises from sales of products that were neither purchased from, nor sold to, related persons; (b) the cost-plus amount paid to CFC2 is not FBCSI or foreign base company services income because the goods are manufactured (and hence the manufacturing services are performed) in the country where CFC2 is incorporated; and (c) the commission income of CFC3 is not FBCSI or foreign base company services income, because the fees are for arranging sales for the use, consumption or disposition of the property in CFC3’s country of incorporation. If successful, CFC1 will have shifted income both from the country of manufacture (i.e., from CFC2) and the country of sale (i.e., from CFC3) to its home country, a low-tax jurisdiction.
3. Avoiding Application of Foreign Base Company Rules
Another technique provides taxpayers with the opportunity to argue for the benefits of both contract manufacturing and commissionaire arrangements while avoiding subpart F treatment if the manufacturing country determines tax residence based on something other than the place of incorporation.
Assume that CFC2 is a manufacturing corporation incorporated in Country A, a high-tax jurisdiction. The U.S. parent forms a sister corporation, CFC1, which is a Country A corporation but non-resident for purposes of Country A’s laws (e.g., because it is managed and controlled in another country). CFC1 enters into a contract manufacturing arrangement for CFC2 to manufacture goods from raw materials that CFC1 purchased from the U.S. parent and provided
to CFC2 (thus leaving less profit in CFC2). CFC1 can then sell through a commissionaire (or branch) established in the country of sale.
CFC1 will not be taxed on its sales profits in Country A because Country A treats it as a non-resident. U.S. tax law treats CFC1 as a Country A corporation because it was incorporated in Country A. For the FBCSI rules to apply, the sales income would have to be derived in connection with the sale of products both manufactured and sold for use outside CFC1’s country of incorporation (Country A). A taxpayer might take the position that CFC1’s sales income is not
FBCSI because the income is derived from the sale of products manufactured in Country A. In this case, CFC2 will have reduced its tax in country A without corresponding subpart F income in the hands of CFC1 because of arbitrage between the U.S. and foreign determination of where the corporation resides.
III. Is Subpart F Still Effective?
The examples in this chapter show that it may be possible to circumvent crucial provisions of subpart F. In these cases, subpart F may no longer effectively prevent deflection of income. The next chapter examines challenges that subpart F faces now and will face in the future.
CHALLENGES TO SUBPART F: ENTITY CLASSIFICATION, SERVICES AND ELECTRONIC COMMERCE (Author note: such as the cloud computer tax planning)
The last chapter described how parts of subpart F may now be avoided, particularly by the use of hybrid entities. The creation of these hybrid entities is facilitated by changes in the federal tax entity classification rules. However, changes in the entity classification rules are not the only changes that have challenged the current rules of subpart F.
The nature of business is also changing. Subpart F was designed and enacted in the 1960s when the foreign business paradigm was a manufacturing plant. Since that time, however, services activities have grown significantly as a percentage of the overall U.S. economy, and this growth appears likely to continue. The treatment of services under subpart F is already posing a number of challenges to subpart F. Further, it is possible now to perceive some of the challenges to subpart F that will be posed by electronic commerce.
II. Impact of the Check-The-Box Entity Classification Rules1
As described above, subpart F applies almost exclusively to transactions between one corporation and another. This in part is a reflection of business conditions that existed in 1962 (when subpart F was enacted), when most U.S. businesses operating abroad chose (or in some cases, for local law reasons, were required) to operate in corporate form.
However, it also reflects an assumption that the entity classification rules of the Internal Revenue Code would work in a certain way. For example, at the time, it was assumed that foreign limited liability entities would be treated as corporations both by the United States and by the foreign country of incorporation.2 This assumption is no longer valid.
The most important development in foreign entity classification in the past 40 years has been the growth in opportunities for creating hybrid entities. As discussed in the prior chapter, the proliferation of techniques involving hybrids has lessened the effectiveness of the current subpart F regime.
Although not the exclusive source of these planning techniques, the check-the- box regulations, which became effective January 1, 1997, have resulted in significantly increased use of hybrid entities.
1 The entity classification rules of Treas. Reg. §§ 301.7701-1 through -3, popularly known as the “check-the-box” regulations, allow many entities to elect to be treated as associations taxable as corporations, partnerships, or disregarded entities (i.e., branches). This is done by checking a box on Form 8832, rather than by a legal change in corporate status.
2 See infra Appendix A, part 2, section III.B. (prior to Rev. Rul. 88-76, achieving limited liability outside of corporation/association status was relatively difficult). Please contact me for this appendix.
Entity Classification of Foreign Entities
Planning techniques involving hybrids were available to, and used by, taxpayers before the introduction of the check-the-box regime. Under prior law, entities were classified as corporations or partnerships for U.S. tax purposes based on the presence or absence of four characteristics: continuity of life; centralization of management; limited liability; and free transferability of interests.3
An entity that possessed more than two of these four characteristics would be classified as an association taxable as a corporation. Entities that had two or less of these characteristics were classified as partnerships.
The four-factor test gave taxpayers significant flexibility to employ tax planning techniques involving hybrids. In particular, with respect to many foreign jurisdictions, it was relatively easy for taxpayers to create a hybrid partnership by forming an entity that was a corporation under the national business statute of the jurisdiction, but that lacked continuity of life and free transferability of interests and, therefore, was a partnership for U.S. tax purposes.4
Thus, the availability of tax avoidance techniques involving hybrids did not originate with the check-the-box regulations. However, the check-the-box regulations exacerbated the problem in three significant ways. First, they eliminated the uncertainty associated with applying the four- factor test. This reduced the costs and risks associated with hybrid arrangements and thus greatly facilitated their use. Second, they focused attention on the use of hybrid arrangements.
The result was a considerable increase in design and marketing efforts among tax planners that introduced hybrid planning techniques to mainstream taxpayers.5
Finally, and perhaps most importantly, the check-the-box regulations facilitated the formation of a new type of entity (or non-entity): an entity “disregarded as an entity separate from its owner” (often referred to as a “disregarded entity”).6 It is the disregarded entity that features prominently in a number of significant Subpart F tax planning techniques.
As a result of the check-the-box regulations, the number of foreign hybrid structures, as well as the number of taxpayers employing these structures, has increased dramatically.
Footnote 3 Treas. Reg. § 301.7701-2(a) (1960).
Footnote 4 During the early 1970s, the IRS took the position that entities formed under foreign laws that used a concept of “incorporated” that was substantially similar to the U.S. concept would be treated as corporations for U.S. tax purposes, without regard to whether they met the four-factor test. In 1988, the IRS formally reversed this position, holding that all foreign entities must be classified under the four-factor test. See Rev. Rul. 88-8, 1988-1 C.B. 403. See also Appendix A, part 2, section IV.
Footnote 5 See, e.g., Bruce N. Davis, International Tax Planning under the Final Check-the-Box
Regulations, 26 Tax Mgmt. Int’l J. 3 (1997); David S. Miller, The Tax Nothing, 74 Tax Notes
Footnote 6 Treas. Reg. § 301.7701-2(c)(2).
Specifically, the data available as of March 2000 indicate that, since the regulations became effective, 640 foreign entities have elected to be treated as corporations, 3,920 foreign entities have elected to be treated as partnerships and 7,875 foreign entities have elected to be treated as disregarded entities.7
Based on anecdotal evidence, it appears that prior to 1997, at most a few hundred foreign entities were being treated by their owners as disregarded entities. Thus, the growth in disregarded entities has been particularly dramatic. This may be attributable in part to the considerable doubt as to whether disregarded entity characterization was correct under prior law.8
A change in the law outside of subpart F has thus had an adverse impact on its effectiveness. The data described above suggest that this trend will continue, and perhaps accelerate, in the future.
III. Subpart F and Services
As noted above, services activities are a significantly greater contributor to the overall U.S. economy today than when subpart F was originally enacted, and this growth in services activities seems likely to continue.9 Subpart F was designed principally to deal with manufacturing industries operating in high-tax, developed countries, rather than with service industries. The treatment of services is already posing a number of challenges to subpart F.
One example of these challenges is provided by the financial services exception to subpart F under section 954.
Footnote 7 All data are provided by the Statistics of Income Division of the Internal Revenue Service. These data are based on approximately 25,000 elections under the check-the-box regulations. Actual numbers are higher because data from an additional 10,000 elections were not available for inclusion in this study.
manufacturing employment. In 1950, the ratio of manufacturing employment to services employment was 57 percent. In 1962, it was 48 percent, declining to 41 percent by 1970 and to 18 percent by 1999. Economic Report of the President Transmitted to the Congress February 2000, together with the Annual Report of the Council of Economic Advisers 358-59 (2000).
A. The Financial Services Exception as an Illustration
Dividends, rents, interest, interest equivalents, and other kinds of typically passive income are easily deflected to (or realized in) low-tax jurisdictions and thus are susceptible to tax haven planning. Accordingly, in general, these types of income are considered subpart F income not eligible for deferral. However, under section 954(h), a temporary exception is provided from FPHCI treatment for these types of income if derived in the active conduct of a banking, financing, or similar business.10
This financial services exception, which was first enacted in the Taxpayer Relief Act of 1997,11 and then extended and modified by the Tax and Trade Relief Extension Act of 1998,12 reflects Congress’ belief that certain financial service businesses are active and, therefore, should have the deferral benefits enjoyed by other active businesses.13
A financial services exception raises three main concerns, however. First, because such an exception applies to income that is generally intended to be treated as passive income, it is important to develop a good definition of “active” that can be applied in this context. Second, the types of entities covered by such an exception may be highly mobile in that they can be relatively easily located in a tax-favorable jurisdiction completely unrelated to where the recipients of the services are based. Third, the type of income covered by such an exception is highly mobile in that it may be easily shifted from jurisdiction to jurisdiction, often without imposition of tax. The financial services exception in Section 954 attempts to deal with all three of these concerns.
Footnote 10 A temporary exception from FPHCI treatment is also provided for certain income derived from a securities dealer business ( I.R.C. §§ 954(c)(2)(C)(ii)) and for certain income derived in the active conduct of an insurance business (I.R.C. § 954(i)).
Footnote 11 P.L. No. 105-34, 111 Stat. 788 (1997).
Footnote 12 P.L. No. 105-277, 112 Stat. 2681 (1998).
Footnote 13 The Taxpayer Relief Act of 1997 included a one-year exception from subpart F for certain income earned by financial services companies. The provision was line-item vetoed by the President in August 1997 because of concerns that certain of its provisions would permit the use of tax avoidance techniques, but was reinstated after the Supreme Court ruled that the line-item veto was unconstitutional in June 1998. In a February 8, 1999 letter to Senator Byron Dorgan, Assistant Secretary (Tax Policy) Donald Lubick outlined Treasury’s concerns with the active finance exception as enacted in 1997 and expanded in 1998. See U.S. Treasury Shares Dorgan’s Concerns about CFC Extenders Provision, 1999 Worldwide Tax Daily, February 19, 1999; available in 1999 WTD 33-32. The current version of this provision was passed in December 1999, and is effective only for the taxable years of a foreign corporation beginning after December
31, 1998, and before January 1, 2002. For a detailed description of this provision, see infra Appendix A, part 1, section V.B.11.g. and 12.
2. Services and the Distinction Between Active and Passive
The first issue relates to the question of when a business is active and when income is passive. As noted above, this active/passive distinction is fundamental to subpart F. Congress found no reason to except passive income earned by a foreign corporation from current inclusion in the worldwide income of U.S. taxpayers.
The financial services exception seeks to ensure that the business benefitting from the exception is active. The CFC must be predominantly engaged in the active conduct of a financial services business and the CFC must actively earn the income. This test covers the head office and any branches. It is a facts and circumstances test to be applied with reference to the size of the CFC, the amount of its revenues and expenses, the number of employees and a series of other factors. The legislative history also lists a series of illustrative activities that financial services businesses of certain types generally perform.
It makes clear that the CFC “is required to conduct substantially all of the activities necessary for the generation of income on the business.” In the case of the cross-border business (the amount of which is limited in the case of finance companies and insurance companies by the “home country requirement,” described below), further activity requirements are imposed.
This is because such income is more mobile than home country income. In this case, the statute requires the branch (rather than the CFC as a whole) to perform all of the activities required to generate the income.
The activity rules, however, are imperfect. For example, the insurance industry relies on independent third parties to perform many key tasks for it.14 One of these key tasks is making the investments that produce much of the profit for the business. The explanation of the legislation provided by the staff of the Joint Committee on Taxation specifically states that one of the indicative factors of substantial activity is the “making (or arranging for) investments.”15
The parenthetical language in this portion of the explanation seems specifically to allow outsourcing of investment activities. When marketing can also be performed by independent contractors and actuarial analysis provided by separate actuarial firms, many of the major functions of certain insurance companies can be performed by third parties. As more of these activities are performed by outside contractors, the insurance company begins to look more like a passive entity.
In the case of finance companies, it may also be difficult to distinguish an active company from a passive one. The definition of “finance company” is broad enough to encompass the
Footnote 14 Certain types of insurance, for example, can be very mobile: “unlike the direct writing of insurance, the business of reinsurance is mobile and not subject to uniform regulation. . . . As a result, reinsurance business has thrived in domiciles having a favorable tax and regulatory environment such as Bermuda.” Joe Taylor and Andrew Immerman, The Curious Role of Motive in the Tax Court’s Analysis in UPS, 17 Ins. Tax Rev. 1089, 1091 (1999). See also, e.g., PXRE Corp. Plans to Join Wave, Move to Bermuda for Tax Benefits, Best Week, July 12, 1999, at 1.
Footnote 15 Staff of the Joint Committee on Taxation, General Explanation of the Tax Legislation Enacted in 1998 259 (Joint Committee Print 1998).
incorporated pocket-book of high net worth individuals or a pool of offshore passive assets. For example, it may be possible for a large multinational with a significant amount of retained foreign earnings to capitalize a finance company and then have it engage in a few significant transactions with unrelated persons. While this may be little different from purchasing corporate debt or other passive assets which would generate subpart F income, in this case the income earned will be “active” and, thus, not subject to subpart F.
3. Services and Mobility of Enterprise
The statute also attempts to address concerns related to the mobility of the enterprise.16
One of the premises underlying subpart F, as expressed in the legislative history, is that a U.S.- owned foreign corporation conducting an active business will be in a certain country for valid business reasons (e.g., to be close to the market, for local content requirement purposes, or to exploit a skilled workforce). In the case of certain active financial services businesses, however, the non-tax factors that affect the location of a manufacturing business may not apply, and, accordingly, the financial services business may be able to choose its location based on tax considerations rather than non-tax, business considerations.
The statute attempts to deal with the issue of mobility of enterprise by imposing certain local country customer requirements on finance companies and insurance companies (but not on banks or securities dealers) in order for such companies to qualify for the financial services exception. In the case of a finance company, more than 30% of the gross income of the CFC or qualified business unit (QBU)17 must arise from transactions with unrelated customers located in the CFC or QBU’s home country.18
For insurance companies, more than 50% of aggregate net written premiums must be derived from insurance or reinsurance of home country risks of unrelated persons (i.e., risks in connection with property, liability for activities, or lives or health located in the country of the CFC or QBU).19 Furthermore, the income of any one branch of the
Footnote 16 Interestingly, Rosanne Altshuler and Glenn Hubbard demonstrate in a recent paper that the location of financial services operations became much less correlated to differences in foreign tax rules once deferral for financial services was ended in 1986. See Rosanne Altshuler and Glenn Hubbard, The Effect of the Tax Reform Act of 1986 on the Location of Assets in Financial Services Firms, (Feb. 19, 1999) (conference paper at Taxation of International Investment: Principles and Policies, American Enterprise Institute). This analysis suggests that, when deferral was available for financial services businesses, foreign tax rates may have played a significant role in determining where such businesses chose to locate.
Footnote 17 A QBU is defined in I.R.C. § 989(a) as “any separate and clearly identified unit of a trade or business of a taxpayer which maintains separate books and records.” Because this definition allows taxpayers some flexibility in determining when a QBU exists, it may give rise to planning opportunities.
Footnote 18 See I.R.C. § 954(h)(3)(B).
Footnote 19 See I.R.C. § 953(e)(3)(B).
CFC (including the head office) will only qualify if that branch earns 30% of its net written premiums in respect of same country risks of unrelated persons.20
Currently, therefore, at least for finance companies and insurance companies, the statute may limit the ability of businesses to exploit some of their potential mobility. However, this provision may become less effective in the future as it becomes more difficult to tell where activities are performed and to which QBU (or QBUs) activities should be attributed.
For example, some of these rules might potentially be circumvented if a taxpayer were to provide financial services over the Internet and were to argue that it had a QBU in each country in which there is a customer.21
4. Services and Mobility of Income
Financial services income is by its nature highly mobile, and it is thus often hard to determine precisely where such income is earned.22 The statute attempts to address this problem, for example in the context of “qualified banking or financing income,” by providing that the income must be “treated as earned by such corporation or unit in its home country for purposes of such country’s tax laws.”23
This provision was intended to ensure that the income be reported as earned for tax purposes in the country where it was actually earned as an economic matter. One weakness in the provision, however, is that, although it may ensure that the items are included in gross taxable income where they are actually earned, it does not prevent subsequent deflection of this income for foreign purposes by some of the hybrid transactions described above. Thus, the amount may be included in gross taxable income but not in the actual net amount on which tax is imposed.
Additionally, the statute prevents all active financial services income from constituting foreign base company services income.24 As a result, to the extent that active financial services income can be earned in a low-tax jurisdiction, such income (unlike other types of services income) is insulated from treatment as foreign base company services income.
Footnote 20 See I.R.C. § 953(e)(2)(B).
Footnote 21 The issue of identifying the location of services is considered further in the section below on electronic commerce.
Footnote 22 Financial services income is not tied to hard physical assets or people. The factors of production that give rise to financial services income are cash (which is highly mobile) and risk, the location of which is inherently unclear.
Footnote 23 The statute defines “home country,” in the case of a controlled foreign corporation, as the country under the laws of which the controlled foreign corporation is created or organized.
Footnote 24 See I.R.C. § 954(e)(2).
B. Conclusion on the Potential Impact on Subpart F of a More Service-Based Economy
Subpart F does not deal with other service industries in anywhere near the level of detail of the financial services rules. Nevertheless, despite their level of detail, the financial services rules do not sufficiently address the mobility of business enterprises or income, nor do they adequately distinguish active from passive businesses.
However, even if changes were made to deal properly with services within the current structure of subpart F, the result would be more complexity. Industry specific lists of factors indicating when a business is active, for example, would need to be produced and then kept updated. Bright line rules would be replaced by subjective facts and circumstances tests. This complexity is disadvantageous for both taxpayers and the government. Complexity may require taxpayers to spend more on compliance (or may discourage them from complying).
Government may also be required to devote more resources to administering the system, and the complex nature of the law may hinder uniform government enforcement.
IV. The Challenges to Subpart F Posed by Electronic Commerce
The previous section noted the difficulties of applying subpart F to the provision of services. The ability of taxpayers to provide services (as well as goods) over the Internet and through other electronic media will present further challenges to the current subpart F regime. None of these challenges is entirely new.
The increased commercial use of the telephone, radio, television, and facsimile have contributed to a trend in which the physical location of the provider of goods and services is less significant and more difficult to determine.
Subpart F must be evaluated by considering where this trend might lead and what challenges it poses. For example, as the Treasury observed in its 1996 report on electronic commerce:
If CFCs can engage in extensive commerce in information and services through Web sites or computer networks located in a tax haven, it may become increasingly difficult to enforce Subpart F. . . . because it may be difficult to verify the identity of the taxpayer to whom foreign base company sales income accrues and the amount of such income. It may be necessary to revise Subpart F or the regulations thereunder to take these new types of transactions into account.25
In addition to enforcement challenges, electronic commerce and its underlying technologies also have implications for the content and scope of the substantive subpart F rules. This section briefly considers, through examples, whether the current subpart F regime is capable
Footnote 25 U.S. Treasury, Selected Tax Policy Implications of Global Electronic Commerce § 7.3.5 (1996) (“Treasury E-Commerce Report”).
of achieving its objectives in a world in which electronic commerce and new technologies seem sure to play a large role.26
B. Specific Issues
1. Location of Activities
Electronic commerce may present challenges to the subpart F rules to the extent that such rules look to where transactions or activities take place. For example, the technologies underlying electronic commerce make possible new sorts of services, such as Internet access, and make
easier the remote provision of other services, such as remote database access, video conferencing and remote order processing.
With respect to all such services, it is difficult to assign a place of performance, a factor that is relevant on certain subpart F rules. Similarly, it may be difficult to ascertain a place of use, consumption or disposition (another factor relevant in the application of certain subpart F rules) on the sale of digitizable products, such as images and computer software, delivered electronically.
New technologies increase opportunities for CFCs to be incorporated in low- or no-tax jurisdictions. These technologies increase the ease with which employees of a CFC can be located outside the CFC’s jurisdiction of incorporation, and increase the ease with which certain products and services can be provided to a CFC.27
They also allow CFCs to provide services to customers located outside their jurisdiction of incorporation with relative ease. As discussed in the examples later in this chapter, these developments together increase opportunities for CFCs to earn income that may not be subpart F income.
2. Classifying Income
Electronic commerce also may pose challenges to the extent subpart F has different rules for different types of income. For example, under certain circumstances it may be unclear whether payments for digitized products are treated as payments for a good, a right or a service.28
As discussed in the examples below, results under subpart F may differ significantly depending on how the payment is classified.
Footnote 26 This study does not further address the enforcement or administrative concerns raised by electronic commerce. These concerns are discussed in Treasury E-Commerce Report, supra note
25, at § 8.
Footnote 27 See Allen R. Myerson, Ideas and Trends: Virtual Migrants; Need Programmers? Surf Abroad, N. Y. Times, Jan. 18, 1998, at § IV, 4 (discussing the use of overseas programmers who telecommute from India, the Philippines, South Africa and elsewhere).
Footnote 28 Treasury has provided guidance on the proper characterization of payments for one type of digitized product, computer programs. Treas. Reg. § 1.861-18 provides that a transfer of a computer program is treated as (a) the transfer of a copyright right; (b) the transfer of a copyrighted article; (c) the provision of services; or (d) the provision of know-how, based on all the facts and circumstances of the transaction.
C. Examples of Potential Effects of Electronic Commerce on Subpart F
The following examples illustrate the ways in which electronic commerce and its underlying technologies may present challenges to subpart F. In most cases, the planning techniques described in these examples are available in both the electronic commerce and traditional commerce context. However, because the technologies underlying electronic commerce allow these techniques to be accomplished more easily and effectively than in traditional commerce, these techniques have now become more generally available.29
1. Offshore Development, Production, and Sale and Licensing of Goods
The relocation of activities can be used as a subpart F planning technique. As previously noted, income is foreign base company sales income (FBCSI) if it is derived from the sale of property that (a) is purchased from, or on behalf of, or sold to, or on behalf of, a related person and (b) is both manufactured and sold for use outside the CFC’s country of organization.
Thus, if a CFC purchases copies of software from its parent that the parent has developed and produced in the United States, the income of the CFC from the sales of such software for use outside its country of incorporation would be FBCSI in its entirety.30 Suppose, however, that the parent restructures so that its software development and production activities are conducted within the CFC, rather than the parent. Income from the sale of software manufactured by the CFC and sold by the CFC to unrelated persons will not necessarily give rise to subpart F income, even with respect to sales for use outside the CFC’s country of incorporation.31
Thus, by restructuring its operations, which in this case may mean no more than having software development personnel transferred on paper from the parent to the CFC, the parent company may isolate offshore at least some of the profit from the sale of the software.
The extent to which a U.S. parent could achieve deferral in such a manner, however, would depend on where the software development and production and sales of the software were
Footnote 29 The examples below assume that the CFC is located in a low-tax jurisdiction and that the United States does not have an income tax treaty with that jurisdiction. The United States is actively engaged in discussions at the OECD on electronic commerce issues arising under income tax treaties, including jurisdictional issues (e.g., whether certain activities give rise to a permanent establishment) and issues relating to the appropriate characterization of activities and income.
Footnote 30 This example is not intended to comment on what constitutes the manufacture of software.
Footnote 31 If the CFC conducts its software manufacturing activities within its country of incorporation, the income would be excluded from subpart F income because the FBCSI rules do not apply where manufacture occurs within the CFC’s country of incorporation. If the CFC conducts the manufacturing activities through a branch located in a separate tax jurisdiction, the income may be excluded from subpart F income under the manufacturing exception of Treas. Reg. § 1.954-
3(a)(4) unless the branch rule applies. (The branch rule will treat the sales income as FBCSI if the CFC conducts the sales and manufacturing activities in separate tax jurisdictions and the sales income is subject to a significantly lower tax rate than it would have been in the jurisdiction where the manufacturing occurs. See Treas. Reg. § 1.954-3(b)).
taking place. If the CFC’s development and production activities were kept within the United States, the CFC may be considered engaged in a U.S. trade or business. If so, the CFC would be subject to tax in the United States on the income effectively connected with the conduct of that business.32 Regular and continuous sales of the software into the United States by the CFC would also likely create a U.S. trade or business.
However, sales outside the United States of software developed and produced by the CFC within the United States likely would not generate income taxable by the United States under either subpart F or the U.S. trade or business rules, except to the extent that either the branch rule applies or any such income were deemed to be effectively connected to any U.S. trade or business of the CFC (for example, the U.S. software development).
Assuming the CFC’s sales income was not effectively connected income, U.S. tax on income not subject to the branch rule would be deferred. Further, as noted previously, the technologies underlying electronic commerce make it easier to locate software development activities outside the United States, through the use, for example, of “virtual migrants.”33
Moreover, it may be possible to prevent regular and continuous sales of the software into the United States by the CFC from being treated as a U.S. trade or business. If the CFC advertised its products in the United States and had an agent in the United States that maintained a stock of inventory from which it regularly filled orders for the public, the CFC likely would be engaged in a U.S. trade or business.
If, however, the CFC advertised solely on the Web and digitally delivered its products to U.S. customers, then it is less clear that the CFC is engaged in a trade or business within the United States. If the CFC is not engaged in a U.S. trade or business under those circumstances, even income from sales into the United States could be isolated offshore (at least to the extent that inclusions are not required under section 956).
Finally, the above example also assumes that the sale of the software will be regarded as the sale of a good. If instead the CFC is considered to license the software to customers, then the CFC would be considered to receive royalties, not sales proceeds, and the royalties would not be considered subpart F income if the CFC “has developed, created, or produced, or has acquired
and added substantial value to” the software and if the CFC is “regularly engaged in the development, creation or production of, or in the acquisition of and addition of substantial value to” the software.34
Thus, it may be possible for a CFC that purchases software from its parent and adds substantial value to the software by, for example, customizing the software for unrelated licensees, to receive royalties that are not subpart F income. In addition, even if a CFC/licensor does not develop, or add substantial value to, the property it licenses, the CFC may nevertheless exclude the royalties from subpart F income if it licenses the property as a result of performing marketing functions.35
Footnote 32 This U.S. source effectively connected income, however, is excluded from subpart F income. See I.R.C. § 952(b).
Footnote 33 See supra note 27.
Footnote 34 Treas. Reg. § 1.954-2(d)(1)(i).
Footnote 35 This exception applies only if the CFC/licensor “through its own officers or staff of employees located in a foreign country, [maintains and operates] an organization in such country that is
2. Offshore Provision of Services to Unrelated Third Parties
If the sale of the software is characterized not as the sale of a good or as a license but rather as the provision of services, a different set of rules will apply. Income from the provision of services is foreign base company services income if the services are performed for or on behalf of a related person outside the CFC’s country of incorporation.36
If the CFC purchases software from its U.S. parent, but, instead of selling the software to a third party, either provides services to unrelated third parties making use of the software or, in the alternative, transfers the software to the unrelated third party in the form of services, the income the CFC receives likely would not be foreign base company services income.37
If the sale of the software had been characterized as the sale of a good, however, it would have been foreign base company sales income because the income was derived from the purchase of software, which was manufactured outside the CFC’s country of incorporation, from a related person, the U.S. parent, and sold for use outside the CFC’s country of incorporation.38
Problems arising from the distinction between the provision of a good and a service are not limited to computer programs and may in fact be more acute with respect to digitizable products other than software. Consider, for example, a reference work, such as a legal treatise or regularly engaged in the business of marketing, or of marketing and servicing, the licensed property and that is substantial in relation to the amount of royalties derived from the licensing of such property.” Treas. Reg. § 1.954-2(d)(1)(ii).
Footnote 36 I.R.C. § 954(e). Also, if a related person provides the CFC with substantial assistance contributing to the performance of the services, the services will be treated as performed for or on behalf of a related person. See Treas. Reg. § 1.954-4(b)(1)(iv).
Footnote 37 This example assumes that the parent is not rendering substantial assistance to the CFC within the meaning of Treas. Reg. § 1.954-4(b)(1)(iv).
Footnote 38 It may be difficult to manipulate the rules to change the classification from the sale of goods to the provision of services with respect to computer programs, because Treasury Regulations clarify the distinction between the sale of goods and the provision of services in the context of computer software. Treas. Reg. § 1.861-18(d) provides that whether the transfer of a computer program is treated as the provision of services or otherwise “is based on all the facts and circumstances of the transaction” including “the intent of the parties . . . as to which party is to own the copyright
rights in the computer program and how the risks of loss are allocated between the parties.” For example, the regulations provide that, if a developer of computer programs agrees to provide upgrades of the program when they become available, the developer is not treated as providing services to its customers. Treas. Reg. § 1.861-18(h), Ex.12. In contrast, if the person commissioning the creation of the program bears all of the risk of loss associated with its creation and will own all of the copyright rights in the underlying program when it is completed, the developer is treated as providing services. Treas. Reg. § 1.861-18(h), Ex.15. With respect to the provision of other digitizable products, the distinction between the provision of a good and the provision of a service may not be as clear.
set of court cases, that previously would have been sold only as a set of bound volumes. The sale of the bound volumes would have resulted in sales income. Today, a potential purchaser might be able to choose between a set of bound volumes, a set of CD-ROMs and an on-line database.
The sale of the CD-ROMs may be characterized as the sale of a good.39 However, a taxpayer may take the position that income arising from the provision of access to an on-line database should be considered the provision of a service.
If so, taxpayers may claim that sales by a CFC to unrelated third parties of access to an on-line database the CFC purchases from its parent would not generate subpart F income because the services are not performed for or on behalf of a related person.40 Similar issues may be implicated with respect to the provision of other services such as telecommunications services and Internet access.
3. Offshore Provision of Services to Related Parties within the Country of Incorporation
Electronic commerce and its underlying technologies make it possible to set up CFC offshore service centers to provide services to related parties.41 Foreign base company services income includes income from services performed for or on behalf of a related person only if the services “are performed outside the country under the laws of which the controlled foreign corporation is organized.”42
Thus, under the current subpart F rules, depending on how the place where services are performed is determined, taxpayers may claim that formation of such offshore service centers to service related parties may not generate subpart F income.
For example, assume a U.S. corporate vendor of goods over the Internet establishes a CFC in Country A to process customer orders and arrange for product delivery outside of Country A through the use
of the CFC’s computer software and servers and other equipment located within Country A.
The U.S. corporate vendor pays CFC a fee for performing these processing and product delivery services. Unless it is determined that the services are performed outside Country A, the U.S. vendor may be able to use such an arrangement to isolate offshore income associated with the processing and delivery function with no corresponding income inclusion under subpart F.
As communication equipment becomes more efficient and reliable, the relationship between the service provider’s location and the service consumer’s location will be further weakened. For example, increased use of the Internet, as well as intranets, e-mail and video conferencing, will make it easier to provide services across vast distances. That increases the
Footnote 39 See Priv. Ltr. Rul. 96-33-005 (Aug. 19, 1996).
Footnote 40 As under the prior example, the foreign base company services income would nevertheless apply if the parent were rendering substantial assistance to the CFC within the meaning of Treas. Reg. § 1.954-4(b)(1)(iv).
Footnote 41 This example assumes that income that was previously earned by people performing certain functions (e.g., accepting orders) can now be “earned” by machines performing the same functions.
Footnote 42 I.R.C. § 954(e).
possibility that rules that are premised on the coincidence of the service provider’s and service customer’s locations may no longer be adequate.
D. Summary of Possible Effects of Electronic Commerce on Subpart F
Many of the issues identified in this section (e.g., classifying and locating activities and associated income) are not unique to CFCs engaged in electronic commerce. As noted above, some of the same issues arise, for example, with respect to CFCs that provide financial services and businesses involved in more “traditional” activities, such as the development and manufacturing of tangible goods.
Electronic commerce and new technologies do, however, affect the ease with which structures that are not contemplated by the rules of subpart F can be used. Furthermore, they affect the interaction between subpart F and the more general international taxation rules, such as the general source of income rules and the definition of a U.S. trade or business.
As planning opportunities become more generally known, offshore companies may become the operating vehicles of choice for many newly formed electronic commerce companies. Also, many U.S. electronic commerce companies are relatively new.
Therefore, it may be possible for them to move offshore without incurring a significant tax liability. These developments, taken together, may pose greater challenges to subpart F in the future.
V. Conclusions Relating to Challenges to Subpart F
As noted in Chapter 1, subpart F was intended to address a systemic problem in the U.S. tax system that created inequity and caused tax base erosion. Many of the specific rules of subpart F, however, may no longer operate effectively. Also, weaknesses in these rules are exacerbated by the new entity classification rules, which have facilitated the creation of hybrid entities.
The growth in service industries is creating new issues that may be difficult to resolve without adding considerable complexity to the subpart F rules. The challenges that will be posed by electronic commerce and the Internet are only just beginning to emerge. Thus, although the policies underlying Subpart F may be as important (or more important) today as they were in 1962 (when subpart F was enacted), new developments are already challenging the effectiveness of subpart F, and these challenges seem likely to increase in the future.