Interaction of the subpart F dual-character property and majority-use rules.

AuthorSmith, Annette B.

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 FPHC1). Such property is referred to as "dual character property" by Regs. Sec. 1.954- 2(e)(i )(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...

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