Potential U.S. tax consequences of using foreign sales or manufacturing branches.

• Author: Hedgpeth, Todd W.

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 (Kegs. 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 CFCs 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...