The Sixth Circuit's Whirlpool Opinion - What's the Impact? Ruling disregards regulatory manufacturing exception but preserves right to rely on regulations in applying branch rule.

• Author: Yoder, Lowell

The US Court of Appeals for the Sixth Circuit issued a majority opinion in Whirlpool Financial Corporation & Consolidated Subsidiaries v. Commissioner (1) that disregards the regulatory manufacturing exception to foreign base company sales income (FBCSI). That said, taxpayers still have the right to rely on the regulations in applying the branch rule.

The Whirlpool case involves a Luxembourg controlled foreign corporation (CFC) that sold products to related parties. The products were manufactured by a wholly owned Mexican disregarded entity that was treated as a corporate branch for US federal income tax purposes. Income earned by a CFC from the sale of personal property is subpart F income only if it falls within the definition of FBCSI. A CFC's income generally is FBCSI if it meets the requirements in either Section 954(d)(1) (the "general rule") or Section 954(d)(2) (the "branch rule").

Under Section 954(d)(1), a CFC's income generally is FBCSI if the income is earned by a CFC through the purchase of personal property from any person and its sale to a related person or through the purchase of personal property from a related person and its sale to any person. (2)

Several exceptions are provided. A CFC's sales income is not FBCSI if the property is sold for use in, or manufactured in, the CFC's country of organization (the "same country of use exception" and the "same country of manufacturing exception," respectively). (3) In addition, a CFC's sales income is not FBCSI if the CFC manufactured the products resulting in the income (the "regulatory manufacturing exception"). (4)

Section 954(d)(2), the branch rule, provides additional rules for determining a CFC's FBCSI when the CFC carries on purchasing, selling, or manufacturing activities in a foreign branch and the CFC's income is not considered FBCSI under Section 954(d)(1). If the requirements for applying the branch rule are met, then under Section 954(d)(2) and the associated regulations, the FBCSI rules may be reapplied to determine if a portion of the CFC's income is FBCSI by treating the CFC's head office (remainder) and its branch as separate CFCs. (5)

The branch rule applies, however, only to certain described structures and if a tax rate disparity test is met. There are different operating rules depending on whether the foreign branch carries on purchasing or selling activities (the selling branch rule) or manufacturing activities (the manufacturing branch rule).

Treasury regulations issued under Section 954(d)(2) provide that a branch's (or remainder's) income is not FBCSI if it would not be FBCSI if derived by a separate CFC. (6) Therefore, income earned by a foreign branch cannot be FBCSI under the branch rule if, for example, the regulatory manufacturing exception would apply to income derived by the foreign branch with respect to products that it manufactured. (7)

Majority Opinion

In its majority opinion in Whirlpool, the Sixth Circuit interpreted the "branch rule" of Section 954(d)(2) without regard to the longstanding regulatory manufacturing exception. Rather, the Sixth Circuit majority's opinion misconstrued the branch rule as applying to any structure where a CFC carries on activities in a branch and the CFC's income is tax-deferred. This expansive interpretation of the branch rule treats the regulatory manufacturing branch rules as meaningless and ignores the detailed rules that limit the scope of the branch rules. Under this flawed reading, if a CFC carries on activities in a foreign branch, and its income otherwise is not subject to current-basis, full-rate US tax, all of its sales income is FBCSI.

Here is a simple example of how the Sixth Circuit majority's interpretation of Section 954(d) (2) would apply:

* A CFC organized in Country X manufactures and sells products through a branch in Country Y. Ten percent of the products are sold to Country Y customers and ninety percent are sold for export. The CFC's sales income is not subject to tax in Country X. Country Y has a fifty percent tax rate, but taxes only income from selling products to Country Y customers. To illustrate, if the CFC has $100 of sales income, it would pay $5 of tax ($100 x 10 percent x 50 percent), and $90 would be untaxed.

* Under the Sixth Circuit majority's opinion, which disregards the regulatory manufacturing exception, the entire $100 would be FBCSI, even though all $100 would qualify for the manufacturing exception, because Branch Y manufactures the products. This is squarely inconsistent with the Treasury regulations that taxpayers have relied upon for over fifty years.

The Treasury regulations, in fact, contain this exact example and conclude that none of the income derived by the Country Y branch would be FBCSI, because the Country Y branch, treated as a separate corporation, would qualify for the manufacturing exception, and therefore the manufacturing branch rules should not apply and thus should not cause its income to be FBCSI. (8) The Treasury regulations contain numerous other examples that apply the manufacturing exception for purposes of Section 954(d)(2) to all or a portion of the income of a CFC that manufactures and sells products. (9)

What Will This Mean?

Taxpayers understandably may wonder whether the majority's decision to disregard the regulatory manufacturing exception in applying Section 954(d)(2) could extend to other regulatory rules that limit a CFC's FBCSI. Below we address this question and explain why the...