Source: https://www.bna.com/proposed-new-subpart-n17179925313/
Timestamp: 2016-12-10 20:25:56
Document Index: 444683405

Matched Legal Cases: ['§954', '§1', '§954', '§954', '§1', '§954', '§954', '§1', '§1', '§954', '§954', '§1', '§1', '§1', '§1', '§1', '§1', '§1', '§1', '§1', '§1']

Proposed New Subpart F Income Category: 'Foreign Base Company Digital Income' | Bloomberg BNA
Proposed New Subpart F Income Category: 'Foreign Base Company Digital Income'
The Obama Administration's 2016 Budget proposes a new category of
Subpart F income that would apply to certain "digital income," and be
labeled "foreign base company digital income."1
This category generally would include income from selling or licensing digital
products or providing digital services where the controlled foreign corporation
("CFC") uses intangible property developed by a related party to
produce the digital income. The Administration's 2015 Budget contained the same
The current Subpart F rules are applied by first classifying the
income derived by a CFC from its business operations, e.g., sales, services,
rents, or royalties. Then, a determination is made concerning whether an item
of income falls within the relevant definition of Subpart F income, i.e.,
foreign base company sales income, foreign base company services
income, or foreign personal holding company income. There is no Subpart F rule
that applies specifically to digital income.
Income from the sale of a product is foreign base company sales
income if the product sold is purchased from a related person, the product is
purchased from any person and sold to a related person, or the product is
purchased or sold on behalf of a related person. This category applies only if
the product is both manufactured outside, and sold for use outside, the CFC's
country of organization.3 Income
from selling products that are neither purchased from a related person nor sold
to a related person is not foreign base company sales income. In addition,
income derived by a CFC from selling products that it manufactures is not
Subpart F income. A CFC qualifies for the manufacturing exception if it
physically manufactures the products or substantially contributes to the
physical manufacture of the products by a contract manufacturer.4
Services income is foreign base company services income if it is
derived from performing services for, or on behalf of, a related person, and
the services are performed outside the CFC's country of organization.5 Income from services performed for an
unrelated person falls outside this Subpart F income category provided the
services are not performed on behalf of a related person. Services are
considered as performed on behalf of a related person if a related person
subcontracts the services to a CFC, guarantees the services, and a related person
performs any of the services, or 80% of the costs of providing the services are
paid to related U.S. persons for assistance in providing the services.6 Income from services performed for or
on behalf of a related person is not Subpart F income if the services are
performed within the CFC's country of organization.
Rental or royalty income is foreign personal holding company income
unless it is derived in the active conduct of a leasing or licensing business
and received from unrelated persons.7
The active business requirement is met if the CFC manufactures or produces the
property, acquires the property and adds substantial value thereto, or actively
markets the property.8 Rents
and royalties received from a related CFC are excluded from foreign personal
holding company income provided the expense does not reduce Subpart F income of
the CFC payor.9
An item of income is classified for purposes of applying the foreign
base company income rules based on its substance.10 A single transaction may give
rise to income that falls within more than one of the foreign base company
income categories. As a general rule, the income must be apportioned among the
various relevant categories or, if the portion falling within particular
categories is indeterminate, then the income from the transaction is classified
in accordance with the predominant character of the particular integrated
An item of income that is foreign personal holding company income is first
tested under those rules, and if it qualifies for an exception and is also
classified as sales or services income, such item is again tested under the
foreign base company sales or services income rules.12
Therefore, under current law, any digital income that is sales
income is not foreign base company income if the products sold are not
purchased from or sold to related persons. Income from providing digital
services to unrelated persons generally does not give rise to foreign base
company services income, provided a related U.S. person does not substantially
assist in providing those services (the 80% cost test), and no related person
guarantees the services and a related person performs a portion of the services
(or significant related services). Income from licensing or leasing a digital
product to unrelated persons is not foreign personal holding company income
provided the CFC actively markets the property, or materially contributes to
the development of the property. Whether intangibles are developed by a related
person is not determinative of whether these foreign base company income
definitions are met, and there is flexibility in structuring transactions to
classify the income in a manner that minimizes the potential application of the
foreign base company income rules under particular circumstances (e.g., to
treat income as services income where provided to unrelated persons).
The Obama Administration expressed concern that taxpayers can choose
different forms for substantially similar transactions involving digital goods
and services (leases, sales, or services), and thereby avoid the application of
the existing Subpart F rules. The 2016
Green Book provides the following example: "[A] transaction involving a
transfer of a computer program (i.e., a copyrighted article) could be
characterized as a sale or lease of the computer program, depending on the
facts and circumstances concerning the benefits and burdens of ownership with
respect to the computer program. A computer program hosted on a server also
might be used in a transaction characterized as the provision of a service to a
user who accesses the server from a remote location."
The 2015 Green Book explains, "In this regard, the subpart F
rules, which are generally intended to require current U.S. taxation of passive
and highly mobile income, have not kept pace with advances in technology. This
shortcoming enables CFCs to shift income related to digital goods and services
to low-tax jurisdictions, in many cases eroding the U.S. tax base. For example,
a CFC may be able to conduct business with remotely-located customers through
the `cloud' using intangible property acquired from a related party and without
conducting any substantial business activities of its own."
The Obama Administration's new foreign base company digital income
category would apply to income arising from the lease or sale of a
"digital copyrighted article," or the provision of a "digital
service." No definition is provided of the term "digital." As
mentioned above, a digital copyrighted article would include a computer
program. This category might also apply to income from transferring goods digitally
(e.g., movies, books, music, games), and providing services remotely (e.g.,
hosting computer software).13
The new rule would apply only in cases where the CFC uses intangible
property developed by a related party to produce the income. It apparently
would not be relevant how the CFC obtains the rights to use the intangibles,
e.g., it may purchase or license the property. The 2015 Green Book expressly
states that property developed pursuant to a cost sharing arrangement satisfies
this requirement. Digital income earned
from using intangible property developed by the CFC or by an unrelated party
would not be subject to the new Subpart F income category.
Foreign base company digital income would not include digital income
if the CFC, though its own employees, makes a "substantial
contribution" to the development of the property or services that give
rise to the income (e.g., a computer program). No guidance is given concerning
the application of this definitional limitation. The Administration may have in
mind concepts similar to those provided in regulations treating a CFC that
substantially contributes to the manufacture of property as not subject to the
foreign base company sales income rules.14
In any event, there appears to be an intention to not apply this new category
of Subpart F income if a CFC makes an important contribution to the development
of the property or service giving rise to the digital income. Nevertheless,
this is likely to be complex and unclear in application (e.g., digital income
should not be subject to the new Subpart F income category if the CFC substantially
contributes to version three of a computer program but not to prior versions).15
An exception is provided where the CFC earns income directly from
customers located in the CFC's country of organization that use or consume the
digital copyrighted article or digital service in such country. Again, this
exception raises complexities in application. Where does a customer use an item? In the country where it is
downloaded, or where the customer is resident? And, how would the relevant
facts be determined?
The proposal does not contain a priority rule relative to the other
categories of foreign base company income. Presumably, if an item falls within the definition of foreign base
company digital income, it will be Subpart F income, even if it qualifies for
an exception to another category of foreign base company income. On the other hand, if an item of digital
income qualifies for an exception to foreign base company digital income, it
would seem appropriate that such income should not be Subpart F income under
another definitional category of foreign base company income.
Thus, the proposed new Subpart F income category potentially applies
to any item of digital income regardless of whether the income is classified as
sales, services, or rental income — it would remove the flexibility of applying
different rules to different types of income.16 In addition, such income would be
foreign base company income where a related person developed the intangibles
used to generate the digital income without meaningful involvement of the CFC
in developing the property or services (subject to a limited same-country
exception). This new rule would not apply to a CFC that develops the relevant
intangibles or obtains them from unrelated persons.
This proposal is counterproductive. It is complex in application and
inconsistent with the taxation of similar income by other industrialized
countries. The digital business sector is America's jewel — our best interests
are not served by undermining its global competitiveness with increased tax
costs. This commentary also will appear in the April 2015 issue of the Tax Management International Journal. For more information, in the Tax Management
Portfolios, see Yoder, 928 T.M., CFCs — Foreign Base Company Income (Other
1 Department of the
Treasury, General Explanations of the Administration's Fiscal Year 2016
Revenue Proposals (2015) (hereinafter 2016 Green Book), at pp. 32-34.
2 Department of the
Treasury, General Explanations of the Administration's Fiscal Year 2015
Revenue Proposals (2014) (hereinafter 2015 Green Book), at p. 58; see
also Staff of the Joint Committee on Taxation, Description of Certain
Revenue Provisions Contained in the President's Fiscal Year 2015 Budget
Proposal, JCS-2-14 (Dec. 2014), at p. 25.
3 §954(d).
4 Reg. §1.954-3(a)(4).
Where a CFC engages in manufacturing, purchasing, or selling activities in a
foreign branch, under certain circumstances a branch rule can apply to treat a
portion of the CFC's income as foreign base company sales income. §954(d)(2). 5 §954(e).
6 Reg. §1.954-4(b)(1);
Notice 2007-13, 2007-5 I.R.B. 410.
7 §954(c)(1)(A),
§954(c)(2)(A).
§1.954-2(c), §1.954-2(d).
9 §954(c)(6); Notice
2007-9, 2007-5 I.R.B. 401. See also §954(c)(3)(A)(ii); Reg.
§1.954-2(b)(5) (same-country exception).
10 Reg. §1.954-1(e)(1). See
Reg. §1.861-18 (rules for classifying income derived from computer programs).
11 Reg. §1.954-1(e)(2)
and §1.954-1(e)(2)(3). If an item is
classified as either sales or services income and qualifies for an exception,
it should not be retested under the other category. See Rev. Rul. 86-155, 1986-2 C.B. 134.
12 Reg. §1.954-1(e)(4).
Income that is initially classified within a particular category of foreign
personal holding company income but qualifies for an exception is not retested
under another category of foreign personal holding company income. Reg.
§1.954-2(a)(2)(i).
See OECD
Report, Addressing the Tax Challenges of the Digital Economy, Action 1
(Sept. 16, 2014).
§1.954-1(e)(4)(iv) (substantial contribution activities for purposes of the
manufacturing exception include oversight and direction, quality control, and
developing or directing the development of trade secrets, technology, or other
intellectual property); Yoder, Subpart F: `Indicia of Manufacturing', 38
Tax Mgmt. Int'l J. 642 (Oct. 9, 2009).
Cf. Reg.
§1.954-2(d) (exception for royalties received from an unrelated person for
licensing property the CFC developed, created, or produced, or acquired and added
substantial value thereto); Reg. §1.954-2(c) (similar exception for rents).
16 Royalty income from
licensing digital products would not be subject to the new rule.