Section 954(e) Foreign Base Company Services Income. William R. Skinner, Esq. Fenwick & West LLP. Last Updated January 2013

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1 Section 954(e) Foreign Base Company Services Income William R. Skinner, Esq. Last Updated January 2013 This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (expressed or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law,, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. The views expressed herein are those of the author, and not necessarily those of his employer. 1. Introduction. The foreign base company services income rules apply to treat services income as subpart F income where a (A) CFC performs the services for, or on behalf of, a related person, and (B) performs such services outside its country of organization. The paradigm case can be illustrated by the following simple example: CFC-1 manufactures and sells products in Germany. Pursuant to its sales contracts, it provides customers with a discount if they hire CFC-2, located in Ireland, to perform installation, warranty, etc., services. CFC-2 performs most of these services by sending employees to the customer s site in Germany, but does not have a permanent establishment in Germany and is not subject to German tax. A portion of CFC-1 s sales income has been diverted to a lower-tax CFC. However, CFC-2 s income is foreign base company services income to the extent it performs maintenance services outside of Ireland. (As discussed below, it will be treated as performing services for, or on behalf of, CFC-1 because CFC-1 s customers hire CFC-2 as a condition of the sale of property). While the Foreign Base Company Services Income s substantial assistance test has been significantly relaxed, see Notice , the other 954(e) rules 1

2 remain relevant in cases where entities like CFC-2 perform services directly for a customer that contracts with a related CFC or for the related CFC itself. The Foreign Base Company Services Income rules also offer planning opportunities and pitfalls, particularly in the case of branch structures discussed below. On the one hand, a CFC (or DRE) not meeting the two conditions of 954(e) may be able to earn services income in a low-tax environment. On the other hand, a CFC (or DRE) with ample business activities may run afoul of 954(e) if it performs these activities for a related person outside of its country of incorporation. These rules also can be relevant in the context of software, where the distinction between sales and services depends on relatively small differences in the underlying business model. 2. Conditions for Applying 954(e) (1) services for, or on behalf of a related person that are (2) performed outside the CFC s country of organization. a. Type of services included. The statute refers to income derived from the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial or like services. This is a broad definition of the type of services that potentially generate foreign base company services income. Thus, foreign base company services income may encompass any income that is characterized as services income for tax purposes. b. Services performed for or on behalf of a related person. The regulations set out four cases in which services are considered performed for, or behalf of, a related party 1 : i. The CFC is paid or reimbursed by, is released from an obligation to, or otherwise receives a substantial financial benefit from a related person. ii. The CFC performs services which a related person is, or has been, obligated to perform. iii. The CFC performs services with respect to property sold by a related person, and the performance of such services constitutes a condition or material term of the sale. iv. The CFC receives substantial assistance contributing to the performance of the services by a related person or persons. In the first three cases, the related person generally has the relationship with the customer (acts as the principal or general contractor) and subcontracts / delegates some services to the CFC. 1 Treas. Reg (b)(1). 2

3 The fourth case (the substantial assistance test), by contrast, applies where the CFC is the principal, but relies heavily on related persons to perform the services under the contract. Under Notice , this test only applies if assistance is furnished by related U.S. persons exceeds 80% of the CFC s total costs. c. Case 1 CFC receives payment, or other financial benefit, directly from related person. This is the most straightforward case of a related-party services arrangement. For example, assume CFC-1 hires CFC-2 to perform installation and maintenance services on machines sold by CFC To the extent CFC-2 performs these services outside its country of incorporation, it will earn foreign base company services income. This rule can apply in branch structures where the services are performed in the DRE s country of organization. For example, assume that a CFC-1 Singapore owns a Malaysian DRE engaged in manufacturing in Malaysia. CFC-2 in Hong Kong hires Malaysian DRE to perform contract manufacturing services. Since Malaysia is a branch of Singapore, Singapore is treated as performing services for Hong Kong outside of its country of incorporation (Singapore). Its income for performing contract manufacturing services for CFC-2 would be foreign base company services income. This sort of subpart F inclusion would be eliminated by unchecking the box on the Malaysian DRE. d. Case 2 CFC performs services that a related person is, or has been, obligated to perform. This case deals with situations where a person obtains the contract with the customer, and then assigns the rights and delegates the duties to a related CFC. There is an important exception for contractual guarantees of the CFC s performance. This guaranty exception will apply and exclude the transaction from 954(e) under this case if: (1) the related person s sole obligation with respect to the contract is to guarantee performance of such services; (2) the CFC is fully obligated to perform the services under the contract; and (3) the related person does not in fact pay for or perform the guaranteed services or any significant services related to such services. 3 The guarantee may be effected by means of a separate guarantee or by entering into the contract solely for purposes of effecting a guarantee and delegating performance to the CFC. 4 2 Treas. Reg (b)(3), Example 1. 3 Treas. Reg (b)(2). 4 Id. Under general principles of contract law, a delegation of contractual performance generally does not extinguish the original contracting party s obligations, absent an express agreement to release that party, in which case the transaction is considered a novation. See Restatement Second of Contracts, 318(3). 3

4 This rule applies separately from the substantial assistance test. Thus, even if the related person does not furnish substantial assistance to a CFC, the contract can be subject to 954(e) based on the CFC s performance of duties that the related person is, or has been, obligated to perform. 5 For example, assume U.S. Person is in the construction business, and holds a contract to build a highway with a foreign government. It assigns the entire contract to its CFC. Since U.S. person was obligated to perform the contract, this will be treated as a 954(e) transaction (giving rise to subpart F income if performed outside the CFC s country of incorporation) even if the foreign person agrees to release the U.S. person from all liability. 6 By contrast, the guaranty exception will apply if the U.S. person enters into the contract and immediately assigns the rights and duties to the CFC. Absent an express release, under general principles of contract law, the U.S. person remains liable for the performance of duties delegated to the CFC. Thus, the transaction is, in substance, the same as a guarantee. The Example in the regulations to this effect further stipulates that the CFC is capable of performing the contract, and that neither the U.S. person nor any related person performs the duties under the assigned contract. In this case, section 954(e) will not apply. 7 Lastly, if the U.S. person performs some significant services related to the guaranteed services, the guaranty exception cannot apply. The regulations provide an example of such significant services where the U.S. person, preparatory to entering into the construction contract, prepares plans and specifications which enable the submission of bids for the contract. 8 The U.S. person then guarantees the contract. This is treated as significant services that prevent the guaranty exception from applying. The distinction between the first example and the second example discussed above appears to be that in the first Example, the US Parent does not immediately assign the contract to the CFC. The longer elapses between USP s entering the contract and assigning it to the CFC, the harder it would be to show that the U.S. parent s entering into the contract was solely for the purpose of effecting a guarantee. For a real-life example of where this rule might have been invoked, but was not invoked, see Hospital Corp. of America v. Commissioner, 81 T.C. 520, 574 (1983). 5 See Technical Memorandum accompanying T.D. 6981, 1968 TM Lexis Treas. Reg (b)(3), Example 5. 7 Treas. Reg (b)(3), Example 6. 8 Treas. Reg (b)(3), Example 7. 4

5 Planning Pointers. The first example above illustrates the importance of good housekeeping. CFCs should initially enter into contracts within their territory, and the U.S. parent should, if possible, avoid granting an express guarantee of the CFC s performance. Second, if the U.S. parent expressly guarantees performance under the contract, any significant services related to the contract will cause the CFC to be within this category of 954(e) transaction. By contrast, if the U.S. parent does not make an express guarantee, it can furnish services up to the 80% of cost threshold under Notice (see below). Thus, whether the U.S. parent makes an express guarantee can be very important. Note that an implied guarantee by virtue of the CFC being part of the same multinational group is distinguishable from an actual guarantee. 9 e. Case 3 CFC renders services that the customer purchases as a condition, or material term, of sale of property by a related party. This case primarily concerns warranty, installation, and other services ancillary to a sale of property. If the customer is contractually required to hire the CFC to perform these services, this category will apply. Likewise, if the customer is given a discount to the sale price of property if it hires the CFC, this category will apply. However, if the customer chooses the CFC of its own volition from among a number of qualified service providers, this category will not apply. 10 f. Case 4 CFC receives substantial assistance from other related parties in performing its services under a contract. Under the current regulations, this category applies in a number of cases where the CFC earns income as principal from providing services to an unrelated customer. In this case, subcontract services provided by related parties will cause 954(e) to apply if the subcontract services rise to the level of substantial assistance under either a subjective or an objective test. 11 Notice , effective January 1, 2007, substantially relaxes the substantial assistance test. Under the Notice, the subjective test will no longer apply. Further, the objective test will only apply to cause the CFC to receive Substantial Assistance if more than 80% of the CFC s total costs are provided, directly or indirectly, by related U.S. persons. Thus, assistance provided by related CFCs will generally not cause the substantial assistance rule to apply, and even assistance provided by U.S. persons will cause the rule to apply only in rather limited circumstances. 9 See Treas. Reg (l), Example 15; Merck & Co., Inc. v. United States, 24 Cl. Ct. 73 (1991). 10 See Treas. Reg (b)(3), Examples See Treas. Reg (b)(2)(ii)(B). 5

6 The Notice provides three rather straightforward examples of how the 80%-of-costs test applies. In cases of indirect assistance, for example, Example 2, presumably any mark-up the intermediary CFC earns is not included in the costs of services indirectly furnished by the U.S. parent. However, Notice does not address this point. As noted above, if the U.S. person guarantees the CFC s performance under the contract, this would be tested under the rules for case 2 and could give rise to 954(e) income if the U.S. parent s assistance is significant even if it does not amount to 80% of total costs. g. Excluded services. Certain sales-related services are excluded from the definition of foreign base company services income. Specifically, the regulations exclude income that the CFC earns from performing services that directly relate to a sale of personal property manufactured by the CFC, which are performed before the sale or exchange of property is completed. 12 Likewise, if the services directly related to an offer to sell property manufactured by the CFC that was not consummated, they also are excluded. For example, CFC-1 manufactures personal property and sells it to other CFCs for distribution worldwide. In connection with the distribution of the products, CFC-1 s personnel provide marketing and promotional services to the distributor CFCs and CFC receives a fee for sales support services. The exclusion applies to these pre-sale support services. However, the exclusion would not apply to after-sale support services, such as warranty or maintenance services. Planning Pointer. If the local distributors are DREs and render services to the CFC that sells the property, then there is no related party services transaction (because it is disregarded as a branch transaction). CFC then could provide the services directly to the customer and earn income that is not from a related party transaction subject to 954(e). h. The second condition for Subpart F Income Services performed outside the CFC s country of incorporation. The place where services is performed for 954(e) purposes looks to where the persons performing services are physically located. Where services are performed in multiple countries, this generally require apportionment between different countries based on employee-time spent in each country, adjusted for value of the functions. 13 Where services are performed is a factual issues. 12 Treas. Reg (d)(1). 13 Treas. Reg (c). 6

7 The imputation of activities of an agent or independent contractor of the CFC has been addressed in a number of cases and other authorities. 14 The terms of the agent s relationship to the CFC and the other facts and circumstances must be carefully considered to resolve the imputation question. 3. Income Characterization; Planning Considerations. a. Planning with branch / DRE structures under 954(e). Assume that multiple CFCs are engaged in a business of providing services to unrelated customers. Alternatively, assume that the CFCs earn income from providing various services (e.g., manufacturing, sales support, R&D services) to related persons in the group. When will it be advantageous or disadvantageous to make a check-the-box election? Services to unrelated customers. Assume that HoldCo is a Swiss CFC that owns significant IP used in a services business. HoldCo owns OpCo, which is a German CFC. OpCo performs some functions related to the services business. The customers may contract with HoldCo, in which case HoldCo will subcontract out some functions to OpCo. Alternatively, the customers may enter into agreements with OpCo, in which case OpCo will license IP and/or receive services from HoldCo. Assume that USP does not furnish substantial assistance or a contractual guarantee to HoldCo or OpCo. Should OpCo make a check-the-box election? The answer is that it depends on the structure of the intercompany services relationship. If OpCo is a DRE, income earned by the HoldCo-OpCo aggregate will not be Foreign Base Company Services Income because the only regarded transaction is the transaction with the end customer in this fact pattern. This applies whether HoldCo or OpCo enters into the agreement with the customer. By contrast, if OpCo is a separate CFC, any subcontract or license between OpCo and HoldCo is regarded for U.S. tax purposes. The entity holding the contract with the customer will still not earn Foreign Base Company Services income, absent application of the substantial assistance test (which requires substantial assistance from the U.S.). However, the other entity (the subcontractor) will earn income from providing services 14 See, e.g., GCM (imputing activities of US Parent to CFC for 954(e) purposes where US Parent performed certain functions related to factoring of receivables). See Inverworld, Inc. v. Commissioner, T.C. Memo ; Miller v. Commissioner, T.C. Memo ; Le Beau Tours Inter-America, Inc. v. United States, 547 F.2d 9 (2d Cir. 1976), aff g 415 F.Supp, 48 (SDNY 1976); see also GCM (imputing activities of US Parent to CFC for 954(e) purposes where US Parent performed certain functions related to factoring of receivables). 7

8 to a related person. To the extent it performs these services outside its country of incorporation, it will earn Foreign Base Company Services Income. Also, any royalty earned by HoldCo would generally be FPHCI. Intra-group / related-party services. Assume the same ownership structure of HoldCo and OpCo, except that OpCo performs R&E or contract manufacturing services for affiliates. OpCo performs these services in Germany. Should OpCo be a DRE or a separate CFC? If OpCo is a DRE, then HoldCo is treated as performing contract R&D for affiliates outside of Switzerland and earning Foreign Base Company Services Income. If OpCo were a separate CFC, by contrast, OpCo would earn this income and it would not be Foreign Base Company Services Income because the Services are performed in Germany. Thus, there is a potential trap in the Foreign Base Company Services Income rules in certain cases. b. Characterization of income. i. The character of a CFC s income as from services, or from some form of property transaction (sale of goods, lease or license of property) determines whether it is subject to the rules and exceptions of 954(e) or some other subpart F provision (section 954(d) sales income, section 954(c) FPHCI rules on royalty income, etc.). ii. Separate Transactions or Predominant Character? Generally, if the CFC derives separate items of income from a transaction, those separate items are classified and tested under the respective 954 rules. 15 For example, if a CFC manufactures and sells personal property to a related party, and also provides installation and warranty services, the CFC will usually be viewed as earning separate items of sales income and services income tested under 954(d) and 954(e), respectively. However, the regulations state there are unusual circumstances in which the character of income may not be separately determinable. For example, if the CFC enters into an integrated transaction to design, build, and install a drilling rig for a single contract price, the CFC s income may be characterized as one type of income (sales or services) based on the predominant character of the overall transaction. 16 The ruling cited above also notes that the 15 Treas. Reg (e). 16 Rev. Rul ; see also TAM (addressing whether food and beverage service is a service or sale of goods and service). 8

9 CFC does not separately account for the elements of the transaction. Thus, whether any embedded services (or embedded property) component in a larger transaction is separately invoiced may be relevant for subpart F characterization purposes. Consider whether one could analogize to the provisions in the 460 regulations governing severability of the elements of a single contract. Those regulations identify as relevant factors for segregation: (1) whether the items are independently or interdependently priced; (2) whether the items are susceptible of separate delivery or acceptance under the terms of contract; and (3) whether a reasonable business person would have entered into one transaction on the price agreed without also entering into the other transaction. 17 iii. Sales vs. Services. There is also the question of whether the CFC, in substance, is providing a service or selling property. For this purpose, the tax rules look to the substance of the transaction. 18 In TAM , the IRS analyzed whether a CFC s income from a film production project was sales or services income. Although the contract was denominated as a sale of property, the IRS treated it as a service contract. Key facts to the Service s determination were: (1) that the CFC agreed to convey all rights, title and interest to the film to the studio; (2) the CFC could be removed from the project by the Studio; (3) the Studio financed the production and bore the risk of loss as to the film if production failed. The same characterization issue arises in contract manufacturing. Does the person doing the physical manufacturing provide a service or sell custom-made goods? Here, the Service has focused on the benefits and burdens of ownership during production, such as control and possession of the raw materials, risk of loss by destruction, and an economic stake in the property produced (i.e., is it a fixed price or time-and-materials contract). 19 In the context of software development, the Service has treated the developer as a service provider where the developer was paid on a time-and-materials basis and was instructed in the details of programming by the principal, and where the principal received 17 Treas. Reg (e)(2). 18 Treas. Reg (e)(1). 19 See, e.g., PLR (addressing issue under 471); Treas. Reg (f)(3), Examples 1 and 2 (addressing issue under 199); Suzy s Zoo v. Commissioner, 273 F.3d 875 (9 th Cir. 2001) ( producer for purposes of 263A is the party that owns the property during the production process under Federal income tax principles). 9

10 complete ownership of the code and could cancel the project at any time and keep the work-in-progress. See Treas. Reg (h), Example 15. iv. Commission agent services. TAM provides an important analysis of whether a CFC acting as a commission purchasing agent earns foreign base company services income or foreign base company sales income. Under this TAM, the CFC s commission for purchasing goods on the US Parent s behalf was tested under the foreign base company sales income rules. Under 954(d), the same country exceptions would look to the country where the goods originated, rather than the country where the services are performed. v. Services vs. Lease / License. Whether a taxpayer is renting property (or licensing intangibles) to the customer, or providing an integrated service, can determine its foreign base company services income. If the income is services income, it would not be foreign base company services income if the customer is unrelated. If the income is leasing income, the CFC (or its DREs) must satisfy the active business tests of 954(c). For a recent application of 7701(e) s statutory factors to resolve a services vs. lease question, see Tidewater Inc. v. United States, 565 F.3d 299 (5 th Cir. 2009). vi. E-Commerce / Online Software. The characterization issues under subpart F appear most readily in the case of software, where the distinction between property and services rests on relatively small differences in the business model of software delivery. For example, assume that the CFC owns and operates a website hosted on servers located in its country of incorporation. The CFC makes the software available to customers online for a fee, but does not permit downloads. If the CFC s income were characterized as services income, 20 it would be Foreign Base Company Services income tested under 954(e). By contrast, if a CFC derived income from a download of software programs pursuant to an end-user license agreement, it would earn foreign base company sales income. 20 The IRS has provided fairly limited guidance on the characterization of Software as a Service / cloudbased income. See Notice , Example 2 (assuming that business of being application service provider gives rise to services income); Treas. Reg (i)(6) (treating online hosted software as giving rise to sales / leasing income for 199 purposes if certain conditions are met). 10

11 CIRCULAR 230 DISCLOSURE To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice in this communication is not intended or written by to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. 11