The Sixth Circuit recently issued its opinion in Whirlpool Financial Corp. v. Commissioner (No. 20-1900), affirming a Tax Court opinion granting summary judgment for the government and finding that income generated by a controlled foreign corporation (CFC) as part of a foreign manufacturing and sales structure was foreign base company sales income (FBCSI) under Section 954(d). The court also ruled that the Subpart F “branch rules” applied. For additional background on the Tax Court ruling, see our previous story, “Tax Court applies manufacturing branch rules.”
The case originally arose after the IRS reviewed Whirlpool’s 2009 federal income tax return. The IRS determined that income Whirlpool’s Luxembourg CFC earned from sales of appliances manufactured through the CFC’s Mexican branch was FBCSI under Section 954(d) and was taxable to Whirlpool as Subpart F income under Section 951(a). Whirlpool filed a petition with the Tax Court refuting that the sales income was FBCSI, instead arguing that the appliances sold by the Luxembourg CFC were substantially transformed prior to the sale. The Sixth Circuit appeal followed Whirlpool’s loss at the Tax Court.
In affirming the Tax Court’s decision, the Sixth Circuit examined the branch rule, noting that:
“Section 954(d)(2) consists of a single (nearly interminable) sentence that specifies two conditions and then two consequences that follow if those conditions are met. The first condition is that the CFC was ‘carrying on’ activities ‘through a branch or similar establishment’ outside its country of incorporation. The second condition is that the branch arrangement had ‘substantially the same effect as if such branch were a wholly owned subsidiary corporation [of the CFC] deriving such income[.]’ If those conditions are met, then two consequences follow as to ‘the income attributable to’ the branch’s activities: first, that income ‘shall be treated as income derived by a wholly owned subsidiary of the controlled foreign corporation’; and second, the income attributable to the branch’s activities ‘shall constitute foreign base company sales income of the controlled foreign corporation.’”
The Sixth Circuit found that the first condition was “undisputedly met,” because Whirlpool’s CFC was incorporated in Luxembourg, carried on its manufacturing activities through its wholly owned subsidiary in Mexico, and the subsidiary asked to be treated as a disregarded entity for U.S. federal income tax purposes.
In discussing whether the second condition was met, the Sixth Circuit court found that the “effect” referenced should be interpreted to mean a tax-deferral effect. Based on that interpretation, the court concluded that the CFC’s carrying on of activities through a Mexican branch clearly had a tax deferral effect, as the arrangement entirely avoided any taxation of the sales income of the CFC in Luxembourg and Mexico.
Having found the conditions of Section 954(d)(2) satisfied, the Sixth Circuit concluded that the statute required the consequences stated therein: that the income attributable to the activities of the Mexican branch shall be treated as derived by a wholly-owned subsidiary of the Luxembourg CFC and that the income shall constitute FBCSI of the CFC.
The court rejected Whirlpool’s arguments to the contrary based on the regulations under Section 954(d)(2) noting “the agency’s regulations can only implement the statute’s commands, not vary from them.”
Thus, the Sixth Circuit agreed with the Tax Court and the IRS that the sales income derived from Mexican operations was FBCSI under Section 954(d)(2) and must be included in Whirlpool’s income under Subpart F.
The case divided the Sixth Circuit three-judge panel. Analyzing both the statute and the regulations, the dissenting opinion concluded that the Luxembourg CFC “didn’t generate taxable foreign base company sales income because it ‘manufactured’ the property it bought and sold.” The dissenting judge also noted that “[a}t the very least, there’s a question of fact over whether [the Luxembourg CFC] ‘manufactured’ the appliances.”
The case is particularly significant for entities with foreign-run operations in Mexico that export goods to other countries (i.e., Mexican maquiladora structures). Other CFC structures where manufacturing and sales operations are in separate jurisdictions may be similarly implicated.
Note that the House-passed reconciliation bill currently being considered in the Senate would amend Section 954(d)(2) by replacing the branch rules with new rules that limit FBCSI to income generated by transactions with or on behalf of a person that is a taxable unit with tax residency in the United States or is subject to tax based on that person’s activities in the United States. Taxpayers should continue to follow developments in this area.
David E. Sites
National Managing Partner, International Tax Services Practice Leader
David leads the firm's International Tax practice, which focuses on global tax planning, cross border merger and acquisition structuring, and working with global organizations in a variety of other international tax areas.
Washington DC, Washington DC
- Technology and telecommunications
- Retail and consumer products
- International tax
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