The Archaic Subpart F Services Rules: Ill-Fitting and Disruptive for Modern Services Businesses By Lowell D. Yoder and David G. Noren Lowell D. Yoder and David G. Noren analyze the Subpart F services rules and demonstrate LOWELL D. YODER is a Partner in the Chicago office of McDermott Will & how these antiquated rules—which have not Emerryy LLLLPPP.. DAAVVVIIDD GG.. NNOOORREENN iiss a Parttnneerr iinn tthhe beenn uppdated since thee 1199660s—are ill-fi tting WWaasshhhiinnggttooonn DD...CC.. ooffffifi ccee of MccDDeerrmmootttt aanndd ddissrruppttiivvee ffoorr mmoddeerrnn sserrvviicceess bbuussiinneesssseess. WWWiiillllll &&& EEEmmmeerryy LLLLLLPPP.. Table of Contents I. Introduction ....................................................39 3. Predominant Character ....................45 II. Taxation of Services Income Earned by 4. Intangible Property Used or Developed Foreign Subsidiaries ............................................39 in Performing Services ......................46 A. Generally Not Subject to U.S. Taxation .......39 V. Services Performed for or on Behalf B. Limited Current Taxation Under Subpart F ......40 of a Related Person ...........................................47 III. Foreign Base Company Services Income .............41 A. Defi nition of Related Person ........................48 IV. Defi nition of “Services” Income for B. Performing Services for a Related Person ......48 Subpart F Purposes .............................................41 C. Related Person Services for Unrelated Persons ..48 A. General ........................................................41 D. Disregarded Entity Structure Eliminates B. Types of Services ..........................................41 Related Foreign Person Transactions ............49 1. List of Services ......................................41 VI. Services Deemed Performed 2. Services Income Separated from for a Related Person ............................................49 Manufacturing Activities ..................43 A. General ........................................................49 3. Building Dams, Drilling Oil Wells and B. Related Person Pays a CFC for Performing Constructing Superhighways ............43 the Services ..................................................50 4. Interpretative Guidelines ..................43 C. Related Person Obligated to Perform C. Services Income Distinguished from Other the Services ..................................................50 Types of Income ........................................44 1. General Rule .........................................50 1. Substance of Transaction ......................44 2. Related-Person Guaranty 2. Separately Determined Items of Income of Performance .................................51 from Single Transaction ....................45 3. Updating the Regulations .................52 MARCH 2016 © 2016 L.D. YODER AND D.G. NOREN 37 THE ARCHAIC SUBPART F SERVICES RULES D. Services Are a Condition or Material Term 4. Location of Machines ........................68 of a Sale of Property by a Related Person ......53 VIII. Coordination with Other Categories of E. Substantial Assistance Furnished Subpart F Income ............................................69 by a Related U.S. Person ...............................54 A. Priority of Other Categories .........................69 1. General .............................................54 1. General Rules ....................................69 2. Th e Regulations .................................55 2. Retesting Under Code Sec. 954(e) ......69 a. History of Regulations ....................55 B. Coordination of Services and Sales Income .70 b. Assistance Furnished by a 1. Mutually Exclusive .............................70 Related Person ................................56 2. Certain Services Income Treated i. General ........................................56 as Sales Income ..................................70 ii. Use of Personnel of a 3. Tested Once ....................................73 Related Person ......................................56 IX. Exceptions from Foreign Base Company iii. Joint Offi cers and Directors ...........56 Services Income ..................................................74 c. Types of Assistance Taken A. Services Income Related to the Sale into Account ................................56 of Property ...................................................74 i. Direction, Supervision, Services B. Securities, Finance and Insurance-Related and Know-How .................................56 Income .........................................................75 ii. Financial Assistance, Equipment, X. Low-Taxed Foreign Services Structures ................75 Material or Supplies ...........................57 A. Providing Services Remotely .........................75 d. “Substantial” Assistance ................57 B. Services Principal Structure ...........................76 i. Direction, Supervision, Services C. Intangible Property Holding Company ........77 or Know-How ...................................58 XI. Recommendations for Updating ii. Financial Assistance, Equipment, the Regulations ....................................................78 Materials and Supplies .......................59 A. Clarify and Limit the Scope of Deemed iii. Aggregation of Assistance .............59 Related-Person Services Rules .......................78 3 3.. NNoottiice 2000077--1133:: UUppddaated Subbsstannttial 1. Cllaarriiffyy AApppplication of Substantial AAsssssiisstancee RRuullee .......................................................5599 Assssiissttaancee TTesstt ............................................................7799 aa a.. GGGenerall ..........................................................................5599 2 2. Elliimmiinnate tthee PPerffoormmaannccee b b.. AAssssssiistanccee PPrroovviiddeed bbyy RReellaattedd Guuaarraanntteee RRuullee ........................................................880 UU.SS. Persons .........................................59 3. Eliminate the Assignment-of-Contracts i. General ........................................59 Rule ..................................................80 ii. Indirect Assistance ........................60 4. Clarify the Rule Concerning Services iii. Use of Personnel of Performed in Connection with the Sale Related Person ...................................60 of Property ........................................80 c. Types of Assistance Taken B. Clarify Th at the Location of Services Is Deter- into Account ................................61 mined Based on Activities of a CFC’s Employees i. General ........................................61 When Performing the Contracted Services ....81 ii. Services Involving Intangibles ......62 C. Clarify Th at Commission and Fee Income Is d. “Substantial” Assistance ..................62 Analyzed as Sales Income Only When a CFC VII. Services Performed Outside the CFC’s Country Functions as a Purchasing or Selling Agent ...81 of Organization ...............................................63 D. Th e IRS and Treasury Should Not Issue A. CFC’s Country of Organization ...................64 Guidance Targeting Services Structures Solely 1. General .............................................64 on the Basis of Low Eff ective Tax Rates .......82 2. Companies Not Subject to Taxation XII. International Tax Reform Proposals ................86 in Th eir Country of Organization .......64 A. Obama Administration’s FY 2016 3. Disregarded Entities ...........................64 Budget Proposals ..........................................86 B. Where Services Are Performed ......................65 1. Minimum Tax Proposal ......................86 C. Apportionment of Services Income ...............66 a. Overview ........................................86 1. General Rules ....................................66 b. Application to Services Income .......87 2. Activities Incidental to Performing 2 . Subpart F Digital Income ...................88 the Contracted Services ......................66 B . International Tax Reform Proposals 3. Activities of Persons Other Th an the Advanced by Members of Congress ..............89 CFC’s Employees ...............................67 XIII. Conclusion ........................................................90 38 TAXESThe Tax Magazine® MARCH 2016 T his article analyzes the Subpart F services rules and substantial overseas operations in multiple countries demonstrates how these antiquated rules—which often are forced to adopt burdensome terms and disrup- have not been updated since the 1960s—are ill- tive arrangements in order to conform ordinary business fi tting and disruptive for modern services businesses. deals to antiquated and ill-fi tting rules, and to live with Th e authors recommend that the Subpart F category for substantial tax uncertainties in many cases. At the same services income be repealed as part of any international time, technological advances permit high-value services to tax reform. While awaiting tax reform, the Treasury and be provided remotely, causing some to express concerns the IRS are urged to eliminate or at least rationalize cer- that the current rules may facilitate low-tax structures that tain overbroad rules in the regulations that cause many could not have been anticipated 50 years ago. modern business-driven structures to have Subpart F Th is article addresses the rules for determining whether income by deeming the existence of related-person ser- services income earned by a CFC falls within the defi nition vices transactions—these regulatory rules, lacking any of Subpart F income. Th e focus is on income derived by basis in the statute, exacerbate the burden of the out- foreign subsidiaries of U.S. corporations from operating of-date Subpart F services provisions. Treasury and the services businesses outside the United States. Th is article IRS also should clarify regulatory rules for determining discusses common global structures used by U.S.-based the location of services to address important new issues companies for the performance of services, and the com- raised by today’s services businesses. plexities and uncertainties encountered in applying the Subpart F rules to modern services businesses. I. Introduction Th e article recommends actions that Treasury and the IRS might (and could) take to clarify and update certain Service businesses make up over half of today’s U.S. rules in the regulations, and discusses legislative options in economy—including consulting, fi nancial, transportation, the context of current international tax reform proposals. technnoolloooggyy,, ee--ccoommerce and software services.1 U.S.-based We advocate modifying the regulations to limit the scope muullttiiinnaatttiiioonnaaalll ggrrooouups perform services for customers glob- of the deemed related pperson rules and to clarify that the allllllyyy ttttthhhrrrooouuuuuggghhh mmmmmuuullltttiiippplllee entiittiieess iinn nnuummeerroous counttrriies,, ooften determinationn ooff tthhee looccation of services should be based wwiitthhh ssuubbbssttaannttiiaall oooppeerationnss ccaarrrriieedd oonn oouuttssiiddee thhe UUnniitteedd oonn wwwhheerree the CCFFCC’s emmpllooyyeeeess ppeerrffoorrmm tthhee ccoonnttrraacctteedd- Sttaatteeess aass aa mmaarrkkkeettt nneecceessityy.. ffoor seerrvviicces. ThTh ee aarrtticllee allssoo rreeccommmmeennddss thhaatt aass ppaarrt of F Foooorrreeeiiigggggnnn sssuuuuubbbsssiiiddddiiaarriieeesss of UU.SS. ccoommpanniieess ggenneerrallllyy aarree iinnterrnnaattiioonal ttaaxx rreeffoormm prrooppoossaals tthhaatt wwoouldd ttaarrggett llow- not subbjjeecctt ttto direct U.S. taxation on their services in- tax structures (through a Subpart F expansion and/or a come. Under Subpart F, however, services income of a “minimum tax” construct), Congress should repeal the controlled foreign corporation (CFC) can be included foreign base company services income rules and ensure currently in the income of its U.S. parent. Subpart F that the key characteristics of the modern services economy applies to income derived by a CFC from performing are taken into account in designing any new generally services outside its country of organization for, or on applicable subpart F or minimum tax rule. behalf of, a related person. Th e Subpart F services rules in the Internal Revenue II. Taxation of Services Income Code (“the Code”) have remained unchanged since they Earned by Foreign Subsidiaries were enacted in 1962, and most of the regulations have not been updated in almost 50 years. Congress focused at the time on relatively limited situations involving the A. Generally Not Subject to U.S. Taxation separation of supporting services from sales of industrial machines. Th e drafters of the regulations expanded the A foreign corporation2 as a general rule is not subject to focus to target income derived from building dams, con- U.S. taxation. Foreign corporations are subject to U.S. structing highways and drilling oil wells, promulgating income taxation only on income derived from the conduct broad rules deeming services performed for unrelated of a business in the United States and on certain types of persons as being performed for related persons with U.S.-source income.3 Th is treatment applies equally to a certain kinds of fi nancial or functional involvement in foreign-based corporation and to a foreign subsidiary of the arrangements. a U.S. corporation.4 Today’s services economy is much larger and more A foreign corporation that derives income from multifaceted than the services economy of 50 years performing services in the United States is subject to ago. Modern services businesses that inherently require U.S. taxation on that income. Such income generally is MARCH 2016 39 THE ARCHAIC SUBPART F SERVICES RULES considered as U.S.-source income 5 attributable to carrying under Subpart F is not subject to current taxation under on a trade or business in the United States.6 On the other the Subpart F rules—there is no miscellaneous or “catch- hand, a foreign corporation that derives services income all” category, nor is there any provision requiring that an only from foreign operations is not subject to U.S. taxa- item of income be “analogized” into a Subpart-F-relevant tion on that income.7 kind of income even if the item does not fi t within the A U.S. corporate parent of a foreign subsidiary is not four corners of any Subpart F defi nition. 18 Exceptions subject to tax on income earned by the subsidiary.8 Cor- may apply to cause what would otherwise be Subpart F porations are taxed as separate entities.9 Th e earnings of a income not to be taxable under Subpart F. 19 foreign subsidiary become taxable only when distributed U.S. shareholders that are corporations generally are to the U.S. corporation as a dividend. 10 Foreign taxes eligible to claim a deemed-paid foreign tax credit for associated with the earnings distributed to a corporate foreign income taxes paid or accrued by a CFC on the parent can be used as a foreign tax credit to reduce U.S. earnings of the CFC that are deemed distributed under tax on the dividend.1 1 Subpart F.2 0 Earnings of a CFC that have been included Th erefore, services income derived by a foreign subsid- in the gross income of a U.S. shareholder under Subpart F iary from operations carried on outside the United States are then excluded from income when actually distributed is not subject to direct U.S. taxation, and such income to the shareholder.2 1 will generally not be included in the income of the sub- Subpart F was fi rst proposed by the Kennedy admin- sidiary’s U.S. parent. Only when the earnings arising istration, which recommended that tax deferral practices from performing such services are distributed to a U.S. be eliminated by legislation which “would tax each year shareholder will they become taxable (with a foreign tax American corporations on their current share of the un- credit). Th is framework is subject to the limited exception distributed profi ts realized in that year by subsidiary cor- provided under Subpart F. porations in economically advanced countries.” 22 Under that proposal, all income of foreign subsidiaries would be B. LLLLiiimmiiittteeddddd CCCuuurrrent Taxation Under subject to current U.S. taxation. SSSuuubbbbbpppaaaaarrrttt FFFFF A bill was innttrroodduuccedd in the House in 1962 addressing tthhee ccoonncceerns off tthhee Kennnneddy addmmmiinnisttrraatioonn. 2233 ThTh ee reessuulltt- Suubbbpppaarrtt FF oofffff SSuubbbbbttiittllee AA, CChhaapptteerr 11,, Suubbcchhaappteerr NN,, Paarrtt iinng leeggiissllaation aaddooppttedd bby bbootthh thee HHoouussee aanndd tthhee Seennate III oooofff ttthhheeeee IIInnnttttteeerrrnnnaaaall RReeevvveenue CCooddee ((C Codee SSeeccss. 995511– –9 96655) ), iinn thhee RReevvenuee AAcctt ooff 11996622 iinncclluudedd SSuubbppart FF, pprroovviidding which wwaass eennacted in its original form in 1962, provides for the current taxation of U.S. shareholders of CFCs on a limited exception to the above general rule that income certain undistributed earnings of CFCs.2 4 earned by a foreign corporation from business opera- Th e legislation as enacted, however, fell short of the tions carried on outside the United States is not subject President’s recommendations. It did not eliminate tax to U.S. taxation. Certain income (“Subpart F income”) deferral generally. 25 In this regard, the House Report states: of a CFC is subject to current U.S. taxation.1 2 Th e CFC itself is not subject to U.S. tax, but the net amount of an Your committee’s bill does not go as far as the Presi- item of Subpart F income is included in the gross income dent’s recommendations. It does not eliminate tax of the U.S. shareholders of the CFC (essentially like an deferral in the case of operating businesses owned by accelerated dividend).1 3 Americans which are located in the economically de- U.S. shareholders are U.S. persons1 4 who own 10 veloped countries of the world. Testimony in hearings percent or more of the voting stock of a foreign corpo- before your committee suggested that the location of ration.1 5 A CFC is a foreign corporation more than 50 investments in these countries is an important factor percent of the stock of which is owned, by vote or value, in stimulating American exports to the same areas. by U.S. shareholders.1 6 Moreover, it appeared that to impose the U.S. tax cur- Subpart F income includes certain categories of in- rently on the U.S. shareholders of American-owned surance income, passive income, sales income, services businesses operating abroad would place such fi rms income and oil-related income.1 7 Th is article analyzes the at a disadvantage with other fi rms located in the same Subpart F income category for services income (foreign areas not subject to U.S. tax.2 6 base company services income, which is a component of foreign base company income, which in turn is a compo- Th erefore, services income earned by a CFC is subject nent of Subpart F income). An item of income that does to current U.S. taxation only if it falls within the defi ni- not fall within any of the taxable categories of income tion of a specifi c category of Subpart F income. Services 40 TAXESThe Tax Magazine® MARCH 2016 income from conducting operations outside the United IV. Defi nition of “Services” Income States that is not Subpart F income is not subject to cur- for Subpart F Purposes rent U.S. taxation.2 7 III. Foreign Base Company A. General Services Income Code Sec. 954(e) applies only to income derived in con- nection with the performance of services. Th erefore, an As discussed above, a foreign subsidiary of a U.S. corpora- item of income earned by a CFC must fi rst be charac- tion is not subject to U.S. taxation on income it derives terized as s ervices income before it is subject to analysis from performing services outside the United States. Under under the foreign base company services income rules. Subpart F, however, the U.S. corporate shareholder in- An item of income that is not properly characterized cludes in its gross income the foreign subsidiary’s services as services income cannot be foreign base company income to the extent it falls within the defi nition of foreign services income. base company services income. 28 Code Sec. 954(e) contains a list of specifi c types of Code Sec. 954(e) provides that an item of income is for- services that are subject to analysis under the foreign eign base company services income if the income is derived base company services income rules and ends with “or by a CFC from performing services (i) outside the country like services.” Th e list was drafted over 50 years ago, with under the laws of which the CFC is created or organized a very diff erent set of activities in mind from those now (ii) for or on behalf of a related person. Services income common in the modern services economy. Th e legislative derived by a CFC must satisfy both of these requirements history indicates that Congress was targeting services that in order to be foreign base company services income. 29 taxpayers might separate from the manufacture and sale Th eerreefffoorree,, sseerrvices performed for persons unrelated to of industrial machines. Nevertheless, the kinds of services thee CCCFFFCCCCC ggeennneerraalllllllyy do not give rise to foreign base com- listed are broad enouggh to include most types of services paaannnyyyyy ssseeerrrvvvvviiiccceeesssss iiinnncccooooommme. ThTh iiss iiss tthhee ccaassee eeven if thhee seerrvvices income derivedd bbyy mmooddern services businesses. arree pppeerrffooorrmmeeddd oouuttssiidde the CCFFCC’’ss ccoouunntrryy ooff oorrgaanniizzaattiioonn.. S Suubbppaarrt F dooeess nnot ccoonnttaain aa ddeefifi nniittiioonn oooff sseerrvviiceess iinn- ThThTh uuuss,, sseerrrvviicceeess mmaaayy bbee perffoorrmmeedd aannyywwhheerree iinn tthhe wworlldd ccoomee ffoorr purppoosseess oof CCoddee Seecc. 995544((ee)) . . ThTh ee rreegguulaattions for uuuunnnrrreeelllaaattteeeddddd pppeeerrrrssonnsss,, incluuddiinngg iinn thee UUnniittedd SStaatteess. 3300 ssttatee tthhaatt the ssuubbssttaannccee ooff aann aarrrannggeemmeennt is aannaallyyzzeed to As discuusssseeddd bbelow, the Subpart F regulations provide determine whether a particular item of income is char- that services performed by a CFC for an unrelated person acterized as income from the performance of services. 32 under certain enumerated circumstances can be d eemed to be performed for or on behalf of a related person, in B. Types of Services which case this prerequisite of the defi nition of foreign base company services income would be satisfi ed, thereby 1. List of Services rendering the locational prerequisite determinative. Code Sec. 954(e) provides that income from the follow- If a CFC does earn income from performing services ing list of services can give rise to foreign base company for or on behalf of a related person (actually or by way of services income: “technical, managerial, engineering, deeming), such income is still not foreign base company architectural, scientifi c, skilled, industrial, commercial, services income to the extent the income is derived from or like services.”3 3 Neither the legislative history nor the performing services within the CFC’s country of organiza- regulations provide any further detail or description of tion. Only to the extent the income is attributed to services the types of services within the scope of Code Sec. 954(e) . performed outside the CFC’s country of organization is Th ere have been no amendments since 1962 to the Code the income foreign base company services income. modifying the list of the types of services subject to analysis Th e following sections analyze the defi nition of “ser- under Code Sec. 954(e) . vices” for purposes of Code Sec. 954(e) , when services Under the expressio unius est exclusio alterius canon of are considered as performed for or on behalf of a related construction, the express mention of certain items gener- person, and when services are considered as performed ally should be interpreted as an exclusion of other items. 34 outside the CFC’s country of organization. In addition, Congress’s use of a list of types of services rather than coordination rules with other categories of Subpart F in- simply referring to “services” suggests that certain types of come and exceptions for certain types of services income services are not intended to be included within the scope of are discussed.3 1 Code Sec. 954(e) . Th ere has been no guidance identifying MARCH 2016 41 THE ARCHAIC SUBPART F SERVICES RULES any services that may be excluded from analysis under the confl ict with the principle of construction that statutory foreign base company services income provision. language should not be construed as mere surplusage.4 0 Th at being said, the list also ends with “or like services,” One possible limiting eff ect of the enumerated list in indicating that there are types of services not expressly list- this regard is that it appears to contemplate only rela- ed that can be subject to analysis under Code Sec. 954(e) . tively complex activities, such that relatively unskilled Under the ejusdem generis canon of construction, such a or clerical/ministerial activities might fall outside the defi nition. However, various provisions of the regula- tions appear to assume that the performance of routine, The Subpart F services rules in the ministerial services may be relevant to the application of the foreign base company services income rules. For Internal Revenue Code (“the Code”) example, the regulation addressing the location where have remained unchanged since services are performed takes into account income ap- they were enacted in 1962, and most portioned to clerical work.4 1 Taking into account this kind of activity in applying Code Sec. 954(e) is in some of the regulations have not been tension with the language of the Code and the legislative updated in almost 50 years. history, although the inclusion of this activity argu- ably may be permitted to the extent incidental to or in support of enumerated (or “like”) services—“income general phrase should be restricted to the same kind or class derived in connection with the performance of” such of things as the items preceding it.3 5 Indeed, even without services arguably may capture all services necessary to resorting to Latin maxims, the use of the word “like” here generate income from the listed (or “like”) services, gets the same idea across in plain English—“like” services including incidental or supporting activities. must ddeesssccrriibbee ssoomething less than “all” services. Whether to take into account relatively low-skill, routine ThThTh Th ee dddrrraafffttiiinnngg ooff the statute thus suggests an intent to activities may not be a signifi cant issue for most modern exxxcccllluuudddeee sssooommmeeeee ssseeerrrrrvvviiiccces froomm tthhee ccoonncceepptual scooppe oof the services busineesssseess.. IIt iiss unlikely that a material portion sttaattuuuttee,, bbuutt tthhee eennuumeraatteedd iitteemmss ssuucchh aass ““teecchhnniiccaall,,”” ooff sseerrvviiccees incoommee deriivvedd bbyy aa CCCFFCC wwoouulldd bbee aattttrribbuutteed “sskkkiilllllllleeddd,,””” ““ccooommmmmeerrcciiaall” anndd ““iinndduussttriaall”” sseerrvviccees aarre ssoo ttoo thiiss kkiinnd off aaccttiivviity oor tthhaatt ttaakiinngg tthhiiss aaccttiivviittyy iinnttoo ac- brooaaaaddd ttthhhaaattt ttthhhhheeeyyy wwwwooullddd sseem ttoo iinncclluudde esssseennttiiaallyy aanyy ttyyppee ccoounntt iinn applyyiinngg tthhe vvaarriioouuss rruless ooff CCoode SSeecc. 9554(e) of arranggeemmeent for the provision of services. Th erefore, would provide a materially diff erent result. If the result it would seem appropriate to subject to analysis under were materially diff erent, then it may be defensible to Code Sec. 954(e) most or all types of services income take a position excluding low-skill, routine activity from derived by modern services businesses. For example, while consideration (although in some situations such a position e-commerce did not exist as a global services business in might be inconsistent with the regulations).4 2 1962, services income derived by a CFC from engaging Another possible solution to the “mere surplusage” in such a business generally will be subject to analysis problem could be that the enumerated services are all under C ode Sec. 954(e). 36 things that businesses commonly do for each other. In Th e IRS apparently has adopted a broad interpreta- other words, the list seems to envision “B2B” activities, as tion of the list of services, viewing all types of business- opposed to, say, dance lessons, lawn-mowing or babysit- related services as being subject to analysis under Code ting services marketed to individual consumers. Th is kind Sec. 954(e) . Th e IRS addressed the application of Code of activity typically would not be provided by a CFC to a Sec. 954(e) to income from factoring, 37 as well as to fi lm related person, but treatment as such is entirely possible production services performed for a studio (as technical, under the broad “for or on behalf of” concepts addressed managerial and skilled services).3 8 Congress has indicated in detail below, thus arguably requiring an exclusion from that insurance and fi nancing income may be considered the conceptual scope of relevant services. So perhaps the as services for purposes of C ode Sec. 954(e) . 39 limiting principle is that foreign base company services in- Still, the list of services should be interpreted as impos- come does not include relatively simple retail-type services ing some limit on the nature of the services—otherwise the that could otherwise be caught up due to the “for or on statute’s enumerated items and limitation of covered non- behalf of” rule. Th us, under this view, relatively simple or enumerated items to “like services” would be superfl uous clerical B2B activity is included, as those services may be ( i.e. , Congress could have just said “services”). Applying industrial or commercial (even if not skilled). And more Code Sec. 954(e) to all services without limitation would complex activities ( e.g. , architectural) are caught up even if 42 TAXESThe Tax Magazine® MARCH 2016 provided on a retail basis to household consumers because from A Corporation. Th e services performed for C the nature of the services is such that they are commonly Corporation by B Corporation are considered to be provided on a B2B basis. performed on behalf of A Corporation.4 4 2. Services Income Separated from Th e services income derived by B Corporation would Manufacturing Activities be foreign base company services income to the extent the Th e legislative history indicates that Code Sec. 954(e) was services are performed outside Country Y. principally directed at situations where a CFC organized Examples similar to the above example are contained in a low-tax jurisdiction performs services which have in the fi nal regulations.4 5 Th e examples analyze the ap- been separated from manufacturing activities of a related plication of Code Sec. 954(e) to income derived by a person to obtain a lower rate of tax for the services income. CFC from the installation and maintenance of machines Th e 1962 Senate Report explained the intent underlying sold by a related person to an unrelated customer, 46 and Code Sec. 954(e) as follows: address warranty and maintenance services provided by a CFC for equipment sold by a related person to an un- Foreign base company services income is income related customer.4 7 derived from the performance of technical, mana- While the legislative history reveals that Congress was gerial, engineering, architectural, scientifi c, skilled, targeting income from services that is separated from industrial, commercial, or similar services, but only manufacturing income, the Code does not so limit the where they are performed for a related person and are scope of Code Sec. 954(e) . Th us, the legislative history performed outside the country in which the controlled explained much less than the full scope of what Congress foreign corporation is organized. was doing, and the reference to services being separated from the manufacture and sale of machines in the legis- As iinn ttthhee cccaassee of sales income, the purpose here is to lative history does not operate as a limit on the types of ddeeennyy tttaaxx dddddeefffeerrrrraal where a service subsidiary is sepa- services that are subject to analysis under Code Sec. 954(e) . rrraaaaattteeeddd fffffrrrooommmmm mmmaaaaannnuuufactuurriinngg oorr ssiimmiillaar activittiiees ooff a 33.. BBuuiilldding DDaamms, DDriilllingg OOiill WWeellllss rreellaatteeddd ccoorrpppoorraatttiioonn and oorrggaanniizzeedd iinn aannootthheer ccoouunnttrryy pprrriimmaarrriilllyy tttoo oobbbbbttaaiinn aa lowweerr rraattee ooff taaxx ffoorr tthhee sservviice aand CCoonnstruuccttiinng SSuppeerhhiighhwwaayyss innnncccooommmmmeee..44 33 SShhorrttllyy aafter SSuubbppaarrtt FF wwaass eennaactedd, tthhee TTreaassuurryy appppar- ently became concerned with services income derived Th us, the legislative history shows that Congress had a by a CFC from major foreign construction projects. rather narrow view of the purpose of Code Sec. 954(e) as Regulations were issued with a specifi c focus on such denying tax deferral where services income is earned in services businesses. a subsidiary and separated from functionally connected Th e majority of the examples contained in the fi nal manufacturing or similar activities of a related corporation. regulations analyze the application of the foreign base Th e only example in the initial proposed regulations company services income rules to income derived from: issued under Code Sec. 954(e) in 1962 refl ects a similar contract oil well drilling4 8; description of the types of services intended to be covered building a dam4 9 ; and by the provision. construction of a superhighway.5 0 Th ere is substantial informal guidance from decades ago Example. Foreign corporation A, incorporated under discussing how the foreign base company services income the laws of foreign country X, and foreign corporation regulations apply to such items of income.5 1 B, incorporated under the laws of foreign country Y, 4. Interpretative Guidelines are both wholly owned subsidiaries of domestic corpo- ration M. Corporation A, a manufacturer of industrial Income arising from most types of services performed by machinery sells products which it manufactures to modern global services companies appears to be subject C Corporation, not a related person, for use by C to analysis under Code Sec. 954(e) , even though the Corporation in foreign country Z. B Corporation, by legislation was focused on the separation of services from contract with C Corporation, not a related person, manufacturing. Such services generally would seem to agrees to render technical advice to C Corporation fall within the meaning of “technical,” “skilled,” “com- in connection with the installation, maintenance and mercial” or “industrial” services. For example, services operation of the machines C Corporation purchases income from e-commerce businesses, even though not a MARCH 2016 43 THE ARCHAIC SUBPART F SERVICES RULES global business in 1962 or likely even imaginable by that paid by a U.S. subsidiary to its Mexican parent company Congress, would be subject to analysis under Code Sec. should be treated like a service fee or interest for purposes 954(e). Nevertheless, it would appear that consideration of determining the source of the fee in applying the with- of low-skilled, routine labor in applying the rules of holding tax rules. Th e Tax Court referenced the general Code Sec. 954(e) may not be required by the language notion that labor or personal services generally employ the of the Code (although again the regulations do reference use of human capital as opposed to the salable product of unskilled labor for certain purposes), and arguments may the person's skill. Th e Tax Court concluded that a guaran- be made for excluding certain other kinds of services that tee fee is not actually a payment for services. However, the seem to have been far from Congress’s mind (e .g. , services Court found that a guarantee fee most closely analogized of a kind that typically are not provided on a B2B basis). to a service because it represents a promise to possibly Th e inclusion of a specifi c list of the types of services perform a future act.5 7 intended to be subject to analysis under Code Sec. 954(e) , Applying the source rules to items of income char- along with the limited focus of Congress in enacting that acterized on the basis of analogy is necessary and well provision, counsels that some restraint be exercised in accepted, as every item of income must have a source for extending these rules to new kinds of services—although tax purposes. 58 Subpart F, in contrast, does not charac- the statute is indeed broad, some consideration should terize income by analogy—rather, if an item of income be given to the threshold question whether a new kind of falls outside a particular Subpart F defi nition, the item service is conceptually within the scope of services covered simply is not subject to the Subpart F rules applicable to by the statute. that category of income.5 9 Not every kind of income is “Subpart F relevant” in the fi rst place. C. Services Income Distinguished Th e regulations illustrate the rule that substance controls from Other Types of Income and not the label, stating that an amount that is designated as rent but actually constitutes income from s ervices is not 1. SSSuubbbsssttaannccee oooff Transaction characterized as rent, but as income from services.6 0 In TAM 952277001100 , tthhe IRS concluded for Subpart F AAnn iiitteemmm ooff iinnccoommmee is anaallyyzzeedd uunnddeerr C Cooddee Seecc. 995544((ee)) ppuurrppoosseess that iinnccoomme rreeceiivved vv iaaa aa ppuurrppoorrtteeedd ssaalleess aaggrreeee- onnlllyyy iifff tthhhhhee iitteemm iinnn ssuubbssttancee iiss sseerrvviicceess innccoommee.. ThTh e reeggulaa-- mment ffoorr a fi lmm wwaass serrvviceess inccoommee aanndd nnoot ssaalleess iinccoome tionnnnsss ssstttaaattttteee ttthhhaaaaattt::: ““FFFFoorr pppuuurposeess ooff sseeccttion 995544, iinccoommee sshhallll bbecaauussee tthhe othheerr ccoonnttrraaccttiinngg ppaartyy hheelldd tthe bbeenneefifi ttss and be charaacctteerriiized in accordance with the substance of the burdens of ownership of the fi lm throughout the period transaction, and not in accordance with the designation of production. In the TAM, the IRS states: applied by the parties to the transaction.” 52 Th e regulations further state that the determination Th e economic substance, rather than the form, will of whether an item of income is characterized as services control in determining whether to characterize the income is based on all facts and circumstances.5 3 Local law agreement between Studio and [the CFC] as a pur- is not controlling in characterizing income for purposes chase and sale agreement or instead as a contract to of Subpart F.5 4 provide services. B ailey v. Commissioner, 90 T.C. 558, As mentioned above, Subpart F does not provide a 607 (1988), a ff ’d, vacated and remanded 912 F.2d 44 defi nition of transactions that give rise to services income. (2d Cir. 1990). Th e use of purchase and sale language Th e regulations only provide examples of activities giving in the agreement will not determine whether the agree- rise to services income analyzed under Code Sec. 954(e) , ment is in fact a sale. T olwinsky v. Commissioner, 86 such as maintenance and installation of machines, drilling T.C. 1009, 1043 (1986). For tax purposes, a sale occurs oil wells, building dams and constructing superhighways. when the benefi ts and burdens of ownership have been In the absence of a defi nition of services income in the transferred rather than when the technical requirements Subpart F rules, generally accepted defi nitions of services of title passage have occurred. B ailey, 90 T.C. at 607. 61 provide guidance. Courts generally defi ne services as the deployment of labor and capital for the benefi t of another Th e income was foreign base company services income person, with the provider not retaining an ownership because it was attributed to services performed for, or interest in the fruits of the activities performed.5 5 on behalf of, a related person outside the CFC’s country A recent Tax Court opinion provides helpful analysis of organization. concerning the defi nition of services. In C ontainer Corpo- Similarly, in General Counsel Memorandum 33455,6 2 ration , 56 the Tax Court considered whether a guarantee fee income that a CFC received from assembling television 44 TAXESThe Tax Magazine® MARCH 2016 tuners for its U.S. parent was found to be services rather income should not also be analyzed as services income than sales income for purposes of applying Subpart F. Th e under Code Sec. 954(e) . 68 CFC received the parts on consignment from the parent, 2. Separately Determined Items of Income which retained title to the components throughout the assembly process. Although the taxpayer assumed the from Single Transaction income would be sales income, the IRS determined that Th e regulations address situations where a single transac- the “parent’s express retention of title to the component tion gives rise to income in more than one category of parts indicated that the CFC was performing services of a Subpart F income. As a general rule, the separate categories manufacturing nature for its parent and not manufactur- of income are to be separately analyzed under Code Sec. ing and selling its own product.”6 3 Because the services 954 . 69 If the income cannot be separately determined, then were performed within the country of organization of the the single item of income is classifi ed in accordance with CFC, the income arising from performing the services was the predominant character of the transaction.7 0 not foreign base company income.6 4 Th e regulations illustrate an arrangement where services Th e regulatory requirement that a transaction is charac- income and sales income can be separately identifi ed. terized by reference to its substance for Subpart F purposes A CFC, in its business of purchasing personal property should apply equally to the taxpayer and the IRS. Th at is, and selling it to related persons outside its country of both the taxpayer and the IRS should be permitted to (and, organization, also performs services outside its country in fact are required to) characterize income for Subpart of organization with respect to the property it sells. Th e F purposes based on substance, and the label applied to regulations state that the sales income will be treated a transaction should not control. Th is is diff erent from as foreign base company sales income, and the services other areas of tax law where no specifi c substance-based income will be treated as foreign base company services characterization rules are set forth in the regulations.6 5 In income for purposes of these rules. 71 the abbsseennnccee oooff ssuuch substance-based characterization rules, Th e regulations state that the portion of income or gain a taaxxxppaayyeeerr iiiss oooffftteennn bbound by the form of its transaction.6 6 derived from a transaction that is included in the com- D DDD Diiiffffff eeerrreeeeennnccceeesssss bbbeeetttwwwwweeeeen subbssttaannccee aanndd ffoorrm are noott likkeely to putation of forreeiggnn pperrssonal holding company income is bee aaa nnoorrmmmaall oooccccuurrrreence, ass aa wweellll--aaddvviiseedd ttaaxxppayyeerr ggeenneeerr-- aallwwaayyss sseeparateellyy ddeterrmminnablee aanndd tthhuuss mmuusstt aallwwaayyss bbe allllllyy wwiillllll uussee aaa ttrraannnssaaaccttiionall aarrrraannggeemmenntt tthhaatt alliignss witthh sseegreggaatteedd fromm ootthher iinccoome aandd sseeppaarraattelyy ccllaassssififi eed. 72 thee tttaaaxxxpppppaaayyyeeerrr’’’sss dddeeessiireeddd tax ppoossiittiioonnss. DDiiffiffi ccuullt ssiittuaattiioonnss FFor eexxaammple, wwhheerree iinnccoommee iiss dderiivveedd bbyy a CCFFCC frroom a may ariisee, hhoowever, with cross-border transactions where services arrangement and includes an amount for interest, a diff erent form provides a more favorable tax result in a the interest component would be required to be analyzed foreign country, the form follows industry classifi cation under the foreign personal holding company income standards, or the income is inadvertently mislabeled by the rules, and the services component under the foreign base taxpayer. If the treatment under Subpart F of an arrange- company services income rules. 73 ment is challenged by the IRS during an audit, the taxpayer 3. Predominant Character should be able to argue that the income in substance is subject to analysis under another category that provides As noted above, the regulations acknowledge that “the a better Subpart F result if the income in substance falls portion of income or gain derived from a transaction within the type of income subject to analysis under the that would meet a particular defi nitional provision under other category. section 954 or 953 (other than the defi nition of foreign Th e form of remuneration should not bear on the de- personal holding company income) in unusual circum- termination of whether an item of income is characterized stances may not be separately determinable.”7 4 If such as services income. Th e Code and regulations expressly portion is not separately determinable, then the income provide that income from services can be in the form of from the transaction must be classifi ed in accordance with compensation, commissions, fees or otherwise. 67 the predominant character of the transaction.7 5 As discussed below, in some cases it is possible that an Th e regulations provide the following example. A CFC item of income characterized as services income based engineers, fabricates and installs a fi xed off shore drilling on its substance also might be treated as sales income for platform as part of an integrated transaction. Th e por- purposes of Code Sec. 954 . Code Sec. 954(d) expressly tion of income that relates to services is not accounted provides that commissions or fees received for purchasing for separately from the portion that relates to sales and or selling property on behalf of a related person is subject is otherwise not separately determinable. Th erefore, the to analysis under Code Sec. 954(d) . Income treated as sales classifi cation of income from the transaction shall be MARCH 2016 45 THE ARCHAIC SUBPART F SERVICES RULES made in accordance with the predominant character of performance of the services, but at a minimum it is clear the arrangement.7 6 that the performance of the services results in the devel- Th e IRS analyzed the application of the predominant opment of valuable intangible property for the customer. character test to income derived by a CFC from provid- It would be unusual for an arrangement for the per- ing food and beverages aboard cruise ships operating in formance of services to contain a separate charge for the international waters.7 7 If the income were classifi ed as intangible value underlying the provision of the service. sales income, it would not be subject to Subpart F, but if Rather, a single charge generally would be invoiced for the classifi ed as services income, it would have been subject services provided. Th is concept of course is not unique to to Subpart F (under the former foreign base company services transactions—the value of a pill sold by a phar- shipping income provision). Th e IRS in two Technical maceutical company may be largely attributable to the Advice Memoranda concluded that the income derived intangible property that the pill embodies, but the sale of by the CFCs from the food and beverage concessions the pill is still simply a sales transaction, and the tax law was services income rather than sales income under the does not attempt to pull apart diff erent elements of value predominant character test7 8: in the sales consideration into diff erent tax transactions. Th e long-established approach of the U.S. federal in- A restaurant's income is attributable more to the come tax rules is that the consideration received for the labor of its chef, the services of the wait staff , and the provision of services (just like that received for the sale ambiance of the surroundings than to the sale of the of tangible property) that uses valuable intangibles is not ingredients that the chef uses. Similarly, the operation disaggregated and reconstructed into separate tax transac- of a lounge entails more services than sales. In addi- tions. Th us, the foreign personal holding company income tion to the liquor, a customer is paying a bartender rules are not applied to some portion of the service fees to mix his drink, pour it into a glass, serve it hot or representing intangible value as if the CFC had received coldd,, aaass tthheee ccaase may be, and for the ambiance of the royalties on a license of the intangibles. Rather, if the ssuuurrrroouuunndddiiinnnggss ……… the predominant character of these transaction is characterized as a services transaction in aaaccccctttiiivvviiitttiiieeesss iiisssss ttthhheeeee pppeerformmaannccee ooff sseerrvvices rathheer thhan substance, the eennttiirree ammount is treated as services income tthhhee ssaalllee ooff ppeerrssooonnaal proppeerrttyy ……. ffoorr SSuubbppaart F ppuurrpposess.. 82 Unnddeerr tthe Suubbppaarrt F rruleess ffoorr cchaarraacctteerriizziinngg iinnccoommee,, the ThThThTh eeerrreeefffffooorrreee,, ttthhheee IIIIRRSS cccooncluuddeedd tthhaat thhee iinnccoommee deerriivvedd ffuunddaammeenntal qquueessttiioonn iiss wwwhheetthheerr thhee iinnccoomme iiss ddeerriiveedd for therefromm wwaas foreign base company shipping income.7 9 providing services or for transferring intangible property, Th e issue addressed in the above TAMs was subject or both. If the customer does not receive any rights to to litigation.8 0 Th e IRS ultimately reversed its position, use the intangible property but instead receives only the conceding that the income derived by the food-and- services, then the income stream should be characterized beverage concessionaires was not foreign base company only as services income.8 3 It is the service provider, as op- shipping income.8 1 posed to the customer, that is actually using the intangible property (just as the pharmaceutical company uses its 4. Intangible Property Used or Developed in intangible property to develop, manufacture, market and Performing Services sell a medicine, but the patient does not actually use in- A signifi cant portion of income derived by various modern tangible property by purchasing and using the medicine). global services businesses can be attributed to valuable Even if there is substantial intangible value underlying the intangible property used by the service provider in the provision of the services, without a transfer of intangible performance of the services. For example, a substantial rights there can be no element of a license, lease or sale of portion of income from providing computer software as the intangible property. 84 a service may be attributed to the value of the underlying Th is embedded-value principle is illustrated in the Code copyrights and patents. A material portion of income Sec. 482 services regulations. Th e services regulations from providing consulting services may be attributable expressly apply to a services transaction where intangible to proprietary know-how or other intangible property property is an element used in rendering the services.8 5 necessary to provide the services at the necessary level of Th e regulations generally do not bifurcate the transaction quality or the necessary speed. A CFC also may perform and analyze the intangible element separately, although research and development services resulting in valuable in- they may consider the transfer pricing rules that apply to tangible property for the customer—in this case intangible intangibles in arriving at the proper transfer price for the property may or may not be a major contributor to the services arrangement.8 6 46 TAXESThe Tax Magazine® MARCH 2016