IRS Chief Counsel: Proper allocation of tax rate disparity test

Proper allocation of tax rate disparity test

The IRS today publicly released a memorandum addressing the most appropriate method of calculating the actual effective rate of tax and the hypothetical effective rate of tax for purposes of determining whether there is tax rate disparity pursuant to the regulations under section 954(d)(2) in the case of property manufactured by a controlled foreign corporation (“CFC”). AM2015-002 (release date February 13, 2015, and dated February 9, 2015)

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*The memorandum is legal advice, signed by executives in the National Office of the Office of Chief Counsel and issued to IRS personnel who are national program executives and managers. The memo is issued to assist IRS personnel in administering their programs by providing authoritative legal opinions on certain matters, such as industry-wide issues. It is not to be used or cited as precedent.

Read AM2015-002 [PDF 54 KB]

The memo concludes:

In the case of property manufactured by a CFC, the most appropriate method of calculating the actual effective rate of tax and the hypothetical effective rate of tax is to divide the actual tax and the hypothetical tax by the hypothetical tax base, determined under the laws of the manufacturing jurisdiction.

Background

The branch rules apply the general foreign base company sales income rules of section 954(d)(1) to a CFC that carries on purchasing, selling or manufacturing activities by or through a branch or similar establishment located outside the CFC’s country of incorporation. Absent the branch rules, a CFC that manufactures a product in its country of incorporation and sells that product through a sales branch in a low- or no-tax jurisdiction would not have foreign base company sales income due to the CFC manufacturing exception.

Under section 954(d)(2) a branch or similar establishment of a CFC is treated as though it were a wholly owned subsidiary corporation of that CFC if the use of such branch or similar establishment has “substantially the same effect” as if it were a wholly owned subsidiary corporation.

Tax rate disparity test

In order to determine whether the branch or similar establishment will be treated as a wholly owned subsidiary, the regulations under section 954(d)(2) employ a tax rate disparity test. Whether there is a tax rate disparity is determined by comparing what the effective rate of tax (ERT) on the sales income actually was in the sales jurisdiction (the “actual ERT”) with what the effective rate of tax on the sales income would have been if the sales had occurred in the manufacturing jurisdiction (the “hypothetical ERT”).

The tax rate disparity test is conducted in five steps. First, the relevant income upon which the test will be based must be determined. Second, the actual tax imposed on that income must be determined. Third, the hypothetical tax base must be determined. Fourth, the hypothetical tax that would have been imposed on that income must be determined. Finally, the actual tax and the hypothetical tax are divided by the hypothetical tax base and the resulting ERTs are compared.

IRS Chief Counsel memo

The memo provides the following example:

In Year 1, CFC incorporated in Country B purchases raw materials from an unrelated supplier and uses them to manufacture Product X in Country B. DE is the wholly owned subsidiary of CFC and has elected to be treated as a disregarded entity of CFC. DE is located in Country A and does not engage in any manufacturing activities.

DE derives 100x of commission income in connection with the sale of Product X by CFC to unrelated customers located outside of Country A and B. DE incurs 30x of sales expenses related to the sale of Product X. CFC has no other income that would constitute foreign base company income under section 954. Country A and Country B both impose a 20% statutory rate of tax on sales income.

Country A allows DE to exclude half of its income from the sale of products manufactured and sold for use outside of Country A. Country B does not tax DE’s sales income until it is remitted to CFC as a dividend. Both Country A and Country B would allow a 30x deduction for the sales expenses. DE paid 4x of income tax in Country A in Year 1.

 

Under the first step of the five step process, the branch’s gross income derived in connection with the sale of property sold on behalf of the CFC must be determined (“TRD Gross Income”). Because DE derives 100x of gross income in connection with the sale of Product X, the TRD Gross Income here is 100x.

Second, the actual tax paid or incurred in Country A must be determined. Under the facts, the actual tax paid or incurred in Country A is 4x.

Third, the hypothetical tax base must be determined. Here the hypothetical tax base is 70x, calculated by taking the 100x of TRD Gross Income less the 30x of sales expenses that are allocable and apportionable to the TRD Gross Income under Country B’s tax laws.

The fourth step is to determine the hypothetical tax that would have been incurred if the TRD Gross Income had been derived by Country B. The hypothetical tax is basically 14x, calculated as the hypothetical tax base of 70x by the 20% statutory rate in Country B.

Finally, the actual tax of 4x and the hypothetical tax of 14x is divided by the hypothetical tax base of 70x to determine whether there is tax rate disparity between DE and the remainder of CFC. Because the actual ETR is 5.71% (4x/70x) and the hypothetical tax rate is 20% (14x/70x), there is tax rate disparity and the DE is treated as a wholly owned subsidiary for purposes of the foreign base company sales income rules.

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