When will a CFC's regular-looking business income from regular-looking, normal business operations be classified as Subpart F income?This week I introduce the concept of "foreign base company sales income" with a simple example, which happens to come from a CPA who asked me about a situation he is dealing with. I distilled the fact pattern down to what you see here, because it is a clean demonstration of interesting points.The example shows how a normal corporate structure (domestic parent manufacturer/foreign subsidiary distributor) can cause the foreign subsidiary's profit to be classified as Subpart F income.Specifically, this example shows how CFC income can be classified as a particular type of Subpart F income: foreign base company sales income.

The Example

A U.S. corporation manufactures widgets and sells them to its lower-tier foreign subsidiary, which is a bog-standard distributorship selling widgets to anyone who wants one, worldwide. Buy wholesale, sell retail.The foreign subsidiary buys a widget from ManufacturerCo (the U.S. S corporation) (Sale 1A in the diagram below) and sells the widget to an unrelated customer in the United States (Sale 1B in the diagram below).ManufacturerCo has $20 of profit on Sale 1A to its lower-tier subsidiary, and Foreign Subsidiary has a profit of $50 on Sale 1B to the unrelated customer.

The Question

The question we ask is simple: is Foreign Subsidiary's $50 profit on Sale 1B considered to be Subpart F income?

The Answer for the Impatient

Yes.

• A CFC's Subpart F income includes a category of CFC income called foreign base company income. IRC §952(a)(2).
• Foreign base company income includes foreign base company sales income. IRC §954(a)(2).
• The $50 of profit recognized by Foreign Subsidiary is foreign base company sales income.

These Things are True

Believe me:

• Foreign Subsidiary is a controlled foreign corporation.
• Domestic HoldCo, ManufacturerCo, and U.S. citizen are all United States shareholders of Foreign Subsidiary, and the corporations and individual are all related parties.

I will save this explanation for an appendix to this example. Let's not chase squirrels. At least, not right now.

Foreign Base Company Sales Income Defined

IRC §954(d) tells us exactly what foreign base company sales income looks like.

(d) Foreign base company sales income

(1) In general. For purposes of subsection (a)(2), the term “foreign base company sales income” means income (whether in the form of profits, commissions, fees, or otherwise) derived in connection with the purchase of personal property from a related person and its sale to any person, the sale of personal property to any person on behalf of a related person, the purchase of personal property from any person and its sale to a related person, or the purchase of personal property from any person on behalf of a related person where—

(A) the property which is purchased (or in the case of property sold on behalf of a related person, the property which is sold) is manufactured, produced, grown, or extracted outside the country under the laws of which the controlled foreign corporation is created or organized, and(B) the property is sold for use, consumption, or disposition outside such foreign country, or, in the case of property purchased on behalf of a related person, is purchased for use, consumption, or disposition outside such foreign country.

For purposes of this subsection, personal property does not include agricultural commodities which are not grown in the United States in commercially marketable quantities.

How I Figure Out What a Code Section Says

This is a mess to understand. IRC §954(d)(1) is trying to capture all possible permutations of a particular type of transaction: related party transactions involving inventory sales.I will explore the full and glorious meaning of every possible permutation elsewhere, but for now I just want to demonstrate how IRC §954(b)(1) will cause profit from a transaction be classified as foreign base company sales income. The example we are working with is perhaps as simple as we can get.

Step 1 - Strip Out the Irrelevant Noise

When I analyze a complex tax problem, the first thing I do is strip out the noise. Many Code sections try to occupy first, second, and third base at the same time, if I may mangle a metaphor. If I am trying to figure out if the taxpayer can make it to first base, I find it helps me to understand the law by stripping out the references to second and third base.Here, I strip out everything out of IRC §954(d)(1) that does not apply to the facts:

(d) Foreign base company sales income

(1) In general. For purposes of subsection (a)(2), the term “foreign base company sales income” means income (. . . in the form of profits . . . ) derived in connection with the purchase of personal property from a related person and its sale to any person . . . where—

(A) the property which is purchased . . . is manufactured . . . outside the country under the laws of which the controlled foreign corporation is created or organized, and (B) the property is sold for use . . . outside such foreign country . . . .* * * * .

Step 2 - Insert Real Names and Facts

The next step I take is to insert my facts into the newly-weeded Code section.

(d)   Foreign base company sales income

(1)   In general. For purposes of subsection (a)(2), the term “foreign base company sales income” means income (. . . in the form of profits . . . ) derived in connection with the purchase of WIDGETS from MANUFACTURERCO and its sale to ULTIMATE CUSTOMER . . . where—

(A)   the property which is purchased . . . is manufactured . . . outside FRANCE, and(B)   the property is sold for use . . . outside FRANCE . . . .* * * * .

Now I can start to see whether the if/then argument of IRC §954(a)(1) will classify Foreign Subsidiary's profits as foreign base company sales income.

Step 3 - Tidy Up a Bit More

Finally, I go back and tidy up the language a little bit to make it easier for a mere mortal (like myself) to understand. This time, I'm not deleting irrelevant and inapplicable language. I'm deleting cruft and junk and filler words.

(d)   Foreign base company sales income

(1)   “Foreign base company sales income” means profits of foreign subsidiary derived from the purchase of a WIDGET from MANUFACTURERCO and sale of that WIDGET to ULTIMATE CUSTOMER where—

(A)   the WIDGET is manufactured outside FRANCE, and(B)   the WIDGET is sold for use outside FRANCE.

Facts + Law = Foreign Base Company Sales Income

Now that we have stripped the junk away, it's easy to see that the two-step sale of a widget from ManufacturerCo to Foreign Subsidiary, and then from Foreign Subsidiary to Ultimate Customer will check all of the boxes and be classified as foreign base company sales income:

• Foreign Subsidiary purchased a widget from ManufacturerCo (who we have agreed is a related party).
• The widget was manufactured outside France (it was manufactured in the United States).
• Foreign Subsidiary sold the widget to Ultimate Customer, who is outside France (and happens to be in the United States).
• Therefore, the $50 profit derived from the transaction by Foreign Subsidiary will be foreign base company sales income.

Reverse to Subpart F Income

Foreign Subsidiary has $50 of foreign base company sales income. IRC §954(d)(1).This means that Foreign Subsidiary has $50 of foreign base company income, because foreign base company sales income is a type of CFC income that is included in the definition of foreign base company income. IRC §954(a)(2).In turn, this means that Foreign Subsidiary has $50 of Subpart F income, because foreign base company income is a type of CFC income that comprises Subpart F income. IRC §952(a)(2).

Next Week: Who Pays Tax on the Subpart F Income?

In next week's thrilling episode of the Friday Edition, we will explore the exceedingly interesting question of "who pays the tax on this Subpart F income?"The general hand-wavy understanding is that U.S. shareholders have to take a CFC's Subpart F income into their gross income, pro rata according to their share ownership in the CFC.Here we have three U.S. shareholders: Domestic HoldCo, ManufacturerCo, and U.S. citizen. Which lucky taxpayer's income tax return will include the $50 of Subpart F income from Foreign Subsidiary? And why?But you probably asked yourself an even better "Why?" All of these entities are controlled by one human being: U.S. Citizen. Why not just sell the Widget straight from ManufacturerCo to Unrelated Customer?I will reveal one possible answer. Only the manufacturer and his accountant (who asked thE original question) will know the true answer. But my answer is pretty intriguing and would give you a clue of why a rational taxpayer might deliberately run straight into the shitstorm that is Subpart F of Part III of Subchapter N of Chapter 1 of Subtitle A of Title 26, United States Code. And that, in turn, might give you some planning ideas for your clients.