IV. The Tax Court Decision
A. Introduction and Section 954(d)(1)
The Tax Court began its analysis by explaining why Congress enacted the foreign base company sales income rules as part of subpart F in 1962. The Tax Court observed that “[p]assive and highly mobile income was particularly subject to being shifted abroad, because it could be moved to a shell corporation in a low-tax jurisdiction with little or no impact on the U.S. company’s actual business operations.…Congress regarded sales income as one type of highly mobile income.” The Tax Court noted that the subpart F foreign base company sales income provisions “were aimed at personal property transactions involving related parties. They were intended to capture, and treat as subpart F income, ‘income from the purchase and sale of property, without any appreciable value being added to the product by the selling corporation.’”
While not part of the court’s analysis or Whirlpool’s fact pattern, assume hypothetically that Whirlpool had manufactured appliances in the United States for ultimate sale to related and unrelated distributors in foreign countries. Furthermore, assume Whirlpool first sold these refrigerators and washing machines to a Whirlpool CFC in Bermuda which performed real back-office functions but undertook no further manufacturing on these products and then sold them to foreign distributors outside Bermuda. The income earned by the Bermuda CFC would generally be treated as taxable to Whirlpool as subpart F foreign base company sales income when it was earned by the CFC, whether the earnings from these sales were distributed to the U.S. parent corporation or not. This transaction would come within the requirements of foreign base company sales income as described in section 954(d)(1) because it is:
income…derived in connection with the purchase of personal property from a related person [Whirlpool] and its sale to any 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.
If the appliances in the example were sold for use or consumption in Bermuda, the income would not be included within the scope of section 954(d)(1). Section 954(d)(1) requires that either the CFC purchase the personal property from a related person, as in the hypothetical, or that the personal property be sold to a related person, so that the related party connection need not be at both ends. Furthermore, had there been any significant manufacturing of these appliances in Bermuda, then the income would not be foreign base company sales income. Moreover, while not specifically addressed in section 954(d)(1), under both the Regulations and the applicable legislative history, foreign base company sales income would exclude income earned by the Bermuda CFC in the example above, if significant manufacturing had, in fact, been done by it anywhere in the world.
Section 954(d)(2), captioned “Certain branch income,” serves as a backstop to section 954(d)(1). The Tax Court explained that this provision “prevents a U.S. shareholder from escaping section 954(d)(1) by having its CFC conduct activity through a branch (as opposed to a subsidiary) outside the CFC’s home country.” The court elaborated that “[w]here the carrying on of activities through a branch ‘has substantially the same effect’ as if the branch were a wholly owned subsidiary, then, ‘under regulations prescribed by the Secretary,’ the branch will be treated as a subsidiary of the CFC for purposes of determining FBCSI.” The court, quoting from an earlier important decision it rendered, stated that “‘the branch rule was intended to prevent CFC’s from avoiding section 954(d)(1) because there would be no transaction with a related person.’”
The Tax Court initially decided that the section 954 Regulations that were amended in 2002—and not those revisions promulgated thereafter including the ones promulgated in 2008—applied. Post-2002 modifications, including the substantial contribution Regulations, emphasized the activities of CFC employees in the regulatory manufacturing exception. For example, the Tax Court pointed out that, under the substantial-contribution-to-manufacturing test, “a CFC will be deemed to have manufactured personal property, even if it does not perform the physical assembly, if it ‘makes a substantial contribution through the activities of its employees’ to the manufacturing process.”
The Tax Court then grappled with the possible applicability of section 954(d)(1). As noted above, with respect to section 954(d)(1), Whirlpool had filed a motion for partial summary judgment, “contending that the Luxembourg CFC’s sales income was not FBCSI under section 954(d)(1) because the appliances it sold were substantially transformed by its Mexican branch from the component parts and raw materials it had purchased.” The Service “opposed that motion, contending that genuine disputes of material fact exist as to whether the Luxembourg CFC actually manufactured the products.” The Service’s position, which it indicated was “clarified” by proposed, temporary, and revised final Regulations issued in 2008 and 2009, was “that the manufacturing exception should not apply where ‘the CFC itself performs little or no part of the manufacture of th[e] property.’” The Tax Court ultimately did not decide the issue because it concluded that the branch rule applied and that it triggered foreign base company sales income.
While academic, perhaps the best way to understand the potential relevance of section 954(d)(1) is to pretend Congress never enacted section 954(d)(2). Under this scenario, if WIN is in fact considered to be manufacturing the appliances, then the Luxembourg CFC should avoid generating foreign base company sales income because of the regulatory exclusion intended by Congress that “[f]oreign base company sales income does not include income of a controlled foreign corporation derived in connection with the sale of personal property manufactured, produced, or constructed by such corporation.” The real issue in this scenario would be whether WIN—with no employees of its own—should be treated as producing the appliances.
In this regard, the Tax Court had the following observation of the substance of Whirlpool’s restructured Mexican manufacturing operation:
Despite the interposition of these new entities [i.e., the Luxembourg CFC and WIN], little appears to have changed on the ground in Mexico after 2008. The refrigerators and washing machines were manufactured in the same plants, which continued to be owned by IAW. The workers who assembled the Products were the same workers, whose wages, benefits, and taxes were paid by IAW as they had been paid previously. There is no evidence that these workers were aware of any change in their employment status after 2008. Whirlpool Luxembourg stepped in as the nominal manufacturer by arranging to have WIN lease the plants and have all the workers seconded or subcontracted to it.
The Tax Court correctly concluded that it did not have to decide whether the regulatory manufacturing exception made section 954(d)(1) inapplicable because section 954(d)(2) was applicable. This decision by the court included not determining the merits of an alternative argument advocated by the Service, that Whirlpool’s “motion for partial summary judgment under section 954(d)(1) should be denied under existing judicial precedent…” citing Electronic Arts, Inc. v. Commissioner.” That case dealt with former section 936(h)(5)(B), not section 954(d)(1), but the Tax Court there denied taxpayer’s motion for summary judgment, “emphasiz[ing] what…[we] called the ‘basic general rule’ …that the manufacturing exception applies only to income ‘derived in connection with the sale of personal property manufactured…by such corporation’” (quoting Regulations under section 954(d)(1)). While the Tax Court, in Whirlpool, acknowledged this, it also pointed out that, in Electronic Arts, “we did not find in section 954 or its legislative history ‘an absolute requirement that only the activities actually performed by a corporation’s employees or officers are to be taken into account in determining whether the corporation manufactured … a product,’ within the meaning of section 954(d)(1)(A).” The Service also had asserted that Whirlpool’s motion for partial summary judgment should be denied because a “‘robust factual record is necessary to decide whether a corporation is actually engaged in manufacturing.’”
B. Section 954(d)(2)—The Branch Rule
The Tax Court next analyzed and explained the application of the branch rule of section 954(d)(2). By way of background, Professor Eric T. Laity noted that “[i]n some instances, a foreign branch of a controlled foreign corporation can mimic a foreign base company. For that reason, the branch rule treats certain foreign branches as controlled foreign corporations in their own right.” Professor Laity explained that “[i]f the branch rule transforms a branch into a separate corporation, the rule may then recharacterize transactions in which either the branch or the remainder of the controlled foreign corporation engages as transactions conducted on behalf of related persons.”
Assume, hypothetically, that Whirlpool incorporated a CFC in China to manufacture appliances (China CFC), and that China CFC establishes a sales branch in Bermuda (Bermuda Sales Branch) to sell appliances manufactured by it in China to customers located outside both China and Bermuda. Furthermore, presume China has a territorial based tax system pursuant to which China CFC is subject to a 40 percent income tax on profits earned by it in China, but excludes from Chinese income taxation income not sourced in China, including that of the Bermuda Sales Branch. Finally, assume Bermuda has no corporate income tax. Section 954(d)(2) would treat the income earned by the Bermuda Sales Branch as foreign base company sales income. This is because the tax on income earned by the Bermuda Sales Branch fell below a level established by the Regulations. The foregoing addresses a CFC establishing a sales or purchasing branch.
As noted supra, section 954(d)(2) can also apply to a manufacturing branch fact pattern. To illustrate this, let’s now assume Whirlpool instead incorporated a CFC in Bermuda (Bermuda CFC) which will sell appliances outside of Bermuda and China, but this time the appliances were made in a China manufacturing branch of the Bermuda CFC. Keeping all the tax rates and tax conditions as in the first scenario, section 954(d)(2) would again apply, but in this case to treat the Bermuda CFC’s income from sales outside Bermuda as foreign base company sales income. This latter manufacturing branch regime was found by the Tax Court to pertain to Whirlpool’s actual Luxembourg/Mexico structure.
The Tax Court began its analysis regarding the application of section 954(d)(2) to Whirlpool by pointing out that “[t]he threshold question is whether Whirlpool Luxembourg carried on activities in Mexico ‘through a branch or similar establishment.’” The court determined that it had a branch in Mexico, observing that Whirlpool did “not dispute that Whirlpool Luxembourg did business in Mexico ‘through a branch or similar establishment’ [i.e., WIN] and it would be difficult to contend otherwise.”
Having initially determined that the first precondition of section 954(d)(2) was met here, i.e., “the carrying on of activities by a controlled foreign corporation through a branch or similar establishment outside the country of incorporation of the controlled foreign corporation…,” the Tax Court focused on the second requirement of section 954(d)(2), i.e., “the conduct of activities in this manner must have ‘substantially the same effect’ as if the branch were a wholly owned subsidiary of the CFC.”
The Tax Court explained that section 954(d)(2) applied to circumstances “[w]here a CFC was chartered in a country that employed a territorial tax system [like Luxembourg, and, consequently,] the CFC’s conduct of business through a branch outside of the CFC’s home country and earning only income sourced there could have ‘substantially the same effect’ as if that income were earned by a subsidiary under U.S. tax rules.” In effect, Whirlpool’s Luxembourg/ Mexico arrangement is comparable to the hypothetical Bermuda CFC with a China manufacturing branch fact pattern discussed above.
The Tax Court stated that “[b]y carrying on its activities ‘through a branch or similar establishment’ in Mexico, Whirlpool Luxembourg avoided any current taxation of its sales income.” As noted above, the benefit could in some circumstances become even greater, i.e., moving from deferral to permanent tax exclusion, absent section 954(d)(2)’s application, as well as the possible application of the GILTI regime, in a post-TCJA U.S. tax world, wherein section 245A can often provide many domestic C corporation shareholders with complete exemption from gross income from foreign sourced dividends.
Whirlpool’s revised structure “thus achieved [according to the Tax Court] ‘substantially the same effect’—deferral of tax on its sales income—that it would have achieved under U.S. tax rules if its Mexican branch were a wholly owned subsidiary deriving such income. That is precisely the situation that the statute covers.” Thus, the Tax Court decided that “even without the refinements supplied by the regulations implementing section 954(d)(2), the bare text of the statute, literally read, indicates that Whirlpool Luxembourg’s sales income is FBCSI that must be included in petitioners’ income under subpart F.”
In its examination of the manufacturing branch Regulations, the Tax Court compared the zero percent rate of tax imposed by Luxembourg on the sales income, with the “effective rate of tax that would apply to the sales income, under Mexican law, if Whirlpool Luxembourg were a Mexican corporation doing business in Mexico through a PE [permanent establishment] in Mexico and deriving all of its income from Mexican sources allocable to that PE.” This would have been “28%. . ., the rate applicable to Mexico corporations generally.” As such, pursuant to the Regulations, since “[t]he 0% rate at which Whirlpool Luxembourg’s allocated sales income was actually taxed during 2009 is less than 90% of, and is more than 5 percentage points below, the 28% rate at which its income would have been taxed by Mexico…” then it is necessary to effectively treat the Mexican branch as if it were a separate subsidiary of the Luxembourg CFC. As a result, “[t]he sales income derived by Whirlpool Luxembourg…constituted FBCSI under section 954(d) and was taxable to petitioner as subpart F income under section 951(a).”
C. The Big Picture
The Tax Court then stepped back and focused on the big picture as to why this result was conceptually correct, i.e., it “comports with the overall statutory structure and with Congress’ purpose in enacting subpart F…[:]”
Whirlpool’s manufacturing activity in Mexico was conducted after 2008 exactly as it had been conducted before 2009, using the same plants, workers, and equipment. But the sales income was carved off into a Luxembourg affiliate that enjoyed a 0% rate of tax. The Luxembourg sales affiliate epitomizes the abuse at which Congress aimed: The selling corporation derived “income from the… sale of property, without any appreciable value being added to the product by the selling corporation…” If Whirlpool Luxembourg had conducted its manufacturing operations in Mexico through a separate entity, its sales income would plainly have been FBCSI under section 954(d)(1). Section 954(d)(2) prevents petitioners from avoiding this result by arranging to conduct those operations through a branch.
D. The Tax Court’s Rejection of Whirlpool’s Contentions Regarding the Inapplicability of Section 954(d)(2)
The Tax Court then proceeded to address (and refute) Whirlpool’s arguments as to why section 954(d)(2) should not apply. First, Whirlpool asserted “that Whirlpool Luxembourg had no substance.” According to Whirlpool, because “Whirlpool Luxembourg (‘the remainder’) had only one part-time employee, petitioners urge that ‘the remainder performs no sales or purchasing activities’ and hence that ‘the manufacturing branch rule is inapplicable.’” This is a particularly egregious contention. In effect, Whirlpool was stating that the Luxembourg CFC was just a tax dodge, so how can it be treated as a sales branch under the Regulations. The government in its brief to the Sixth Circuit pointed out that, despite the Luxembourg CFC’s lack of substance “‘over 90% of the profit’ was assigned to…[the Luxembourg CFC remainder], and that only 10% was assigned to Mexican-Branch/WIN.” Whirlpool had evidently no trepidations about recording the sales and income to the Luxembourg CFC remainder.
The Tax Court responded to Whirlpool’s assertion by characterizing this argument as “facetious.” It explained that Whirlpool put this structure together and made various representations to the relevant tax authorities, including that “Whirlpool Luxembourg was a real company engaged in real business activities. It owned all of the manufacturing equipment and purchased the raw materials used to manufacture the Products.” Furthermore, “[i]t took title to the finished…[appliances], as it was required to do in order to comply with Mexico’s maquiladora decree.” The Tax Court pointed out that “[a] transfer pricing study commissioned by WIN represented to the Mexican Government that ‘no sales effort is made’ by WIN and that ‘all responsibility for the distribution, marketing, and sale of [the] products’ fell to Whirlpool Luxembourg.” The Luxembourg legal entity, having “legal title to the [finished goods] …sold $800 million worth of…[appliances] to…[Whirlpool] and Whirlpool Mexico.” As to the one part-time employee in Luxembourg, the Tax Court indicated “[s]ince Whirlpool Luxembourg sold all of the…[appliances] to a pair of related parties, it did not need to expend significant effort to make these sales.”A final nail in the coffin for Whirlpool’s argument, in this respect, was that “[i]n seeking partial summary judgment under section 954(d)(1), petitioners asserted that Whirlpool Luxembourg’s operations ‘[w]ithout question… were substantial’ and that Whirlpool Luxembourg must be treated ‘as having sold a manufactured product.’”
It was through Whirlpool’s efforts that the remainder of the Luxembourg CFC was treated as the seller of the appliances to Whirlpool and Whirlpool Mexico. While the Tax Court wasn’t quite this explicit, it certainly implied that Whirlpool’s reorganization was entirely form-driven with little true substance. It was not then going to allow Whirlpool to ignore the form and focus on the substance for purposes only of claiming section 954(d)(2)’s inapplicability. The Tax Court quoted the Supreme Court that “[w]hile a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he accepts the tax consequences of his choice.”
The Tax Court also rejected Whirlpool’s claim that “no tax rate disparity exists when we compare the actual and hypothetical tax rates applicable to Whirlpool Luxembourg’s sales income.” Whirlpool made two separate arguments with respect to there not being a sufficient rate disparity. It contended “that the hypothetical Mexican tax rate should be 0.56% rather than 28%. . .,[on grounds that] if all of Whirlpool Luxembourg’s income were taxed by Mexico, Whirlpool Luxembourg would still qualify for Mexican tax incentives under the maquiladora program.” The Tax Court dismissed this, stating that “[i]f Whirlpool Luxembourg had a PE in Mexico and all of its income were allocable to that PE, it would be taxed in Mexico at a rate of 28%.”
The other rate disparity objection raised by Whirlpool was that “[i]f a 28% hypothetical tax rate applies in Mexico, …the effective tax rate in Luxembourg should be deemed to be 24.2%. . .[and thus not below the more than 5 percent threshold required by the regulations].” In arriving at this figure, Whirlpool pointed out that “Whirlpool Luxembourg in 2009 paid Luxembourg tax of €6,566 on income (mostly interest income) of €27,135.” The Tax Court indicated this was irrelevant since the Regulations require that “we… not look to the rate of tax that Whirlpool Luxembourg paid on its miscellaneous other income…[but instead] the Regulation directs we look to the worldwide rate of tax that was actually imposed on its allocated sales income.”
The next position advanced by Whirlpool was that section 954(d) was not applicable because of the statutory same-country manufacturing exception. As noted supra, section 954(d)(1) excludes from its scope income from the purchase and sale of property “manufactured, produced, grown or extracted…[in] the country under the laws of which the controlled foreign corporation is created or organized…” While not part of Whirlpool’s argument, sales income is also excluded from foreign base company sales income if “the property is sold for use, consumption or disposition…[in the country under the laws of which the CFC is created or organized].”
Whirlpool contended that the statutory manufacturing exception “should center on WIN (rather than on Whirlpool Luxembourg) and that sales of the Products manufactured by WIN fit within the ‘same country [manufacturing] exception.’” The Tax Court properly rejected this assertion, too, writing “WIN supplied manufacturing services and thus derived manufacturing income; it derived no sales income. Whirlpool Luxembourg was thus the CFC ‘which purchases and sells the property.’” Whirlpool’s claim was irrational. If WIN were a separate CFC from the Luxembourg entity, it is clear that the Luxembourg CFC would be the company that is focused upon with respect to possible foreign base company sales income. That is, WIN’s production would be irrelevant. The statutory manufacturing exception should thus not center on WIN’s activities, but rather on the remainder of the Luxembourg CFC.
The final argument raised by Whirlpool was “that the regulations are invalid as applied to the structure Whirlpool created…” That is, according to the taxpayer, “section 954(d)(2) applies only in situations where a CFC conducts manufacturing activities and has a ‘sales branch,’ as opposed to the converse situation (such as this) where the CFC conducts sales activities and has a ‘manufacturing branch.’” Whirlpool’s position was “that the ‘manufacturing branch rule of Treas. Reg. § 1.954-3(b)(1)(ii) is invalid, as it exceeds the scope of authority granted by the plain language of section 954(d)(2).’”
A key component of Whirlpool’s grounds for the manufacturing branch Regulation being invalid was the final clause of section 954(d)(2) referring to “shall constitute foreign base company sales income…” The Tax Court explained that “[t]he subject of the verb ‘shall constitute’ is ‘income attributable to the carrying on of such activities of such branch.’ In the case of a sales branch, the income attributable to its activities would typically be sales income, which might well constitute FBCSI.” In contrast, “in the case of a manufacturing branch the income attributable to its activities would commonly be manufacturing income, which normally would not constitute FBCSI.” Thus, Whirlpool argued “that Congress must have been thinking of sales branches when it drafted the statute…[and therefore section 954(d)(2)] authorize[s] the Secretary to prescribe regulations only dealing with sales branches.”
The Tax Court, in rejecting Whirlpool’s argument, reasoned that “when stating that the branch’s income shall be deemed derived by a subsidiary ‘and shall constitute FBCSI,’ Congress may have meant that the branch’s income shall be deemed derived by a subsidiary ‘for purposes of determining FBCSI under subsection (d)(1).’” Under this interpretation, “section 954(d)(2) would plausibly envision regulations dealing with any sort of branch. For that reason…[the Tax Court determined,] the statute is ambiguous.” Furthermore, the Tax Court indicated that even if “the statute is not ambiguous… there is nothing in the statute that prevents the Secretary from prescribing regulations that also address manufacturing branches. Section 954(d)(2) simply does not contain the negative pregnant that petitioners seek to read into it.”
In analyzing the validity of the manufacturing branch Regulation, the Tax Court followed the two-step approach set forth by the Supreme Court in Chevron, USA v. Natural Resources Council. The Tax Court found that, as to the first test, i.e., “whether Congress has directly spoken to the precise question at issue…,” the manufacturing branch Regulation did not contravene the clear intent of Congress. The Tax Court observed that “[s]ection 7805… authorized the Secretary to prescribe regulations addressing the treatment of manufacturing branches for subpart F purposes, even if section 954(d)(2) did not direct him to do so.”
Having determined that the first Chevron test was satisfied, the Tax Court needed to assess whether the second test was met, i.e., that the manufacturing branch Regulation “is permissible and not ‘arbitrary, capricious or manifestly contrary to the statute.’” The Tax Court concluded that the Regulation satisfied this second Chevron step, too. The Tax Court observed that the Regulation was consistent with Congress’ concern in enacting section 954(d) “with ‘income of a selling subsidiary…which has been separated from manufacturing activities of a related corporation merely to obtain a lower rate of tax for the sales income.’” The Tax Court pointed out that “an artificial separation of sales income from manufacturing income can be engineered regardless of whether the CFC or its branch makes the sales.” Absent a manufacturing branch provision, “[t]axpayers could easily evade taxation simply by switching the functions around, placing the sales activities in the CFC rather than in the branch.” The Tax Court concluded that, in issuing the manufacturing branch Regulation, Treasury took “reasonable steps” that were “fully consistent with Congress’ intent as expressed in the legislative history…” to avoid the foregoing. As such, the Tax Court found that the Regulations were valid.
The Tax Court’s decision was, as the Sixth Circuit described it, “meticulously reasoned.” It was a very useful roadmap for the appellate court where the judges, deciding mainly non-tax cases, may not have as thorough an understanding of the intricacies of the tax laws, particularly the foreign base company sales income rules, including the branch rule.
V. The Sixth Circuit Decision
In a 2-1 decision, the Sixth Circuit Court of Appeals affirmed the judgment of the Tax Court. The Court of Appeals also denied Whirlpool’s ensuing petition for a panel rehearing or rehearing en banc, with no judge requesting a vote on the suggestion for rehearing en banc. As noted earlier in this Article, the Supreme Court denied Whirlpool’s petition for certiorari. Only Judge Nalbandian agreed to grant a rehearing for the reasons stated in his dissent. The Sixth Circuit described the case as “difficult.” Nevertheless, the Sixth Circuit presented a generally sound analysis as to why the Service should prevail, although not as compelling as that accomplished by the Tax Court, because the Sixth Cirtcuit avoided a detailed regulatory analysis.
A. The Court’s Initial Observations and Its Holding in the Government’s Favor
The Sixth Circuit began its opinion by describing the abuse that led to the enactment of the subpart F provisions, and specifically the foreign base company sales income provision. It posited, as an example, a fact pattern wherein a U.S. parent company set up Mexican subsidiary to manufacture goods that were to be sold by the domestic shareholder. Instead of selling the goods directly to the U.S. parent, “the American parent created a second subsidiary in a country—say, Switzerland—that did not tax income from sales of goods manufactured elsewhere. The Mexican subsidiary could then sell the goods at a low price to the Swiss subsidiary, which could then sell them to the American parent at a relatively high price.”
As part of this contextual background, the Court of Appeals explained why it was necessary that section 954(d)(2) existed. The court referred to section 954(d)(2) as “a failsafe provision that applies ….when a CFC uses a foreign branch to achieve ‘substantially the same’ tax effect—meaning the same tax-deferral effect—that American corporations had been able to achieve…[before subpart F was effective] by parking income with a foreign subsidiary.” In discussing the facts of the case, the Sixth Circuit (as noted above) treated Whirlpool Luxembourg and WOM, which it called “Lux,” as one entity because “Whirlpool Luxembourg was primarily a holding corporation.” Thus, while the Tax Court referred to Whirlpool Luxembourg, the Sixth Circuit used Lux to describe the Luxembourg CFC.
The Sixth Circuit indicated that, in reviewing the Tax Court’s grant of summary judgment, “[t]he question presented is whether Lux’s income from the its sale of appliances to Whirlpool-US and Whirlpool-Mexico in 2009 is FBCSI under section 954(d)(2).” The court agreed with the Tax Court’s observation 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 Court of Appeals pointed out that “[t]he first condition[,]… that the CFC was ‘carrying on’ activities ‘through a branch or similar establishment’ outside its country of incorporation…,[was] undisputedly met here.”
With respect to the second condition of section 954(d)(2), i.e., that “the branch arrangement must have had ‘substantially the same effect as if such branch or similar establishment were a wholly owned subsidiary [of the CFC] deriving’ the income attributable to the branch’s activities…,” the Sixth Circuit stated that its meaning “presents the principal interpretative question in this appeal.” The court noted that “[w]e construe statutory text as it would have been understood ‘at the time Congress enacted the statute.’”
In its review of section 954(d)’s legislative history, the court referred to a Joint Committee report which “observed that ‘in many cases the abuse resulting from the use of a foreign subsidiary consists in the fact that the foreign subsidiary has little, if any substance and does not, in fact, function as an operating commercial corporation.’” The report described, as an example, a U.S. company that engaged in manufacturing which “‘organized an international subsidiary under the laws of Liechtenstein which, nominally at least,’ performed sales operations ‘throughout the world’ for its American parent…[While] the Liechtenstein subsidiary ‘employ[ed] few, if any, salesmen…,’ it received up to ‘80 percent’ of the income from the American company’s foreign operations.”
The foregoing, along with other indicia of what Congress had in mind when it enacted section 954(d), led the court to determine that “[t]he practice of shifting income to ‘wholly owned subsidiar[ies]’ overseas was associated, above all, with one ‘effect’: tax deferral. Subpart F in general and section 954 in particular are overwhelmingly focused on preventing precisely that effect.” The Sixth Circuit thus concluded that “as a matter of historical and statutory context alike, an informed reader would naturally understand the ‘effect’ to which section 954(d)(2) refers to be a tax-deferral effect. We therefore agree with the Tax Court that the phrase ‘substantially the same effect,’ as used in section 954(d)(2), refers to the ‘deferral of tax’ on sales income.”
Accordingly, the Court of Appeals stated that “[t]he second condition of section 954(d)(2)… is that the CFC’s ‘carrying on of activities’ through a foreign branch had a substantial tax-deferral effect.” It concluded that this “condition [was] plainly met here.” That is, according to the Sixth Circuit and the Tax Court, “‘[b]y carrying on its activities ‘through a branch or similar establishment’ in Mexico, [Whirlpool Luxembourg] avoided any taxation of its sales income.’” The Sixth Circuit also observed that even Whirlpool recognized that “Lux’s income from its sales of appliances to Whirlpool-US and Whirlpool-Mexico in 2009 was ‘attributable to’ the activities of its Mexican branch.” As a result, pursuant to section 954(d)(2), “the income attributable to the branch’s activities… ‘constitute[d] foreign base company [. . .] income of’ Lux.’”
B. The Court’s Rejection of Whirlpool’s Arguments
The Sixth Circuit has been subject to criticism for not specifically addressing Whirlpool’s “various arguments as to [. . .] regulations, seeking a result different from the one mandated by the statute itself.” That is, instead of explaining why, for every assertion raised by Whirlpool relating to a regulation, it did not change the outcome, the court stated that “the agency’s regulations can only implement the statute’s commands, not vary from them. . . And the relevant command here—that Lux’s sales income ‘shall constitute foreign base company sales income of’ Lux—could hardly be clearer.” While this writer concurs with the ultimate conclusion that foreign base company sales income resulted here, it certainly would have been better had the Sixth Circuit mirrored the Tax Court in this respect, i.e., had it specifically addressed why the Regulations did not change the outcome.
The Sixth Circuit characterized the taxpayer’s other objections as “insubstantial.” First, Whirlpool, as it had done in the Tax Court, asserted that section 954(d)(2) only applied to income from the branch and not as here, from the remainder. The Sixth Circuit stated that this assertion “glosses over the words of the provision itself…[i.e., the statute requires] that, if the provision’s two conditions are met, ‘the income attributable to’ the branch’s activities ‘shall be treated as income derived by a wholly owned subsidiary and shall constitute foreign base company sales income of the [CFC].’” It follows, according to the Sixth Circuit, that “for income to be ‘attributable to’ a branch’s activities, the branch itself need not hold or obtain the income; rather, the income need only result from the branch’s activities.” This is an area where the Court of Appeals should have adhered to the Tax Court’s reasoning.
The court similarly rejected the assertion by Whirlpool that the heading of section 954(d)(2), i.e., “Certain branch income” buttressed its position. The Sixth Circuit stated that “the provision’s text says ‘attributable to’; and ‘the heading of a section cannot limit the plain meaning of the text.’”
Finally, the Sixth Circuit responded to Whirlpool’s argument that “if the conditions of section 954(d)(2) are met, the transaction at issue must still fit within one of the four types of transactions described in section 954(d)(1)—when treating the branch as a ‘wholly owned subsidiary of the [CFC,]’ as prescribed in the first consequence of section 954(d)(2)—in order for the income from the transaction to be treated as FBCSI of the CFC.” The court rejected Whirlpool’s contention because it had “overlook…[ed] the structure of the two provisions and the emphatic terms of section 954(d)(2) itself.” The Sixth Circuit elaborated as follows: “whereas section 954(d)(1) involves an intermediate step for determining whether a transaction results in tax deferral—namely, the determination whether the transaction at issue is of a type that tends to cause that result—section 954(d)(2) cuts to the bottom line of deferral itself.” Thus, having done so, section “954(d)(2)’s terms are preemptory: if the provision’s two conditions are met, the income at issue ‘shall constitute foreign base company sales income of the [CFC].’” This is certainly highly questionable, but ultimately academic. It is not necessary to ignore section 954(d)(1) to determine that foreign base company sales income occurred here. One should simply apply section 954(d)(1) as if the branch were a separate CFC. This is what the Tax Court concluded when it said that “[t]reating the branch as a subsidiary, in other words, does not seem to be a sufficient condition for determining that FBCSI has been earned. Rather, having adopted that treatment, we must refer back to subsection (d)(1) and ascertain whether a specified category of sales transaction exists.”
C. The Dissenting Opinion
There was a long dissenting opinion by Circuit Judge Nalbandian. Judge Nalbandian agreed that “[t]his was a hard case…[that] involves a complicated statute and an even more complicated set of regulations.” He also conceded that the court had “thoughtfully engage[d] with both and comes to a reasoned conclusion.” While the majority returned the compliment, characterizing the dissenting opinion as “thoughtful,” this writer believes the dissenting opinion is flawed due in large part to a fundamental misunderstanding of the regulatory manufacturing exception.
The dissent took the position that “Lux didn’t generate taxable foreign base company sales income because it ‘manufactured’ the property it bought and sold.” In contrast to the majority opinion, which read sections 954 “(d)(1) and (d)(2) as independent of each other,” the dissent read section 954(d)(2)’s text and structure “as directing us back into the (d)(1) framework.” As a result, the dissent concluded that the manufacturing exception in section 954(d)(1) applied and that “Lux satisfies [it] here. At the very least, there’s a disputed question of material fact whether the Exception applies. And so I think summary judgment for the Commissioner is inappropriate.”
In Judge Nalbandian’s view, section “954(d)(2) explicitly tells us that income a CFC earns through a branch ‘shall constitute’ FBCSI ‘under regulations prescribed by the Secretary [of the Treasury]’… And section 954(d)(2)’s regulations instruct us to subject a (d)(2) transaction to (d)(1)’s framework and exceptions.” The dissent emphasized “that Congress gave Treasury a role in defining when transactions generate FBCSI…And…the regulations applicable here tie (d)(2) back into (d)(1) and instruct us to apply the Manufacturing Exception to the (d)(2) transaction.” According to the dissent, if section 954(d)(2) is not tethered to section 954(d)(1), “any activity could generate FBCSI no matter if it involves a Related Person sales transaction, so long as it’s ‘attributable’ to the branch’s activities.” The dissent suggested that, under this reading, “Lux’s interest income would be ‘income attributable to’ WINs activities and thus FBCSI.”
The dissent stressed that “[s]tep 2 of the (d)(2) manufacturing branch regulations—which we apply when determining ‘whether such branch . . . or remainder . . . has [FBCSI]’—just tells us to treat the branch and remainder as separate corporations and view the remainder’s sales as performed ‘on behalf of’ the branch.’” That is, “[i]t doesn’t say which branch transactions to look at when determining whether a CFC has FBCSI. Nor does it, of its own force, label any income FBCSI.” Judge Nalbandian thus determined that, as to section 954(d)(2), “[w]e just don’t have a provision calling anything FBCSI unless we look back to (d)(1)’s framework.” As noted above, this point is consistent with the Tax Court’s analysis, and as discussed further below, this writer concurs with this part of the dissent’s reasoning.
Furthermore, the dissent took the position that the Regulation “explicitly tells us to apply the (d)(1) exceptions to the (d)(2) transaction. ‘Income derived by the branch . . . or by the remainder . . . shall not be considered [FBCSI] if the income would not be so considered if it were derived by a separate controlled foreign corporation under like circumstances.’” “That means,” the dissent continued, that “even putting the statutory structure to the side, [pursuant to the regulations], we must check if the Manufacturing Exception applies here, even though we are within the Branch Rule under (d)(2).” The dissent summed up its position as follows: “In short, the structure of section 954(d)(2) supports running a branch transaction through the (d)(1) framework, and the regulations—which no one challenges here—tell us explicitly to do so. And applying the Manufacturing Exception here means Lux didn’t generate taxable FBCSI.” To further buttress its position, the dissent observed that “[t]ax scholars, for instance, agree not only that (d)(2) transactions filter through (d)(1), but that section 1.954-3(b)(2)(ii)(e) means we apply (d)(1)’s exceptions, including its Manufacturing Exception, to a branch-remainder transaction.” While the dissent and the Tax Court were right that “the statutory structure only makes sense if (d)(2) transactions filter back through (d)(1)’s framework…[,]” the manufacturing exception in the Regulations should not permit the remainder, Lux, to avoid FBCSI for manufacturing done by WIN in Mexico. Many tax scholars, including one cited in the dissenting opinion, do not construe the application of the manufacturing exception in the same manner as Judge Nalbandian.
While somewhat difficult to decipher, perhaps in Judge Nalbandian’s view of the regulatory manufacturing exception, had WIN been a CFC and not a branch for U.S. tax purposes, Lux would not have foreign base company sales income. This would certainly be an incorrect conclusion since Lux itself is not undertaking the manufacturing. In this scenario, the taxpayer would have separated the related party sales income of a CFC from the CFC doing the manufacturing. This is precisely what section 954(d)(1) was enacted to avoid. As explained in the next section, the same analysis should apply where, as here, WIN is a manufacturing branch of the CFC and the Luxembourg CFC itself is not doing any manufacturing.
As Judge Nalbandian saw the matter, it is irrelevant that it was the branch WIN and not Lux that engaged in the manufacturing. Judge Nalbandian stated that “nothing in the Manufacturing Exception requires the CFC itself to have manufactured anything.” As will be expanded upon below, this misconstrues the manufacturing regulatory exception, which focuses on the entity doing the manufacturing, in contrast to the statutory manufacturing exception, which centers on where, i.e., in which country, did production occur. Under the regulatory manufacturing exception, the Luxembourg CFC should not avoid generating foreign base company sales income for manufacturing done by another Whirlpool entity, or in this case, its branch. The dissenting judge’s apparent confusion regarding the regulatory manufacturing exception perhaps explains the reticence of the majority opinion to analyze the Regulations in connection with some of Whirlpool’s assertions.
The dissenting opinion concluded by reiterating that “[t]his isn’t an easy case.” Nevertheless, it “believe[d] the statute and its regulations lay out a clear path: Apply the (d)(1) framework and exceptions to the (d)(2) branch transaction. Doing so here means Lux didn’t generate FBCSI… [T]here is, at the very least, a disputed fact over whether Lux qualifies for the Manufacturing Exception. And that should’ve precluded summary judgment.”
