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Whirlpool Financial Corporation v. Commissioner (154 T.C. No. 9)

On May 5, 2020, the Tax Court issued its opinion in Whirlpool Financial Services v. Commissioner, 154 T.C. No. 9. The issue presented in Whirlpool Financial was whether the income earned by the petitioner’s Luxembourg controlled foreign corporation (CFC) from sales of appliances to the petitioner and the petitioner’s Mexican CFC constituted foreign base company sales income (FBCSI) under IRC § 954(d) and, as such, was taxable to the petitioner as subpart F income under IRC § 951(a).

Three Refrigerator Salesmen Walk into the Tax Court

This is a bit of a simplification of the facts, but I have tried to distill the important players and relationships from the numerous (15 pages worth in the Tax Court opinion) factual findings made by the Tax Court.

In the present case, there are three players: (1) petitioner, Whirlpool America (PWA), the domestic-beer-drinking parent corporation; (2) Whirlpool Luxembourg (WL), a Bordeaux-savvy controlled foreign corporation (CFC) of PWA; and (3) Whirlpool Mexico (WM), a mezcal-loving branch of WL. WM was not always a branch of its hoity-toity European step-brother. In the beginning it was just (PWA) and a couple of fun-loving, siesta-taking, but most importantly low-taxed Mexican CFCs.

From 2007-2009, economic and tax conditions in Mexico changed, and PWA decided it made sense to restructure. In 2007, PWA created WL and WL took over (in name only) the manufacturing operations conducted by one of the Mexican CFCs. Further, PWA made WM a “branch” of WL, which gave WM a terrible inferiority complex, but PWA was deaf to the entreaties of WM. WL had only one employee, described in the Tax Court opinion as a glorified errand boy named Nour Eddine Nijar.

WL purchased rolls of steel, sheets of plastic, chemicals, resins, paint, tubing, and other raw materials from third-party suppliers, which raw materials were “sold” to and used by WM to manufacture refrigerators and washing machines. All of the appliances produced from the raw materials WL purchased were sold in Mexico and the U.S. It is likely that Nour never saw as much as a sprocket in his days at WL. For Luxembourg tax purposes and with some rather grande latón juevos, WL claimed a permanent establishment in Mexico, and WL actually convinced the Luxembourg taxing authorities to go along with it. As function of the Mexico-Luxembourg tax treaty, this meant that WL’s Luxembourg tax liabilities were ZERO.

On its Federal income tax return for 2009 petitioner took the position that none of the income derived by WL under its supply agreements with WM was subject to tax under subpart F. The IRS, begging to differ, commenced an examination of that return and determined that WL’s sale of the appliances to PWA and WM gave rise to foreign base sales company income (FBCSI) (explained below) of $49,964,080. The IRS included that sum in petitioner’s income under IRC § 954(d) (FBSCI) and IRC § 951(a) (amounts included in gross income of U.S. shareholders of a CFC). Mon dieu, thought WL. Dios mio, thought WM. Well shit, thought PWA.

Foreign Base Company Sales Income under IRC § 954(d) Taxable Pursuant to IRC § 951(a)

IRC § 951 provides that a U.S. shareholder of a CFC must include in his gross income his pro rata share of the CFC’s subpart F income. A U.S. shareholder is defined as a U.S. person owning 10% or more of the voting power of a foreign corporation. See IRC § 951(b). A foreign corporation is a CFC if more than 50% of its voting power or stock value is held by U.S. shareholders. See IRC § 957(a). Subpart F income is defined to include (among other things) foreign base company income. See IRC § 952(a)(2). Foreign base company income includes foreign personal holding company income, e.g., dividends, interest, rents, and royalties. See IRC § 954(a)(1), (c). It also included three types of foreign base company income, one of which is FBCSI. See IRC § 954(a)(2), (3), (5). A taxpayer’s FBCSI is determined under IRC § 954(d), reduced by deductions allowable under IRC § 954(b)(5). See IRC § 954(a)(2).

IRC § 954(d)(1) generally provides that, when a CFC earns income in connection with the purchase or sale of personal property in certain transactions involving a related person, that income will be FBCSI if the property is (A) manufactured outside the country in which the CFC is organized and (B) sold for consumption or use outside that country. Critically, (to this case, and polite cocktail hour conversation at the next tax conference you attend), IRC § 954(d)(2) prevents a U.S. shareholder from escaping IRC § 954(d)(1) by having its CFC conduct activity through a branch (as opposed to a subsidiary) outside the CFC’s home country. It is this “branch rule” that ultimately would tip the scales in the IRS’s favor against WPA.

The Manufacturing Exception to IRC § 954(d)

FBCSI does not include income derived by a CFC in connection with the sale of property manufactured, produced, or constructed by such corporation from personal property which it has purchased. See Treas. Reg. § 1.954-3(a)(4)(i). A CFC will be considered to have manufactured property which it sells if the property sold is in effect not the property which it purchased, which is to say if the purchased personal property is substantially transformed prior to sale. See Treas. Reg. § 1.954-3(a)(4)(ii). The Tax Court noted, however, that WL did not actually manufacture anything, WM did. See IRC § 954(d)(1)(A); Treas. Reg. § 1.954-3(a)(4)(iv).

Takeaways

The IRS determined that the sales income derived by WL a CFC of PWA constituted FBCSI to PWA under IRC § 954(d), and such FBCSI was taxable to PWA as subpart F income under IRC § 951(a). (As an aside, that sentence made complete sense to write, and probably didn’t faze you to read. Taxish is a hell of a language.) Because PWA had not reported such FBCSI, the IRS adjusted (decreased), pro tanto, PWA’s net operating loss (NOL) carryback deduction. PWA argued, however, that WL’s sales income was not FBCSI under IRC § 954(d)(1), because the appliance components that WL sold to WM were, after the sale, “substantially transformed” by WM from the component parts and raw materials it had purchased from WL. OK?  (Holy acronym soup, Batman.)

The Tax Court did not buy PWA’s B.S. that WL did not generate FBCSI from WM’s transactions. The court held that whether or not WL (a CFC) is regarded as having manufactured the products, WM (WL’s branch) under IRC § 954(d)(2) is treated as a subsidiary of WL, and the sales income the latter earned, therefore, constitutes FBCSI taxable to petitioner as subpart F income pursuant to IRC § 951(a).

(154 T.C. No. 9) Whirlpool Financial Corp. v. Commissioner

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