The Tax Times: Manufacturing in Mexico by Luxembourg CFC is Subpart F Income

The Tax Court has held in Whirlpool Financial Corporation, (2020) 154 TC No. 9, that a domestic manufacturer/distributor corporation had to include in income, as Subpart F foreign base company sale income (FBCSI), amounts earned by its Luxembourg controlled foreign corporation (CFC) from appliances manufactured in the CFC’s Mexican branch and sold to the domestic corporation.

U.S. shareholders of a foreign corporation are not subject to U.S. taxation on the income of the foreign corporation until an actual dividend is remitted by the foreign corporation to the U.S. shareholders. However, the U.S. shareholders of a CFC (as defined in Code Sec. 957(a)) must generally include in gross income their pro rata share of the CFC's subpart F income as a deemed dividend inclusion. (Code Sec. 951)

One category of subpart F income is foreign base company income. (Code Sec. 952) Foreign base company income includes FBCSI, among other things. (Code Sec. 954(a), Code Sec. 954(d))

For purposes of determining FBCSI in situations in which the carrying on of activities by a CFC through a branch or similar establishment outside the CFC's country of incorporation has substantially the same effect as if such branch or similar establishment were a wholly owned subsidiary corporation deriving such income, then, under regs, the income attributable to the carrying on of such activities of such branch or similar establishment is treated as income derived by a wholly owned subsidiary of the CFC and constitutes FBCSI of the CFC. (Code Sec. 954(d)(2))

Whirlpool was a domestic corporation that manufactured and distributed household appliances through domestic and foreign subsidiaries. The foreign subsidiaries were CFCs. In 2009, through a branch in Mexico (WIN), Whirlpool’s Luxembourg CFC acted as the nominal manufacturer of appliances in Mexico, using a structure that qualified for Mexican tax and trade incentives. Whirlpool Luxembourg sold these appliances to Whirlpool, which distributed the appliances for sale to consumers.

The Court concluded that the income earned by Whirlpool Luxembourg from its sales of WIN-manufactured products to Whirlpool was FBCSI because that income met the requirements in Code Sec. 954(d)(2).

The Court noted that Code Sec. 954(d)(2) establishes two preconditions for its application:

The CFC must be carrying on activities “through a branch or similar establishment” outside its country of incorporation, and
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 Court said that the first precondition was "clearly met" here: Whirlpool Luxembourg was incorporated in Luxembourg, and it carried on its manufacturing activities “through a branch or similar establishment” in Mexico.

The statute then requires that this mode of operation had “substantially the same effect” as if the Mexican branch were a wholly owned subsidiary of Whirlpool Luxembourg. The Court concluded that it did.

Luxembourg in 2009 employed a territorial system of taxation. Luxembourg exempted from current taxation income earned by a foreign branch of a Luxembourg corporation, provided that the branch constituted a permanent establishment (PE) of the Luxembourg corporation in that foreign country. Whirlpool Luxembourg represented to Luxembourg tax authorities that it had a PE in Mexico. And it received a ruling from them that it had a PE in Mexico and that all income earned from its sales to Whirlpool was attributable to that PE. Whirlpool Luxembourg thus paid no tax to Luxembourg on its sales income.

Under the Mexican tax regime, Mexico taxed WIN on the income it earned from supplying manufacturing services to Whirlpool Luxembourg. But Mexico treated Whirlpool Luxembourg as a “foreign principal” that was deemed, under Mexican law, to have no PE in Mexico. As a result, Whirlpool Luxembourg paid no tax to Mexico on its sales income.

By carrying on its activities “through a branch or similar establishment” in Mexico, Whirlpool Luxembourg avoided any current taxation of its sales income. It thus achieved “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 non-CFC subsidiary deriving such income. The Court said, "That is precisely the situation that the statute covers."

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