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IRS Takes Whirlpool to the Cleaners in Case Involving Subpart F Income

(Parker Tax Publishing May 2020)

The Tax Court held that the sales income of a U.S. appliance manufacturer's Luxembourg-based subsidiary that was a controlled foreign corporation (CFC) was foreign base company sales income (FBCSI) under the branch rule in Code Sec. 954(d)(2) and was, therefore, taxable subpart F income of the U.S. parent company. The court found that, if the CFC had conducted its manufacturing operations through a separate entity, its sales income would plainly be FBCSI under Code Sec. 954(d)(1), and Code Sec. 954(d)(2) prevented the company from avoiding this result by arranging to conduct its operations through a branch. Whirlpool Financial Corporation & Consolidated Subsidiaries v. Comm'r, 154 T.C. No. 9 (2020).


Whirlpool Financial Corp. (Whirlpool) is a Delaware corporation that manufactures and distributes household appliances through its domestic and foreign subsidiaries. Before 2007, Whirlpool indirectly owned Whirlpool Mexico, a company organized under Mexican law. Whirlpool Mexico had two subsidiaries: CAW, which handled administrative functions, and IAW, which manufactured products including refrigerators, washing machines, and other appliances. Whirlpool Mexico and its subsidiaries were treated as controlled foreign companies (CFCs) for U.S. federal income tax purposes.

During 2007-2009, Whirlpool restructured its Mexican manufacturing operations, driven largely by tax considerations. It formed Whirlpool Internacional (WIN), a company organized under Mexican law, and transferred ownership of WIN to Whirlpool Luxembourg, an indirect wholly owned subsidiary organized under Luxembourg law. Whirlpool Luxembourg was a CFC. It had one part-time employee who performed only administrative functions in connection with maintaining the Luxembourg office. WIN, also a CFC, was treated as an entity separate from Whirlpool Luxembourg for Mexican and Luxembourg tax purposes, but for U.S. federal income tax purposes, WIN elected to be treated as a disregarded entity.

After 2007, Whirlpool continued to own Whirlpool Mexico and (through it) CAW and IAW. IAW continued to own the land and buildings used to manufacture the products. However, in 2007 and 2008, IAW (1) leased its two manufacturing plants in Mexico to WIN, and (2) sold to Whirlpool Luxembourg all of the machinery, equipment, and inventory situated within the plants. WIN had no employees of its own. High level employees of IAW and CAW were "seconded" to WIN, while rank and file employees of IAW were subcontracted to WIN to perform manufacturing tasks, and rank and file employees of CAW were subcontracted to WIN to perform back-office tasks.

Thus, during 2009, Whirlpool's Mexican manufacturing operations were structured as follows: Whirlpool Luxembourg owned the machinery and equipment used to manufacture the products, and it purchased and retained title to the raw materials and inventory during the manufacturing process. At the end of the manufacturing process, Whirlpool Luxembourg transferred title and risk of loss to Whirlpool and Whirlpool Mexico. Whirlpool Luxembourg, having no employees of its own, contracted with WIN to supply the necessary manufacturing services. WIN, having no employees or manufacturing plants of its own, leased the plants from IAW and arranged to have its subsidiaries' employees seconded or subcontracted to it. IAW's workers assembled the products, and CAW's workers supplied back-office services.

Under Code Sec. 951, a U.S. shareholder of a CFC must include in gross income its pro rata share of the CFC's subpart F income. Subpart F income includes (among other things) foreign base company income. Under Code Sec. 954(d), one type of foreign base company income is foreign base company sales income (FBCSI).

Code Sec. 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" (e.g., a wholly owned subsidiary), that income is FBCSI if the property is both manufactured and sold outside the country in which the CFC is organized. The "branch rule" in Code Sec. 954(d)(2) prevents a U.S. shareholder from avoiding the rule in Code Sec. 954(d)(1) by having its CFC operate through a branch (as opposed to a subsidiary) outside the CFC's home country. Under Code Sec. 954(d)(2), if the carrying on of activities through a branch has substantially the same tax effect as if the branch were a wholly owned subsidiary, then the branch will be treated as a subsidiary of the CFC for purposes of determining FBCSI. The rules in Reg. Sec. 1.954-3(b) determine if the use of a branch has substantially the same tax effect as if the branch were a wholly owned subsidiary.

Under Reg. Sec. 1.954-3(a)(4)(i), FBCSI does not include a CFC's income from the sale of personal property manufactured, produced, or constructed by the CFC from personal property which it has purchased. A CFC is considered to have manufactured property if the property sold is, in effect, not the property which it purchased. This condition is satisfied if the purchased property is "substantially transformed" before the sale.

On its 2009 federal income tax return, Whirlpool took the position that none of Whirlpool Luxembourg's sales income was taxable under subpart F. The IRS audited Whirlpool's return and determined that the sale of products to Whirlpool and Whirlpool Mexico by Whirlpool Luxembourg gave rise to $49,964,080 of FBCSI and thus was taxable to Whirlpool as subpart F income.

Whirlpool took its case to the Tax Court. It argued that Whirlpool Luxembourg's sales income was not FBCSI because the final products it sold were "substantially transformed" by its Mexican branch from the raw materials it had purchased. Alternatively, it argued that the branch rule did not apply because Whirlpool Luxembourg had no substance. Whirlpool also challenged the validity of Reg. Sec. 1.954-3(b), arguing that Code Sec. 954(d)(2) addresses only sales branches, and the IRS therefore exceeded its authority in issuing regulations addressing manufacturing branches.

Tax Court's Analysis

The Tax Court held that Whirlpool Luxembourg's sales income was FBCSI under the branch rule of Code Sec. 954(d)(2). The court found that the first precondition of Code Sec. 954(d)(2) was met because Whirlpool Luxembourg carried on activities through a branch or similar establishment outside its country of incorporation. The second precondition was met, in the court's view, because this manner of operation had substantially the same effect, for U.S. tax purposes, as if the Mexican branch were a wholly owned subsidiary of Whirlpool Luxembourg.

The court noted that Whirlpool Luxembourg paid no tax on its sales income in either Luxembourg or Mexico; Whirlpool Luxembourg was exempt from Mexican tax on the income it earned under its agreements with WIN, and its income from sales of the finished products was also exempt from Luxembourg tax under the Mexico-Luxembourg tax treaty. Thus, by carrying on its activities through a branch or similar establishment in Mexico, Whirlpool Luxembourg avoided any current tax on its sales income, thus achieving substantially the same effect - deferral of tax on its sales income - that it would have achieved under U.S. tax rules if the Mexican branch were a wholly owned subsidiary deriving such income. That was because, in either case, the income typically would not be currently taxable to its ultimate owner (i.e., the branch's home office or the subsidiary's parent). The court found that this was the precisely the situation covered by Code Sec. 954(d)(2). The court went on to apply the rules in Reg. Sec. 1.954-3(b) and found that Whirlpool Luxembourg's sales income was FBCSI under the regulations.

The court rejected Whirlpool's argument that Whirlpool Luxembourg had no substance. The court noted that Whirlpool claimed that Whirlpool Luxembourg's operations were substantial and that it should be treated as having sold a manufactured product for purposes of Code Sec. 954(d)(1). The court found that, given the corporate structure chosen by Whirlpool, under which Whirlpool Luxembourg owned and sold the products, Whirlpool could not plausibly contend that Whirlpool Luxembourg performed no sales activities. The court also rejected Whirlpool's argument regarding the validity of the regulations, finding that Code Sec. 954(d)(2) does not prevent the IRS from issuing regulations addressing manufacturing branches, and that the regulations are a reasonable interpretation of the statute.

For a discussion of the taxation of U.S. shareholders of controlled foreign corporations, see Parker Tax ¶201,510.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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