A recent private letter ruling illustrates how a non-U.S. procurement corporation can generate Subpart F income, but also illustrates an exception to the creation of that income.
10% or more shareholders of a controlled foreign corporation (CFC) have to pick up their pro rata share of the Subpart F income of the CFC when it is earned, regardless of whether the CFC distributes the income to its shareholders. One type of income that is characterized as Subpart F income is “foreign base company sales income” (FBCSI). FBCSI includes income from the purchase of personal property from any person on behalf of a related person, provided that the property both is manufactured, produced, grown or extracted outside of the CFC's country of organization and is sold for use, consumption or disposition outside of such country. Code §954(d)(1).
In the ruling request, a disregarded entity owned by a CFC entered into a buying agency agreement under which the disregarded entity performed various procurement-related activities. The disregarded entity was responsible for ensuring that the products purchased by related entities met standards of design, image, quality, vendor compliance, and brand. The disregarded entity received payments from affiliates as compensation for the procurement activities. As a disregarded entity, its activities (and income) were attributed to the CFC that owned it.
The IRS first ruled that the income earned by the procurement CFC would normally constitute FBCSI and thus Subpart F income. Interestingly, FBCSI arose even though the disregarded entity did not take title to the purchased goods, even though the language of the Code clearly supports a reading that acquisition of title is required.
The IRS further ruled that there was no FBCSI in this circumstance since the CFC had made a substantial contribution through its employee to the manufacture, production or construction of the property that was sold. Treas. Regs. §1.954-3(a)(4)(iv). It would have been instructive to see what type of contribution the procurement CFC did to meet this exception since I’d be interested to see what activities a procurement agent would be doing to meet this exception. Unfortunately, that information was not included in the ruling request.