Rev. Rul. 72-357

Advice has been requested whether, under the circumstances described below, income earned by a controlled foreign corporation not taxed by any foreign country is exempt from inclusion as subpart F income under the provisions of section 954(b)(4) of the Internal Revenue Code of 1954.

M, a domestic corporation, is the parent of a wholly-owned foreign subsidiary, S, a corporation organized under the laws of foreign country X in 1958. In 1968 S conducted extensive drilling operations in foreign country Y. Country Y did not have an income tax law, thus, S was not subject to an income tax or any other tax on earnings from operations in country Y. Country X did not impose an income tax or any other tax upon S's income earned during the taxable year 1968.

Section 951(a) of the Code provides, in pertinent part, that if a foreign corporation is a controlled foreign corporation for an uninterrupted period of 30 days or more during any taxable year beginning after December 31, 1962, every person who is a United States shareholder of such corporation and who owns stock in such corporation on the last day, in such year, on which such corporation is a controlled foreign corporation shall include in his gross income, for his taxable year in which or with which such taxable year of the corporation ends the sum of, except as provided in section 963 of the Code, his pro rata share of the corporation's subpart F income for such year.

Section 952(a) of the Code defines the term "subpart F income" to include, in the case of a controlled foreign corporation, the foreign base company income as determined under section 954 of the Code.

Section 954(a)(3) of the Code provides, in relevant part, that the term "foreign base company income" means the foreign base company service income for the taxable year.

Section 954(b)(4) of the Code, prior to its amendment by section 909 of the Tax Reform Act of 1969, Public Law 91-172, C.B. 1969-3, 10 at 152, provided an exception for foreign corporations not availed of to reduce taxes; that is, for purposes of section 954(a) of the Code, foreign base company income did not include any item of income received by a controlled foreign corporation if it was established to the satisfaction of the Secretary of the Treasury or his delegate with respect to such item that the creation or organization of the controlled foreign corporation receiving such item under the laws of the foreign country in which it was incorporated did not have the effect of substantial reduction of income, war profits, or excess profits taxes or similar taxes. The above provision applied to taxable years ending before October 10, 1969.

Section 1.954-1(b)(3)(iii) of the Income Tax Regulations provides, in relevant part, that the creation or organization of a controlled foreign corporation will be considered not to have the effect of substantially reducing income, war profits, excess profits, or similar taxes with respect to an item of foreign base company services income if the effective rate of such taxes paid to a country or countries for the taxable year in respect to such item of income by the controlled foreign corporation equals or exceeds 90 percent of, or is not as much as five percentage points less than the effective rate of tax that would have been paid for such year on the item of income to the country which, within the meaning of paragraph (c) of section 1.954-4 of the regulations, is the country where the services are performed, if, under the law of such country, all the income of the corporation for such year had been considered derived from sources therein from doing business through a permanent establishment in such country, received in such country, and allocable to such permanent establishment, and the controlled foreign corporation had been created or organized under the laws of, and managed and controlled in, such country.

Section 1.954-4(c) of the regulations indicates that the place where the services are performed will depend on the facts and circumstances of each case. Such section further provides that generally, the services will be considered to have been performed where the employees are physically located when working for the controlled foreign corporation.

In applying the mathematical test of section 1.954-1(b)(3)(iii)(b) of the regulations it is necessary to determine the country where the services are performed. In the instant case, for the purposes of section 954 of the Code, the drilling operations were performed in country Y.

In determining the mathematical test under section 1.954-1(b)(3)(iii)(b) of the regulations for services performed in country Y, once the source of the item of income has been determined (and the other assumptions made as to receipt, allocation of income, type of establishment, place of doing business, and place of creation, management, and control) the effective rate of tax is computed on the basis of the actual facts concerning the corporation. See section 1.954-1(b)(iv) of the regulations.

S has established as a fact that country Y would not have imposed an income tax on S's service income from operations in that country even if S had been created or organized under the laws of, and managed and controlled in country Y and therefore, section 1.954-1(b)(3)(iii) of the regulations applies. Accordingly, for purposes of applying the foregoing mathematical test had S been created, managed, or controlled in country Y, and had all of its income been from sources within country Y, an income tax or other similar tax would not have been imposed upon S by country Y for the taxable year 1968.

In the instant case, the effective rate of tax paid by S to countries X and Y for the taxable year 1968 on the income from the operation of drilling rigs was not as much as five percentage points less than the effective rate of tax that would have been paid, for the taxable years in respect to the income items from the drilling rigs to country Y, if all the income of S for each of the taxable years had been considered derived from sources within such country from doing business through a permanent establishment in such country as provided in section 1.954-1(b)(3)(iii)(b) of the regulations.

Accordingly, in the instant case, the creation or organization of S with respect to the items of income and taxable year 1968 under the laws of country X, in which it is incorporated did not have the effect of a substantial reduction of income, war profits, or excess profits taxes or similar taxes. Therefore, the items of income earned by S are not included within the term "foreign base company income," by reason of section 954(b)(4) of the Code.