Rev. Rul. 82-226

ISSUE

What is the proper method of computing the mathematical safe-harbor test under section 1.954-1(b)(3)(iii)(b) of the Income Tax Regulations to determine whether certain services income of a controlled foreign corporation (CFC) is foreign base company services income that is taxable to the CFC's U.S. shareholder under subpart F?

FACTS

P, a domestic corporation, owns all of the stock of FS, a foreign corporation incorporated in foreign country FC. FS is a controlled foreign corporation within the meaning of section 957(a) of the Internal Revenue Code.

In 1981 FS performed construction services under a contract in foreign country FD (the FD contract) on behalf of a related person within the meaning of section 954(e) of the Code. FS performed similar services under another contract in foreign country FE (the FE contract) also on behalf of a related person within the meaning of section 954(e).

Neither FC nor FD imposes an income tax. FE imposes an income tax at the rate of 25 percent of the first 100x of net income and 50 percent of all net income in excess of 100x.

During 1981 FS earned 100x net income from the FD contract. Because neither FC nor FD imposes an income tax, FS paid no income tax to FC or FD. Also in 1981, FS earned 100x of net income from the FE contract. FS did not pay any income tax on this income to FC but did pay an income tax to FE of 25x based on the 25 percent rate of tax in FE.

LAW AND ANALYSIS

Section 951(a)(1) of the Code requires that a United States shareholder of a CFC must include in his gross income for the taxable year his share of the subpart F income of the CFC. Under section 952(a)(2), "subpart F income" includes foreign base company income, and under section 954(a)(3) a component of subpart F income is foreign base company services income.

Section 954(e) of the Code provides that the term "foreign base company services income" means income derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, or like services that are performed on behalf of any related person, and that are performed outside the country under the laws of which the CFC is created or organized.

Section 954(b)(4) of the Code, however, provides that foreign base company income does not include any item of income received by a CFC if neither the creation or organization of the CFC, nor the effecting of the transaction giving rise to the income through the CFC, has as one of its significant purposes a substantial reduction of income, war profits, excess profits, or similar taxes.

Section 1.954-1(b)(3)(iii) of the regulations provides:

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 5 percentage points less than--

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(b) In the case of an item of foreign base company services income . . ., the effective rate of income, war profits, excess profits, or similar taxes that would have been paid for the taxable year in respect to the item of income to the country which . . . 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. [Emphasis Added.]

Under the foregoing provisions, the United States shareholder of FS will not be required to take into gross income as subpart F income its share of the construction services income earned by FS under the FD and FE contracts if the terms of the safe-harbor provision in section 1.954-1(b)(3)(iii)(b) of the regulations are satisfied. The mathematical computation required under this regulation depends on the meaning of two terms set forth in section 1.954-1(b)(3)(iii)(b)--"item of foreign base company services income" and "all the income of the corporation."

First, the term "item of foreign base company income" means the income earned separately, such as under each contract involved in this case. An item of income refers to a separate and specifically identifiable income receipt that can be distinguished from other income receipts on the basis of its source, the underlying transaction, or any other meaningful aspect. See section 1.954-1(b)(3)(viii), Ex. (1) and Ex. (2) of the regulations. An example of an underlying transaction is a contract to provide services. Accordingly, income earned by FS under the FD contract is a separate item of income from the income earned by FS under the FE contract.

The second term "all the income of the corporation" concerns the comparison required under section 1.954-1(b)(3)(iii)(b) of the regulations between the effective rate of tax paid on an item of services income and the rate of tax that would have been paid on all the income of the corporation had the CFC been created in the country in which the services were performed (the hypothetical rate). All the income of the corporation means all of the income of the CFC from whatever source derived, regardless of the country in which the income originated or the nature of the generating transaction. Under section 1.954-1(b)(3)(iii)(b) of the regulations, FS is treated as if all of the income it earned is derived from sources within FE from a permanent establishment doing business in FE.

Thus, the first item of income earned by FS is the 100x earned under the FD contract. Because FS pays no tax to FD on this income, nor would FS pay any tax if it had incorporated in FD, the effective rate and the hypothetical rate are equal. Therefore, the service income earned by FS in FD is excluded from subpart F income under section 954(b)(4) of the Code because it comes within the mathematical safeharbor test in section 1.954-1(b)(3)(iii)(b) of the regulations.

The other item of income earned by FS is the 100x earned under the FE contract. FE imposed a tax on this income at the rate of 25 percent and FS paid a tax of 25x. If FS had incorporated in FE it would have paid a hypothetical effective rate of tax of 371/2 percent on all of the income of the corporation. This hypothetical effective is arrived at by combining the FE tax rates of 25 percent on the first 100x, or an amount of 25x, and 50 percent on the 100x income in excess of the first 100x, or 50x. The total hypothetical tax liability of FS to FE is 75x, or a hypothetical effective rate of 371/2 percent. Because the effective rate of tax paid to FE (25 percent) is less than 90 percent of, and is more than 5 percentage points less than the hypothetical effective rate (371/2 percent), the FE contract service income earned by FS in FE fails the mathematical safe-harbor test of section 1.954-1(b)(3)(iii)(b) of the regulations and remains subpart F income.

HOLDING The mathematical test under section 1.954-1(b)(3)(iii)(b) of the regulations must be applied to each separately identifiable income receipt of a CFC, and the income of the CFC that is to be taken into account in applying the test is all of the income of the CFC from whatever source derived.