Firm Suggests Project on Subpart F Commodities Rules for Guidance Priority List

This letter responds to the request in Notice 2009-43 for taxpayers to propose items for inclusion on the 2009-2010 Guidance Priority List (the "Business Plan"). On behalf of a client, we respectfully request that the Treasury Department and Internal Revenue Service (the "Service") include on the Business Plan a guidance project concerning the subpart F commodities rules of section 954(c), which were amended by the American Jobs Creation Act of 2004 (the "2004 Jobs Act"),¹ and in particular, the application of these rules to income earned from the production and sale of electric power.

I. Background on the Commodities Rules and 2004 Jobs Act Amendments

The subpart F provisions of the Code generally require a U.S. shareholder of a controlled foreign corporation ("CFC") to include in income on a current basis its pro rata share of the CFC's subpart F income.² Subpart F income is comprised of several different categories of income, including foreign personal holding company income,³ which in turn includes the "excess of gains over losses from transactions (including futures, forwards, and similar transactions) in any commodities."⁴ The commodities rules also contain an exception (the "Commodities Exception") for gains or losses from transactions in commodities which "are active business gains or losses from the sale of commodities, but only if substantially all of the [CFC's] commodities are property described in paragraph (1), (2), or (8) of section 1221(a) [relating to the definition of a capital asset]."⁵

The Commodities Exception was amended by the 2004 Jobs Act, which removed the requirement under prior law that limited the exception to active sales by a CFC if substantially all of its business was as an "active producer, processor, merchant or handler of commodities," replacing it with the references to section 1221 noted above. (For convenience we refer to the deleted provision as the "producer/processor rule.") The application of the Commodities Exception after the 2004 Jobs Act changes and the current regulations implementing the prior version of the exception present several issues for which additional guidance is required. Further, these rules raise particular difficulties when applied to the production and sale of electric power.⁶

II. Need for Administrative Guidance

The elimination of the producer/processor rule by the 2004 jobs Act presents substantial uncertainty to taxpayers with respect to the existing regulations' implementation of the Commodities Exception as they were promulgated under the old rule.⁷ First, it is unclear to what extent the language of the current regulations continues to provide relevant guidance. The difficulty here is that the structure of the current regulation effectively combines the "active business" component of the statutory language (which remains unchanged) with the former producer/processor rule, resulting in substantial ambiguity as to the precise scope of the regulation following the elimination of the producer/processor rule.

Second, even to the extent that certain provisions of the current regulations remain applicable, those provisions are stated in general terms, requiring that the CFC incur "substantial" expenses, and undertake "substantial" activities. The regulations provide no further guidance concerning the application of these vague standards, and there is virtually no secondary guidance that would give these rules more content by applying them in specific factual circumstances. As a result, a taxpayer planning a significant investment in a power-production facility may find it difficult to predict with any certainty that the Service will agree that its activities and expenses are "substantial."⁸ This is in contrast to a CFC producing goods other than commodities which would not be subject to any such requirement in determining whether the sale of its goods produces subpart F income.

The resulting uncertainty as to the U.S. tax impact is particularly problematic for a power production business, given the significant up-front investment required to construct or acquire a facility, obtain required regulatory approvals, assemble and train a workforce, etc. These up-front costs must be recovered over a significant number of years, and as a result multiple-year financial projections are an important part of any decision to invest in a particular facility. The significance of the forecasted U.S. tax treatment of a facility is heightened in the common circumstance in which a U.S.-based company is engaged in a competitive bidding process against other potential operators of the planned facility. In these situations, the ability of the U.S. bidder to forecast the long-term tax cost of the project with reasonable accuracy is central to its ability to bid competitively for the project.

Furthermore, the general ambiguity of the existing regulation's active business rules can be exacerbated when the level of activity in a power production business is limited after the construction of a facility, based on the nature of the production technology being used. For example, alternative methods of power production, such as solar facilities and wind farms, tend to be more efficient and environmentally friendly than coal or nuclear plants and yet require a lower level of activity after construction. While operating such facilities constitutes an active power production business, the absence of traditional expenses such as inputs (e.g., coal or natural gas) and the reduced need for operating personnel in these situations raise issues about whether the level of activity or expenses is "substantial" in any given case. The significance of the uncertainty in the case of these alternative production methods will only grow as electricity producers continue to expand their use of environmentally friendly means of production.

Finally, the current Commodities Exception applies only if "substantially all" of the CFC's commodities constitute certain categories of property, which is problematic when applied to electricity due to its ephemeral nature. Although the current regulations implement the statutory requirement with a test based on gross receipts, it is unclear whether this approach is still applicable under the new statutory language.⁹ One possible interpretation of the amended provision could require a computation of the value of a CFC's commodities at some specified point, such as the end of the year. While this may be a relatively straightforward computation in the case of most commodities, it raises interesting issues for electricity, which requires instantaneous delivery and cannot be stored. For example, consider an electricity producing CFC that owns a small amount of commodities other than electricity at the end of a taxable year that do not satisfy the section 1221 requirements. Although the value of these other commodities may be insubstantial relative to the total value of electricity produced during the course of a year, the CFC arguably may not qualify for the exception if the value of those commodities were greater than the "snapshot" of the electricity held by the CFC at that particular moment in time.

III. Conclusion

For the reasons discussed above, we respectfully request that the Business Plan for next year include a guidance project concerning the subpart F commodities rules, and in particular, to address the issues that arise when the requirements of the Commodities Exception are applied the production of electric power.

Please feel free to contact us to discuss the issues addressed in this letter or if we can provide any additional information regarding this matter.

Unless otherwise indicated, all section references herein are to the Internal Revenue Code of 1986, as amended (the "Code"), and to the Treasury regulations promulgated thereunder.

² Section 951(a). A U.S. shareholder is a U.S. person that owns ten percent or more of the total combined voting power of all outstanding stock of a CFC. Section 951(b).

³ Section 954(c).

⁴ Section 954(c)(1)(C); see also Treas. Reg. § 1.954-2(f)(1)(i).

⁵ Section 954(c)(1)(C)(ii). Section 1221(a)(1) applies to inventory and similar property, section 1221(a)(2) applies to depreciable property and real property used in a trade or business, and section 1221(a)(8) applies to supplies used in a trade or business.

⁶ There is no authority under section 954 addressing whether electricity is a commodity for this purpose. Although it is unlikely that income from electricity production was intended to be included in subpart F income, it is possible that electricity satisfies the definition of a "commodity" as set forth in the current regulations: "tangible personal property of a kind that is actively traded or with respect to which contractual interests are actively traded." Treas. Reg. § 1.954-2(f)(2)(i).

⁷See Treas. Reg. § 1.954-2(f).

⁸ This uncertainty can be heightened when a CFC engages a service provider to perform certain functions, since such activities do not generally count in applying the regulation's substantial activity test. Given the increasing technical sophistication of power production facilities, engaging specialized service providers to perform technical functions is increasingly common. Even if the specialized provider is a related entity whose services may generally be taken into account under the related party rule of Treasury regulation section 1.954-2(f)(2)(iii)(D), that rule requires that the related party be "supervised on a day-to-day basis by" the hiring CFC, which may raise issues when the related party has been hired precisely because it has specialized technical capabilities that the hiring CFC does not have.

⁹ The legislative history accompanying the amendment states that for purposes of applying this "substantially all test", "it is intended that the 85-percent requirement provided in the current Treasury regulations (as modified to reflect the changes made by the provision) continue to apply." H.R. Conf. Rep. 108-755, at 387, n. 247.