Memo Urges IRS to Identify, Tax Hong Kong Subsidiary

U.S. Direct and Indirect Taxation of Certain Income Earned by an Apparent Hong Kong-Incorporated CFC

February 8, 2020

The Hong Kong Inland Revenue Board of Review¹ released on December 4, 2019, its decision in Case No. D25/17 (“Decision”), dated February 14, 2018. (A copy of this decision is attached.²) The decision, which covers the Hong Kong tax years from 1999/2000 to 2009/2010, involves an unidentified group that appears to be a U.S.-based multinational. This group is referred to in both this memorandum and the Decision as “Group A”.

The Hong Kong tax authority had argued that certain commission income and trading profits recorded by Group A's Hong Kong subsidiary (the “Appellant”) were taxable Hong Kong source income under the Inland Revenue Ordinance because they arose in or were derived from Hong Kong. In brief, based on the facts, the Board of Review decided that all such income and profits were sourced outside Hong Kong and not taxable under Hong Kong's territorial tax system. The facts supporting this were that certain procurement services generating commission income were conducted in Mainland China while activities generating trading profits (i.e., income from sales) were conducted by a related group member in Group A's home country. The Appellant's contention, which the court accepted after its review of evidence, was that:

“activities in Hong Kong are administrative, paper-pushing, filing and bookkeeping, and are not profit generating.”

The factual information documented in this decision establishes that the Appellant was engaged in a U.S. trade or business within the U.S. As such, Appellant was required to file Form 1120-F for years beginning from its 1999 incorporation and report thereon its effectively connected income.

This memorandum recommends that the IRS use its resources to identify Appellant³ and to determine whether Appellant has filed applicable Form 1120-F (U.S. Income Tax Return of a Foreign Corporation) for years beginning from its 1999 incorporation. If not, the IRS should impose tax on Appellant's effectively connected income (“ECI”) for each such year taking into account §§882(c)(2) (denial of deductions and credits if no tax return filed), 6501(c)(3) (open statute of limitations if no tax return filed), and 884 (branch profits tax). In addition, the IRS should determine whether the Appellant's U.S. shareholder's tax returns for years still open have included any applicable subpart F income.

This memorandum summarizes the relevant facts described in the Decision and discusses how these facts establish U.S. tax obligations.

Overall Assumption

The identity of Group A, the country of incorporation of Group A's parent (the country and parent referred to in the Decision and this memorandum, respectively, as “Country U” and “Company A3”), and whether Appellant is a controlled foreign corporation (“CFC”) are not disclosed within the Decision. Despite this, language in the decision strongly implies that A3 is incorporated in the U.S. The Decision discloses on page 10:

There is also language on page 21 that suggests home-country tax avoidance as an important reason for Group A's structuring and formation of Appellant.

“It is not disputed that the setting up of the Appellant and its inter-company arrangements with Company A1 have the effect of giving Group A tax benefit in Country U and avoided tax exposure of becoming a 'permanent establishment' in Country U. . . .”

Based on the above, this memorandum assumes that:

• Country U is the U.S.,

• Company A3, the parent company of Group A, is incorporated in the U.S., and

• Appellant is a CFC with its U.S. Shareholder being A3

Summary of Relevant Facts

Group A is engaged in the manufacturing and distribution of electric fans, heaters, and humidifiers for residential and commercial purposes. Sales are primarily made to mass merchandisers. Historically, Group A's main operating group member, Company A1, maintained in Country U (i.e., the U.S.) manufacturing operations, a design and engineering department, purchasing departments for domestic and foreign products and components, a quality assurance department, and a sales and marketing department.

From the mid-1980s, a Company A1 employee was assigned to spend time in Asia acting as a buyer conducting sourcing activities for Company A1's needs. The Decision specified that “Mr AF spent the majority of the year in Taiwan and travelled through Hong Kong on his way to Mainland China.”

The Appellant was incorporated in Hong Kong in 1999 and registered in mid-2003 a representative office in Shenzhen, which is in mainland China.

While the Decision includes few details, the Appellant maintained offices and personnel both in Hong Kong and its Shenzhen representative office.

Types of Transactions

The Decision sets out five types of transactions that Appellant conducted. They included:

• Procurement of Components 

  Prior to August 2005, the Appellant earned commission income from Company A1 based on components directly acquired by Company A1 from suppliers.

  From August 2005, the Appellant (presumably without any operational changes) sourced components from suppliers/contract manufacturers and sold them to Company A1.

• Sale of Finished Goods

  For finished goods shipped in all years (1999 through 2010) directly from Asian suppliers/contract manufacturers to third-party customers, the Appellant recorded the sales.

  Prior to August 2005 for Appellant's finished goods held in Company A1's warehouse in Country U (i.e., assumed to be the U.S.), Appellant recorded the sales.

  From August 2005, Appellant recorded as its sales all finished goods shipped to Company A1's warehouse in Country U. Company A1 then recorded as its sales shipments from its warehouse to third-party customers.

Intercompany Contracts Between Appellant and Company A1 Including 2005 Restructuring

These transactions reflected certain intercompany agreements that Company A1 and Appellant had executed. These intercompany agreements included:

• 1999 Agreements

  Buyer's Exclusive Agency Agreement

  This agreement governed the procurement services performed by the Appellant for Company A1's Asian purchases.

  On pages 13 and 14 of the Decision, there is a long list of procurement services, for which the Appellant received at the initiation of the agreement a one-time signing fee of US$1.2 million plus a 4% commission on Company A1's purchase of components.

  A “limitation of authority” clause is included that limits the authority of the Appellant in its representation of Company A1.

  Marketing and Distribution Agreement

  This agreement governed Company A1's sale activities performed for Appellant for finished product sales made by Appellant to third party customers in Country U (i.e. the U.S.).

  The Decision states that this Marketing and Distribution Agreement makes Company A1 the Appellant's exclusive agent and representative for the sale of finished products into Country U.

  On pages 14 and 15 of the Decision, there is a listing of Company A1's duties included in the Marketing and Distribution Agreement. For these services, the Appellant paid Company A1 a 5% fee based on the net invoice price for sales made.

  The Agreement also includes a “limitation of authority” clause providing that Company A1

  “does not have any authority to act for or to bind [the Appellant] in any way, to alter any of the terms or conditions of any of [the Appellant's] standard forms of invoices, purchases orders, warranties or otherwise, or to warrant or to execute agreements on behalf of [the Appellant] or to represent that [the Appellant] is in any way responsible for the acts, debts, liabilities or omissions of [Company A1].”

  This clause is presumably meant to arguably prevent the Appellant from having a U.S. trade or business.⁴ However, the Decision includes on page 4 a concise summary of the Appellant's factual situation that belies this “limitation of authority” clause as a sham. The Decision stated:

  “The Appellant's case was that the Commission Income and the Trading Profits are offshore income. The actual activities performed by the Appellant's personnel in respect of the five types of transactions that generated the Commission Income and the Trading Profits did not differ. The Appellant earned income by getting products (both finished goods and components) in Mainland China and elsewhere (but not Hong Kong) for sale in the North America. The sales activities were conducted in Country U by Company A1's Sales Department or other personnel on behalf of the Appellant. The Appellant did not have its own sales personnel. All the customers were located in the North America. The procurement and sourcing activities were done in Mainland China or other places in Asia (but not in Hong Kong). The Appellant earned the Commission Income by providing services outside Hong Kong under the Agency Agreement (as defined in paragraph 56).” [Emphasis added.]

  Commencing on page 24, the Decision describes the sales process in more detail. This description includes the fact that Company A1 in Country U under the Marketing and Distribution Agreement was engaged in soliciting, negotiating, and making sales on behalf of the Appellant. The Appellant had no sales management or other personnel in either Hong Kong or Shenzhen who had any real authority over the company's sales. Rather, personnel who had such authority were in Country U making business decisions on behalf of Appellant and sales contracts with third-party customers that contractually bound the Appellant.

• 2005 Restructuring: Additional Agreements

  The Decision describes the two new agreements, both of which were effective from August 1, 2005. From this date, while the Marketing and Distribution Agreement remained in full effect, the Buyer's Exclusive Agency Agreement was no longer relevant and was presumably cancelled.

  The two new agreements were:

  Development and Technology Agreement

  The Decision describes what must be a cost sharing agreement meant to qualify as such under Reg §1.482-7. It notes the sharing of various costs calculated in accordance with the standards set out in the Company BJ-prepared transfer pricing studies. Those various costs include “product design, development and engineering, testing, safety, quality control processes and procedures; and intellectual property rights etc.”

  The Decision makes no mention of whether the Development and Technology Agreement included any buy-in by Appellant of the intangibles existing as of the August 1, 2005, effective date.

  Purchase and Sale Agreement

  The Decision simply explains that the agreement provides that the Appellant would produce and sell as manufacturer to Company A1 components and finished products on a sole and exclusive source basis.

  Under this new Purchase and Sale Agreement, the gross profit on sales to Company A1 earned by the Appellant would be determined by a benchmarking formula for the purpose of achieving an arm's length pricing structure. Presumably, this pricing structure resulted in Appellant's profit level reflecting Appellant's ownership of relevant intangibles, its manufacturing functions, and the commercial and financial risks it contractually assumed. Likely, the profit level within Company A1 from its U.S. distribution function was not much more than that of a limited-risk distributor. As such, the bulk of Group A's profits on the manufacturing and sale of products to third-parties would be reported by Appellant.

  These new contractual arrangements put into place the now commonly seen profit-shifting structure under which intangibles are transferred to a zero or low-taxed CFC followed by that CFC acting contractually within the group as a manufacturer earning a level of profits that is commensurate with manufacturing functions and risks and the CFC's ownership of applicable intangible rights. It seems likely that few or no operational changes accompanied the contractual changes.

  The Decision on pages 15 and 16 described background to the structural changes and the two new agreements that Group A executed between Appellant and Company A1.

  “There was a change in the legal structure for the sourcing activities undertaken by the Appellant with effect from 1 August 2005 for tax and accounting reasons. The change was based on a study conducted by Company BJ on inter-company transfer pricing policy for the compliance of Country U tax regulations in 2006. Based on Company BJ's recommendations in this study, Company A1 and the Appellant entered into the Purchase and Sale Agreement ('Purchase & Sale Agreement') and the Development and Technology Agreement ('D&T Agreement').”

  Prior to the changes, Appellant solely performed procurement services for Company A1 under the Buyer's Exclusive Agency Agreement. From August 2005 following the execution of the new contractual arrangements, Appellant acted as a manufacturer and principal sourcing all components and finished products from its Asian sources. It then sold all components and finished goods recording its own sales revenue.

  Regarding components from August 2005, Appellant sold directly to Company A1.

  Regarding finished products from August 2005, Appellant sold directly to Company A1 only where delivery was to be made to Company A1's warehouse. Company A1 would then record later sales to customers. If a customer desired delivery directly from Asia, then the Appellant would make the sale to that customer and record the full sales revenue. While the Decision indicates that such sales were made to North America, presumably most sales were to Country U, which would therefore be for use, consumption, or disposition within the U.S.

  It was noted above that the Decision describes Company A1 as the main operating unit of Group A in Country U and that it has, among other departments, the Group's design and engineering department, the imports purchasing department, and the quality assurance department. Company A1 management and personnel must also be involved on a day-to-day basis in deciding on many product and production issues, negotiating specifications and terms including pricing/quantities/timing with third-party component makers and contract manufacturers, and giving guidance and direction to those third-party component makers and contract manufacturer either directly or indirectly through the Appellant's Shenzhen personnel. While the Decision is not explicit about all of Appellant's personnel that work in the Shenzhen representative office, it does seem very likely that much, if not the bulk, of the production support functions, such as those described above and in Reg §1.954-3(a)(4)(iv)(b), continue to be performed by Company A1 personnel and not by Appellant's personnel in Shenzhen. See below section “Active Management and Conduct of Appellant Procurement Business by Company A Personnel”.

  It is typical in structures like this that a foreign group member like Appellant is contractually manufacturing as a principal (often labeled an “entrepreneur”), but can only do so with the support of one or more of its U.S. group members who perform critical and core manufacturing functions, such as those described in Reg §1.954-3(a)(4)(iv)(b). In such cases, there will normally be an intercompany service or other agreement under which applicable U.S. group members charge the foreign group member service fees for the activities and functions conducted. The Decision makes no mention of any such intercompany agreement.

Active Management and Conduct of Appellant Procurement Business by Company A Personnel

Setting the tone on page 21, the Decision provides an important part of Appellant's rationale for the non-Hong Kong source of its income by saying:

“We accept the Appellant's evidence that its senior management personnel were all based in Country U. . . .”

An example from the Decision shows how much more than mere policy direction was being provided from Country U. The Decision provides details on Mr E, who held at various times both Company A1 and Appellant positions as well as being a director of Appellant. From Country U, Mr E was responsible for procurement and purchasing from both domestic and foreign suppliers. The Decision states on page 22:

“Mr E was formally Position BD of the Appellant in 2002, and he focussed entirely on the procurement in Asia. Both Mr B and Mr E testified that before and after 2002, Mr E was in charge of the Appellant. He had general responsibility for the suppliers. These are the works within the operation of the Appellant. . . .

“We find that Mr E was in charge of the Appellant, both before and after 2002 and what he had done, insofar as they relate to the Appellant, were done for the account of the Appellant.”

Later, on page 24, after describing Appellant personnel who perform their procurement and quality control work in mainland China, the Decision summarizes saying:

“These procurement and sourcing works were performed outside of Hong Kong by the Appellant's employees or Company BH engaged by the Appellant.

“For completeness, although the negotiations with the suppliers were done by the Appellant's employees in Mainland China, the final choice of suppliers and the terms were decided by Mr E and/or Ms D in Country U. . . .”

There is additional extensive detail in the Decision on pages 21ff and on page 32 covering procurement. There is no need to repeat it in detail here.

The above describes the procurement activities. Prior to August 2005, certain of these activities were performed as services for Company A1 under the Buyer's Exclusive Agency Agreement. Since Appellant also sold finished products to North American customers during this pre-August 2005 period both via direct shipment from Asian sources and indirectly from inventory held for Appellant by Company A1 in Country U, some of these activities were for Appellant's own benefit.

From August 2005, these procurement activities were solely for Appellant's own benefit since they sourced the components and finished products that Appellant would sell to some North American customers and to Company A1 under the Purchase and Sale Agreement. Because of the Appellant's rights to relevant intangibles under the Development and Technology Agreement, the Appellant for finished products (and perhaps some components) is contractually a “manufacturer” and is not merely purchasing and reselling.

Conduct of Appellant's Sales Business by Company A Personnel

The Decision summarizes on pages 24-25 the situation applicable to the third-party sales made by Appellant, saying:

“All the sales activities of the Appellant were conducted in North America as all the customers of Group A were there. The Appellant does not have its own sales department nor sales personnel. It relied entirely on Company A1's Sales Department for the sale of its finished goods to third-party customers.

“Company A1's Sales Department was headed by Mr AE. The sales teams and sales representatives contacted the customers, negotiated with them on the products to be sold and the terms of sale, and concluded the sales contracts or orders with the customers.

“The Sales Department was also responsible for warehousing products, pending delivery, arranging delivery of products within the North America, invoicing and collecting payment and providing warranty and service support.

“Mr AE approved and conducted the sales contracts on behalf of the Appellant.” [Emphasis added.]

Concluding its fact finding on page 29, the Decision states:

“. . . Having considered the evidence before us, we are satisfied that the relevant sales activities performed by the Company A1 personnel in Country U were done on behalf of and for the account of the Appellant pursuant to the instructions of the Appellant under the relevant inter-company agreements and arrangements between them [i.e., the Marketing and Distribution Agreement], and such activities had been ratified by the Appellant. As such, these acts are attributable to the Appellant.”

The above concerns Appellant's sales to third-party customers, which occurred in all years covered by the Decision. What about Appellant's sales to Company A1, which occurred from August 1, 2005, following the execution of the Purchase and Sale Agreement? What evidence is there regarding who and where the sales activities take place for these related party sales?

The following section, “Issuance of Purchase Orders”, explains how Company A1 decides what is to be ordered and communicates that through Appellant's personnel to the suppliers. Formal purchase orders are only prepared later. Appellant's personnel in China are intermediaries at best in this process. The Decision also notes on page 31 with regard to intercompany orders and sales:

Especially considering that Appellant had no sales personnel of its own, it seems fair to say that any decisions on Appellant's sales to Company A1 were made by Company A1 personnel in Country U on behalf of Appellant.

As a final point in this section on Appellant's sales, the Decision explains on page 31 that a Hong Kong employee of Appellant or the Appellant's accountant prepares invoices for commissions earned or sales made to Company A1 only upon instructions from a Company A1 employee.⁵

Issuance of Purchase Orders

Pages 29-30 of the Decision describe the process under which purchase orders were issued to suppliers.⁶

Company A1 personnel made purchase decisions based on Company A1 information and communicated those decisions to the Appellant's sourcing personnel who passed them on to suppliers. These were binding orders that suppliers acted upon. In some earlier years, Appellant's personnel also typed up formal purchase orders after the fact. In later years, the after-the-fact purchase orders were prepared by Company A1 in Appellant's name and emailed to Appellant's sourcing personnel who would presumably pass them on to suppliers.

In short, Appellant's personnel in Hong Kong and the Shenzhen representative office were not involved in any meaningful manner beyond acting as intermediaries passing binding orders on to suppliers or typing up an after-the-fact formal purchase order to reflect the binding order already communicated.

U.S. Tax Consequences for Appellant⁷

The IRS has typically attacked aggressive structures such as that described in this memorandum through transfer pricing adjustments and re-characterization. It seems clear that either type of adjustment could be appropriate for these Group A arrangements. A few examples of possible adjustments for Group A are provided at the end of this memorandum.

Despite this typical use by the IRS of transfer pricing and re-characterization, this memorandum is focused primarily on the application of ECI taxation to Appellant. As a practical matter, because the coverage of the Decision is from 1999 to 2010, all corresponding taxable periods of U.S. group members are very likely already closed. This practical reality means that it is not possible to apply transfer pricing and re-characterization adjustments to these early years, and probably many of the subsequent years as well. However, if Appellant has filed no Form 1040-F (U.S. Income Tax Return of a Foreign Corporation) for any of these or subsequent taxable periods (which is very likely to be the case), then all such Appellant taxable periods are still open for application of ECI taxation.⁸

Because of this ECI focus and this practical point regarding open taxable periods, the memorandum assumes that the IRS has not attempted to make any re-characterization adjustments to Group A's corporate and contractual structuring or any transfer pricing adjustments. Even if the IRS has made transfer pricing adjustments that lower Appellant's profits in any year or years, that reduced level of profit would still be subject to ECI taxation as described herein. Transfer pricing adjustments and ECI taxation can work together; they are not mutually exclusive.

ECI Taxation Regime

The remainder of the discussion on ECI taxation in this memorandum shows that Appellant has certain income that will be U.S. source income under §865(e)(2) that will be ECI under §864(c)(3). Any such income will be directly taxable to Appellant under §882 (tax on income of foreign corporations connected with United States business), taking into account §882(c)(2) (denial of deductions and credits if no tax return filed). In addition, the §884 branch profits tax will apply at the statutory 30% rate since there is no tax treaty between the U.S. and Hong Kong that would exempt or lower this statutory rate. Again, under §6501(c)(3), each prior year back to the 1999 formation of Appellant will still be open if Appellant filed no tax return (Form 1120-F) for that year.

Appellant Engaged in a Trade or Business within the U.S.

It is crystal clear that Appellant was engaged in a trade or business within the U.S. (§864(b)), which is a prerequisite for ECI taxation. The following supports this.

• In all years Mr E worked in Country U; he did not work from the Appellant's offices in either Hong Kong or Shenzhen. For some years, Mr E held a position with Appellant as well as being a director of the company. This means that Appellant had a management level employee and director working in the U.S. from the offices of Company A1.

• Company A1, as Appellant's exclusive agent and representative for the sale of finished products into Country U, conducted the Appellant's business on a daily basis. Company A1 made business decisions for Appellant, and contracted in Appellant's name with third-party customers. The Decision makes clear that Company A1 and the Appellant ignored the “limitation of authority” clause in the Marketing and Distribution Agreement, which was effective for all years covered by the Decision. Further, this provision was a sham and truly disingenuous because Appellant had no management personnel located in either Hong Kong or Shenzhen who had the authority or were capable of providing the commercial and risk assessments necessary to make pricing, credit, and other decisions regarding the sale of finished goods.

More bullet points could be added from the detail in the Decision. However, given the black-and-white situation, doing so is unnecessary. It may simply be said that case law is clear that the regular activities of an agent (even without authority to conclude contracts on behalf of the foreign principal) is more than enough to create a trade or business in the U.S. Company A1 was a contractual agent of Appellant. Appellant even had its own management-level employee working from Company A1's offices. Appellant was engaged in a trade or business in the U.S. for all years.

Office or Other Fixed Place of Business of the Appellant in the U.S.

The existence of an office or other fixed place of business of the Appellant in the U.S. is one of several criteria set out in §865(e)(2) necessary for finding U.S. source income, and thus ECI, in regard to income from sales activities. Under §865(e)(3), the principles of §864(c)(5) apply in determining whether a taxpayer has an office or other fixed place of business. Such principles are set out in Reg §1.864-7.

It is clear that Appellant had such an office for all years under the following provisions of Reg §1.864-7:

• Reg §1.864-7(b)(2) Fixed Facilities

  Mr E as an employee and director of Appellant worked from the offices of Company A1. His work on behalf of Appellant was not in any way “relatively sporadic or infrequent” as required by the regulation.

• Reg §1.864-7(c) Management Activity

  Appellant's day-to-day business was run from the offices of Company A1. Further, Appellant had no “chief executive officer, whether or not he is also an officer of the domestic parent corporation, who conducts the day-to-day trade or business of the foreign corporation from a foreign office.” Under these conditions, Reg §1.864-7(c) makes clear that there was an office or other fixed place of business in the U.S.

• Reg §1.864-7(d) Dependent Agents

  The overall facts including the sham nature of the “limitation of authority” clause in the Marketing and Distribution Agreement made Company A1 Appellant's dependent agent. Further, prior to August 1, 2005, Company A1 held Appellant's inventory from which it regularly made sales. Given these facts, Company A1's offices constituted an office or other fixed place of business of Appellant.

• Reg §1.864-7(f) Office or Other Fixed Place of Business of a Related Person

  The facts and circumstances show that Appellant is engaged in trade or business in the United States through the offices of Company A1.

It may be added that the various examples in Reg §1.864-7(g) are all consistent with the above discussion and conclusion.

Appellant's Income Attributable to its Office or other Fixed Place of Business in the U.S.

A foreign taxpayer's income from any sale of personal property (including inventory property) must be attributable to its office or other fixed place of business in the U.S. to be sourced in the U.S. under §865(e)(2). Under §865(e)(3), the principles of §864(c)(5) apply in determining whether a sale is attributable to such an office or other fixed place of business. Such principles are set out in Reg §1.864-6.

In brief, Reg §1.864-6(b)(1) provides that income will be attributable to an office or other fixed place of business of a foreign taxpayer “only if such office or other fixed place of business is a material factor in the realization of the income, gain, or loss, and if the income, gain, or loss is realized in the ordinary course of the trade or business carried on through that office or other fixed place of business.”

Reg §1.864-6(b)(2)(iii) provides rules for determining whether this material factor condition is met for the sale of goods or merchandise through a U.S. office. The general rule is that:

“the office or other fixed place of business actively participates in soliciting the order, negotiating the contract of sale, or performing other significant services necessary for the consummation of the sale which are not the subject of a separate agreement between the seller and the buyer.”

The Decision determined as fact that Company A1 in Country U under the Marketing and Distribution Agreement was engaged in soliciting, negotiating, and making sales on behalf of the Appellant for sales to third-party customers. The Appellant had no sales management or other personnel in either Hong Kong or Shenzhen who had any real authority over the company's sales. Rather, personnel who had such authority were in Country U making business decisions on behalf of Appellant and sales contracts with third-party customers that contractually bound the Appellant.

Such sales meet the material factor condition and are attributable to Appellant's office or other fixed place of business within the U.S.

Following the August 1, 2005, restructuring, Appellant initiated making certain intercompany sales to Company A1. Concerning these intercompany transactions, the Decision stated that a Hong Kong employee of Appellant or the Appellant's accountant would prepare invoices for commissions earned or sales made to Company A1 only upon instructions from a Company A1 employee. Considering that all commercial decisions regarding the sourcing of products in Asia through Appellant were made by Company A1 personnel in the U.S., along with the lack of any Appellant personnel with sales authority, these intercompany sales should be treated as being attributable to the office or other fixed place of business within the U.S.

Inapplicability of §865(e)(2)(B) Exception

The Decision states that all sales were made to customers in North America. As such, some of those sales could have been made for use, disposition, or consumption in Canada or Mexico. The exception to U.S. source treatment in §865(e)(2)(B) potentially applicable to these Canadian and Mexican sales requires that there be material participation in the sale by an office or other fixed place of business of the taxpayer (Appellant) in a foreign country. Given that the Decision states that Appellant had no sales management or other sales personnel in either Hong Kong or Shenzhen, there could have been no material participation. As such, the §865(e)(2)(B) exception will not apply.

Is Appellant Conducting Production Activities?

As explained in the explanatory material in REG-100956-19 (released December 23, 2019), the Treasury and the IRS believe that the application of ECI taxation through the operation of §865(e)(2) differs between inventory purchased and sold by the foreign taxpayer and inventory produced and sold. In the case of the former (purchase and sale), 100% of the income from the sale is attributed to the office or other fixed place of business in the U.S. In the case of the latter (produced and sold), REG-100956-19 says on page 27:

“With respect to inventory produced and sold by a nonresident in a sale attributable to an office or other fixed place of business in the United States and subject to section 865(e)(2), the Treasury Department and the IRS have determined that the disposition continues to give rise to gross income that is partly allocable to the nonresident's office or other fixed place of business in the United States (representative of the sales activity with respect to the transaction) and sourced under section 865(e)(2), with the remainder allocable to production activity and sourced under section 863(b).”

This treatment applies both before and after the TCJA change to §863(b). As such, it applies to all years covered by the Decision.

It was noted earlier in this memorandum that the Appellant from August 1, 2005, is contractually a manufacturer. This is primarily based on Appellant's ownership of relevant intangibles under the Development and Technology Agreement. As a result of this contractual status, the bulk of profit was recorded in Appellant to reflect its ownership of intangibles, its conduct (if any) of production activities, and its assumption of commercial and financial risks.

Considering the very limited production activities conducted by the Appellant's direct employees from its Shenzhen representative office (i.e. liaison with suppliers and contract manufacturers, quality control and inspection, etc.), this writer believes that Appellant should be treated as having factually purchased and sold its inventory. With this treatment, 100% of its income attributable to its office or other fixed place of business within the U.S. will be U.S. source and subject to ECI taxation.

In the event that the IRS were to decide to treat Appellant as having produced and sold the relevant property, then the rules of Reg §1.863-3(c) would be applied to determine the source of income attributable to production activities. Considering that many of these functions were performed by departments within Company A1 within the U.S., some significant portion should be U.S. source under the §1.863-3(c) rules.

It should be recognized that Reg §1.863-3(c)(1)(i)(A) (Prop Reg §1.863-3(c)(1)(i) after the changes in REG-100956-19) provides that only production activities conducted directly by the taxpayer are taken into account. This of course suggests that the production activities conducted by Company A1 would be ignored. Reg §1.863-3(c)(1)(iii) (Prop Reg §1.863-3(c)(3) after the changes in REG-100956-19), fortunately, provides an anti-abuse rule that should be applied in this case so that the U.S. production activities of Company A1 are included in the sourcing determination.

Subpart F Issues

Because the application of subpart F results in income inclusions by U.S. shareholders, subpart F will only be relevant for years that are still open for Group A's U.S. group members. At this point in January of 2020, it seems likely that all years covered by the Decision (1999 through 2010) will be closed. More recent subsequent years, though, should still be open. In the event that the IRS chooses to identify and audit Group A's foreign structuring involving Appellant, then the following should be considered for years that are still open during which the Group continued the structural arrangements involving Appellant described in the Decision.

Part III of Notice 97-40 (IRB 1997-28, page 6, July 14, 1997) provides, in part:

“. . . the Service will continue to treat Hong Kong and China as separate countries on and after July 1, 1997, for purposes of the Code and regulations, including subpart F. . . .”

In general, ECI taxation takes precedent over subpart F. Because of the U.S. source treatment of income from sales described in §865(e)(2) and its inclusion in ECI by §864(c)(3), such income is excluded from subpart F income by §952(b).

As a result of ECI priority, subpart F will only be relevant if income is identified that is factually not attributable to Appellant's office or other fixed place of business in the U.S. For the sake of discussion, assume that the IRS were to decide that intercompany sales made by Appellant to Company A1 were not attributable to Appellant's office or other fixed place of business within the U.S. In this case, the relevant income would meet the conditions of §954(d)(1) to be treated as foreign base company sales income.

In short, as applicable to Appellant, the two conditions are

Under the facts described in the Decision, none of the property was manufactured in Hong Kong; most or all was manufactured in China. As such, under the position expressed in Notice 97-40, the first condition is met. The second condition is, of course, met as well since it is assumed that only sales to Company A1 have been excluded from ECI taxation.

The only exception to foreign base company sales income treatment would be if the manufacturing exception of Reg §1.954-3(a)(4) were to apply. In this regard, Appellant does not itself conduct any physical manufacturing. It does, though, conduct some very limited functions described in Reg §1.954-3(a)(4)(iv)(b). Given, though, the very limited nature of functions performed by Appellant's employees, Appellant should not be seen to rise to the level of making a substantial contribution to the manufacturing of personal property as that term is defined in Reg §1.954-3(a)(4)(iv). As such, the manufacturing exception should not apply.

Examples of Re-Characterization and Transfer Pricing Adjustments Potentially Applicable to Company A1 and Appellant (See reference to this section in first paragraph on page 10 above)

• Company A personnel conduct the business of Appellant and Appellant's personnel act at the direction of Company A. As such, it would be appropriate to re-characterize Appellant so as to treat it as an agent of Company A.

• The one-time signing fee of US$1.2 million under the Buyer's Exclusive Agency Agreement in 1999 at the incorporation of Appellant may be more than slightly overstated. Or, the payment should be re-characterized as equity capitalization of Appellant.

• No mention was made of any buy-in payment at the time of the 2005 Development and Technology Agreement. If the intangibles transferred had any value (which is likely to be the case), then there should have been a buy-in payment under Reg §1.482-7A(g).

• Sales by Appellant to third-party customers in all years as well as sales to Company A1 following the 2005 restructuring place the bulk of profits in Appellant with only limited sales commissions being recognized by Company A1 under the Marketing and Distribution Agreement. There was no mention in the Decision of any inter-company agreement under which Appellant would pay Company A1 for its contribution to the sourcing/production of the components and finished products. Further, in years prior to the 2005 restructuring when Appellant acquired intangibles under the Development and Technology Agreement, there should have been royalties or other compensation paid by Appellant to Company A1 for the rights to source/manufacture products and sell to third-party customers in North America. Considerable transfer pricing adjustments may be appropriate.

Attachment:

Hong Kong Inland Revenue Board of Review decision Case No. D25/17, dated February 14, 2018, released December 4, 2019, available at https://www.info.gov.hk/bor/en/docs/D2517.pdf