Retired CPA Identifies Several Projects for Priority Guidance Plan

July 16, 2020

Internal Revenue Service
Attn: CC:PA:LPD:PR (Notice 2020-347) Room 5203
P.O. Box 7604
Ben Franklin Station
Washington, D.C. 20044

Re: Notice 2020-47, 2020-2021 Priority Guidance Plan

Dear Sir or Madam:

I am a retired CPA who has worked both domestically and internationally for many years. Based on my working experience with numerous clients and my studies over the past decade both as an academic and in connection with my published articles, I have identified several projects that should be considered a high priority for the Treasury and the IRS. These projects, which are attached as appendices to this letter, cover a number of areas. I have not been a paid advisor for over a decade, which allows me to make recommendations free of influence from potentially affected taxpayers. My goal is a system that works better and fairer for all concerned. Many of the recommendations are focused on the pervasive profit-shifting structures that have so eroded the U.S. tax base.

Notice 2020-47 lists factors that the Treasury and the IRS consider in selecting projects for inclusion in its 2019-2020 Priority Guidance Plan. They include, for example, whether a project (i) involves significant issues relevant to many taxpayers, (ii) will reduce controversy and lessen the burden on taxpayers or the IRS, and (iii) promotes sound tax administration.

All of the suggestions for projects covered in this submission more than satisfy these factors. More specifically, the effect of issuing new and/or amended regulations as well as publishing guidance in these areas would create a fairer and more level playing field between the IRS and all taxpayers, including particularly multinational corporations (MNCs) that have enjoyed increasing informational and resource advantages over the government in recent years. These suggestions would allow U.S. tax laws to be fairly enforced and achieve the results intended by Congress.

A principal focus of these suggestions is the modernization and updating of regulations as well as providing guidance that will affect all taxpayers. With respect to MNCs whose operations take place partially or wholly within the U.S., many have embarked on complicated and legalistic schemes that have as a primary purpose the shifting of profits. Generally, these MNCs, which record much or most of their profits within zero- and low-taxed foreign group members, adopted these schemes without any meaningful operational changes that moved actual profit-making activities outside the U.S. Rather, such activities remained within the U.S.¹

Importantly, MNCs adopting these schemes include not only U.S.-based MNCs, but also the many inverted MNCs that structured their inversions to remain untouched by the §7874 anti-inversion rules. For these inverted and other foreign-based MNCs (e.g. private equity foreign acquisition vehicles that acquire U.S. MNCs), shifted profits will often avoid both subpart F and Global Intangible Low-Taxed Income (GILTI) income inclusions, thereby completely avoiding any U.S. corporate taxation on shifted profits.

The government expends significant efforts and resources attempting to attack a multitude of MNC profit shifting structures. These efforts are labor intensive, time consuming, and have uncertain outcomes for all parties. Such attacks have relied on either transfer pricing (e.g. Microsoft, Amazon, Facebook, etc.) or re-characterization adjustments (e.g. Caterpillar, Perrigo, etc.).

With respect to transfer pricing adjustments, the IRS has limited its application to the value of outbound IP transfers and the calculation of annual payments under cost sharing agreements. This limited application leaves in place and legitimizes the structures through which MNCs shift profits annually out of the U.S. and into tax havens and other low-tax countries. Thus, even in the event that the government wins its transfer pricing adjustment on a particular taxpayer, additional millions and billions of profits continue to be shifted annually as long as the MNC's structure continues to exist.²

Some of our suggestions focus on the Code's sourcing and effectively connected income (ECI) rules as well as its entity classification rules. I believe that updated and modernized rules will give the Treasury and IRS additional tools that will be objective, fact-based, and easy to apply. They can be an important supplement or an alternative to the transfer pricing and re-characterization tools now commonly used.

The December 2017 Tax Cuts and Jobs Act (P.L. 115-97) has made substantial changes in how the U.S. taxes foreign income and foreign activities. One thing that did not change, however, is the continued incentive to maintain and even expand the above-mentioned schemes. Under pre-TCJA law, successfully shifted profits were not taxed in the U.S. until some future repatriation, which might never occur. These shifted profits created the stockpiling of foreign earnings in CFCs that the TCJA cured through the §965 one-time tax and the §959 and §245A mechanisms that allowed the tax-free repatriation of GILTI (because it had already been taxed under §951A) and the §245A dividend received deduction. However, the significantly lower effective tax rate on GILTI continues the pre-TCJA profit-shifting incentive. As a result, few MNCs have restructured or abandoned the above-mentioned schemes.

The issuance by the Treasury and the IRS of modernized sourcing and ECI regulations along with adopting our entity classification and other suggestions focused on profit shifting structures would provide clarity for both MNC taxpayers and the IRS.

These ECI rules are not new. They apply not only to future years after some of the suggested modernizations and other changes are made, but also to past years where the facts support it. Strong bases for application to past years will be common.³

In addition, clear guidance would assist outside audit firms in providing guidance to their audit clients to make more meaningful disclosures of potential tax liabilities in their financial statements or to accrue tax, interest, and penalties where some clients may have inappropriately pushed the envelope in their profit shifting structures. The IRS should also designate tax motivated structures having relevant factual, profit shifting characteristics as a “listed transaction”.

The undersigned has authored or co-authored nine articles covering subjects related to MNC profit-shifting structures and how they may be subject to U.S. taxation under the ECI rules.⁴ The third of these articles details how such structures often create an unanticipated partnership for U.S. tax purposes that includes two or more MNC group members as partners in a partnership that conducts the joint business of the group members. The existence of a partnership often makes the practical application of ECI taxation an easier and more objective exercise. The sixth article covers how ECI taxation should be applied after the TCJA and notes how the manufacturing branch rule included in the Subpart F regulations may often apply to cause some gross income not caught by the ECI rules to be subpart F income. The seventh article is focused on the TCJA amendment of the §863(b) sourcing rule for inventory property that has been both produced and sold by the same taxpayer. Additional background and issues relevant to suggestions made within this letter and its appendices are covered in detail in those articles.

Many MNCs erode the U.S. tax base through deductible payments by U.S. group members to foreign group members, including disregarded entity subsidiaries. Often, these payments would be subject to the 30% U.S. withholding tax, but this tax is most typically reduced or eliminated by the claimed coverage of a tax treaty. The same is true for claims that do not involve withholding tax such as a claim by a foreign group member that it has no permanent establishment under an applicable tax treaty. Appendix H provides specific guidance for needed regulatory amendments that would prevent the inappropriate use of tax treaties to achieve double non-taxation.

The Treasury and IRS should make clear to all taxpayers its intention to pursue profit shifting structures through notices, revenue rulings, or regulations, as appropriate. Doing so would send a strong signal to the boards of directors and managements of MNCs as well as to their legal and tax advisors, thereby causing some MNCs to scale back or even unwind existing structures, and to stop initiating new ones. Note that clear indications of Treasury and IRS intentions would achieve one of the stated goals of the "Form 1120-F Non-Filer Campaign” released on January 31, 2017. That campaign states, in part:

. . . The goal is to increase voluntary compliance by foreign corporations with a U.S. business nexus.

* * * * *

I hope that the above information is useful to the Treasury and the IRS. I would be glad to speak by telephone with you or to respond to emailed questions if that would be helpful.

Very truly yours,

Jeffery M. Kadet
(206) 285-1324
jeffkadet@gmail.com
kadetj@uw.edu
Seattle, WA

Attached Appendices

Appendix A — Modernization of Sourcing of Income and Effectively Connected Income Regulations (Regulations under §§861 - 864)

Appendix B — Section 863(b) including TCJA Amendment affecting Taxpayer-Produced Inventory Property under Paragraph (2)

Appendix C — Prop Reg §1.865-3 — “Purchased and Sold” or “Produced and Sold”

Appendix D — Partnership Status for Certain Profit-Shifting Structures: Amendment of Entity Classification Rules — Reg §301.7701-1(a)(2)

Appendix E — Designate Certain MNC Profit-Shifting Structures as Listed Transactions

Appendix F — Profit-Shifting Structures Implemented Following Inversions and Acquisitions by Foreign Acquirers

Appendix G — Addition of Examples to the Subpart F Manufacturing Branch Rule

Appendix H — Regulatory and Ruling Guidance Concerning Tax Treaties

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NOTICE 2020-47, 2020-2021 PRIORITY GUIDANCE PLAN
SUBMISSION FROM JEFFERY M. KADET

JULY 16, 2020

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Table of Contents

APPENDIX A

APPENDIX B

APPENDIX C

APPENDIX D

APPENDIX E

APPENDIX F

APPENDIX G

APPENDIX H

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APPENDIX A

Modernization of Sourcing of Income and Effectively Connected Income (ECI) Regulations (Regulations under §§861 - 864)

Problem

Existing income sourcing and ECI regulations are sufficient to determine, calculate, and impose ECI taxation for traditional (old) businesses but lack clarity when applied to new business models prevalent in the 21^st century. These include large MNCs that depend on the use of digital and internet tools in their centrally managed worldwide business models (e.g. high-tech manufacturers, pharmaceutical companies, internet-based companies earning advertising and commission income, etc.). The existing regulations need modernization to provide the IRS with another and even more effective tool to use against profit-shifting structures. Currently, the IRS's primary tools to reverse profit-shifting structures have been transfer pricing and re-characterization, both tools that are very subjective to apply and uncertain of success in the complex litigation that inevitably follows. Further, in the case of the much more commonly used transfer pricing adjustments, the IRS has limited their application to the value of outbound IP transfers and the calculation of annual payments under cost sharing agreements. This limited application leaves in place and legitimizes the structures through which MNCs shift profits annually out of the U.S. and into tax havens and other low-tax countries. Thus, even in the event that the government wins its transfer pricing adjustment on a particular taxpayer, additional millions and billions of profits continue to be shifted annually as long as the MNC's structure continues to exist. Modernizing the rules for applying ECI taxation would tax appropriate portions of these annually shifted profits, encourage taxpayers to avoid aggressive structures, and add another enforcement tool for the IRS to apply and sustain due to ECI's more objective, fact-based criteria.

Two peer-reviewed articles authored or co-authored by Stephen Curtis⁵ set out economic analyses showing that profit shifting structures overvalue the ownership of IP and grossly undervalue the exploitation of that IP, which includes both production functions and the conduct of internet-platformed based businesses. It is absolutely critical that source rules reflect the factual reality of where MNCs conduct the activities that are actually responsible for their profits.

The discussion in this Appendix A concerning tax-motivated structuring applies to a broad range of MNCs, including:

• U.S. MNCs,

• Former U.S. MNCs that have inverted,⁶

• Former U.S. MNCs acquired by private equity and other investment funds, and

• Former U.S. MNCs acquired by foreign MNCs that have left U.S. management intact.

Solution

It is critical that sourcing and ECI regulations be updated to reflect modern-day business models such as supply chains, contract manufacturers, centrally run and operated worldwide internet-based platforms, etc. Moreover, updating these regulations and making them consistent with other parts of the Code and regulations would make ECI taxation easier for both taxpayers and the IRS to apply. Failing to up-date these regulations will likely result in situations where ECI taxation should apply but which may go unrecognized by taxpayers, outside auditors, and the IRS.

Just one example of a regulation that must be modernized is Reg. §1.864-6 (regarding sales of goods or merchandise through a U.S. office of a foreign taxpayer). This regulation focuses closely on the sales contract and not on the many critical business activities, often performed within the United States by related persons, that strongly support not only consummated sales but critical purchase and/or production functions. For example, many profit shifting structures start with the transfer of production intangibles to a zero- or low-taxed foreign group member entrepreneur that itself has no personnel or capacity to:

• Conduct production through its own facilities;

• Direct production physically performed by a contract manufacturer;

• Control the risks associated with production or the holding of the production intangibles.

Capacity to carry out these functions remains within one or more U.S. group members that act on behalf of the foreign group member entrepreneur. These U.S. group members conduct production operations, make day-to-day business decisions, and manage production risk for that foreign member. Overall, they perform the functions that constitute a substantial contribution to manufacturing as described in Reg §1.954-3(a)(4)(iv)(b). Such operations and decisions can include the contractual terms of agreements executed in the name of the foreign group member entrepreneur with component suppliers, raw material vendors, and contract manufacturers. It also includes decisions on production processes, production quantities, quality control, etc. Such functions and activities, and the commercial risks that arise from them, are a crucial and critical part of any manufacturing business.

This sort of profit shifting structure, voluntarily created by many MNCs seeking to shift profits into zero- or low-taxed foreign group members, creates solely in legal form an independent company that produces products and sells them. Most or all production functions (short of the physical manufacture that is performed by a usually unrelated contract manufacturer) are performed by group members in the U.S., which are ostensibly acting as independent contractors under a service agreement and not as an agent, joint venturer, or partner.

Modernization of the §§861-864 regulations is needed to reflect the reality that U.S. group members are performing critical production functions and making day-to-day business decisions that control the potential profitability of and commercial risks borne by the foreign group member entrepreneur.

If the Treasury and IRS do issue modernized regulations, they should consider issuing a notice as soon as possible to alert taxpayers to any planned regulatory changes. This could be done in a manner similar to the notices issued for inversions (i.e. Notice 2014-52 and 2015-79) and anticipated regulations to implement certain TCJA changes. Such a notice could not only announce the planned amendments to the sourcing and ECI rules, but it could also alert taxpayers that ECI is subject to higher effective tax rates due to the branch profits tax (see §884) and the loss of deductions and credits and the open statute of limitations where no tax return has been filed (see §§882(c)(2) and 6501(c)(3)).⁷ Such notice(s) would strongly encourage MNCs to refrain from implementing or continuing profit shifting structures.

Modernization of regulations should include:

Meaning of “Produced”

Reg §1.864-1 should be amended to read:

For purposes of sections 1.861-1 through 1.864-7, the word "sale" includes "exchange"; the word "sold" includes "exchanged"; the word "produced" includes "created", "fabricated", "manufactured", "extracted", "processed", "cured", "aged", and activities that constitute a substantial contribution (within the meaning of section 1.954-3(a)(4)(iv)) to the manufacture, production, or construction of personal property through the activities of a taxpayer's employees, agents, and related persons (within the meaning of section 1.954-1(f)).

Clarity of Engaged in Trade or Business within the United States

Reg §1.864-2 should be amended to clarify that a foreign taxpayer having no capacity or personnel to conduct all or any material portion of its business or to manage the commercial risks of all or any material portion of its business will be engaged in trade or business within the U.S. when those functions or management of risks are conducted by one or more persons within the U.S. Such persons include not only agents of the foreign taxpayer, but also putative independent contractors (whether related or not) acting under a service or similar agreement. The following should be added at the end of paragraph (a) of Reg §1.864-2:

The term also includes the performance of activities within the United States (for example the purchasing or production of products, the substantial contribution to the manufacturing of personal property within the meaning of section 1.954-3(a)(4)(iv)(b), the sale of products, the maintenance and management of an internet-based platform through which sales are made or cloud transactions are conducted that earn advertising or other internet-based service revenues, the rental or licensing of intangibles, etc.) by another person (whether related or not and including activities performed under any independent contractor service agreement or agency) who conducts all or any material portion of these activities or manages the commercial risks thereof for or on behalf of any taxpayer when the taxpayer itself has insufficient personnel or capacity to conduct all or any material portion of its business or manage the commercial risks thereof. The actual conduct and activities of the persons will be decisive rather than any contractual label or description that provides, for example, that the person conducting the activities or managing the commercial risk is an independent contractor providing a service.

Gross Income from Internet-Based Platforms

Until New Cloud Services Source Rules Are Issued

Many MNCs and other taxpayers conduct centrally managed worldwide businesses that involve the provision of digital goods and services, a subject for which certain proposed regulations covering limited issues were released in August 2019 (REG-130700-14). This section focuses on digital services.

At the core of these businesses are the central ongoing control and decision-making concerning the business being conducted and the day-to-day maintenance and management of the internet platforms that are accessed by users globally. For many MNCs, these platforms were not only developed primarily within the U.S., but both the ongoing control and decision-making and the platform maintenance and management are also conducted mostly, if not wholly, within the U.S.⁸ While users (including advertisers) from a particular country, territory, or region may access a platform presented in their local language with some localization of the products or services offered, the platform and the digital goods and services offered are essentially the same worldwide. It is MNC personnel located in the U.S. who maintain and manage these worldwide platforms and are the decision makers with regard to matters such as the products or services to be offered, the terms on which they will be offered including pricing, etc.

These digital goods and services include providing advertisers and others with access to the MNC's user base and information about users. They also include without limitation providing platforms for gig economy workers (e.g. ride sharing), acting as agents selling the products and services of others (e.g. software and non-physical products like ebooks, music, movies, etc. as well as hotel and other travel services), and providing other cloud services.

For some years now, the regularly issued Priority Guidance Plan has included a project focused on income related to digital goods and services. The most recent quarterly update issued on June 11, 2020, of the 2019-2020 Priority Guidance Plan in the International section on page 21 at F.1. states:

Regulations under §861, including on the character and source of income arising in transactions involving intellectual property and the provision of digital goods and services.

As noted above, proposed regulations covering certain limited issues were released in August 2019 (REG-130700-14). Future regulations that provide guidance on source of income, particularly for cloud transactions, are critical. Many MNC groups conduct their worldwide cloud businesses mostly within the U.S. through internet platforms that earn significant income from cloud services provided to customers around the globe. Future regulations must recognize this economic reality that the bulk of services are performed within the U.S.⁹ These future regulations must therefore include sourcing rules that will provide that some material portion of the revenue generated will be U.S. source gross income, irrespective of where in the world the user, advertiser, or customer may be.

For prior and current years until cloud service regulations are issued, source of income will be based on the existing regulations, IRS rulings, other IRS pronouncements, and case law. While there of course can be arguments made for specific taxpayer situations regarding the character of income and the source rule to be used, it seems that often the facts and circumstances approach of Reg §1.861-4(b)(1) will be the most appropriate sourcing rule to apply. Where this is the case, the day-to-day U.S.-based maintenance and management of the group's business and internet platform will cause material amounts of U.S. source income, again irrespective of where in the world the user, advertiser, or other customer may be.

Many MNC profit shifting structures involve the license or transfer of IP created primarily within the U.S. to zero- or low-taxed foreign group members. Such transactions provide the basis for the foreign group members to record revenues generated by the internet platform from digital goods and services. A transfer often involves first an ownership transfer of existing IP along with a cost sharing agreement that allows the group member participants to own their respective shares of future IP development for exploitation within their respective geographic areas.

The foreign group member licenses or owns its IP, but it participates minimally, if at all, in the actual operation of the internet platform through which it earns its revenues from digital goods and services. Rather, one or more U.S. group members conduct within the U.S. the bulk or all of the maintenance and management of the business and platform for foreign group members (including management of risk of the group's investment in the platform), presumably under a service or similar agreement. The foreign group member's personnel (including the employees of any disregarded entity subsidiaries) are typically involved in marketing, customer support, logistics, and similar activities. They normally have neither the knowledge nor the capacity to participate in maintaining and managing the platform or in managing the risk of the IP they license or own. Further, they do not have the capability of directing an independent service provider to perform these functions and manage these risks.

In these circumstances, note that under Reg §1.482-7(j)(3)(i), cost sharing transaction payments will be considered the payor's costs of developing intangibles at the location where such development is conducted. Reg §1.482-7(j)(2)(ii) provides that a foreign participant in a cost sharing agreement will not be treated as engaged in trade or business within the U.S. solely by reason of its participation in a CSA. However, if other factors create a trade or business within the U.S., the paragraph (j)(3)(i) characterization rule means that the foreign participant is considered to directly own a share of an intangible asset (the internet platform) that is maintained and managed on a day-to-day basis within the U.S. This means that the existing regulations characterize the foreign participant as earning gross income from “directly-owned” assets that are part of an active business being managed and conducted within the U.S. This characterization further supports that there must be some material amount of U.S. source income.

A change to Reg §1.864-2(a) was suggested above that would make clear that a foreign group member earning gross income from digital goods and services through an internet platform that is maintained and managed within the U.S. as described will be engaged in trade or business within the United States. The following Example (4) should be added to Reg §1.864-4(b) to make clear that any U.S. source income earned by such a foreign group member would be effectively connected income. (An additional Example (5) concerning production activities conducted within the U.S. is included below under the heading “Income, Gain, or Loss Attributable to an Office or Other Fixed Place of Business in the United States — Purchasing and Production Functions”.)

Example (4). In 2005, U.S. Parent (USP) and its wholly owned Foreign Subsidiary (FS) execute a cost sharing agreement (CSA) to develop digital goods and services, an internet platform, related software, and business processes for earning revenues worldwide from the sale, exchange, rental, lease, or similar transactions related to such digital goods and services. Under the CSA, each of USP and FS owns a share of the internet platform and holds the economic rights for exploitation of the developed IP within its respective geographic territory (for USP, North America, and for FS, the rest of the world). FS (including its disregarded entity subsidiaries) conducts marketing, customer service, logistics, and related activities within its territory. Under a service agreement, FS contracts with USP for USP to maintain and manage the internet platform that USP and FS jointly own. It is determined that the facts and circumstances of USP and FS cause FS to be engaged in trade or business within the United States under the provisions of section 1.864-2. FS's income or loss from sources within the United States is treated as effectively connected for 2005 with the conduct of a business in the United States.

It was noted above that prior Priority Guidance Plans have included a project focused on the sourcing and character of income related to digital goods and services. It was also said that until this new contemplated guidance is issued that the facts and circumstances approach of Reg §1.861-4(b)(1) may often be the most appropriate sourcing rule to apply to the sourcing of gross income from cloud services. I do not know what position MNCs may or may not be taking with respect to the sourcing of such income. I think it likely, though, that such MNCs treat all such cloud services income as foreign source based on a position that the U.S. group members operating the group's internet platform are doing so in the capacity of independent contractors. As such, their activities within the U.S. would not be attributed to the foreign group member entrepreneur. In regard to ECI, this is likely a non-issue on the surface since such MNCs would also be maintaining that their zero- and low-taxed foreign group member entrepreneurs have no U.S. trade or business. With no U.S. trade or business, even if their income were U.S. source under Reg §1.861-4(b)(1), there would be no ECI. With respect to the foreign tax credit limitation of any U.S. parent where a U.S.-based group is involved, §904(h) will make the foreign group member entrepreneur's source relevant for the parent. This expected position that there is only foreign source income (despite the fact that the bulk of activities that earn the income occur within the U.S.) means that the parent is inappropriately maximizing its utilization of foreign tax credits. Again, clear sourcing rules that reflect the economic reality of the business are necessary to prevent both the avoidance of ECI and the over-claiming of foreign tax credits.

An example in Prop Reg §1.861-19 should be added that will be suggestive of sourcing under Reg §1.861-4(b)(1) principles until new cloud services sourcing rules are issued. I propose that below Example 6A be added to Prop Reg §1.861-19(d).

(6A) Example 6A: Access to online software via an application

(i) Facts. The facts are the same as in paragraph (d)(6)(i) of this section (the facts in Example 6), except that Corp A, a U.S. resident, and its foreign subsidiary, CFC, have entered into a cost sharing agreement that allows CFC to exploit outside the U.S. all intangibles for the word processing, spreadsheet, and presentation software. Corp A and CFC have each entered into a separate agreement with Corp B to provide the employees of Corp B access to the software. The Corp A/Corp B agreement covers employee access for all Corp. B employees based within the U.S. The CFC/Corp B agreement covers access for all Corp. B employees based outside the U.S. CFC's personnel are engaged in marketing and customer support functions, but they conduct only de minimis DEMPE functions (development, enhancement, maintenance, protection, and exploitation of intangibles). Instead, through the cost sharing agreement and a service agreement executed by Corp A and CFC, Corp A performs these DEMPE functions for CFC. The DEMPE and other functions performed by Corp A include not only the R&D that developed and enhances the software, but also the day-to-day operation of the web browser and app platforms as well as management and decision-making regarding what digital content is to be offered, how it will be updated, how content will be marketed, the pricing at which content will be offered, etc. In addition, Corp A directs the maintenance and replacement of servers and other required hardware worldwide, though CFC owns servers and hardware physically located outside the U.S. and performs certain maintenance and other functions for them.

(ii) Analysis:

(A) For the reasons set out in paragraphs (d)(6)(ii)(A) and (B), both Corp A and CFC's transactions with Corp B are cloud transactions described in paragraph (b) of this section and are classified as the provision of services under paragraph (c) of this section. For the reasons set out in paragraph (d)(6)(ii)(C), the download of the app is de minimis, and under paragraph (c)(3) of this section, the entire arrangement is classified as a service.

(B) Although CFC is providing services to Corp B, all but a de minimis portion of those services are factually conducted by Corp A. To reflect the substance of this arrangement, the application of relevant source rules to CFC's income will be made as if Corp A's performance of services were conducted directly by CFC. Thus, for example, if sourcing of this services income is determined by the location where the services are performed, then the services performed by Corp A will directly affect the source of CFC's income.

Until new regulations are issued under this existing Priority Guidance Plan project for the sourcing of income related to cloud services, guidance should be provided through a revenue ruling, notice, or other means. Such guidance should apply the principles of Reg §1.861-4(b) and identify the criteria to be used to determine the respective amounts of U.S. and foreign source income that arise when U.S.-based group members manage, direct, or conduct critical aspects of a foreign group member entrepreneur's internet platform-based business.

In this regard, Example 5 from Reg §1.937-3(e) should be retained in final regulations. The proposed changes included in REG-130700-14 would delete this example.

Example 5 concerns an application service provider. After describing the provider's business, the example includes:

. . . Assume for purposes of this example that Corporation B's income from these transactions is derived from the provision of services.

This assumption is fully consistent with the rules included in Prop Reg 1.861-19.

Example 5 then provides guidance under the existing regulations on the sourcing of the taxpayer's income, referring to §861(a)(3) and Reg §1.861-4(a) in the process. With the assumption of the classification of the transactions as the provision of services, the principal focus of Example 5's guidance is on sourcing.

Example 5 concerns sourcing rules for the described cloud services, about which Prop Reg §1.861-19 is totally silent. Until future sourcing rules for cloud services are released, Example 5 continues to provide relevant guidance and should not be removed.

Suggestion for New Cloud Services Source Rules

Source is important to domestic taxpayers because they are concerned with applying the foreign tax credit limitation mechanism, both to their own business operations and those of their foreign subsidiaries due to §904(h). Source is also important to foreign taxpayers (including foreign subsidiaries of U.S. taxpayers) because they are concerned with the U.S. taxation of their effectively connected income.

There is an increasing likelihood of foreign countries either unilaterally or through the ongoing BEPS 2.0 project imposing tax on cloud services when users and customers are located within their countries. In the case of MNCs, most of which earn cloud services income through foreign group member entrepreneurs, those foreign entrepreneurs would be the taxpayers of such newly imposed taxes. In discussion above, it was suggested that such MNCs likely treat all such cloud services income as foreign source. In contrast, there are some domestic U.S. taxpayers, especially small and medium-sized businesses, that conduct cloud service businesses. They operate their businesses only within the U.S. and have not created international corporate structures and/or implemented common profit-shifting structures used by many MNCs. Where such domestic taxpayers must pay these new foreign taxes due to having foreign customers and users, under current Reg §1.861-4 sourcing rules, they would not be able to claim any FTCs due to there being no foreign source income. I discuss below how future source rules could cause appropriate portions of MNC income to be U.S. source and how domestic taxpayers could have some foreign source income to allow appropriate FTC benefits.¹⁰

Need for Clarification of Definition of Cloud Transaction

Before considering specific sourcing rules, the definition of cloud transaction in Prop Reg §1.861-19(b) should be clarified to make clear the apparent broad definition intended, with which I agree. With this in mind, the following sentence be added at the end of Prop Reg §1.861-19(b):

Cloud transactions include, without limitation, business models involving internet-based platforms that provide (i) advertising targeted at platform users, (ii) sales and rental agent services through online marketplaces, (iii) the service of putting gig economy service providers and customers together, (iv) job recruiting services, (v) hotel reservation and travel services, and (vi) subscription-based game services.

Need for a Unitary Approach Applied to Multiple Group Members

Cloud services sourcing rules could be included as a new paragraph in Reg §1.861-4. Given, though, the broad authority granted under §863(b), the following suggested rules could be also be issued under §863(b).

In general, I believe that income from cloud transactions that are treated as income from services under Prop Reg §1.861-19 should be sourced based on the facts and circumstances approach that has been included within Reg §1.861-4 and case law for many years. The reality, though, must be recognized that many MNCs conduct their cloud service businesses (i) with centrally managed personnel mostly located within the U.S., and (ii) using tax-motivated corporate structuring and intercompany agreements. This reality means that an MNC through its multiple group members is operating what is truly a unitary business. The normal application of sourcing rules to taxpayers as separate legal entities means that only an entity's recorded transactions, its assets, and personnel are considered. Activities performed by other group members benefitting the entity are not considered. With MNC groups intentionally crafting their structures to achieve a specific tax-motivated result within each group member entity, a sourcing result that will truly reflect the group's business can only be achieved by applying the facts and circumstances approach on a groupwide and unitary basis.

With this in mind, income source for cloud services must be determined on a unitary basis that takes into account the activities of all group members. This groupwide treatment would be subject to a rebuttable presumption. Thus, if a group conducts more than one type of internet-platform business that is separately managed with separate groups of operating personnel, then that group could determine source separately for the income from each business. This determination for each separate business would be on a unitary basis that includes all group members that participate in that separate business.

Although this sourcing determination would be on a unitary basis taking into account the facts and circumstances of multiple group members, federal taxation of course continues to be applied on a separate entity basis. (Consolidated tax return filing for U.S. group members is a common exception.) Thus, U.S. taxation of U.S. group members and foreign group members would be applied to the income reported by each group member. To reflect the unitary nature of MNC cloud service businesses and the need for separate application of taxation to each entity, the percentages of U.S. and foreign source income as determined on the unitary basis would be applied to the income recorded within each group member.

As an example of this, assume an MNC conducting a cloud service business through two group members: one established in the U.S. (X) and one established outside the U.S. (Y). Under a cost sharing agreement, each of X and Y owns the business's intangible property necessary to exploit the business within its own territory, which is the U.S. for X and the rest of the world for Y. Management and other personnel responsible for the business's DEMPE functions (development, enhancement, maintenance, protection, and exploitation) are primarily within X in the U.S. Both X and Y have sales, marketing, and customer service personnel within their respective regions as well as relevant tangible assets (e.g. servers, data centers, office equipment, etc.). Under the above described rebuttable presumption, X and Y are treated as a unitary group conducting one cloud service business. From applying on a unitary basis applicable sourcing rules (a suggested approach is described below), it is found that 70% of the business's income is sourced in the U.S. and 30% is sourced outside the U.S. When computing the relevant foreign source income that will be used in X's FTC limitation calculation, 30% of X's own directly earned cloud service income will be foreign source. Further, in applying §904(h) for the source of subpart F and GILTI inclusions, 30% of Y's directly earned cloud service income will be foreign source. If it is found that Y is engaged in a trade or business within the U.S., then 70% of Y's cloud service income will be ECI.

Sourcing Methodology

The Reg §1.861-4 facts and circumstances approach focuses on the performance of the services and not on “the residence of the payer, the place in which the contract for service was made, or the place or time of payment”. This approach was applied to cloud services in Reg §1.937-3(e), Example 5, where there was a relatively vanilla factual situation described in which all activities and servers were in one location and there was no user content that added to the value of the platform. The example appropriately concluded that that one location was the income source, even though there were customers in other locations around the world.

In today's multinational environment, MNCs conduct unitary cloud service businesses that have customers worldwide and operate through personnel, assets, and offices in many countries. Many small and mid-sized companies and groups have customers and users internationally, even if all of their personnel and assets are located within one country (the factual situation described in Example 5 in Reg §1.937-3(e)). To determine where such taxpayers earn their cloud services income, it is necessary to take relevant personnel and assets into account (on a unitary basis where multiple group members are involved). Further, as discussed further below, consideration should be given to also taking customers/users, sales, and/or marketing intangibles into account.

Personnel factor. In considering personnel, the following functional categories should be considered:

Strictly following the approach in Reg §1.861-4, only personnel functions that constitute the direct provision of services should be included. On this basis, the A and D categories should be excluded (though see below for additional comments concerning category A development and enhancement). If a tax policy decision were made to place simplicity of application first, then all personnel could be included in the computation. With category A personnel likely being mostly in the U.S. and category D personnel being at locations both within and without the U.S., perhaps the percentage results in many cases would not differ materially from a strict application of the Reg §1.861-4 approach.

Assets factor. As noted, consistency with the historical sourcing of income from services means that development and enhancements (the first two of the five DEMPE functions) should not be a part of the sourcing determination. However, given the different character of the digital world and its contrast with services that are primarily supplied through personnel whose efforts benefit only one customer or client at a time, the development and enhancement of internet-based platforms through which services are provided can be seen as the development of an asset.

With development and enhancement costs being expensed (at least until 2022 when §174 as amended by the TCJA goes into effect), there should normally be no adjusted basis due to the §174 expensing of R&D costs.

The value of IP, including internet-based platforms, is most closely related to the personnel who created or acquired it and the personnel who manage and control its use and commercial risks. As such, personnel or personnel costs, which are a surrogate for the asset itself, are an objective approach to get to a fair result for taxpayers and the government alike. In theory, cumulative R&D personnel costs for, say, the prior three years (or any other appropriate formula) could be used to more precisely reflect the value of IP as a part of the personnel factor. However, to achieve simplicity and less taxpayer burden, development and enhancement personnel could be simply included within the personnel factor.

For the capitalized cost of purchased platforms, platform enhancements, and products, or for capitalized R&D from 2022, there will be adjusted bases that should be a part of the asset factor. With the intangible nature of an internet-based platform, this asset should be located where the personnel are located who manage and control the platform and the risks related to it. While simplicity suggests that the each year's average balance of the capitalized costs or capitalized R&D would be used, a formula such as is described in the preceding paragraph could also be used.

As for tangible assets, there will of course be relevant tangible property including computer equipment, office facilities, data centers, servers, etc. Such property that is used in providing the services should be included. Again, a simplified approach could use all property.

Sales factor. It was noted above that an increasing number of countries will be imposing tax on cloud services provided to users and customers located within their countries. The international BEPS 2.0 dialogue concerning taxation of income from automated digital services and consumer-facing businesses is importantly focused on the belief that customers and users play a significant role in adding to content, value, and profitability of covered businesses. Some discussion and proposals go further and consider the value of sales and/or marketing intangibles that may exist even in the absence of important customer or user participation. If an international consensus on some coordinated approach to market country taxation is not reached within the OECD's Inclusive Framework, OECD leadership has estimated that perhaps 40 or 50 countries around the world could unilaterally impose digital service taxes on some or all cloud services. Whether or not consensus is reached, it is a certainty there will be increased foreign taxes on cloud services income.

With this development of increased foreign taxes, tax policy decisions will be necessary in the design of any new approach to source determination for cloud services income. With current Reg §1.861-4 ignoring factors such as the residence of the customer or user and the location where the contract for services is made, as a first step, a tax policy decision must be made whether to add a “sales factor” to the source determination. If the answer to this first step is “yes”, the second step is considering how to implement the new factor.

Reg §1.861-4 and applicable case law¹¹ provide no basis for U.S. source rules for services to look beyond a taxpayer's own performance of services to the activities and contributions of the taxpayer's customers, clients, or users. Despite this, the ongoing BEPS 2.0 international discussions, within which the U.S. is a participant as a member of the OECD Inclusive Framework, are now considering as part of “Pillar One” the right of market countries to tax a calculated share of income from “automated digital services”. This calculated share would be payable to a market country where an MNC group's customers and users are located even in the absence of any physical services being performed within that market country.

By way of illustration, assume U.S. taxpayer A conducts a cloud service business solely from within the U.S. with customers and users located both within and without the U.S., including some located in country X. A has no personnel or assets located in country X or elsewhere outside the U.S. Under either a consensus reached within BEPS 2.0 Pillar One or, in the absence of consensus, under a country X unilateral digital service tax, A pays some amount of tax to country X that is calculated in part on the revenues generated by country X customers and users.

It is assumed for purposes of this submission that the taxes paid to country X qualify as creditable taxes under Reg §§1.901-2 or 1.903-1 (see footnote 10). Taxpayer A will only be able to claim a credit to the extent that it has foreign source income with which to determine its §904 foreign tax credit limitation. Under the principles of existing Reg §1.861-4, with all physical performance of services by A being within the U.S., A would have no foreign source income and no ability to claim any foreign tax credits.

If the Treasury and IRS as a policy matter decide that foreign tax credit relief should be granted, then it will be necessary to allow the value added by customers and users to be a component in the income source determination.

A simple approach would be to include the sales factor representing customer/user value in the income source determination for all cloud service revenues, no matter whether or not customers or users actually create any value. On the other hand, there is some logic to limit the use of the factor to those cloud service situations where a customer or user's participation or personal content truly adds value to the cloud service business. For example, one business that provides an interactive user platform where users post their own materials for view by other users might be seen as having users who clearly add value. This could be the same where a business operates an online marketplace for third-party sellers and user reviews are a major value-adding feature. On the other hand, another business that only provides, say, cloud storage that is held in encrypted form and is not available for access by other users would appear to have little if any customer or user-added value. Considering the historic focus in regulations and case law on the location where services are performed, merely being a passive user or customer of cloud services should not be sufficient to include a factor for customer/user value.

Having said the above, there will undoubtedly be many cloud service businesses where multiple services are offered, some of which have customer/user value and some of which do not. Attempting to break down these multiple services and determine relative value for each may be theoretically attractive. It does seem, though, a very subjective exercise that is asking for taxpayer/tax authority disputes. Rather, it seems sensible to simplify things and assume that all customers and users add value and to not require subjective judgments about which services have customer/user value and how much each might have.

The approach suggested below to determine income source includes a simplified sales factor for this customer/user value. If as tax policy matter it is decided not to allow foreign tax credit relief, then this sales factor would not be included.¹²

Before getting to the suggested approach to determine income source, it may be helpful to provide some brief thoughts about tax policy concerning this suggested sales factor.

It would seem that if a BEPS 2.0 Pillar One consensus is reached, then there would be a strong policy reason to grant foreign tax credit relief so as to avoid double taxation. The U.S. as a member of the Inclusive Framework will have agreed to the right of market countries to tax income from automated digital services, even if there is no physical activities or presence of the taxpayer in the market country. The U.S. will have agreed to the formula for computing the tax and will likely have some ability to audit or otherwise review the computation of the tax imposed.

If no consensus is reached and many countries impose unilateral digital service taxes, then the situation is more nuanced. A pure domestic taxpayer such as U.S. taxpayer A in the above illustration reports all income within its U.S. tax return. (Note that taxpayer A may often be a small or mid-sized company. Note also that unilateral digital service taxes may often have income thresholds that will be significantly lower than the Euro 750 million that might be applied within Pillar One.) Given the broad U.S. treaty network, the bulk of such a taxpayer's foreign income would likely be earned from customers and users in countries with which the U.S. maintains a tax treaty. While it may be expected that many countries imposing unilateral digital service taxes will maintain that existing tax treaties do not prevent such taxes, a U.S. taxpayer such as A could seek protection through each treaty's mutual agreement procedure. For such taxpayers, which will not have initiated any profit-shifting structures, it seems very appropriate to grant foreign tax credit relief for any tax ultimately paid and to include a factor in the calculation of foreign source income for customer/user value.

In contrast to taxpayers such as A, which is a U.S. person paying U.S. tax on its worldwide income, many if not most MNCs have initiated profit-shifting structures through which cloud service income is earned by foreign group members and not by U.S. group members. Some of these major MNCs use Irish group members as the entrepreneur that earns the group's cloud services income. Such foreign group members would not have the benefit of U.S. tax treaties. Rather, they would have to rely on the Irish tax treaty network. From a tax policy perspective, it seems less appropriate to provide favorable provisions that would grant such taxpayers double tax relief to the extent of the foreign tax credit that would be allowed under §960(d). Frankly, any tax policy decision to include a sales factor that causes some amount of foreign source income in this case would be somewhat gratuitous in nature.

Having said the above, the norm for determination of income source is to apply the same sourcing rule to all taxpayers, whether domestic or foreign. As such, whatever decision is made should apply uniformly to all taxpayers.

Especially if it appears as we get near to the end of 2020 and into 2021 that there will be a BEPS 2.0 consensus reached on Pillar One taxation of automated digital services, then any Treasury and IRS determination on how to deal with a sales factor within cloud sourcing regulations should be delayed until there is an Inclusive Framework agreement so that new U.S. sourcing regulations may reflect, as appropriate, the agreed Pillar One methodology. For example, OECD Inclusive Framework documents include the sourcing of automated digital service revenues as one of the matters on which consensus is required.¹³ If on the other hand (i) it becomes evident that there will be no consensus and many countries will initiate unilateral digital service taxes, and (ii) a tax policy decision has been made to reflect customer/user value in the source determination, then consideration should be given to including a sales factor as discussed herein.

Combining and weighting the factors. In this suggested approach, only objective, tangible, and measurable factors are used. Subjective factors, such as valuations of intangible assets, including both trade and marketing intangibles, should not be used. Principle goals include objectivity and simplicity, but at the same time recognizing that theoretical accuracy is being sacrificed. In any case, I believe that this approach will provide results that are fair to both taxpayers and the government alike.

A percentage for each factor would be determined and applied to a taxpayer's income or taxpayer group's unitary income. The factors, of course, must be appropriately weighted. Given the importance of the contribution of personnel both to the development of intangible assets and the actual management and conduct of any business, it seems appropriate to suggest that the personnel factor should be given a greater weighting in comparison to other factors. Thus, for example, if there are three factors (e.g., personnel, assets, and sales), the personnel factor could be given, say, two times or three times the weighting of the other two factors Thus, if the personnel factor were given three times the weighting, the factor weightings would be 60% for personnel, 20% for assets, and 20% for sales. If there were only two factors (e.g. personnel and assets, but no sales factor), it would be 75% for personnel and 25% for assets.

As an illustration of this factor-weighting approach, assume that USP and its CFC conduct a cloud service business for customers and users worldwide. They jointly own through a cost sharing arrangement their respective shares of group IP including the internet-based platform through which they each conduct their business in their defined territory (within the U.S. for USP and the rest of the world for CFC). Under user agreements posted on the group's website, customers and users contract with USP if they are located within the U.S. and with CFC if located outside the U.S. USP and CFC each record their respective cloud service revenues on this same basis.

Regarding actual operations, USP employs all personnel involved in DEMPE functions concerning the group's IP and internet-based platform as well as most business line management and personnel conducting sales and marketing, logistics, and customer and user support in the U.S. CFC employs personnel involved in sales and marketing, logistics, and customer and user support in a number of locations around the world outside the U.S. through disregarded entity subsidiaries. Regarding tangible assets, USP and CFC each own within their respective territories office furniture and equipment as well as computers, data centers, and servers.

Personnel factor. For simplicity, the costs of all personnel (including any equity-based compensation) are included and it is determined that 25% of personnel costs are located outside the U.S.

Assets factor. The average adjusted basis of tangible assets owned by USP and CFC total 1000. Based on location, it is determined that 60% of tangible assets (600) are located outside the U.S. USP also has adjusted basis of 1000 for certain purchased intangible assets on its books. Applying the personnel factor to apportion the intangible assets, 25% of these intangible assets (250) are located outside the U.S. Combining these figures, the assets factor for assets outside the U.S. is 42.5% ((600 + 250) / (1000 + 1000)).

Sales factor. Revenues from USP and CFC's cloud services would be determined as within or without the U.S. based primarily on the location of the customer who uses the service or the user if some other party (e.g. an advertiser) makes payment to USP or CFC. Note that the following is from paragraph 41 of the January 2020 Inclusive Framework statement (see footnote 13):

. . . It is of particular importance to deliver sourcing rules to cover certain digital transactions, for example by sourcing the revenue from online advertising services where the users (“eyeballs”) are located and revenue from other in-scope digital services where they are consumed. . . .

On this basis, it is determined that 70% of USP and CFC's combined revenue is without the U.S.

Application of weighting to determine source. With the above three factors and a weighting of three times for personnel, the foreign source income is 37.5% ((3 X 25% + 42.5% + 70%) / 5) and the U.S. source income is the remainder, which is 62.5%.

Under this unitary approach, USP and CFC would each report in relevant tax filings that its foreign and U.S. source income is 37.5% and 62.5%, respectively.

When USP files its Form 1120, it would reflect in its foreign tax credit limitation calculations that 37.5% of its own gross income from cloud services is foreign source. Further, to the extent of any subpart F or GILTI inclusions, they would similarly be treated as being 37.5% foreign source under §904(h).

As for CFC, it would treat 62.5% of its income as U.S. source. If CFC is found to be engaged in a trade or business within the U.S., then that 62.5% of income would be treated as effectively connected income under §864(c)(3).

I have included possible statutory language that could be used for many of the matters discussed within this submission. I have not done so, though, for this suggested approach for amendments to Reg §1.861-4 (or alternatively to regulations under §863). If Treasury or the IRS would find suggested language useful, I would be glad to make the effort. Please just let me know and I will develop a draft.

Office or Other Fixed Place of Business Within the United States

There are many profit shifting structures where critical production and product sourcing functions are performed by U.S. group members while the revenue is recorded within zero or low-taxed foreign group members. The following suggested additions to Reg §1.864-7 are meant to make clear the existence of an office or other fixed place of business within the U.S. when U.S. group members perform such functions.

Amend Reg §1.864-7(c) by adding the following sentence at the end of this paragraph.

However, where the officers or other personnel of the domestic parent corporation are not only responsible for policy decisions affecting the related foreign sales corporation, but also conduct activities that represent the business of that foreign sales corporation (for example, officers or other personnel are involved in soliciting or negotiating with major customers, approve the terms of specific sales contracts, manage or control the purchasing and sourcing of inventory property from vendors or from contract manufacturers, etc.) or manage its commercial risks, then that foreign sales corporation will be considered to have an office or other fixed place of business in the United States.

Amend Reg §1.864-7(g) by adding the following new Example (7) at the end of this paragraph.

Example (7). S, a foreign corporation, is engaged in the business of manufacturing a microphone and selling it to customers within its territory, which is all countries outside North America. S is a wholly owned subsidiary of P, a domestic corporation engaged in the business of manufacturing the same microphone and selling it to customers in North America. The physical manufacture of the microphone is performed by an unrelated contract manufacturer under separate contract manufacturing agreements that each of P and S have executed with the contract manufacturer. P and S have executed a cost sharing agreement (CSA) for the development of the microphone and the production processes to produce it.

Employees of P conduct the bulk of the development work under the CSA. They also conduct the functions described in section 1.954-3(a)(4)(iv)(b), which represent a substantial contribution to the manufacture of the microphones. The performance of these functions is integral and necessary for both P and S to source their respective microphones from the contract manufacturer.

S does not have a fixed facility in the United States, and none of its employees are stationed in the United States. Officers and employees of P are generally responsible for the policies followed by S and are directors of S. S has a chief executive officer in Country A who, from its office therein, handles the day-to-day conduct of S's business. However, the chief executive officer does not have the knowledge or capability to perform the functions described in section 1.954-3(a)(4)(iv)(b) or to direct another person to do so. If P did not perform these functions, S would be incapable of either manufacturing, or having manufactured, the microphones for which it holds IP rights under the CSA.

Based upon the facts presented, S is considered to have an office or other fixed place of business in the United States for purposes of this section.

Income, Gain, or Loss Attributable to an Office or Other Fixed Place of Business in the United States — Purchasing and Production Functions

Reg. §1.864-6, which in part concerns sales of goods or merchandise through a U.S. office of a foreign taxpayer, focuses closely on the sales contract and not on the many critical activities, often performed within the United States by related persons, that strongly support not only consummated sales but critical purchase and production functions. The first sentence of Reg §1.864-6(b)(2)(iii) should be amended to read as follows:

Income, gain, or loss from sales of goods or merchandise specified in paragraph (b)(3) of section 1.864-5, if the office or other fixed place of business is involved in purchasing such goods or merchandise, conducts production activities with respect to such goods or merchandise (within the meaning of section 1.954-3(a)(4)(i), including activities described in paragraph (4)(iv)(b)), or 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 effect of this amendment is best illustrated by an example. Say that a zero- or low-taxed foreign group member entrepreneur sells products through an internet platform that is maintained and managed by a U.S. group member. The U.S. group member could also conduct certain product purchasing functions for the foreign group member entrepreneur. Assume that the foreign group member entrepreneur does not have any foreign office that is a material factor in the realization of income (see Reg §1.864-6(b)(3)(i)). Assume also that the foreign group member entrepreneur through its own employees (including the employees of any disregarded entity subsidiary) does not perform any product purchasing functions.

Under the current regulation, the foreign group member entrepreneur takes the position that neither the operation of the internet platform nor the purchasing activities conducted by the U.S. group member cause the sales income to be attributable to an office or other fixed place of business within the U.S. This means that even with no foreign office that is a material factor in the realization of income (that would allow the §865(e)(2)(B) exception to apply) and with no purchasing activities performed by the foreign group member, the gross income from sales will not be ECI.

With the suggested amendment of the first sentence of Reg §1.864-6(b)(2)(iii) (and the other suggested regulatory changes included in this submission), it will be clear that the sales income will be attributable to an office or fixed place of business within the U.S. Once this “attributable to” condition is met, the sales income will be U.S. source income under §865(e)(2) and ECI under §864(c)(3) (except to the extent that the §865(e)(2)(B) exception applies).

The following Example (5) should be added to Reg §1.864-4(b). It has been drafted to be relevant both before and after the TCJA §863(b) amendment.

Example (5). In 2005, U.S. Parent (USP) and its wholly owned Foreign Subsidiary (FS) execute a cost sharing agreement (CSA) for product P. Under the CSA, each of USP and FS owns its share of the economic rights for exploitation of the IP for product P within its respective geographic territory (for USP, North America, and for FS, the rest of the world). FS (including its disregarded entity subsidiaries) conducts marketing, customer service, logistics, and related activities within its territory. Under a service agreement, FS contracts with USP for USP to provide services and other activities that contribute to FS's production of product P. These services and other activities include selection of and negotiation with vendors of product P components and contract manufacturers for production services. The services and other activities also include product P production planning and management involving, for example, quantities of production, control of inventory levels of raw materials, work-in-progress, and finished goods, quality control, and other functions listed in section 1.954-3(a)(4)(iv)(b). It is determined that the facts and circumstances of USP and FS cause FS to be engaged in a trade or business within the United States under the provisions of section 1.864-2 and that FS has U.S. source income under section 863(b) since the location of manufacture is partially or wholly within the United States. FS's income or loss from sources within the United States is treated as effectively connected for 2005 with the conduct of a business in the United States.

Required Technical Correction of §864(c)(4)(D)(i)

Code §864(c)(4)(D)(i)) provides an exception to ECI treatment when a foreign corporation pays dividends, interest, or royalties that are foreign source income in the hands of the foreign taxpayer recipient and the foreign “. . . taxpayer owns (within the meaning of section 958(a)), or is considered as owning (by applying the ownership rules of section 958(b)), more than 50 percent of the total combined voting power of all classes of stock entitled to vote . . .”

Given the potentially expansive effect on this provision by the deletion of §958(b)(4), it would appear that there should be a technical correction proposed to make this sub-clause read:

(i) consists of dividends, interest, or royalties paid by a foreign corporation in which the taxpayer owns (within the meaning of section 958(a)), or is considered as owning (by applying the ownership rules of section 958(b) as in effect before its amendment by the Tax Cuts and Jobs Act), more than 50 percent of the total combined voting power of all classes of stock entitled to vote, or

In order to reverse the effect of the deletion of §958(b)(4) by the Tax Cuts and Jobs Act within the regulations, Reg §1.864-5(d)(1) should be amended by adding the phrase “as in effect before its amendment by the Tax Cuts and Jobs Act (P.L. 115-97)”, so that after amendment this subparagraph reads:

Dividends, interest, or royalties paid by a foreign corporation in which the nonresident alien individual or the foreign corporation described in paragraph (a) of this section owns, within the meaning of section 958(a), or is considered as owning, by applying the ownership rules of section 958(b) as in effect before its amendment by the Tax Cuts and Jobs Act (P.L. 115-97), at the time such items are paid more than 50 percent of the total combined voting power of all classes of stock entitled to vote.

Update of Reg §§1.864-5(d)(2)(iv) and (v)

Reg §1.864-5(d)(2) provides an exclusion from ECI treatment for certain subpart F income of a CFC. One reference in this clause is to §954(c)(3) instead of §954(c)(2)(A). Another is to §954(c)(4) instead of §954(c)(3). These differences are due to subsequent reordering of the paragraphs within §954(c). Reg §§1.864-5(d)(2)(iv) and (v) should be amended to reflect these changes so that they would read:

(iv) Any income derived in the active conduct of a trade or business which is excluded under section 954(c)(2)(A), or

(v) Any income received from related persons which is excluded under section 954(c)(3).

Update of Reg §§1.864-5(b) and 1.864-6(b)

Reg §1.864-5(b), which deals with the treatment of certain foreign source income, refers in subparagraph (1)(ii) to gain or loss on the sale of intangible personal property. The Tax Reform Act of 1986 (P.L. 99-514) inserted §865, which deals with sales of intangibles and causes §§865(d)(1)(A) and (e)(2) to govern the treatment of such transactions. P.L. 100-647, §1012(d)(10)(A), also amended §864(c)(4)(B) to eliminate coverage of such sales of intangibles by paragraph (4). Since §865(e)(2) can make such sales U.S. source and therefore covered by §864(c)(3), clause (ii) of Reg §1.864-5(b)(1) no longer has any relevance and should be deleted. In addition, Reg §§1.864-5(b)(3)(iii) and 1.864-6(b)(2)(i) should be amended to remove any reference to gains or losses on the sale or exchange of intangible personal property.

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APPENDIX B

Section 863(b) including TCJA Amendment affecting Taxpayer-Produced Inventory Property under Paragraph (2)

REG-100956-19 with proposed regulations concerning §863(b) and other related sections including §865(e)(2) and (3) were released in December 2019. This Appendix B covers §863(b) while Appendix C covers §865(e)(2) and (3).

In today's reality, MNCs operate and are structured in a different manner than the independent company producers that the current regulations were written for many decades ago. If regulations do not address modern manufacturing business models now pervasively used by MNCs, they will provide often nonsensical sourcing results. This is a major issue.

Considering all of Part I of Subchapter N, there should be acknowledgement and integration within the sourcing rules of today's reality that a high proportion of international business is conducted not by independent taxpayers, but rather by MNCs that operate with a central management that directs individual group members, each of which is merely a cog performing a portion of the integrated business. Each separate group member taxpayer does not in any practical sense operate as an independent entity conducting its own business.

As a final introductory comment, these particular source rules are important for both the foreign tax credit limitation and for the imposition of U.S. taxation on foreign persons that are engaged in a trade or business within the U.S. (i.e. tax on effectively connected income). The comments in this submission primarily focus on the taxation of ECI. However, due to Code §904(h) (Source rules in case of United States-owned foreign corporations), which provides look-through sourcing for dividends, interest, and subpart F/GILTI inclusions, these sourcing issues are very important for the foreign tax credit limitation of persons recognizing these income items. Given the pervasive use of profit-shifting structures that result in oversized profitability within foreign group member entrepreneurs and significant amounts of GILTI inclusions under §951A, it is critical that U.S. sourcing rules result in income sourcing that truly reflects where MNCs actually produce the products they are selling. If the existing and proposed regulations remain as they are now, MNCs will be overstating their foreign source income and overclaiming FTCs.

Background Relevant to Regulations under §863(b)

Over the past three decades, MNCs have increasingly adopted contract manufacturing business models under which the physical manufacturing of products is performed as a service. A group member “entrepreneur” holding applicable intangible rights to manufacture, or have manufactured, the group's products contracts with a related or unrelated contract manufacturer to produce products in accordance with design, quality, and other specifications. The contract manufacturer does not need to hold the intangible rights since it is only performing what is effectively a service for the entrepreneur, which does hold those rights. As such, the contract manufacturer is economically remunerated on a service basis and receives nothing in respect of the product's intangible rights.

MNCs have also adopted supply chain structuring that places various production, marketing, sales, and other functions in various locations around the world. These various operations act as cogs in a centrally managed and integrated worldwide business that is intended to appear seamless to third parties (e.g. suppliers, customers, etc.). In contrast, prior to the development of modern communications, MNCs typically set up independent standalone manufacturing subsidiaries with their own production facilities, managements, and operating functions. The group parent of course supplied corporate policy, direction, oversight, financing, and necessary centrally developed intangibles via licensing agreements, but the parent neither ran the day-to-day operations of these manufacturing subsidiaries nor controlled their production and other commercial risks such as is common today in supply chain structures.¹⁴

The above two paragraphs speak generally about actual operations and not about any tax structuring that an MNC may have utilized.

The following discussion concerning tax-motivated structuring generally applies to:

• U.S. MNCs,

• Former U.S. MNCs that have inverted,¹⁵

• Former U.S. MNCs acquired by private equity and other investment funds, and

• Former U.S. MNCs acquired by foreign MNCs that have left U.S. management intact.

The characteristics of supply chains and the increasing use of contract manufacturers provided a convenient backdrop for the initiation of profit-shifting structures, which were often conducted with little or no change in actual operations. MNCs established these structures by transferring relevant intangibles off-shore into zero or low-taxed foreign group member entrepreneurs and then having those foreign group members contract directly with suppliers, contract manufacturers, and customers. Since the entrepreneur holds the rights to manufacture the products, or have them manufactured, the entrepreneur is in legal form conducting a manufacturing business and earning a level of income that is economically appropriate for a manufacturer. Contractually, the U.S. group members cease to be a part of the business conducted by the foreign group member entrepreneur, except to the extent that they perform support functions benefiting the entrepreneur, for which they receive service fees from their acting as independent contractors.¹⁶

Through this structure, MNCs are able to place the bulk of group manufacturing earnings within foreign group member entrepreneurs and relatively little in U.S. group members and other foreign group members that conduct physical activities. This is achieved through intercompany contracts and limited-risk transfer pricing that typically place the contractual bearing of commercial and other risks within the entrepreneur.

Despite the contractual assumption of these risks by the foreign group member entrepreneur, often the personnel who control the risks remain within U.S. group members. While this will often be the case within today's centralized management structures for all principal business functions including, for example, sales, it is particularly true for production functions.¹⁷

Foreign group member “entrepreneurs” often have few or even no employees or other personnel. Such entrepreneurs may, though, have operating subsidiaries that have elected disregarded entity (DRE) status. From a U.S. tax perspective, this means that the business operations performed by those DRE subsidiaries are treated as the operations of the entrepreneurs. Such business operations are, however, often limited to marketing, sales, and support functions such as warehousing, delivery, and local customer support. Entrepreneurs and their DRE subsidiaries will often conduct few, if any, production functions.

In these cases, the foreign group member entrepreneurs neither perform themselves nor have the management-level personnel capable of supervising U.S. group member independent contractors (as labeled in service or similar intercompany agreements) that perform day-to-day production functions on their behalf.

What are these production functions that U.S. group member independent contractors perform on behalf of their foreign group member entrepreneurs? Such functions typically involve managing the worldwide supply chain and conducting many of its key functions including, for example, identifying sources of raw materials and components, negotiating terms including pricing with such sources, identifying and negotiating with contract manufacturers, determining production timing and costs, controlling inventory levels, quality control, etc. See Reg. §1.954-3(a)(4)(iv)(b) for a more complete listing of functions and activities that constitute production.

Within profit-shifting structures, contracts with suppliers of raw materials and components, contract manufacturers, and others will be executed in the name of the foreign group member entrepreneurs, but the negotiations and business decisions on pricing and all other important terms (e.g. quality and other product specifications, quantities, timing, etc.) are made by U.S. group member personnel.¹⁸ The entrepreneur, including its DRE subsidiaries, simply do not have the personnel capable of making, or even understanding, many of these decisions.

In regard to these production functions conducted by U.S. group members, it will be appreciated that §863(b), as amended by the TCJA to determine source based solely on the location of production activities, recognizes the value of the production functions over other factors, which include the location of sales activities and IP rights, whether established via license or ownership under a CSA. In this regard, two peer-reviewed articles authored or co-authored by Stephen Curtis¹⁹ set out economic analyses showing that profit shifting structures overvalue the ownership of IP and grossly undervalue the exploitation of that IP, which of course includes these production functions. It is absolutely critical that source rules reflect the factual reality of where MNCs conduct their production activities. Source regulations as they currently exist or as proposed [REG-100956-19] do not in any way accomplish this.

The actions of U.S. group members on behalf of a foreign group member entrepreneur can cause that entrepreneur to be engaged in a trade or business within the U.S. This can arise either because:

• The U.S. group members are conducting the business of the entrepreneur, thereby acting as the entrepreneur's de facto agents, or

• The U.S. group members and the foreign group member entrepreneur are conducting a joint business, thereby causing (i) a partnership²⁰ for U.S. tax purposes under the entity classification rules, and (ii) a U.S. trade or business under §875(1).

With a U.S. trade or business and the production and sale of inventory property, a foreign group member entrepreneur must file its U.S. tax return on Form 1120-F and calculate its effectively connected income. Specifically, §864(c)(3) makes the sourcing rules under both §§863(b) and 865(e)(2) relevant to the determination of ECI.

For such a foreign group member entrepreneur that has some sales that are not attributable to an office or other fixed place of business within the U.S., then the source of those sales is determined under §863(b) and Reg §1.863-3. Section 863(b) and Reg §1.863-3 also apply to any sales that are so attributable and that would otherwise be covered by §865(e)(2), but that qualify for the “exception” from that treatment as described in §865(e)(2)(B) and Prop Reg §1.865-3(b). Such described sales are any sales of inventory property sold for use, disposition, or consumption outside the United States with an office or other fixed place of business of the nonresident in a foreign country that materially participated in the sale.

For a foreign group member entrepreneur's sales that are attributable to an office or other fixed place of business within the U.S. (and that do not come within the §865(e)(2)(B) “exception”), then its U.S. source income is determined under §865(e)(2) and Prop Reg §1.865-3(d)(2). For 50% of the gross income (or such other amount using the books and records method), Prop Reg §1.865-3(d)(2) refers back to Reg §1.863-3 for the source determination. The other 50% of the gross income (or amount determined under the books and records method), being attributable to the office or other fixed place of business in the U.S., will be fully U.S. source.

With the sourcing of all sales of taxpayer-produced inventory property being partially or fully based on §863(b) and Reg §1.863-3, these sourcing rules must reflect the actual production activities of the centrally managed worldwide businesses of MNCs. Both current and proposed regulations under §863(b) fail to do so. For example, in the case of a typical foreign group member entrepreneur (including its DRE subsidiaries) that performs no production functions (since they are performed primarily by U.S. group members), that entrepreneur will have good authority to take the position that it has no U.S.-located production activities. Based on the existing and proposed regulations, the source of production is defined as the production activities “conducted directly by the taxpayer”. Such a position in no way reflects the reality of where production occurred, thereby allowing a taxpayer to avoid being subject to U.S. tax even though significant production activities are regularly performed in the U.S. and the structure was consciously chosen to achieve the shifting of profits out of the U.S.

Irrespective of ECI taxation issues, the §904(h) look-through rules importantly affect sourcing for the FTC limitation of recipients of dividends, interest, and subpart F/GILTI inclusions from certain U.S.-owned foreign corporations. As stated above, profit-shifting structures result in significant amounts of GILTI inclusions under §951A. As such, it is critical that U.S. sourcing rules result in income sourcing that truly reflects where MNCs actually produce the products they are selling. If the existing and proposed regulations remain as they are now, MNCs will be overstating their foreign source income and overclaiming FTCs.

Expansion of Source Determination Beyond Only the Taxpayer

I present below suggestions to change the existing and proposed regulations under §863(b), which was importantly amended by the TCJA to source taxpayer-produced inventory property based solely on the basis of production activities.

Reg §1.863-3(c)(1)(i)(A) continues to expressly limit production activities to “those conducted directly by the taxpayer”. This “conducted directly by the taxpayer” limitation must be eliminated and coverage expanded.

The current limitation to only “those [production activities] conducted directly by the taxpayer” is adequate for an independent company that directly conducts its own business and only outsources limited production activities to unrelated persons. However, today, MNCs conduct much of their manufacturing through unrelated (and sometimes related) contract manufacturers, a development that was reflected a decade ago by the addition of Reg §1.954-3(a)(4)(iv) to the “foreign base company sales income” rules.²¹ Further, in those situations where U.S. group members manage the supply chain for their integrated and centrally-managed worldwide businesses, control supply-chain risk, and conduct many supply-chain functions within the U.S., a broader and more inclusive definition of production activities is needed. Other group members outside the U.S. each perform their designated functions as mere cogs within the overall structure. The foreign group member entrepreneur, as the “taxpayer”, conducts little or none of these manufacturing activities.

With this integrated group business model, it is meaningless to compute source looking only at one cog in the process, especially when that cog (i.e., the entrepreneur) performs little or no production activities. With this being the case, the sourcing determination must take into account all group members involved in production. That determination (i.e., the calculated split between domestic source and foreign source) should then be applied to the relevant income earned by each group member conducting production activities for which U.S. taxation and source is relevant.

As this approach to manufacturing by MNCs is so pervasive, it is a major issue. Reg §1.863-3(c)(1)(i)(A) must be expanded to explicitly include the production activities conducted by other group members. The amendment suggested below to Reg §1.863-3(c)(1)(i)(A) will accomplish this. Note that this amendment defines production in a manner that is consistent with the regulation for foreign base company sales income in subpart F.

Reg §1.863-3(c)(1)(i)(A) (Prop Reg §1.863-3(c)(1)(i))

Amend the first five sentences of this subclause to read:

For purposes of this section, production activity means an activity that creates, fabricates, manufactures, extracts, processes, cures, or ages inventory including activities that constitute a substantial contribution (within the meaning of section 1.954-3(a)(4)(iv)) to the manufacture, production, or construction of personal property. See section 1.864-1. Subject to the provisions in section 1.1502-13 or paragraph (f)(2)(ii) of this section, the production activities that are taken into account for purposes of sections 1.863-1, 1.863-2, and this section are those conducted directly by the taxpayer and those conducted by the taxpayer's agents and related persons within the meaning of section 1.954-1(f) under service or similar intercompany arrangements. Where the taxpayer's production activities as evidenced by its production personnel and production assets are located only within the United States or only outside the United States, gross income is sourced where the taxpayer's production activities are located. For rules regarding the source of income when production activities are located both within the United States and without the United States, see paragraph (c)(2) of this section. . . .²²

While I do not recommend this at all because of the subjectivity it would add, if Treasury and the IRS were to desire it, they could make this change regarding related persons a rebuttable presumption. If this were done, then language could be added to say that in the event that a taxpayer establishes to the satisfaction of the Commissioner that the foreign group member exercises through its own officers and operating personnel working from its offices in its country of incorporation management and direction of an independent contractor that is a related person, then the production activities of that related person would not be taken into account.

The discussion above regarding expansion of Reg §1.863-3 applies equally to Reg §1.863-1(b)(3)(i). Reg §1.863-1(b)(3)(i) should be similarly expanded to include, in addition to those production activities conducted by the taxpayer directly, “those conducted by the taxpayer's agents and related persons within the meaning of section 1.954-1(f) under service or similar intercompany arrangements.”

Reg §1.863-3(c)(1)(i)(B) (Prop Reg §1.863-3(c)(1)(ii))

Amend the first sentence of this subclause to read:

Subject to the provisions of section 1.1502-13 and paragraph (f)(2)(ii) of this section, production assets include tangible and intangible assets owned directly by the taxpayer, the taxpayer's agents, and related persons (within the meaning of section 1.954-1(f)) that are directly used to produce inventory described in paragraph (a) of this section.

An Alternative Manner of Apportionment is Needed

Reg §1.863-3 was written decades ago and worked appropriately with a manufacturer that used its own plant and equipment for the production of its products. For such a manufacturer, it made sense to use the adjusted basis of its production assets to apportion gross income between U.S. and foreign sources. This approach could still work well for manufacturers that continue to operate in this manner.

Today, however, as explained earlier, MNCs use contract manufacturers and foreign group member entrepreneurs that hold intangibles and contractually bear the commercial and manufacturing risks, while U.S. group members typically conduct high-value-adding portions of the production process and manage the risks the entrepreneur contractually bears.

In saying that U.S. group members typically conduct high-value-added portions of the production process, I am not speaking of R&D that develops products (though of course R&D is of high value and is often conducted substantially within, or is directed and managed from, the U.S.). Rather, I am speaking of the ongoing day-to-day work that is required for physical production to occur and for risks to be managed. In short, the managing of the supply chain, the control of supply-chain risk, and the conduct of many critical supply-chain functions. These high-value ongoing day-to-day work activities and functions can include: evaluating sources of raw materials and components, negotiating with vendors, making business decisions concerning contractual terms as well as the decisions on which vendors or contract manufacturers to use, overseeing and controlling the production process as well as the levels of raw materials, work-in-process, and finished goods inventories, etc. While not all-inclusive, these are just a few of the high-value-added functions typically conducted by U.S. group members. Reg §1.954-3(a)(4)(iv)(b) includes a more complete listing.

The use by MNCs of multi-group member structures with foreign group member entrepreneurs and contract manufacturers is pervasive. For such MNCs, the production-asset basis for allocating income between U.S. and foreign sources is simply not appropriate. This is because many of the high-value-added core production and risk management functions require only office premises, desks, and computers. Where unrelated contract manufacturers are used, which is often, there would be little or no plant and equipment included in the production-asset allocation. Where there are limited-risk group member contract manufacturers owning plant and equipment, whether within or without the U.S., and U.S. group members conducting high-value-added core production functions, managing risks, and owning and/or renting only office premises, desks, and computers, the production-asset basis is terribly skewed and can only provide nonsensical results.

Reg. §1.863-3 must be modernized to reflect new business models such as those using foreign group member entrepreneurs, limited-risk contract manufacturers (whether related or unrelated), and activities constituting a “substantial contribution to the manufacture of personal property” as described in Reg. §1.954-3(a)(4)(iv)(b). As such, consideration must be given to alternative methods of apportionment as applied to the group as a whole rather than basing the apportionment solely on the location of production assets of simply the one taxpayer.

For example, where only unrelated contract manufacturers are used, allocations should be based solely on the location of personnel (including those employed by the taxpayer, its agents, and its related parties) involved in Reg. §1.954-3(a)(4)(iv)(b) production activities. Or, the personnel costs of such production-involved personnel could be used since cost may be a closer indication of relative value than headcount. If any significant tangible assets other than normal office premises, desks, and computers are involved, then an assets factor could be included.

Where an MNC has group member contract manufacturers with production facilities, plant, and equipment, then perhaps a two-factor allocation could be used with one factor being location of production assets and the other factor being the location of personnel involved in the production process (including Reg. §1.954-3(a)(4)(iv)(b) production activities) on a head count or personnel cost basis. If Treasury and the IRS believe that personnel are relatively more important than physical assets, then rather than an equal weighting of these two factors, perhaps a 2:1 or 3:1 weighting could be used. This would be a bright-line approach similar to the long-used 50-50 method of determining gross income attributable to production activities and sales activities.

The above discussion on high-value-added portions of the production process focused on activities other than the R&D that develops products. It is important to note, though, that in any determination of source on a group-wide basis, there should be some acknowledgement of relevant production IP. For IP self-created by the taxpayer, the taxpayer's agents, and related persons within the meaning of Reg §1.954-1(f), there should normally be no adjusted basis due to the §174 expensing of R&D costs, at least until 2022 when §174 as amended by the TCJA goes into effect. For purchased IP or for capitalized IP from 2022, there will be adjusted basis.

The value of IP is most closely related to the personnel who created or acquired the IP and the personnel who manage and control the use and risk of the production IP. As such, personnel or personnel costs, which are a surrogate for the asset itself, are an objective approach to get to a fair result for taxpayers and the government alike. In theory, cumulative R&D personnel costs for, say, the prior three years (or any other appropriate formula) could be used to more precisely reflect the value of IP in the allocation. However, to achieve simplicity, the below possible regulatory language simply locates the capitalized costs of intangible production assets based on where the production personnel are located who manage and control the assets and risks related to the assets.

If there are significant tangible R&D fixed assets beyond normal office premises, desks, and computers, then a property factor could be included.

The following is possible regulatory language for Prop Reg §1.863-3(c). It has been drafted to reflect this alternative manner of apportionment.

Prop Reg §1.863-3(c)

(c) Determination of the source of gross income from production activity

It will be noted that existing Reg §1.863-3(c)(1)(i)(C) (Prop Reg §1.863-3(c)(1)(iii)) includes:

. . . An intangible production asset will be considered located where the tangible production assets owned by the taxpayer to which it relates are located.

If by any chance our above suggestion to change the current “adjusted basis of production asset” allocation is not accepted, there is still an important need to change this allocation rule for intangible production assets.

To better reflect that within today's MNEs intangible assets accompany key personnel functions and not tangible production assets, the location of intangible production assets should be based on where the personnel are who manage and control the intangible assets and risks concerning them. Accordingly, the following alternative language should be considered:

Reg §1.863-3(c)(1)(i)(C) (Prop Reg §1.863-3(c)(1)(iii))

. . . An intangible production asset will be considered located where the personnel are located who manage and control the asset and risks related to the asset.

Partnerships

In accordance with the earlier described alternative manner of apportionment, there is a need to make certain small changes to Prop Reg §1.863-3(f)(2)(ii) and in Examples 1 and 2 within Prop Reg §§1.863-3(f)(3)(i) and (f)(3)(ii). In addition, to make clear the determination of effectively connected income and substantial contribution to production within the meaning of Reg §1.954-3(a)(4)(iv)(b), I suggest the addition of two additional examples within Prop Reg §1.863-3(f)(3)(iii) and (f)(3)(iv), respectively.

Reg §1.863-3(g)(2)(ii) (Prop Reg §1.863-3(f)(2)(ii))

The following alternative language should be considered:

(ii) Attribution of production personnel and assets to or from a partnership.

A partner will be treated as employing and owning its proportionate share of the partnership's personnel and production assets, respectively, only to the extent that, under paragraph (f)(2)(i) of this section, the partner's activity includes production activity conducted through a partnership. A partner's share of partnership personnel and assets will be determined by reference to the partner's distributive share of partnership income for the year attributable to such production personnel and production assets. Similarly, to the extent a partnership's activities include the production activities of a partner, the partnership will be treated as employing and owning the partner's production personnel and production assets, respectively, related to the inventory that is contributed in kind to the partnership. See paragraph (c)(*)(*) and (c)(2)(ii) of this section for rules apportioning, respectively, personnel and the basis of assets to Section 863(b)(2) Sales.

Reg §1.863-3(g)(3) (Prop Reg §1.863-3(f)(3))

To make clear the application of the §863 rules to a foreign partner in a partnership for purposes of determining effectively connected income, amend the last sentence of Example 1 within Prop Reg §1.863-3(f)(3)(i) as follows:

To make clear the application of the §863 rules to a foreign partner in a partnership for purposes of determining effectively connected income, amend the last sentence of Example 2 within Prop Reg §1.863-3(f)(3)(ii) as follows:

(f)(3)(ii) Example 2. Distribution in kind.

. . . In applying paragraph (c) of this section, A is treated as employing and owning its proportionate share of the partnership's production personnel and production assets, respectively, based upon its distributive share of partnership income.

To make clear the application of the §863 rules to a foreign partner in a partnership for purposes of determining effectively connected income, add the following Example 3 to Prop Reg §1.863-3(f)(3)(iii):

(f)(3)(iii) Example 3. Distribution in kind to foreign partner.

Assume the same facts as in Example 1 except that the partnership, instead of selling the widgets, distributes the widgets to A and B. B sells the widgets outside the United States through a sales office in its country of incorporation. In determining the effectively connected income earned by B on its gross profit from sales outside the United States, B is treated as conducting the activities of the partnership related to production of the distributed widgets. Accordingly, in applying this section, B is treated as employing and owning its proportionate share of the partnership's production personnel and production assets, respectively, based upon its distributive share of partnership income. The source of gross income on the sale of the widgets is determined under section 863 and this section. B, as the taxpayer, makes sales of inventory property produced in whole by the taxpayer within the United States and sold without the United States. Accordingly, income from B's sale of widgets shall be allocated and apportioned between sources within and without the United States solely on the basis of the production activities. As all production activities represented by all production personnel and production assets are within the United States, all gross profits on B's sale of widgets are sourced within the United States.

To make clear the application of the §863 rules to a foreign partner in a partnership that uses a contract manufacturer for the physical production and makes a substantial contribution to production within the meaning of Reg §1.954-3(a)(4)(iv)(b), add the following Example 4 to Reg §1.863-3(f)(3)(iv):

(f)(3)(iv) Example 4. Partnership makes substantial contribution to the production of inventory.

Assume the same facts as in Example 3 except that the partnership, instead of manufacturing widgets in the partnership's plant located in the United States, engages an unrelated contract manufacturer in another county for the physical manufacture of the widgets. The partnership through its facilities and personnel within the United States conducts the activities specified in Reg §1.954-3(a)(4)(iv)(b), thereby making a substantial contribution to the manufacture, production, or construction of the widgets. The partnership is accordingly considered to have produced the widgets sold. In determining the effectively connected income earned by B on its gross profit from sales outside the United States, B is treated as conducting the activities of the partnership related to production of the distributed widgets. The consequences described for Example 3 apply as well for this Example 4.

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APPENDIX C

Prop Reg §1.865-3 — “Purchased and Sold” or “Produced and Sold”

Background

Whether a foreign taxpayer is considered to have “Purchased and Sold” or “Produced and Sold” makes a significant difference to the sourcing of a taxpayer's gross income from the sale of inventory property where §865(e)(2) is applicable because the sales are attributable to an office or other fixed place of business of the taxpayer in the U.S. Specifically, Prop Reg §1.865-3(d)(2) applies where inventory property has been produced and sold while Prop Reg §1.865-3(d)(3) applies where the property has been purchased and sold.

Sourcing of income for a foreign taxpayer is important for potential direct taxation on effectively connected income if the foreign taxpayer is engaged in a trade or business in the U.S. It is also important under 904(h) for the foreign tax limitation of any taxpayer receiving certain payments or reporting income inclusions under subpart F and GILTI from United States-owned foreign corporations.

In above Appendix B concerning Reg §1.863-3(c), the centralized worldwide management and integrated operations of MNCs that produce and sell inventory property was described along with how each group member acts as a mere cog performing limited functions as part of the integrated group's operations. The description also included (i) the common use of contract manufacturers, (ii) how primarily U.S. group members perform joint production activities and manage and conduct supply chain functions for all inventory property sold by group members, and (iii) how profit-shifting structures typically use a foreign group member entrepreneur, which holds relevant IP and acts as if it conducts an independent manufacturing business in legal form by contracting directly with unrelated contract manufacturers and customers for sales into its market territory. That market territory is commonly customers located outside the U.S. Since the foreign group member entrepreneur performs little or none of the production activities, presumably it pays some amount to the U.S. group members under some service agreement or similar arrangement that labels the U.S. group members as independent contractors and not as agents, partners, or joint venturers. Appendix D discusses how such MNC group interactions and joint business operations create partnerships for federal tax purposes and suggests regulatory changes to make this clear. The discussion in the remainder of this Appendix C assumes that there is no partnership so that the only taxpayer at issue is the foreign group member entrepreneur.

Reg §1.863-3(c), both as it currently reads and as proposed in Prop Reg §1.863-3(c), determines source based only on the production activities of the taxpayer. There is no inclusion of production activities conducted by either the taxpayer's agents or related persons. Further, Prop Reg §1.865-3(d) includes no guidance for determining whether Prop Reg §1.865-3(d)(2) or (d)(3) applies for a particular sale of property.

Appendix B suggested an expansion of the source determination under Prop Reg §1.863-3 so that the activities of not only the taxpayer, but also the activities of the taxpayer's agents and related persons should be included in the determination of source. Such an expansion should be similarly made in Prop Reg §1.865-3 for purposes of determining whether Prop Reg §1.865-3(d)(2) or (d)(3) applies.

Suggested Alternative Amendments

If this expansion is made to Prop Reg §1.863-3, then the following should be added to Prop Reg §1.865-3(d)(2) as paragraph (d)(2)(iii):

(iii) Inventory property produced by the taxpayer. For purposes of this section 1.865-3, a taxpayer (whether or not a controlled foreign corporation within the meaning of section 957(a)) will only be considered to have produced inventory property if that taxpayer, its agents, or its related persons within the meaning of section 1.954-1(f) manufactured, produced, or constructed that property within the meaning of section 1.954-3(a)(4), including making a substantial contribution through the activities of its employees at its offices and other fixed places of business outside the U.S. to the manufacture, production, or construction of the personal property within the meaning of section 1.954-3(a)(4)(iv).

If Treasury and the IRS decide not to expand Prop Reg §1.863-3 as suggested, then as an alternative the following guidance should be added as paragraph (d)(2)(iii) to Prop Reg §1.865-3(d)(2):

(iii) Inventory property produced by the taxpayer. For purposes of this section 1.865-3, a taxpayer (whether or not a controlled foreign corporation within the meaning of section 957(a)) will only be considered to have produced inventory property if that taxpayer manufactured, produced, or constructed that property within the meaning of section 1.954-3(a)(4), including making a substantial contribution through the activities of its employees at its offices and other fixed places of business outside the U.S. to the manufacture, production, or construction of the personal property within the meaning of section 1.954-3(a)(4)(iv).

This suggested language referring to “its employees” would include the employees of any disregarded entity subsidiaries of that taxpayer. It would not include the production activities and functions conducted by any agent or related person of the taxpayer.

If Treasury and the IRS do not adopt the suggestion to expand both Prop Reg §§1.863-3 and 1.865-3 to include the activities of agents and related persons, the above alternative approach will reach a practical tax answer that will in most cases result in the right substantive taxation under the ECI rules.

The reason for saying this is that in most MNC profit-shifting structures that move profits out of the U.S. and into tax havens, the bulk of the management and functions involving production and the supply chain are performed by U.S. group members in the U.S. Little or no such production activities are performed by the foreign group member entrepreneur or its disregarded entity subsidiaries. Despite this lack of any production activities, without the above suggested alternative approach providing guidance, it seems likely that affected MNC foreign group member entrepreneurs having sales of inventory property sourced under Prop Reg §1.865-3 will take the positions (i) that they had “produced and sold” thereby making Prop Reg §1.865-3(d)(2) applicable, and (ii) that all production activities were outside the U.S., even if the entrepreneur and its disregarded entity subsidiaries had performed zero production activities. Taking these positions would cause the portion of gross income from production activities (whether 50% or some other percentage based on the books and records method) to be foreign source, thereby avoiding effectively connected income taxation and maximizing the foreign source income of any affected U.S. person under §904(h). Such entrepreneurs would be taking the position that their U.S. group members that conduct production activities on their behalf under service agreements are merely independent contractors. As such, they would ignore these U.S. production activities.

Again, in the absence of the recommended expansion for a taxpayer's agents and related persons in Prop Reg §§1.863-3 and 1.865-3, where the bulk of production activities are conducted by an MNC within the U.S., then the sourcing of income should reflect this economic reality. By requiring Prop Reg §1.865-3(d)(3) treatment where the foreign group member entrepreneur and its disregarded entity subsidiaries play no significant role in production, all gross income will be U.S. source, which achieves the right economic result.

Having said this, though, the better approach is the expansion of both Prop Reg §§1.863-3 and 1.865-3 so that there is consistent group-wide recognition of the real production activities that an MNC group performs and where the group performs them.

Need for Reference in Prop Reg §1.865-3 to Reg §1.863-3(g) (Prop Reg §1.863-3(f))

While the above discussion in this Appendix C has assumed no partnership, there is a need for Prop Reg §1.865-3 to acknowledge that there will be instances where a partnership having one or more foreign partners is conducting activities covered by §865(e)(2). To deal with this, the following should be added to Prop Reg §1.865-3(d)(2) as paragraph (d)(2)(iv):

(iv) Partnerships. For purposes of this section, the special rules for partnerships of section 1.863-3(g) [proposed section 1.863-3(f)] apply.

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APPENDIX D

Partnership Status for Certain Profit-Shifting Structures: Amendment of Entity Classification Rules — Reg §301.7701-1(a)(2)

Background

Many MNC profit-shifting arrangements involve U.S. and foreign group members that conduct joint business activities using personnel, assets, and activities of two or more of the group members. Despite this reality of how many MNCs are operating, they take the position that such group members are totally independent of each other. Two examples will help demonstrate this.

First, consider an MNC that conducts a seamless worldwide business earning advertising revenues through a software platform, developed and expanded primarily by U.S. group members, that displays advertisements to the users of free services (e.g. email, search, etc.). While individual MNC group members record income from advertisers based on the advertiser's geographic location, U.S. group members conduct within the U.S. the bulk or all of the DEMPE functions (development, enhancement, maintenance, protection, and exploitation) in one integrated operation that benefits all applicable group members. The maintenance, protection, and exploitation functions represent the day-to-day management and activities that allow the platform to operate and generate advertising revenues worldwide. These day-to-day activities are the guts of business operations and the actual activities that earn the profits.

Although zero- and low-taxed foreign group members, which license group IP or own it through cost sharing agreements, record their revenues and related expenses as if they were separate independent businesses, from a management and operational standpoint, they are not independently run businesses. Rather, they are part of one enterprise centrally run and conducted from within the U.S. Typically, such foreign group members do not have either the personnel or capabilities to conduct their own independent business or to even direct independent contractors acting on their behalf.

(Note that to keep the example simple, the above paragraph assumes a platform that is generating advertising revenues. The example could also cover platforms such as those that serve the gig economy and those that sell third-party produced products on either a buy-and-resell or commission basis.)

Second, using an unrelated Asian contract manufacturer, an MNC produces products for sale worldwide through a centrally managed supply chain. U.S. group members manage and conduct the bulk of the product development. Importantly, U.S. group members also manage and conduct the day-to-day production process itself, including functions such as:

(i) Oversight and direction of production activities;

(ii) Material selection, vendor selection, control of raw materials, work-in-process, or finished goods;

(iii) Management of manufacturing costs or capacities;

(iv) Control of manufacturing-related logistics; and

(v) Quality control.

The MNC makes product sales through a number of sales channels. One channel is large volume sales made to major multinational customers and distributors around the world. Personnel within the U.S. not only set group-wide sales policy, but they may also be involved in maintaining relationships and negotiating sales terms with these major customers and distributors. Another channel involves sales made through a software platform used worldwide, for which U.S. group members conduct within the U.S. for all group members the day-to-day management and functions that allow the platform to operate and make sales. Despite this critical involvement of U.S. group members, sales to all foreign customers and distributors are recorded within zero- and low-taxed foreign group members. Such group members (typically through disregarded entity subsidiaries) may provide local sales and marketing, warehousing, and other customer, logistical, and technical support, but they do not have the personnel or capability to independently conduct critical aspects of their own business (e.g. the production process through which they acquire products for resale directly from the Asian contract manufacturer). They are unable to direct the U.S. group members that are nominally acting as independent contractors, but that are in reality conducting crucial sales and production management, decision-making, and operational functions for the benefit of all group members making product sales.

(Note that this second example has been described as one that involves tangible inventory property. It could also involve the sale of intangible inventory property such as group-produced software.)

Although operationally the above two MNC group examples each conduct a globally seamless and centrally managed joint business, there is no overt partnership, joint venture, or similar contract governing the manner in which the group members conduct their joint business. Rather, each group member contracts separately with third parties (e.g. customers, raw material and component vendors, contract manufacturers, etc.) to give the legal appearance of separate and independently operating companies. Reflecting the reality that many functions benefiting zero- or low-tax foreign group members are being conducted by U.S. group members, intercompany service and similar agreements are executed that treat the U.S. group members as independent contractors and not as agents, partners, or joint venturers.

Basis for Partnership Treatment

As covered in detail within the undersigned's article on unexpected partnership status, the above-described MNC profit shifting structures often create separate entities for federal tax purposes under Reg §301.7701-1(a)(2). Under the Reg §301.7701-3(b) default rules, these separate entities are characterized as partnerships.

It will be useful to contrast today's business models such as those described above with multinational businesses of decades ago that had a much different format than what has become so common today. Under this decades-old format, a U.S. parent company set group policies and provided oversight over its subsidiaries. However, these subsidiaries had a full complement of their own corporate officers (e.g. CEO, operations director, sales director, finance director, etc.) working from the subsidiary's facilities. The subsidiaries were truly standalone operations. Real on-the-ground management was an absolute necessity given the pre-internet communications and other technologies of the time (e.g. the telephone, telex, and fax machines). Enterprise software was in its infancy and even email did not emerge as a business communications device until the mid-1990s. Given these independently run subsidiaries, there were not sufficient “joint business activities” that would ever cause any separate entity for tax purposes or a partnership. The issue simply didn't arise.

Today, however, there is no longer any need for each subsidiary to have a full complement of its own corporate officers. And in fact, they seldom do have any such full complement. The technology advances of the past several decades have allowed both a true centralized management and an isolation of specific and often narrow business functions that contribute to one worldwide business. The subsidiaries are each mere cogs contributing to the group's worldwide business; they are no longer conducting their own independent businesses. The rise of supply chains where various functions occurring in different locations all contribute to one worldwide business is just one example. Another is the centralized management and operation of a worldwide internet-based business. Today's reality within many, if not most, MNCs is actual joint business activities and integrated management and operations.

Over the past several decades, the now commonly used centralized management of worldwide business has become the norm. It is easier, more cost effective, and commercially viable to manage and control a world-wide business using a management structure that relies on integrated technology and that directs personnel, assets, and activities located around the world toward a common goal. The reality of this centralized management of group members and each member's sometimes narrow contribution to the group's worldwide business falls squarely within the applicable rules to create a separate entity and a partnership for tax purposes.

Consequences of Partnership Treatment

Once the relationship between the U.S. and foreign group members is determined to be a partnership, there are several consequences.

• The U.S. and foreign group members are partners with the activities conducted and the assets used in that business considered to be those of the partnership and no longer the activities and assets of the respective partners.²³ With the partnership carrying on a business through one or more U.S. offices, the foreign group member partners are similarly conducting a trade or business in the U.S. (§875(1)), which is the threshold test for applying the effectively connected income rules (§864(c)). Application of the ECI rules will be clear and unambiguous.

• Both partnership filing and §1446 withholding will apply.

Given both the important deterrence effect that partnership status will have on aggressive profit shifting structures and the important tool it represents for the government in its efforts to attack such structures, two actions are strongly recommended: First, the Treasury and the IRS should make appropriate regulation amendments. Second, they should issue one or more revenue rulings that find separate entity and partnership status for relevant group members in certain profit shifting structures.

Amendment of Reg §301.7701-1(a)(2)

Reg §301.7701-1(a)(2) should be amended to read as follows:

A separate entity for federal tax purposes shall include a joint venture or other arrangement, whether or not evidenced by a contract or other written agreement, through or by means of which the participants carry on any business, financial operation, or venture. For example, a separate entity exists for federal tax purposes if co-owners of an apartment building lease space and in addition provide services to the occupants either directly or through an agent. On the other hand, mere co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute a separate entity for federal tax purposes. A joint undertaking merely to share expenses does not create a separate entity for federal tax purposes. For example, if two or more persons jointly construct a ditch merely to drain surface water from their properties, they have not created a separate entity for federal tax purposes. Similarly, if an individual owner, or tenants in common, of farm property lease it to a farmer for a cash rental or a share of the crops, they do not necessarily create a separate entity for federal tax purposes. Participants, however, may create a separate entity for federal tax purposes if they actively carry on a trade, business, financial operation, venture, or any portion thereof and divide in any manner the profits or the products or other results thereof. Such a trade, business, financial operation, or venture may include, for example, (i) the joint production of inventory property, whether tangible or intangible, where the participants take in-kind or dispose of their shares of any property produced, extracted, or used, or (ii) the joint conduct of an internet platform-based business (e.g. giving advertisers access to platform users or providing cloud or other services including, for example, providing software and applications to users and acting as a sales agent or intermediary between users and third-party providers).

The above recommended language does two things. First, it adds examples that take into account modern business models using digital technologies. Second, it moves and expands the phrase “divide the profits therefrom”.

While the addition of modern business model examples is self-explanatory, the movement and expansion of the “profits” phrase deserves some explanation.

The first sentence of present Reg §301.7701-1(a)(2) reads:

A joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom. [Emphasis added.]

This sentence implies that for a separate entity to exist for federal tax purposes, the arrangement amongst the participants must have profits (or presumably losses) that are shared in some manner between them. Importantly, this implication is neither consistent with other Code and regulatory provisions nor with the historical regulations on which the current Reg §301.7701-1(a)(2) is based.

Regarding this inconsistency with other Code and regulatory provisions, first note §§761(a) and 7701(a)(2) that provide, with only minor language differences:

For purposes of this subtitle, the term "partnership" includes a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a corporation or a trust or estate.

Focusing solely on this statutory language, joint production alone carried out by MNC group members reasonably falls within "any business, financial operation, or venture." This is made 100% certain by §761(a)(2), which effectively states that an organization that is availed of “for the joint production, extraction, or use of property, but not for the purpose of selling services or property produced or extracted” may elect to be excluded from the application of all or part of subchapter K. If such an organization were not a partnership covered by subchapter K in the first place, it would not be necessary to have a specific provision allowing it to elect out of subchapter K. The point here, of course, is that an arrangement in which two or more participants solely produce inventory property with each participant taking its share in-kind will have no revenues from joint sales or services. As such, it will have no profit to share amongst the participants. Hence, without question, a separate entity for federal tax purposes can exist without the sharing of profits.

Note that even if this §761(a)(2) were not already a 100% certainty for joint production, for any MNC group members that also conduct joint sales, licensing, and service activities, these joint activities absolutely fall within these statutory provisions.

It was stated above that there is also an inconsistency between the current regulation (Reg §301.7701-1(a)(2)) and the historical regulation on which the current regulation is based. This inconsistency directly involves the phrase “divide the profits therefrom”.

Specifically, to repeat, the first sentence of Reg §301.7701-1(a)(2) is:

A joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom. [Emphasis added.]

This placement of the “divide the profits” phrase makes it appear that the existence of profits and their being divided amongst the participants is a condition for there to be a separate entity for federal tax purposes. By contrast, the pre-1997 regulation (Reg §301.7701-3(a)) from which this language was taken reads, in part:

(a) In general. The term "partnership" is broader in scope than the common law meaning of partnership and may include groups not commonly called partnerships. Thus, the term "partnership" includes a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not a corporation or a trust or estate. . . . Mere co-ownership of property which is maintained, kept in repair, and rented or leased does not constitute a partnership. . . . Tenants in common, however, may be partners if they actively carry on a trade, business, financial operation, or venture and divide the profits thereof. For example, a partnership exists if co-owners of an apartment building lease space and in addition provide services to the occupants either directly or through an agent. [Emphasis added.]

This “divide the profits” phrase was previously only a means of distinguishing within the regulation one example of a situation involving co-ownership of property and did not modify the basic definition of a partnership, which was: “a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on.” This use in one example was, of course, fully consistent with the statutory definitions in both §§761(a) and 7701(a)(2), neither of which included any “divide the profits” requirement and neither of which was changed when the current regulation was promulgated in 1997.

By moving this “divide the profit” phrase to the first sentence in Reg §301.7701-2(a), it became in appearance a principal part of the definition of a separate entity for federal tax purposes, and thus narrowed the meaning of that term.

Was there any intention when the new 1997 the check-the-box regulations were issued to actually change the meaning, or at least the emphasis, of the definition of separate entity for federal tax purposes and narrow it through the addition of this “divide the profit” phrase?

The answer must be “no”. There could have been no intention for any change that would narrow the meaning. First, of course, the statutory definition of “partnership” of many decades had not changed in either of §§761(a) or 7701(a)(2). Thus, there was no authority for any narrowing of the definition of “partnership” or the term “separate entity for federal tax purposes”, which is critical for defining the classification of entities under the new check-the-box regulations. Second, with the overall intention of the 1997 check-the-box regulations being simplification, the Treasury and IRS were likely just cleaning up the language of the reconfigured regulations without intending any change of meaning.

Interest in Partnership for Determining Distributive Share (§704(b))

As indicated earlier, the statutory definition of partnership, and by extension the definition of a separate entity for federal tax purposes, is very broad and includes organizations established under applicable local law and those established through contracts and the joint actions of the parties. The MNC group member relationships briefly described in the above examples are established through the operating joint activities of the parties and by other relevant factors, including verbal understandings, internal group policies, management lines of authority, and intercompany contracts — including any licensing and cost sharing agreements as well as any intercompany service agreements under which U.S. group members provide services to foreign group members. All of these will be factors in defining each participant's interest in the separate entity for federal tax purposes, and thus each participant's interest in the partnership for determining its distributive share under §704(b).

Consideration should be given to adding guidance and examples to Reg §1.704-1.

First, as a simplified approach that would be practical and easy to apply, the partnership profits (i.e., generally the combined profits of the joint business conducted by the group member partners) could be apportioned each year based on some appropriate factor(s) that each group member partner brings into the partnership. These factors could include, for example, the year's average net tangible assets, average personnel, average compensation, gross income from sales, etc. An additional factor that could often be relevant would be cumulative R&D expenses (including personnel, supplies, depreciation, etc.) to reflect the contribution of intangibles.²⁴ Such a cumulative intangibles factor would reflect not the dollars contributed by each partner under any CSA that the group member partners had executed, but rather on the actual personnel and other costs each partner had expended in developing the R&D. Where production occurs through use of a contract manufacturer and group personnel are performing the functions described in Reg §1.954-3(a)(4)(iv)(b), the personnel performing these manufacturing functions may be quite important and indicative of what each group member partner contributes to the partnership with net tangible assets having little relevance. For many profit shifting structures, the zero- or low-taxed foreign group members will likely bring little or nothing into the partnership in the way of many of these factors.

The above simplified approach seems preferable for its use of actual personnel and activities that, in effect, ignore intercompany agreements that are typically drafted with tax motivations in mind. A possible second approach that does rely on intercompany agreements would be to determine partner interest-in-the-partnership percentages as of the creation of the partnership. Those percentages would then be applied to the partnership profits for each subsequent year. Such percentages could be based on the original terms of the intercompany agreements executed among the group members when the partnership was created (i.e. likely at the same time that the group initiated its profit shifting structure). The terms of those various agreements (cost sharing agreement, any licensing agreements, intercompany service agreements, etc.) should reflect any IRS transfer pricing adjustments or advance pricing agreement that may have been obtained by the group.

A third approach, which also relies on intercompany agreements, would be to apportion the partnership profits by determining for each year each partner's interest-in-the-partnership, and thus its distributive share, based on the various written agreements between them (e.g. the cost sharing agreement, service agreements, etc.) and each partner's separate agreements with third parties (e.g. customers, contract manufacturers, suppliers, etc.).

Issuance of Revenue Rulings

It is recommend that one or more revenue rulings be issued that prescribe (i) when a joint business conducted by an MNC group's members shall create a partnership for tax purposes with those group members as the partners, and (ii) that their activities (i.e. the activities that are a part of the joint business but which have been conducted in the name of each partner) are treated as activities of the partnership. Such guidance for certain profit shifting structures should be a simple approach to demonstrating the government's resolve to fight artificial profit shifting structures.

One or more revenue rulings could also explore the issue of what group members' activities might be factually included within the joint business, and therefore included as activities of the partnership and not the separate activities of any partner. In addition to activities such as joint purchasing, production, and sales activities, research and development benefiting all group member partners would be included as well. As noted above in footnote 24, when so included, a ruling could provide that any cost sharing agreement signed by the group member partners would no longer be recognized for tax purposes.

Article 3 in footnote 4 provides detailed information from which a ruling may be drafted. The writers of this letter would be pleased to provide further guidance if it would be helpful.

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APPENDIX E

Designate Certain MNC Profit-Shifting Structures as Listed Transactions

Many MNC profit-shifting structures exhibit three factors that suggest the existence of a U.S. trade or business, a partnership, and ECI. The three factors are:

Profit-shifting structures with these characteristics should be designated as a “listed transaction” under Reg §1.6011-4(b)(2). If so designated, all parties will be on notice concerning the various penalty and disclosure requirements that apply to taxpayers that fail to report relevant income and pay tax. This should encourage some MNCs and their advisors to scale back or unwind existing profit-shifting structures as well as discourage the creation of new structures. It should also discourage professional firms from pushing risky structures on existing and potential clients due to the disclosure and penalties applicable to any material advisor.

If for any reason it is determined that it is not possible to designate these structures as “listed transactions”, they could be designated as “transactions of interest” under Reg §1.6011-4(b)(6).

Whether or not it is decided to designate certain profit-shifting structures as listed transactions or transactions of interest, and to the extent that doing so would not require Congressional action, consideration should be given to providing administrative relief to unwind profit-shifting structures so as to encourage compliance and self-reporting of prior years' tax obligations on amended or late filings through abatement of penalties and/or other amounts that might otherwise be due.

In clear support of this suggestion for “listed transaction” designation, the U.S. District Court for the Western District of Washington in a January 17, 2020, decision clearly labeled a Microsoft tax structure involving Puerto Rico as a tax shelter.²⁵ This Microsoft structure, which involved KPMG as an advisor, clearly evidenced the above three factors. With the benefit of this court decision, it seem clear that not only this Microsoft structure but also many other profit-shifting structures so commonly used would similarly be tax shelters within this definition.

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APPENDIX F

Profit-Shifting Structures Implemented Following Inversions and Acquisitions by Foreign Acquirers

Background

There have been and continue to be both inversion transactions and acquisitions of U.S.-based MNCs by foreign persons (including foreign acquisition vehicles owned by U.S. private equity funds). In all of these cases, following the inversion or acquisition, there is motivations to transfer U.S.-owned intangible assets to foreign group members and establish profit-shifting structures that route profits to group members that are not CFCs.

Treasury and the IRS should consider issuing one or more notices to make clear that following any such inversion or acquisition the valuation of any transferred assets and the potential for ECI and earnings stripping will be priorities for examination. This could also be made a part of the LB&I Campaign program.

The following paragraphs include two examples. The first clearly illustrates post acquisition transfers of U.S. intangibles and related issues. The second, while not a tax case, illustrates how the acquisition of IP may be an important motivation for a foreign acquirer. In such cases, IRS examinations should be looking not only for undervaluation of IP transfers, but also for unrecorded transfers where acquirer group members merely start using the IP in their other products. This may have occurred in this Segway example.

Example 1 — Valeant Pharmaceuticals International

The first and perhaps best example is Valeant Pharmaceuticals International, a Canadian public company listed in the U.S. that is the result of a 2010 inversion. Interestingly, because Valeant was invited on July 30, 2015, to testify before the Senate Homeland Security and Affairs Permanent Subcommittee on Investigations (“PSI”), there is significant internal company information on tax avoidance involved in Valeant's acquisitions of U.S. groups (including, for example, Salix Pharmaceuticals (2015) and Bausch and Lomb (2013)).²⁶

The PSI Majority Staff Report,²⁷ on pages 12 through 31 provides significant detail on how Valeant transferred intangibles owned by the acquired companies out of the U.S. shortly after each acquisition and set up profit-shifting arrangements. Not only is there the issue of valuation for transferred intangibles, which were transferred to an Irish subsidiary, but with the apparent lack of any change in the conduct of the acquired companies' businesses, it is likely that the Irish company has significant taxable ECI following the transfer of these intangible assets.

Example 2 — Segway

Turning to another U.S. taxpayer, on September 9, 2014, Segway Inc. filed a trade complaint²⁸ against a number of companies, most of which were Chinese. The basis for the trade complaint was that the respondents were importing products that infringed various Segway patents. Later in April 2015, it was announced that one of the Chinese respondents, Ninebot Inc., would acquire Segway.²⁹ An interview with a co-founder of the acquirer stated:

The primary benefit of buying Segway is the patents. . . . Ninebot is still young, as is Xiaomi [a major Chinese company partially funding Ninebot], so we can't successfully apply for many patents. Segway has the core patents for the self-balancing vehicle industry, so this acquisition will help us with our patents a lot.³⁰

It seems likely that in many acquisitions like this, there may be not only undervalued transfers of intangibles to foreign acquirers, but there may be many undocumented transfers of designs, processes, and patent rights to foreign acquirers. IRS audit activity must identify such transferred intangibles and discourage such transfers through giving notice to applicable taxpayers of this priority.

The TechCrunch piece cited in footnote 29 commented regarding Xiaomi:

This marks the latest in a series of hardware and Internet of Things investments by Xiaomi, which has also given funding to companies like Misfit, Pebbles Interfaces, and iHealth Labs. Alliances with these startups can potentially help Xiaomi build its e-commerce unit, which, along with Internet services and hardware like its smartphones, form the core parts of its business.

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APPENDIX G

Addition of Examples to the Subpart F Manufacturing Branch Rule

Background

Appendices A, B, and C discuss effectively connected income and sourcing rules including both the §863(b) and §865(e)(2) rules as they govern taxpayer-produced inventory. Appendix D of this submission and Article 3 in footnote 4 explain the creation of unanticipated partnerships for U.S. tax purposes. Article 6 listed in footnote 4 includes discussion of how the manufacturing branch rule applies to cause some gross income not caught by the ECI rules to be subpart F income. Since these issues are not sufficiently covered within the existing subpart F regulation on foreign base company sales income, examples as described below should be added to Reg §1.954-3.

In brief, assume that the facts underlying an MNC's profit shifting structure cause there to be an unanticipated partnership for U.S. tax purposes with U.S. group members and zero- or low-taxed foreign group members as partners.

Although the MNC group uses one or more unrelated Asian contract manufacturers for the physical production of inventory property, the joint production activities of the group members conducted through the partnership meet the requirements of Reg §1.954-3(a)(4)(iv)(a) so that the inventory property sold by the partnership is considered manufactured, produced, or constructed by the partnership, and in turn by the CFC partners (Reg §1.954-3(a)(6)). As a result of this, the manufacturing branch rule of Reg §1.954-3(b)(1)(ii) applies. Note the last sentence of subparagraph (a) of Reg §1.954-3(b)(1)(ii), which reads:

. . . The provisions of this paragraph (b)(1)(ii) will apply only if the controlled foreign corporation (including any branches or similar establishments of such controlled foreign corporation) manufactures, produces, or constructs such personal property within the meaning of paragraph (a)(4)(i) of this section, or carries on growing or extracting activities with respect to such personal property.

Reg §1.954-3(b)(4) Example 10 — All Manufacturing Performed in U.S.

Assume first that all of the partnership's production activities within the meaning of Reg §1.954-3(a)(4)(iv)(b) occur at offices and other facilities within the U.S. so that each CFC partner “carries on [through the partnership] manufacturing, producing, constructing, growing, or extracting activities by or through a branch or similar establishment located outside the country under the laws of which such corporation is created or organized”. Also assume that the portion of the partnership's sales that are made for use, consumption, or disposition outside the U.S. are not attributable to any office or other fixed place of business within the U.S within the meaning of §865(e)(2) and Reg §1.864-6.

Before the December 2017 Tax Cuts and Jobs Act and its amendment of §863(b), gross income from the production of inventory property within the U.S. and its sale outside the U.S. was sourced through one of several regulatory approaches that sourced a portion of the gross profit based on the taxpayer's production activities and the remainder based on the taxpayer's sales activities. After this TCJA amendment of §863(b), all (100%) of the gross profit is sourced at the location(s) of production. (Note that sales of taxpayer produced property that are attributable to a U.S. sales office (and are not excepted from this treatment by §865(e)(5)(B)) are now sourced under §865(e)(2) and Prop Reg 1.865-3(d)(2).)

Prior to the TCJA §863(b) amendment, the manufacturing branch rule is relevant for this Example 1, which involves production activities solely within the U.S. This is because the pre-TCJA partnership will have some foreign source income due to sales made outside the U.S. Because this foreign source gross income is not ECI and therefore could not be directly taxable to a CFC partner, this foreign source income must be subjected to subpart F analysis. After the TCJA, with 100% of the gross profit based at the location of production, all gross profit under the facts of this Example 1 will be ECI, thereby causing subpart F and the manufacturing branch rule to no longer be relevant. (However, see Example 2 below with different facts where the manufacturing branch rule is relevant post-TCJA.)

With the partnership's manufacturing branch being located in the U.S., the manufacturing branch rule (Reg §1.954-3(b)(1)(ii)(b)) is applied to pre-TCJA years by comparing the effective tax rate on the relevant foreign source sales income with 30%. This 30% is the lower of 90% of, or 5 percentage points less than, the 35% U.S. tax rate that existed prior to the TCJA. If the actual taxes imposed are less than 30%, the manufacturing branch rule applies to relevant foreign sales income that would otherwise be caught by the Code §954(d)(1) definition of foreign base company sales income (FBCSI).

Note that not all foreign source income will be FBCSI. For example, say that the partnership (or a low-taxed foreign member partner) has a sales office in Singapore. In that case, inventory property sold for use, consumption, or disposition within Singapore would not be caught by the Code §954(d)(1) FBCSI definition. However, sales into nearby Malaysia where there is no sales office would be caught.

Based on the above, the following example 10 should be added to Reg §1.954-3(b)(4) Illustrations.

Example 10. Manufacturing activities performed by partnership branch in the United States. (i) Facts. Controlled foreign corporation FS organized in Country M maintains a disregarded entity sales subsidiary in Country N, which is treated as a sales branch (Branch S) of FS for U.S. tax purposes under section 301-7701-3. FS is wholly owned by USP, which is organized in the United States and operates only within the United States. USP and FS jointly own certain intangible property under the terms of a cost sharing agreement within the meaning of §1.482-7 regarding Product X. USP makes sales of Product X for use, consumption, or disposition within the United States. FS, through Branch S, makes sales for use, consumption, or disposition in Countries N and O. These Branch S sales are not attributable to any office or other fixed place of business within the U.S within the meaning of §865(e)(2) and Reg §1.864-6. Each of USP and FS, using the intangible rights each holds under the cost sharing agreement, contracts directly with an unrelated contract manufacturer CM for production of Product X. CM physically performs the substantial transformation, assembly, or conversion of raw materials into Product X in Country P. On behalf of both itself and FS, USP conducts all relevant production activities described in paragraph (a)(4)(iv)(b) of this section, thereby making a substantial contribution to the manufacturing of personal property within the meaning of paragraph (a)(4)(iv)(a). Because of their integrated management and operations, USP and FS conduct a joint business that is treated as a separate entity for federal tax purposes under section 301.7701-1(a)(2) and a partnership under the section 301.7701-3(b) default rule. As a result, this partnership (Partnership Z) is considered for federal tax purposes to directly own, employ, and conduct all assets, personnel, and activities involved in the joint business of producing and selling Product X. These assets, personnel, or activities are no longer the assets, personnel, or activities of the two partners, each of which is now considered to own an interest in Partnership Z.

(ii) Result. Partnership Z manufacturers Product X in the United States and sells through sales offices both in the United States and in Country N. The application of relevant sourcing rules causes some portion of the partnership's income to be U.S. source and effectively connected income under section 864(c)(3) and excluded from subpart F income under section 952(b). Any portion of partnership income that is foreign source is subject to paragraph (b) of this section, including in particular paragraph (b)(1)(ii). In applying paragraph (b)(1)(ii), Partnership Z's production activities within the United States are treated as a manufacturing branch. Sales made by Partnership Z for use, consumption, or disposition in Country O potentially qualify as foreign base company sales income under section 954(d)(1). For years prior to the Tax Cuts and Jobs Act, the comparison of effective rates of tax described in Reg §1.954-3(b)(1)(ii)(b) will be made based on the then effective 35 percent corporate rate under section 11. Accordingly, the comparison rate will be 30 percent, which is is the lower of 90 percent of, or 5 percentage points less than, the 35% U.S. tax rate. Paragraph (a)(6) of this section applies to determine the foreign base company sales income of FS.

Reg §1.954-3(b)(1)(ii)(c)(3)(v) Example 7 — Manufacturing Performed Both Within and Without the U.S.

Assume now that 50% of the partnership's production activities for certain personal property occurs at offices and other facilities within the U.S. and 50% occurs at offices in China adjacent to the facilities of an unrelated contract manufacturer. All activities performed by the partnership within the U.S. and in China are those described in Reg §1.954-3(a)(4)(iv)(b) and the partnership (and each CFC partner) is considered to have manufactured these items of personal property under Reg §§1.954-3(a)(4)(iv)(a) and (a)(6). The countries of incorporation of the CFC partners are zero- or low-taxed countries other than the U.S. or China. Through these U.S. and Chinese facilities, the partnership (and each CFC partner) “carries on manufacturing, producing, constructing, growing, or extracting activities by or through a branch or similar establishment located outside the country under the laws of which such corporation is created or organized”. The partnership makes sales for use, consumption, or disposition both within and outside the U.S.

With production activities being conducted both within and outside the U.S., under §863(b), whether prior to or following the above-mentioned TCJA §863(b) amendment and the December 2019 issuance of proposed regulations under §§863(b) and 865(e)(2) and (3), some portion of the gross income earned will be foreign source and, therefore, not ECI. With this foreign source income not being directly taxable ECI to any CFC partner, this foreign source income must be subjected to subpart F analysis.

The facts of this Example 11 make Reg §1.954-3(b)(1)(ii)(c)(3) applicable, which provides in part:

This paragraph (b)(1)(ii)(c)(3) applies to determine the location of manufacture, production, or construction of personal property for purposes of applying paragraph (b)(1)(i)(b) or (b)(1)(ii)(b) of this section where more than one branch or similar establishment of a controlled foreign corporation, or one or more branches or similar establishments of a controlled foreign corporation and the remainder of the controlled foreign corporation, each engage in manufacturing, producing, or constructing activities with respect to the same item of personal property which is then sold by the controlled foreign corporation. . . .

Without going into unnecessary detail, Reg §1.954-3(b)(1)(ii)(c)(3) includes a number of examples that cover various possible factual situations involving a CFC's production activities in multiple locations and the use of unrelated contract manufacturers. Understandably, the examples consider situations involving one CFC with multiple operating locations and with its own personnel in each such location. None of the examples specifically consider a situation where multiple CFCs are conducting joint business operations in a manner that has created a partnership for tax purposes.

Based on the above, the following example 7 should be added to Reg §1.954-3(b)(1)(ii)(c)(3)(v) Examples.

Example 7. Manufacturing activities performed by partnership branch in the United States and Country C. (i) Facts. Controlled foreign corporation FS organized in Country M maintains a disregarded entity sales subsidiary (Branch S) in Country N and a disregarded entity manufacturing subsidiary (Branch P) in Country P, both of which are treated as branches of FS for U.S. tax purposes under section 301-7701-3. FS is wholly owned by USP, which is organized in the United States and operates only within the United States. USP and FS jointly own certain intangible property under the terms of a cost sharing agreement within the meaning of §1.482-7 regarding Product X. USP makes sales of Product X for use, consumption, or disposition within the United States. FS, through Branch S, makes sales for use, consumption, or disposition in Countries N and O. These Branch S sales are not attributable to any office or other fixed place of business within the U.S within the meaning of §865(e)(2) and Reg §1.864-6. Each of USP and FS, using the intangible rights each holds under the cost sharing agreement, contracts directly with an unrelated contract manufacturer CM for production of Product X. CM physically performs the substantial transformation, assembly, or conversion of raw materials into Product X in Country P. USP and FS (through Branch P) conduct all relevant production activities described in paragraph (a)(4)(iv)(b) of this section, thereby making together a substantial contribution to the manufacturing of personal property within the meaning of paragraph (a)(4)(iv)(a). Because of their integrated management and operations, USP and FS conduct a joint business that is treated as a separate entity for federal tax purposes under section 301.7701-1(a)(2) and a partnership under the section 301.7701-3(b) default rule. As a result, this partnership (Partnership Z) is considered for federal tax purposes to directly own, employ, and conduct all assets, personnel, and activities involved in the joint business of producing and selling Product X. These assets, personnel, or activities are no longer the assets, personnel, or activities of the two partners (including for FS those of Branch S and Branch P), each of which is now considered to own an interest in Partnership Z.

(ii) Result. Partnership Z manufacturers Product X through branches in the United States and Country P and sells through sales offices both in the United States and in Country N. The application of relevant sourcing rules causes some portion of the partnership's income to be U.S. source and effectively connected income under section 864(c)(3) and excluded from subpart F income under section 952(b). Any portion of partnership income that is foreign source is subject to paragraph (b) of this section, including in particular paragraph (b)(1)(ii). In applying paragraph (b)(1)(ii), Partnership Z's production activities within the United States and Country P are treated as manufacturing activities conducted by two manufacturing branches and the rules of paragraph (b)(1)(ii)(c)(3) apply. Sales made by Partnership Z for use, consumption, or disposition in Country O potentially qualify as foreign base company sales income under section 954(d)(1). Paragraph (a)(6) of this section applies to determine the foreign base company sales income of FS.

Reg §1.954-3(a)(6)(ii) Example 2 — Treatment of Partnerships

Many MNC profit shifting structures implemented over the past two decades involve multiple group members (including both U.S. group members and CFCs) that conduct portions of a centrally managed and conducted worldwide business that is seamless to vendors, customers, and other third parties. As discussed in Appendix D of this submission, despite the lack of any partnership or joint venture agreement, the joint business activities conducted by these group members will often create a separate entity for federal tax purposes and a partnership under the Reg §301.7701-1 to -3 entity classification rules. Given such unanticipated partnerships, it is important to add clarity to Reg §1.954-3 such that taxpayers have increased guidance and the IRS has more specificity in taxing aggressive profit shifting structures that involve such jointly conducted businesses.

Such clarity may be added to Reg §1.954-3 by including the following as a second example in Reg §1.954-3(a)(6)(ii):

Example 2. USP, a U.S. corporation, wholly owns CFC, a controlled foreign corporation organized under the laws of Country A. CFC owns disregarded entity subsidiaries X and Y established, respectively, in countries B and D. X conducts certain production activities while Y conducts certain marketing and sales activities. It has been determined that USP and CFC (including its disregarded entity subsidiaries) conduct their centrally managed worldwide business in a manner that creates a separate entity for federal tax purposes under section 301.7701-1(a)(2) and a partnership under the section 301.7701-3(b) default rules (Partnership Z). As a result of this partnership classification, all assets, personnel, and activities involved in the joint production and sales are considered for federal tax purposes the assets, personnel, and activities of Partnership Z and not the assets, personnel, or activities of either partner.

Through offices, facilities, and employees within the United States and Country B, Partnership Z performs activities within both countries that constitute the manufacture of Product P, within the meaning of paragraph (a)(4) of this section (including paragraph (a)(4)(iv)), if performed directly by CFC. Partnership Z, through its sales office in Country D, sells Product P to unrelated customers in Country E, a country in which Partnership Z maintains no sales branch.

CFC's distributive share of Partnership Z's sales income must be analyzed to determine whether it is foreign base company sales income taking into account all of section 1.954-3 including both the manufacturing exception of paragraph (a)(4) and the branch rules of paragraph (b).

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APPENDIX H

Regulatory and Ruling Guidance Concerning Tax Treaties

A. Countering the Abusive Use of Tax Treaties

There has been significant profit shifting out of the U.S. and erosion of the U.S. tax base by both MNCs based in the U.S. and MNCs based abroad. Those based abroad include inverted MNCs, private equity acquisitions through foreign acquisition vehicles, and legitimate foreign-based groups. In some cases, such profit shifting has taken advantage of U.S. tax treaty provisions to reduce or eliminate withholding taxes or to apply treaty rules such as permanent establishment definitions in place of the lower-threshold standard of “engaged in trade or business within the United States”.

Brief Background on Common Situations Involving Taxpayer Abuse of Treaties

Structures that Shift Business and Intangible Profits

With U.S.-based MNCs and some MNCs based abroad, especially inverted MNCs and private-equity structures, the foreign group member that is the “taxpayer” for U.S. tax purposes is a controlled foreign corporation (CFC) that is operating through one or more disregarded entity (DRE) subsidiaries. Some of those DRE subsidiaries are established in countries with which the U.S. maintains tax treaties. While such a DRE subsidiary is a bona-fide legal entity, fully respected as a separate taxable entity by its country of formation, it is treated solely for U.S. tax purposes as not existing and as a branch or division of its CFC owner, i.e., not an “entity”. Accordingly, the U.S. views all DRE subsidiary personnel, assets, and activities as being employed, owned, and conducted by the CFC.

As an example, assume that a U.S.-based MNC has established a CFC in a tax haven such as Bermuda. As that CFC has few or no employees of its own, it conducts business through subsidiaries in other countries for which check-the-box elections have been made to treat them as DRE subsidiaries. As a result of this structure, from a U.S. tax perspective, the only “taxpayer” is the Bermuda CFC. And that CFC operates through branches/divisions within the various countries where the DRE subsidiaries employ personnel, own assets, and conduct their respective operations. Those branches and divisions are not considered to be “entities” for U.S. tax purposes.

The author of this submission have written a number of articles³¹ describing some structures through which MNCs have shifted business and profits from intangible assets out of the U.S. and into zero- and low-taxed group members, one of which may be a CFC while others are DRE subsidiaries of that CFC. An important focus of these articles has been the application of effectively connected income taxation to some portion of these shifted profits (§864(c)). Typically, these profit shifting structures not only shift profits out of the U.S. They also shift profits out of the foreign countries in which they operate through DRE subsidiaries. As a result, these structures normally bear very low levels of foreign taxation.

ECI taxation requires that the foreign taxpayer (i.e., the CFC in this case) be engaged in a trade or business within the U.S. (§864(b)). Where a tax treaty properly applies, this “trade or business within the U.S.” threshold is replaced by the permanent establishment definition included in the treaty. Further, where there is a permanent establishment and some amount of ECI is present, it is taxable at the normal corporate rate (pre-TCJA 35%, post-TCJA 21%). In addition, the branch profits tax (§884) applies at rate of 30% to the calculated dividend equivalent amount. If a tax treaty were to apply, then that 30% branch profits tax may be reduced or eliminated if the treaty specifies a lower rate or exemption.

Structures Involving Interest, Royalties, and Dividends

DRE Subsidiaries. In addition to business income, DRE subsidiaries may license IP for use in the U.S. or loan money to U.S. persons, thereby earning U.S. source royalties and/or interest. A DRE subsidiary might also invest in the shares of unrelated U.S. companies, thereby earning U.S. source dividends. Where a DRE subsidiary is established in a country with which the U.S. maintains a tax treaty, it might maintain that it should receive a reduction or elimination of the 30% withholding tax that applies under domestic law to these types of payments.

Other Foreign Entities. Foreign-based MNCs have aggressively eroded the U.S. tax base through interest and royalties charged to their U.S. operating subsidiaries. Concern about this has resulted in the TCJA adding new §59A, the base erosion minimum tax. This sort of base erosion by foreign-based MNCs normally does not involve either CFCs or DRE subsidiaries. It does, though, often involve routing interest and royalties though structures that arguably provide tax treaty benefits that reduce or eliminate the 30% U.S. withholding tax while avoiding any significant tax in the country of the treaty partner.

Description of Treaty Abuses

The U.S. enters into treaties to prevent double taxation; not to provide the opportunity for double non-taxation. Despite this, situations abound where taxpayers go through complicated structuring that arguably allows them to claim inappropriate treaty benefits. Most commonly, this means that they claim a treaty benefit from the U.S. while the relevant income is not taxed in the other treaty country on a normal resident basis. Thus, the sorts of profit-shifting structures and channeling of income from U.S. sources described above are normally only set up in treaty countries that offer special arrangements under which only a mere fraction (if any) of the normal resident tax is imposed. Well-known examples include Ireland and Luxembourg. Both have been documented as agreeing to special rulings and artificial practices that allow zero or little taxation far below the domestic effective corporate rates that apply to resident taxpayers. These special arrangements and low effective tax rates were not what U.S. treaty negotiators agreed to nor what the Senate thought it was ratifying.

The first example above assumes that the CFC is established in Bermuda, which maintains no tax treaty with the U.S. The CFC could also have been established in a country with which the U.S. maintains a tax treaty such as the U.K., Ireland, Switzerland, etc. In such cases, all (or virtually all) of the operating income is earned not within the CFC itself, but rather within the CFC's DRE subsidiaries. As such, that operating income would not be reported in the tax returns that the CFC submits to its own tax authorities in, say, the U.K. Further, due to the territorial tax systems and other exemptions and special rules employed by many countries, DRE subsidiary earnings actually distributed to the CFC typically go untaxed in the CFC's country of establishment.

Say that this CFC established in the U.K. claims that the activities of its DRE subsidiaries do not cause a permanent establishment in the U.S. under the U.S.-U.K. tax treaty. Or, say that the CFC has ECI and files a U.S. tax return to report profits earned within its DRE subsidiaries, but claims that the U.S.-U.K. tax treaty reduces the 30% branch profits tax to 5%. With the relevant income for which the CFC is claiming benefits under the U.S.-U.K. tax treaty not being reported within any U.K. tax filings, it is inappropriate for treaty benefits to be granted.

It could also occur that a DRE subsidiary claims tax treaty benefits based on the U.S. treaty with the country of establishment of the DRE subsidiary. This could occur, for example, where the DRE subsidiary claims that it has no permanent establishment within the U.S. or that the 30% branch profits tax should be reduced or exempted. It could also occur where the DRE subsidiary claims treaty reductions in the 30% U.S. withholding tax on dividends, interest, and royalties. Often, such claims involve taxpayer abuse that seeks benefits not anticipated by either U.S. treaty negotiators or the Senate.

The second section above concerning structures involving interest, royalties, and dividends notes the inappropriate use of tax treaties by foreign-based MNCs to erode the U.S. tax base. In contrast to foreign-based MNCs, CFCs and DRE subsidiaries are seldom involved in such claims for treaty benefits.

Discussion

Fiscally Transparent Entities.

The above-described abusive situations involving a CFC taxpayer that conducts business operations or records transactions (including investments, loans, licenses, etc.) through DRE subsidiaries should never receive any treaty benefits, either at the CFC level or at the level of any DRE subsidiary. (The only exception might be where the DRE subsidiary is incorporated within the same country as the CFC for solely non-tax reasons and tax on a normal resident basis is being paid to that country by both the CFC and the DRE subsidiary.) Almost without exception, schemes involving CFCs and DRE subsidiaries have been carefully crafted to avoid or significantly reduce both foreign and U.S. taxation by carefully working to fall within mismatches between the tax laws of the U.S. and one or more other countries to arbitrage their tax systems.

Both Fiscally Transparent and Non-Fiscally Transparent Entities.

Sometimes, carefully crafted structures involve a special arrangement between a foreign entity (whether a DRE subsidiary or any non-fiscally transparent foreign entity) and the foreign tax authorities that allows these companies to pay tax at zero or discounted rates not allowable absent such arrangement. In these cases, since the home county is not taxing the foreign entity on a true resident basis, no reduction in or elimination of U.S withholding taxes or other tax treaty benefits (e.g. the application of business profits provisions and reduction in or elimination of the §884 branch profits tax) should be permitted.

The remainder of this Appendix F provides specific recommendations on regulation amendments or guidance that could be provided in a revenue ruling that would disallow these inappropriate treaty benefits.

Fiscally Transparent Entities — Treaty Benefits Other than Reduction or Elimination of Withholding Taxes

With respect to non-withholding tax treaty benefits claimed where CFC and DRE subsidiary structures are involved, the terms of tax treaties and current law allow the IRS to disallow these benefits. The IRS may directly enforce these rules against such abusive arrangements.

For the CFC, the fact that its tax filings made to its home country will exclude all income, deductions, credits, etc. recorded within its DRE subsidiaries means that it cannot be a resident for purposes of the tax treaty under the last sentence of Article 4, paragraph 1. This sentence in the February 17, 2017, version of the U.S. Model Income Tax Convention reads:

. . . This term does not include any person whose tax is determined in that Contracting State on a fixed-fee, “forfait” or similar basis, or who is liable to tax in respect only of income from sources in that Contracting State or of profits attributable to a permanent establishment in that Contracting State. [Emphasis added.]

For the DRE subsidiaries, as indicated above, a DRE subsidiary is not recognized as an “entity” for U.S. tax purposes. As such, the IRS may simply refuse to grant any relevant tax treaty benefits under the treaty between the U.S. and the country of establishment of the DRE subsidiary on the basis that the DRE subsidiary cannot be a “person” for purposes of that treaty under Article 3, and therefore not a treaty “resident” under Article 4.

Needed: Regulatory and/or ruling guidance concerning the non-applicability of tax treaty benefits in the above circumstances.

Fiscally Transparent Entities — Treaty Benefits for Withholding Taxes

With respect to reduction in or elimination of withholding taxes, Reg §1.894-1(d) provides relevant rules.³²

A critical first rule relevant to these abusive arrangements is that the regulation provides for DRE subsidiaries at paragraph (d)(3)(i) an expansive definition of “entity”. As such, this definition overrides the lack of any “entity” (as explained in the section immediately above) that otherwise occurs under the domestic U.S. rules.

Needed: An anti-abuse rule that will override this paragraph (d)(3)(i) definition.

A critical second rule is the regulation's concept of “derived by a resident” found in paragraph (d)(1). T.D. 8889 (65 F.R. 40993-41000, 2000) consciously included this concept as the mechanism to determine qualification for withholding tax treaty benefits. In brief, T.D. 8889 included the following explanation:

Commentators suggested that the term subject to tax in the proposed and temporary regulations was ambiguous and could be misinterpreted. Commentators suggested that the term subject to tax could be interpreted as requiring that an actual tax be paid rather than requiring an exercise of taxing jurisdiction by the applicable treaty jurisdiction, whether or not there is an actual tax paid. Commentators suggested that such an interpretation would lead to anomalous results, for example, in cases when the applicable treaty jurisdiction provides an exemption from income for U.S. source dividends under its tax laws.

The IRS and Treasury agree that the term subject to tax could cause unintentional confusion and that a more direct and simpler way of ensuring that an item of income is subject to the taxing jurisdiction of the residence country is to determine if the item of income is derived by a resident of a treaty jurisdiction. The concept of derived by a resident is a more useful surrogate for the concept of subject to the taxing jurisdiction of the residence state, the necessary prerequisite for the grant of treaty benefits on an item of income.

Because of this expansive “derived by a resident” rule that is totally divorced from any actual or potential tax liability or inclusion in taxable income, special rulings, administrative practices, and other artificial means have expanded to meet the needs of MNCs intent on creating complex structures that shift profits and/or erode the U.S. tax base, making full use of the U.S. treaty network in the process. The light shed on this from the LuxLeaks disclosures³³ and other sources has been extensive.

Needed: An anti-abuse rule that will override this “derived by a resident” test and replace it with a “subject to tax” test.

In considering the above, the Treasury and IRS should keep in mind that the MNCs that create these CFC and DRE subsidiary structures have voluntarily-made check-the-box elections. The applicable taxpayer (i.e., the CFC) was not coerced into making these elections for its subsidiaries. Rather, these elections are made only after careful group-wide study of how to maximize profit-shifting and base erosion benefits. This being the case, it is more than reasonable that such taxpayers must live with the consequences of their actions. The above recommendations are appropriate and in no way excessive.

Abuse Not Involving Fiscally Transparent Entities

Many foreign MNCs abuse the U.S. treaty network on interest and royalty flows. One of the clearest examples is described in some detail in the Majority Staff Report titled “Impact of the U.S. Tax Code on the Market for Corporate Control and Jobs” issued on July 30, 2015, by the Permanent Subcommittee on Investigations (Committee of Homeland Security and Governmental Affairs) under the Chairmanship of Rob Portman. The example involves Valeant Pharmaceuticals International, Inc., a Canadian pharmaceutical MNC that resulted from a 2010 inversion transaction. It is understood that Valeant's management is still located within the U.S.

The following is from pages 25-30 of this 2015 Majority Staff Report:

In connection with the Bausch & Lomb acquisition, Valeant pushed down $2.4 billion of the acquisition debt from its foreign affiliates to a Delaware subsidiary (VPI-Delaware), thereby creating a stream of deductible interest payments that have significantly reduced Bausch & Lomb's U.S. tax base. Specifically, Valeant-Canada issued an aggregate $7.3 billion in debt financing from third-party banks. Valeant-Canada then made an interest-free loan of $3.1 billion to a Luxembourg subsidiary, Biovail International S.a.r.l., which in turn made an interest-bearing loan (at 6%) of $2.4 billion to VPI-Delaware.

The result of this intercompany lending is evident in the rise in Valeant-U.S.'s tax-deductible, outbound related-party interest payments. In the two years preceding the Bausch & Lomb acquisition, Valeant's U.S. group made an average of $219,000 per quarter in related-party interest payments. In the first full year following the acquisition, those payments swelled to $59.9 million per quarter — a 273-fold increase. To date, Valeant's U.S. group has made $320.2 million in interest payments on the Bausch & Lomb acquisition debt to Biovail International S.a.r.l. and projects another $375 million in interest payments through the first quarter of 2017; those payments will continue through the life of the loan. The interest payments are fully deductible in the U.S. and subject to no U.S. federal withholding taxes. Only a portion of the interest income received by Valeant in Luxembourg is taxable — at single-digit tax rates.

[Emphasis added and footnotes omitted.]

As if this insult to the U.S. taxation system were not enough, the following is from page 30 of the 2015 Majority Staff Report:

Valeant structured the Salix acquisition debt in a manner that will significantly reduce Valeant's U.S. tax base. Valeant-Canada raised $15.2 billion in debt financing from third parties to support the Salix acquisition. Valeant then made an interest-free loan of $16.5 billion to VFL (Luxembourg). VFL, in turn, made six intercompany loans totaling $16.5 billion to VPI Delaware at an average interest rate of approximately 6.2%. Valeant projects that, from the first quarter of 2015 through the first quarter of 2017, it will make $1.67 billion in interest payments on the Salix debt to VFL; those payments are scheduled to continue until the maturity date of each loan (ranging from 2021 to 2025). To date, Valeant's interest payments on the Salix acquisition debt have been fully deductible in the U.S. and subject to no U.S. federal withholding taxes. Only a portion of the interest income received by Valeant in Luxembourg is taxable — at single-digit tax rates. [Emphasis added and footnotes omitted.]

This sort of artificial arrangement (very low effective tax rate in Luxembourg due to deemed interest deductions on an interest-free loan), and most likely a special ruling from the Luxembourg tax authorities, is abusive. The group's international planning likely results in a double deduction of interest and little or no effective taxation ever of the interest income in either Luxembourg or in Valeant's home country of Canada.

Needed: Regulatory and/or ruling guidance to help taxpayers and the IRS identify abusive situations where tax treaty coverage should no longer be appropriate given that the relevant income is not being taxed in the treaty country of residence in the same manner as a normal resident would be taxed.³⁴

As an indication of the basis for such broad guidance, the following is from T.D. 8999 (67 F.R. 40157-40162, 2002). The initial sentence refers to abuses involving domestic reverse hybrids.

. . . The overall effect of these transactions, if respected, would be (1) a deduction under U.S. law for the “outbound” payment of an item of income, (2) the reduction or elimination of U.S. withholding tax on that item of income under an applicable treaty, and (3) the imposition of little or no tax by the treaty partner on the item of income. This result is inconsistent with the expectation of the United States and its treaty partners that treaties should be used to reduce or eliminate double taxation of income. The legislative history of section 894(c) supports this analysis. Congress specifically expressed its concern about the use of income tax treaties to manipulate the inconsistencies between U.S. and foreign tax laws to obtain similar benefits. See H.R. Conf. Rep. No 220, 105th Cong., 1st Sess. 573 (1997); Joint Committee on Taxation, 105th Cong., 1st Sess., General Explanation of Tax Legislation Enacted in 1997 (JCS-23-97), at 249 (December 17, 1997). The approach adopted by these regulations also is consistent with the U.S. view that contracting states to an income tax treaty may adopt provisions in their domestic laws to prevent inappropriate use of the treaty. . . .

As further encouragement of the critical need for additional regulatory and/or ruling guidance in this general area, it may be noted that Reg §1.894-1(d) was promulgated soon after the issuance of the new check-the-box entity classification rules and without anticipating how MNCs would aggressively utilize them to shift profits outside the U.S. and erode the U.S. tax base.

T.D. 8889 and T.D. 8999 expanded Reg §1.894-1 in 2000 and 2002, focusing principally on structures that would involve income flows to “real” foreign persons. Further, they were expressly limited to treaty benefits applicable to withholding taxes and domestic reverse hybrids. T.D. 8889 commented:

These regulations apply with respect to all U.S. income tax treaties regardless of whether such treaties contain partnership provisions, unless the competent authorities agree otherwise. As with the proposed and temporary regulations, the final regulations address only the treatment of U.S. source income that is not effectively connected with the conduct of a U.S. trade or business. The IRS and Treasury may issue additional regulations addressing the availability of other tax treaty benefits, such as the application of business profits provisions, with respect to the income of fiscally transparent entities, particularly where a conflict in entity classification exists. [Emphasis added.]

After these regulations were issued, abusive profit shifting and base erosion by U.S. MNCs involving foreign hybrid entities grew quickly, if not exponentially, especially after the 2004 Jobs Act repatriation incentive. Despite this quick growth, detailed study and knowledge only started to become public in 2010 when the Staff of the Joint Committee on Taxation issued its report titled “Present Law and Background Related to Possible Income Shifting and Transfer Pricing” (JCX-37-10), dated July 20, 2010, for a Ways and Means Committee public hearing. This public hearing and the JCT's report, along with other hearings and investigative reporting in subsequent years (Google, Microsoft, Apple, Caterpillar, etc.), laid clear the aggressive and artificial nature of many of the structures that our MNCs eagerly adopted.

In short, it's high time for regulatory and ruling guidance that eliminates inappropriate treaty benefits both within the framework of Code §894(c) and broader.

B. Comments on the Application of Articles 5 and 7 to Foreign Treaty Residents

Background

Where a treaty country resident, which sells inventory property that it has produced, maintains a permanent establishment within the U.S., it will be taxed on any income attributable to that permanent establishment. Domestic law under §864(c) and relevant sourcing rules (generally Prop Reg §1.863-3 or Prop Reg §1.865-3, depending on the underlying factual situation) provide for all or a portion of the gross income from such sales to be sourced based on the location of production. Recognizing the existence of pervasive MNC centrally-managed and run multi-group member supply chains, Appendices A through C suggest that sourcing regulations generally, including those proposed in December 2019 under Prop Reg §§1.863-3 and 1.865-3, be expanded so that determinations under those sections are made not on a taxpayer-only basis but rather on a group-wide basis that recognizes the real production activities that multiple group members commonly perform.

These Appendices also make suggestions regarding source rules for internet-platform businesses where those platforms are primarily managed and conducted from within the U.S.

Where a resident of a treaty country

maintains a permanent establishment within the U.S. that is involved in the production of property or the management, maintenance, or other material operation of an internet platform or other business mechanism through which the resident earns gross income, then §863(b), §865(e)(2), or Reg §1.861-4(b)(1) apply to create some amount of U.S. source income that will be effectively connected income under domestic law. Item (iii) in the above listing reflects the suggested expansion of Reg §1.864-2 in Appendix A included in the section “Clarity of Engaged in Trade or Business within the United States”.

As noted above, Appendices A through C of this submission include suggested regulatory changes that would deal much better with profit shifting structures, including those that involve centrally-managed supply chains, internet platforms, or both. These suggestions highlight two treaty issues that are discussed below. One is the suggested clarification of a U.S. trade or business to include actions by another person that conducts within the U.S. important portions of the business of a foreign taxpayer. This raises the permanent establishment definition in Article 5 as an issue. The second issue is the effect that the suggested sourcing rules along with group-wide application of those rules might have in relation to Article 7 regarding taxation of business profits. This and guidance more generally could be useful to taxpayers concerning Article 7 and its application to groups that include disregarded entity subsidiaries under both the Authorized OECD Approach (AOA) and the pre-AOA approach which is still found in many U.S. tax treaties.

It should be noted that many profit shifting structures that move profits into low-taxed foreign group members use entities that are not treaty country residents. A review of publicly available information about a number of major household-name multinationals would show that many have used tax haven and other countries with which the U.S. maintains no tax treaty, or have placed group members in treaty-partner countries where the group member is not resident in that country under the applicable treaty (e.g. non-tax-resident Irish company). In such cases, domestic U.S. tax law will apply. Section A of this Appendix H included suggestions concerning treaty coverage in a number of situations, including foreign group members that are disregarded entities and claim treaty benefits. This is an area that is ripe for some regulatory amendments, rulings, or other approaches that will prevent inappropriate and abusive uses of tax treaties.

Clarification of U.S. Trade or Business/Permanent Establishment

This submission in Appendix A included adding the following at the end of paragraph (a) of Reg §1.864-2 to clarify the definition of “engaged in trade or business within the United States”:

The term also includes the performance of activities within the United States (for example the purchasing or production of products, the substantial contribution to the manufacturing of personal property within the meaning of section 1.954-3(a)(4)(iv)(b), the sale of products, the maintenance and management of an internet-based platform through which sales are made or cloud transactions are conducted that earn advertising or other internet-based service revenues, the rental or licensing of intangibles, etc.) by another person (whether related or not and including activities performed under any independent contractor service agreement or agency) who conducts all or any material portion of these activities or manages the commercial risks thereof for or on behalf of any taxpayer when the taxpayer itself has insufficient personnel or capacity to conduct all or any material portion of its business or manage the commercial risks thereof. The actual conduct and activities of the persons will be decisive rather than any contractual label or description that provides, for example, that the person conducting the activities or managing the commercial risk is an independent contractor providing a service.

This language is meant to make clear that where a person conducts activities within the U.S. for the benefit of a foreign person where those activities represent the conduct of that foreign person's business, then that foreign person will have a U.S. trade or business. The essence of this is that the person conducting the activities is a de facto agent of the foreign person.

Where the foreign person is a resident of a treaty country, then the permanent establishment article in the treaty will apply. Assuming that Treasury issues an amendment to Reg §1.864-2(a) that clarifies that these activities conducted by other persons will cause a U.S. trade or business, then some guidance regarding the interaction of this clarification and the Article 5 definition of permanent establishment would be useful.

The first point is what guidance to provide. A second point is where to provide that guidance.

Regarding the first point, where the person conducting the activities within the U.S. is factually managing risks and/or making decisions on the foreign person's business within the meaning of Reg §1.864-2(a) as clarified, thereby creating a de facto agent, then guidance should provide that that will equate to exercising “an authority to conclude contracts that are binding on the enterprise”. Doing so will allow paragraph 5 of Article 5 to apply, which will cause the foreign person to have a permanent establishment.

As for where to provide that guidance, perhaps something could be issued under §894(b). Or, perhaps it's possible to add guidance within Reg §1.864-2. Alternatively, guidance could be included within the explanation section of the Treasury Decision within which the amendment is made adding the clarifying language to Reg §1.864-2(a). A revenue ruling, of course, is another possibility. Another would be to add this guidance to the Technical Explanation of the 2016 U.S. Model Tax Convention when that Technical Explanation is eventually issued. If the issuance of this Technical Explanation is not expected anytime soon, perhaps there could be an amendment of the Technical Explanation for the 2006 U.S. Model. Needless to say, it seems important that this guidance be provided at the same time or shortly after expanded Reg §1.864-2 is adopted.

Effect of Expanded Sourcing Rules, Disregarded Entity Subsidiaries, Etc.

It was indicated above that the application of §863(b), Prop Reg §§1.863-3 and 1.865-3, or Reg §1.861-4(b)(1), especially with suggestions made in Appendices A through C, could find U.S. source income and therefore effectively connect income under domestic law when the foreign taxpayer conducts a trade or business within the U.S. In cases covered by a tax treaty when there is a permanent establishment, the applicable treaty's Business Profits article determines the amount of profits that are attributable to the permanent establishment and taxable within the U.S.

The 2016 U.S. Model Tax Convention provides in Article 7, paragraphs 1 and 2:

The above from the 2016 U.S. Model reflects the Authorized OECD Approach (AOA). Some tax treaties entered into by the U.S. have been more consistent with the pre-AOA OECD approach and the still current approach in the U.N. Model Double Taxation Convention. Paragraph 2 in both the pre-AOA version and the current U.N. version is:

2. Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment. [Emphasis added.]

One other item worthwhile noting is the following from page 22 of the 2006 U.S. Model Technical Explanation:

The "attributable to" concept of paragraph 2 provides an alternative to the analogous but somewhat different "effectively connected" concept in Code section 864(c). In effect, paragraph 2 allows the United States to tax the lesser of two amounts of income: the amount determined by applying U.S. rules regarding the calculation of effectively connected income and the amount determined under Article 7 of the Convention. That is, a taxpayer may choose the set of rules that results in the lowest amount of taxable income, but may not mix and match. [Emphasis added.]

It was suggested in Appendix A that an Example (4) be added to Reg §1.864-4(b) to make clear that there could be U.S. source income earned by a foreign person from the management, maintenance, or other operation of an internet platform through which the foreign person earns gross income. An Example (5) was suggested to make this clear as well for production activities. In both these cases, there would be some amount of taxable effectively connected income under domestic law.

Where a treaty applies to a foreign person, then that person has the option to apply Article 7 of the treaty to arrive at a lower amount of taxable profits.

Since the initiation over twenty years ago of the check-the-box rules in Reg §§301.7701-1 through -3, hybrid entities have become an increasingly important part of the tax landscape. Recently proposed regulations such as those dealing with the §267A hybrid rules and §904(d) foreign branch income have included relevant rules concerning hybrids entities and disregarded transactions including disregarded payments.

Focusing again on tax treaties, Article 7 analyses required under the AOA may recognize certain dealings between a permanent establishment and other parts of the enterprise. These dealings may or may not follow actual transactions that are disregarded for U.S. tax purposes because parties to the transactions are entities that are disregarded for U.S. tax purposes. Considering this complicated landscape, it seems sensible to study this area and provide some guidance of how the AOA and pre-AOA approaches would work when dealings exist between a permanent establishment and other parts of the enterprise. Perhaps such guidance could include several examples where the same set of facts is analyzed under both the pre-AOA and the AOA.

Consideration could be given to providing such guidance in a revenue ruling and/or in the future Technical Explanation that would be issued in connection with the 2016 U.S. Model Tax Convention.

Within this section, I am only raising the point that guidance is needed. If it is decided to develop this guidance, I could give this area further thought and consider what guidance might be offered.