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IRS Puts Whirlpool Through the Wringer With Branch Income Claim

Posted on June 28, 2019

Whirlpool Corp. is trying to fend off an IRS assessment that it had unreported subpart F income of $50 million from the sale of washing machines and refrigerators manufactured by a Luxembourg subsidiary’s Mexican branch.

In a June 24 reply brief in support of its motion for partial summary judgment, the U.S.-based home appliance manufacturer criticized the IRS for attempting to transform a Mexican manufacturing branch’s profits — exempt from tax under Mexico’s maquiladora incentive — into “untaxed Luxembourg profits.” The reply responds to the IRS’s April 24 memorandum in support of a motion for summary judgment, which argues that Whirlpool’s tax structure represents “the paradigm of the abuses” targeted by Congress when it enacted the foreign base company sales income (FBCSI) regime. After restructuring its Mexican manufacturing organizational structure in 2007 to obtain “significant tax savings,” Whirlpool created stateless income in 2009 by shifting its sales to a shell company, the agency asserted.

The crux of the controversy revolves around the FBSCI rules under section 954(d) and two entities created during the 2007 restructuring: Whirlpool Overseas Manufacturing Sarl (WOM), a controlled foreign corporation organized in Luxembourg; and Whirlpool Internacional, S. de RL de CV (WIN), which is a disregarded entity not separate from WOM and organized in Mexico. After the restructuring, WIN provided manufacturing and assembly services, while WOM held title to all raw materials, work in process, and inventory.

Both Whirlpool and the IRS have filed motions for summary judgment in the case.

In its April memorandum, the IRS accused Whirlpool of paying no income taxes on WOM’s sales income in any jurisdiction. Whirlpool obtained a tax ruling from Luxembourg confirming that WOM’s sales income was attributable to a Mexican permanent establishment and was therefore outside of Luxembourg’s tax jurisdiction. The income was not taxed in Mexico either, because WOM was considered not to have a Mexican PE under the country’s maquiladora incentive scheme. The structure also results in the deferral of U.S. tax.

According to the IRS, the formation of WIN and WOM resulted in sales income being separated from manufacturing solely for tax reasons without WOM, as the selling corporation, adding value — a restructuring that has left the agency nearly apoplectic in its brief. Whirlpool’s structure resulted in the “siphoning of sales profits” on sales of Mexican-manufactured goods out of the United States and into WOM, according to the government.

“A review of Whirlpool’s Mexican operations before and after the 2007 restructuring created exactly the type of tax haven operation that Congress intended to thwart when it enacted the FBCSI rules,” the IRS said. “Indeed, Congress’ description of the foreign operations that it legislated against when it promulgated section 954(d) is identical to Whirlpool’s foreign operations in every way.”

According to Whirlpool’s new reply brief, the government’s claims of “stateless income” are based on the incorrect premise that the profits at issue were Luxembourg’s to tax. Citing the 2001 Luxembourg-Mexico tax treaty, the reply brief says Luxembourg had no taxing rights over the income because it was attributable to a Mexican PE. Mexico’s policy choice to offer an exemption from local tax under its maquiladora incentive does not make the income attributable to Luxembourg, the brief says.

“The profits at issue are Mexico's to tax and not Luxembourg’s, a point confirmed by the commentary to articles [23A and 23B] of the OECD model convention. This point is of critical importance and is outcome determinative on the tax rate disparity issue,” the reply brief says. “Only by erroneously claiming that Luxembourg could have taxed, but did not tax, the profits attributable to WOM’s Mexican PE, can respondent even claim that a tax rate disparity exists.” (OECD model tax convention.)

The Branch Rules

While there is a manufacturing exception to income treated as FBCSI for related-party sales, the IRS asserts that WOM cannot avail itself of that exception because of the branch rules.

Under section 954(d)(2), foreign branch sales are FBCSI when a CFC uses a branch outside its country of organization, and that use has substantially the same effect as use of a wholly owned subsidiary would.

To determine if there is substantially the same effect, the branch rules institute a tax rate disparity test. Under the test, if the actual effective tax rate is less than 90 percent of and at least 5 percent below the hypothetical tax rate, the manufacturing branch and the remainder will be treated as separate corporations when determining FBCSI.

Whirlpool, however, contends in its February 22 motion for partial summary judgment that there was no sales activity in the remainder, WOM, which only had a single part-time employee engaged in general administrative and accounting duties. It argues that the regs make clear that only the remainder’s sales and purchasing activities could result in FBCSI under the manufacturing branch rules.

“Lest there be any doubt, the Service has considered exactly this situation, one in which the remainder has no sales or purchasing activities,” the brief states, citing TAM 8509004. “The Service unambiguously ruled that if the remainder does not engage in sales or purchasing activities, the remainder cannot have FBCSI under the manufacturing branch rule.”

Whirlpool’s new reply brief argues that the manufacturing branch tax rate disparity test cannot be applied unless the CFC’s remainder has income allocable to purchasing or selling activities.

“The sine qua non of the manufacturing branch rule is the separation of a CFC’s manufacturing activities in a foreign branch from the CFC's purchasing or selling activities in the remainder of the CFC. Indeed, the structure of the manufacturing branch rule makes it impossible to apply the rule if there are no purchasing or selling activities in the remainder,” Whirlpool argues.

The IRS, however, counters that TAM 8509004 is inapposite, as WOM held title to the materials and products and the products were sold through the remainder. Managers of WOM also signed off on supply agreements, according to the government. The IRS contends that Whirlpool interprets selling activities too narrowly and that its position is “not supported by the regulations, any precedent, or common sense.”

“Petitioners’ position implies that if WOM did not have a sales department working on behalf of the Mexican branch, then the branch rule cannot be applied. This is simply incorrect and has no basis in the law,” the IRS states. “Such an interpretation would also yield results that directly contradict congressional intent and sound tax policy. Congress was concerned with ‘income of a selling subsidiary (whether acting as principal or agent) which has been separated from manufacturing activities of a related corporation merely to obtain a lower rate of tax.’ . . . Congress was clearly aware that a corporation needs no sales force to sell to a related party.”

Whirlpool insists that the manufacturing branch rule does not treat income as FBCSI unless it is within the definition of FBCSI under section 954(d)(1). The branch does not have FBCSI because it manufactures the products and it can avail itself of the same-country exception if it is deemed to be incorporated in Mexico, it argues.

Whirlpool also filed another motion for partial summary judgment on February 4, asserting that its sales did not constitute FBCSI under section 954(d)(1). It argues that the sales of refrigerators and washers to related parties was not the same property purchased, which consisted of raw materials that were subsequently substantially transformed by the company.

In its latest reply brief, Whirlpool emphasizes that section 954(d)(1) does not apply because the raw materials purchased by WOM differed from the final goods sold by WOM. According to Whirlpool, use of the word “its” in the phrase “the purchase of personal property from any person and its sale to a related person” indicates that the property purchased must be the same as the property sold. The IRS argued that differences between the products purchased and products sold do not shield sales income from FBCSI if the manufacturing process is not carried out by the seller using its own employees.

“Contrary to respondent's assertion, neither the plain language of the statute nor the legislative history requires the CFC to use its own employees to manufacture the final product sold to avoid FBCSI. If the property sold is different than the property purchased, then income from the sale will not be FBCSI, regardless of whose employees provide the manufacturing labor,” Whirlpool’s reply brief says.

The two sides are also at odds over the rates to be used in calculating the tax disparity.

Validity of Regs

As a final argument, Whirlpool also challenges the validity of the manufacturing branch rule, arguing the regs exceed the scope of section 954(d)(2).

“The legislative history of section 954(d)(2) confirms that Congress enacted this provision to address exclusively income attributable to a sales branch,” Whirlpool states, while also citing a 1962 Treasury report that echoed the congressional record. “This report made no mention of manufacturing branch operations, and the draft language that Treasury proposed evidenced an intent to address solely FBCSI attributable to branch operations.”

The IRS has attempted to parry this argument by asserting that Whirlpool’s interpretation would “lead to an absurd result squarely at odds with the purpose of the statute because . . . it would enable taxpayers to avoid the application of the FBCSI rules simply by reversing the place of incorporation of the CFC.”

Whirlpool returned to the point in its new reply brief, noting that the statute is unambiguous that only a sales branch rule fell within Treasury’s authority. “Treasury not only promulgated regulations creating the sales branch rule, but exceeded its authority by creating a new rule not even considered by Congress that provided for income of the CFC itself to constitute FBCSI in circumstances not authorized,” the company argued.

The case is Whirlpool Financial Corp. v. Commissioner, No. 13986-17 and No. 13987-17. Whirlpool is represented by Mark A. Oates of Baker & McKenzie LLP.

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