Whirlpool Argues in Appeal That Manufacturing Branch Rule Is Invalid

Whirlpool Financial Corporation, et al.
Petitioners-Appellants
v.
Commissioner of Internal Revenue,
Respondent-Appellee

UNITED STATES COURT OF APPEALS
FOR THE SIXTH CIRCUIT

ON APPEAL FROM THE DECISIONS OF
THE UNITED STATES TAX COURT

REPLY BRIEF FOR PETITIONERS-APPELLANTS,
WHIRLPOOL FINANCIAL CORPORATION, ET AL.

Mark A. Oates
Robert H. Albaral
A. Duane Webber
Summer M. Austin
Joseph B. Judkins
Meerah Kim
Cameron C. Reilly

Baker & McKenzie LLP
300 E. Randolph Dr.
Suite 5000
Chicago, IL 60601
(312) 861-7594

Rodney H. Standage

Whirlpool Corporation
325 N LaSalle
Chicago, IL 60605
(269) 277-6623

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TABLE OF CONTENTS

INTRODUCTION

ARGUMENT

CONCLUSION

TABLE OF AUTHORITIES

Cases

Am. Bus Ass'n v. Slater, 231 F.3d 1 (D.C. Cir. 2000)

Arangure v. Whitaker, 911 F.3d 333 (6th Cir. 2018)

Ashland Oil, Inc. v. Commissioner, 95 T.C. 348 (1990)

Brown v. Gardner, 513 U.S. 115 (1994)

Busey v. Deshler Hotel Co., 130 F.2d 187 (6th Cir. 1942)

Cent. United Life Ins. Co. v. Burwell, 827 F.3d 70 (D.C. Cir. 2016)

Chapman v. Tristar Prods., Inc., 940 F.3d 299 (6th Cir. 2019)

Davis v. Michigan Dept. of Treasury, 489 U.S. 803 (1989)

In re Davis,s 960 F.3d 346 (6th Cir. 2020)

Faygo Beverages, Inc. v. United States, 640 F.2d 27 (6th Cir. 1981)

Herr v. United States Forest Serv., 803 F.3d 809 (6th Cir. 2015)

Howard Hughes Co., LLC v. Commissioner, 142 T.C. 355 (2014), aff'd, 805 F.3d 175 (5th Cir. 2015)

Iselin v. United States, 270 U.S. 245 (1926)

Koshland v. Helvering, 298 U.S. 441 (1936)

La. Pub. Serv. Comm'n v. FCC, 476 U.S. 355 (1986)

Little Sisters of the Poor v. Pennsylvania, 140 S. Ct. 2367 (2020)

Littriello v. United States, 484 F.3d 372 (6th Cir. 2007)

Mayo Found. v. United States, 562 U.S. 44 (2011)

NLRB v. SW Gen., Inc., 137 S. Ct. 929 (2017)

Pub. Employees Ret. Sys. of Ohio v. Betts, 492 U.S. 158 (1989)

Rapanos v. United States, 547 U.S. 715 (2006)

Shannon v. United States, 512 U.S. 573 (1994)

Sierra Club v. EPA, 2021 U.S. App. LEXIS 2493 (D.C. Cir. Jan. 29, 2021)

SIH Partners LLLP v. Commissioner, 923 F.3d 296 (3d Cir. 2019)

Summa Holdings, Inc. v. Commissioner, 848 F.3d 779 (6th Cir. 2017)

TRW Inc. v. Andrews, 534 U.S. 19 (2001)

United States v. Calamaro, 354 U.S. 351 (1957)

United States v. Gillispie, 929 F.3d 788 (6th Cir. 2019)

United States Telecom Ass'n v. FCC, 359 F.3d 554 (D.C. Cir. 2004)

Vetco, Inc. v. Commissioner, 95 T.C. 579 (1990)

W. Va. Univ. Hosps, Inc. v. Casey, 499 U.S. 83 (1991)

Statutes

26 U.S.C. §482

26 U.S.C. §954(d)(1)

26 U.S.C. §954(d)(2)

26 U.S.C. §7805(a)

Regulations

Treas. Reg. §1.482-1

Treas. Reg. §1.482-2

Treas. Reg. §1.482-3

Treas. Reg. §1.482-4

Treas. Reg. §1.482-5

Treas. Reg. §1.482-6

Treas. Reg. §1.482-7

Treas. Reg. §1.482-8

Treas. Reg. §1.482-9

Treas. Reg. §1.954-3(a)(4)

Treas. Reg. §1.954-3(a)(4)(i)

Treas. Reg. §1.954-3(a)(4)(ii)

Treas. Reg. §1.954-3(b)(1)(ii)(b)

Treas. Reg. §1.954-3(b)(2)(i)

Treas. Reg. §1.954-3(b)(2)(ii)(e)

Legislative History

108 Cong. Rec. 17,751 (1962)

H.R. Rep. No. 87-1447 (1962)

S.Rep. No. 87-1881 (1962)

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INTRODUCTION

WOM bought raw materials, substantially transformed them into Products, and sold those Products — all in Mexico. WOM did not sell what it purchased. Yet the Commissioner seeks to avoid the obvious — that income from such sales was not FBCSI under §954(d)(1) — by inventing a prerequisite found in neither the statute nor the regulations; namely, that WOM's employees perform the transformation. Striving to escape this inevitable result, the Commissioner invokes §954(d)(2) and attempts to use a regulation it had no authority to issue and then misconstrues it to tax income attributable to manufacturing activities in Mexico as though it were income from non-existent selling activities outside of Mexico. Ironically, despite the Commissioner's strident claims of tax abuse, the US fisc collects more tax, not less, upon repatriation due to Mexico's policy choice to reduce its tax under the Maquiladora structure and the resulting decrease in US foreign tax credits.

Section 954(d)(2), entitled “Certain branch income,” addresses “situations in which the carrying on of the activities by a [CFC] through a branch . . . has substantially the same effect as if such branch . . . were a wholly owned subsidiary corporation deriving [FBCSI],” and mandates that, in such situations, “under regulations prescribed by the Secretary the income attributable to the carrying on of such activities of such branch . . . shall be treated as income derived by a wholly owned subsidiary of the [CFC] and shall constitute [FBCSI] of the [CFC].” (Emphases added.) In short, §954(d)(2) concerns only a branch, the activities of the branch, and the income attributable to the activities of the branch, and stipulates that the income attributable to the activities of the branch — and only income of the branch — shall constitute FBCSI of the CFC.

The Commissioner contends, in contrast, that §954(d)(2) authorizes him to create a different rule, the Manufacturing Branch Rule, that treats income attributable to activities outside of the branch as FBCSI of the CFC. The Commissioner's argument reflects three fundamental errors. First, he misreads the statute, which unequivocally directs that “the income attributable to the carrying on of such activities of such branch . . . shall constitute [FBCSI] of the [CFC].” Second, he misstates the legislative history, which is devoid of any Congressional intent to establish a branch rule that would treat income not attributable to the branch as a new class of FBCSI. Third, the Commissioner turns administrative law on its head, arguing that the absence of a prohibition on agency action grants authority to the agency to act. The Commissioner's Manufacturing Branch Rule is simply not authorized by §954(d)(2) and is invalid.

Even if valid, the Commissioner makes two fundamental errors in applying the Manufacturing Branch Rule. First, he improperly limits the Manufacturing Branch (and thus its income) to only the labor provided by WIN, and ignores the other factors of production essential to the Manufacturing Branch, including more than $650 million in raw materials and inventory, and an investment of $146 million in manufacturing equipment and tooling. Second, the Commissioner ignores both the plain meaning of “selling activities” in his own regulation and that term's role within the regulation. “Selling activities” connotes active efforts to sell, not mere passive passage of title. Further, the legal fiction of the Manufacturing Branch Rule posits that the Remainder (the operations outside the Branch) undertakes any selling activities “on behalf of” the Branch. The “on behalf of” language is taken from §954(d)(1) and its legislative history and refers to a fee or commission agent that does not take title. Here, the Remainder neither engaged in selling activities nor made sales. Indeed, the Manufacturing Branch sold its Products in Mexico at the end of the manufacturing lines. Moreover, the Manufacturing Branch Rule uses the objective value of “selling activities” to allocate income between any selling activities of the Remainder and the manufacturing activities of the Manufacturing Branch. Without the anchor of the objective value of actual “selling activities,” the Manufacturing Branch Rule would have no rule of law upon which to determine the Remainder's income from selling activities, which would result in, as here, the necessarily improper allocation to the Remainder of income attributable to manufacturing activities.

Finally, summary judgment on the §954(d)(1) issue in Whirlpool's favor is appropriate because WOM did not sell the property it purchased. First, the parties and the Court below agree that the Products sold were not the same as the raw materials purchased. Under the statute, FBCSI cannot arise if the property sold is not the property purchased. Second, neither §954(d)(1) nor Treas. Reg. §1.954-3(a)(4)(i) require a company to use its own employees to manufacture the Products. Third, even if the regulations so required, WOM's legal right to control manufacturing personnel made them WOM's common-law employees.

ARGUMENT

A. The Manufacturing Branch Rule Is Contrary to Statute, Exceeds Treasury's Rulemaking Authority, and Is Invalid.

1. The Plain Statutory Text Unambiguously Forecloses the Manufacturing Branch Rule.

Words, particularly in the “highly reticulated” Internal Revenue Code, matter. Summa Holdings, Inc. v. Commissioner, 848 F.3d 779, 789 (6th Cir. 2017). Because §954(d)(1) did not address the use of foreign branches, Congress enacted §954(d)(2), which unambiguously is titled “Certain branch income,” to address situations in which a CFC conducts activities outside its country of incorporation through a branch that has substantially the same effect as if the branch were a wholly owned subsidiary of the CFC, and only then authorizes Treasury to issue regulations to treat the income attributable to the activities of the branch as income derived by a subsidiary of the CFC and as FBCSI of the CFC. Section 954(d)(2) thus focuses solely on the activities of the branch and the treatment of the income attributable to such branch activities as FBCSI of the CFC if the branch was substantially similar to a subsidiary. In that single situation, Treasury was authorized to issue regulations to treat the branch's income as FBCSI of the CFC — as Treasury did in the Sales Branch Rule.

Section 954(d)(2), however, does not authorize Treasury to treat income attributable to activities outside of the branch as FBCSI — as Treasury did in the Manufacturing Branch Rule.

The Commissioner disregards the plain statutory text. First, the Commissioner leaps from reciting the statute to the conclusion that §954(d)(2) has two separate and independent consequences, the second of which has “the sole operative effect” of “mak[ing] explicit that the CFC itself has FBCSI even if . . . the income would be considered FBCSI of the branch-deemed-subsidiary.” (IRS-Br.36.)

The Commissioner now argues that “Consequence 1” of §954(d)(2) applies to the income of both sales and manufacturing branches, but “Consequence 2” applies only to sales branches, and §954(d)(1) must be applied to make it effective to manufacturing branches. (IRS-Br.32-33.) In the nearly 60-year history of §954(d)(2), this new position has never appeared in any legislative history, IRS guidance, Commissioner brief, or other pronouncement. The Commissioner's new construction of §954(d)(2) is “bad wine of recent vintage.” TRW Inc. v. Andrews, 534 U.S. 19, 37 (2001) (Scalia, J., concurring).

The Commissioner's novel interpretation violates basic rules of grammar and frustrates the ordinary reading of the text. The second half of §954(d)(2) (beginning with “under regulations”) identifies the specific income at issue — “the income attributable to” the branch's activities — and then sets forth a pair of clauses, each of which begins with “shall.” Both clauses are yoked to “the income attributable to” the branch's activities. The first clause describes how the branch's income shall be treated (i.e., as if it were income of a separate subsidiary of the CFC), and the second describes the attendant tax consequence (treatment of the income of the branch as FBCSI of the CFC). “Consequences 1 and 2” are not standalone, separate, or independent; both are necessary to effectuate the intended result in §954(d)(2) — to treat income attributable to the branch's activities as a related-party transaction and thus as FBCSI of the CFC.

Instead, the Commissioner attempts to rewrite §954(d)(2) to say that if the CFC uses a branch in substantially the same manner as a subsidiary, then the branch will be treated as a related corporation and the now-recharacterized transaction will be run back through §954(d)(1) to determine if the income attributable to the carrying on of the activities of either the branch or the CFC (outside the branch) constitutes FBCSI under §954(d)(1). To reach this reading, the language of §954(d)(2) after the comma would have to be re-written as follows (deletions in strike-out and insertions in bold):

, under regulations prescribed by the Secretary the income attributable to the carrying on of such activities of such branch . . . shall be treated as income derived by activities carried on by a wholly owned subsidiary of the [CFC] and the income of the deemed subsidiary and the remainder of the CFC shall be tested again under section 954(d)(1). and shall constitute [FBCSI] of the [CFC].

Unquestionably, Congress could have written such a statute. But Congress did not. As actually enacted, §954(d)(2) concerns only the branch's income. If the use of a branch has substantially the same effect as if the branch were a wholly owned subsidiary, then §954(d)(2) authorizes Treasury to promulgate regulations to treat the “income attributable to the carrying on of the activities of such branch” as FBCSI of the CFC. Contrary to the Commissioner's contentions, the plain language of the statute is directed at the branch's income and does not authorize regulations to treat income outside of the branch as an additional class of FBCSI.

Of course, the Commissioner cannot amend a statute, Koshland v. Helvering, 298 U.S. 441, 447 (1936), “add[ ] to the statute . . . something which is not there,” United States v. Calamaro, 354 U.S. 351, 359 (1957), or effectively delete or ignore statutory language, TRW, 534 U.S. at 31 (citation omitted) (“no clause, sentence, or word [of a statute] shall be superfluous, void, or insignificant”).

Resisting the plain language of the entire statute, the Commissioner isolates “branch” and “activities,” contending those words are “unqualified.” (IRS-Br.33.) “It is a fundamental canon of construction that the words of a text must be read in their context with a view to their place in the overall scheme.” United States v. Gillispie, 929 F.3d 788, 790 (6th Cir. 2019); see also Davis v. Michigan Dept. of Treasury, 489 U.S. 803, 809 (1989) (same). Keeping with its title, §954(d)(2) focused narrowly on “certain branch income,” not “certain CFC income.” Yet the Commissioner ignores the full text, which explicitly instructs that it is the “income attributable to the carrying on of such activities of such branch” that shall constitute FBCSI of the CFC.

Defying the plain statutory text, the Commissioner seeks refuge in canons of construction that lend no support. The primary canon of construction for tax statutes construes those statutes narrowly against the government. (Br.32.) The Commissioner could not and did not attack this primary canon on its merits. Instead, the Commissioner erroneously invoked the deferral canon, but that canon depends on the existence of a US tax statute that affirmatively defers inclusion of income. Howard Hughes Co., LLC v. Commissioner, 142 T.C. 355, 383 (2014) (§460(e) completed-contract method defers income recognition), aff'd, 805 F.3d 175 (5th Cir. 2015). The deferral canon cannot apply here because §954(d)(2) does not defer income; as the Commissioner concedes, it “is a limitation on deferral.” (IRS-Br.41.) Instead, under the general rule, both before and after the 1962 enactment of Subpart F, a foreign corporation's income was not taxed until repatriated to the United States, subject to any US provision that affirmatively imposed immediate taxation without repatriation (i.e., the Subpart F provisions). As no tax statute granted deferral here, the canon cannot apply.

The Commissioner's “presumption against ineffectiveness” argument also fails. (IRS-Br.41.) That canon applies only if “the plain meaning of a provision is not clear.” In re Davis, 960 F.3d 346, 354 (6th Cir. 2020) (citing United States v. Hayes, 555 U.S. 415, 427 (2009)). The text of §954(d)(2) unambiguously authorizes the Secretary to treat “income attributable to the carrying on of the activities” of the branch as FBCSI of the CFC. Far from being “ineffective,” it fully achieves the purpose reflected in its text — to eliminate the use of sales branches to avoid FBCSI. While Treasury may have preferred a broader statute and grant of authority, “[d]isagreeing with Congress's expressly codified policy choices isn't a luxury administrative agencies enjoy.” Cent. United Life Ins. Co. v. Burwell, 827 F.3d 70, 73 (D.C. Cir. 2016). The Commissioner's strident “allegations of tax avoidance” are nothing more than a smokescreen to hide his “text avoidance.” Summa Holdings, 848 F.3d at 787.

The Commissioner also seeks refuge from the text by arguing that the Manufacturing Branch Rule must be valid because it is old. (IRS-Br.39-40.) However, there is no old-rule exception for invalid regulations. “Regulated parties may always assail a regulation as exceeding the agency's statutory authority in enforcement proceedings against them.” Herr v. United States Forest Serv., 803 F.3d 809, 822 (6th Cir. 2015) (collecting cases and citing Horne v. Dep't of Agric., 135 S. Ct. 2419, 2424-25 (2015); Pub. Employees Ret. Sys. of Ohio v. Betts, 492 U.S. 158, 171 (1989); Rapanos v. United States, 547 U.S. 715, 752 (2006).

The Commissioner's legislative-reenactment argument also fails. (IRS-Br.40.) Where, as here, regulations contradict statutory requirements, “reenactment has no interpretive effect.” Brown v. Gardner, 513 U.S. 115, 121 (1994).

In short, §954(d)(2) is targeted and precise; like other Code provisions, it “uses language, lots of language, with nearly mathematical precision.” Summa Holdings, 848 F.3d at 789 (emphasis added). The Commissioner's failure to account for such textual precision undermines his attempt to conjure ambiguity from otherwise clear language.¹

2. The Legislative History Confirms the Plain Meaning of the Statute and Does Not Support the Commissioner's Position.

A court “do[es] not resort to legislative history to cloud a statutory text that is clear.” Chapman v. Tristar Prods., Inc., 940 F.3d 299, 306 (6th Cir. 2019) (citation omitted). Section 954(d)(2) is unambiguous, but the legislative history nonetheless shows that the purpose of §954(d)(2) was to capture situations in which a CFC used a branch rather than a corporation to avoid §954(d)(1) and, in that situation, authorized Treasury to issue regulations solely to treat the “income attributable to the carrying on of the activities” of the branch as FBCSI of the CFC. The legislative history shows that Congress did not intend §954(d)(2) to operate as a broad “loophole” closing device. See Ashland Oil, Inc. v. Commissioner, 95 T.C. 348, 358 (1990); Vetco, Inc. v. Commissioner, 95 T.C. 579, 593 (1990). The legislative history supports Whirlpool's position, and does not suggest that Congress intended §954(d)(2) to treat income — other than a branch's income — as the CFC's FBCSI. (Br.31.)

The Commissioner nonetheless contends that §954(d)(2) has a vastly broader purpose: “to effectively eliminate deferral of taxation for tax haven activities.” (IRS-Br.45.) For support, the Commissioner relies on a staff report — not a report of any Congressional committee — which makes a passing reference to a manufacturing branch. The staff report, moreover, predates the proposal of any statutory language by more than a year and is thus not anchored in any statutory text considered by Congress. As the Supreme Court admonishes, legislative materials not “anchored in the text of the statute” have no authoritative weight and are not considered when interpreting the text of a statute. Shannon v. United States, 512 U.S. 573, 583-84 (1994).

Although the Commissioner also points to a floor statement by Senator Kerr (IRS-Br.44), Senator Kerr was not speaking about §954(d)(2) and referenced no use of a branch to avoid FBCSI. Instead, he was focused on §954(d)(1). See 108 Cong. Rec. 17,751 (1962). Moreover, courts “do not permit [unambiguous statutory text] to be expanded or contracted by the statements of individual legislators or committees during the course of the enactment process.” W. Va. Univ. Hosps., Inc. v. Casey, 499 U.S. 83, 98-99 (1991) (emphasis added). This is especially true of precisely drawn statutes like those in Subpart F. “What Congress ultimately agrees on is the text that it enacts, not the preferences expressed by certain legislators.” NLRB v. SW Gen., Inc., 137 S. Ct. 929, 942 (2017).

At bottom, the Commissioner asks this Court to expand §954(d)(2) to tax immediately income earned outside the branch. For nearly a century, courts have rejected this plea. Iselin v. United States, 270 U.S. 245, 250-51 (1926) (Commissioner cannot seek “enlargement” of the statute so that “omitted” text “may be included within its scope”).

3. Section 7805(a) Does Not Authorize Treasury to Alter the Clear Text of §954(d)(2).

An agency has no power to act unless Congress grants it. La. Pub. Serv. Comm'n v. FCC, 476 U.S. 355, 374 (1986). The Supreme Court has articulated a simple, three-part framework for determining the scope of Treasury's rulemaking authority. If “the act uses ambiguous terms . . . a clarifying regulation . . . is permissible.” Koshland, 298 U.S. at 446. Likewise, Treasury can regulate if “the statute merely expresses a general rule.” Id. at 446-47. “But where, as in this case, the provisions of the act are unambiguous, and its directions specific, there is no power to amend it by regulation.” Id. (emphasis added).

The Commissioner misconceives Treasury's rulemaking authority, arguing that §954(d)(2) does not expressly “preclude[ ] Treasury from treating a CFC/Remainder's income as FBCSI when the deemed subsidiary is the manufacturer,” (IRS-Br.36), and that “nothing prohibits Treasury from exercising its authority under §7805(a) to address manufacturing branches.” (IRS-Br.37) (emphases added).

The Commissioner effectively concedes that §954(d)(2) does not authorize the Manufacturing Branch Rule because “[s]ection 954(d)(1) already provides Treasury that authority and there was no need for Congress to repeat it in §954(d)(2).” (IRS-Br.36.) Of course, §954(d)(1) does not address branches and is limited to transactions involving a “related person.” A branch is not a related person. Only §954(d)(2) authorizes treatment of the branch as a separate entity, and then only to treat the “income attributable to the carrying on of the activities” of the branch as FBCSI of the CFC.

Moreover, courts uniformly reject the notion that silence coupled with general rulemaking authority to “enforce” a statute authorizes a rule that transcends the statute; “a statutory silence on the granting of a power is a denial of that power to the agency.” Am. Bus Ass'n v. Slater, 231 F.3d 1, 8 (D.C. Cir. 2000) (Sentelle, J., concurring) (emphasis in original); see also Arangure v. Whitaker, 911 F.3d 333, 338 (6th Cir. 2018) (“Silence, however, does not necessarily connote ambiguity, nor does it automatically mean that a court can proceed to Chevron step two.”) (citing Ry. Labor Execs.' Ass'n v. Nat'l Mediation Bd., 29 F.3d 655, 671 (D.C. Cir. 1994) (en banc)). “To suggest . . . that Chevron step two is implicated any time a statute does not expressly negate the existence of a claimed administrative power (i.e. when the statute is not written in 'thou shalt not' terms), is both flatly unfaithful to the principles of administrative law . . . and refuted by precedent.” Sierra Club v. EPA, 2021 U.S. App. LEXIS 2493 at *33 (D.C. Cir. Jan. 29, 2021) (quoting Railway Labor, 29 F.3d at 671); United States Telecom Ass'n v. FCC, 359 F.3d 554, 566 (D.C. Cir. 2004).

By its terms, §954(d)(2) unambiguously defines the full scope of Treasury's rulemaking authority — it applies only to income attributable to carrying on the activities of the branch. As §7805(a) hinges on “enforcing” a statute, Congress' choice in §954(d)(2) to authorize the treatment as FBCSI of only income related to the branch's activities is fatal to the Commissioner's argument under §7805(a). Courts repeatedly have prevented Treasury from issuing regulations under §7805(a) and its predecessors that enlarge the plain text of an unambiguous statute. Simply put, Treasury cannot, by regulation, “add[ ] to the statute . . . something which is not there.” Calamaro, 354 U.S. at 359 (holding invalid regulation that taxed persons not specified in the statutory text); Koshland, 298 U.S. at 447 (Treasury could not by regulation “add a provision” to alter taxation); Busey v. Deshler Hotel Co., 130 F.2d 187, 190 (6th Cir. 1942) (Treasury could not “enlarge the scope of the statute” by regulation). Congress simply did not authorize Treasury to issue the Manufacturing Branch Rule.

To support his view of Treasury's rulemaking authority, the Commissioner cites only cases involving statutory ambiguity. Mayo Found. v. United States, 562 U.S. 44, 53 (2011) (term “student” ambiguous); Littriello v. United States, 484 F.3d 372, 377-78 (6th Cir. 2007) (definition of “corporation” ambiguous); Faygo Beverages, Inc. v. United States, 640 F.2d 27, 29 (6th Cir. 1981) (payor of fuel tax ambiguous); Little Sisters of the Poor v. Pennsylvania, 140 S. Ct. 2367, 2381 (2020) (content of “comprehensive guidelines” unknown); SIH Partners LLLP v. Comm'r, 923 F.3d 296, 304 (3d Cir. 2019) (amount of guarantee ambiguous).

These cases do not apply where, as here, the statutory text is unambiguous. To trigger Treasury's rulemaking authority, the statute first must have some gap — rooted in the statute's text — to fill. Here there is no gap.

B. If Valid, Whirlpool Prevails Under the Manufacturing Branch Rule.

1. The Commissioner Erroneously Limits the Scope of WOM's Manufacturing Branch Under §954(d)(2) to WIN.

The parties agree that WOM carried on activities in Mexico through a branch, but disagree about the scope of WOM's branch. The Commissioner defines a “branch” as “a business function that a corporation performs in a given jurisdiction without forming a separate corporation to do so.” (IRS-Br. 3, n.3) (emphasis added). All agree that the Products were manufactured in Mexico, and the Commissioner characterizes WOM's “branch” functionally as a “manufacturing branch.” The “business function” of WOM's “manufacturing branch” necessarily included all inputs required to manufacture the Products in Mexico, including labor, raw materials, inventory, manufacturing equipment, tooling, and dedicated manufacturing facilities.

Having defined “branch,” the Commissioner promptly ignores the “business function” of WOM's Manufacturing Branch and limits it to the function performed by WIN² — provision of labor to manufacture and sell the Products in Mexico. (IRS-Br. viii). The Commissioner's artificial segregation ignores the fundamental elements of the business function of WOM's Manufacturing Branch, which also required WOM's contributions in Mexico (equipment, tooling, raw materials, and inventories). The Commissioner thus ignores WOM's permanent establishment in Mexico (that is, an unincorporated business function in Mexico), which directly owned raw materials, work-in-process inventory, and finished-goods inventory in Mexico, used dedicated manufacturing plants to produce its Products, and had dependent agents that routinely entered into contracts on its behalf in Mexico.

The Commissioner's threshold failure to properly identify WOM's Manufacturing Branch riddles his entire brief with errors. First, the Commissioner argues that the “Mexican-Branch/WIN” paid Mexican tax on the manufacturing income related to the Products (IRS-Br.51), but in reality WIN paid Mexican tax only on its labor income related to the Products. Mexico chose not to tax the manufacturing income earned by WOM's permanent establishment (i.e., WOM's Manufacturing Branch). (Br. 8-9.)

Second, the Commissioner contends that “Whirlpool-Lux,” and not the “Mexican-Branch/WIN,” had to “take title to and sell the finished goods” (IRS-Br. 52), but WOM's Manufacturing Branch held title throughout the manufacturing process in Mexico and sold the finished Products (i.e., for US tax purposes, transferred title to customers) at the end of the manufacturing lines in Mexico. (Br. 8.)

Third, the Commissioner mischaracterizes WIN's Transfer Pricing Study as representing that “Mexican-Branch/WIN” did not sell the Products, that its functions were limited to contract manufacturing services, and that it did not take part in distribution or marketing activities. (IRS-Br. 52-53.) But WIN's Transfer Pricing Study related solely to WIN and its labor services, and did not address WOM's Manufacturing Branch. WOM's Manufacturing Branch in Mexico owned and held title to raw materials, work-in-process-inventory, manufacturing equipment and tooling, and sold the Products to customers in Mexico.

2. The Remainder Did Not Perform Any “Selling Activities.”

As relevant to this case, only income attributable to “selling activities” can be allocated to the Remainder to determine if a Tax Rate Disparity exists and only income attributable to “selling activities” performed by the Remainder outside of Mexico can constitute FBCSI. (Br. 38-39.)

The Commissioner acknowledges that the Remainder did not actively engage in selling activities (IRS-Br.57), but disregards the threshold prerequisite in his own regulation and asserts that “[n]othing in the statute or the regulation requires 'active efforts[.]'” (IRS-Br. 56.) Instead, the Commissioner invokes the inapposite language of §954(d)(1) and the regulation thereunder to contend that “[o]nly a 'sale of personal property,' . . . is required.” (IRS-Br. 56.) By ignoring the ordinary meaning of the term “selling activities” — which requires active conduct designed to achieve sales (Br. 42-43) — and conflating it with “sale,” the Commissioner undermines the regulatory mechanism for allocating income to the Remainder based on an objective valuation of the Remainder's selling activities.

At bottom, the Commissioner relies solely on the “mere transfer of title” to allocate more than $45 million to the Remainder as compensation for “the sale itself.” (IRS-Br. 57.) The mere fact of sale, however, does not constitute “selling activities,” and that compensation was for the Products, not some abstract notion of a “sale.” Moreover, the Manufacturing Branch (correctly defined) — not the Remainder — sold the Products, and did so in Mexico. (Br. 8, 41.)

The Commissioner nonetheless argues that WOM: (1) “was required under Mexican law to take title to and sell the finished goods to qualify” for the Maquiladora program; (2) “sold the Products to related parties” and “transferred title and risk of loss to them”; (3) “derived gross receipts that exceeded $800 million from its sales”; and (4) “derived income of $45,231,843 from sale of the Products.” (IRS-Br.50-51.) These facts all took place in Mexico, are not “selling activities,” are attributable to WOM's Manufacturing Branch, and cannot serve as a basis for allocating income to WOM's Remainder. (Br. 14-16, 39-44.) Further, WOM's Manufacturing Branch (i.e., WOM's permanent establishment in Mexico that Mexico elected not to tax under the Maquiladora program) sold the Products (i.e., transferred title) and earned the income related to manufacturing activities in Mexico. No selling activities — or even sales — were performed or made by WOM's Remainder outside of Mexico.

Similarly, the Commissioner argues that WOM “took the position that it — and not Mexican-Branch/WIN sold the Products.” (IRS-Br.51.) This assertion is wrong, and again highlights the Commissioner's failure properly to identify the Manufacturing Branch, which included not just WIN, but also all of WOM's manufacturing operations and assets in Mexico. Under the Maquiladora program, the foreign principal (WOM) held title to the raw materials, inventory, and Products, and manufactured the Products in dedicated plants, all in Mexico. These activities constituted a permanent establishment in Mexico (WOM's branch), which otherwise subjected to tax the profits attributable to the permanent establishment (the $45 million in income). Under the Maquiladora incentives, Mexico chose to forego this tax (except on the labor component) and effectively exempted from Mexican tax the $45 million attributable to WOM's Mexican permanent establishment (beyond WIN's labor profit). Luxembourg had no power to tax the $45 million in profits — under the Luxembourg-Mexico Tax Treaty, only Mexico could tax profits attributable to WOM's Mexican permanent establishment (that is, WOM's Manufacturing Branch). (Br.10-11.)

The Commissioner also argues to no avail that the execution of the Manufacturing Supply Agreements by WOM's Board of Managers constituted a “selling activity.” (IRS-Br.50.) As discussed below, under §954(d)(2)'s legal fiction treating the branch as a separate corporation, such execution of the agreements must be treated as performed by directors of the hypothetically incorporated Manufacturing Branch, not by the Remainder. See Treas. Reg. §§1.954-3(b)(1)(ii)(b) and -3(b)(2)(i). Moreover, these agreements were signed in prior years and did not involve any activity — selling or otherwise — in 2009. (R.53 (Pet'r-Resp.) 45, Apx. 3215.)

The Commissioner's argument that the Remainder sold the Products outside of Mexico, while contrary to fact, also is undermined by his own regulation, which explicitly treats the Remainder's “selling activities” as performed “on behalf of” the Manufacturing Branch. (Br.16.) Contrary to the Commissioner's assertion that “nothing in the statute or the regulation precludes the CFC/Remainder from holding title to the property when selling on the branch's behalf” (IRS-Br.55), the legislative history of §954(d)(1) — from which the “on behalf of” language derives — shows that the Remainder in this context does not hold title, but rather acts on a “fee or commission basis.” (Br.40.) Acting in this capacity, the Remainder cannot legally sell or transfer ownership, and even if the Remainder held bare legal title on behalf of the Manufacturing Branch, the nominee Remainder still would not be considered the seller. (Br.40-41.) The facts and the law uniformly contradict the Commissioner's argument that all income should be attributable to the Remainder as the seller of the Products.

3. Whirlpool Explicitly and Consistently Argued that the Manufacturing Branch Rule Allocates Income to the Remainder Based Only on the Objective Value of Any Selling Activities of the Remainder.

Throughout this proceeding, Whirlpool has consistently maintained that, under the Manufacturing Branch Rule, no income is allocable to the Remainder, whose single part-time employee did not perform any “selling activities.” (R.33 (Pet'r-Br.) 3, 11, 21, 24, 27, 34, Apx. 362, 370, 380, 383, 386, 393; R.46 (Pet'r-Reply) 37, 46, Apx. 2655, 2664). Whirlpool also has consistently maintained that 100% of the $45 million at issue was income attributable to the activities of WOM's Manufacturing Branch in Mexico to produce the Products. (R.33 (Pet'r-Br.) 9-11, Apx. 368-70; R.53 (Pet'r-Resp.) 28-36, Apx. 3198-206.) For purposes of applying the Tax-Rate-Disparity Test, allocation of income between the Manufacturing Branch and the Remainder is based on a determination of the objective value of the selling activities performed by the Remainder.³ Even if the Tax-Rate-Disparity Test is triggered, the amount of income allocable to the Remainder (and potentially FBCSI) under the Manufacturing Branch Rule is equally limited to the objective value of the selling activities that the Remainder performed. (R.33 (Pet'r-Br.) 27, Apx. 386.) Under both tests, no income is allocable to the Remainder, as it performed no selling activities.

Despite abundant evidence to the contrary, and despite the Manufacturing Branch Rule's direction to allocate income to the Remainder based on the objective value of its selling activities, the Commissioner contends that Whirlpool waived any argument regarding the allocation based on the value of the selling activities performed by the Remainder. (IRS-Br.59.) The Commissioner is wrong.

Whirlpool certainly contends that the Remainder performed no selling activities and thus is allocated no income under the Manufacturing Branch Rule. This contention is necessarily an allocation based on the objective valuation of the selling activities of the Remainder. By repeatedly contending that income should be allocated between the Remainder and the Manufacturing Branch based on the value of the selling activities, and by demonstrating that the Remainder should not be compensated for selling activities it did not perform, Whirlpool has consistently advocated this position.⁴ The fact remains: The Commissioner has not identified — and cannot identify — any selling activities performed by the Remainder. If the Commissioner does, then Whirlpool of course can respond.

4. The Commissioner's Arbitrary Allocation Deprives the Manufacturing Branch of the Profit Attributable to Its Activities and Assets in Mexico.

The Commissioner fully accepted the arm's-length nature of the prices paid by Whirlpool US for WOM's manufacture of the Products. The §482 transfer-pricing rules allow no price or profit for non-existent functions or activities. §482; Treas. Reg. §§1.482-1 to -9. As WOM conducted only nominal administrative activities outside of Mexico, the transfer price Whirlpool US paid WOM was for the value of the Products themselves, and could not have included any profit for selling activities outside of Mexico (i.e., in Luxembourg), certainly not the $45 million at issue. Rather, the Commissioner accepted the transfer pricing precisely because the price (including the $45 million at issue) represented an arm's-length price for the manufacture of the Products in Mexico.

The Commissioner accepts WOM's transfer pricing, and all of the income at issue was attributable to WOM's manufacture of the products in Mexico, but allocates to the Manufacturing Branch only a small return on labor ($4 million) and no return for other manufacturing inputs (i.e., more than $650 million of raw materials and inventory, $146 million of manufacturing equipment and tooling, and various other assets). The Commissioner thereby leaves the Manufacturing Branch with profits of just 0.5% on costs of over $750 million, and allocates over 90% of the income attributable to manufacturing activities ($45 million) to a single employee in Luxembourg for selling activities he did not perform. (IRS-Br.64.) Contrary to the Commissioner's contention that “Whirlpool itself dictated that outcome” (IRS-Br.63), this nonsensical conclusion reflects the Commissioner's misidentification of the branch. In so doing, the Commissioner improperly allocates over 90% of the manufacturing income to the Remainder. (Br.64.)

While the Commissioner now asserts that Whirlpool has disavowed its transfer pricing (IRS-Br.67), in reality exactly the opposite is true. Whirlpool stands by its transfer pricing, which was correct and accurate. It is the Commissioner who now seeks to retreat from his prior acceptance of the prices Whirlpool US paid for the Products manufactured in Mexico by WOM.

As to the Commissioner's assertions regarding WIN's intercompany transactions, WIN's intercompany transactions are both disregarded for US tax purposes and reflect only a fraction of WOM's Manufacturing Branch. Instead, as required by the regulations, income must be allocated between WOM's Manufacturing Branch (including WOM and WIN) and the Remainder based on the objective value of “selling activities” performed by the Remainder outside of Mexico.

The Commissioner concedes that the Remainder engaged in no selling activities of any objective value. (IRS-Br.57.) Thus, the Commissioner simply mischaracterizes income attributable to manufacturing activities in Mexico as income attributable to selling activities by the Remainder.

C. There Are No Material Questions of Fact That Preclude Summary Judgment in Whirlpool's Favor Under §954(d)(1) Because WOM Did Not Sell What It Purchased.

1. Section 954(d)(1) Is Unambiguous: If the Property Sold Was Not the Same Property Purchased, There Is No FBCSI.

Section 954(d)(1) defines FBCSI to include income derived in connection with “the purchase of personal property from any person and its sale to a related person.” (Emphasis added.) “[I]ts” refers to “personal property” and makes clear that FBCSI includes only income derived from the purchase and sale of the same personal property. (Br.20-23.)

The Commissioner argues that the statute does not contain this requirement because “its” refers to “purchased property,” regardless of whether it is altered between purchase and sale. (IRS-Br.68-69.) For support, the Commissioner uses the example of a fully manufactured refrigerator that is purchased, branded, and then sold. The Commissioner asserts that, in this example, the property purchased is different from the property sold but still meets the requirements of §954(d)(1). The Commissioner's example, however, points to an instance in which the property that is purchased is the same property that is sold, as branding an otherwise complete refrigerator does not transform the refrigerator into a different piece of property.

Confirming this straightforward meaning, the legislative history provides that “the sale of the final product would not be [FBCSI] if . . ., in effect, the final product is not the property purchased.” H.R. Rep. No. 87-1447, at A94-A95 (1962); S. Rep. No. 87-1881, at 245 (1962) (emphasis added). Transforming raw materials into a refrigerator differs substantially from merely placing a label on a refrigerator. That branded refrigerator is, in effect, the same refrigerator that is sold. In contrast to Respondent's example of a resale of the same refrigerator purchased, WOM “converted,” “substantially transformed,” and “manufactured” “the raw materials that it purchased” “into refrigerators and washing machines by a multi-step manufacturing process,” a point the Commissioner concedes. (R.54 (Op.) 24-26, Apx. 3244-3246.) Indeed, the Tax Court held that “the items that [WOM] sold were not the same as the items that it purchased.” (R.54 (Op.) 24, Apx. 3244) (emphasis added). Because the statute unambiguously provides that FBCSI arises only if the property sold was the same property purchased, WOM cannot have FBCSI under §954(d)(1) as “the items that it sold were not the same as the items that it purchased.” Id.

2. Section 954(d)(1) and Treas. Reg. §1.954-3(a)(4)(i) Do Not Require the CFC to Use Its Own Common-Law Employees to Perform Manufacturing.

There is no dispute that §954(d)(1) “sets no parameters on what a CFC must do to qualify as a 'manufacturer.'” (R.54 (Op.) 27, Apx. 3247.) The Commissioner, however, contends that Treas. Reg. §1.954-3(a)(4)(i) requires the CFC to carry on the manufacturing through the use of its own common-law employees. (IRS.-Br.69-70.) The Commissioner's position hinges on the phrase “by such corporation” in the first sentence of Treas. Reg. §1.954-3(a)(4)(i), which provides that FBCSI does not include income of a CFC on “the sale of personal property manufactured . . . by such corporation in whole or in part from personal property which it has manufactured.”

The very next sentence provides: “A foreign corporation will be considered, for purposes of this subparagraph, to have manufactured . . . personal property which it sells if the property sold is in effect not the property which it purchased.” (Emphasis added.) Treas. Reg. §1.954-3(a)(4)(ii), in turn, provides that if purchased property is “substantially transformed prior to sale,” then “the property sold will be treated as having been manufactured . . . by the selling corporation.” (Emphasis added.) Both regulations turn on the quantum of transformation, not the identity of the actor. The Tax Court found and the Commissioner conceded that the raw materials purchased by WOM were both manufactured into the Products and substantially transformed prior to sale by WOM. (R.54 (Op.) 24-26, Apx. 3244-3246.) Thus, under Treas. Reg. §1.954-3(a)(4)(i), WOM “will be considered . . . to have manufactured” the Products, and under Treas. Reg. §1.954-3(a)(4)(ii), the Products “will be treated as having been manufactured . . . by” WOM. (Br.23-25.)

3. Even if Treas. Reg. §1.954-3(a)(4) Requires a CFC's Common-Law Employees to Perform Manufacturing, WOM's Manufacturing Personnel Constituted Its Common-Law Employees Because WOM Had the Legal Right to Control Those Employees.

The fundamental criterion for establishing a common-law-employment relationship is the right to exercise control, not the actual exercise of control. (Br.25-26.) The Tax Court found that “[t]he agreements among IAW, CAW, and WIN appear to have given WIN the right to control the employees' work.” (R.54(Op.)32,Apx.3252) (emphasis added). Since WIN is disregarded for U.S. Federal income tax purposes, WOM thus had the legal right to control the employees' work. There is no material question of fact whether WOM had the right to exercise control over the seconded and leased employees. The Commissioner's contrary assertion relates to whether WOM actually exercised control over the seconded and leased employees — an immaterial question that does not preclude summary judgment in Whirlpool's favor.

CONCLUSION

For the reasons stated above, this Court should reverse the decisions below and grant summary judgment in favor of Whirlpool under both §954(d)(1) and §954(d)(2).

Dated: February 12, 2021

Respectfully submitted,

Mark A. Oates
Baker & McKenzie LLP
300 E. Randolph Street
Suite 5000
Chicago, IL 60601
(312) 861-7594
Mark.Oates@BakerMcKenzie.com
Attorney for Appellants