The Foreign Service Corporation in Transnational Corporate Structures

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Injecting a conduit offshore corporate entity in a transnational corporate structure can implement cost savings. One useful purpose is characterized as an offshore corporate entity that provides services within the organizational structure.

As stated in a previous segment, (Foreign Corporations and Subpart F Income – Part II on TaxConnections, 17/September 2013 – Corporate – International – Tax Blogosphere) the essence of this type of corporate planning is to combine the concept of ownership structure that subjects a foreign corporation to controlled status and activities of the corporate entity. The two concepts are intertwined in the implementation of Subpart F Income tax consequences.

If a foreign corporate entity has Subpart F Income because it has Foreign Base Company Income, but it is not deemed a controlled foreign corporation by virtue of ownership, it is not subject to Subpart F Income treatment. Those are two distinct planning features.

Conversely if the aspect of controlled ownership or the characterization of corporate activity of Subpart F Income treatment is averted by virtue of it not being deemed Foreign Base Company Income, it achieves the same planning result. The elimination of either enables the corporate taxpayer to remove itself from the application of Subpart F Income treatment. The gist of this financial planning is to structure in safe harbors to avoid being deemed income derived as Foreign Base Company Service Income.

The technique requires coordination of Subpart F Income rules, source of income concepts, and arm’s length pricing between related entities. This writing is designed to focus upon the principles associated with the essence of the application of the activities rules of a service company that can accomplish the desired result and an overview of what the practitioner shall want to give consideration regarding how that coordination inter-relates to the arm’s length pricing principles of related entities.

Service Company and Subpart F Income Activity Principles

Foreign Based Company Service Income is income derived by a foreign corporation in connection with the performance of technical, managerial, scientific, skilled, industrial, commercial or similar type service. This Subpart F Income type is directed to the Offshore Financial Center, administrative or service companies that are conduit entities in the foreign corporate structure. The service industry provides numerous opportunities to enable a taxpayer to make use of corporate structural planning.

Foreign Base Company Service Income is comprised of two distinguishing elements. The services are performed for or on behalf of a related person and performed outside the country in which the controlled foreign corporation is incorporated. For purposes of the first element, a related person is an individual, corporation, partnership, trust, or estate which controls or is controlled by the controlled foreign corporation or a person who is a corporation, partnership, trust or estate which is controlled by the same person or persons that control the controlled foreign corporation.

The statute is designed to pick up as Subpart F Income transactions in which a taxpayer receives a substantial financial benefit from a related party. There are several basic transactional sequences to which the statute directs its focus. To some degree, each of these transactional arrangements embodies principles of tying arrangements. It is an effort to discourage income being shifted among related parties by the trade off of some remuneration.

One type of transaction occurs when a controlled foreign corporation is paid, reimbursed by, or released from an obligation, or otherwise receives substantial financial benefit from a related party for performing services. A second transactional sequence dealing with the performance of service for or on behalf of a related person is one in which one of the related parties has an obligation to perform as if in arrangement with a related person. Where a controlled foreign corporation performs services that a related person is or has been obligated to perform, the services are deemed as being performed on behalf of the other person. This is true whether or not the services are with respect to property sold by a related person.

The obligation to perform is distinguished from a guaranty of performance. Under a guaranty of performance, services are not regarded as performed on behalf of a related party in specified circumstances. Where a controlled foreign corporation pursuant to a contract performs services where a related person guarantees performance, it is not performed on behalf of a related party if specified conditions are met.

First, the related person’s sole obligation regarding a contract whose performance is guaranteed, is to guarantee performance of the services. Second, the controlled foreign corporation is required to be fully obligated to perform the contractual services. And lastly, the related person or any other person who is related to the controlled foreign corporation does not pay for performance, perform any of the services whose performance is guaranteed, or pay for performance or perform any significant services related to those services.

In the event a related person or another person related to the controlled foreign corporation does pay for performance or perform any of the services guaranteed or any significant services related to the services, it shall be deemed as services performed for or on behalf of a related person. A related person is to be considered to have guaranteed performance of services by a controlled foreign corporation whether it guarantees performance of the service by a separate contract of guaranty or enters into a service contract solely for the purpose of guaranteeing performance of service and immediately thereafter assigns the entire contract to a controlled foreign corporation for execution.

A third type of transaction deemed to be a performance of services or on behalf of a related person involves the sale of property and the servicing of it in a tying arrangement. Where a related person furnishes substantial assistance contributing to the performance of services, the service is deemed as performed for or on behalf of a related person. The term substantial assistance is defined in the various methods that enable a related person to pass services to a corporate structure member. Assistance to a controlled foreign corporation by a related person includes direction, supervision, service, know how, financial assistance, equipment, materials, and supplies. It does not include contributions to capital.

To constitute Foreign Base Company Service Income, the service must be performed for a related person as previously stated and performed outside of the country where the controlled foreign corporation was organized or created. Key to this second element is where the services are considered performed. The place where services are considered performed is dependent upon the facts and circumstances of each case.

Generally services are considered performed where the persons performing the services for a controlled foreign corporation are physically located when they performed their duties in the execution of the service activity resulting in income. In the case where an employee has allotted time to related persons located within the country of incorporation and without, an apportionment must be made. In making any type of allocation of income between that earned within and without the Offshore Center of incorporation, relative weight must be given to the value of the various functions performed by persons in fulfillment of a service contract or arrangement.

Arm’s Length Concepts and Subpart F Income

Arm’s length pricing is detailed and complex in its theory of transactional analysis. Its possible application is involved in every related party or structured analysis in foreign financial planning. Its coordinated meshing with other Offshore Financial Center and concepts of controlled status of ownership, Subpart F Income, and sourcing of income from activities is imperative to any meaningful financial planning. Those are the basic financial planning concepts that must be analyzed for any transnational corporate structure: (a) ownership structure of the entity; (b) Subpart F Income principles, (c) sourcing of income rules, and (d) the arm’s length concepts in the corporate structuring of related parties.

Related taxpayers are required to charge and take into account income, deductions, and credits in a manner consistent with similar types of transactions occurring between unrelated taxpayers. The Service utilizes Section 482 in the examination of corporate structures to insure that taxpayers are clearly reflecting income attributable to controlled transactions. Involved in this scrutiny is a focus upon the economic links of a taxpayer’s substantive structure and its related entities. It is necessary for the practitioner to devise mitigation techniques when evaluating planned offshore structures for potential Section 482 allocation results.

One of the underpinnings of Section 482 is to place a controlled taxpayer on a tax parity with an uncontrolled one. This is accomplished by calculating the true taxable income of the controlled taxpayer in a manner reasonably reflecting the relative economic realities actually undertaken by each taxpayer. Economic realities are the cornerstone of appropriate corporate structure planning. A general technique to analyze economic realities is to isolate each transaction between related parties.

In utilizing this technique, the focus is to determine the actual ownership of each item of allocation subject to Section 482 because the taxpayer has command of the income and its benefits. This method provides a safeguard to avoid some pitfalls inherent in the broad reach of this statute in policing related party transactions.

A shifting of taxation attributes can be for a valid business purpose because it is peculiar due to varying factors of each business. Allocation analysis is founded upon economic reality. This will be true even where there is a bona fide purpose in the allocation reasoning. The Service may assert an allocation is inappropriate due to a finding that an evasion of taxes results because of the economic realities. This is the essence of the government’s position. In this regard, intent to defraud encompasses the breadth of the avoidance of taxes. Where the allocation assertion is made, the taxpayer has the burden of proving the government’s contention is arbitrary, capricious and unreasonable

Foreign Service Company and Arm’s Length

Performance of services between related members of corporate structures are subject to Section 482 allocation adjustments. This normally results from the performance of service by a member of a controlled group for another member. The term services for purposes of Section 482 analysis embraces activities such as marketing, management, administration, and services characterized as of a technical nature. Related member structures are subject to scrutiny to determine proper allocation of charges for services to reflect true taxable income.

To avoid Section 482 allocation adjustments, services rendered or received are required to be consistent with the relative benefits intended from the services. This determination is based upon those facts known at the time the services were rendered. That is the case even though the potential benefits anticipated from the services are not actually realized. This is a concept characterized as the benefit test.

Generally, a service will be determined to be of benefit where the service when performed relates to carrying on an activity by a member of a controlled entity and is intended to be of benefit to another member. This benefit can be one that is derived in the member’s overall operations or with respect to its day-to-day activities. Conversely, allocations to achieve arm’s length results are not enforced where the probable benefits to the other related members are perceived as so indirect or remote that unrelated parties would not charge for such services.

In the application of Section 482 to service income between related entities, arm’s length expense for services rendered will generally be what charges would have been in independent transactions with or between unrelated parties. One of the government’s rules of thumb in this kind of analysis is that the arm’s length charge should be equated to the calculations of costs or deductions incurred in rendering the services. A taxpayer will be given an opportunity to rebut this notion by establishing standards by which the charges should be deemed appropriate.

In utilizing costs and deductions in the calculation of arm’s length determinations, it is generally a government contention that a taxpayer is required to provide adequate books and records to establish verification. An exception to this general proposition is the circumstance where the services that are the focus of an arm’s length scrutiny comprise an integral portion of the business activity of either a member rendering the services or the member receiving the benefit of the services.

Services are considered an integral part of business activity of a controlled group member where the party rendering service is peculiarly capable of rendering that service. Such a member of a controlled group is considered an integral part when the renderer, in connection with the rendition of services, makes use of a particularly advantageous situation or circumstance. That is accomplished by utilizing the special skills and reputation and by utilization of an influential relationship with customers in connection with intangible property. In other circumstances, a renderer of services will not be considered peculiarly capable of rendering services unless the value of the services is substantially in excess of the costs or the deductions attributable to the entity rendering the services.

In gaining a meaningful feeling and effects of the terminology integral part of business activities, it is helpful to focus upon two functions, management and supervisory activities. There is an important distinction drawn between the activities of supervision and management. The distinction is when a controlling entity among a controlled group of entities renders supervisory control over one of the controlled member entities. The nexus of this question arises when the supervisory services rendered by a parent corporation have benefited its subsidiary. The shifting of income and deductions within the concept has been the source of litigation.

Where a Section 482 allocation has been sought for services alleged to have benefited a controlled entity, a distinction is drawn and no allocation permitted on the theory activities of a supervisory nature are distinguishable from managerial services of a subsidiary. The prevailing view of courts has been that when contrasting service activities of a supervisory nature and those of specific managerial services, supervisory services are not viewed as being controlling.

Where a court finds from the facts that services are supervisory, the inclination is to find the parent benefiting from supervising its subsidiary. An aspect of this reasoning is based upon the notion that attention to significant investment by a parent in extending supervisory service to its subsidiary is an ordinary and necessary part of the duties of conducting and managing business.

The concept of peculiarly capable, as does supervisory and managerial, deals with issues arising in the shifting of service income and deductions. These distinctions direct themselves to services performed by one controlled entity, yet are booked as income to another member entity. This occurs in the context of sales and service companies booking income derived from product sales of a controlled entity and sham structures.

In accordance with Circular 230 Disclosure

William Richards is a Sole Practitioner in Orlando, Florida, USA 32626. Attorney at Law, Legal Advisor. 1978 – Present

PUBLICATIONS: International Financial Centers, Adell Financial Series, AD Adell Publishing, Copyright 2012, 378 pages. The Handbook of Offshore Financial Centers, Adell Financial Series, AD Adell Publishing, Copyright 2004, 266 pages; Offshore Financial Centers and Tax Havens, Archives of Tulane Law Library, Tulane Law School, Tulane University, New Orleans, Louisiana, Copyright, 1996, 512 Pages.

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