Tier I Issue – Industry Director Directive on Section 936 Exit Strategies #3
August 14, 2009
LMSB Control No.: LMSB-04-0809-031
Impacted IRM 4.51.2
|MEMORANDUM FOR||INDUSTRY DIRECTORS, LMSB
DIRECTOR, FIELD SPECIALISTS, LMSB
DIRECTOR, PRE-FILING & TECHNICAL GUIDANCE, LMSB
DIRECTOR, INTERNATIONAL COMPLIANCE STRATEGY AND POLICY
|FROM:||Sergio Arellano /s/ Sergio Arellano
Retailers, Food, Pharmaceuticals & Healthcare Industry
|SUBJECT:||Tier I Issue – Industry Director Directive on Section 936 Exit Strategies #3|
On February 2, 2007, the Industry Director for Retailers, Food, Pharmaceuticals, and Healthcare (the Industry Director) issued an Industry Director’s Directive on Section 936 Exit Strategies (Exit Strategies #1). On June 28, 2007, the Industry Director issued an alert to notify examiners of certain U.S. income tax consequences of Puerto Rican withholding taxes that may be imposed when examiners make adjustments to royalty payments made by a Puerto Rican branch operation or other related foreign entity to a U.S. parent or another U.S. related entity for the use of U.S. owned intangible property (the Alert). On February 13, 2008, the Industry Director issued a second Industry Director’s Directive (Exit Strategies #2) to supplement Exit Strategies #1 by focusing on the section 367 issues that arise out of the restructuring of section 936 corporations.
This Directive supplements Exit Strategies #1 and #2 by providing further information and instructions regarding the issues discussed in the Alert. This Directive is about the collateral effects of section 482 and/or section 367(d) adjustments. It provides a uniform format and approach for examiners to evaluate potential compliance risk related to the potential Puerto Rican tax issues and to outline the issue management and oversight process that has been established. This Directive is not an official pronouncement of law or the position of the Service and cannot be used, cited, or relied upon as such.
Former section 936 provided a tax credit against U.S. taxes imposed on income earned by a Possession Corporation (a U.S. corporation engaged in operations in Puerto Rico or other U.S. possession and electing application of section 936), from the active conduct of a trade or business in a possession of the United States. Under a typical structure, a Possession Corporation was a wholly-owned U.S. subsidiary of a U.S. Parent corporation (hereinafter, “U.S. Parent” refers to the U.S. Parent and other controlled U.S. corporations other than the Possession corporation). The Possession Corporation was generally established to manufacture products in Puerto Rico to qualify for the section 936 tax credit. As a result of the ten-year phase out of the section 936 tax credit (for taxable years beginning after 1995 and beginning before 2006), many taxpayers began restructuring their Possession Corporations to preserve the historically low levels of taxation that they would have paid had section 936 remained in effect.
Most restructurings of Possession Corporations involve transfers of assets under section 351 or section 361 and licensing of intangible assets to a new controlled foreign corporation. The most common form of such restructuring is as follows:
Step 1: The Possession Corporation (or the U.S. Parent) forms a controlled foreign corporation in a low tax jurisdiction.
Step 2: The Possession Corporation transfers all of its manufacturing assets (consisting mainly of property, plant, equipment, accounts receivable, and inventory) located in Puerto Rico to the controlled foreign corporation (the controlled foreign corporation that engages in the former activities of the Possession Corporation is hereinafter referred to as the CFC). After this transaction, the Puerto Rican assets of the former Possession Corporation comprise the assets of a Puerto Rican manufacturing branch of the CFC.
Step 3: The CFC enters into a license agreement with the U.S. Parent that allows the CFC to use the U.S. Parent’s intangible assets related to the manufacturing and sale of the manufactured product.
The structure of the manufacturing and distribution operations after the restructuring may vary by taxpayer and product. In many cases, the manufacturing operations are structured in one of the following ways: (1) the CFC manufactures 100-percent of the product in Puerto Rico; (2) the U.S. Parent manufactures and transfers components of the product to the CFC to manufacture as a finished product; (3) the CFC performs most of the manufacturing and transfers the unfinished product to the U.S. Parent for finishing; or (4) the U.S. Parent manufactures and transfers components of the product to the CFC, the CFC performs most of the remaining manufacturing processes, and the CFC transfers the product to the U.S. Parent for finishing.
In cases where the CFC manufactures the finished product, such as #1 and #2, the CFC typically sells the finished product to the U.S. Parent and/or to a foreign affiliate to distribute to unrelated parties. In cases where the U.S. Parent performs the finishing processes, such as in #3 and #4, the CFC typically compensates the U.S. Parent for performing those processes either through payments (if the product is not sold to the U.S. parent before the U.S. Parent performs the finishing processes) or through the sales price (if the product is sold to the U.S. parent before the U.S. Parent performs the finishing processes). The finished products are then usually distributed by the U.S. parent (in cases of products ultimately consumed in the United States) or a foreign affiliate (in cases of products consumed in foreign countries).
These restructurings raise a number of sections 482 and 367 issues (see Exit Strategies #1 and #2 for a description of these issues). Of relevance to this Directive, these issues include whether adjustments should be made under section 482 to: (1) the transfer price of components, products (either unfinished or finished), or services arrangements between the U.S. Parent or foreign affiliate and the CFC, and (2) the royalties paid by the CFC to the U.S. Parent. These restructurings also raise issues regarding the proper characterization, source, and foreign tax credit consequences stemming from the resulting structure. This Directive provides further description of these issues and includes instructions on how to analyze these issues and coordinate with the Issue Management Team for section 936 Exit Strategies (IMT).
Puerto Rican Taxation:
CFCs formed to replace Possession Corporations frequently negotiate a grant of industrial tax exemption issued by the Puerto Rico Office of Industrial Tax Exemption (the Grant). The Grant typically specifies the tax rates a CFC will be subject to during the period the Grant is effective.
Puerto Rican income and withholding tax rates,including the authority to negotiate Grants that specify the income tax and withholding tax rates the CFC and related U.S. affiliate will be subject to, are set forth in several Puerto Rican statutes. Puerto Rico generally imposes a fixed income tax rate of 7 percent on industrial development income of a business operating under a Grant. However, that rate can be reduced to as low as 2 percent or less in some situations. Since May 13, 2006, Puerto Rico has generally imposed a withholding tax rate of 15 percent on royalty payments made by a business operating under a Grant for the right to use patents, copyrights, formulas, technical know-how, and other similar property in Puerto Rico. Prior to May 13, 2006, that withholding tax rate was 10 percent . However, those withholding tax rates could be reduced to as low as 2 percent . Puerto Rico does not impose a withholding tax on royalties paid by a business operating under a Grant for the use of trademarks and other marketing intangibles. If the CFC is not operating under a Grant, Puerto Rico generally imposes a 29 percent withholding tax rate on royalties paid to a foreign corporation not engaged in business in Puerto Rico.
Because of the complexity of the Puerto Rican tax rate structure as well as the possibility for an individually negotiated rate, the best way to determine a particular taxpayer’s rate is to issue an IDR requesting the taxpayer to provide copies of any Grants the CFC, U.S. Parent, and any other related parties have entered into, or requests for grants filed, with the Puerto Rico Office of Industrial Tax Exemption and to specify the Puerto Rican income tax rates and withholding tax rates to which the CFC, U.S. Parent, and any other related parties are subject.
Considering the Puerto Rican tax implications of a potential adjustment also typically raises other issues, including:
- What methodology or methodologies for determining the appropriate section 482 adjustment would be considered to be the “best method” under section 1.482-1(c) to provide an arm’s length result for each transaction involved (e.g., licensing intangible property to the CFC, purchasing manufactured property from the CFC, and providing services to the CFC)?
- Would a method that did not separately identify the appropriate royalties, manufactured product sales prices, and services prices nonetheless provide a more reliable transfer pricing method for determining the overall income that should be recognized in the United States? If so, how should that allocation be attributed to services prices, sales prices for manufactured property, and royalties for use of intangibles?
- What information is available for determining arm’s length sales and services prices and royalties?
- In light of the potentially increased burden on taxpayers and the IRS in order to properly analyze these issues, the reliability of any possible analysis, and the relative significance of the issue, what level of resources should be committed to separating services prices, sales prices, royalties on which Puerto Rico withholds, and royalties on which Puerto Rico does not withhold?
- Is the taxpayer in an excess credit or excess limitation foreign tax credit position for the taxable year? What effect would an adjustment to the taxpayer’s foreign source income or the amount of creditable foreign taxes paid or deemed paid have on this position? Has the taxpayer exhausted all effective and practical remedies to reduce its Puerto Rican tax liability under Puerto Rican law?
Planning and Examination Guidance:
Section 482 allocations in these cases may have significant impact on Puerto Rican taxes, and in turn, on the foreign tax credits available to U.S. taxpayers. See attached Diagram 1 showing an adjustment to royalties paid by a CFC to the U.S. Parent. An allocation to increase the U.S. Parent’s income will typically result in correlative decreases to the income of the CFC to reflect increased royalties, decreased sales prices on tangible property, increased services prices, or any combination thereof. However, such an adjustment may also increase the amount of the U.S. Parent’s income subject to Puerto Rican withholding tax.
Accordingly, if the adjustments are respected by Puerto Rico, there may actually be an overall increase in Puerto Rican tax paid by the CFC and U.S. Parent,
even though the correlative adjustments would generally decrease the CFC’s Puerto Rican income.
For example, consider the case of a CFC that negotiated a Grant with the Puerto Rican taxing authorities that resulted in a higher withholding rate than income tax rate. Under these facts, a U.S. section 482 allocation to increase the royalties paid by the CFC would have the effect (if respected by Puerto Rico) of reducing the income tax paid by the CFC to Puerto Rico, but would increase the tax Puerto Rico withheld on the royalty paid by the CFC to the U.S. Parent by an amount larger than the corresponding decrease in income tax. The foreign tax credit consequences of this increase can be significant in comparison to the section 482 adjustment. In extreme cases, additional Puerto Rican taxes could offset U.S taxes on unrelated foreign source income of the U.S. Parent, effectively reducing (not increasing) U.S. taxes as a result of the adjustment. On the other hand, a U.S. section 482 allocation to decrease the price of manufactured property sold by the CFC to the U.S. Parent would generally decrease Puerto Rican income, but would not result in an increase in withholding on royalties paid by the CFC to the U.S. Parent.
As a result, one issue that arises is whether the section 482 allocation must be made to the royalty paid by the CFC to the U.S. Parent for licensed intangibles, to the sales price of the manufactured products sold by the CFC to the U.S. Parent, to the services provided by the U.S. Parent to the CFC, or to some combination thereof in order to clearly reflect income from those transactions. It is not appropriate to propose adjustments solely to transfer prices of components, manufactured products, or the performance of U.S.-sourced services unless those adjustments are supported by appropriate facts and analysis by the exam team.
In past practice, Puerto Rico has also treated royalties on different types of licensed intangibles differently. For example, when a business operates under a Grant, Puerto Rico typically requires withholding on royalties for patents, copyrights, formulas, technical-know how and other similar property, but not on royalties for trademarks and other marketing intangibles. Additionally, there are sometimes disagreements between the United States and Puerto Rico regarding the proper source of the income from certain manufacturing intangibles. Thus, to the extent a section 482 adjustment is made to increase the royalty paid by the CFC to the U.S. Parent, the type of underlying intangible may be significant. As a result, identifying the breakdown of royalty adjustments into royalties for different types of intangibles should also be considered. It is not appropriate to propose adjustments solely to royalties on which Puerto Rico does not withhold unless those adjustments are supported by appropriate facts and analysis by the exam team.
In determining the U.S. tax consequences of a royalty adjustment, consideration must be given to the proper source of the royalty, since Puerto Rico may properly withhold only on payments that give rise to income sourced in Puerto Rico. In some cases, the place of use of the intangible may fall outside Puerto Rico, in which case the royalty may not be subject to Puerto Rican withholding tax. To the extent a taxpayer fails to take advantage of substantive and procedural rules of foreign law to minimize its reasonably expected liability for foreign tax over time, taxes paid in excess of the amount reasonably owed are considered noncompulsory payments for which credit may be disallowed. This obligation is separately applied to each taxpayer in a related group. See Treas. Reg. §1.901-2(e)(5).
Issues may also arise relating to a section 367(d) adjustment. It is possible that a taxpayer could attempt to characterize a transaction that is properly taxable under section 367(d) (i.e., a transfer of intangible property by a U.S. person to a foreign corporation in a section 351 or section 361 transaction) as a transaction taxable under section 482 (i.e., a sale or license of intangible property). Alternatively, the reverse could occur--a transaction subject to section 482 could be characterized as a transaction subject to section 367(d). Thus, if a transaction appears to be improperly characterized, an examiner should consider the possibility that it was characterized in this manner in order to achieve collateral tax benefits. An examiner should be diligent in conducting an analysis to ensure that these transactions are properly characterized based upon the particular factual circumstances present in the case so as to ensure that the proper collateral tax consequences flow from those transactions. If an examiner encounters a situation where a section 367(d) transaction is being improperly characterized as a section 482 transaction (or the reverse situation), the examiner should contact the Issue Management Team.
Planning and Examination Risk Analysis:
As discussed above, sourcing and foreign tax credit issues may have a material impact on the ultimate U.S. taxes imposed by an adjustment. In extreme cases, an increase in the royalties paid to a U.S. taxpayer could actually reduce overall U.S. taxation of foreign source income because of increased availability of foreign tax credits. Consequently, exam teams must be cognizant of the impact of Puerto Rican taxes on their proposed adjustments. If an exam team is developing issues described in Exit Strategies #1 and #2, the exam team should apply the appropriate LMSB risk analysis procedures to determine whether the further development discussed below is appropriate in light of the facts and circumstances of the individual case. Among the things to consider are compliance impact, materiality, rollover-tax impact, current stage of the examination, and any other relevant criteria. Proper development of the issues discussed in this Directive generally requires simultaneous development with the underlying section 482 and 367 issues.
Steps to Determine if Potential Issues Exist:
The appropriate response to the issues described above will vary with the facts and circumstances of particular taxpayers and the resources available to the exam team. Because the appropriate analysis will rely on the work of the IRS economist or outside economist retained by the exam team, close consultation and coordination with the economist will also be necessary.
As a preliminary analysis of the issues relating to Puerto Rican taxation, exam teams should:
(i) determine whether the CFC and/or U.S. Parent are operating under Grants and the Puerto Rican income tax rates and withholding tax rates, respectively, to which the CFC and U.S. Parent are subject;
(ii) if the CFC and U.S. Parent are subject to a Puerto Rican income tax rate and withholding tax rate, respectively, of over 2-percent, determine whether the CFC requested that it and the U.S. Parent be subject to a 2-percent Puerto Rican income tax rate and withholding tax rate. Also ask for the reasons provided by the Puerto Rico Office of Industrial Tax Exemption or other Puerto Rican Office for not granting the 2-percent income tax and withholding tax rates; and
(iii) develop an understanding of the taxpayer’s circumstances and attributes that affect the availability of any additional foreign tax credits.
A review of the following information may also assist the exam team in evaluating the issues related to Puerto Rican taxation:
agreements, such as licensing agreements, that authorize the use of U.S. owned intangibles by the CFC;
valuation reports and other documentation related to the valuations of patents, copyrights, formulas, technical know-how, trademarks, and trade-names licensed to the CFC and the amount or percentage of the total royalties allocable to compensating the U.S. Parent for use of those intangibles assets. This may include documentation prepared for general business purposes, foreign tax compliance, etc.; and
data on all relevant intercompany services between the U.S. Parent and CFC and sales of tangible property between the U.S. Parent, the CFC, and any other foreign affiliate, including sales of raw materials or components of products and sales of finished products.
For purposes of allocating an overall adjustment to intercompany sales, services, and royalties and determining a break-down of the royalties, the economist should try to reach a reasonable allocation. See attached Example for a demonstration of the potential impact of a break-down of a royalty adjustment. If the economist believes that allocating an overall adjustment to intercompany sales, services, and royalties or breaking-down the royalties into the amount or percentage allocable to compensating the licensor for its manufacturing intangibles and other intangibles will result in a determination that is difficult to substantiate, the economist should clarify in the transfer pricing report that allocating the overall adjustment to intercompany sales and royalties and breaking-down the royalties was performed for purposes of determining the proper amount of Puerto Rican income and withholding tax. The economist should also indicate the impact that the analysis of the break-down has, if any, on the reliability of the overall section 482 adjustment.
For further information:
This Directive was issued to help examiners identify and analyze issues relating to Puerto Rican taxation that arise in the context of restructurings of Possession Corporations. If examiners have additional questions about the issues discussed in this Directive or other related issues, they should contact:
Technical Advisor Natalie Hodapp (212) 719-6321
Economist Soheila Crane (949) 389-4546
LMSB Field Counsel Michael Calabrese (414) 231-2811
LMSB Field Counsel Naseem Khan (312) 368-8662
cc: Commissioner, LMSB
Deputy Commissioner, LMSB
Deputy Commissioner, International
Division Counsel, LMSB
Director, Performance, Quality and Audit Assistance
P.R. Laws Ann. tit. XIII § 10102.
P.R. Laws Ann. tit. XIII § 10105(k); P.R. Act No. 88 § 1 (May 13, 2006).
P.R. Act No. 135 § 6(k) (Dec. 2, 1997).
P.R. Laws Ann. tit. XIII § 10105(k); P.R. Act No. 88 § 1 (May 13, 2006); P.R. Act No. 289 § 2 (Dec. 24, 2002).
P.R. Laws Ann. tit. XIII §§ 8550(a) and 8547(a).
To assist with this determination, issue an IDR requesting the taxpayer to provide copies of any grants of industrial tax exemption the CFC, U.S. Parent, and any other related parties have entered into, or requests for grants filed by those persons, with the Puerto Rico Office of Industrial Tax Exemption and to specify the Puerto Rican income tax rates and withholding tax rates to which the CFC and the U.S. Parent are subject.
For instance, submit an IDR to determine the U.S. Parent’s current foreign tax credit posture and whether additional Puerto Rican taxes would increase the amount of foreign tax credits the U.S. Parent may claim in the current year or that it is likely to be able to claim in carry-to years.
|Taxable Income from Puerto Rico Operations per PRCo Return||5,000|
|Puerto Rico Income Taxes Paid per PRCo Return||100|
|Current US Tax from Puerto Rico Operations||-|
|USCo/PRCo Total Adjustment (Increase in income to USCO/
decrease in income or increase in deduction to PRCO)
|Adjustment without Components Breakdown||Adjustment with Components Breakdown|
|USCo/PRCo Total Adjustment||500||500|
|Adjustment with Components Breakdown|
|Transfer Price (Distribution) Adjustment||180|
|Corporate Name Royalty Adjustment||20|
|Manufacturing Royalty Adjustment||100|
|Technology Royalty Adjustment||200|
|Adjustment without Components Breakdown|
|Single Royalty Adjustment||500|
|Impact of Adjustment on PRCo|
|Puerto Rico Taxable Income per Return||5,000||5,000
|Puerto Rico Income Tax per Return||100||100|
|Taxable Income from Puerto Rico Operations after Adjustment||4,500||4,500|
|Total Puerto Rico Income Tax after Adjustment||90||90
|Reduction in Puerto Rico Income Tax from Adjustment||(10)||(10)|
|Impact of Adjustment on USCo|
|Total Royalty Subject to Withholding||500|| 300
|Puerto Rico Withholding Tax||75||45|
|US Income Tax on Total Adjustment||175||175|
|Section 901 FTC with respect to Puerto Rico Withheld Tax||75||45|
|Net US Tax (after FTC) from Adjustment||100||130|
|Creditable Puerto Rico Income Taxes Paid (available for FTC when dividend paid)||90||90|
|1) Manufacturing and Technology royalties subject to 15% Puerto Rico withholding tax (see Exit Strategies #3, Background).|
|2) Royalty adjustment in the example without a breakdown did not specify the underlying intangibles, therefore Puerto Rico treats the full royalty adjustment as subject to withholding.|
|3) PRCo subject to 2% income tax rate per grant with Puerto Rico.|
|4) PRCo pays no dividend to USCo during the year.|
|5) USCo subject to 35% tax rate on US income.|
|6) Puerto Rico respects the US adjustment and assesses withholding tax.|
|7) USCo Pays Puerto Rico withholding tax in year of assessment.|
|8) After taking royalty adjustment into account, USCo has sufficient limitation to claim a full foreign tax credit on the withholding tax paid.|