May 13, 2020

Tax Court Upholds Application of Subpart F Manufacturing Branch Rule

Holland & Knight Alert
Lawrence R. Kemm | Alan Winston Granwell | William B. Sherman


  • In a case involving the Whirlpool Financial Corp. and related foreign affiliate corporations, the U.S. Tax Court upheld the Internal Revenue Service's (IRS) application of the Subpart F "branch rule" to impose U.S. federal income tax on Whirlpool on approximately $50 million of profits generated by certain controlled foreign corporations of Whirlpool.
  • The controversy centered on whether a Luxembourg/Mexican manufacturing/sales arrangement that resulted in no local taxation of sales income ran afoul of the arcane Subpart F "branch rule."
  • The case, which involved tax years prior to the enactment of the Tax Cuts and Jobs Act (TCJA), is important not only because of its explication of the branch rule but also because it continuing application under current law, particularly with respect to the interaction of the Subpart F rules with the Global Intangible Low-Taxed Income (GILTI) provisions.

A U.S. shareholder of a foreign corporation generally is not subject to U.S. federal income tax on the income of the foreign corporation until the shareholder receives an actual distribution from the corporation. However, under an anti-deferral regime contained in Subpart F of the Internal Revenue Code, certain types of "movable" income earned by a controlled foreign corporation (CFC) are currently included in the income of the CFC's U.S. shareholders even if the CFC does not actually distribute the income to its shareholders in that year.

One such type of "movable" income is Foreign Base Company Sales Income (FBCSI). That type of income relates to income derived by a CFC from a purchase or sale of personal property involving a related party in which the goods are both manufactured and sold for use/consumption outside the CFC's country of organization. Thus, if property is manufactured or sold for use or consumption within the CFC's country of organization, the income generally would not be FBCSI. For example, FBCSI would not include income from the purchase or sale of property manufactured within the CFC's country of organization, even if that property were to be sold to a related person for use outside of the CFC's country of organization. Further, under a manufacturing exception, subject only to the branch rule discussed in this alert, FBCSI does not include income derived by a CFC from the sale of personal property manufactured by the CFC itself (regardless of whether manufactured within the CFC's country of organization).

FBCSI also includes income from the purchase and sale made by a branch outside of the CFC's country of incorporation if use of the branch (either a sales branch or a manufacturing branch) has substantially the same effect as if the branch were a wholly owned subsidiary of the CFC.

Under the manufacturing branch rule, when 1) a CFC conducts manufacturing outside its country of incorporation by or through a branch or similar establishment, and 2) the use of the branch has substantially the same tax effect as if the branch were a wholly owned subsidiary deriving the income,1 the manufacturing branch and the remainder of the CFC are treated (for purposes of the FBCSI rules) as separate corporations and the sales made by or through the remainder of the CFC are treated as made on behalf of the manufacturing branch, which generally results in FBCSI.

Simplified Version of the Facts

Whirlpool historically manufactured household appliances in Mexico through a wholly owned Mexican subsidiary and its lower-tier subsidiaries (Whirlpool Mexico), which sold its products to unrelated distributors in Mexico and to Whirlpool in the U.S. In 2007 and 2008, Whirlpool reorganized its Mexican manufacturing operations by forming a new Luxembourg entity (LUX) and a new Mexican company (WIN) that was owned by LUX. WIN was treated as a disregarded entity of LUX (for U.S. tax purposes) pursuant to a check-the-box election.

Under the restructured manufacturing arrangements, WIN became the lessee of Whirlpool Mexico's manufacturing plants, LUX became the owner of the machinery, equipment, inventories, furniture and other assets situated within the manufacturing plants, LUX held title to all raw materials, work-in-process and finished goods inventory, and WIN, through employees subcontracted from Whirlpool Mexico, provided manufacturing and assembly services to LUX to produce the goods.

As a result, LUX became the owner of the manufactured products, which it then sold as finished products to Whirlpool and to Whirlpool Mexico for distribution in the U.S. and Mexico, respectively. For U.S. tax purposes, Whirlpool took the position that LUX was the company that manufactured and sold the products.

From a Luxembourg/Mexican perspective, LUX's sales income was not subject to tax either by Luxembourg or Mexico. LUX obtained a Luxembourg tax ruling confirming that its sales income was attributable to a Mexican permanent establishment and therefore was not subject to Luxembourg taxation. In Mexico, LUX was not considered to have a Mexican permanent establishment under the Mexican maquiladora provisions and thus was not subject to Mexican taxation. WIN was taxed at a 17 percent rate in Mexico as a resident maquiladora company, although corporations resident in Mexico at that time generally were taxed at a 28 percent rate.

The net effect of the restructuring was that LUX paid no tax in Luxembourg and little tax was paid by WIN in Mexico. Further, because Whirlpool took the position that Whirlpool LUX's sales did not constitute FBCSI, no U.S. tax was paid on LUX's sales income.

The Internal Revenue Service (IRS) determined that LUX's sales income was FBCSI taxable to Whirlpool.

The Tax Court's Opinion

Initially in the case2, the court found it unnecessary to decide whether LUX was engaged in manufacturing because LUX's sales resulted in FBCSI under the Subpart F "manufacturing branch" rule.

Turning to the branch rule, the court found that because WIN elected to be disregarded as a separate entity, it would be treated as a branch of LUX for U.S. tax purposes. Further, although LUX had no employees in Mexico, LUX owned assets in Mexico, acted as a "contract manufacturer" in Mexico, and sold the products that it manufactured in Mexico to related parties. Therefore because LUX was incorporated in Luxemburg and carried on its manufacturing activities "through a branch or similar establishment" in Mexico, the first precondition to the application of the branch rule was satisfied.

The second precondition to the manufacturing branch rule (i.e., that the use of the branch has substantially the same tax effect as if the branch were a wholly owned subsidiary deriving the income) was satisfied because LUX was not taxable in Luxembourg on any of its sales income. Thus, by deferring all tax on its sales income, LUX achieved "substantially the same effect" that it would have achieved under U.S. tax rules if its Mexican branch had been a wholly owned subsidiary deriving such income. Thus LUX's sales income failed the tax rate disparity test because LUX was taxed at an appreciably lower tax rate than the rate at which Mexico would have taxed the income.3

In sum, the branch rule was intended to prevent CFC's from avoiding FBCSI because there would be no transaction with a related person. By treating LUX's branch (i.e., WIN) as a separate taxable entity, LUX derived income in connection with "the sale of personal property to any person on behalf of a related person." The Tax Court succinctly summarized its rationale:

The Luxembourg sales affiliate epitomizes the abuse at which Congress aimed: The selling corporation derived 'income from the * * * sale of property, without any appreciable value being added to the product by the selling corporation.' [citation omitted]. If [LUX] had conducted its manufacturing operations in Mexico through a separate entity, its sales income would plainly have been FBCSI under section 954(d)(1). Section 954(d)(2) prevents petitioners from avoiding this result by arranging to conduct those operations through a branch.

Application to TCJA

Under the law prior to Tax Cuts and Jobs Act (TCJA), from a U.S. tax perspective, U.S. shareholders of CFCs sought to structure their offshore active operations in a manner so as to avoid the U.S. anti-deferral regime contained in Subpart F. If from a non-U.S. tax point of view, a CFC's foreign income producing activities between two foreign countries could be structured not only to sidestep the U.S. anti-deferral rules, but also to arbitrage discontinuities in differing tax laws, stateless income could be produced, which, until repatriated, would not be subject to U.S. taxation.

That result was changed in the TCJA with the addition of the Global Intangible Low-Taxed Income (GILTI) provisions, which, if applicable, could reduce the effective rate of U.S. taxation to 10.5 percent for tax years through 2025 and 13.125 percent thereafter, whereas Subpart F income would be taxable at a 21 percent rate but with full use of foreign tax credits, rather than the 80 percent limitation of foreign tax credits imposed by the GILTI regime. Thus, depending on the circumstances, the application of the Subpart F regime (to include the branch rule) to current international tax planning continues to be relevant, as Subpart F income is not includible in the computation of GILTI.


Whirlpool tried to thread the needle by generating income that would not be taxed by Luxembourg or Mexico, at least on a current basis. Years later, the OECD Base Erosion and Profit Shifting (BEPS) initiative, and now, the current OECD/G20 Inclusive Framework on BEPS collaboration, have sought to address multi-country tax discontinuities. Although, as the U.S. Supreme Court wrote in Gregory v. Helvering, "The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted," the question nonetheless must be asked is "whether what was done, apart from the tax motive, was the thing which the statute intended."

The TCJA enacted at the end of 2017 made significant changes to U.S. international tax rules, including the introduction of the GILTI anti-deferral rules. Nevertheless, the Subpart F rules, including the branch rule, have significant continuing importance in determining the tax effect of international transactions involving foreign affiliates of U.S. multinationals. The U.S. government continues to have an incentive to invoke the application of the branch rule and Subpart F generally to maximize tax revenues. For this reason, the Whirlpool decision should not be viewed as merely of historical interest.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.


1 A tax rate disparity test is used to determine whether the use of the branch has substantially the same tax effect as if it were a separate corporation. That test compares the hypothetical effective rate of tax with respect to the hypothetical net sales income computed under the laws of the manufacturing jurisdiction (i.e., "hypothetical tax base," to the actual effective rate of tax with respect to that hypothetical tax base). A manufacturing branch and the remainder of the CFC are treated as separate corporations if the actual effective tax rate with respect to the hypothetical tax base is less than 90 percent of, and at least 5 percentage points below, the hypothetical effective rate of tax that would apply to that base in the country where the goods are manufactured.

2 Whirlpool Financial Corporation & Consolidated Subsidiaries v. Commissioner of Internal Revenue; Whirlpool International Holdings S.a.r.l., f.k.a. Maytag Corporation & Consolidated Subsidiaries, v. Commissioner of Internal Revenue, 154 T.C. No 9 (May 5, 2020).

3 For purposes of allocating income between the branch and the "remainder" of LUX, the Tax Court noted that under Mexican law, WIN was required to engage in manufacturing and only in manufacturing based on its status as a maquiladora company. The manufacturing income earned by WIN was deemed to be arm's length under Mexican transfer pricing rules. Moreover, despite the fact that LUX owned the machinery and equipment, it allowed WIN to use that machinery and equipment free of charge. Thus, the Tax Court concluded that the proper allocation of income was "intuitively clear," finding that the Mexican branch earned all of the manufacturing income (which was taxed at a preferential rate of 17 percent, rather than the normal 28 percent rate), while LUX derived all of the income from selling the products.

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