Whirlpool profits routed through foreign subsidiary subject to US tax, court holds

By Doug Connolly, MNE Tax

The US Court of Appeals for the Sixth Circuit in a December 6 decision held that Whirlpool must pay taxes on more than USD 45 million in profits for which the appliance manufacturer had evaded paying taxes by shuffling the income through a Luxembourg subsidiary with a single part-time employee.

Although the arrangement enabled Whirlpool to avoid taxes on the income both in Mexico at the level of its manufacturing subsidiary and in Luxembourg at the holding company level, the court affirmed that the income is ultimately taxable to the US parent under the “foreign base company sales income” provisions.

Shifting profits

Whirlpool US manufactures appliances in Mexico via wholly-owned Mexican subsidiaries. In 2007, Whirlpool US created a holding company subsidiary in Luxembourg. Whirlpool-Luxembourg, with one part-time employee, then took over Whirlpool’s manufacturing in Mexico “on paper” through the use of a new, zero-employee Mexican subsidiary that Whirlpool-Luxembourg wholly owned.

Whirlpool-US then entered into an agreement to buy its appliances from Whirlpool-Luxembourg – with no change in who was actually making the appliances in Mexico.

Through operation of the Mexican maquiladora program, which enabled a foreign principal to be deemed not to have a permanent establishment in Mexico if it met certain requirements, Whirlpool-Luxembourg was exempt from tax on its profits in Mexico. Those profits amounted to more than USD 45 million in the year at issue (2009).

On the other hand, for Luxembourg tax purposes, Whirlpool-Luxembourg established that it did have a permanent establishment in Mexico. Under Luxembourg’s tax treaty with Mexico, this enabled Whirlpool to avoid tax on the income in Luxembourg as well.

After avoiding liability for tax on the USD 45 million in profits in both Mexico and Luxembourg, Whirlpool-US filed its return for the year at issue reporting that it did not owe tax on the profits in the US either.

The Internal Revenue Service disagreed. The IRS determined that the income should have been included in Whirlpool-US’s income as foreign base company sales income. The Tax Court agreed with the IRS. Whirlpool appealed.

Liability for tax under US law

Under Subpart F of the US tax code, US corporations are liable for tax on certain types of income held by controlled foreign corporations. This includes foreign base company sales income, which generally consists of certain income that a controlled foreign corporation earns from related entities in connection with the purchase or sale of goods that are neither manufactured nor sold in the controlled foreign corporation’s country of organization. Associated rules apply if the controlled foreign corporation effects the transactions through a foreign branch.

The Sixth Circuit Court of Appeals examined the statute under Internal Revenue Code section 954(d)(2) with respect to certain branch income in connection with the foreign base company sales income rules. It noted the provision specifies two consequences that follow if two conditions are met.

The first condition is that the controlled foreign corporation carries on its activities through a branch or similar establishment outside of its country of incorporation. The court concluded this condition was met as Whirlpool-Luxembourg carried out its activities through a Mexican entity that it elected to treat as a branch for Luxembourg tax purposes.

The second condition is that the branch arrangement “have substantially the same effect as if such branch or similar establishment were a wholly-owned subsidiary deriving” the income attributable to the branch’s activities. The court explained that the case hinged on this phrase and the meaning of the term “effect” within it. The court concluded that the statutory context and legislative history make clear that the “same effect” referred to in the statute is the deferral of taxes. As the arrangement enabled Whirlpool-US to avoid paying any tax on the income, the second condition was met.

So follow the consequences. The statute states that when the conditions are met, the sales income attributable to carrying on the activities through the foreign branch will be treated as derived from a wholly-owned subsidiary. And – central to the case at hand – the income shall constitute foreign base company sales income. (The statute further points to the corresponding regulations – an issue addressed separately by the court and a dissenting opinion).

Accordingly, the Sixth Circuit affirmed the Tax Court decision, concluding that the USD 45 million in profits constitute “foreign base company sales income” subject to US taxation.