Quality Corporation created a foreign subsidiary in Country C this year. The subsidiary receives components from Quality, assembles the components into a finished product using local labor, and sells them to unrelated wholesalers in Countries A, B, and C using its own sales force. The foreign subsidiary has paid no dividends to the parent this year. What tax issues should Quality's Director of

Question

Taxes consider with respect to these activities?

What will be an ideal response?

Answer 1

• Is the Country C corporation a controlled foreign corporation?
• Do the Country A, B, and C sales constitute foreign-based company sales income?
• Do the Country C assembly activities constitute manufacturing or a substantial transformation so as to be an exception to the foreign-based company sales income definition?
• If the Country A and B sales constitute foreign-based company sales income, what is the amount of the constructive dividend deemed paid at the year-end?
• What portion of the sales are foreign-based company income? Do any of the subsidiary's expenses offset the Subpart F income? Does the Subpart F income de minimis rule permit exclusion of the Subpart F income?
• What exchange rate is used to translate the foreign income? The foreign taxes? Are the Country A income taxes creditable against the foreign-based company income under the deemed paid credit rules? What foreign tax credit limitation basket applies to the Subpart F income? How is the foreign tax credit reported?
• What effect does the Subpart F income constructive distribution have on the CFC's E&P? Can the constructive dividend be distributed to Quality Corporation tax-free?
• Did the Country A subsidiary invest any money in U.S. property that may be an investment in U.S. property? Is such an investment taxable in the United States?
• What effect does the constructive dividend have on Quality Corporation's basis for the Country C subsidiary corporation's stock?
• Do the Sec. 482 rules apply to the transfer of the components to the Country C subsidiary?

It appears that the subsidiary corporation is majority U.S. controlled and therefore is a CFC. The assembly operation may qualify as Country Z manufacturing and permit all the sales to be exempt from Subpart F. Since direct labor costs and overhead exceed 20% of the total cost of goods sold, it is highly likely the assembly operation is manufacturing and excluded from the Subpart F income category. If it is not manufacturing, the Country A and B sales will be foreign-based company sales income and taxed to the U.S. shareholders currently. If Subpart F income, the sales income is taxed to Quality in the current year, and the dividend is eligible for the deemed paid credit. Special translation rules found in Subpart F will govern translation of the dividend and any related taxes. The look-through rules for the foreign tax credit will place the income in the other basket. The credit election will be made on Form 1118. Quality stock basis is increased by the constructive dividend that can be distributed tax-free from the CFC's previously taxed Subpart F income E&P pool. Since Quality and the foreign subsidiary are related parties, the Sec. 482 transfer pricing rules will apply to the transfer of the components.