PORTION OF CFC'S DISTRIBUTIVE SHARE OF PARTNERSHIP INCOME IS TREATED AS FOREIGN BASE COMPANY SALES INCOME.

Rev. Rul. 89-72

ISSUE

Is a portion of a controlled foreign corporation's distributive share of partnership income treated as foreign base company sales income in the circumstances described below?

FACTS

P, a domestic corporation, is engaged in the business of manufacturing machines in the United States. PRS, an entity classified as a partnership for United States federal tax purposes, is organized under the laws of Country X. S, a wholly owned Country Y subsidiary of P that is a controlled foreign corporation (a CFC) as defined in section 957 of the Internal Revenue Code, owns a 25 percent interest in PRS. The remaining 75 percent interest in PRS is owned by an unrelated Country X corporation.

PRS purchased machines from P for sale and use in Country X. The income earned from the sale of machines in Country X is not subject to an effective rate of income tax imposed by a foreign country that is greater than 90 percent of the maximum rate of tax specified in section 11 of the Code.

In 1988, S's distributive share of PRS's income included income from the sale in Country X of machines purchased from P.

LAW AND ANALYSIS

Section 951(a) of the Code generally requires the United States shareholders of a CFC to include in income their pro rata shares of the CFC's subpart F income for each taxable year. P must therefore include S's subpart F income in its income for 1988.

Under section 954(a) of the Code, subpart F income includes foreign base company sales income, including income derived from the purchase of property from a related person where the property is both manufactured and sold for use outside of the CFC's country of organization. P and S are related persons under section 954(d).

Under section 701 of the Code, a partnership as such is not subject to income tax. Persons carrying on business as partners are liable for income tax only in their separate or individual capacities. The partners of the partnership generally take into account their distributive shares of the partnership's income, gain, loss, deduction and credit as determined under section 704.

Under section 703 of the Code, a partnership must separately state certain items specified in section 702(a). These items are taken into account separately by the partners of the partnership, and under section 702(b) the character of each such item is determined as if it were realized directly by the partner from the source from which realized by the partnership. Among the items to be separately stated by the partnership and separately taken into account by the partners are items set forth in regulations prescribed by the Secretary under section 702(a)(7). Section 1.702-1(a)(8)(ii) of the Income Tax Regulations provides that, in addition to other items specified in section 702(a) and the regulations thereunder, each partner must also take into account separately his distributive share of any partnership item which if separately taken into account by any partner would result in an income tax liability for that partner different from that which would result if that partner did not take the item into account separately. See Rev. Rul. 85-60, 1985-I C.B. 187. See, also, the district court opinion in MCA, Inc. v. United states, 502 F. Supp. 838, 841 (C.D. Cal. 1980), rev'd, 685 F.2d 1099 (9th Cir. 1982), where a dictum suggests that a CFC partner's distributive share of partnership income would be deemed to derive directly from the persons with whom a partnership transacted business.

S's gross income for 1988 includes its distributive share of partnership income from the sale of machines manufactured in the United States that PRS purchased from P and sold outside S's country of organization. In accordance with sections 702(a) and (b) of the Code and section 1.702-1(a)(8)(ii) of the regulations, such income is taken into account separately by S, and the character of such income is determined as if it were realized directly by S from the source from which PRS realized such income. For purposes of section 954(a) of the Code, the character of an item of income included in a CFC partner's distributive share includes such attributes of the income as would make it subpart F income if realized directly by the CFC partner, including whether the person from whom the goods are purchased is a related person with respect to the CFC partner and whether the sale of the goods occurs outside the CFC partner's country of organization. Income from PRS's sales of U.S.-manufactured machines purchased from P and sold outside Country Y, if realized directly by S, would constitute foreign base company sales income. Therefore, S's distributive share of such income is foreign base company sales income in S's hands.

HOLDING

S's distributive share of PRS's income earned from the sale of machines purchased from P is treated as foreign base company sales income in these circumstances.

DRAFTING INFORMATION

The principal author of this revenue ruling is Phyllis Elayne Marcus of the Office of the Associate Chief Counsel (International). For further information about the ruling, call Ms. Marcus at (202) 566-6645 (not a toll-free call).