U.S. Taxation of E-Commerce under Subpart F -- Missing Pieces Leave Uncertainty

Published: October 15, 2001
Source: 2001 International Bureau of Fiscal Documentation


The birth of the World Wide Web and the attendant rise of e-commerce as a rapidly growing form of commercial activity raises a number of challenges to the classical income tax system of the United States.(1) This challenge is particularly evident under the anti-deferral rules of Subpart F of the U.S. Internal Revenue Code of 1986, as amended (I.R.C.), which relies on historical models of commercial activity to characterize income by reference to transaction types and the physical location of activities in particular jurisdictions. This article explores some of the ways in which Subpart F meets, or fails to meet, the challenge of properly taxing e-commerce, and the article suggests at least one possible legislative approach to reconcile the competing tax policy concerns.


Subpart F is part of the I.R.C.'s anti-deferral regime, which reflects the historical tension between limiting tax deferral for mobile sources of income without adversely affecting the competitive position of American enterprise.(2)

The Subpart F rules treat certain categories of income (Subpart F income) of a controlled foreign corporation (CFC), i.e. a foreign corporation controlled by U.S. shareholders,(3) as currently taxable to its U.S. shareholders (I.R.C. Search7RH 951(a)). The categories of Subpart F income that are most relevant to e-commerce are: (1) passive income, (2) related-party sales income, (3) and related-party services income (I.R.C. Search7RH 954(a)). In addition, certain e-commerce activities may give rise to Subpart F "shipping income". Furthermore, under Subpart F, a CFC's earnings that are invested in certain "U.S. property" can be treated as deemed distributions to its U.S. shareholders (I.R.C. Search7RHSearch7RH 951(a)(1)(B) and 956).

Subpart F passive income

Among the items of passive income that result in Subpart F income are dividends, interest and, of particular relevance to e-commerce activities, rents and royalties (I.R.C. Search7RH 954(c)). Rents and royalties that are derived in the active conduct of a trade or business and that are received from an unrelated person are generally excluded from the definition of Subpart F income (I.R.C. Search7RH 954(c)(2)(A)). In addition, rents and royalties received from a related corporation for the use of, or the privilege of using, property within the country under whose laws the CFC is organized are excluded from the definition of Subpart F income, unless the payments reduce (or create a deficit) in the Subpart F income of the payer (I.R.C. Search7RH 954(c)(3)(A)(ii)).

Subpart F has been expanded to include a broader range of passive income categories than other anti-deferral regimes in the I.R.C. that target passive income. Among the categories of passive income subject to the Subpart F regime are income from foreign currency transactions (I.R.C. Search7RH 954(c)(1)(C)), income from certain derivatives (I.R.C. Search7RH 954(c)(1)(D)), and income equivalent to interest (I.R.C. Search7RH 954(c)(1)(E)), such as loan commitment fees. Gain from the sale of property that gives rise to passive income, or that does not give rise to any income, is also included in Subpart F income (I.R.C. Search7RH 954(c)(1)(B)).

Under these rules, for example, a CFC's gain from the sale of stock of one of its wholly owned subsidiaries would result in Subpart F income even if the subsidiary is engaged in an active business. This is true even if the subsidiary is engaged in the same line of business as the selling parent (CFC) and even if the subsidiary conducts its activities in the country of incorporation of both the CFC and the subsidiary. In an effort to avoid this oddly formal rule, taxpayers may seek to liquidate a subsidiary prior to selling it so that the sale is one of assets used in the subsidiary's trade or business, which would not result in passive income. The U.S. Internal Revenue Service (IRS) may seek to attack such transactions under the "Court Holding" doctrine if the transaction first agreed to is a sale of stock.(4)

The promulgation of the "check-the-box" regulations made it possible for taxpayers to achieve a deemed asset sale for U.S. tax purposes: by "checking the box", the subsidiary could be treated as a disregarded (i.e. tax transparent) entity for U.S. tax purposes without triggering any of the adverse foreign tax consequences that could flow from an actual liquidation of the subsidiary. The IRS viewed such techniques as an abusive use of the check-the-box regulations and has proposed rules to invalidate elections made to treat an entity as a disregarded entity shortly before a sale of 10% of the interests in the entity.(5)

Subpart F income from sales activities

Related-party sales income that is included in Subpart F income is any income (whether in the form of profits, commissions, fees or otherwise) derived in connection with any of the following: (1) the purchase of personal property from a related person and its sale to any person, (2) the sale of personal property to any person on behalf of a related person, (3) the purchase of personal property from any person and its sale to a related person, or (4) the purchase of personal property from any person on behalf of a related person (I.R.C. Search7RH 954(d)). There are, however, several important exceptions to the inclusion of gain on sales in Subpart F income. First, income from property that is sold by a CFC for use, consumption or disposition within the country in which the CFC is organized does not result in Subpart F income. In addition, income from property that is manufactured in the CFC's country of incorporation (even if manufactured by a third party) also does not result in Subpart F income. Finally, and most importantly, income from property manufactured by the CFC (regardless of the location of the manufacturing activities) is not Subpart F income.

In certain cases, a branch of a CFC located outside of the CFC's country of incorporation can be treated as a separate corporation for purposes of determining whether the CFC's income is related-party sales income (the "branch rule") (I.R.C. Search7RH 954(d)(2) and Treas. Reg. Search7RH 1.954-3(b)). In effect, this rule may treat property that is manufactured by the branch and purchased or sold by the CFC's head office (or by a different branch of the CFC) as if the property had been purchased or sold by the CFC on behalf of a separate corporation that is related to the CFC. Conversely, property that is purchased or sold through a branch which is subject to the branch rule is treated as if it had been purchased or sold by a related subsidiary of the CFC on behalf of the CFC. In either case, the income allocable to the purchasing or sales activity (but not the income allocable to the manufacturing activity) is treated as related-party sales income. The branch rule applies in any case in which the income earned from the purchasing or sales activity is taxed at a rate that is less than 90% of, and at least 5 percentage points less than, the rate that would have applied if the sales activity had been conducted in the CFC's country of incorporation (or, in the case of a manufacturing branch, the country in which the branch is located) (Treas. Reg. Search7RH 1.954-3(b)(1)(ii)(b)).

At one time, the IRS took the position that a CFC that uses an independent contract manufacturer to produce the goods sold by the CFC is treated as having manufactured the goods and is eligible for the exception to related-party sales income for goods manufactured by the CFC.(6) The IRS reasoned that, since the activity of the contract manufacturer was, in such a case, attributed to the CFC, the contract manufacturer was treated as constituting a branch of the CFC for purposes of the branch rule. The U.S. Tax Court has refused to accept the argument that a contract manufacturer should, in such cases, be viewed as a branch.(7) Consequently, the IRS reversed its initial position on contract manufacturers, ruling instead that activities conducted through a contract manufacturer will no longer be treated as performed by the CFC for purposes of applying the manufacturing exception.(8) Many tax advisers question whether this change of position is binding, given the case law in this and other analogous areas.(9)

Subpart F income from services

Related-party services income under Subpart F is any income (whether in the form of compensation, commissions, fees or otherwise) derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial or like services that are performed for, or on behalf of, a related person and that are performed outside the CFC's country of incorporation (I.R.C. Search7RH 954(e)(1)). Services are considered to be performed for, on behalf of, a related person if: (1) the CFC is paid or reimbursed by the related person, (2) the CFC performs services which the related person is, or has been, obligated to perform, (3) the CFC performs services with respect to property sold by the related person as a condition of such sale, or (4) the related party renders "substantial assistance" to the CFC contributing to the performance of the services (Treas. Reg. Search7RH 1.954-4(b)(1)). An exception exists, however, for services performed in connection with the sale of property that was manufactured by the CFC.

Subpart F shipping income

Subpart F shipping income includes income derived from, or in connection with, the use (or the hiring for lease or use) of any aircraft or vessel in foreign commerce or in connection with the performance of services directly related to the sale or disposition of an aircraft or vessel (I.R.C. Search7RH 954(f)). Of particular relevance to e-commerce is the rule that treats income derived from any "space or ocean activity" as shipping income (I.R.C. Search7RH 954(f)). As discussed further below, the definition of "space or ocean activity" is fairly broad and may include certain income from the performance of communications services as well (Prop. Treas. Reg. Search7RH 1.863-8(d)(2)(ii)(A)).

For purposes of the Subpart F income definitions, a person is considered to be a "related person" with respect to the CFC if such person controls, or is under common control with, the CFC (I.R.C. Search7RH 954(d)(3)). For this purpose, control means ownership of more than 50% of the voting power of a corporation or more than 50% of the value of a partnership, trust or estate. In addition, ownership of shares or interests may be attributed from certain related persons.(10)

Application of Subpart F to E-Commerce

Issues in applying Subpart F to E-Commerce

In attempting to apply the existing Subpart F rules to e-commerce, some difficult issues arise. Most of these issues fit within two broad categories: character and location.

First, resolving the issue whether income from e-commerce activities constitutes Subpart F income depends on the type of income generated by each activity, e.g. royalties, rentals or sales or services income. Then, it is necessary to determine whether the transaction meets the specific tests of the applicable Subpart F income category. Thus, seemingly similar transactions may give rise to different results depending on the character of the income. For example, for sales income to generate Subpart F income, a related party must be involved, but no such requirement exists for royalty income. Until fairly recently, there was almost no guidance on how common e-commerce transactions are characterized for U.S. federal income tax purposes.

The IRS recently issued regulations that contain detailed rules regarding the characterization of transactions involving software (Treas. Reg. Search7RH 1.861-18). The regulations generally classify software transactions in one of four ways: (1) as a transfer of a copyright, which may be a sale or a license, (2) as a transfer of a copyrighted article, which may be a sale or a lease, (3) as the performance of services, or (4) as the provision of computer software "know-how", which would be treated as a form of sale or license.

Under the regulations, a transfer of software is generally not viewed as involving the transfer of a copyright, unless the transferee receives the right to copy or otherwise publicly disseminate the software. The characterization of a transaction does not depend on whether the transfer is accomplished by means of a transfer of a physical disc or via some method of digital delivery, such as downloading over the Internet. Assuming a transfer is a transfer of a copyrighted article, the transfer is treated as a sale if the transferee acquires the benefits and burdens of ownership of the article, as would occur in a typical sale of mass-produced software. If, however, the transferee does not acquire the full benefits of ownership, the transfer is treated as a lease; this might occur, for example, where the software can be used only on a limited number of occasions or for a limited period of time.

A transfer involving customized software may require the transferor to perform significant services to tailor the software to the particular needs of the transferee. If these services are not de minimis, taking into account the magnitude of the transaction, a portion of the income earned from the transaction is to be allocated to the services performed.

While the IRS has made some progress in clarifying the characterization issues in e-commerce, a great deal of uncertainty remains. A Technical Advisory Group (TAG) to the OECD Committee on Fiscal Affairs recently published its report on the recommended treaty characterization of various of e-commerce activities (TAG Report).(11) The TAG Report includes a comprehensive discussion of how various e-commerce transactions should properly be characterized for treaty purposes.(12) Since the United States is a member of the OECD, the TAG Report is a potential source of insight into how the U.S. Treasury Department might approach these issues. The TAG Report is of limited value in that regard, however, since the categories relevant for treaty purposes (e.g. "business profits" versus "independent services") are in many cases different from those relevant for U.S. tax purposes, including Subpart F. Moreover, even where the issues in the treaty context are identical to the U.S. tax issues, any conclusions reached by the OECD would not be authoritative for U.S. tax purposes unless the U.S. Treasury Department chose to adopt conforming regulations or other rules.

As suggested above, in determining whether a particular transaction results in Subpart F income, a determination must be made as to the location in which particular activities occurred. E-commerce transactions often involve little direct human participation, which makes it more difficult to determine where the activities occur.

Examples of how Subpart F might apply to E-Commerce

Following are some examples of how the Subpart F rules might apply to common e-commerce transactions.(13)

Example 1

A, a CFC incorporated in Country X, enters into an agreement with B, an unrelated corporation located in Country Y, pursuant to which B hosts A's web site, which includes an online catalogue and which accepts and processes customer orders for tangible consumer goods online. Orders are forwarded to employees of A located in Country X, or in a third country, and by A to A's unrelated supplier; goods are shipped to customers directly by A's supplier. Assume that Country X views the activity occurring in its jurisdiction as insufficient to result in taxation under its internal law.

Analysis: Here, it is clear that the income earned by A constitutes sales income. Since the goods are purchased from, and sold to, unrelated parties, the income does not constitute (Subpart F) related-party sales income, unless the branch rule could be applied.(14)

Example 2

A, a CFC, sells software programs to unrelated customers online. Customers may obtain the software by downloading it from a server maintained by A or by requesting a disc containing the program.

Analysis: Assuming the sales by A to its customers are classified under the software regulations as sales of copyrighted articles, it is necessary to determine whether the sales result in related-party sales income. Since the sales here are made to unrelated customers, the sales result in Subpart F income only if the software is purchased from a related person or if the sales are made on behalf of a related person. This would prevent a U.S. software developer from selling its software to a foreign subsidiary for resale to customers. It is fairly easy to circumvent this restriction, however. One possibility would be for the related corporation that developed the software to license it to A rather than selling it outright. Alternatively, if the software is sold by A only by delivery of a disk which A copied from a master disk, A might qualify for the manufacturing exception even if it purchased the software from a related corporation.(15) In order for an activity to qualify as manufacturing, however, the regulations require either that the property purchased by the CFC be "substantially transformed" prior to its sale or, if the purchased property is a component part of the final product, that the operations conducted by the seller in connection with the property be substantial (Treas. Reg. Search7RH 1.954-3(a)(4)). Software recording might be viewed as too simple a task to constitute manufacturing and might be compared to packaging a product, which does not constitute manufacturing under the regulations (Treas. Reg. Search7RH 1.954-3(a)(4)(iii)).

Suppose instead that the program sold by A includes a feature that prevents it from being used more than once. Here, the transfer would likely be characterized as a rental transaction under the software regulations. Rent ordinarily constitutes passive income resulting in Subpart F income. The rent would not be considered passive income, however, if it is derived by A in the active conduct of a trade or business. Rent would be considered to have been derived by A in the active conduct of a trade or business if A developed or added substantial value to the software (Treas. Reg. Search7RH 1.954-2(c)(1)(i)). Alternatively, the income would be treated as derived in the active conduct of a trade or business if A has officers or employees located in its jurisdiction who are regularly engaged in marketing, or marketing and servicing, its software products and such activities are substantial in relation to A's rental income (Treas. Reg. Search7RH 1.954-2(c)(1)(iv)). Substantiality is generally determined on the basis of all the facts and circumstances, unless the activities meet a safe harbor (applicable where "active leasing expenses" are at least equal to 25% of the "adjusted leasing profit") (Treas. Reg. Search7RH 1.954-2(c)(2)).

Example 3

A, a corporation incorporated in Country X, enters into an application hosting agreement with B, a U.S. corporation that owns all of the outstanding shares of A. Under the agreement, A makes its servers available to B for B to use in running software that is owned by A. B agrees to provide technical support to maintain the servers and assure that the software is operating smoothly. The servers are located in Country X, but A's employees responsible for maintaining the servers are located in Country Y. B pays A a fixed monthly fee.

Analysis: The threshold issue here is whether the income earned by A from the application hosting arrangement is properly characterized as income from services or as rental income. The TAG Report concludes that application hosting arrangements generally result in services income. The regulations state that services are generally considered to be performed where the persons performing the services are located (Treas. Reg. Search7RH 1.954-4(c)). Assuming the income earned by A is in fact characterized as services income, the income should constitute related-party services income resulting in Subpart F income since A's employees are located outside Country X.

If, on the other hand, the income from such an arrangement is characterized as rental income, it would not result in Subpart F income since it is received from a related party for the use of property located in its country of incorporation. The proper characterization of the income may depend on the precise details of the specific arrangement. Factors that might support rental income characterization include: (1) whether the payer has the exclusive right to run applications on the equipment, (2) whether the provider is restricted from moving or replacing the equipment at will, and (3) the extent of the maintenance activities performed by the provider. In some cases, it may be appropriate to treat a portion of the income as services income and the remainder as rental income.

Example 4

A, a CFC incorporated in Country X, employs computer programmers who provide services to B, a U.S. corporation that owns all of the shares of A. The employees are located in Country X, and the services, which include troubleshooting B's computer networks and writing codes for B's servers located in the United States, are performed via remote access over the Internet and/or direct modem connections.

Analysis: Although A's employees are servicing B's equipment located in the United States, the regulations appear to support the conclusion that the services are viewed as occurring in Country X. Accordingly, the fees paid by B for the services should not result in Subpart F income.

Example 5

A, a CFC formed under the laws of Country X, operates a web site that hosts one or more online catalogues on its servers. Users accessing the web site can select products from the catalogue and place orders online. A transmits orders to the merchants responsible for accepting and fulfilling orders. The merchants pay the web site operator a commission equal to a percentage of the orders placed through the web site. (This is similar to the fact pattern in Example 1, which considers the treatment of the merchants who use A's web site.)

Analysis: The result in this case may depend on whether A is viewed as earning income from services or sales income. The TAG Report concludes that such income constitutes income from advertising or similar services. Under this analysis, the income earned by A should not constitute Subpart F income, unless a merchant whose online catalogue is hosted by A is related to A. If the merchant is related to A, A might still avoid Subpart F income as long as its employees are located in Country X.

An alternative characterization of the income earned by A is that the income constitutes commissions on sales solicited by A on its web site. See e.g. Treas. Reg. Search7RH 1.954-3(a)(1)(iii), Example (3), where commissions based on a gross percentage of sales are tested as Subpart F income under the related-party sales income provisions. If the income earned by A constitutes sales income, it could result in Subpart F income even if the merchants who sell through A's web site are unrelated to A. This could occur under the branch rule if A's operation is located outside Country X, is not subject to current tax in Country X, and Country X would tax such income at a rate of at least 5%.(16)

Example 6

A, a CFC, owns and operates a stationary communications satellite located near the eastern seaboard of the United States. Customers of A transmit data to A's satellite from satellite transponders located at various points in space above the United States (above the territorial jurisdiction of the United States), and A retransmits the data to another satellite.

Analysis: Income earned from communications services would ordinarily be tested under the related-party services income rules. The income earned by A, however, constitutes income from a space or ocean activity. See Prop. Treas. Reg. Search7RH 1.863-9(d)(3)(v). Such income is specifically included in Subpart F (I.R.C. Search7RH 954(f)).


As illustrated by these examples, e-commerce poses a challenge to the existing Subpart F regime in at least two substantive respects. First, new forms of commercial activity, as well as novel forms of doing business, present characterization issues that are not adequately addressed by Subpart F. Second, the ability of computers to provide services with minimal or remote human involvement gives taxpayers new opportunities to shift the location of income-producing activities, with results not contemplated under Subpart F. On a separate front, the ability of taxpayers to engage in extensive commercial activity through web sites and computer networks raises enforcement issues for the IRS because of the difficulty in identifying the taxpayers who operate such businesses and the associated flow of funds. This issue was emphasized in the Treasury White Paper(17) and the Treasury Subpart F Report.(18)

The shifting nature of global commerce resulting from the Internet revolution could provide an ideal opportunity for the United States to revisit the basic structure of Subpart F and its underlying policies. One possible approach that would eliminate many of the issues illustrated by the examples discussed above would be to eliminate the relevance of where activities occur under the various categories of Subpart F income and to focus instead on the effective tax rate to which the income is subject. Under such an approach, income earned by a CFC would not result in related-party sales or services income if the income is subject to an effective rate of tax that is not significantly lower than the rate imposed under the laws of the CFC's jurisdiction, regardless of where the activity that produces the income occurs. The Treasury Subpart F Report in fact recommends: "To address the increasing mobility of businesses, rules should, to the extent possible, not be based on the location of business activities". Alternatively, the existing "high tax" exception (I.R.C. Search7RH 954(b)(4)), which excludes from the definition of Subpart F income any income subject to a rate of tax greater than 90% of the maximum U.S. corporate income tax rate (currently 35%), could be expanded to exclude any income subject to a rate of tax at least as high as the lowest rate imposed on such income by any country that is a member of the OECD.

At the present time, basic structural reform of Subpart F does not appear to be a major topic of discussion in Washington, D.C. Any such reform would require action by Congress, which may not be forthcoming in the near future. Moreover, such reform should not be undertaken without considerable discussion of the impact of any new rules on capital flows and on the competitive positions of the affected countries and taxpayers.(19) It seems more likely that the U.S. Treasury Department will be forced to address the U.S. tax issues raised by e-commerce through the issuance of additional targeted rules and regulations, such as the software regulations.


1. See generally Office of Tax Policy, U.S. Department of the Treasury, Selected Tax Policy Implications of Global Electronic Commerce (21 November 1996), the U.S. Treasury's seminal discussion paper on e-commerce (hereafter "Treasury White Paper").

2. See generally Office of Tax Policy, U.S. Department of the Treasury, The Deferral of Income Earned Through U.S. Controlled Foreign Corporations (December 2000) (hereafter "Treasury Subpart F Report").

3. Only U.S. persons who own at least 10% of the voting stock of the foreign corporation are taken into account for this purpose.

4. Commissioner v. Court Holding Co., 324 U.S. 331 (1945).

5. Prop. Treas. Reg. Search7RH 301.7701-3(g). It is uncertain, at best, whether these proposed regulations will ever be finalized.

6. Rev. Rul. 75-7, 1975-1 C.B. 244.

7. Ashland Oil v. Commissioner, 95 T.C. 348 (1990); Vetco v. Commissioner, 95 T.C. 579 (1990).

8. Rev. Rul. 97-48, 1997-2 C.B. 89.

9. In Rev. Rul. 97-48, id., the IRS noted that its new position on contract manufacturing is consistent with the rules applicable under I.R.C. Search7RH 863(b), which provides the source rules for property manufactured within the United States and sold outside the United States or vice versa. The logic of focusing on the taxpayer's direct manufacturing activity, however, seems more compelling in I.R.C. Search7RH 863(b), where the location of the activity is a determinative factor, than in the manufacturing exception, which, as noted above, applies regardless of the location of the manufacturing activity. See Di Fronzo, Michael A. and Marin R. McClintock, "Contract Manufacturing: Still a Viable Strategy?", 80 Tax Notes 1497 (1998).

10. I.R.C. Search7RH 954(d)(3) cross-references the constructive ownership rules of I.R.C. Search7RH 958. See Treas. Reg. Search7RH 1.954-1(f).

11. Technical Advisory Group on Treaty Characterization of Electronic Commerce Payments, Tax Treaty Characterization Issues Arising From E-Commerce (1 February 2001).

12. See Annex 2 of the TAG Report.

13. Some of the examples used here are derived from the TAG Report. See also Maguire, Ned and Stuart Anolik, "Subpart F and Source of Income Issues in E-Commerce", 21 Tax Notes International 1935 (23 October 2000), which contains a good discussion several e-commerce examples.

14. Arguably, the position taken by the U.S. Tax Court and the IRS with regard to contract manufacturing, i.e. that manufacturing activities performed by an independent contractor do not result in a branch, should also apply to sales activities performed by an independent contractor.

15. See e.g. Bausch & Lomb v. Commissioner, T.C. Memo 1996-57 (assembly of sunglasses components purchased by a CFC from a related party qualifies as a manufacturing activity).

16. See Example (3) of Treas. Reg. Search7RH 1.954-4(c), which concludes that the branch rule could apply even in a case where neither the CFC nor its branch is engaged in manufacturing.

17. See note 1, supra.

18. See note 2, supra.

19. The authority of the U.S. Treasury Department in the area of Subpart F is limited to issuing interpretive regulations.