Hypothetical Guidance

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By James J. Tobin, Esq.*

Ernst & Young LLP, New York, NY

A recent General Legal Advice Memorandum, AM 2015-002, is yet another effort by the IRS to explain the arcane mechanics of the manufacturing branch rule of Reg. §1.954-3(b)(1)(i)(b).  Several PLRs over recent years have provided guidance in this area (PLR 200945034, PLR 200945036, and PLR 201002024) and this commentator and others have written extensively about the prior guidance. (This commentator alone contributed three earlier rants on the subject and this piece will make it an even four: The Proposed Contract Manufacturing Regulations: A Journey of a Thousand Miles Begins with a Single Step, 37 Tax Mgmt. Int'l J. 407 (July 11, 2008); Branching Out: The Subpart F Contract Manufacturing Regulations v2.0, 38 Tax Mgmt. Int'l J. 295 (May 8, 2009); Bringing Some Truth to the Fiction That Is the Branch Rules, 39 Tax Mgmt. Int'l J. 29 (Jan. 8, 2010).) The AM provides some further explanation and takes a new step, but in my view the result is a further departure from practical guidance allowing sensible application of the manufacturing branch rule in the real world.

Recall that the purpose of the manufacturing branch rule is to characterize certain income as foreign base company sales income in a situation where a CFC conducts manufacturing and sales activity in different jurisdictions and where the sales income is conducted in a branch that benefits from a tax rate that is lower than (less than 90% of or at least five points lower than) the tax rate of the manufacturing location. The government concern back in 1962 when Subpart F was enacted was the potential ability to divert profit from a typically higher tax manufacturing location to a lower tax sales location.

The AM provides guidance on the computation of the rate disparity test in the regulations for determining whether the sales income was taxable at a tax rate sufficiently lower than the manufacturing income to trigger application of the branch rule.  The AM makes clear, as do the regulations and the PLRs, that the rate comparison is not based merely on the relative statutory tax rates in the manufacturing and sales locations but rather on the comparative effective tax rates. In order to compare effective tax rates, the IRS states that one must use an equivalent tax base for the comparison, which is what brings the complexity and practical difficulties.

The regulations provide that the rate disparity test compares the actual effective rate of tax in the sales branch to a hypothetical effective rate of tax that would have applied in the manufacturing location if the income in question had all been derived by the CFC in the manufacturing location from local sources attributable to a permanent establishment in such location and if the CFC were created or organized and managed and controlled in such location. The AM's contribution to applying this rule is a new comparative formulation. It compares the actual tax of the sales branch divided by the hypothetical tax base of the sales income as if realized in the manufacturing location to the hypothetical tax in the manufacturing location divided by the same hypothetical tax base (departing from the regulation's reference to the actual effective rate of tax in the sales branch). The AM breaks it down into a "simple" five-step process:

  •   Step 1 — Determine the relevant income upon which the rate disparity test will be based
  •   Step 2 — Determine the actual foreign income tax imposed on that income
  •   Step 3 — Determine the hypothetical tax base in the manufacturing location
  •   Step 4 — Determine the hypothetical tax which would have been imposed in the manufacturing location
  •   Step 5 — Compare the actual tax's effective tax rate with the hypothetical tax's effective tax rate, in both cases determined using the hypothetical tax base as the denominator.

The facts in the AM to which the five-step process is applied are fairly straightforward. A CFC incorporated in country B manufactures in country B and has a disregarded entity (DRE) in country A which receives a sales commission of 100 for sales occurring outside of country A. The DRE has selling expenses of 30. Both country B and country A have a 20% statutory tax rate, but country A allows a special deduction equal to 50% of non-country A sales.

Applying the five steps above:

  •   The relevant income is the 100 commission
  •   The actual tax paid in country A is 4 (100 less 30 expenses less 50 special deduction times 20%)
  •   The hypothetical tax base in country B is 70 (100 less 30 expenses)
  •   The hypothetical tax is 14 (70 times 20%)
  •   The rate differential comparison is the actual effective tax rate of 5.71% (4 actual tax divided by 70 hypothetical tax base) compared to the hypothetical effective tax rate of 20% (14 hypothetical tax divided by 70 hypothetical tax base). Thus, the rate disparity test is failed and the country A DRE would be treated as if it were a separate corporation for purposes of computing foreign base company sales income.

Presumably a primary purpose of the AM was to illustrate the point that the rate disparity test can be failed merely due to the effect of differing tax bases. This is easy to appreciate in the simple fact pattern described where in essence a non-economic deduction was granted in the sales country that is not available in the manufacturing country. In the not so simple real world, however, the concept will be much more difficult, and often quite impractical, to apply.


Recomputing the taxable base of the sales branch under the manufacturing country's tax rules raises all kinds of issues.  PLR 200942034 made clear that non-economic deductions available in the manufacturing country (in that case, specifically the deduction for interest on net equity) should be taken into account in computing the hypothetical tax. Taking this hypothetical to its logical(?) conclusion, presumably one likewise would need to consider interest deduction rules, thin capitalization rules, local transfer pricing, tax incentives, allowable purpose deduction restrictions, depreciation and amortization rules, NOLs, accounting methods, forex rules, etc.  And I guess one should do this on a cumulative, and not merely year by year, basis to take into account the hypothetical use of NOLs over the period and to determine theoretical local asset bases in the case of dispositions, etc. Because these rules would all have only hypothetical application for purposes of this computation, presumably any prohibited-purpose-type rule in the manufacturing location would not have to be hypothetically applied on the basis of an assumed hypothetical bad purpose – but it is hard to tell how far one is to be expected to carry the fiction. Suffice it to say, I can imagine countless questions. It seems like a great potential business opportunity actually – providing hypothetical opinions for purposes of the hypothetical tax calculations. Perhaps a low-risk retirement option for me some day?

Footnote 17 in the AM at first blush seems to offer some possible relief in providing that "minor differences in the deductions allowed or the timing of the deductions in the two jurisdictions should not materially affect the analysis and therefore may be ignored in appropriate cases." But the implied relief seems less comforting when one reads the example used to illustrate such not material effects, which involves a depreciation period for a particular asset that is 19 years in the sales jurisdiction versus 20 years in the manufacturing jurisdiction. A difference that is very, very minor indeed.

The last footnote in the AM (footnote 19) provides another unpleasant surprise that is more dramatic – at least to me. It states that when a rate disparity exists, "additional steps must be performed to determine the correct amount of net income under US tax principles attributable to the branch."

Neither the regulations nor prior rulings had made this point clear. Indeed, a sentence from PLR 200945036 referring to "determining the amount of taxable FBSCI under principles of local law" led me to believe that the U.S. inclusion would be based on the local law calculations. After all, the branch rule construct looks to the amount of local income that is taxed at favorable rates, so while default to local law for calculating the U.S. inclusion might seem unusual, it seems the right policy result in the fiction of the branch rules. As noted in my commentary about that PLR, this reading made me a somewhat happier guy than I had been before the PLR, although still pessimistic enough to worry that this happy state wouldn't last.  And after more than five years, the very last footnote of this new AM may offer unfortunate vindication to the pessimist in me.

But I won't give up that easily. Recomputing the branch income under U.S. tax principles after having to compute it hypothetically under the manufacturing location tax principles would add another level of unanswered questions and impracticalities.  An obvious question would be how to deal with disregarded payments.  Because the first step of the branch rule rate comparison is in essence to regard the potentially disregarded sales or commission income realized by the DRE, I would think that other branch payments or receipts would be similarly regarded for purposes of determining foreign base company sales income. And because the branch rule is limited in scope to foreign base company sales income, such disregarded payments should not in my view be retested for Subpart F under other provisions, such as foreign personal holding company income, as if the DRE/branch were a separate CFC (Reg. §1.954-3(b)(2)(ii)). No doubt we'll have to wait for yet another PLR or AM to provide the IRS view of this issue.

Other than the prospect of hypothetical post-retirement consulting opportunities, I'm no fan of the branch rule, particularly the manufacturing branch rule which is not even mentioned in the statute (which only explicitly refers to a sales branch rule). At most I would think it might be appropriate in situations involving manufacturing to have an anti-abuse-type rule that supplements a simple statutory tax rate comparison in cases where the sales country grants some form of phantom deduction as a way of purposely lowering its effective rate, as seems to be the fact pattern in the AM. This would eliminate the need for the endless hypotheticals. But going further, as I've stated in this column before, the branch rule is over 50 years old and we still have more questions than answers in how to apply it.  I suggest we stop trying to answer questions that have not been answered in 50-plus years (and have rarely been asked), delete the manufacturing branch rule from the regulations, and overhaul Subpart F more broadly.  Though I have to say I'm not a fan of the recent proposal to go to a minimum tax on foreign earnings either…

This commentary also will appear in the May 2015 issue of the  Tax Management International Journal. For more information, in the Tax Management Portfolios, see Yoder, 928 T.M., CFCs — Foreign Base Company Income (Other than FPHCI), and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Income.

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  The views expressed herein are those of the author and do not necessarily reflect those of Ernst & Young LLP.