President's Budget Would Apply Subpart F to Toll Manufacturing Arrangements

By Lowell D. Yoder, Esq.

McDermott Will & Emery, Chicago, IL

The Obama Administration's FY 2015 budget proposes to expand the
definition of "foreign base company sales income" (FBCSI). The new
rule would apply to income earned by a controlled foreign
corporation (CFC) from selling products that a related person
manufactures on its behalf.

The proposal targets the following structure.  A CFC
operates as a principal. It purchases raw materials and components
from unrelated suppliers and consigns them to a related "toll"
manufacturer to produce finished products. The CFC then sells the
finished products to unrelated persons. The CFC principal pays the
related toll manufacturer a fee for its services. The CFC principal
may also pay service fees to related persons to assist with other
supply chain functions, and typically would own or license the
relevant intangible property.

Section 954(d)(1) provides, in relevant part, that income from
the purchase and sale of property is FBCSI only if it is derived by
a CFC in connection with either: (1) the purchase of personal
property from a related person1 and its sale to
any person; or (2) the purchase of personal property from any
person and its sale to a related person.2 Therefore, FBCSI
generally does not include income derived by a CFC from selling
products where the CFC does not purchase the products from a
related person nor sell the products to a related person.3)

In the above example, the CFC principal purchases the raw
materials and components from unrelated suppliers and owns the
property throughout the manufacturing process, and then sells the
finished products to unrelated persons. Therefore, since the CFC
neither purchases property from a related person, nor sells the
finished products to a related person, its sales income is not

The Tax Court has analyzed the above structure and held in favor
of the taxpayer. In Vetco, Inc. v. Commissioner,5 a Swiss CFC sold
products manufactured on its behalf by a related U.K. CFC. The
Swiss CFC purchased raw materials from unrelated suppliers,
consigned them to the U.K. CFC which manufactured finished
products, and then the Swiss CFC sold the products to unrelated
customers. The Swiss CFC paid the U.K. CFC for procurement and
manufacturing services. The Tax Court held that the sales income
was not FBCSI.

The IRS asserted that the U.K. CFC should be treated as a
manufacturing branch of the Swiss CFC for purposes of the branch
rule of §954(d)(2) to create a related person transaction causing
the Swiss CFC's income to become FBCSI. The Tax Court rejected the
IRS's argument, holding that a separate corporation is not a

In its description of the Administration's proposal, the
Treasury acknowledges in the Green Book7 that "[i]n order
for the foreign base company sales income rules of subpart F to
apply, a CFC generally must engage in both a purchase and
subsequent sale of personal property where such property is either
purchased from, or sold to, a related person." The Treasury further
notes that "[u]nder current law, taxpayers take the position that a
CFC can avoid foreign base company sales income by structuring the
related party transaction by which the CFC obtains the property
that the CFC sells to customers as the provision of a manufacturing
service to the CFC rather than as a purchase of the property by the

The Administration expresses concern with a related manufacturer
being based in the United States. The Green Book observes that
"[i]n some cases, taxpayers take this position with respect to
property produced in the United States on behalf of a related CFC."
The Treasury states that the "policy concerns that underlie the
foreign base company sales income rules" include "U.S. base
erosion," and that such concerns "apply with respect to income
earned by a CFC from the sale of property produced by a related
party, regardless of whether the CFC is characterized as obtaining
the property through a purchase transaction or through a
manufacturing service."9

The Administration's proposal would expand the category of FBCSI
to include income of a CFC from the sale of property manufactured
on behalf of the CFC by a related person. Apparently, the CFC would
be treated as purchasing the products it sells from a related
person, i.e., the toll manufacturer. Under this construct, the
transaction would effectively be recast from a services arrangement
with the related manufacturer to a buy-sell arrangement.10

The exceptions to FBCSI would continue to apply. 
Accordingly, income otherwise subject to the new rule would not be
FBCSI if the products are manufactured in a CFC's country of
organization, or sold for use in a CFC's country of
organization.11 In
addition, if a CFC manufactures the property it sells, then the
proposal would not cause its income to be FBCSI.12 For example, if
a CFC principal substantially contributes to the manufacture of the
property by a related toll manufacturer, then the CFC's income from
selling the finished products would not be FBCSI.13

The proposal would not apply to other structures where the CFC
does not purchase property from, nor sell property to, a related
person. For example, it would not apply where a CFC purchases
products from an unrelated contract manufacturer, and then sells
the products to unrelated customers.14 Such sales
income would not be FBCSI under the proposal even if the CFC paid
service fees to a related person to assist with supply chain
functions (provided those functions did not rise to the level of
"substantial contribution" manufacturing).15

The Administration's proposal to apply Subpart F to "toll"
manufacturing structures is short-sighted.  Causing income
derived by foreign subsidiaries from the manufacture and sale of
products to be subject to taxation in the United States-which has
the highest tax rate of any industrialized country-puts U.S.-based
companies at a competitive disadvantage. Similar operations of
non-U.S.-based companies generally are not subject to home country
taxation. In addition, targeting U.S. manufacturing is
counterproductive, as the high U.S. tax costs may incentivize
U.S.-based multinationals to look for manufacturing opportunities
outside the United States.  The better answer is to repeal the
FBCSI rules to level the playing field.

This commentary also will appear in the August 2014 issue of
 Tax Management International Journal.  For
more information, in the Tax Management Portfolios, see Yoder, 928
, CFCs - Foreign Bae Company Income (other than FPHCI),
 and in Tax Practice Series, see ¶7150, U.S. Persons -
Worldwide Taxation.


  1 A person is related to a CFC if such person is
controlled by the CFC or is controlled by the same persons that
control the CFC. For this purpose, "control" means, with respect to
a corporation, the direct or indirect ownership of more than 50%
(by vote or value) of the stock of such corporation.

  2 Reg. §1.954-3(a)(1)(i).  Section 954(d)(1)
can also apply to commissions and fee income derived by a CFC from
purchasing or selling products on behalf of a related person. The
paradigm addressed herein involves a CFC that derives sales income
from actually selling products.

  3 Under certain circumstances a branch rule can
apply to treat a portion of the CFC's income as FBCSI. §954(d)(2);
Reg. §1.954-3(b).

  4 See Reg. §1.954-3(b)(4),
Ex. 3 (since "[Corporation] D [is] unrelated to [CFC] E,
none of the income would be foreign base company sales income
because [CFC] E [is] purchasing from and selling to unrelated
persons….").  See NPRM, REG-124590-07, 73 Fed.
Reg. 10716, 10722 (Feb. 28, 2008) ("NPRM") ("In addition, the
result in [Reg.] §1.954-3(b)(4), Example 3 is further
revised to add two alternative factual scenarios ([including a]
purchase from an unrelated party…) to illustrate the point that, in
general, a branch will not have FBCSI if a separate CFC would not
have FBCSI under like circumstances.").

  5 95 T.C. 579 (1990).

  6 See also Ashland Oil Inc. v.
, 95 T.C. 348 (1990) (Tax Court rejected IRS's
argument that an unrelated contract manufacturer is a branch of a
CFC that purchases products from the manufacturer).  The IRS
will follow Ashland Oil and Vetco
Rev. Rul. 97-48, 1997-2 C.B. 89. See also NPRM, 73 Fed.
Reg. at 10718 (noting that Rev. Rul. 97-48 states that the IRS will
follow Ashland Oil and Vetco and "therefore
confirms that the IRS will not treat a separate contract
manufacturer as a branch for purposes of section 954(d)(2)").

  7 Department of the Treasury, General
Explanations of the Administration's Fiscal Year 2015 Revenue

  8 Green Book, at p. 60.

  9 Id.

  10 The new rule would apply prospectively to years
beginning after December 31, 2014.

  11 Reg. §1.954-3(a)(2) and Reg. §1.954-3(a)(3).
See Yoder, "Same-Country-of-Manufacturing Exception
Applied to Subpart F Sales Income," 38 Tax Mgmt. Int'l J.
240 (Apr. 10, 2009).

  12 Reg. §1.954-3(a)(4).

  13 See Yoder, "Subpart F: Indicia of
Manufacturing," 38 Tax Mgmt. Int'l J. 642 (Oct. 9, 2009);
Yoder, "Supply Chain Distribution Structures Outside the Scope of
Subpart F," 42 Tax Mgmt. Int'l J. 367 (June 14,

  14 See Ashland, above, n. 6.

  15 See Yoder, "The Application of
Subpart F to a Distributor Principal," 40 Tax Mgmt. Int'l
 241 (Apr. 18, 2011); Yoder, "No Subpart F Income if no
Related Party Purchase or Sale of Products," 40 Int'l Tax
 3 (July-August 2014).