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On February 27, Treasury and the IRS published significant new proposed Subpart F regulations¹ on contract manufacturing by a controlled foreign corporation (CFC). Herewith a few brief comments, questions, and an absurd example.

Section 954(d)(1) defines “foreign base company sales income” (FBCSI) as income derived by a CFC in connection with: (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, where in each case the property both is manufactured, produced, grown, or extracted outside the CFC's country of organization and is sold for use, consumption, or disposition outside such country. As to cases (1) and (3), it has frequently been asked, What if the property that is sold is “not the same” as the property that was purchased--e.g., because of manufacturing after purchase but before sale--and, assuming manufacturing makes a difference, does it matter by whom or how the manufacturing occurs?

Existing Regs. §1.954-3(a)(4)(i) states in part that “[a] foreign corporation will be considered … to have manufactured, produced, or constructed personal property which it sells if the property sold is in effect not the property which it purchased.” That seems a straightforward interpretation of the “its” rule. Query what it means to speak of the “effect” of property changing as a result of manufacturing. Presumably it means that the property sold has a substantially different commercial “effect” than the property purchased--e.g., raw tuna versus canned tuna. The tax law typically values economic substance in this context above “mere” form.

Accordingly, some have argued that the statutory word “its” implies (or even requires) that there is no FBSCI if the property sold is not “the same” as the property that was purchased, and further that it is irrelevant whether or not the CFC “itself” performs all, most, some, little or none of the transformative activities (the “manufacturing”) that cause the transformation of the property so that it is no longer “the same” property. Much ink, and even more brain cells (and hot and cold air), have been expended debating what the words “it” and “itself” might mean. Far fewer resources have been devoted to the more relevant question, “What do any of these verbal nuances have to do with whether payment of U.S. tax by U.S. shareholders on CFC income should be deferred--i.e., what tax policy objective are we seeking to achieve?” Is the objective to reward (via deferral) a CFC which “itself” actively transforms a product before sale as contrasted with a CFC which bears the economic benefits and burdens of the manufacturing process, although contracting with someone else who “does the work for hire”?

The proposed regulations now add clarity to this sorry story, but in my view little or no understanding or wisdom on the relevant policy question. Treasury and the IRS believe that the “its” position is contrary to existing law. They claim the statute requires only a purchase of personal property and the sale of that personal property, “with no indication as to form”--i.e., manufacturing before sale is irrelevant under the statute. They say that §954(d)(1) is concerned with the segregation of purchases or sales and manufacturing into different jurisdictions, “not merely with whether the property was manufactured.” Notice that the words “not merely” usually are not read to mean “not at all”--but “not at all” appears to be the government's intended reading.

The government then cites the legislative history, which, we are told, “contemplates that property sold will be considered different from the property purchased only when the CFC itself manufactures that property.” See S. Rep. No. 1881, 87^thCong., 2d Sess. (1962), 1962-3 C.B. 841, 949 (stating that “[i]n a case in which a controlled foreign corporation purchases parts or materials which it then transforms or incorporates into a final product, income from the sale of the final product would not be foreign base company sales income if the corporation substantially transforms the parts or materials, so that, in effect, the final product is not the property purchased”). Notice that the quotation does not address the issue of a corporation that acts through an agent (a “contract manufacturer”). Apparently based on this snippet, and in what seems a contradiction (gloss) of the government's reading of the statute, it is now suddenly relevant if manufacturing occurs before sale--such that the product “in effect” changes--but only if the CFC “itself” performs the manufacturing, and performs not only in substance but also in form (i.e., physical manufacturing).

The proposed regulations, Prop. Regs. §1.954-3(a)(1)(i), state in part: “[P]ersonal property sold by a controlled foreign corporation will be considered to be the same property that was purchased by the controlled foreign corporation regardless of whether the personal property is sold in the same form in which it was purchased, in a different form than the form in which it was purchased, or as a component part of a manufactured product….,” except as specifically provided by the same country manufacturing exception in §1.954-3(a)(2) and the manufacturing exception in §1.954-3(a)(4). The regulations state that in general a CFC qualifies for the manufacturing exception only if the CFC, acting through “its” employees, manufactured the product. The government calls this the “physical manufacturing” criterion. Deferral or not is thus tied to the status of workers as employees or not of the CFC and the “physical” manufacture or not of the property. The relevant economics--e.g., ownership of assets, bearing of risks--are not explicitly considered.

At this point, one might ponder the relevance of: (1) the distinction between manufacturing performed by the CFC's “employees” and manufacturing by its “independent contractors”; and (2) the Subpart F question--i.e., deferral or not of tax on the U.S. shareholders. Employee versus independent contractor is, of course, another sorry tale of expended intellectual resources, driven largely, if not solely, by the important issue of whether a U.S. corporation should withhold tax and report on the wages of its U.S. employees or do no withholding or reporting for its U.S. independent contractors, who will then be responsible for their own reporting and tax payments. The issue is all about taxes and compliance for American workers and has virtually no relevance to foreign workers. The economics of employee versus contractor are often virtually the same to the corporation--aside from the administrative cost of withholding and reporting. Why is this issue relevant to Subpart F? The government does not say.

Well, having established a new paradigm (economics are irrelevant), the new regulations then promptly back off such conundrums, not wholly but in major part. The reason, we are told, is that “global economic expansion and globalization have led to significant changes in manufacturing. Many multinational groups have extensive manufacturing networks that straddle geographic borders. These cross-border manufacturing networks are created primarily to leverage expertise and cost efficiencies. In addition, the use of contract manufacturing arrangements has become a common way of manufacturing products because of the flexibility and efficiencies it affords.” Thus, as cross-border manufacturing is not primarily tax-motivated, a modern exception to Subpart F is needed for “contract manufacturing.” Valid insights, no doubt, but I think they provide precious little elucidation of the tax policy issues relevant to interpreting the statute. Why exactly do some forms of cross-border contract manufacturing further the purpose of Subpart F, and some do not?

The new regulations modify §1.954-3(a)(4) to provide that a CFC that meets the “substantial contribution test” through the activities of its own employees, but could not satisfy the “physical manufacturing test” by its own employees, may satisfy the manufacturing exception to Subpart F. Factors to be considered in the substantial contribution test include but are not limited to: (1) oversight and direction of the activities or process (including management of the risk of loss) pursuant to which the property is manufactured; (2) performance of activities that are considered in but that are insufficient to satisfy the manufacturing test itself; (3) control of the raw materials, work-in-process, and finished goods; (4) management of the manufacturing profits; (5) material selection; (6) vendor selection; (7) control of logistics; (8) quality control; and (9) direction of the development, protection, and use of trade secrets, technology, product design and design specifications, and other intellectual property used in manufacturing the product.

Thus, the focus is on activities needed for manufacturing that are performed by employees versus activities performed by independent contractors. The CFC's own employees must be substantially involved in the manufacturing process, even if an independent contractor physically performs the manufacturing. Again, no attempt to distinguish, on a tax policy basis, the economic substance or relevance of “physical” versus “substantial involvement.”

Forgive me, dear readers, an absurd example. A CFC purchases oils and canvas. It hires Pablo Picasso (assume still living) to paint a scene of carnage in war. The CFC doesn't much care the size of the canvas, the colors used, whether the picture includes animals or humans, whether they scream or smile. The CFC satisfies none of the nine factors listed above. “Guernica” is painted, Picasso is paid, the masterpiece is sold by the CFC. Subpart F income? Perhaps yes. Ah well, not a problem. We shall make Pablo an employee and withhold on his wages. No good you say, there is no direction and control of this nominal employee by his employer. So, the CFC must have a “real” not a nominal employee. We must consult a tax expert on when a worker is in substance an employee. Someone experienced in wage withholding questions, who, of course, has never heard of Subpart F.

This commentary also will appear in the May 9, 2008, 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 ¶7130, U.S. Persons' Foreign Activities.