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By Lowell D. Yoder, Esq.
McDermott Will & Emery, Chicago, IL
An exception to the definition of foreign base company sales income is provided for certain agricultural commodities. The Chief Counsel's Office recently issued a Chief Counsel Advice ("CCA") addressing a limitation on the availability of this exception for income from the sale of agricultural commodities that are processed or manufactured.1
Agricultural Commodities Exception
Section 954(d)(1) defines "foreign base company sales income" as income derived by a controlled foreign corporation ("CFC") from the purchase of personal property from a related person and its sale to any person, the purchase of personal property from any person and its sale to a related person, or the purchase or sale of personal property on behalf of a related person. Such income is not foreign base company sales income if the personal property was either: (1) manufactured, produced, grown, or extracted in the CFC's country of organization; or (2) sold for use, consumption, or disposition in such country.2
A CFC's income from the sale of personal property is also not foreign base company sales income if the CFC manufactures or produces the property it sells. A CFC is considered as manufacturing property if it physically manufactures the property or substantially contributes to the manufacture of the property that is physically manufactured by a contract manufacturer.3
Section 954(d)(1) provides another exception to the foreign base company sales income rules by excluding from the definition of "personal property" certain agricultural commodities. This exception applies to agricultural commodities "which are not grown in the United States in commercially marketable quantities."4
The agricultural commodities exception was added to the Code by the Tax Reduction Act of 1975,5 13 years after Subpart F was enacted in 1962. While the legislative history to the 1975 Tax Act is silent as to the purpose behind this exception, Congress shed some light on its rationale for enacting this exception during its consideration of a proposed amendment to this provision in connection with the Tax Reform Act of 1976. The House Ways and Means Committee Report states, in pertinent part:
Your committee believes that sales of foreign-grown agricultural products which are not readily substitutable for U.S.-grown agricultural products should not be included within the definition of foreign base company sales income in the case of sales made to third countries. Your committee is aware that these sales are highly competitive and that if the profits on these sales were subject to U.S. tax on a current basis, U.S.-controlled foreign companies would have difficulty competing with foreign-controlled companies. Accordingly, your committee believes it is appropriate to permit this category of income to retain the tax advantages of deferral until the profits are repatriated to the United States.6
Neither the Code nor the regulations provide a general definition of "agricultural commodities." The regulations list numerous products included within this definition, including basic farm crops, poultry, fish produced on fish-farms, fruit, furbearing animals, as well as the products of truck farms, ranches, nurseries, ranges, and orchards. The term "agricultural commodities" does not include timber.
The regulations provide that the agricultural commodities exception generally applies to commodities that, in consideration of all facts and circumstances, are "shown to be produced" in the United States "in insufficient quantity and quality to be marketed commercially." The regulations expressly provide that bananas, black pepper, cocoa, coconut, coffee, crude rubber, and tea are not considered grown in the United States in commercially marketable quantities and thus qualify for the exception.
This exception does not apply to agricultural commodities that are grown in the United States in commercially marketable quantities. The regulations contain a non-exclusive list of 96 specific crops, livestock, and products that are considered as grown in the United States in commercially marketable quantities and that, as a result, do not qualify for this exception. This list includes, for example, chickens, horses, milk, cotton, potatoes, and wheat.
The regulations provide that the agricultural commodities exception is not available for otherwise qualifying agricultural commodities that are subject to substantial processing. They state that the term "agricultural commodities" does not include any commodity at least 50% of the fair market value of which is attributable to manufacturing or processing. The term "processing" does not include handling, packing, packaging, grading, storing, transporting, slaughtering, and harvesting.7
The application of the 50% test is to be determined in a manner consistent with the regulations under §993(c). Those regulations provide guidelines for determining whether 50% of the value of products that are manufactured or processed is attributable to certain content for purposes of determining whether the property qualifies as export property under the domestic international sales corporation rules.8
In CCA 201532033 the Chief Counsel's Office addressed the application of the 50% manufactured or processed limitation on the agricultural commodities exception. The specific issue addressed was whether a 2009 amendment to the foreign base company sales income regulations eliminated that limitation.9 The CCA concluded that the limitation still applies.
Under the facts of the ruling, CFC-B is organized under the laws of Country B. It purchases commodities from farmers located in Country A. The commodities are delivered to CFC-A, a related person organized under the laws of Country A. CFC-A produces finished products from the commodities at its manufacturing facilities in Country A pursuant to a contract with CFC-B. The finished products are sold by CFC-B to a U.S. related person.
CFC-B's income is derived from selling personal property to a related person. In addition, the commodities apparently were grown outside CFC-B's country of organization and manufactured into finished products outside such country, i.e., in Country A. According to the CCA, CFC-B did not physically manufacture the products sold, and did not substantially contribute to the manufacture of the finished products by CFC-A. Thus, under the general rules, the income derived by CFC-B from selling the finished products would be foreign base company sales income.
The taxpayer took the position that the exception for agricultural commodities applied to the income earned by CFC-B from selling the finished products. The Chief Counsel's Office apparently agreed that the agricultural commodity was generally eligible for the commodities exception. However, it concluded that the 50% manufactured or processed limitation applied under the facts, and thus the agricultural commodities exception did not apply to the income earned by CFC-B from selling the finished products.
The taxpayer argued that the 50% manufactured or processed limitation no longer applied because such requirement was eliminated when Reg. §1.954-3(a)(1)(i) was amended in 2009. The Chief Counsel's Office rejected this argument.
2009 Amendment to theRegulations
Consistent with the Code and the legislative history, the regulations provide an exception for income derived by a CFC from the sale of products that it has manufactured. For many years the regulations expressly applied the exception to products physically manufactured by a CFC. Treasury and the IRS issued final regulations in 2009 expanding the regulatory exception to apply to income derived by a CFC from the sale of property where the CFC substantially contributes to the physical manufacture of the property by a contract manufacturer.
Prior to the 2009 regulations, taxpayers took the position that the manufacturing exception could apply where a CFC hired another party to manufacture property on its behalf. The basis for the position was that the CFC could be attributed to the manufacturing activities of a contract manufacturer,10 or that the literal definition of foreign base company sales income did not apply if the property sold by a CFC (a manufactured product) was not the property purchased (raw materials) by the CFC.11
The second position has been referred to as the "its" position. Section 954(d)(1) defines foreign base company sales income as the "purchase of personal property and…its sale." When a CFC acquires raw materials or components and hires another person to convert such property into a finished product that the CFC then sells, it is not selling the property that it purchased, and therefore the sales income literally falls outside the statutory language, i.e., the CFC is not acting merely as a distributor.12
Reg. §1.954-3(a)(1)(i) was amended in 2009 to eliminate the "its" position. The regulation as amended provides that personal property sold by a CFC generally will be considered the same property purchased by the CFC, regardless of whether the personal property is sold in the same form as purchased.13
The CCA states that the amendment to Reg. §1.954-3(a)(1)(i) was to clarify that the relevant CFC itself, through its own employees, must perform the manufacturing, or substantial contribution, for purposes of the manufacturing exception, and changes to the form of personal property are otherwise irrelevant for purposes of the manufacturing exception. According to the Chief Counsel's Office, unlike the manufacturing exception, the 50% manufactured or processed limitation on the availability of the agricultural commodities exception has never depended on the identity of the manufacturer.14
The Chief Counsel's Office points out that the amendments made in the 2009 regulations did not revise the agricultural commodities exception, which still contains the 50% limitation. The CCA states that the amended regulation can be reconciled with the agricultural commodities rule by interpreting the former provision as providing the scope of application of the manufacturing exception, and the latter provision as providing the scope of application of the agricultural commodities exception. Therefore, these two distinct provisions address different issues, and the sentence added to Reg. §1.954-3(a)(1)(i) in the 2009 regulations does not override the 50% manufactured or processed limitation.
Accordingly, the Chief Counsel's Office determined that the 2009 regulations did not eliminate the 50% manufactured or processed limitation on the agricultural commodities exception. Therefore, the CCA concludes that CFC-B's income from sales of finished products does not qualify for the agricultural commodities exception.
The CCA does not discuss the application of the 50% test, and thus it might be possible for the taxpayer to establish that the 50% limitation does not apply under the facts.15 Alternatively, CFC-B might be able to establish that it qualifies for the manufacturing exception by showing that it substantially contributed to the manufacture of the finished products by CFC-A. If these positions are not available, going forward CFC-B might consider selling the raw commodities to CFC-A, in which case the 50% processing and manufacturing limitation would not apply.16
This commentary also appears in the December 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 Taxati
6 H. Rep. No. 658, 94th Cong., 2d Sess., at p. 221. A similar explanation appears in the Senate Finance Committee Report. S. Rep. No. 938, 94th Cong., 2d Sess., at pp. 232-33. The exception is available for sales to customers in any country, including the United States.
7 There is no manufacturing or processing limitation in the Code. Whether this rule in the regulation constitutes a valid exercise of Treasury's rulemaking authority has not been challenged in court. See, e.g., Lovett v. United States, 621 F.2d 1130 (Cl. Ct. 1980) (invalided Subpart F regulation as unsupported by express statutory language); Altera Corp. v. Commissioner, 145 T.C. No. 3 (July 27, 2015) (unanimous reviewed Tax Court opinion held that Reg. §1.482-7(d)(2) was invalid because Treasury failed to engage in reasoned decision-making as required by the Administrative Procedure Act).
10 This position was based on rulings issued by the IRS. See, e.g., Rev. Rul. 75-7, 1975-1 C.B. 244, revoked by Rev. Rul. 97-48, 1997-2 C.B. 89. For a discussion of the history of this attribution position, see Yoder, 928 T.M., CFCs—Foreign Base Company Income (Other than FPHCI), VII.E.7.
11 The CCA states, "The IRS and the Treasury Department have always interpreted the statute to require the relevant CFC itself to manufacture the product it sells to avoid FBCSI (the `CFC manufacturing exception'), unless the manufacturing is performed within the CFC's country of organization (the `same-country manufacturing exception')."
13 The 2009 regulations added the following sentence (the third sentence) to Reg. §1.954-3(a)(1)(i): "For purposes of the preceding sentence [relating to the definition of foreign base company sales income], except as provided in paragraphs (a)(2) and (a)(4) of this section, personal 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." For a discussion of this amendment, see Preamble to REG-124590-07, 73 Fed. Reg. 10,716, at pp. 10,718-19 (Feb. 28, 2008).
14 The CCA points out that this is similar to the exclusion for income from the sale of products manufactured in a CFC's country of organization, which also applies whether or not the CFC itself is considered as manufacturing the property. See Reg. §1.954-3(a)(4)(iv)(d) Ex. 4.
15 Apparently the income from the sale of the finished products did not fall within any category of foreign personal holding company income (§954(c)). See Reg. §1.954-1(e)(4) (coordination rules for foreign base company income categories).
16 Another possible planning idea is for CFC-B to be formed under the laws of Country A and qualify for a low or zero tax rate, e.g., as a nonresident company or a reverse hybrid entity. CFC-B would own CFC-A, and CFC-A would electively be disregarded. Under this structure, the product would be grown and manufactured in CFC-B's country of organization (now Country A), and therefore income from selling the finished product should be excluded from foreign base company sales income. Reg. §1.954-3(a)(2), §1.954-3(a)(4). See Office of Tax Policy of the Treasury Department, The Deferral of Income Earned Through U.S. Controlled Foreign Corporations, A Policy Study (Dec. 29, 2000), at pp. 66-67 (discusses dual resident structure for avoiding the foreign base company sales income rules); Yoder, Planning Techniques Described in the Treasury's Subpart F Study, 30 Tax Mgmt. Int'l J. 221 (May 11, 2001).
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