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by Jeffrey Levenstam, Esq., Margie Rollinson, Esq., and John Karasek, Esq.*
Ernst & Young LLP, San Jose/San Francisco, CA, and Washington, D.C.
* The views expressed herein are those of the authors and do not necessarily reflect the views of Ernst & Young LLP or any other member firm of Ernst & Young Global Limited.
Working with speed uncommon in the rulemaking process, the IRS and Treasury recently finalized regulations addressing contract manufacturing arrangements under the foreign base company sales income (FBCSI) rules. The final regulations (Final Regulations) and temporary regulations (Temporary Regulations) were released only 10 months after they had been proposed. 1 They are effective for taxable years of controlled foreign corporations (CFCs) beginning after June 30, 2009, and for taxable years of U.S. shareholders in which or with which such taxable years of the CFCs end. Compared to the timeframe by which multinational manufacturing companies measure their lifecycle, the effective date is, effectively, immediate.
1 Revisions and additions to Regs. §§1.954-3 and -3T adopted by T.D. 9438, 73 Fed. Reg. 79334 (12/29/08), from proposed rules at REG-150066-08, 73 Fed. Reg. 10716 (2/28/08). All references to “Section” or “§” herein are to the Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder.
In their rush to establish a vast set of new rules, the IRS and Treasury created an unwieldy regulatory framework, the complexity of which confuses the most important underlying issues. A simple solution, based on the plain language of §954(d) and guided by the legislative history of Subpart F, would have alleviated confusion among the government, taxpayers, and their tax advisors.
This article will discuss the Final and Temporary Regulations, review the history of §954(d), and argue that the regulations are unnecessarily oversized. Instead of expanding the universe of manufacturing exceptions to FBCSI and further complicating the branch rules, the regulations should have focused on resolving two basic problems. First, the Final Regulations should have recognized that consignment manufacturing arrangements, absent potential application of the branch rules, did not generate FBCSI under the existing law. Simply put, these arrangements do not involve the purchase and sale of property to or from a related party, one of the key requirements under §954(d). In doing this, the regulations would have dismissed the irrelevant issues that obscure this fact and lead to continued confusion (e.g., whether or not attribution of activities is appropriate and necessary, and whether this creates a branch of the CFC). Second, the Final Regulations should have established a simpler rule for determining whether contract manufacturing arrangements qualify for the manufacturing exception to FBCSI. This article will show how a test based on non-physical manufacturing factors (such as those identified in Rev. Rul. 75-7 and §199) would have worked very well in these circumstances. With regard to the branch rules, the Temporary Regulations should have established a simpler method for determining circumstances where a CFC has created an artificial shift of taxable income away from the location of manufacturing activities, consistent with the purpose of §954(d)(2). Moreover, regulations which proliferate the number of times the branch rules might apply should not have been issued until other fundamental issues with the branch rule were addressed (such as the allocation of income).
The Final Regulations — Where Are We Now?
The Final Regulations introduced the substantial contribution exception (Substantial Contribution Exception) to the list of existing exceptions from FBCSI. Based on the statutory requirements (which are confirmed by the existing regulations), a CFC does not have FBCSI when it: (1) purchases or sells personal property that was manufactured, produced, constructed, grown, or extracted in the CFC's country of incorporation (Same Country Source Rule); 2 or (2) purchases or sells property for use, consumption, or disposition in the CFC's country of incorporation (Same Country Use Rule). 3 Under the prior regulations, a CFC could also avoid generating FBCSI by selling personal property that was manufactured, produced, or constructed by the CFC in whole or in part from personal property that the CFC purchased (Manufacturing Exception). 4 In order to be considered to have manufactured the property, the prior regulations required only that the CFC sold property that was “in effect not the property that it purchased.” 5 This could only happen in two ways: (1) property owned by the CFC was substantially transformed before its sale (Substantial Transformation); 6 or (2) property owned by the CFC was used as a component part in the manufacture of another item of property, which was subsequently sold by the CFC (Component Parts Assembly). 7 Only Component Parts Assembly required that the activity be performed by the CFC itself.
2 Regs. §1.954-3(a)(2).
3 Regs. §1.954-3(a)(3).
4 Regs. §1.954-3(a)(4)(i).
6 Regs. §1.954-3(a)(4)(ii).
7 Regs. §1.954-3(a)(4)(iii). Component Parts Assembly includes a safe harbor, which applies when conversion costs incurred in connection with the property (i.e., direct labor and factory burden) constitute 20% or more of the total costs of goods sold. Id.
The Final Regulations modified the Substantial Transformation provision in a manner clearly intended to extend the concept to encompass contract manufacturing arrangements in addition to consignment manufacturing arrangements. In the Treasury's and IRS's view, this was not entirely clear in the 2008 proposed regulations (or under existing law). However, the technical corrections to the proposed regulations, which were incorporated into the Final Regulations, made several revisions to clarify that a CFC does not need to hold title to property before its transformation in order to accomplish the requisite Substantial Transformation. For example, the technical corrections revised the results of Example 3 under Prop. Regs. §1.954-3(a)(4)(iv)(c) to provide that manufacturing activities do not need to be “undertaken with respect to [a product] between the time the raw materials were purchased and the time [the product] was sold.”
The Substantial Contribution Exception only applies if the CFC itself would have been considered to have manufactured, produced, or constructed the personal property before sale had its own employees conducted the manufacturing activities that actually were conducted by the manufacturer. 8 For this requirement, the manufacturer can only have manufactured the product by Substantial Transformation or Component Parts Assembly. 9 If the Substantial Contribution Exception applies, then the CFC may avoid generating FBCSI by showing that the facts and circumstances “evince that the [CFC] makes a substantial contribution through the activities of its employees to the manufacture, production, or construction of the personal property sold.” 10 The determination of whether a substantial contribution has been made “involves, but will not necessarily be limited to” consideration of the following activities:
1. Oversight and direction of the activities or process pursuant to which the property is manufactured, produced, or constructed;
2. Activities that are considered in, but are insufficient to satisfy, the substantial transformation or component parts tests;
3. Material selection, vendor selection, or control of raw materials, work-in-process, or finished goods;
4. Management of manufacturing costs or capacities (for example, management of the risk of loss, cost reduction or efficiency initiatives associated with the manufacturing process, demand planning, production scheduling, or hedging raw material costs);
5. Control of manufacturing-related logistics;
6. Quality control (for example, sample testing or establishment of quality control standards); and
7. Developing, or directing the use or development of, product design and design specifications, as well as trade secrets, technology, or other intellectual property for the purpose of manufacturing, producing, or constructing the personal property. 11
8 Regs. §1.954-3(a)(4)(iv)(a).
11 Regs. §1.954-3(a)(4)(iv)(b).
The Final Regulations provide broad (and generally taxpayer-favorable) rules regarding the application of the Substantial Contribution Exception. For example, the performance of any of the indicia of manufacturing activities by a CFC's employees are to be taken into account by the CFC in the aggregate in determining whether it satisfies the Substantial Contribution Exception. This is true regardless of the location in which the employees are located when conducting such activities. In addition, the performance or lack of performance of any single activity or of any particular number of activities is not in and of itself determinative. According to the Preamble, “there is no single activity that will be accorded more weight than any other activity in every case or that will be required to be performed in all cases.” The Preamble further provides that there is “no minimum threshold” of functions needed to be performed by the employees with regard to a particular activity before such functions are taken into account. Rather, all employee functions are taken into account and assigned an appropriate weight. The weight accorded to the performance of any “quantum of activity” will vary with the facts and circumstances of the particular business and will be based on the economic significance of the particular function to the manufacture of the property. Most importantly, the Final Regulations clarify that more than one person can satisfy the Substantial Contribution Exception with regard to the manufacture of the same product. The fact that other persons make a substantial contribution will not preclude a CFC from making a substantial contribution as well. 12
12 See generally Regs. §1.954-3(a)(4)(iv)(c).
The Temporary Regulations — Brand New Branch Rules
Under §954(d)(2), FBCSI may also include income derived by a CFC that conducts its activities through a branch (or similar establishment) located outside its country of incorporation. Specifically, FBCSI includes income earned by a CFC where the CFC carries on activities through a branch outside the country of its organization and such use of the branch has substantially the same effect as if the branch were a wholly owned subsidiary corporation deriving such income. 13
The existing regulations expanded upon the statutory rules and provided specific rules with regard to a CFC that conducts its activities through: (1) a sales branch; (2) a manufacturing branch; and (3) one or more sales branches in addition to one manufacturing branch. 14 In general, to determine whether use of the branch has substantially the same tax effect as if it were a wholly owned subsidiary of the CFC, the regulations require the application of a tax rate disparity test (RDT), which compares the hypothetical effective tax rate that would apply to sales income had it been earned in the jurisdiction where manufacturing activities occur with the actual effective tax rate where the CFC is created or organized. 15 To the extent that a CFC “fails” the RDT, i.e., the actual effective tax rate is significantly lower than the hypothetical effective tax rate, the income allocated to the branch (in the case of the sales branch rules) or the remainder (think “head office”) of the CFC (in the case of the manufacturing branch rule) would be classified as FBCSI, because the branch (or remainder) would be treated as a separate corporation which is making sales “on behalf of” a related person under §954(d)(1).
14 Regs. §1.954-3(b)(1)(i) and (ii).
The Temporary Regulations set forth new rules addressing situations where a CFC has multiple manufacturing branches each of which performs manufacturing activities with respect to the same item of personal property. Because the location of manufacturing is crucial to applying the RDT, the rules operate to determine which one location will be considered the manufacturing branch for each sales branch. If only one branch of the CFC (or only the remainder of the CFC) independently satisfies a Manufacturing Exception with regard to an item of property, then the location of manufacture is the location of that branch (or remainder of the CFC). 16 If more than one branch of the CFC (or at least one branch and the remainder of the CFC) each independently satisfies a Manufacturing Exception with respect to an item of personal property, then the location of manufacture is deemed to be the location that imposes the lowest effective rate of tax on the income allocated to such branch (or remainder of the CFC). 17 Finally, if none of the branches (or the remainder of the CFC) independently satisfies a Manufacturing Exception, but the CFC as a whole would make a substantial contribution to the manufacture of the personal property, then the location of manufacture is the “tested manufacturing location,” unless the “tested sales location” provides a “demonstrably greater contribution to the manufacture of the personal property.” 18 If the tested sales location provides a demonstrably greater contribution, then the tested sales location is the location of manufacture and the branch rules will not operate to treat the sales branch as a separate corporation. A “demonstrably greater contribution” is determined by weighing the relative contributions to the manufacture by the tested sales location and the tested manufacturing location, using the facts and circumstances test set forth in the Substantial Contribution Exception. 19
16 Regs. §1.954-3T(b)(1)(ii)(c)(3)(ii).
18 Regs. §1.954-3T(b)(1)(ii)(c)(3)(iii).
For purposes of this test, the tested manufacturing location is the location of any branch (or remainder of the CFC) that contributes to the manufacture of the personal property and that would: (1) be treated as a separate corporation from the remainder of the CFC (or the sales branch if it is treated as the remainder) after applying the RDT; and (2) impose the lowest effective rate of tax on the income allocated to such branch. The tested sales location is the location of the purchasing or selling branch (or similar establishment) or the remainder of the controlled foreign corporation by or through which the purchasing or selling activities are carried on with respect to the personal property. 20 Presumably, there can be more than one tested sales location for any single item of personal property.
20 Id., as modified by technical corrections. See 74 Fed. Reg. 11843 (3/20/09).
The Manufacturing Exception — How Did We Get Here?
Section 954(d)(1) provides that FBCSI includes “income … derived in connection with the purchase of personal property from a related person and its sale to any person, the sale of personal property to any person on behalf of a related person, the purchase of personal property from any person and its sale to a related person, or the purchase of personal property from any person on behalf of a related person.” 21 In addition, the purchased property must be manufactured outside the country under whose laws the CFC is organized (the statutory basis for the Same Country Source Rule) and must be sold for use, consumption, or disposition outside such foreign country (the statutory basis for the Same Country Use Rule). 22
22 §954(d)(1)(A) and (B).
There is no basis for a Manufacturing Exception in the language of the statute. In fact, there is no basis for any “exception” to FBCSI in the statute, but for the carve-out given to producers of agricultural commodities which are not grown in the United States in commercially marketable quantities. 23 The statute merely sets out the four types of related-party purchases and sales that fall within its scope. (Note that it is incorrect, therefore, to identify the Same Country Source Rule and the Same Country Use Rule as “exceptions” to FBCSI — they are part of the definition of FBCSI.)
Nevertheless, the drafters of the original 1964 regulations viewed the language of §954(d)(1) as providing another limitation on the scope of FBCSI. Thus, the original regulations did contain a substantial transformation provision. The IRS and Treasury, in an apparent attempt to distance themselves from the passive nature of the original substantial transformation provision, refer to this as the “its” defense. As stated previously, FBCSI includes income from the “purchase of personal property from a related person and its sale to any person” and the “purchase of personal property from any person and its sale to a related person.” Although it would seem clear that the primary purpose of each of these clauses is to define the type of related-party transactions that are elemental in the classification of FBCSI, the use of the word “its” has caused quite a bit of confusion. Many believe that the plain meaning of the statute suggests that if the property purchased by the CFC is in some manner different from the property sold by the CFC, then the income arising from the sale of such property should not be FBCSI. Moreover, because such an interpretation of these two clauses rests upon a strict passive-voice reading of the pronoun “its” within each clause, there is no room left for any indication as to who would have to perform the transformation. Thus, proponents of the “its” defense argued that the transformation of the property could be conducted by any person.
The idea that manufacturing would play some role in determining whether sales income should be classified as FBCSI likely comes from the legislative history to §954(d). Both the House of Representatives Report and the Senate Report on §954 provide the following:
The “foreign base company sales income” referred to here means income from the purchase and sale of property, without any appreciable value being added to the product by the selling corporation. This does not, for example, include cases where any significant amount of manufacturing, major assembling, or construction activity is carried on with respect to the product by the selling corporation. On the other hand, activity such as minor assembling, packaging, repackaging or labeling will not be sufficient to exclude the profits from this definition. 24
24 S. Rep. No. 1881, 87th Cong., 2d Sess. (1962) H.R. 10650 at 84, and also H. Rep. No. 1447, 87th Cong., 2d Sess. (1962) H.R. 10650 at 62.
Under this rationale, it appears that Congress intended there to be some form of an exception to FBCSI based on the economic investment that the CFC makes in the property. The statement “without any appreciable value being added to the product by the selling corporation” appears to establish a guideline for distinguishing between “bad” sales income (i.e., income earned by a CFC that did not add any appreciable value to the product) and “good” sales income (i.e., income earned by a CFC that did add appreciable value to the product, regardless of whether there was a related-party transaction). The next sentence clearly states that manufacturing, major assembling, or constructing are mere examples of a CFC adding appreciable value to a product.
Section 954(d), however, does not explicitly state that there should be a “value added” exception, whether in the form of manufacturing, major assembling, or constructing. However, any underlying concern that the legislative history would be overlooked was quickly alleviated as interpretive regulations (the 1964 Regulations) under §954(d) rather swiftly introduced the Manufacturing Exception (i.e., the provisions on Substantial Transformation and Component Parts Assembly, discussed above). The 1964 Regulations specifically provide that FBCSI does not include income of a CFC derived in connection with the sale of personal property manufactured by the corporation from personal property that it purchased. Regs. §1.954-3(a)(4)(ii) provides that “[i]f purchased personal property is substantially transformed prior to sale, the property sold will be treated as having been manufactured, produced, or constructed by the selling corporation.” There is no indication that the activities must be conducted by the selling corporation.
The examples contained in the 1964 Regulations indicate that substantial transformation involves an irreversible change in the nature of the products purchased. The 1964 Regulations provide the following examples of substantial transformation: (1) the conversion of wood pulp into paper products; (2) the production of nuts, bolts, and screws from steel rods; and (3) the processing and canning of fresh tuna fish. 25 Even the Component Parts Assembly provision is framed in language suggesting that manufacturing is the standard by which the exception should be determined. Regs. §1.954-3(a)(4)(iii) provides that a CFC may satisfy the regulatory manufacturing exception for the “manufacture of a product when purchased components constitute part of the property sold.” In this case, the 1964 Regulations specifically provide that “if purchased property is used as a component part of personal property which is sold, the sale of the property will be treated as the sale of a manufactured product … if the operations conducted by the selling corporation … are substantial in nature and are generally considered to constitute the manufacture, production, or construction of property. [Emphasis added.]”
25 Regs. §1.954-3(a)(4)(ii) Exs. (1), (2), and (3).
The 1964 Regulations seemingly turned the “value added” exception on its head. If the regulations had followed the logic set forth in the legislative history to §954(d), then they would have framed the exception to FBCSI as being one where the selling corporation added appreciable value to the product before its sale. Manufacturing, major assembling, and constructing would have been mere examples of appreciable value having been added to property. Instead, manufacturing has become the standard by which the exception is measured, and the degree of transformation is now dispositive in determining whether manufacturing actually occurred. The example has become the rule.
Attribution and the Branch Rules
How Did Attribution Enter the Picture?
Despite what appears to be clear wording in §954(d) and the 1964 Regulations that the manufacturing of the personal property does not need to be conducted by the selling corporation in order to qualify as an exception to FBCSI, the IRS has struggled with the issue as long as the regulations have been in place.
In Rev. Rul. 75-7, 26 a CFC purchased raw materials from related persons outside of its country of organization, contracted with an unrelated manufacturer located outside of its country of organization to process the raw materials into a finished product, and then sold the finished product to unrelated persons outside of its country of organization. Under the terms of the arrangement, the contract manufacturer was paid a conversion fee. The raw materials, work-in-process, and finished product remained the property of the CFC at all times. The CFC alone had complete control over the time and quantity of production as well as complete quality control over the conversion process. The IRS ruled that “since the arrangement between X and Y is one of principal and agent,” the activities performed by the contract manufacturer should be considered to be performed by the CFC. Thus, the CFC was treated as having substantially transformed the personal property. The ruling further concluded that, because the CFC conducted the manufacturing activity outside of its country of organization, it was considered to do so through a branch or similar establishment. Because the effective tax rate in the manufacturing country did not fail the RDT, the manufacturing activity was not considered to have substantially the same tax effect as a wholly owned subsidiary. 27
26 Rev. Rul. 75-7, 1975-1 C.B. 244.
The IRS's conclusions in Rev. Rul. 75-7 resulted from a decade's worth of volleying between the IRS Director for the Income Tax Division and the Chief Counsel's office. In fact, the questions that Rev. Rul. 75-7 addressed were originally presented to the IRS in a private letter ruling request in 1964, the same year that the first set of regulations under §954 were released. In PLR 6412105700A, 28 the Director of the Tax Rulings Division also ruled that the CFC did not generate FBCSI on the sale of the finished product, but he reached this conclusion using a completely different analysis. Rather than focusing on the branch and the RDT, PLR 6412105700A provided that “a careful examination of all the information submitted discloses that the property to be sold … is clearly not the property which [the CFC] purchased.” Therefore, Substantial Transformation was clearly satisfied.
28 PLR 6412105700A, Dec. 10, 1964.
The ruling noted, however, “There remains to be decided whether the 1954 Code provisions relating to foreign base company sales income and the regulations thereunder, permit someone other than the CFC to perform the functions whereby the purchased property is substantially transformed prior to its sale.” 29 The ruling did not address the issue, however, and instead surmounted the problem by attributing the activities performed by the manufacturer to the selling corporation. It concluded that there could be no FBCSI on these facts.
Two years later, the Income Tax Division submitted the same question to the Chief Counsel's office. 30 In its response, the Chief Counsel's office objected to the conclusion that the arrangement would not generate FBCSI. Specifically, the GCM states that any conclusion regarding FBCSI “can only be made after consideration of the branch rules.” 31 The Chief Counsel's office stated that the agency principles “should … be invoked in applying the branch rule” because they had been used to attribute the activities of the manufacturer to the selling corporation for purposes of the Substantial Transformation provision. Not doing so, claimed the Chief Counsel, would result in an imbalance in the application of the branch rules and the Manufacturing Exception, thus “enlarging out of all proportion the manufacturing exception.” The GCM, however, did not address the musings in the 1964 ruling regarding whether the CFC itself had to be the manufacturer. Thus, the primary question of whether the CFC must transform the product in the first place was subordinated by the assumption that attribution must occur and that it resulted in the application of the branch rules.
30 GCM 33357 (10/24/66).
The revenue ruling was not issued in 1966. Instead, eight years later, the Chief Counsel's office released a new memorandum, which included a proposed text of Rev. Rul. 75-7. In GCM 35961, the Chief Counsel's office again reviewed the same fact pattern, and suggested a new rationale for the proper analysis of the Manufacturing Exception and the branch rules. In this new GCM, the Chief Counsel's office reiterated its position that the branch rules must be invoked whenever a CFC conducts activities outside of its country of incorporation, whether conducted directly or through a related or unrelated party. In fact, the GCM made the rather strong statement that “[the Chief Counsel's office] is not bothered by the fact that in the typical case involving an application of the branch rule the manufacturing activity is conducted by a permanent establishment of the CFC rather than by an unrelated corporation on behalf of the CFC.” 32 It believed that “in either case, the CFC will be incurring a separate tax on the manufacturing, either directly or indirectly as a cost of the manufacturing, and thereby separating the taxation of its manufacturing and selling activities.” 33
32 GCM 35961 (8/23/74).
The development of the attribution and branch rule issues in Rev. Rul. 75-7 is curious. Recall that neither the 1964 Regulations nor §954(d) actually required that a CFC be the manufacturer to avoid FBSCI. PLR 6412105700A confused this fact by questioning whether it was true, and then not answering the question. Nonetheless, the existing law only required that the property sold be different from the property purchased. Arguably, Rev. Rul. 75-7 obfuscated the issues by attributing the activities of one entity to another. If there had not been attribution, then perhaps the branch rules would not have been invoked. Perhaps the real motivation for Rev. Rul. 75-7 was to make taxpayers believe that the use of another entity could create a branch for the CFC.
Attribution Causes Branch Confusion
Another aspect of Rev. Rul. 75-7 would later prove significant. Even assuming that attribution of the manufacturing activities to the CFC was necessary to avoid foreign base company sales income, the ruling did not predicate such attribution on the finding of a branch or similar establishment. The ruling expressly stated that “since” the CFC was considered to be manufacturing, then a branch would be deemed to exist; it explicitly did not rule that without a branch, there could be no attribution of manufacturing activities.
Several years later, the Tax Court addressed the IRS's ruling with regard to the creation of a branch. In Ashland Oil, 34 a CFC entered into a contract with an unrelated manufacturer located outside of the CFC's country of organization. The contract manufacturer provided finished products for the CFC using intangibles owned by the CFC (i.e., intellectual property) and raw materials purchased under the direction of the CFC. The contract manufacturer was reimbursed its costs for the purchase of the goods and also paid a fixed fee for its manufacturing services. The IRS challenged the taxpayer's position that the contract manufacturer was not a “branch” of the CFC for purposes of the FBCSI rules. Siding with the taxpayer, the Tax Court held that the manufacturer was not a “branch” because the ordinary definition of the term “branch” does not include an unrelated corporation operating under an arm's-length contractual arrangement. Similarly, the court ruled that the contract manufacturer could not be a “similar establishment” because this required “an establishment that bears the typical characteristics of an ordinary-usage branch, yet goes under another name for [legal or business] purposes.” 35 Ultimately, the Tax Court ruled that the CFC did not generate FBCSI because it did not purchase or sell property to a related party. The Tax Court held similarly in Vetco, 36 finding that a wholly owned subsidiary of a CFC in a contract manufacturing arrangement cannot be treated as a branch or similar establishment of the CFC for purposes of the FBCSI rules. 37
34 Ashland Oil, Inc. v. Comr., 95 T.C. 348 (1990).
35 Id. at 357.
36 Vetco, Inc. v. Comr., 95 T.C. 579 (1990).
37 Id. at 590-593.
The IRS immediately indicated informally that they would react to Ashland and Vetco by revoking or modifying Rev. Rul. 75-7. As contract manufacturing issues began coming up in audits after Ashland and Vetco, the IRS began taking the position that the logic sequence of Rev. Rul. 75-7 was actually reversed from its express language, i.e., that acceptance of a branch for purposes of the FBCSI branch rules was a prerequisite for attribution of any activities to the CFC from another entity, and that such attribution was in fact required in order for the CFC to have any income that was not Subpart F income. It was rumored that taxpayers in settlement discussions with the IRS were being presented with the choice of: (1) ignoring Ashland and Vetco, thereby accepting the application of the branch rules to separate subsidiaries; or (2) losing the ability to attribute manufacturing activities of another entity to the CFC altogether. In fact, the IRS filed a motion for summary judgment in a Tax Court case on the theory that, in the absence of a branch, there could be no manufacturing income earned by the CFC as a matter of law. 38 The Tax Court denied this motion without issuing an opinion, and the case settled before trial. Without an opinion explaining the basis for the denial of the summary judgment motion, it is not possible to determine whether the court determined that the IRS's formulation of the law was incorrect or whether there were issues of material fact that would have to be resolved before a legal conclusion could be reached.
38 The Limited, Inc. v. Comr., T.C. Dkt. No. 12004-94.
In 1997, the IRS revisited the branch issue and the holdings in Ashland and Vetco. In Rev. Rul. 97-48, 39 the IRS stated that it was revoking its ruling in Rev. Rul. 75-7 and choosing to follow (and extend) the holdings in Ashland and Vetco. Specifically, the IRS ruled that “[the] activities of a contract manufacturer cannot be attributed to a controlled foreign corporation for purposes of either section 954(d)(1) or section 954(d)(2) of the Code to determine whether the income of a controlled foreign corporation is foreign base company sales income.” The reasoning provided by the IRS was that “Rev. Rul. 75-7 allows the activities of a contract manufacturer performed outside the controlled foreign corporation's country of incorporation to be attributed to the controlled foreign corporation without treating those activities as performed through a branch or similar establishment of the controlled foreign corporation.” 40
39 Rev. Rul. 97-48, 1997-2 C.B. 89.
As a result of the IRS's ruling in Rev. Rul. 97-48, it became clear that the government's position was that taxpayers could not rely solely upon the attribution of manufacturing activities to satisfy the Manufacturing Exception. However, the IRS did not go so far as to require the CFC to be conducting all of the manufacturing activities itself. In addition, under the 1964 Regulations, attribution does not even seem to be relevant when, for example, the substantial transformation activities are undertaken for the CFC by a contract manufacturer. Therefore, since Rev. Rul. 97-48, it has remained unclear whether a CFC could satisfy the Manufacturing Exception without directly carrying out the physical manufacturing specified in the regulations.
The Substantial Contribution Exception Is an Oversized Solution To a Small Problem
The Final Regulations establish a complicated array of rules that are intended to address, with one fell swoop, the myriad problems that arose in the wake of Rev. Rul. 75-7, Ashland, Vetco, and Rev. Rul. 97-48. Having lost in court on the branch rules, the IRS and Treasury needed to “win” on the Manufacturing Exception. Thus, the IRS and Treasury had to stop taxpayers from being able to use the Manufacturing Exception by shutting down use of the passive Substantial Transformation provision (and publicly referring to this as a “rejection of the ‘its' defense”), eradicating any reference to the significance of the form of a product, establishing the requirement that the CFC's employees must conduct all activity, and eliminating any notion of attribution.
Doing this was no small feat. In the Preamble to the proposed regulations, the IRS and Treasury indicated that the position taken by taxpayers regarding the “its” defense and Regs. §1.954-3(a)(4)(i) was “contrary to existing law, and results from an incorrect reading of [the statute and regulation].” 41 In support of this statement, the IRS and Treasury contended, “ Section 954(d)(1) requires only a purchase of personal property and the sale of that personal property by the CFC with no indication as to form.” 42 They further claimed that §954(d)(1)(A) limits FBCSI to income derived in connection with the purchase or sale of property manufactured outside the CFC's country of incorporation. This allowed the IRS to reiterate its conclusion from Rev. Rul. 75-7, namely, that §954(d)(1) “is concerned with the segregation of purchase or sales and manufacturing into different jurisdictions, not merely with whether the property was manufactured.” 43 Finally, the IRS and Treasury indicated that Regs. §1.954-3(a)(4) provides the only set of rules under which a change in form of property is relevant for purposes of determining FBCSI. 44
41 Preamble's Explanation of Provisions, at A (second paragraph), for REG-150066-08, 73 Fed. Reg. 10716 (2/28/08).
44 Id., at A (third paragraph).
Changes had to be made throughout the regulations to accommodate the new position. For example, the Final Regulations added this sentence to Regs. §1.954-3(a)(1)(i), describing FBCSI in general:
For purposes of the preceding sentence, 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. [Emphasis added.]
Similarly, in Regs. §1.954-3(a)(1)(iii), the Final Regulations modified Examples 1 and 2 by surgically removing the language “in the form in which purchased” from each fact pattern. In Regs. §1.954-3(a)(4)(i), the Final Regulations excised language which stated that a foreign corporation will be considered to have manufactured “personal property which it sells if the property sold is in effect not the same property which it purchased.” In its place, the Final Regulations provided that a “controlled foreign corporation will not be treated as having manufactured … personal property which the corporation sells merely because the property sold is in a different form than the form in which it was purchased. [Emphasis added.]”
With regard to attribution, the Final Regulations stated that manufacturing activities must be performed by the CFC itself in order for it to qualify for the Manufacturing Exception. For support of this position, the IRS and Treasury in the Preamble to the proposed regulations cited the legislative history of §954(d), stating that “[i]n a case in which a CFC 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 [FBCSI] if the corporation substantially transforms the parts or materials, so that, in effect, the final product is not the property purchased.” 45
45 Preamble's Explanation of Provisions, at A (fourth paragraph), for REG-150066-08, 73 Fed. Reg. 10716 (2/28/08) (citing S. Rep. No. 1881, 87th Cong., 2d Sess. (1962)).
To this end, the Final Regulations amended the existing Manufacturing Exception rules to provide that a CFC will qualify for the Manufacturing Exception only if the CFC, acting through its own employees, manufactures the product within the meaning of Regs. §1.954-3(a)(4)(i). Moreover, according to the Final Regulations, “[a] controlled foreign corporation will have manufactured … personal property which the corporation sells only if such corporation satisfies the provisions of paragraph (a)(4)(ii), (a)(4)(iii), or (a)(4)(iv) of this section through the activities of its employees … with respect to such property. [Emphasis added.]” 46
46 Regs. §1.954-3(a)(4)(i).
As discussed, §954(d) does not indicate that manufacturing is even a possible exception to FBCSI. Obviously, it cannot therefore discuss by whom the manufacturing would have to be performed in order to meet the exception. The legislative history only provides us with a hint that Congress intended §954(d) to capture income earned by a CFC from a related party transaction, where no appreciable value had been added to the property by the CFC before its sale.
The 1964 Regulations established a standard very close to this stated purpose in providing that a CFC would be considered to have manufactured personal property which it sold only if the personal property was not in effect the same property it purchased. There never has been any indication that the CFC had to perform the manufacturing.
Neither should there have been. It simply does not make sense to require the CFC to perform manufacturing activities in order to avoid generating FBCSI. In a typical consignment manufacturing arrangement, a foreign corporation will purchase raw materials, contract with a manufacturer to process the raw materials into a finished product, and then sell the final product. During this process, the foreign corporation retains title to the raw materials during the manufacturing process and bears the risk of loss. The foreign corporation must also pay the manufacturer to transform the raw materials into the finished product. Would it make sense to say that the foreign corporation's income should be classified as FBCSI in this situation merely because it did not actually perform manufacturing activities? After all, the foreign corporation did add value to the personal property by paying to have it transformed. Attribution is not required in this case, nor would it make sense. A simple, plain language interpretation of §954(d) and its legislative history should suffice to exclude consignment arrangements from the FBCSI regime.
The treatment of contract manufacturing arrangements is less clear. In a typical contract manufacturing arrangement, the foreign corporation may contract with a related or unrelated manufacturer to create a final product that the foreign corporation intends to sell to its customers. The foreign corporation develops the product plans and design specifications, and then instructs the contract manufacturer on how to finish the product. The contract manufacturer will typically obtain the raw materials and hold title to them during the manufacturing process; however, the foreign corporation may even dictate where and how the contract manufacturer completes this task. After the product has been completed, the contract manufacturer transfers title to the corporation, and the corporation then sells it to its customers.
Under the plain language of §954(d), this arrangement may be viewed as generating FBCSI if the foreign corporation purchases from or sells to a related party (or if it does so on behalf of a related party under the branch rules) and the other requirements are satisfied (i.e., the Same Country Source Rule and the Same Country Use Rule do not apply). Nevertheless, there are situations when the selling corporation has so much involvement with the development of the product and the oversight of the manufacturing process that it would go against the purpose of §954(d) to classify its sales income as FBCSI. In other words, if the foreign corporation undertakes a significant amount of non-physical manufacturing with regard to a product, it cannot be said that the corporation did not add appreciable value to the product before its sale.
In this case, the non-physical manufacturing factors, already set forth in the Substantial Contribution Exception, would make a good test for determining whether a contract manufacturer has run afoul of the purpose of §954(d). However, it would make more sense if this test only applied as an exception to FBCSI in these circumstances, rather than in all circumstances where any foreign corporation fails to satisfy the Manufacturing Exception, regardless of whether it has entered into a consignment manufacturing arrangement, a contract manufacturing arrangement, or if it even has a related-party purchase or sale (as it currently stands).
The Branch Rule Can Also Be Simplified
The Temporary Regulations have created a huge conundrum: CFCs will find themselves with many more branches, and yet there is still no certainty on fundamental questions, such as how to allocate income between the branches and the remainder of the CFC, and how to perform the RDT. It appears that a substantial motivation for the issuance of the Temporary Regulations was to deal with the absence of a branch for consignment manufacturers. The rules seem overly complex for this purpose. Having defined substantial contribution, the regulations then provide multiple sets of rules for applying the RDT: rules for single manufacturing branches, multiple manufacturing branches, single and multiple sales branches, and single and multiple products. While the term “branch” is not defined, it appears that activities which would fall short of the definition of a “taxable presence” or permanent establishment might be considered a branch. No wonder such complex rules are needed to deal with the very real possibility of a veritable multiplex of manufacturing and/or sales branches.
The legislative history of §954(d)(2) indicates that the branch rule is intended to prevent CFCs from segregating sales activities from the remainder of the CFC, where the sales activities would be subject to a lower effective tax rate in another country. It also begs the question why Congress thought this to be necessary; after all, the activity does not lower U.S. tax. It only lowers foreign tax. Nonetheless, the Code is clear: if sales activity is separated from the CFC, the branch rule can create FBCSI. The Temporary Regulations appear to suggest that a very minimal level of activity may constitute a manufacturing branch that somehow may abuse the Manufacturing Exception. Here, the IRS and Treasury have gone far beyond the concern voiced in the legislative history and the statutory authorization.
More importantly, the Temporary Regulations fail to fully recognize, as the Preamble to the proposed regulations suggests was intended, the realities of modern manufacturing. Many businesses now select their manufacturing locations for reasons completely unconnected to tax minimization. For example, manufacturing may be located in areas that are close to the raw material or component sources or low-cost manufacturing service providers. Supply chain logistics may be located where efficient and low-cost warehousing and transportation service providers are located. Sales operations may or may not be located centrally, depending upon whether the company requires direct customer interface. To say that manufacturing is moved away from the customer or sales office due to tax planning is out of step with the modern way of doing business.
Therefore, the impact of creating more manufacturing branches seems to be at odds with recognizing how business is done. In fact, the opposite would be desirable: the elimination of the manufacturing branch rules.
If the IRS and Treasury really believe that a manufacturing branch rule is needed, a simple approach would be the best approach. If a CFC has entered into a consignment or contract manufacturing arrangement, and the principal in the contract manufacturing arrangement is a branch (using a concrete definition, such as that of a permanent establishment) or disregarded entity of the CFC, rather than the CFC itself, then the branch rule could treat the branch or disregarded entity as a manufacturing branch. If the principal is the CFC itself, then only sales branch rules should apply. If the CFC is a physical manufacturer, then, of course, the manufacturing branch rules would continue to apply to a branch that performs any physical manufacturing. Now, there's a solution that isn't oversized.
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