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By Philip D. Morrison, Esq. Deloitte Tax LLP, Washington, DC
The Subpart F, foreign base company sales income (“FBCSI”) rules under §954(d)(2) dealing with branches, particularly manufacturing branches, are one of those sets of rules that, no matter how often you deal with them, you'd better re-read them before expressing a view on any new situation. This is in part due to the complexity of the language used and in part due to the complexity of the rules the language is intended to express. Notwithstanding this dual complexity, there have been “holes” in these rules for years that have frustrated the conscientious adviser and often forced the muddying of one's advice. While complex, these regulations have been far from comprehensive.
The recently-published temporary regulations under §954(d)(2) address a portion of the comprehensiveness issue, filling in some important holes in the old regulations. Unfortunately, the new regulations do little or nothing to make these rules less complicated, either in the rules to be applied or in the language used to express them. On the former, perhaps this is unavoidable. On the latter point, there is some clumsiness and lack of clarity that should be eliminated when these regulations are made final.
Perhaps the biggest open issue in the old regulations was how to identify whether one had (or could have) multiple manufacturing branches and what the result would be if one did. The old regulations had rules for multiple purchase or sales branches, and for multiple purchase/sales branches along with a manufacturing branch, but not for multiple manufacturing branches. There was further confusion because a manufacturing branch needed only to perform “manufacturing activities,” a phrase that might imply a lesser level of activity than that necessary to meet the overall manufacturing exception. Where one argued that a principal in a contract manufacturing arrangement was a manufacturer via an attribution concept or by having adequate indicia of manufacturing despite not actually bending metal or physically assembling a product, this issue was particularly acute. With the final regulations confirming that one could manufacture by “substantial contribution” to physical manufacturing conducted by others, this problem became imperative to address.
The new temporary regulations, like the proposed regulations that preceded them, address the multiple manufacturing branch issue head on. If a CFC has more than one branch that carries on manufacturing activities with respect to separate items of property, then the tax rate disparity (“TRD”) test is applied separately to each branch as if it were the only such branch and all other such branches were separate corporations.1 If a CFC has more than one branch that carries on manufacturing activities with respect to the same item of property, then the analysis gets more complex.2 In that case, one must apply new rules to determine which of the several branches is the manufacturer. Unlike the case with sales branches, only one manufacturing branch will be considered a manufacturing branch that can implicate the manufacturing branch rule to create FBCSI with respect to a single item. This is perhaps the most helpful and simplifying aspect of the entire regulations package.
Where only one branch (or the remainder) independently satisfies Regs. §1.954-3(a)(4)(i) (“(a)(4) manufacturing”), then that branch (or remainder) alone will be the location of manufacturing for purposes of applying the manufacturing branch rule, regardless of whether other branches perform manufacturing activities.3 Where multiple branches (or one or more branches and the remainder) each independently satisfies Regs. §1.954-3(a)(4)(i), then there still will only be a single location of manufacturing. That location will be the branch (or remainder) which has the lowest effective tax rate. Thus, not only will not there be multiple manufacturing branches in such a case, but, since the lowest-taxed branch is the sole location of manufacturing, the TRD test is least likely to be met. This is the simplest and most taxpayer-favorable result, and a great relief to many companies that have a multi-jurisdictional supply chain.
Where no location independently satisfies the (a)(4) manufacturing test but the CFC as a whole (i.e., the remainder plus all the branches taken together) does,4 then the analysis gets even more complicated. Still, however, the regulations will create only a single place of manufacture (per item) for purposes of applying the manufacturing branch rule to create FBCSI. The single place of manufacture will be either the “tested manufacturing location” (“TML”), if any, or the “tested sales location” (“TSL”), depending on whether or not the TSL provides a “demonstrably greater contribution” to the manufacture of the property than the TML does.
The TML is the location of the branch (or remainder) that: (1) contributes to the manufacturing; (2) has a TRD; and (3) has the lowest effective tax rate. In determining the contribution of the TML to the manufacture of the property (to apply the “demonstrably greater contribution” concept to choose between the TSL and the TML), the activities of all branches (and the remainder) that have a TRD are combined. The TSL is the location where a branch (or remainder) sells the property. Like with the TML, in determining the contribution of the TSL to the manufacture of the property (to apply the “demonstrably greater contribution” concept to choose between the TSL and the TML), the activities of all branches (and the remainder) that do not have a TRD are combined. Thus, one big TSL and one big TML are compared to see which has made the demonstrably greater contribution.
While I get a bit dizzy every time I read these rules, I think the rule that combines branches to determine the TML's contribution makes irrelevant item (3) in the basic rule for determining the TML. If we combine all branches with TRDs to create a single TML to compare to the TSL to see whether the TSL provides the demonstrably greater contribution, who cares whether the TML has a small TRD or a large TRD -- it has a TRD and if the TSL is not the demonstrably greater contributor, there will be a manufacturing branch issue. Presumably this will be clarified if and when the temporary regulations are made final.
A further complication arises where there are two TSLs. This can happen if there are two locations where a branch purchases or sells property and there is a TRD between the two. In that case one does not combine them for purposes of measuring their relative contribution to the manufacture of the property versus the TML. Presumably, then, one must compare the TML to each of the two TSLs to measure whether either TSL provides a demonstrably greater contribution. A specific provision so saying would be helpful, although there is an example so providing.
While these rules are not easy to parse, the practical complexity is not so much in the complexity of the rules themselves but in the complexity and ambiguity in the application of the “demonstrably greater contribution” concept. If no branch independently does (a)(4) manufacturing, and my TSL makes a demonstrably greater contribution than my TML (if any) does, then I likely have no manufacturing branch issue.5 But how do I tell whether the TSL makes a demonstrably greater contribution? The temporary regulations say only that I must weigh the relative contributions to the property's manufacture under the facts and circumstances test of the substantial contribution final reg. While that final reg is helpful in providing that different factors matter differently for different situations (i.e., raw material procurement activities may matter a lot in the apparel industry, but less so in the electronics), they provide no guidance regarding the meaning of “demonstrably greater.” This is, of course, a subjective measure inherently incapable of precise measurement. Still, an aggressive IRS examiner will construe “demonstrably greater” as something much further apart than 51:49, or even 60:40. While clarification here can only be modest (i.e., the comparison will always be fuzzy), some further guidance should be provided in the final regulations.
On the whole, the temporary manufacturing branch regulations are helpful and well-crafted. Some clean-up in drafting and some further guidance regarding the central “demonstrably greater contribution” rule are needed, however.
This commentary also will appear in the April 2009 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.
1 The tax rate disparity test is, all by itself, a Gordian knot of complexity. While one might have hoped the regulation writers would have adopted some Alexandrian solution (perhaps an impossibility), they chose, instead, to untie a little bit in their Preamble and in an example to declare that “uniformly applicable” incentive tax rates can be used in the hypothetical determination of the TRD test. Unfortunately, they provide no guidance on what “uniformly applicable” or “uniformly available” means. Fortunately, they also do not make the “uniformly applicable” concept a requirement.
2 It would be a helpful clarification if the final rules explained briefly how the two rules work in tandem, i.e., when one has both multiple branches producing separate items and multiple branches producing each of those separate items.
3 I.e., manufacturing activities that do not independently rise to the level of (a)(4) manufacturing.
4 Actually, the temporary regulations say the rules discussed below apply where no branch independently satisfies Regs. §1.954-3(a)(4)(i) but the CFC as a whole “makes a substantial contribution to the manufacture…within the meaning of §1.954-3(a)(4)(iv)” (the “substantial contribution” way of meeting the manufacturing exception). The comparison between contributions of the TML and the TSL are also written only in terms of (iv). Query what happens if the CFC as a whole satisfies Regs. §1.954-3(a)(4)(ii) or (iii) (the physical manufacturing ways of meeting the manufacturing exception), rather than (iv), but no branch (or the remainder) independently satisfies Regs. §1.954-3(a)(4)(i)? After all, the same piece of metal might be bent twice, or a product assembled, in two different locations, where neither location “substantially transforms” the property or is generally considered to manufacture, though both, in combination, do.
5 But see footnote 3, above.
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