Subpart F Manufacturing Exception Applies to Sales Commissions

By Lowell D. Yoder, Esq.  

McDermott Will & Emery LLP, Chicago, IL

In a recent private letter ruling,1 the
IRS ruled that income from payments received for manufacturing and
selling services qualified for the "Subpart F"2
manufacturing exception. The ruling clarifies that a controlled
foreign corporation (CFC) is not required to own or pass title to
the products manufactured and sold to qualify for the manufacturing
exception.

Operating structure. Under the facts of the
ruling, a U.S. corporation (USP) owns several foreign entities
located throughout the world that facilitate the group's worldwide
manufacture and sale of certain products (the Products) outside the
United States. The relevant foreign business is carried out by two
foreign subsidiaries (CFC-1 and CFC-2) and a legal branch (BR-U) of
a foreign entity classified as a partnership for U.S. tax purposes
(FP). The partnership is owned by other foreign subsidiaries owned,
directly and indirectly, by USP.

CFC-1 purchases raw materials from related and unrelated
parties, and physically manufactures the finished Products as a
contract manufacturer. CFC-1 sells the Products to CFC-2, which
then sells the Products to dealers. Both CFC-1 and CFC-2 are
organized under the laws of Country T, and the Products are both
physically manufactured in Country T and sold for use in Country
T.

BR-U operates as a principal that provides overall support to
the manufacturing, marketing, and selling of the Products in
Country T. BR-U, through the activities of its employees located in
Country U, also performs manufacturing activities with respect to
the Products. CFC-2 remits a percentage of the sales proceeds to
BR-U to compensate it for its services. Although BR-U is
significantly involved in the manufacturing, marketing, and selling
activities, it does not take title to the raw materials,
work-in-process, or the finished Products sold in Country T.

BR-U is located in Country U. FP is formed under the laws of
Country V and its CFC owner-partners are organized in countries
other than Country U or Country T. (We will assume Country W.)

The issue addressed in the ruling concerns the application of
the foreign base company sales income (FBCSI) rules to payments
received by BR-U from CFC-2 and included in the incomes of the CFC
owner-partners of FP.3 The IRS ruled
that the payments qualify for the manufacturing exception.

Application of Subpart F to partnerships.  The
first consideration in analyzing the application of the Subpart F
rules to the income derived by BR-U is how to apply Subpart F to a
partnership owned by CFC partners. For this purpose, transactions
engaged in by the partnership are generally considered as engaged
in by the partners (with several exceptions).

Accordingly, initially each CFC partner's distributive share of
BR-U's income is determined under the partnership rules.4 Subpart F then
generally is applied separately to each CFC partner as if the
partner had realized its distributive share of BR-U's income
directly.5 The regulations
require a CFC partner to separately take into account partnership
items that would be Subpart F income if realized directly by the
partner.

Character of income. The next issue is to determine the
character of BR-U's income for purposes of applying Subpart F.6 Different foreign
base company income rules apply depending on whether the income is
sales, services, or another type of income.

The items of gross income of a partnership are characterized at
the partnership level.7 Subpart F is then
applied to the CFC partners as if each partner had realized its
distributive share of an item of income directly.8

As an initial impression, the income derived by BR-U would seem
to be services income. BR-U performs manufacturing and selling
services for CFC-2 and receives a payment.9 It does not
derive its income from purchasing and reselling products.

Nevertheless, Subpart F has a unique characterization rule. The
FBCSI rules apply to income derived in connection with the purchase
or sale of personal property on behalf of a related person "whether
in the form of profits, commissions, fees or otherwise."10 Thus, a
CFC does not need to derive income from buying and reselling
products for the income to be analyzed as FBCSI. Rather, the FBCSI
rules can apply to income in any form to the extent it is derived
in connection with the purchase or sale of property on behalf of a
related person.11

The income addressed in the ruling is derived by BR-U for the
performance of manufacturing, marketing, and selling activities for
a related person with respect to the Products. BR-U never takes
title to the raw materials, work-in-process, or the finished
Products. Without discussion, the ruling treats the payments
received by BR-U from CFC-2 as sales income to be analyzed under
§954(d).12

General application of FBCSI rules.  The next step
is to determine whether the income falls within the definition of
FBCSI. Section 954(d)(1) provides generally that a CFC's sales
commissions or fees are FBCSI if they are derived, in relevant
part, from the sale of personal property on behalf of a related
person.

For purposes of applying the related person test, the
determination is separately made concerning whether CFC-2 is
related to each CFC partner.13 Since USP
owns all entities involved with the manufacture and sale of the
Products and owns all of the CFC partners, the related person test
is met.14 Accordingly,
each CFC partner's distributive share of BR-U's income generally is
FBCSI because the income is treated as derived from selling
products on behalf of a related person (i.e., CFC-2).

Section 954(d) provides that sales income is not FBCSI if the
Products are either manufactured in the CFC's country of
organization or sold for use in such country.15 For purposes of
applying these same country exceptions to the facts herein, the
relevant country is the country of each CFC partner (not the
country of the partnership or the country of the branch).16 We have assumed
that the CFC partners are organized in Country W. The ruling states
that the Products are physically manufactured in Country T and sold
for use in Country T.  Accordingly, the same country
exceptions would not apply to any CFC partner's distributive share
of BR-U's sales income.17

Manufacturing exception. Income generally
classified as FBCSI nevertheless will not be FBCSI if the
manufacturing exception applies. Regs. §1.954-3(a)(4)(i) provides,
in relevant part, that FBCSI does not include "income of a
controlled foreign corporation derived in connection with the
sale
 of personal property manufactured, produced, or
constructed by such corporation." (Emphasis supplied.) The
regulations further provide that a CFC "will have manufactured,
produced, or constructed 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 supplied.)

In relevant part, Regs. §1.954-3(a)(4)(iv)(a) provides that, if
an item of personal property would be considered physically
manufactured "prior to sale by the controlled foreign
corporation
 had all of the manufacturing, producing, and
constructing activities undertaken with respect to that property
prior to sale been undertaken by the controlled foreign corporation
through the activities of its employees, then this paragraph
(a)(4)(iv) applies." (Emphasis supplied.) That regulation further
provides, "If this paragraph (a)(4)(iv) applies and if the facts
and circumstances evince that the controlled foreign corporation
makes a substantial contribution through the activities of its
employees to the manufacture, production, or construction of the
personal property sold, then the personal property sold by the
controlled foreign corporation
 is manufactured, produced,
or constructed by such controlled foreign corporation."18 (Emphasis
supplied.)

Generally, the manufacturing exception is applied as if each
partner earned its distributive share of sales income
directly.  For this purpose, only the activities of the
employees of the partnership, and property owned by the
partnership, are taken into account, not the activities of the CFC
partner.19

It is represented that CFC-1 physically manufactures the
Products within the meaning of Regs. §1.954-3(a)(4)(ii) and (iii).
It is further represented that BR-U makes a substantial
contribution to the manufacture of the Products.20 Such activities
are taken into account for purposes of applying the manufacturing
exception to each CFC partner's distributive share of BR-U's sales
income. Accordingly, it would seem clear that the manufacturing
exception should apply to the sales income derived by BR-U, because
the FP is considered as satisfying the substantial contribution
manufacturing test.

Nevertheless, there is language in the regulations that might
raise a technical issue concerning whether commissions and fees
(i.e., the payments) derived by BR-U are eligible for the
manufacturing exception. The regulations providing the
manufacturing exception contain language referring to the CFC as
"selling" the manufactured property (see italicized
words in above quotes). The question arises as to whether BR-U must
take title to the Products to qualify for the exception.

The ruling addresses this point, stating that the references in
the regulations to a CFC being the selling entity must be construed
consistently with the statutory definition of FBCSI to refer to any
case in which the CFC derives income from selling activities that
would otherwise be FBCSI. Accordingly, the ruling states that the
terms "sale," "sells," and "sold" in the regulations are
interpreted to include the performance of sales activities on
behalf of a related person.21

Thus, the IRS ruled that the payments received by BR-U from
CFC-2 are excluded from FBCSI because BR-U makes a substantial
contribution to the manufacture of the Products.22 It is not
necessary for BR-U to own or take title to the Products to be
eligible for the manufacturing exception. Because the activities of
BR-U satisfy the definition of manufacturing, each CFC partner's
distributive share of BR-U's sales income qualifies for the
manufacturing exception.

The application of the manufacturing exception to sales
commission income is consistent with the application of the two
same-country exceptions to the definition of FBCSI. A CFC does not
have FBCSI if the products sold were manufactured in the CFC's
country of organization, or if the products are sold for use in the
CFC's country of organization.23 These two
exceptions are expressly made applicable to income derived by a CFC
for purchasing products on behalf of a related person or selling
products on behalf of a related person.  The IRS has ruled
that sales commission income earned by a CFC with respect to
property sold on behalf of a related person was not FBCSI because
the product sold was manufactured in the CFC's country of
organization.24

The application of the manufacturing exception to a CFC that
derives sales commissions also is sound tax policy. 
Fundamentally, a CFC that engages in activities through its
employees that satisfy the definition of substantial contribution
manufacturing should qualify for the manufacturing exception,
whether it derives income in the form of sales income, commissions,
fees, or otherwise.  This result carries out the essential
purpose of the manufacturing exception to exclude income from the
definition of FBCSI where the CFC engages in manufacturing-related
functions sufficient to meet the definition of manufacturing.

Indeed, it would be incongruous to treat commissions as sales
income for purposes of §954(d) and then prohibit such income from
being eligible for the manufacturing exception, when the exception
would otherwise apply if the CFC had purchased and resold the
property. Deeming a commission to be a kind of sales income in the
first place necessarily implies that the CFC is treated for FBCSI
purposes as selling the relevant property. Therefore, if a CFC is
regarded as having sales income under §954(d)(1), the CFC should be
regarded as selling that same property for purposes of applying the
manufacturing exception under §954(d)(1).25

Manufacturing branch rule. While BR-U is a branch
engaging in manufacturing activities, the ruling does not mention
the manufacturing branch rule. This is because that rule does not
apply under the circumstances addressed in the ruling.  Where
the manufacturing and selling activities all occur in a branch and
the income is derived in the manufacturing branch, the
manufacturing branch rule does not apply, i.e., purchasing or
selling income is not separated from the country of
manufacture. 26 For this
purpose, manufacturing activities performed by CFC-1 are not taken
into account when applying the manufacturing branch rule to
BR-U. 27

Income tested once. The PLR does not reanalyze the
income from the payments BR-U receives from CFC-2 as services
income for purposes of §954(e). Once an item of income is
classified as sales or services income for purposes of §954, it is
analyzed only once (even if it qualifies for an exception). 
Commission and fee income that is characterized as sales income
should only be analyzed under §954(d), and not under
§954(e).28

This ruling is a welcomed confirmation that commission and fee
income that is treated as sales income for purposes of §954(d) is
eligible for the manufacturing exception. A CFC does not have to
actually own or pass title to the property sold for that exception
to apply.29

This commentary also will appear in the October 2013 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 Taxation.

 


 

  1 PLR 201325005 (6/21/13).

  2 §§951-965.

  3 §954(d).

  4 §§702, 704.

  5 Regs. §§1.702-1(a)(8)(ii) and 1.952-1(g).

  6 Income is characterized for Subpart F purposes
based on the substance of the transaction. Regs.
§1.954-1(e)(1).

  7 Preamble (T.D. 9008), 67 Fed. Reg. 48020
(7/23/02); Preamble (REG-112502-00), 65 Fed. Reg. 56836, at 56837
(9/20/00).  See also Campbell v. United States, 813
F.2d 694, 696 (5th Cir. 1987); United States v. Basye, 410
U.S. 441, 448 (1973); Davis v. Commissioner, 74 T.C. 881,
895 (1980) (the language of §702(b) "has been consistently
interpreted to mean that the character of partnership income is
determined at the partnership level"); Rev. Rul. 68-79, 1968-1 C.B.
216.

  8 See Regs. §1.952-1(g)(2),
Ex.

  9 See, e.g., British Timken Ltd.
v. Commissioner.
, 12 T.C. 880 (1949) (sales commissions
analyzed as services income for purposes of applying the source
rules); Rev. Rul. 60-55, 1960-1 C.B. 270 (similar conclusion);
Hawaiian Philippine Co. v. Commissioner, 100 F.2d 988 (9th
Cir. 1939) (amounts received for manufacturing services analyzed as
services income for purposes of applying the source rules).

  10 §954(d); Regs. §1.954-3(a).

  11 See Regs. §1.954-3(a)(1)(iii),
Ex. 3 (commission income derived by a CFC for soliciting
sales orders analyzed as sales income); PLR 7947050 (commissions
received by a CFC for selling products on behalf of a related
person analyzed as sales income); TAM 8536007 (commissions received
by a CFC for arranging for the purchase of products on behalf of a
related person analyzed as sales income).

  12 The ruling treats all of the payments received
by BR-U from CFC-2 for manufacturing and selling activities as
income to be analyzed under §954(d), and no portion of the payments
received by BR-U is analyzed as services income subject to §954(e).
Cf. Regs. §1.954-1(e)(2) and (3) (rules addressing
separable character of income generated from a single transaction
and rules for determining the predominant characteristic of income
from a transaction where the income is not separately
determinable).

  13 Regs. §1.954-1(g)(1).

  14 A person is related to a CFC if it controls or
is controlled by the CFC or is controlled by the same persons that
control the CFC (control requires greater than 50% ownership).
§954(d)(3); Regs. §1.954-1(f).

  15 Regs. §1.954-3(a)(2) and (3).

  16 Regs. §1.954-1(g)(1).

  17 As discussed below, the substantial contribution
manufacturing activities are performed in Country U, also outside
the country of organization of the CFC partners.

  18 See Regs. §1.954-3(a)(4)(iv)(b)
(provides factors for determining whether a CFC makes a substantial
contribution through the activities of its employees to the
manufacture of the personal property sold). 
See Yoder, "Subpart F: `Indicia of Manufacturing,'"
38 Tax Mgmt. Int'l J. 526 (8/14/09).

  19 Regs. §1.954-3(a)(6).

  20 It is noted that CFC-2 makes the payments to
BR-U for its manufacturing and sales activities, but that it is
CFC-1 that physically manufactures the Products, i.e., the payments
do not have to be received from the entity that physically
manufactures the Products to be eligible for the substantial
contribution manufacturing exception.

  21 This view is consistent with the branch
regulations, which apply the manufacturing exception to a
manufacturing branch that may not actually take title to the
products.  See, e.g., Regs. §1.954-3(b)(4),
Exs. 2 and 6; Regs. §1.954-3(b)(1)(ii)(c)(3)(v),
Exs. 1-5; Regs. §1.954-3(b)(4), Ex. 9.

  22 The sales income earned directly by CFC-1 should
qualify for the manufacturing exception because it physically
manufactures the Products sold. In addition, the sales income
earned directly by CFC-2 should qualify for the
same-country-of-manufacture exception because the Products sold are
physically manufactured in Country T, its country of organization.
Regs. §1.954-3(a)(3).  Since the Products are sold for use in
Country T, CFC-1's and CFC-2's sales income should also qualify for
the same-country-of-use exception.  Regs. §1.954-3(a)(2).
See Yoder, "Same-Country-of-Manufacture Exception
Applied to Subpart F Sales Income," 38 Tax Mgmt. Int'l J.
240 (4/10/09); Yoder, "Subpart F Same-Country-of-Manufacture
Exception Applied to Products Manufactured in Two Countries," 41
Tax Mgmt. Int'l J. 302 (6/8/12).

  23 Regs. §1.954-3(a)(2), (3).

  24 PLR 7947050 (8/23/79).

  25 Prior Regs. §1.954-3(a)(4)(i) stated the
manufacturing exception applies to "personal property which [the
CFC] had purchased." This language was removed from the current
regulations to allow the manufacturing exception to apply to
consignment (or "toll") manufacturing arrangements (i.e., where the
CFC owns the raw materials, work-in-process, and finished products
during the manufacturing process and therefore does not purchase
the products that are sold).

  26 See Regs. §1.954-3(b)(2)(i)(c),
(ii)(c), (b)(4), Ex. 3. It is unclear whether the
manufacturing branch rule even applies to a CFC's distributive
share of partnership income, because an interest in a partnership
generally is not considered as a branch. Cf. PLR
201002024 (considers the possible application of the branch rules
to a branch of a partnership).

  27 Ashland Oil, Inc. v. Comr., 95 T.C. 348
(1990); Vetco, Inc. v. Commissioner, 95 T.C. 579
(1990).

  28 See Rev. Rul. 86-155, 1986-2 C.B.
134; TAM 8536007; PLR 7947050. Cf. Regs. §1.954-1(e)
(coordination rules for other types of income).

  29 See also PLR 201332007 (8/9/13)
(purchasing commissions qualified for the manufacturing
exception).