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By Lowell D. Yoder, Esq.
McDermott Will & Emery LLP, Chicago, IL
The IRS has ruled that income from payments received for
procurement services qualifies for the Subpart F manufacturing
exception.1 The exception
applied even though the controlled foreign corporation (CFC) did
not own or pass title to the products.
The taxpayer is a U.S. corporation (USP) that directly and
indirectly owns a number of subsidiaries (domestic and foreign)
that carry out manufacturing, sales, and services operations around
the world. USP and certain of its foreign subsidiaries purchase
products (Products) from unrelated foreign manufacturers
(Vendors). The Products are manufactured outside the United
States and sold to customers both inside and outside the United
USP indirectly owns a foreign subsidiary organized in Country X
(CFC-X) that is classified as a corporation for U.S. tax purposes.
CFC-X wholly owns another Country X entity that is disregarded for
U.S. tax purposes (FDE-X).
USP and its foreign affiliates entered into a buying arrangement
with FDE-X under which FDE-X performs various procurement-related
activities. FDE-X is responsible for ensuring that the Products
purchased by USP and its foreign affiliates from Vendors meet USP's
standards of design, image, quality, vendor compliance, and brand.
USP and its foreign affiliates pay FDE-X a commission for its
procurement services based on a percentage of the price of ordered
merchandise received by the buyer. FDE-X has "Q" employees in
Country X that perform these procurement-related
CFC-X is a CFC subject to the rules of "Subpart F" (§§951-965).
USP must include in its income currently any income realized by
CFC-X that falls within the definition of foreign base company
For purposes of applying the FBCI rules, the character of the
income must be determined. As relevant to the ruling, the
procurement commissions must be classified as either sales income
or services income. Section 954(d) applies if the income is
classified as sales income, and §954(e) applies if the income is
classified as services income. Whether an item of income is FBCI
can differ depending on which paragraph applies.
Under general rules, the commissions received by FDE-X for
procurement services would be classified as services income.3 FDE-X does not
derive its income from purchasing and reselling products.
Nevertheless, Subpart F has a special characterization rule. In
relevant part, §954(d) applies to income derived in connection with
the purchase of personal property on behalf of a related person
"whether in the form of profits, commissions, fees or otherwise."4 Thus, under certain
circumstances, fees received for procurement-related services can
be treated as sales income for purposes of applying the FBCI
Without discussion, the ruling treats the commissions received
by FDE-X from USP and the other affiliates as sales income.
Thus, the ruling addresses the application of §954(d) to FDE-X's
commission income. 6
Under §954(d)(1), a CFC's sales income in the form of
commissions may be foreign base company sales income (FBCSI) if the
commissions are derived, in relevant part, from the purchase of
personal property on behalf of a related person. Since FDE-X
receives commissions for procurement services provided to related
persons, such income generally would be FBCSI.
Under §954(d), the sales income is not FBCSI if the Products are
either manufactured in CFC-X's country of organization or sold for
use in such country.7 The ruling does
not address the application of the same-country exceptions.8
In addition, income generally classified as FBCSI will not be
FBCSI if another 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 regulation goes on to state 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 goes on to state, "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."9 (Emphasis
It is represented that Vendors physically manufacture the
Products within the meaning of Regs. §1.954-3(a)(4)(ii) and (iii).
It is further represented that FDE-X makes a substantial
contribution through its employees to the manufacture of the
the commissions earned by FDE-X should qualify for the
Nevertheless, there is language in the regulations that might
raise a technical issue concerning whether procurement commissions
derived by FDE-X are eligible for the manufacturing
exception. The regulations providing the manufacturing
exception refer to the CFC as "selling" the manufactured property
(see italicized words in above quotes). The question
arises as to whether FDE-X must take title to the Products to
qualify for the exception.
The ruling addresses this point. It states that the exceptions
to FBCSI for property manufactured by the CFC are construed to
apply consistently with the statutory definition of FBCSI.
Accordingly, the manufacturing exception is interpreted to include
the performance of purchasing activities on behalf of a related
person. Thus, the ruling states that those regulations apply to any
case in which the CFC makes a substantial contribution to the
manufacture of property and the CFC derives income from purchasing
activities in connection with the property that would otherwise be
Based on the above facts, the ruling states that the commissions
received by FDE-X for the performance of procurement activities in
connection with the Products are excluded from FBCSI by application
of the manufacturing exception.12
This conclusion is entirely appropriate. 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. Treating the commissions as
sales income 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).13
While FDE-X is a branch engaging in manufacturing activities,
the ruling does not mention the manufacturing branch rule.14 This is
because FDE-X is a branch located in Country X, the same country in
which the home office is located; thus, there is no foreign
This ruling is a welcomed confirmation that procurement
commissions that are treated as sales income for purposes of
§954(d) are 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. 15
This commentary also will appear in the December 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.
3 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).
5 See TAM 8536007 (commissions
received by a CFC for arranging for the purchase of products on
behalf of a related person analyzed as sales income). See
also 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).
6 The ruling treats all of the payments received by
FDE-X for procurement activities as income to be analyzed under
§954(d), and no portion of the payments received by FDE-X is
analyzed as services income subject to §954(e).
Cf. Regs. §1.954-1(e)(2) and (3).
8 As discussed below, the substantial contribution
manufacturing activities are performed in Country X, and thus the
same-country-of-manufacturing exception might be available (as well
as the manufacturing exception).
9 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).
10 It is noted that the payments for manufacturing
activities do not have to be received from the party physically
manufacturing the products (i.e., the Vendors) to be eligible for
the substantial contribution manufacturing exception.
11 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.
1-5; Regs. §1.954-3(b)(4), Ex. 9.
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