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By Lowell D. Yoder, Esq.
McDermott Will & Emery LLP, Chicago, IL
The IRS recently issued a ruling1 concluding that, under
certain circumstances, the "Subpart F"2 manufacturing
exception can apply to products that are grown (e.g., crops). The
IRS further ruled that growing activities that also are production
activities are taken into account for purposes of determining
whether products sold are manufactured or produced by a controlled
foreign corporation (CFC).
Under the facts of the ruling, a U.S. corporation (USP)
indirectly wholly owns a CFC formed under the laws of Country X.
CFC wholly owns another Country X entity, which is disregarded
(DE1). DE1 wholly owns a third Country X entity which is
disregarded (DE2), collectively the "CFC Group" or the "CFC."
CFC Group produces final stage products (the Final Stage
Products) in four phases. During the initial phase, CFC makes
decisions as to the types of product traits that are needed to meet
demand and provide market opportunities. CFC enters into cost-plus
arrangements with related and unrelated persons for research and
development, as a result of which intellectual property is
developed for the risk and account of CFC, and ultimately the Stage
A products are developed.
During the second phase, the Stage A Products are planted, and
the Stage B Products are harvested from the resulting crop grown
from the Stage A Products. During the third phase, the Stage B
Products are planted, and the Stage C Products are harvested from
the resulting crop grown from the Stage B Products.
CFC Group directly produces some of the Stage B and Stage C
Products in Country X or in jurisdictions outside of Country X. CFC
Group also contracts with related persons or unrelated persons
pursuant to contract manufacturing or toll manufacturing
arrangements to produce the Stage B and Stage C Products in
jurisdictions outside of Country X. If a contract manufacturing
arrangement is used, CFC Group may transfer title of the Stage A or
Stage B Products to the contracting party in exchange for a nominal
amount. Thus, during the growing and harvesting processes, legal
title to the Stage B or Stage C Products is held either by CFC
Group or by the contracting party. In cases where title is
transferred to the contracting party, title to the Stage B or Stage
C Products is subsequently transferred for a nominal amount to CFC
Group, and the contracting party is remunerated by CFC Group
through a fee.
During the fourth phase, the Stage C Products are organized at
processing facilities for final cleaning, quality assessment, and
packaging based on relevant marketing requirements. CFC Group
either performs these activities directly, or contracts with a
related person to perform these activities in a jurisdiction
outside of Country X in exchange for a fee. At the conclusion of
the fourth phase, the Stage C Products are in their final form. CFC
Group sells the Final Stage Products to related persons and
unrelated persons for use in jurisdictions inside and outside of
"Subpart F income" generally includes income derived by a CFC
from selling to any person products purchased from related persons,
or selling products to related persons that were purchased from any
person, i.e., foreign base company sales income (FBCSI).3 Nevertheless, income
derived by a CFC from the sale of products that it manufactures or
produces is excluded from the definition of FBCSI, subject to the
More specifically, FBCSI generally does not include income of a
CFC derived in connection with personal property "manufactured,
produced, or constructed by such corporation." A CFC will have
manufactured or produced such property if it meets either a
physical manufacturing or production test, or the CFC substantially
contributes to the physical manufacture or production of the
property. Only the activities of the CFC's employees are taken into
account for this purpose.4
The regulations provide that property is considered as
physically manufactured if:
Minor assembly and packaging do not qualify as manufacturing.5 The Tax Court,
however, has broadly interpreted this definition of manufacturing
(e.g., assembly of sunglasses qualified as manufacturing).6
The regulations further provide that property physically
"manufactured, produced or constructed" taking into account
activities of a contract manufacturer on behalf of a CFC will be
considered as manufactured by the CFC if the facts and
circumstances evince that the CFC makes a substantial contribution
through the activities of its employees to the manufacture or
production of the personal property sold. The regulations list a
number of factors that are taken into account for this purpose,
including quality control, oversight and direction, vendor
selection, physical manufacturing activities, demand planning,
management of manufacturing costs and capacities, and control of
manufacturing-related logistics. 7
The IRS ruling states that certain income the CFC derives from
selling Final Stage Products meets the definition of FBCSI "because
the income is derived in connection with the purchase of personal
property from a related person, or a sale of personal property to a
related person." Nevertheless, income derived from the sale of
Final Stage Products would not be FBCSI to the extent the
manufacturing exception applies (subject to the branch rule).8
The manufacturing exception would apply if the activities of the
employees of CFC and its disregarded entities satisfy the physical
manufacturing definition with respect to Final Stage Products that
are sold. In addition, the manufacturing exception would apply if
the physical manufacturing definition is satisfied taking into
account the activities of the contract manufacturers hired by CFC
Group and CFC Group substantially contributes to the manufacture or
production of the Final Stage Products.
The ruling addressed whether the manufacturing exception is
available for products that are grown and, if so, how to determine
whether such products are considered as physically "manufactured or
produced" by CFC Group or the contract manufacturers.
The issues particularly require analysis because other FBCSI
rules expressly refer to products that are grown, while no such
reference is contained in the rules providing the manufacturing
exception. For example, FBCSI does not include income from the sale
of property that "is manufactured, produced, constructed,
grown or extracted" in the CFC's country of
In addition, the manufacturing branch rule refers to products
that are grown. That rule can apply with respect to "personal
property manufactured, produced, constructed,
grown or extracted by or through a foreign
branch."10 Thus, a CFC
that grows products in a foreign branch can have a "manufacturing
The ruling first notes that the regulations do not specifically
address whether income derived from the sale of products grown by a
CFC is excluded from FBCSI pursuant to the manufacturing exception.
Nevertheless, the ruling states that property that is grown may
also be considered as manufactured or produced and thus income from
the sale of such property can qualify for the manufacturing
The ruling points out, however, that the terms "produced" and
"grown" are not interchangeable. The mere fact that property is
"grown" does not mean that it will be considered as "produced" for
purpose of the manufacturing exception.
The ruling further states that the terms "grow" and "produce"
are not mutually exclusive. The use of the term "grow" to describe
a process or part of a process is not determinative of whether the
process constitutes a production activity. Rather, growing
activities that also are producing activities are taken into
account for purposes of applying the manufacturing exception.
In sum, for products that are grown, in applying the
manufacturing exception the determination is whether the products
are also considered as manufactured or produced within the meaning
of the manufacturing exception. This is a facts and circumstances
test. If a particular activity is a producing activity, it is taken
into account, even if such activity may also be considered as a
The ruling specifically states that activities-of CFC Group and
contract manufacturers-related to the physical growing of the Stage
B and Stage C Products that constitute production activities are
taken into account in determining whether CFC produced the Final
Stage Products for purposes of the manufacturing exception.
Thus, taking into account such activities performed by the CFC
itself may cause the CFC to satisfy the physical manufacturing or
producing definition. In addition, taking into account such
activities performed by the contract manufacturers may cause the
Final Stage Products to be considered as physically manufactured or
produced for purposes of qualifying for the substantial
contribution definition of manufacturing.
The taxpayer represented that CFC Group's activities with
respect to the Final Stage Products constituted production if
activities that are both growing and production activities are
taken into account in determining whether a CFC has "produced"
property for purposes of the manufacturing exception.
Based on the information submitted and the representations made,
the ruling concluded that income derived by CFC Group from the sale
of Final Stage Products produced by CFC Group that otherwise is
FBCSI is excluded from FBCSI pursuant to the manufacturing and
The ruling did not address the types of growing activities that
also are considered as producing activities. It would seem that
production activities in this context should be broadly defined.
This would be consistent with the same-country-of-manufacturing
exception as well as the manufacturing branch rule, which both
treat growing itself as equivalent to manufacturing or
inclusive definition of "production activities" would also be
consistent with case law, which has broadly defined physical
manufacturing and production for purposes of the Subpart F
manufacturing exception.13 Thus, it
would seem appropriate that where a CFC engages in substantial
activities (directly or through contract manufacturers) related to
growing and preparing products for sale, that the CFC should be
considered as producing the property sold.14
The ruling appears to analyze the application of the
manufacturing exception to the sale of the Final Stage Products by
aggregating activities undertaken at all four phases. Thus, all
production activities performed by CFC Group and by all contract
manufacturers, and all substantial contribution activities
performed by CFC Group during all four phases of producing the
Final Stage Products, should be taken into account for purposes of
determining whether the Final Stage Products were manufactured or
produced. This is the case whether or not different stage products
are sold and repurchased from contract manufacturers for nominal
amounts, and whether the products undergo transformation during a
particular phase of production. All phases are considered as the
process of producing the Final Stage Products for purposes of the
In sum, income from the sale of products that are grown can
qualify for the manufacturing exception. For purposes of satisfying
the physical manufacturing and producing definition, all production
activities are taken into account, even if such activities might
also be considered as growing activities.
This commentary also will appear in the February 2014 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.
6 Bausch & Lomb, Inc. v. Commissioner,
71 T.C.M. 2031 (1996); see also Dave Fischbein Mfg. Co. v.
Commissioner, 59 T.C. 338 (1972) (assembly of bag-closing
machine in six-hour, 58-step process met definition of
11 See also Regs. §1.954-3(a)(1)(ii)
(special rule for agricultural commodities). Other rules of the
Code that have provided an export or domestic manufacturing
incentive referring to manufacturing and production also have
included a reference to products that are grown. See
§993(c) (Domestic International Sales Corporation (DISC) rules);
§927(a)(1)(C) (Foreign Sales Corporation rules); §941(a)(1)(A)
(Extraterritorial Income rules); §199(c)(4)(A) (deduction for
domestic production activities).
12 Indeed, it would seem odd if a CFC is considered
as having a manufacturing branch based on growing products in a
branch, but then for that branch not to qualify for the
manufacturing exception with respect to its own income from the
sale of the products.
13 See Yoder, "Subpart F: LMSB Provides
Guidance Concerning the Definition of Manufacturing," 35 Tax
Mgmt. Int'l J. 360 (7/14/06); Yoder, "The Subpart F Physical
Manufacturing Exception," 34 Int'l Tax J. 3 (Nov.-Dec.
2008); Yoder, "Bausch & Lomb: The `Manufacturing' Exception to
Foreign Base Company Sales Income," 25 Tax Mgmt. Int'l
J. 427 (4/29/96).
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