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By Lowell D. Yoder, Esq.
McDermott Will & Emery LLP, Chicago, IL
Income derived by a controlled foreign corporation (CFC) from the sale of products manufactured in the CFC's country of organization is not Subpart F foreign base company sales income (FBCSI).1 The exception applies regardless of whether the CFC purchases the products from, or sells the products to, a related person. In addition, this exception does not require the CFC itself to manufacture the property.
The FBCSI regulations generally define manufacturing as the transformation, conversion, or assembly of purchased property ("physical manufacturing"), and the Tax Court has broadly interpreted this definition (e.g., assembly of sunglasses).2 In addition, if a CFC hires a contract manufacturer to physically manufacture property on its behalf, the CFC is considered as manufacturing the property if its employees perform functions that substantially contribute to the physical manufacture of the property, even if such functions do not in and of themselves entail physical manufacturing (e.g., oversight and direction, demand forecasting, material and vendor selection, and quality control).3
The same-country-of-manufacture exception applies to products physically manufactured in a CFC's country of organization by either a related or unrelated person. This exception also applies when a related person satisfies the substantial contribution definition of manufacturing in the CFC's country of organization.4
For example, CFC1 imports into Country X rough diamonds mined in Country Y. In Country X CFC1 cuts, polishes, and shapes the diamonds in a process that constitutes manufacturing. CFC1 sells the finished diamonds to CFC2, a related person also organized in Country X. CFC2 sells the diamonds for use in Country Z. CFC2's sales income is not FBCSI because the finished diamonds are manufactured in Country X.5
A recent private letter ruling addressed the application of the same-country-of-manufacture exception to income derived by a CFC from the sale of products purchased from an unrelated person that physically manufactured the products.6 Separate stages of manufacture took place in different countries and were performed by different corporations that were members of the unrelated manufacturer's group. The CFC was organized under the laws of the country in which an earlier stage of manufacturing took place, but was not organized in the country in which the products were finished.
Under the facts of the ruling, the CFC was organized under the laws of Country 1 (assume Germany) (CFC-G). It purchased products (the "Products") from Corporation Y (a German corporation) and its affiliates which were organized under the laws of other countries (assume Ireland). Corporation Y and its affiliates were not related to CFC-G. CFC-G sold the Products to related distributors for ultimate sale to unrelated customers.
The Products were physically manufactured by Corporation Y and its Irish affiliates from raw materials (which included components purchased from other parties). Several components were manufactured exclusively in Germany by Corporation Y, and then shipped to Ireland. Affiliates of Corporation Y manufactured additional components in Ireland. The components manufactured in both Germany and Ireland were then assembled into finished Products by the affiliates in Ireland.
It was represented that the activities performed in Germany by Corporation Y were substantial in nature and constituted the physical manufacture of property. The activities performed by Corporation Y's affiliates in Ireland were also substantial and might constitute the physical manufacture of the finished Products.7 The ruling held that the full amount of CFC-G's income from the sale of the Products was not FBCSI because it qualified for the same-country-of-manufacture exception.8
The ruling provides important guidance. First, a product initially manufactured in one country and then further manufactured in a second country can be treated as manufactured in the first country for purposes of the same-country-of-manufacture exception. Second, the exception can apply when a CFC purchases property from the company that further manufactures the products outside of the CFC's country of organization. The ruling does not elaborate on the rationale for its holding and perhaps no rationale was needed other than the absence of a rule providing to the contrary (such as those applicable for DISC and FSC purposes).9 The facts of the ruling nevertheless provide insights concerning the circumstances underlying the conclusion reached by the IRS.
The facts described show that the IRS needed to be satisfied that a certain quantity and quality of manufacturing activity occurred in the CFC's country of organization, but redactions give us only a partial window into this aspect of the Service's analysis. At a minimum, the activities occurring in a CFC's country must satisfy the definition of physical manufacturing. In addition, the ruling indicates that it is important that the physical manufacturing activities performed by Corporation Y in Germany be substantial with respect to the manufacture of the finished Products as a whole. The ruling states that a certain percentage of the components as a whole and of the critical components (from both a value and cost perspective) are manufactured in Germany. The manufacturing activities are performed by a significant number of employees of Corporation Y in factories located in Germany.
There is no indication, however, that the activities performed in the CFC's country of organization must be greater than the manufacturing activities that are performed in other countries.10 The activities of the Corporation Y affiliates in Ireland included the manufacture of components and the finishing of the Products in manufacturing plants, and might have been substantial enough to alone be considered as the physical manufacture of the Products. In addition, the Products finished at these plants were designated "Made in Ireland."
The facts of the ruling also indicate that it is not necessary that the finished product be purchased from the corporation that conducted the first stage of physical manufacture of the product in the CFC's country of organization. Under the facts, Corporation Y manufactured the Products in CFC-G's country of incorporation (Germany), and CFC-G purchased the Products from an Irish affiliate of Corporation Y, which had further manufactured the Products in a different country (Ireland). The facts do suggest that the taxpayer's group contracted with Corporation Y as well as its affiliates for the manufacture of the Products.
The ruling appropriately recognizes the economic realities of the current global business environment. The manufacturing process for many products is conducted in stages that occur in more than one country. The ruling accommodates this common business practice, by concluding that where activities in one country qualify as manufacturing activities with respect to a product, and are substantial, the same-country-of-manufacture exception can apply to a CFC organized in such country, even if the product is further manufactured and finished in another country.11
This commentary also will appear in the June 2012 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 §954(d)(1)(A); Regs. §1.954-3(a)(2).
2 Regs. §1.954-3(a)(4)(ii), (iii); Bausch & Lomb, Inc. v. Comr., 71 T.C.M. 2031 (1996); Dave Fischbein Manufacturing Co. v. Comr., 59 T.C. 338 (1972).
3 Regs. §1.954-3(a)(4)(iv). See Yoder, "Subpart F: `Indicia of Manufacturing,' " 38 Tax Mgmt. Int'l J. 526 (8/14/09).
4 See Yoder, "Same-Country-of-Manufacture Exception Applied to Subpart F Sales Income," 38 Tax Mgmt. Int'l J. 240 (4/10/09).
5 Regs. §1.954-3(a)(2), Ex. 2. See also PLR 7947050 (sales commission income earned by a CFC with respect to the sale of products on behalf of a related person was not FBCSI because the property was manufactured in the CFC's country of organization).
6 PLR 201206003.
7 Different stages of the manufacture of a product may each qualify as manufacturing a product within the Subpart F definition of manufacturing. See Yoder, "Subpart F: LMSB Provides Guidance Concerning the Definition of Manufacturing," 35 Tax Mgmt. Int'l J. 360 (7/14/06). This point is also recognized in the recently finalized manufacturing branch regulations which provide rules addressing situations where activities with respect to a single product qualify as manufacturing in more than one country. See Regs. §1.954-3(b)(1)(ii)(c)(3)(ii), (v), Ex. 2.
8 The ruling does not address whether CFC-G might also qualify for the manufacturing exception under the substantial contribution definition of manufacturing. Regs. §1.954-3(a)(4)(iv).
9 Regs. §1.993-3(c)(1) (DISC), Regs. §1.927(a)-1T(c)(1) (FSC).
10 Cf. Regs. §1.954-3(b)(1)(ii)(c)(3)(iii) (for purposes of the manufacturing branch rule, where no location alone satisfies the definition of manufacturing, the manufacturing location is the country in which a "greater" contribution to manufacturing is made).
11 If the activities in the second country performed by the Corporation Y affiliates qualify as physical manufacturing, a CFC organized under the laws of the second country also should qualify for the same-country-of-manufacture exception.
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