International Tax Alert
On February 27, 2008, the Treasury Department and the IRS issued long promised subpart F contract manufacturing guidance in the form of proposed regulations. While the proposed regulations offer a few surprises, they generally follow the blueprint broadcast by the Treasury Department and the IRS over the last year. The proposed regulations provide that a controlled foreign corporation (“CFC”) may qualify for the manufacturing exception to foreign base company sales income (“FBCSI”) if its activities satisfy a new “substantial contribution” test. The proposed regulations also provide that personal property sold by a CFC will be considered to be the property purchased by the CFC regardless of any changes made to the property, thereby rejecting the so-called “its” defense. These changes, as well as the addition of rules to clarify the application of the manufacturing branch test in situations involving multiple manufacturing branches, are discussed in greater detail below.
FBCSI, a category of subpart F income, generally includes income of a CFC from the sale of personal property in cases where the property was either purchased from or on behalf of, or sold to or on behalf of, a related person. Income from sales of property for use in the CFC’s country of incorporation is excepted from FBCSI. Longstanding regulations have provided a “manufacturing” exception from FBCSI where the CFC manufactured the property sold under one of two alternative tests: (1) the property was substantially transformed, or (2) the property was converted or assembled through activities that were substantial in nature and generally considered manufacturing. This manufacturing exception was based both on the legislative history to the subpart F rules, and a reasonable construction of the statute itself, which provides that FBCSI could arise only if the CFC sold personal property that it had purchased (rather than property that had been transformed).
The statute also provides a manufacturing branch rule that applies where the CFC is engaged in manufacturing activities in one country and sales activities in another country. In general, this provision requires the CFC’s sales branch to be treated as a wholly owned subsidiary in certain circumstances, with the result that the sales component of the CFC’s income must be tested separately from the manufacturing component to determine if it constitutes FBCSI.
The IRS in Rev. Rul. 75-7, 1975-1 C.B. 244, articulated the circumstances under which the activities of a contract manufacturer may be attributed to a CFC that acts as the principal in the contract manufacturing arrangement, thereby allowing the CFC to qualify for the manufacturing exception notwithstanding the fact that the physical manufacturing was conducted by a service provider. Rev. Rul. 75-7 listed a number of factors that appeared to be drawn from authority in similar circumstances, including investment tax credit and manufacturing excise tax case law. Rev. Rul. 75-7 also provided, however, that the service provider will be considered a manufacturing branch of the CFC, thereby limiting the positive consequences of attribution. The Tax Court overturned this aspect of the ruling, holding that neither a related nor unrelated contract manufacturer constituted a manufacturing branch of the CFC principal. See Ashland Oil Co. v. Comm’r, 95 T.C. 348 (1990), and Vetco, Inc. v. Comm’r, 95 T.C. 579 (1990).
The IRS then changed course in Rev. Rul. 97-48, 1997-2 C.B. 89, which withdrew Rev. Rul. 75-7 and provided that a contract manufacturer’s activities could not be attributed to a CFC principal for purposes of the manufacturing exception. Many taxpayers took positions contrary to the intended effect of the ruling, arguing that the CFC principal in a contract manufacturing arrangement did not earn FBCSI because: (1) the activities of the contract manufacturer were attributable to the CFC principal under general tax law; (2) the CFC principal’s own activities, including its direction of the manufacturing process and the fact that it bore risk of loss with respect to the process, constituted manufacturing; or (3) the manufacturing issue was irrelevant given that the personal property sold by the CFC was different than the personal property purchased by the CFC. Taxpayers had considerable success sustaining these positions, and the IRS and Treasury Department were left with a published position that did not reflect the practice in the area.
Contract Manufacturing and Substantial Contribution Test
The proposed regulations carry over the existing exceptions that apply if a CFC substantially transforms raw materials into finished goods, or converts components into products through activities that are substantial in nature and are generally considered to constitute manufacturing. The proposed regulations provide explicitly, however, that these exceptions apply only if the physical manufacturing is performed by the CFC’s own employees. This position is consistent with Rev. Rul. 97-48.
The preamble to the proposed regulations notes that Rev. Rul. 97-48 did not address the circumstances in which the “non-physical activities” of a CFC principal in a contract manufacturing arrangement may qualify as manufacturing. The proposed regulations include a new “substantial contribution” test that articulates the position of the Treasury Department and the IRS on this issue.
As a threshold matter, for the substantial contribution test to apply, the activities of the CFC and a contract manufacturer must, in the aggregate, constitute physical manufacturing under Treas. Reg. § 1.954-3(a)(4)(ii) or (iii). Once this threshold determination is made, the contract manufacturer’s activities are not relevant for purposes of determining whether the CFC itself satisfies the substantial contribution test. To qualify under the substantial contribution test, the CFC through its own employees must substantially contribute to the manufacturing process. The substantial contribution test is a facts and circumstances test that considers whether a CFC makes a substantial contribution through the activities of its employees to the manufacture, construction, or production of personal property. Activities that will be considered in determining whether the CFC makes a substantial contribution include, but are not limited to, the following: (1) oversight and direction of the manufacturing activities or process (including management of the risk of loss); (2) performance of physical manufacturing activities; (3) control of the raw materials, work-in-process, and finished goods; (4) management of the manufacturing profits; (5) material selection; (6) vendor selection; (7) control of logistics; (8) quality control; and (9) direction of the development, protection, and use of trade secrets, technology, product design and design specifications, and other intellectual property used in manufacturing the product. These are similar to the factors set out in Rev. Rul. 75-7. The examples make clear that mere ownership and control of the raw materials, work in process, and finished goods, coupled with ownership of the manufacturing intangibles and the contractual right to direct or supervise the manufacturing process, is not enough to meet the test. Significant activities by the CFC’s employees appear to be required.
The proposed regulations contain a rebuttable presumption that provides that if a branch of a CFC satisfies one of the physical manufacturing tests with respect to personal property sold by the remainder of the CFC, the remainder of the CFC is presumed not to make a substantial contribution to the manufacture of the property. The preamble to the proposed regulations states that the rule is intended to alleviate difficulties of administration, and notes that taxpayers may rebut the presumption or avoid the rule altogether by incorporating the branch.
Further, the proposed regulations modify the definition of manufacturing for purposes of the same country manufacturing exception set forth in Treas. Reg. § 1.954-3(a)(2), to exclude manufacturing activities as defined under the substantial contribution test. Therefore, the same country manufacturing exception will apply only if physical manufacturing, production, or construction activities with respect to the relevant personal property are performed in the CFC’s country of organization.
“Its” Defense Rejected
The proposed regulations acknowledge the position taken by some taxpayers that, because the statute applies to “the purchase of personal property … and its sale,” the property sold must be the same as the property purchased to fall within the scope of the FBCSI rules. See I.R.C. § 954(d)(1) (emphasis added). Under this interpretation, income from the sale of property purchased by the CFC is not FBCSI if the property is transformed into, or becomes part of, a different kind of property before it is sold. The proposed regulations reject the “its” defense by providing explicitly that personal property sold by a CFC will be considered to be the same property purchased by the CFC, regardless of whether the personal property is sold “in the same form in which it was purchased, in a different form than the form in which it was purchased, or as a component part of a manufactured process,” except as provided in the same country manufacturing exception of Treas. Reg. § 1.954-(3)(a)(2) or the manufacturing exception of Treas. Reg. § 1.954-(3)(a)(4).
Application of Branch Rules to Multiple Manufacturing Branches
The proposed regulations clarify the application of the branch rules where a CFC has multiple manufacturing branches. First, where multiple branches perform manufacturing activities with respect to separate items of personal property that are then sold by the CFC, the manufacturing branch tax rate disparity test will be applied separately to each branch. Second, where multiple branches, or one or more branches and the remainder of the CFC, perform manufacturing activities with respect to the same item of personal property that is then sold by the CFC, the proposed regulations provide a series of rules that identify which of the manufacturing branches (or the remainder of the CFC) the manufacturing branch tax rate disparity test will be applied to in order to determine if the CFC has FBCSI. In general, a branch whose activities would satisfy the physical manufacturing tests, if any, is given precedence over other branches. However, the regulations contain numerous ordering rules for various situations.
Proposed Effective Date and Request for Comments
The new rules are proposed to be effective for CFC tax years beginning on or after the date the regulations are finalized. Until then, taxpayers may choose to apply the proposed regulations in their entirety to all open tax years as if they were final.
The Treasury Department and the IRS have asked for comments on several specific aspects of the proposed regulations, including (1) comments on the activities listed as factors to be considered in applying the substantial contribution test; (2) comments on whether the rebuttable presumption rule is more appropriate than a rule that would deny a CFC’s use of the substantial contribution test where a branch of the CFC is engaged in physical manufacturing; and (3) comments on the consequences of and potential alternatives to certain aspects of the rules for applying the manufacturing branch tax rate disparity test where there are multiple manufacturing branches. The Treasury Department and the IRS will consider written comments submitted before the regulations are adopted as final. No public hearing has been scheduled with regards to the proposed regulations at this time.
As noted at the outset, the proposed regulations generally follow the blueprint broadcast by the Treasury Department and the IRS over the last year, by providing that a CFC principal in a contract manufacturing arrangement may satisfy the manufacturing exception through its own activities if such activities are substantial under an analysis of factors similar to those articulated in Rev. Rul. 75-7. This generally is consistent with the practice that has developed in this area since the issuance of Rev. Rul. 97-48. The effect of the regulatory guidance in specific cases, however, may be different than the practice that has developed absent regulatory guidance. Taxpayers are encouraged to review the regulatory criteria to ensure that they are appropriate given specific company or industry concerns.
The proposed regulations also put a thumb on the scale against taxpayers in intra-CFC contract manufacturing arrangements, establishing a presumption against the finding that the remainder of the CFC satisfies the substantial contribution test where a branch undertakes the physical manufacturing. Although this presumption is defended on administrative grounds, it may be evidence of some discomfort with check-the-box structures in this area, and it is inconsistent with the general proposition that the branch rule should not create FBCSI where there would be no such income if the relevant branches were separate CFCs. This presumption is likely to attract considerable attention and debate.
Finally, it is worthwhile noting the issues that the proposed regulations do not address. There is no effort, for example, to define what constitutes a manufacturing branch. In particular, the proposed regulations make no effort to deviate from -- and, in fact, explicitly support -- the courts’ holdings in the Ashland Oil and Vetco cases. Thus, the manufacturing activities of a separately incorporated entity are not subject to the manufacturing branch tax rate disparity test of the branch rules. Even with respect to the main rule, the guidance is quite general and may not adequately address specific company or industry concerns.
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