On December 29, 2008, the Internal Revenue Service (IRS) issued guidance in the form of final and temporary regulations (“Final Regulations”) addressing the treatment of contract manufacturing arrangements under the foreign base company sales income (FBCSI) rules of Treas. Reg. § 1.954-3. These Final Regulations were issued in response to the many comments received by the IRS to the earlier proposed regulations issued in February of 2008.

Overall, the Final Regulations provide much needed clarification in a number of areas and will apply to taxable years of controlled foreign corporations (CFCs) beginning after June 30, 2009, and for taxable years of U.S. shareholders in which or with which such taxable years of the CFCs end. As a practical matter, the Final Regulations will be effective for calendar year CFCs beginning January 1, 2010.


Generally speaking, U.S. shareholders of CFCs must include their pro-rata share of a CFC’s Subpart F income. One element of Subpart F income is a CFC’s FBCSI. Under Code section 954(d)(1), FBCSI is income derived by a CFC in connection with (1) the purchase of personal property from a related person and its sale to any person, (2) the sale of personal property to any person on behalf of a related person, (3) the purchase of personal property from any person and its sale to a related person or (4) the purchase of personal property from any person on behalf of a related person, provided that, in each of these four cases, the property is manufactured, produced, grown or extracted outside the CFC’s country of organization and is sold for use, consumption or disposition outside of that country.

There are several exceptions to FBSCI, one of which relates to personal property manufactured by the CFC. The existing regulations set forth two alternative tests to determine whether a CFC satisfies the manufacturing exception: (1) a test for determining whether the purchased property has undergone a substantial transformation by the CFC and (2) a test for determining whether the operations conducted by the CFC in connection with purchased property used by the CFC as a component of property ultimately sold by the CFC are substantial in nature. These tests are collectively referred to as the physical manufacturing tests.

The Proposed Regulations

In an attempt to modernize the rules in this area, the proposed regulations introduced a third test, the substantial contribution test, for satisfying the manufacturing exception. This test applies when a CFC is involved in the manufacturing process but does not meet the physical manufacturing test. Under the test, if a CFC makes a substantial contribution through the activities of its employees to the manufacture, production or construction of personal property, the CFC will satisfy the manufacturing exception through the substantial contribution test, even if a related or unrelated party does the physical manufacturing. Accordingly, for the manufacturing exception to apply, a CFC would either have to meet one of the physical manufacturing tests or the new substantial contribution test.

The proposed regulations set forth various employee activities which are to be analyzed in determining whether the CFC meets the substantial contribution test and the regulations made clear that the mere right, contractually or otherwise, to exercise these rights would not be sufficient. The proposed regulations also rejected the “its” defense, pursuant to which some taxpayers would take the position that FBCSI arises under Sec. 954(d)(1) only if the property sold by the CFC is the same property purchased by the CFC.

Finally, the proposed regulations attempted to clarify the application of the branch rule of Section 954(d)(2) in light of the new substantial contribution test. The branch rule generally provides that, if a CFC conducts activities through a branch outside the country where the CFC is organized, the income from those activities may be treated as derived by a wholly-owned subsidiary of the CFC. The effect of the branch rule is to create a related party transaction between the CFC and its branch (treated as a wholly-owned subsidiary) for purposes of determining whether the income from the branch’s activities is FBCSI. The existing regulations provide specific criteria for determining whether the branch should be treated as a wholly-owned subsidiary of the CFC for purposes of FBCSI. Namely, the tax imposed on the remainder of the income of the CFC must meet the manufacturing branch tax rate disparity test for the branch to be treated as a subsidiary of the CFC, with the result that the branch’s income would be FBCSI to the CFC. (A separate tax rate disparity test applies to sales or purchase branches.)

The Final Regulations

The Final Regulations provide a non-exclusive list of activities that contribute to a determination of whether a CFC meets the substantial contributions test through the activities of its employees. They include (a) oversight and direction of the manufacturing activities and process; (b) activities that are considered in, but are insufficient to satisfy, the physical manufacturing tests; (c) material selection, vendor selection or control of raw materials, work-in-process or finished goods; (d) management of manufacturing costs or capabilities; (e) control of manufacturing-related logistics; (f) quality control; and (g) developing or directing the use or development of product design and design specifications, as well as trade secrets, technology or other intellectual property for the purpose of manufacturing the product.

The factors do not focus on contract rights or ownership but, rather, on whether the employees of a CFC are actually involved in the manufacturing process, running operations and making critical decisions regarding manufacturing. However, in response to practitioner comments to the proposed regulations, the Final Regulations clarify that

  1. all CFC employee functions contributing to the manufacture of the personal property will be considered in the aggregate when determining whether a substantial contribution is made,
  2. no single activity will be accorded more weight than any other activity in every case or will be required to be performed in all cases, and
  3. no minimum threshold of activity with respect to functions performed by employees of a CFC is needed.

The IRS also clarified that (1) only activities of the CFC employees are considered in the substantial contribution analysis and, consequently, purely contractual assumptions of risk are not considered in the analysis, (2) a CFC will not be precluded from making a substantial contribution to the manufacture of the personal property simply because other persons also make a substantial contribution to the manufacture, production or construction of that property and (3) the substantial contribution test can be made in a variety of ways and in multiple locations.

The Final Regulations also define the term “employee” to refer to common law employees as defined in Treas. Reg. § 31.3121(d)-1(c). Essentially, this means that the term “employee” can be met through seconded workers, part-time workers, contractors and workers on the payroll of a related employment company. The Final Regulations also make a number of revisions to the interrelationship between the branch rules and the new substantial contribution rules. For example, the IRS eliminated the controversial rebuttable presumption rule contained in the proposed regulations pursuant to which, if a branch of a CFC satisfied the physical manufacturing test with respect to property sold by the remainder of the CFC, the remainder of the CFC would be presumed not to make a substantial contribution unless the presumption could be rebutted. Thus, satisfaction of the physical manufacturing test and satisfaction of the substantial contribution test will be treated equally. However, in “unrelated to unrelated” transactions, the IRS acknowledged that a CFC may be subject to the FBCSI rules as a result of its employees performing indicia of manufacturing activities through a branch (even if the FBCSI rules would not otherwise be met). The IRS also made several other changes with respect to the branch rules including rules relating to multiple manufacturing branches, multiple sales branches and the various rate disparity tests.

Finally, the Final Regulations confirm the absolute rejection of the “its” defense. Thus, for purposes of determining FBCSI, personal property sold by a CFC will be considered to be the property purchased by the CFC, regardless of whether it is sold in the same or different form in which it was purchased or as a component part of a manufactured product, except to the extent that either of the physical manufacturing tests or the new substantial contribution test is met.


The Final Regulations, as a general proposition, represent a welcome set of taxpayer-friendly rules in the context of prevailing commercial contract manufacturing arrangements and can be appropriately planned for. Nonetheless, compliance with these new rules, especially in terms of their application in a branch setting, may require corporations to restructure their operation