On February 27, 2008, the Treasury Department (Treasury) and the Internal Revenue Service (the Service) released proposed regulations that provide comprehensive guidance on the treatment of contract manufacturing arrangements under the foreign base company sales income (FBCSI) rules of subpart F. The proposed regulations represent an effort on the government’s part to resolve a number of longstanding and controversial issues raised under subpart F by modern global business models employed by U.S.-based multinational companies that sell products abroad.1
In the proposed regulations, the government for the first time provides a detailed framework for ensuring that the income of a controlled foreign corporation (CFC) operating as the principal in a contract manufacturing arrangement is not subjected to immediate U.S. taxation under either the general FBCSI rule of § 954(d)(1) or the branch rule of § 954(d)(2), provided that the CFC engages in a sufficient level of particular kinds of activities through its own employees. These activities include oversight and direction of the physical manufacturing activities; quality control; management of risk; direction of the development, protection and use of intellectual property; and other activities that do not in and of themselves entail the direct physical transformation or conversion of raw materials into finished products. At the same time, the proposed regulations reject the position widely taken by taxpayers under the statute and current regulations that an analysis of such activities on the part of a CFC principal is irrelevant where the CFC consigns property to a manufacturer and then sells a finished product that is substantially different from the property that it purchased (often referred to as the “its” position). The proposed regulations thus place a premium on the existence of substantial activity in the CFC principal, confirming that deferral of U.S. taxation results where sufficient substance can be established, and denying deferral where it cannot be established.
Perhaps the most detailed and complex provisions of the proposed regulations address issues raised in applying the FBCSI branch rules in light of the changes to the general rule accommodating substantial non-physical activities—i.e., activities that can satisfy the manufacturing exception other than those under the existing regulations—that are performed by the CFC principal. The proposed regulations effectively define these activities as a type of manufacturing, which could lead to a broader application of the manufacturing branch rule and to the creation of multiple manufacturing branches. The proposed regulations provide rules that mitigate the possibility of an adverse result in this regard in many, but not all, cases.
The proposed regulations generally will be effective prospectively from the date on which they are issued as final regulations, but taxpayers may elect to apply the proposed regulations in their entirety immediately, including retroactively to all open taxable years. Taxpayers also are invited to provide comments on the proposed regulations over the next three months.
The proposed regulations present a range of new opportunities and risks for taxpayers operating under modern global business models. The vast majority of U.S.-based multinational companies that sell products abroad will find it necessary or advantageous to revisit their structures in light of this new guidance, in order to seize these opportunities and reduce these risks. In addition, the proposed regulations leave a number of important issues open to interpretation, and thus many companies will find it desirable to submit comments seeking clarification of these issues.
General FBCSI Rule: Eligibility for Manufacturing Exception on Basis of “Substantial Contributions” to Manufacturing
FBCSI generally includes income of a CFC derived in connection with the purchase and sale of property that is both manufactured and sold for use outside the CFC’s country of organization, where a related party is involved on the purchase or sale side of the arrangement. Under the regulations, a CFC does not have FBCSI under the general rule if it is considered as having manufactured the property that it sells (the manufacturing exception). Taxpayers have taken the view that the manufacturing activities of a contract manufacturer can be attributed to a CFC principal in a typical contract manufacturing arrangement for purposes of the manufacturing exception. The Service itself adopted this position for many years under Rev. Rul. 75-7, but then reversed itself in Rev. Rul. 97-48, asserting that the activities of a contract manufacturer may not be attributed to a CFC principal. Taxpayers have continued to rely on attribution, however, based on a widespread view that Rev. Rul. 97-48 is an incorrect application of the relevant statute, regulations and case law.
The proposed regulations do not directly reverse the Service’s “no attribution” position under Rev. Rul. 97-48, but they accomplish a result similar to attribution by expanding the definition of manufacturing contained in the current regulations. The current regulations generally define manufacturing in terms of physically transforming raw materials into finished products, or engaging in substantial operations in converting or assembling components into finished products (physical manufacturing). In contrast, the new definition of manufacturing added by the proposed regulations applies to certain manufacturing-related activities performed by CFC principals (through their own employees) that do not themselves perform activities satisfying the physical manufacturing requirements of the current regulations.
Specifically, a CFC principal will qualify for the revised manufacturing exception if the facts and circumstances evidence that the CFC, acting through its own employees, makes a “substantial contribution” to the manufacture of the property sold. Relevant factors taken into account in determining whether a substantial contribution has been made include, but are not limited to the following:
1. Oversight and direction of the physical manufacturing activities or process (including management of risk of loss) with respect to the products sold
2. Performance of physical manufacturing activities that are insufficient in extent to constitute full physical manufacturing in and of themselves (under the “substantial transformation” or “substantial operations” tests of both the current and the proposed regulations)
3. Control of 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
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
he weight given to any particular activity will vary based on the facts and circumstances of the particular business, and the presence or absence of any particular activity, or of a particular number of activities, will not be determinative (i.e., the factors are not intended to be used as a “checklist”). In addition, the fact that other persons make contributions to the manufacture of the property does not necessarily prevent the CFC from satisfying the substantial contribution test through the activities of its own employees.
The substantial contribution test may be relied upon by a CFC principal for purposes of satisfying the manufacturing exception provided that the manufacturing, producing and constructing activities undertaken by the contract manufacturer satisfy the definition of physical manufacturing. The substantial contribution test appears to apply equally to both consignment/toll manufacturing and buy-sell contract manufacturing structures, provided the CFC retains control of the raw materials and work-inprocess and finished goods during the transformation, conversion or assembly process.
Where a CFC principal carries out through its own employees substantial functions of the kind described above, the proposed regulations confirm that no FBCSI results under the general rule. In this respect, the proposed regulations represent a step forward in recognizing and accommodating modern global business models that U.S.-based multinationals employ in order to manage their businesses efficiently and without unnecessary duplication of functions and costs in each national market into which they sell. At the same time, a number of interpretative and practical questions remain open. The proposed regulations provide more qualitative than quantitative direction, leaving the necessary level of activity and relative weight of various activities open to interpretation. In addition, the applicability of the substantial contribution test to buy-sell contract manufacturing structures, as opposed to consignment/toll manufacturing structures, is less clearly stated than it ideally would be. There would appear to be no reason to apply a different approach to the substantial contribution analysis based on this distinction, and thus it presumably will be made clear, possibly through an additional example, that the substantial contribution test embraces both buy-sell and toll manufacturing. The proposed regulations also include an example in which the CFC principal’s ownership and maintenance of sophisticated supply chain operations-and-monitoring software, coupled with a U.S. parent’s conduct of other manufacturing activities (including assisting with the exercise of the CFC principal’s contractual oversight right), does not rise to the level of a substantial contribution. It would be helpful for this example to be paired with another example illustrating how a CFC principal could satisfy the substantial contribution test in a similar context.
General FBCSI Rule: Rejection of “Its” Position
The proposed regulations also reject the “its” position under both the statutory FBCSI rule and the current regulatory manufacturing exception, that no FBCSI can result if the property sold by the CFC is different property from that purchased by the CFC, regardless of who directly transforms the property. Treasury and the Service disagree with the “its” position as an interpretative matter under the existing statute and regulations, and they describe the proposed regulations as merely clarifying this point. In this regard, the proposed regulations specifically state that the property sold by a CFC will be considered the same property purchased by the CFC regardless of whether the property is sold in the same form in which it was purchased, in a different form from that in which it was purchased or as a component part of a manufactured product, except as specifically provided under the proposed regulations.
Treasury and the Service are effectively stating that, in a contract manufacturing context involving a related-party purchase or sale, all roads lead through the “substantial contribution” test. CFC principals with sufficient substance under that test will qualify for deferral under the FBCSI general rule; CFC principals with insufficient substance as determined under that test will not. Because the regulations are prospective from the date of finalization, this position should not affect the viability of the “its” position with respect to prior or current taxable years—taxpayers and the Service may continue to dispute this issue as to such years on the same basis as they could before. However, once the regulations are finalized, the regulatory basis for the “its” position will disappear, prospectively. It should be noted that the “its” position also has an independent statutory (and legislative history) basis, which remains intact, although the elevation of the Service’s position to the level of regulations presumably will make the taxpayer’s position more difficult to sustain in the future, as it would entail directly challenging a regulation.
Branch Rule: Single “Substantial Contribution” Location Under “Predominant Amount” Test
Under the branch rule of the current regulations, FBCSI may result where a CFC carries on purchasing, selling or manufacturing activities outside its country of organization through a “branch or similar establishment,” notwithstanding a CFC’s satisfaction of the manufacturing exception under the general FBCSI rule. The branch rule applies, however, only if the use of the branch or similar establishment has substantially the same tax effect as if such branch or similar establishment were a separate corporation, which is determined under regulations using an effective tax rate disparity test. The U.S. Tax Court has held that separate corporate contract manufacturers, whether related or unrelated, cannot be treated as manufacturing branches for this purpose. The proposed regulations do not alter the definition of a “branch or similar establishment” for purposes of applying the branch rule.
The proposed regulations make a number of changes relating to the application of the branch rule. Some of these changes are necessary to address collateral consequences of the substantial contribution approach under the general FBCSI rule, while other changes address longstanding issues. With respect to the former, as noted above, the treatment of substantial contributions to manufacturing as effectively another form of manufacturing could create multiple manufacturing branches in a structure in which supervision, oversight and other manufacturing-related activities are performed by employees of multiple branches of a CFC principal. The proposed regulations avoid this unnecessary complication by providing that, in a situation in which the CFC principal (including its branches) does not perform physical manufacturing (in the sense of meeting the “substantial transformation” or “substantial operations” tests), but does make a substantial contribution to the manufacture of the property, the location of manufacturing for purposes of applying the branch rule will be the location (home office or branch) in which the “predominant amount” of the CFC’s substantial contribution to manufacturing occurs. The predominant amount of the substantial contribution will be regarded as occurring in a location where the portion of such contribution is “significantly greater” than the portion of such contribution made in any other single location. If no such location exists, then the manufacturing location will be that jurisdiction among those in which manufacturing-related activities are performed that imposes the highest effective tax rate.
It should be emphasized that, for purposes applying the manufacturing branch rule, only those manufacturing activities that take CFC’s home office to the contract manufacturer’s plant generally should not give rise to a manufacturing branch in the country in place in a foreign branch or similar establishment are considered (e.g., having quality control personnel periodically travel from a which the plant is located).
The predominant amount test is a sensible approach to mitigating the possibility that the substantial contribution test could lead to the proliferation of manufacturing branches throughout a structure. Under the predominant amount test, if a critical mass of principal-type activities is gathered in a CFC principal’s home office or branch, and that same location sells the finished products, then neither the general rule nor the branch rule should jeopardize deferral. Again, however, as in the case of the substantial contribution test, interpretative and practical issues remain. For example, a plurality of the relevant activities (determined under a “significantly greater” standard) must occur in a single location in order for that location to be “predominant” in this sense, but little guidance is given regarding the relative weight of various activities. In many structures, however, no interpretative difficulties should arise, as one principal location will obviously constitute the predominant location based on the nature and relative scale of activities in various locations. That said, the new definition of manufacturing will likely result in a broadening of the application of the manufacturing branch rule for some taxpayers. The kinds of activities that may be taken into account for purposes of the substantial contribution test will have to be identified and located, and an analysis performed to determine if such location may be considered a manufacturing branch.
Branch Rule: Treatment of Structures with Physical Manufacturing in Branches; Possibility of Multiple Manufacturing Branches
The proposed regulations present some difficulties for structures in which physical manufacturing is performed in a branch of the CFC principal. Specifically, the proposed regulations establish a rebuttable presumption that, if a branch of the CFC satisfies the physical manufacturing test with respect to property sold by the remainder of the CFC, the remainder of the CFC will be presumed not to make a substantial contribution to the manufacture of the property. Thus, if the tax rate disparity test is satisfied, the sales income of the CFC principal’s home office will qualify for the manufacturing exception only if this presumption is rebutted to the Service’s satisfaction. In addition, the proposed regulations for the first time provide rules addressing the possibility of multiple manufacturing branches of a single CFC. The current regulations do not provide for this possibility, despite providing rules dealing with multiple sales or purchase branches, and combinations of such branches with a manufacturing branch. Treasury and the Service, however, maintain that the new rules dealing with the possibility of multiple manufacturing branches represent a clarification of existing law. The new multiple manufacturing branch rule can apply where the CFC engages in manufacturing activities with respect to separate items of personal property in separate branches. In such case, the manufacturing branch rules are applied separately to each branch.
The proposed regulations also provide priority rules for determining the location of manufacturing for purposes of applying the tax rate disparity test in cases involving both physical manufacturing and substantial contributions to manufacturing within a single CFC and its branches. Under the proposed regulations, where the CFC (including its branches) engages in physical manufacturing of the product, the location of manufacturing for purposes of applying the branch rule is the place of the physical manufacturing (i.e., the location of physical manufacturing takes precedence over the substantial contribution test). If the physical manufacturing of a single product occurs in two countries, then the location of manufacturing is considered to be the country of physical manufacturing with the lowest tax rate.
The provisions of the proposed regulations dealing with the branch rule effects of having physical manufacturing under a CFC principal are very complex and may prove prohibitively unwieldy for structures in which a contract manufacturer is a branch of the CFC principal. Treasury and the Service have implicitly acknowledged this problem, noting that any difficulties in this regard can be avoided by incorporating any branch that performs physical manufacturing. Thus, for certain taxpayers that manufacture the products they sell, the proposed regulations will make it strongly preferable to place physical manufacturing into separate corporate subsidiaries, and to perform only substantial contributions to manufacturing through the CFC principal and its branches, particularly where physical manufacturing takes place in a relatively high-tax country.
Branch Rule: Miscellaneous Issues
The proposed regulations also address a number of other issues arising under the branch rule. Perhaps most significantly, the regulations confirm that the manufacturing branch rule cannot give rise to FBCSI where the CFC does not engage in physical manufacturing or provide substantial contributions to manufacturing, nor can the rule result in the elimination of any FBCSI that may result under the general FBCSI rule. The proposed regulations also address a longstanding issue relating to the sales branch rule, clarifying that the sales branch rule should not give rise to FBCSI where a branch purchases property from unrelated suppliers and sells such property to unrelated customers. Furthermore, an example in the proposed regulations confirms an important conclusion that had previously been reached in a private ruling, that the branch rules do not result in FBCSI where a branch of the CFC both manufactures and sells the product, as the branch can avail itself of the manufacturing exception.
Treasury and the Service have taken the opportunity presented by revisiting the FBCSI rules to address some longstanding interpretative issues that have been raised in particular contexts under the branch rule. In view of the complexity of both the current and the proposed versions of the branch rule, these provisions should be examined closely to determine whether they affect a taxpayer’s structure. In addition, the proposed regulations raise another point of particular concern to many common structures. Specifically, under the statute, the FBCSI rules cannot apply where the CFC neither purchases property from nor sells property to a related person. Thus, a CFC that purchases raw materials from unrelated persons, consigns them to a contract manufacturer and then sells the finished product to unrelated persons should not have FBCSI under the general rule. However, the proposed regulations might be interpreted by the Service as allowing it to assert that “substantial contribution” activities occurring in a foreign branch of a CFC in this context could cause the manufacturing branch rule to apply, which could cause the CFC to be treated as selling the products on behalf of a related person, notwithstanding the clear lack of a related-party purchase or sale under the FBCSI general rule. This result would be both harsh and beyond the statutory bounds of the FBCSI rules. The final regulations hopefully will clarify that no such result is intended.
The proposed regulations will apply to taxable years of CFCs beginning on or after the date they are published as final regulations, and for taxable years of U.S. shareholders in which or with which such taxable years of the CFCs end. However, taxpayers may choose to apply the proposed regulations in their entirety to all open taxable years as if they were final regulations.
Taxpayers with structures that already entail a relatively high degree of activity in a CFC principal may consider whether to elect retroactive and immediate application of the proposed regulations. On the other hand, it appears unlikely that the Service will continue to attack such structures (e.g., under the non-attribution approach of Rev. Rul. 97-48) where sufficient substance exists under the standards of the proposed regulations, so the benefits of such an election are somewhat uncertain. The branch rule ramifications of such an election also would need to be carefully examined, particularly in view of the fact that it will presumably not be possible to make any entity classification election changes necessitated by the new guidance on the same retroactive basis. In addition, the election to apply the proposed regulations apparently must be made either to all open years or not at all. Thus, in cases in which the substance in a CFC principal has been increasing over the relevant years from relatively low levels to relatively high levels, such an election may be viable only as earlier years close.
Request for Comments
Treasury and the Service have requested comments on the proposed regulations by May 28, 2008. They are particularly interested in comments on the following subjects: (1) whether safe harbors should be added to the substantial contribution test (e.g., based on a list of mandatory activities, costs, compensation, value, tax rate disparities or a comparison of CFC employee compensation costs to other manufacturing costs relating to the same process); (2) the status for purposes of these rules of nonpayroll contractors working under the control of employees of the CFC; (3) the possibility of adding an “anti-abuse” test that would render the manufacturing exception inapplicable in cases in which a related U.S. person provides a large amount of the multinational group’s contribution to the relevant manufacturing; and (4) the multiple manufacturing branch rules.
In view of the significant opportunities and risks presented by the proposed regulations, and the inevitable interpretative questions that will arise in applying these rules to existing and future structures, many companies will find it worthwhile to seek clarification of key issues through the comment process, as well as commenting on the specific items as requested by Treasury and the Service.
Treasury and the Service are to be commended for their efforts to establish a comprehensive and coherent set of rules to govern an area that has long suffered from unnecessary uncertainty and controversy. Nevertheless, as in any undertaking of this magnitude, a number of issues and challenges remain to be addressed, both by taxpayers and by the government. Most, if not all, U.S.-based multinationals selling products through CFCs will need to examine the proposed regulations and determine whether and how they need to adapt their structures to the new rules. In addition, the dialogue between taxpayers and the government must continue in order to ensure that the eventual final regulations provide appropriate and workable results for the widest possible range of taxpayers relying on modern global business models.