Generally good news: the recent interpretation of manufacturing in Bausch & Lomb.

Part of the law for almost 35 years, subpart F (Secs. 951-964) imposes tax on a U.S. shareholder's pro rata share of certain categories of income ("subpart F income") of U.S.-controlled foreign corporations. One such category of subpart F income is "foreign base company sales income." As part of the statutory scheme, Sec. 954(d) (1) provides:

...the term "foreign base company sales income" means income...derived in connection with the purchase of personal property from a related person and its sale to any person...[or] the purchase of personal property from any person and its sale to a related person...where--

(A) the property which is purchased...is manufactured [or] produced outside the country in which the controlled foreign corporation is created or organized, and (B) the property is sold...or...purchased for use...outside such foreign country. (Emphasis added.)

In a recent memorandum decision, the Tax Court analyzed what constitutes manufacturing for purposes of determining foreign base company sales income (Bausch & Lomb, TC Memo 1996-57). The case involved two foreign subsidiaries of Bausch & Lomb, Inc. (B&L), located in Ireland and Hong Kong, which assembled nonprescription sunglasses. The subsidiaries purchased the parts from B&L and then sold the assembled sunglasses for use outside of their respective countries after assembly was complete.

In determining whether the assembly operations constituted manufacturing, the Tax Court applied two tests set forth in Regs. Sec. 1.954-3(a) (4), under which a foreign corporation will be "considered...to have manufactured...personal property which it sells if the property sold is in effect not the property which it purchased." The property sold will be considered as not being the property purchased if either the property is substantially transformed or the operations conducted by the selling corporation in connection with the property purchased and sold are "substantial in nature and are generally considered to constitute the manufacture, production, or construction of property."

In its opinion, the Tax Court spelled out the factors it will consider in determining whether the tests described in the regulation are met. The court also cited Dave Fischbein Manufacturing Co., 59 TC 338 (1972), which held that the operation of assembling parts into portable bagclosing machines was substantial in nature and generally was considered to constitute the manufacture of property under the regulations.

"Substantial in Nature" Test

The Tax Court reviewed the training and experience required of operators at the two subsidiaries to become proficient at assembling the sunglasses. Especially important was the consideration of efficiency levels of employees immediately following the training period compared to those of second-year employees. The results showed both low output and high failure rates by new employees. Other facts considered included the quality inspections of the sunglasses by highly trained inspectors, the control and inspection of incoming inventory parts, cleaning functions, additional training for switching to a new style of sunglasses, and the short amount of time required to complete assembly of each pair.

The court concluded that the operations were substantial in light of the following factors:

* A substantial investment in physical capital is not required for "manufacturing"--the investment in training the assembly operators or in human capital was sufficient.

* The output and failure rates of new employees suggest that the process requires skill.

* The fact that premium sunglasses were produced required rigorous quality controls.

* Operations that do not require substantial amounts of time nonetheless may be substantial in nature.

* In determining substantiality, assembly operations are to be examined alone, with no regard given to the operations of related parties.

"Generally Considered to Be Manufacturing" Test

The Tax Court noted two items in particular in considering whether the operations were generally considered to be manufacturing--the accounting methods used and the opinions of the industry and governments.

The court specifically noted the following:

* The subsidiaries used standard cost accounting, consistent with their contention that they were a manufacturing operation.

* Sunglass industry trade organizations recognized the subsidiaries' activities as the manufacture of quality sunglasses.

* The government of Ireland generally considered the assembly operations to be the manufacture of sunglasses.

It is important to note that the Sec. 954 regulations also state that packaging, repackaging, labeling or minor assembly operations may not constitute manufacturing. The Tax Court held that due to the extensive training and quality control involved, the operations involved were not "minor assembly."

While this decision is favorable for many companies with foreign assembly operations, the same is not true in the foreign sales corporation (FSC)/domestic international sales corporation (DISC) arena. Corporations that have FSCs may find themselves violating rules under Sec. 927 requiring that export property eligible for FSC benefits be manufactured in the U.S. and not subject to further manufacture, production or processing outside the U.S. prior to sale. Corporations with DISCs also may have problems with the requirement that no U.S. manufacturing occur after the initial sale.