IRS revokes key Subpart F ruling.

The IRS has revoked Rev. Rul. 75-7, which provided that a controlled foreign corporation (CFC) could employ a contract manufacturer without subjecting the income from sales of the manufactured product to current inclusion under subpart F. The revocation of Rev. Rul. 75-7 and the Service's rationale for its new policy are set forth in Rev. Rul. 97-48. Rev. Rul. 97-48 will force many U.S.-based multinational manufacturers to reconsider their overseas tax strategies.

Under subpart F, U.S. persons owning 10% or more of a CFC are taxed on the CFC's foreign base company sales income (FBCSI), whether or not such income is distributed. Under Sec. 954(d)(1), FBCSI includes income from the purchase and sale (to or from a related party) of personal property that is both produced and consumed outside the CFC's country of incorporation.

Regs. Sec. 1.954 provides that Sec. 954(d)(1) does not apply if the CFC manufactures the purchased property into something different before selling it. Rev. Rul. 75-7 reached the same result when the manufacturing was done by a contractor of the CFC, if the manufacturing process was closely controlled by the CFC. Unfortunately, Rev. Rul. 75-7 also treated a closely controlled contractor as a "branch" of the CFC, turning the CFC's income into FBCSI under Sec. 954(d)(2) if the CFC had a lower effective tax rate than the contract manufacturer.

In 1990, in both Ashland Oil Co., 95 TC 348, and Vetco, Inc., 95 TC 579, the Tax Court rejected the "branch" analysis of Rev. Rul. 75-7. Since then, many taxpayers with CFCs that use contract manufacturers have ignored the Sec. 954(d)(2) holding of Rev. Rul. 75-7 while relying on its Sec. 954(d)(1) holding. Feeling "whipsawed," the IRS declared in Rev. Rul. 97-48 that it would follow the 1990 court decisions but was revoking Rev. Rul. 75-7 for tax years beginning after Dec. 7, 1997. Rev. Rul. 97-48 allows taxpayers to rely on Rev. Rul. 75-7 for prior years only if they accept the "branch" holding rejected by the Tax Court.

Rev. Rul. 97-48's conditioning of nonretroactivity on disregard of decisional law has been criticized by practitioners and may be unprecedented. However, taxpayers may have better luck arguing that Rev. Rul. 75-7 was right in the first place than in demanding nonretroactivity. Because Regs. Sec. 1.954 does not itself preclude attribution of contract manufacturing to a CFC, a court might decline to follow Rev. Rul. 97-48 absent an amendment to the regulations.

All taxpayers with CFC structures that depended on Rev. Rul. 75-7 need to reconsider their positions and the possibility of restructuring. The check-the-box rules (which did not exist when Rev. Rul. 75-7 was issued) may facilitate restructuring. Companies that claim the Sec. 936 credit based on possessions contract manufacturers also need to reevaluate their positions.

Rev. Rul. 97-48 exemplifies the uncertainties as to when the activities of an independent contractor can be attributed to a principal for international tax purposes. For example, Regs. Sec. 1.863 requires "direct" activity by the taxpayer to count foreign manufacturing for sourcing purposes; yet, in Miller, TC Memo 1997-134, the Service unsuccessfully argued for U.S. sourcing of service payments to a foreign corporation, based on the U.S. location of a contractor thee performed the services. Clearly, attribution is a double-edged sword; depending on the application of permanent establishment and sourcing rules, attribution of an independent contractor's activities to its foreign customers can lead to zero or double taxation.