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New subpart F Regs. address manufacturing exception and branch rules.

On December 29, 2008, Treasury published final, temporary, and proposed regulations under Sec. 954 addressing the treatment of contract manufacturing arrangements and the branch rules applicable to foreign base company sales income (FBCSI), a type of subpart F Subpart F

Special category of foreign-source "unearned" income that is currently taxed by the IRS whether or not it is remitted to the US
 income applicable to the sale of inventory (T.D. 9438, REG-150066-08). The new regulations leave the original regulations largely intact, provide an additional test for the "manufacturing exception" (the substantial contribution test), and provide a protocol for administering the branch rules. The new regulations also eliminate the "its defense," which is described in the preamble A clause at the beginning of a constitution or statute explaining the reasons for its enactment and the objectives it seeks to attain.

Generally a preamble is a declaration by the legislature of the reasons for the passage of the statute, and it aids in the interpretation of
 as being contrary to existing law and representing an incorrect reading of the FBCSI rules. These regulations are generally effective for tax years of controlled foreign corporations Controlled foreign corporation (CFC)

A foreign corporation whose voting stock is more than 50% owned by US stockholders, each of whom owns at least 10% of the voting power.
 (CFCs) beginning after June 30, 2009, and the corresponding tax years of U.S. shareholders.

In general, the FBCSI rules impose U.S. tax on income derived by a CFC CFC

See: Controlled foreign corporation
 in connection with the sale of products purchased from a related party and sold outside the CFC's country of organization (Sec. 954(d)). Exceptions exist for products manufactured in the CFC's country of organization, de minimis An abbreviated form of the Latin Maxim de minimis non curat lex, "the law cares not for small things." A legal doctrine by which a court refuses to consider trifling matters.  transactions, and transactions subject to high rates of foreign tax. An additional exception exists for products that are manufactured by the CFC (the manufacturing exception). In many cases, the selling CFC may perform some but not all of the manufacturing functions in connection with the property it sells. These new regulations address the issue of what level of manufacturing activities a CFC must perform to become eligible for the manufacturing exception.

Two alternative tests are available under the existing regulations to determine if a CFC has performed sufficient manufacturing activities to satisfy the manufacturing exception. The first is the substantial transformation test, under which property is considered manufactured if it is substantially transformed prior to sale. The regulations give as illustrations of substantial transformation examples such as converting wood pulp wood pulp: see paper.  into paper, steel rods into screws and bolts, and flesh fish into canned tuna tuna or tunny, game and food fishes, the largest members of the family Scombridae (mackerel family) and closely related to the albacore and bonito. They have streamlined bodies with two fins, and five or more finlets on the back.  (Regs. Sec. 1.9543(a)(4)(ii)). The second is the substantive test/safe harbor, under which property is considered manufactured if the CFC purchases components and performs substantial operations that are generally considered to be manufacturing activities (Regs. Sec. 1.954-3(a)(4)(iii)). A safe harbor Safe Harbor

1. A legal provision to reduce or eliminate liability as long as good faith is demonstrated.

2. A form of shark repellent implemented by a target company acquiring a business that is so poorly regulated that the target itself is less attractive.
 is available if the conversion costs (direct labor and factory burden) incurred by the CFC in the integration process account for 20% or more of the total cost of goods sold Cost of goods sold

The total cost of buying raw materials, and paying for all the factors that go into producing finished goods.

cost of goods sold 
. Packaging, repackaging, labeling, or minor assembly will in no event constitute manufacturing. The new regulations refer to these two tests collectively as the physical manufacturing tests.

Arguably ar·gu·a·ble  
1. Open to argument: an arguable question, still unresolved.

2. That can be argued plausibly; defensible in argument: three arguable points of law.
, another basis for claiming the manufacturing exception is available under the statute, which provides that FBCSI is defined as "income ... derived in connection with the purchase of personal property from ... any person and its sale to a related person" (Sec. 954(d)(1); emphasis added). Taxpayers have taken the position, commonly referred to as the "its defense," that as long as the property purchased and the property sold by the CFC is not the same property, its sale does not give rise to FBCSI. CFCs relying on this defense take and hold title to raw materials, work in process, and finished goods inventories, while a related third party performs the manufacturing processes on a contract fee basis.

Branch Rules

The branch rules are intended to prevent circumvention CIRCUMVENTION, torts, Scotch law. Any act of fraud whereby a person is reduced to a deed by decree. Tech. Dict. It has the same sense in the civil law. Dig. 50, 17, 49 et 155; Id. 12, 6, 6, 2; Id. 41, 2, 34. Vide Parphrasis.  of the FBCSI rules by taxpayers that conduct business through a branch, thereby eliminating the inter-company sale that would otherwise give rise to FBCSI.

Example: H is a CFC based in Hong Kong Hong Kong (hŏng kŏng), Mandarin Xianggang, special administrative region of China, formerly a British crown colony (2005 est. pop. 6,899,000), land area 422 sq mi (1,092 sq km), adjacent to Guangdong prov. , which in turn owns C, a manufacturing CFC based in the People's Republic People's Republic
A political organization founded and controlled by a national Communist party.
 of China (PRC). H purchases products from C and resells them to customers outside Hong Kong.

Such sales would give rise to FBCSI. However, if C were instead structured as a branch of H (either as a branch in fact or as a disregarded dis·re·gard  
tr.v. dis·re·gard·ed, dis·re·gard·ing, dis·re·gards
1. To pay no attention or heed to; ignore.

2. To treat without proper respect or attentiveness.

 entity), the intercompany sale of products from C to H would be a mere transfer from a branch to the remainder of the CFC (remainder). Absent the branch rules, FBCSI would be avoided. However, if the branch rules apply, the branch is treated as a CFC separate from the remainder, and the branch transfer becomes an intercompany sale resulting in FBCSI.

The branch rules are triggered based on the disparity dis·par·i·ty  
n. pl. dis·par·i·ties
1. The condition or fact of being unequal, as in age, rank, or degree; difference: "narrow the economic disparities among regions and industries" 
 in tax rates between the branch and the remainder of the CFC. The manufacturing branch rule applies if the sales or procurement The fancy word for "purchasing." The procurement department within an organization manages all the major purchases.  function attributed to the remainder is subject to tax at an effective rate that is less than 90% of, and at least five percentage points less than, the tax rate that would apply to that income if it were subject to tax in the manufacturing branch's home country (Regs. Sec. 1.954-3(b)(1)(ii)(b)).

Returning to the example, if the effective tax rate in Hong Kong is 17.5% and the effective tax rate in the PRC is 25%, the Hong Kong rate is less than 90% of the PRC rate (90% x 25% = 22.5%) and less than the PRC rate minus five percentage points (25% - 5% = 20%). Accordingly, the manufacturing branch rule applies.

Similarly, the sales or procurement branch rule applies if the branch's income is subject to tax at an effective rate less than 90% of, and at least five percentage points less than, the tax rate that would apply to such income if it were subject to tax in the remainder's home country (Regs. Sec. 1.954-3(b)(1)(i)(b)). In both tests, the branch rule is triggered by the sales or procurement function being subject to a lesser tax rate than the manufacturing function, with the presumption A conclusion made as to the existence or nonexistence of a fact that must be drawn from other evidence that is admitted and proven to be true. A Rule of Law.

If certain facts are established, a judge or jury must assume another fact that the law recognizes as a logical
 being that the purpose of separating the relatively mobile sales or procurement function from the relatively fixed manufacturing function is to gain the advantage of the lower tax rate.

The branch rules have grown increasingly unwieldy as a result of globalization globalization

Process by which the experience of everyday life, marked by the diffusion of commodities and ideas, is becoming standardized around the world. Factors that have contributed to globalization include increasingly sophisticated communications and transportation
, segmentation of manufacturing practices, and the proliferation proliferation /pro·lif·er·a·tion/ (pro-lif?er-a´shun) the reproduction or multiplication of similar forms, especially of cells.prolif´erativeprolif´erous

 of foreign branches resulting from U.S. check-the-box elections. Today it is not uncommon for multinational corporations

Main article: multinational corporations

  • ABB
  • ABN-Amro
  • Accenture
  • Aditya Birla
  • Affiliated Computer Services Inc
  • Airbus
  • Allianz
  • Altria Group
  • American Express
  • Akzo Nobel
  • Apple Inc.
 to employ multiple manufacturing facilities around the world, each manufacturing different components or performing final product assembly and test functions. At the same time, modern multinational corporations employ procurement, sales, and distribution entities in many countries. Check-the-box elections are often made to treat some or all of these entities as either disregarded entities or branches of one or more foreign holding companies.

These new and complex structures, which were not envisioned when the original regulations were published, have raised important questions with respect to the application of the branch rules. For example, if multiple entities are involved in the manufacture of a product, which entity is deemed to be the manufacturer, and where is the location of manufacture? If a CFC has multiple sales and manufacturing branches, how is the tax rate disparity test administered? The new FBCSI regulations attempt to address such issues.

New Regs.: Substantial Contribution Test

If a CFC does not meet one of the physical manufacturing tests, the new regulations provide a new test, the substantial contribution test, whereby the CFC may qualify for the manufacturing exception if it makes a substantial contribution through the activities of its employees to the manufacture, production, or construction of personal property (Regs. Sec. 1.954-3(a)(4)(iv)).

Only the activities performed by the CFC's employees are considered. The regulations provide a nonexclusive list of activities to be considered in determining whether the substantial contribution test is met based on the facts and circumstances CIRCUMSTANCES, evidence. The particulars which accompany a fact.
     2. The facts proved are either possible or impossible, ordinary and probable, or extraordinary and improbable, recent or ancient; they may have happened near us, or afar off; they are public or

* Oversight and direction of manufacturing activities or processes. Although the regulations single out this activity as being important in most cases, the regulations qualify that the performance of this activity may not be required in every case, depending on the facts.

* Activities considered in, but insufficient to satisfy, the physical manufacturing tests.

* Material selection, vendor selection, or control of the raw materials, work in process, or finished goods.

* Management of manufacturing costs or capacities. This includes activities that help ensure that a plant is run in an economically efficient manner, such as optimizing plant capacity, reducing waste, managing the risk of loss, working on cost reduction or efficiency initiatives associated with the manufacturing process, demand planning, production scheduling, or hedging raw material costs. Not all corporate managerial decisions Managerial decisions

Decisions concerning the operation of the firm, such as the choice of firm size, firm growth rates, and employee compensation.
 are intended to be considered in the test because many decisions are not "directly related to the manufacture of the personal property."

* Control of manufacturing-related logistics. This includes, for example, arranging for delivery of raw materials to a contract manufacturer but excludes, for example, delivery of finished goods to a customer.

* Quality control; for example, sample testing or establishment of quality control standards.

* 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, producing, or constructing the personal property. Only manufacturing-related activities are considered.

The location of manufacture is based on where the employees perform the activities, rather than where the CFC is located. For this purpose, the definition of an employee generally includes certain nonpayroll workers (such as certain seconded workers, part-time workers, and contractors) who are considered common-law employees under Regs. Sec. 31.3121(d)-1(c). The definition does not go so far as to include anyone in an agency relationship, as this may create unintended branch rule issues.

In connection with the substantial contribution test analysis, all CFC employee functions that contribute to the manufacture of the personal property are considered in the aggregate and are weighted based on the economic significance of such functions to the manufacturing activities. The performance (or lack thereof) of any particular activity is not determinative, and there is neither one activity that must be performed in all cases nor any minimum number of activities or a performance threshold (Regs. Sec. 1.954-3(a)(4)(iv)(c)). (Note that eleven examples in the regulations in which the test is satisfied involve at least three, and often four, of the factors listed above.)

The fact that other persons make a substantial contribution to the manufacturing activities does not preclude pre·clude  
tr.v. pre·clud·ed, pre·clud·ing, pre·cludes
1. To make impossible, as by action taken in advance; prevent. See Synonyms at prevent.

 the CFC from making a substantial contribution of the same activities through its employees. Therefore, in applying the test, each CFC takes into account its own employees' individual activities, considers all functions performed by the employees, and weights the functions based on the facts and circumstances of the particular business in order to determine if sufficient activity has been performed.

The mere right to perform these activities is not sufficient; the CFC's employees must actually exercise their right and perform the activities. Thus, contractual rights A contractual right is a claim, on other persons, that is acknowledged and perhaps reciprocated among the principals associated with that claim. Specialized contractual rights exist as part of a "contract" or agreement between persons to whom these rights belong. , legal title, tax ownership, or assumption of economic risk are not determinative. The substantial contribution test is administered on a product-by-product basis. For this purpose, a product is defined by reference to the distinctions made by the CFC in its business operations Business operations are those activities involved in the running of a business for the purpose of producing value for the stakeholders. Compare business processes. The outcome of business operations is the harvesting of value from assets  and in its books and records, not by a third-party definition or industry classification (e.g., SIC code). There is no special documentation required in connection with the substantial contribution test.

New Branch Rules

The new regulations provide a protocol for applying the branch rules to modern multinational business models. This protocol may he best addressed by way of a summary of its principles:

* Each branch's functions stand on their own for purposes of determining if a manufacturing test is met. (An exception applies to multiple branches in the same country, which are considered in aggregate.)

* The location of a manufacturing activity is determined based on where employees perform such activity.

* The functions of branches not treated as separate CFCs under the tax rate disparity tests are attributed back to the remainder.

* The hypothetical Hypothetical is an adjective, meaning of or pertaining to a hypothesis. See:
  • Hypothesis
  • Hypothetical
  • Hypothetical (album)
 effective tax rate, for purposes of the tax rate disparity test, takes into account any uniformly available tax incentives available in the foreign jurisdiction.

* In a case in which sales, procurement, and manufacturing functions are performed through branches (e.g., the remainder is a pure holding company), the tax rate disparity test is applied on a branch-to-branch basis.

* If multiple branches (or one or more branches and the remainder) independently satisfy a manufacturing test, the location of manufacture is determined based on the jurisdiction that imposes the lowest effective tax rate.

* If the CFC as a whole is determined to satisfy the substantial contribution test, but no branch individually satisfies a manufacturing test, the manufacturing location is determined using an approach that employs both a functional analysis and a comparison of effective tax rates.

Effective Date

These regulations are generally effective for tax years of CFCs beginning after June 30, 2009, and for tax years of U.S. shareholders in which or with which such tax years of the CFC end (e.g., 2010 for calendar-year taxpayers). Taxpayers may elect retroactive Having reference to things that happened in the past, prior to the occurrence of the act in question.

A retroactive or retrospective law is one that takes away or impairs vested rights acquired under existing laws, creates new obligations, imposes new duties, or attaches a
 application to all open tax years, and the regulations expire in three years.


The new FBCSI regulations largely succeed in updating the regulations to address modern business models. The new substantial contribution test provides a welcome third alternative to the existing physical manufacturing tests. The revised branch rules also provide a greater degree of clarity and certainty, albeit at the cost of additional complexity. Taxpayers that may be adversely affected by these regulations include those that have relied on the "its defense" and those employing foreign holding company/check-the-box structures. All taxpayers involved in cross-border trade should revisit re·vis·it  
tr.v. re·vis·it·ed, re·vis·it·ing, re·vis·its
To visit again.

A second or repeated visit.

 their structures in light of these new regulations and be mindful mind·ful  
Attentive; heedful: always mindful of family responsibilities. See Synonyms at careful.

 of permanent establishment, transfer pricing Transfer pricing refers to the pricing of goods and services within a multi-divisional organization, particularly in regard to cross-border transactions. For example, goods from the production division may be sold to the marketing division, or goods from a parent company may be , and other foreign implications arising from any operating modifications made to comply with the new regulations.

From Bert J. Hawkins, CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , MST See micro systems technology. , and Carl A. Koval, CPA, Los Angeles Los Angeles (lôs ăn`jələs, lŏs, ăn`jəlēz'), city (1990 pop. 3,485,398), seat of Los Angeles co., S Calif.; inc. 1850. , CA
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Author:Hawkins, Bert J.; Koval, Cari A.
Publication:The Tax Adviser
Date:Apr 1, 2009
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