Treasury bolsters its position on contract manufacturing.

Buried in the proposed Brown Group regulations (REG. 104537-97) relating to partnerships and subpart F are two significant amendments to the subpart F regulations, attacking the use of contract manufacturing arrangements to claim the "manufacturing exception" from foreign base company sales income (FBCSI). These proposed amendments have nothing to do with the treatment of partnerships, but would bolster the Treasury's recent revocation of Rev. Rul. 75-7 in Rev. Rul. 97-48. The Treasury proposes that these amendments be effective for tax years of controlled foreign corporations (CFCs) beginning on or after the date the final regulations are published.

In Rev. Rul. 97-48, the IRS stated that the manufacturing activities of a contract manufacturer cannot be attributed to a CFC in determining whether the CFC income is exempt from FBCSI under the manufacturing exception of Regs. Sec. 1.954-3(a)(4).

Existing final regulations might be read to suggest otherwise. The second sentence of Regs. Sec. 1.954-3(a)(4)(i) provides that "A foreign corporation will be considered, for purposes of this subparagraph, to have manufactured, produced, or constructed personal property which it sells if the property sold is in effect not the property which it purchased" (emphasis added). In, addition, the first sentence of Regs. Sec. 1.954-3(a) (4) (ii) provides that, "If purchased personal property is substantially transformed prior to sale, the property sold will be treated as having been manufactured, produced, or constructed by the selling corporation" (emphasis added). Neither of these sentences identifies the person who would have transformed the property purchased by the CFC prior to its sale, implying that the manufacturing exception may apply to a CFC that hired a contract manufacturer to perform services for it.

The notice of proposed rulemaking released on March 23 would amend these two sentences to read as follows: "A controlled foreign corporation (selling corporation) will be considered, for purposes of this paragraph (a) (4), to have manufactured, produced, or constructed personal property that it sells if, as a result of the operations conducted by such selling corporation in connection with the property that it purchased and sold, the property sold is in effect not the property that it purchased" (Prop. Regs. Sec. 1.954-3(a)(4)(i) (emphasis added)). "If, prior to its sale of property that it has purchased, a selling corporation substantially transforms the property, the selling corporation will be treated as having manufactured, produced, or constructed such property" (Prop. Regs. Sec. 1.954-3(a)(4)(ii) (emphasis added)). Under these proposed reformulations of the regulations, the question of whether the CFC was the person that transformed the property would take on legal significance arguably absent under the existing regulation.

The preamble to the proposed regulations explains these changes as follows: "The regulations would clarify the Service's current position that, in general, a controlled foreign corporation can apply the [manufacturing] exception,[of Regs. Sec. 1.954-3(a)(4)] only if it has performed the manufacturing activities itself. Thus, manufacturing activities of a contract manufacturer will not be taken into account "