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The application and analysis of the new proposed contract manufacturing regulations.

Not surprisingly, most taxpayers prefer to pay as little tax as possible. In the context of the international sales of goods, prior to the creation of the Transfer Pricing and Subpart F rules, a taxpayer could create a subsidiary corporation in a foreign low-tax jurisdiction and then sell goods to that foreign subsidiary at a price equal to or slightly above cost, triggering a small amount of U.S. taxable gain. The foreign subsidiary could then sell those goods in foreign jurisdictions at a marked-up price, triggering only the low-tax jurisdiction's tax rate on the gain. One of the reasons Congress imposed the foreign base company sales income (FBCSI) rules of Subpart F was to currently tax U.S. taxpayers on the gain realized by the foreign subsidiary on sales income generated in such low-tax jurisdictions.1 Congress was concerned with income of a selling subsidiary that had been separated from manufacturing activities of a related corporation merely to obtain a lower rate of tax for the sales income. However, Congress only intended the FBCSI rules to apply where the foreign subsidiary did not add any appreciable value to the product, such as manufacturing, major assembling, or construction activity. Therefore, the FBCSI rules contain an exemption for manufacturing activities conducted by the foreign subsidiary.

Since the current regulations were promulgated in 1964, manufacturing has increasingly been outsourced to third-party manufacturers in so-called contract manufacturing arrangements. Under a typical contract manufacturing arrangement, a party contracts with the contract manufacturer to convert raw materials into finished goods or to assemble component parts into a finished product, in accordance with the party's specifications. Title to the property changes hands depending on the type of arrangement entered between the parties. In turnkey arrangements, the contract manufacturer retains title to the raw materials or component parts during the manufacturing process and title is transferred to the party at the time the finished product is delivered.

In consignment manufacturing arrangements, the party retains title to the raw materials during the entire manufacturing process. The question of whether a controlled foreign corporation (CFC) may enter into a contract manufacturing arrangement while still meeting the manufacturing exception to the FBCSI rules has been a matter of contention between taxpayers and the IRS for over three decades. The current regulations do not address the issue of contract manufacturing arrangements. However, on February 27, 2008, the Treasury finally issued new regulations to address the contract manufacturing debate (the proposed regulations). This article provides an overview of the current regulations, the historical background regarding the application of contract manufacturing to the current regulations, the application of the recently issued proposed regulations, and a discussion of a potential unintended consequence of the proposed regulations.

Current Law

A U.S. shareholder of a controlled foreign corporation is required to include his or her pro rata share of Subpart F income in his or her gross income for the taxable year. (2) IRC [section]951(b) Subpart F income is made up of foreign base company income derived by the CFC. (3) Finally, foreign base company income is made up of FBCSI. (4) FBCSI is income derived by the CFC where the CFC purchases property from or on behalf of a related person, sells property to a related person, or purchases property on behalf of a related person. Furthermore, the property must be manufactured, produced, grown, or extracted outside the country of the CFC's incorporation and the property is sold outside the CFC's country of incorporation. (5) Thus, property manufactured, produced, constructed, grown, or extracted within the CFC's home country is not FBCSI regardless of who actually manufactures the product (the same country manufacturing exception). (6) Furthermore, property sold for use, consumption, or disposition within the country in which the CFC is created is also not FBCSI (the same country sales exception). (7) Finally, FBCSI does not include income of a CFC derived in connection with the sale of personal property manufactured, produced or constructed by such corporation from personal property that it has purchased (the manufacturing exception).

Under the manufacturing exception, a foreign corporation will be considered to have manufactured, produced, or constructed personal property if the activities meet the requirements of either one of the physical manufacturing tests--the "substantial transformation" test or the "substantive" test. The substantial transformation test is met when purchased personal property is substantially transformed prior to sale. (9) The regulations do not define substantial transformation, but give the following examples: the conversion of wood pulp to paper, the transformation of steel rods to screws and bolts, and the transformation of tuna fish into canned tuna fish. (10) The substantive test is met where purchased property is used as a component part of personal property that is assembled and sold.(11) The sale of the property will be treated as the sale of a manufactured product, rather than the sale of component parts, if 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. The conversion of component parts, which are purchased from a related party, into an automobile engine is an example of a conversion that meets the substantive test. (12) Furthermore, the substantive test includes a safe harbor whereby the test is satisfied if conversion costs of such corporation account for 20 percent or more of the total cost of goods sold.

Furthermore, in situations where the CFC carries on selling or manufacturing activities through a branch in a foreign country, the Internal Revenue Code and regulations impose a branch rule causing the foreign branch to be treated as a foreign subsidiary of the CFC (the branch rule).13 The branch rule is imposed because, without it, a CFC could easily bypass the FBCSI rules. The impact of the branch rule is more easily explained through the following example. FS is incorporated in foreign jurisdiction A, which is a low-tax jurisdiction.

FS physically manufactures widgets in Country B, which is a high-tax jurisdiction, through a factory directly owned by FS in that country. FS sells the widgets to consumers in foreign jurisdiction C through its offices in A. Country C does not impose tax on the sale of widgets when the sale occurs in A, and because A is a low-tax jurisdiction, FS pays a relatively small amount of tax. Furthermore, disregarding the branch rules, the sales would not be subject to the FBCSI rules because FS meets the manufacturing exception because it physically manufactures the widgets. However, as described below, the branch rule applies and treats the manufacturing branch in Country B as a wholly owned subsidiary corporation of FS. FS is deemed to perform selling activities on behalf of its deemed related subsidiary in B, and is, therefore, subject to the FBCSI rules.

When the branch is deemed as a manufacturing branch, the branch is treated as a subsidiary of the CFC in which the CFC is performing selling activities on behalf of the manufacturing branch. (14) Therefore, when the branch rule applies to a manufacturing branch, the CFC's income is treated as FBCSI because the CFC is deemed to perform selling activities on behalf of the CFC, which is a related party.

A branch is treated as a manufacturing branch where a CFC carries on manufacturing activities by or through a branch located outside the CFC's country of incorporation and the remainder of the CFC purchases or sells the personal property. (15) Additionally, the tax rate disparity test must also be met. In the context of the manufacturing branch, the tax rate disparity test is met, if the income allocated to the remainder of the CFC is taxed at an effective rate that is less than 90 percent of and at least five percent less than the effective rate of tax, which would apply to such income under the laws of the country in which the branch is located. (16) The current regulations do not contain rules on the application of the tax rate disparity test in the case of multiple manufacturing branches.

Contract Manufacturing

In 1975, the Service issued Rev. Rul. 75-7, which was the first major pronouncement of its view on contract manufacturing arrangements in the context of the FBCSI rules. (17) Under the facts of Rev. Rul. 75-7, a CFC incorporated in Country X entered into an agreement with a contract manufacturer located in County O to convert metal ore concentrate into a ferroalloy. The CFC paid the contract manufacturer a conversion fee, retained title to the ore concentrate before and during the conversion process, bore the risk of loss at all times in connection with the operation, maintained complete control of the time and quantity of production, and maintained complete control of the quality of the product. The contract manufacturer was required to use such processes as were directed by the CFC, and the CFC could send engineers or technicians to the plant to inspect, correct, or advise with regard to the processing of the ore concentrate. The Service concluded that the performance by the contract manufacturer was considered to be a performance by the CFC. Therefore, the CFC was determined to substantially transform the personal property. Furthermore, the Service concluded that because the manufacturing activity occurred outside the CFC's country of incorporation, the contract manufacturer should be treated as a branch of the CFC. Thus, the branch rule should apply.

Following the promulgation of Rev. Rul. 75-7, taxpayers only followed half of its conclusions. Taxpayers attributed the manufacturing conducted by contract manufacturers to the CFC but did not treat the contract manufacturer as a branch of the CFC. Therefore, the CFC could engage a contract manufacturer to manufacture its product while avoiding the FBCSI rules.

In response, the IRS unsuccessfully litigated these arrangements in the Ashland Oil v. Comm'r, 95 T.C. 348 (1990), and Vetco Inc. and Subsidiaries v. Comm'r, 95 T.C. 579 (1990), cases. The issue in both cases was whether a separate manufacturing corporation should be treated as a branch of the CFC. In Ashland Oil, the separate manufacturing corporation was an unrelated party, and in Vetco the separate manufacturing corporation was its wholly owned subsidiary. In both cases, the IRS ruled in favor of the taxpayer, holding that the separate manufacturing corporation should not be deemed a branch of the CFC. In response to these decisions, the Service issued Rev. Rul. 97-48, revoking Rev. Rul. 75-7 and noting its acquiescence to the Ashland Oil and Vetco decisions. (18) The Service further noted that it had never been of the view that the manufacturing activities of the contract manufacturer should be attributed to the CFC unless the contract manufacturer was also deemed a branch of the CFC.

After the revocation of Rev. Rul. 75-7, taxpayers began relying on the so-called "its" argument to avoid the imposition of the FBCSI rules. Under this argument, taxpayers relied on the statutory language of IRC [section]954(d), which states that FBCSI is "income derived in connection with the purchase of personal property from a related person and its sale to any person." (19) Under this theory, the personal property is transformed by the contract manufacturer into a finished product and, thus, is no longer the "its" that is referred to in the code section. Thus, the FBCSI rules would not apply because the sale is outside the statutory bounds of IRC [section]954(d).

Proposed Regulations

The IRS issued proposed regulations in attempts to put an end to the lack of certainty surrounding FBCSI in the context of contract manufacturing. The major changes of the proposed regulations include:

* Rejection of the "its" argument;

* The addition of the substantial contribution test when the substantial transformation and the substantive tests are not met;

* The application of the substantial contribution test to the branch rule with a rebuttable presumption that the CFC does not meet the requirements of the test; and

* Guidelines to apply the branch rule when multiple manufacturing branches exist.

The proposed regulations have been amended to put an end to taxpayers' use of the "its" argument. (20)

The proposed regulations clarify that the manufacturing exception is only met if the manufacturing activity is conducted by the employees of the CFC. (21) Thus, the CFC must meet the substantial transformation and substantive tests through the efforts of its own employees. Additionally, as described below, the substantial contribution test has been added as a new standard to determine whether the CFC has engaged in manufacturing activity. (22) Likewise, the substantial contribution test must be met by the employees of the CFC. (23)

The substantial contribution test has been added in addition to the substantial transformation and substantive tests under the manufacturing exception of the current regulations. It is an alternative to the substantial transformation and substantive tests and applies only when the substantial transformation and substantive tests are not met. (24) The substantial contribution test is met if the facts and circumstances evidence that the CFC makes a substantial contribution through the activities of its employees to the manufacture, production, or construction of the personal property sold. Therefore, a CFC is deemed to meet the manufacturing exception where a third party located in a jurisdiction outside the CFC's country of incorporation meets the substantial transformation or substantive test and the CFC substantially contributes to the manufacturing activities. (25) The activities of a CFC's employees that are to be considered to determine whether the CFC has made a substantial contribution to manufacturing are:

1) Oversight and direction of the activities or process (including management of the risk of loss) pursuant to which the property is manufactured, produced, or constructed;

2) Performance of activities that are considered in, but that are insufficient to satisfy, the substantial transformation and substantive tests;

3) Control of the 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; and

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. (26)

The number of factors required and the weight that each factor carries varies with the facts and circumstances of the particular business. (27) The examples shed some light on the outside boundaries of the substantial contribution test. On one hand, the mere contractual ownership of materials and intellectual property combined with the contractual rights to exercise powers of direction and control (without the exercise of those powers) are not sufficient to meet the substantial contribution test. (28) On the other hand, if the CFC maintains contractual ownership of materials and intellectual property, regularly exercises powers of direction and control, and is engaged in product design and control, the CFC meets the substantial contribution test. (29)

With regard to the branch rules, the proposed regulations make two significant changes. First, a CFC may meet the manufacturing exception if it substantially contributes to the physical manufacturing of its manufacturing branch. (30) However, the proposed regulations impose a rebuttable presumption that the CFC does not make a substantial contribution. (31)

Second, the proposed regulations create rules for the use of more than one manufacturing branch. The proposed regulations distinguish between multiple branches in the case where each branch manufactures a separate item of personal property and the case where multiple branches each contribute to the manufacture of the same item of personal property. Where each branch manufactures a separate item of personal property, the proposed regulations are analogous to the multiple sales branch rules. Each branch is treated as if it were the only branch of the CFC and as if any other branches were separate corporations.

Where multiple branches or one or more manufacturing branches and the remainder of the CFC manufacture the same item of personal property, the proposed regulations impose a more complex set of rules. (32) First, if only one branch or only the remainder of the CFC satisfies the substantial transformation or substantive test, then that branch or the remainder of the CFC will be the location of manufacturing for purposes of the tax rate disparity test. (33) If more than one branch or one or more branches and the remainder of the CFC each independently satisfy either the substantial transformation or substantive tests, then the branch of the CFC or the remainder of the CFC that satisfies the test and is located in the lowest tax jurisdiction is the location of the branch for purposes of applying the tax rate disparity test. Where none of the branches nor the remainder of the CFC satisfy the substantial transformation or substantive tests, but the CFC as a whole satisfies the substantial contribution test, the branch or the remainder of the CFC that makes the predominant amount of the CFC's substantial contribution will be the location of manufacturing for purposes of applying the tax rate disparity test. (34) For purposes of this rule, a branch or the remainder of the CFC makes a predominant amount of the CFC's substantial contribution only if it makes a significantly greater contribution to the manufacture of that property than any other branch or the remainder of the CFC. Finally, where no branch or the remainder of the CFC makes a predominant contribution, the tax rate disparity test is applied in the jurisdiction that makes a contribution and possesses the highest effective tax rate. (35)

Potential Unintended Consequences Exist Under the Proposed Regulations

The substantial contribution test provides a lower threshold for the activities of a branch of the CFC to be deemed manufacturing. In cases where the current regulations would not apply to a branch because no physical manufacturing is conducted by the branch and no related party sales or purchases are made, the proposed regulations may still apply if the branch makes a substantial contribution to contract manufacturing. For example, assume a foreign branch of a CFC employs a large team of research and development engineers and an intellectual property legal team. The CFC enters into a contract manufacturing arrangement with an unrelated contract manufacturer to manufacture products using the IP developed in the foreign branch. Furthermore, the CFC does not purchase property from nor sell property to any related party. Under the current regulations, this scenario would not trigger FBCSI because the branch is not a manufacturing branch and the CFC does not purchase property from nor sell property to a related party. However, under the proposed regulations, the foreign branch may be deemed a manufacturing branch under the substantial contribution test for the activities it performs in the foreign jurisdiction.

This consequence is likely unintended because the purpose of the branch rule was to prevent CFCs from using a branch to avoid FBCSI not to impose new scenarios that create FBCSI income where under the current statutes and regulations it otherwise would not exist. Essentially, the proposed regulations would create FBCSI, where it does not otherwise exist under the current regulations, for conducting R&D activity through a foreign branch in a high-tax jurisdiction. A simple solution to this problem is to allow CFCs to elect out of the substantial contribution test.

Conclusion

Overall, the proposed regulations provide long-awaited certainty to U.S. multinationals who have or are planning to restructure their supply chains. The proposed regulations recognize that manufacturing activity is constituted of oversight and control activities in addition to the physical process of manufacturing. They also serve as notice to those relying on the "its" argument to restructure accordingly.

(1) S. Rep. No. 1881, 87th Cong., 2d Sess. at 84.

(2) I.R.C. [section]951(a). All references made to the Internal Revenue Code shall mean the Internal Revenue Code of 1986 as amended. A U.S. shareholder is a U.S. person who owns 10 percent or more, by applying the rules of ownership of [section]958(b), of the total combined voting power of all classes of stock entitled to vote of a controlled foreign corporation.

(3) I.R.C. [section]952(a).

(4) I.R.C. [section]954(a)(2).

(5) I.R.C. [section]954(d)(1).

(6) TREAS. REG. [section]1.954-3(a)(2).

(7) TREAS. REG. [section]1.954-3(a)(3).

(8) TREAS. REG. [section]1.954-3(a)(4).

(9) TREAS. REG. [section]1.954-3(a)(4)(ii).

(10) TREAS. REG. [section]1.954-3(a)(4)(ii) Ex. (1), (2), and (3).

(11) TREAS. REG. [section]1.954-3(a)(4)(iii).

(12) TREAS. REG. [section]1.954-3(a)(4)(iii) Ex. (1).

(13) I.R.C [section]954(d)(2).

(14) TREAS. REG. [section]1.954-3(b)(2)(ii)(c).

(15) TREAS. REG. [section]1.954-3(b)(1)(ii)(a).

(16) TREAS. REG. [section]1.954-3(b)(1)(ii)(b).

(17) Rev. Rul. 75-7, 1975-1 CB 244.

(18) Rev. Rul. 97-48, 1997-2 CB 89.

(19) I.R.C. [section]954(d)(1) (emphasis added).

(20) Preamble to PROP. Treas. Regs. Feb. 28, 2008. Fed. Reg. Vol. 73, No. 40, p. 10716.

(21) PROP. TREAS. REG. [section]1.954-3(a)(4)(i).

(22) PROP. TREAS. REG. [section]1.954-3(a)(4)(iv).

(23) PROP. TREAS. REG. [section]1.954-3(a)(4)(i).

(24) PROP. TREAS. REG. [section]1.954-3(a)(4)(iv)(a).

(25) If the third party were located in the CFC's country of incorporation, the same country manufacturing exception would apply regardless of the substantial contribution test.

(26) PROP. TREAS. REG. [section]1.954-3(a)(4)(iv)(b).

(27) PROP. TREAS. REG. [section]1.954-3(a)(4)(iv)(a).

(28) PROP. TREAS. REG. [section]1.954-3(a)(4)(iv)(c) Ex. 1.

(29) Id. Ex. 2.

(30) PROP. TREAS. REG. [section]1.954-3(b)(1)(ii).

(31) PROP. Treas. reg. [section] 1.954-3(b)(2)(ii)(c)(2).

(32) See PROP . TREAS . REG. [section]1.954-3(b)(2)(ii)(c)(3).

(33) PROP. TREAS. REG. [section]1.954-3(b)(2)(ii)(c).

(34) Id.

(35) Id.

Steven Hadjilogiou is a tax attorney at Baker & McKenzie, LLP, in Miami. He counsels multinational businesses and individuals with respect to international tax planning, including advice on local country tax, inbound and outbound transactional planning, partnership, corporate, and estate tax issues in numerous jurisdictions throughout the world.

This column is submitted on behalf of the Tax Section, David Pratt, chair, and Michael D. Miller and Benjamin A. Jablow, editors.
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Author:Hadjilogiou, Steven
Publication:Florida Bar Journal
Date:Jan 1, 2009
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