[Federal Register: December 29, 2008 (Volume 73, Number 249)]
[Rules and Regulations]
[Page 79334-79354]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr29de08-13]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 9438]
RIN 1545-BI50
Guidance Regarding Foreign Base Company Sales Income
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final and temporary regulations.
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SUMMARY: This document contains final and temporary regulations that
provide guidance relating to foreign base company sales income in cases
in which personal property sold by a controlled foreign corporation is
manufactured,
[[Page 79335]]
produced, or constructed pursuant to a contract manufacturing
arrangement or by one or more branches of the controlled foreign
corporation. These regulations modify the foreign base company sales
income regulations to address current business structures and
practices, particularly the growing importance of contract
manufacturing and other manufacturing arrangements. These regulations,
in general, will affect controlled foreign corporations and their
United States shareholders. The text of the temporary regulations also
serves as the text of the proposed regulations set forth in the notice
of proposed rulemaking on this subject in the Proposed Rules section in
this issue of the Federal Register.
DATES: Effective Date. These regulations are effective July 1, 2009.
Applicability Date. For dates of applicability, see Sec. 1.954-
3(c) and Sec. 1.954-3T(e). The final regulations shall apply to
taxable years of controlled foreign corporations beginning after June
30, 2009, and for taxable years of United States shareholders in which
or with which such taxable years of the controlled foreign corporations
end. The temporary regulations shall apply to taxable years of
controlled foreign corporations beginning after June 30, 2009, and for
taxable years of United States shareholders in which or with which such
taxable years of the controlled foreign corporations end.
FOR FURTHER INFORMATION CONTACT: Ethan Atticks, (202) 622-3840 (not a
toll-free number).
SUPPLEMENTARY INFORMATION:
Background
On February 28, 2008, the IRS and the Treasury Department published
in the Federal Register proposed regulations (REG-124590-07, 2008-16
IRB 801, 73 FR 10716, as corrected at 73 FR 20201), which provided
proposed amendments to Sec. 1.954-3, addressing the treatment of
contract manufacturing arrangements under the foreign base company
sales income (FBCSI) rules. Written comments were received in response
to the notice of proposed rulemaking, and a public hearing on the
proposed regulations was held on July 29, 2008.
Section 954(d)(1) defines FBCSI to mean income derived by a
controlled foreign corporation (CFC) in connection with: (1) The
purchase of personal property from a related person and its sale to any
person, (2) the sale of personal property to any person on behalf of a
related person, (3) the purchase of personal property from any person
and its sale to a related person or (4) the purchase of personal
property from any person on behalf of a related person, provided (in
all these cases) that the property is manufactured, produced, grown or
extracted outside of the CFC's country of organization and is sold for
use, consumption or disposition outside of such country.
The existing regulations further define FBCSI and the applicable
exceptions from FBSCI, including the exceptions to the FBCSI rules for
personal property that is: (1) Manufactured, produced, constructed,
grown, or extracted within the CFC's country of organization (same
country manufacture exception); (2) sold for use, consumption or
disposition within the CFC's country of organization; and (3)
manufactured, produced, or constructed by the CFC (the manufacturing
exception). See Sec. 1.954-3(a)(2)-(4).
The existing regulations set forth certain tests to determine
whether a CFC satisfies the manufacturing exception: The ``substantial
transformation test'' of Sec. 1.954-3(a)(4)(ii) and the ``substantive
test'' and safe harbor of Sec. 1.954-3(a)(4)(iii). For purposes of
this preamble, the requirements of Sec. 1.954-3(a)(4)(ii) and 1.954-
3(a)(4)(iii) will be referred to collectively as the ``physical
manufacturing test'' and the satisfaction of either test will be
described as ``physical manufacturing.''
The proposed regulations provide a third test for satisfying the
manufacturing exception, which may apply when a CFC is involved in the
manufacturing process but does not satisfy the physical manufacturing
test. In particular, the proposed regulations provide that a CFC will
satisfy the manufacturing exception if the facts and circumstances
evince that the CFC makes a substantial contribution through the
activities of its employees to the manufacture, production, or
construction of personal property (substantial contribution test). The
proposed regulations also propose other modifications to the existing
regulations to address the treatment of contract manufacturing
arrangements under the FBCSI rules.
Written comments were received in response to the notice of
proposed rulemaking, and a public hearing was held on July 29, 2008.
After consideration of all the comments, the proposed regulations, as
revised by this Treasury decision, are adopted as final and temporary
regulations.
Summary of Comments and Explanation of Provisions
This Treasury decision contains final and temporary regulations
relating to FBCSI. The temporary regulations contained in this Treasury
decision also serve as the text of proposed regulations set forth in a
notice of proposed rulemaking on this subject in the Proposed Rules
section in this issue of the Federal Register. The preamble to this
Treasury decision will refer to the proposed regulations published in
the Federal Register on February 28, 2008, as the proposed regulations.
The preamble will refer to the regulations that are published
simultaneously as temporary regulations in this Treasury decision and
as proposed regulations in this issue of the Federal Register as the
temporary regulations.
A. Substantial Contribution Test
The proposed regulations provide that a CFC will satisfy the
substantial contribution test with respect to personal property only if
all the facts and circumstances evince that the CFC makes a substantial
contribution through the activities of its employees to the manufacture
of the property. Prop. Reg. Sec. 1.954-3(a)(4)(iv)(b) includes a non-
exclusive list of activities (collectively, ``indicia of
manufacturing'') to be considered in determining whether the CFC
satisfies the substantial contribution test with respect to the
manufacture, production, or construction of the personal property
(manufacture of the personal property) under all the facts and
circumstances.
1. General Operation of Substantial Contribution Test
In response to the proposed regulations, commentators requested
further elaboration of the general operation of the substantial
contribution test. For example, commentators requested guidance on the
amount of activity performed by a CFC's employees that would be
necessary to ``satisfy'' each individual activity listed among the
indicia of manufacturing. Several commentators requested clarifications
that suggested they believed that a certain threshold of employee
activity was required before the activity would be considered in
determining whether a CFC satisfied the substantial contribution test.
Commentators requested, for example, clarification as to whether the
``vendor selection'' activity is satisfied if the CFC provides a
contract manufacturer with an approved list of vendors but allows the
contract manufacturer to make the final determination regarding the
vendors to be used.
Commentators also requested guidance on how the indicia of
manufacturing should be weighed in relation to one another and whether
performing a certain minimum number of activities was required in order
for
[[Page 79336]]
the substantial contribution test to be satisfied. Others asked that
the regulations explain whether a CFC must perform any particular
activity in all cases to satisfy the substantial contribution test (for
example, whether a CFC must always perform oversight and direction of
the manufacturing process to satisfy the substantial contribution
test). Some commentators requested that the regulations emphasize that
the importance of each activity would vary by industry and by taxpayer.
Commentators also requested that the regulations make clear that a CFC
need not perform all of the indicia of manufacturing to establish a
substantial contribution, and that the weight given to activities
performed by employees of the CFC will depend on the economic
significance of those activities to the business of the taxpayer with
respect to the product being manufactured.
Although the proposed regulations provide guidance on many of these
issues, the IRS and the Treasury Department believe that additional
guidance with respect to the application of the substantial
contribution test is warranted in light of the comments received.
Consequently, Sec. 1.954-3(a)(4)(iv)(c) is added to the final
regulations to provide further clarification on the application of the
substantial contribution test. First, Sec. 1.954-3(a)(4)(iv)(c)
clarifies that all CFC employee functions contributing to the
manufacture of the personal property will be considered in the
aggregate when determining whether a substantial contribution is made
to the manufacture of the personal property through the activities of a
CFC's employees. Second, Sec. 1.954-3(a)(4)(iv)(c) clarifies that
there is no single activity that will be accorded more weight than any
other activity in every case or that will be required to be performed
in all cases. Third, it clarifies that there is no minimum threshold
with respect to functions performed by employees of a CFC before their
functions with respect to a given activity may be taken into account as
part of the substantial contribution test. Therefore, all functions
performed by a CFC's employees are considered (and given appropriate
weight) under the substantial contribution test, even if the CFC's
employees perform only some of the functions in connection with any one
activity (for example, some, but not all, of the vendor selection)
considered under that test. The weight given to any functions performed
by employees of the CFC with respect to any activity will be based on
the economic significance of those functions to the manufacture,
production, or construction of the relevant personal property.
Corresponding amendments and additional examples have been added to the
final regulations to illustrate further the application of the
substantial contribution test. See Sec. 1.954-3(a)(4)(iv)(d).
Other commentators sought clarification as to the extent to which
purely contractual assumptions of risk are considered in a substantial
contribution analysis. The IRS and the Treasury Department believe that
no further clarification in the final regulations is necessary to
address this point. Both the proposed and final regulations provide
that only activities of the CFC's employees are considered in the
substantial contribution analysis and, consequently, purely contractual
assumptions of risk are not considered in the substantial contribution
analysis.
In addition, commentators requested that the regulations clarify
that more than one person can provide a substantial contribution to the
manufacturing process with respect to a given product. In response to
this comment, the IRS and the Treasury Department amended the
regulations to clarify that a CFC will not be precluded from making a
substantial contribution to the manufacture of the personal property by
the fact that other persons also make a substantial contribution to the
manufacture, production, or construction of that property. Further,
Sec. 1.954-3(a)(4)(iv)(d) Example 9 is added to the final regulations
to illustrate that more than one person can provide a substantial
contribution to the manufacture of the same property.
2. Indicia of Manufacturing
The IRS and the Treasury Department received numerous comments with
respect to the specific activities listed in the proposed regulation
that are considered in determining whether a CFC makes a substantial
contribution through its employees to the manufacture, production, or
construction of personal property.
a. Oversight and Direction of Manufacturing
Commentators requested that the IRS and the Treasury Department
clarify certain issues related to the ``oversight and direction of the
activities or process'' pursuant to which personal property is
manufactured, produced, or constructed. Some commentators asked that
the regulations provide that oversight and direction of the activities
or process pursuant to which personal property is manufactured,
produced, or constructed be a prerequisite for satisfying the
substantial contribution test. Other commentators requested that the
IRS and the Treasury Department clarify that in certain industries a
substantial contribution can be made by a CFC without its employees
engaging in significant oversight and direction of the activities or
process pursuant to which personal property is manufactured, produced,
or constructed. Some commentators focused on the fact that in an
example in the proposed regulations the CFC was not treated as making a
substantial contribution to the manufacture of personal property when
the CFC did not ``regularly exercise'' oversight and direction with
respect to the contract manufacturer. See Prop. Reg. Sec. 1.954-
3(a)(4)(iv)(c) Example 1.
The importance of oversight and direction of the activities or
process pursuant to which personal property is manufactured, produced,
or constructed will vary based on the facts and circumstances
associated with the specific manufacture, production, or construction
at issue. The IRS and the Treasury Department acknowledge that
oversight and direction of the activities or process pursuant to which
personal property is manufactured, produced, or constructed is likely
to be an important element in many, but not all, substantial
contribution analyses. Thus, to address taxpayer comments, the examples
in the final regulations are amended to make clear that oversight and
direction is not a prerequisite for satisfying the substantial
contribution test and that in certain industries a substantial
contribution could be made by a CFC without its employees engaging in
oversight and direction of the activities or process pursuant to which
personal property is manufactured, produced, or constructed. Finally,
the examples in the final regulations do not use the potentially
confusing reference to ``regularly'' exercising oversight.
b. Material Selection, Vendor Selection, and Control of the Raw
Materials, Work-in-process, and Finished Goods
Some commentators asked if other activities listed among the
indicia of manufacturing also represented means of exercising control
of the raw materials, work-in-process and finished goods. The IRS and
the Treasury Department acknowledge that some of the activities in the
indicia of manufacturing may overlap with other activities in that
list. The final regulations require a substantial contribution to the
manufacture of the personal property through the activities of the
CFC's employees and not
[[Page 79337]]
satisfaction of any specific activity in the indicia of manufacturing.
Therefore, the IRS and the Treasury Department determined that it was
not necessary to clarify whether any particular function might
reasonably be included under more than one heading in the indicia of
manufacturing. However, to provide further clarity, the final
regulations group material selection, vendor selection, and control of
the raw materials, work-in-process, and finished goods as a single
activity in the indicia of manufacturing.
Commentators asked whether the control of the raw materials, work-
in-process, and finished goods refers to the CFC having the contractual
right to take possession of the personal property, to have title to the
property, or to have economic risk of loss with respect to the
property. These commentators requested clarification regarding whether
tax ownership of raw materials, work-in-process and finished goods is
required to have control of the raw materials, work-in-process, and
finished goods. In connection with this question, commentators also
asked whether a CFC can satisfy the substantial contribution test when
the contract manufacturing arrangement is buy-sell or ``turnkey'' (that
is, when the contract manufacturer purchases the raw materials).
Both the proposed and final regulations provide that only
activities of the CFC's employees are considered in the substantial
contribution analysis. Thus, mere contractual rights, legal title, tax
ownership, or assumption of economic risk are not considered in the
substantial contribution analysis. To provide greater clarity, the
final regulations revise Prop. Reg. Sec. 1.954-3(a)(4)(iv)(a),
deleting the phrase ``purchased by a controlled foreign corporation''
in the first sentence of Prop. Reg. Sec. 1.954-3(a)(4)(iv)(a) to
eliminate any inference that a CFC needs to own the raw materials that
are used in the manufacturing process. In addition, examples in the
final regulations clarify that buy-sell or turnkey contract
manufacturing arrangements may satisfy the substantial contribution
test. See Sec. 1.954-3(a)(4)(iv)(d) Examples 3 and 9.
c. Management of Manufacturing Profits and Management of Risk of Loss
Commentators requested clarification regarding which functions
would qualify as ``management of the manufacturing profits'' or
``management of the risk of loss.'' Some commentators expressed
concerns regarding the term ``management of the manufacturing
profits.'' Other commentators suggested that it would add clarity if
``management of the risk of loss'' were deleted from Prop. Reg. Sec.
1.954-3(a)(4)(iv)(b)(1) and included with ``management of manufacturing
profits'' in a single item in the indicia of manufacturing. Some
commentators expressed concern that the term ``management of the risk
of loss'' implicitly excluded all other risk management functions. One
commentator expressed the view that the indicia of manufacturing should
include reference to management of enterprise risk, other than risks
pertaining exclusively to sales and marketing functions. Some
commentators suggested that management of the manufacturing profits
might refer to such activities as the management of risks related to
the raw materials and the utilization of plant capacity, but others
thought it might encompass the finance function of a company.
The IRS and the Treasury Department agree that further
clarification is needed as to the functions that are intended to be
included within what was labeled ``management of the manufacturing
profits'' and ``management of the risk of loss'' in the proposed
regulations. The IRS and the Treasury Department intend that the
substantial contribution test recognize contributions made by a CFC's
employees to the manufacturing process through functions which help to
ensure that a plant is run in an economically efficient manner, such as
optimization of plant capacity and reduction of waste (for example,
waste of raw materials). On the other hand, not all corporate
managerial decisions are intended to be considered in the substantial
contribution test, because many such decisions are not directly related
to the manufacture of the personal property with respect to which the
substantial contribution analysis is being performed. For example, the
IRS and the Treasury Department do not intend that corporate finance
decisions be considered in the substantial contribution test.
Similarly, the IRS and the Treasury Department do not intend that the
general management of enterprise risk be considered in the substantial
contribution test.
The IRS and the Treasury Department concluded that the term
``management of the manufacturing costs or capacities'' more accurately
reflects the type of functions originally contemplated by ``management
of the manufacturing profits'' in the proposed regulations and is also
related to the types of functions contemplated by the ``management of
the risk of loss.'' Accordingly, the activity labeled ``management of
the manufacturing profits'' in the proposed regulations is replaced in
the final regulations with an activity entitled ``management of
manufacturing costs or capacities.'' Further, the final regulations
include a parenthetical list of functions (that is, managing the risk
of loss, cost reduction or efficiency initiatives associated with the
manufacturing process, demand planning, production scheduling, or
hedging raw material costs) to elaborate on the meaning of the
activity.
d. Control of Logistics
Commentators asked for clarification regarding the scope of
logistical functions that will contribute towards a substantial
contribution by a CFC. This activity is intended to include, for
example, arranging for delivery of raw materials to a contract
manufacturer, but to exclude, for example, delivery of finished goods
to a customer. The final regulations provide further clarity on this
issue by revising the activity to read ``control of manufacturing
related logistics.''
e. 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
Commentators noted that the ``and'' in the description of this
activity in the proposed regulations could be read to mean that
directing the ``development, protection, and use'' of intellectual
property are all required for this activity to be considered in the
substantial contribution analysis. Commentators requested that these
activities be stated in the disjunctive. The IRS and the Treasury
Department adopted this comment, replacing ``and'' with ``or'' in the
final regulations. This clarification is consistent with providing that
all functions performed by a CFC's employees are considered (and given
appropriate weight) under the substantial contribution test. Thus, the
CFC's employees' activities are considered regardless of whether the
CFC's employees perform all or only some of the functions listed in any
enumerated item in the indicia of manufacturing.
The term ``protection'' is also deleted from the final regulations.
The IRS and the Treasury Department were concerned that absent this
clarification the final regulations could be read to provide that legal
work performed by a CFC's in-house legal staff was considered under the
substantial contribution test, including in cases where, for example,
litigation success could be heavily correlated to
[[Page 79338]]
profitability or business failure with respect to a product. Further,
the IRS and the Treasury Department modified the description of the
activity in the final regulations to clarify that developing, or
directing the use or development of, trade secrets, technology, or
other intellectual property, are considered under the substantial
contribution test, but only when activities of this nature are
undertaken for the purpose of the manufacture of the personal property.
Commentators asked whether the intellectual property referred to in
Prop. Reg. Sec. 1.954-3(a)(4)(iv)(b)(9) included marketing
intangibles. The activity as described in both the proposed and final
regulations is with respect to intellectual property used in the
manufacture of the personal property. Thus, developing, or directing
the use or development of, marketing intangibles is not intended to be
considered in the substantial contribution test.
3. Anti-abuse Rule and Safe Harbor
The IRS and the Treasury Department requested comments on whether
the substantial contribution test should include an anti-abuse rule and
safe harbor. In particular, comments were requested as to whether it
would be appropriate to add an anti-abuse rule to prevent a CFC from
satisfying the substantial contribution test in cases in which a
significant portion of the direct or indirect contributions to the
manufacture of personal property provided collectively by the CFC and
any related U.S. persons are provided by one or more related U.S.
persons. Commentators recommended that in determining whether a CFC
makes a substantial contribution it should not be relevant whether
other persons (whether U.S. or foreign, related or unrelated)
contribute to the manufacturing process. The IRS and the Treasury
Department agree with commentators that the substantial contribution
test should focus on whether the activities of the CFC itself are
substantial without comparing those activities to those of other
persons. Thus, the final regulations do not adopt such a rule. Examples
in the final regulations also illustrate that the contributions of
other persons to the manufacture of a product are not relevant to the
analysis of whether a CFC makes a substantial contribution to the
manufacturing process. See Sec. 1.954-3(a)(4)(iv)(d) Examples 6, 7,
and 9.
The IRS and the Treasury Department also requested comments as to
whether one or more safe harbors should be added to the substantial
contribution test of the proposed regulations. Some commentators
suggested that a CFC that contributes at least twenty percent of the
costs of manufacturing personal property should be deemed to have
substantially contributed to its manufacture. Other commentators
suggested that a safe harbor was only appropriate if it were made clear
that such a safe harbor would not function as a minimum standard and
would be flexible enough to accommodate multiple industries. Many other
commentators recommended that the IRS and the Treasury Department not
adopt a safe harbor. The IRS and the Treasury Department concluded that
no safe harbor could fairly apply across the range of industries
potentially subject to Sec. 1.954-3, and therefore no safe harbor is
provided in the final regulations.
4. Definition of Employee
The IRS and the Treasury Department requested comments as to
whether the requirement in the proposed regulations that the activities
of the CFC be performed by its employees should take into account
commercial arrangements where individuals performing services for the
CFC while not on its payroll are nevertheless controlled by employees
of the CFC. Commentators requested that the regulations expand the
definition of the term ``employee'' to include various commercial or
economic arrangements where individuals who perform services for a CFC
under the CFC's direction and control are not necessarily the CFC's
employees under local law. In particular, commentators suggested that
the term ``employee'' could be defined for purposes of the substantial
contribution test using section 3121(d)(2). Other commentators asked
that the term ``employee'' be defined more broadly to include anyone in
an agency relationship with a CFC.
The IRS and the Treasury Department agree that clarification of the
term ``employee'' will promote more effective application of these
regulations. The IRS and the Treasury Department also agree that
activities performed by certain non-payroll workers should be
considered in determining whether the CFC provides a substantial
contribution through ``its employees.'' However, the IRS and the
Treasury Department concluded that it would be inappropriate to broaden
the definition of employee to include anyone in an agency relationship
with a CFC, because it could create unintended branch rule issues for
taxpayers (for example, as a result of employees of a contract
manufacturer being treated as employees of the CFC under such a
definition). Thus, the final regulations provide that the term employee
means any individual who, under Sec. 31.3121(d)-1(c), has the status
of an employee for U.S. Federal tax purposes. This definition of the
term ``employee'' may encompass certain seconded workers, part-time
workers, workers on the payroll of a related employment company whose
activities are directed and controlled by CFC employees, and
contractors, so long as those individuals are deemed to be employees of
the CFC under Sec. 31.3121(d)-1(c). Consistent with commentators'
request, this definition of the term employee may result in an
individual being treated as an employee of two or more entities
simultaneously.
5. Product Grouping
Commentators requested that the determination of whether a CFC
provides a substantial contribution to the manufacture of the personal
property be made on the basis of a group or line of related products
rather than on a product-by-product basis. The IRS and the Treasury
Department believe that the substantial contribution test must be met
with respect to each product. Whether manufactured goods are separate
products or a single product for this purpose is determined by
reference to the distinctions or lack thereof made by the CFC in its
business operations and in its books and records, rather than by
reference to a third party's definition of a product or an industry
product classification system, such as the Standard Industrial
Classification Code. The IRS and the Treasury Department recognize that
some activities taken into account under the substantial contribution
test are not performed with respect to each individual unit of a
particular product manufactured under a contract manufacturing
arrangement. Section 1.954-3(a)(4)(iv)(d) Example 11 has been added to
the final regulations to address these comments.
6. Treatment of Partnerships
Commentators requested that the regulations adopt principles to
determine when the employees of a partnership should be treated as
employees of the CFC for purposes of determining whether the CFC's
relative economic interest in the partnership should be relevant in
determining whether the CFC satisfies the substantial contribution
test. The IRS and the Treasury Department concluded that this issue was
beyond the scope of this regulatory project. However, the IRS and the
Treasury Department continue to study this issue and welcome comments.
[[Page 79339]]
7. Rebuttable Presumption
The proposed regulations provide a rebuttable presumption that the
CFC does not satisfy the substantial contribution test when the
activities of a branch of the CFC satisfy the physical manufacturing
test. The presumption can only be rebutted if the taxpayer can prove to
the satisfaction of the Commissioner that the CFC satisfied the
substantial contribution test. Commentators suggested that satisfaction
of the physical manufacturing test and satisfaction of the substantial
contribution test should be treated equally under the regulations.
Commentators also expressed the view that the standard required to
rebut the presumption was either too subjective, imposed an improperly
high standard, or both. They recommended that if a rebuttable
presumption was retained, the standard required to rebut the
presumption should be clear and convincing evidence.
In response to the comments received, the IRS and the Treasury
Department reconsidered the ability to examine a CFC's claim that it
substantially contributes to the manufacture of the personal property
when the activities of its branch satisfy the physical manufacturing
test. Upon further study, the IRS and the Treasury Department concluded
that the substantial contribution test can be administered without the
benefit of a rebuttable presumption that a CFC does not satisfy the
substantial contribution test when the activities of a branch of the
CFC satisfy the physical manufacturing test. Thus, these final and
temporary regulations do not contain a rebuttable presumption. The IRS
and the Treasury Department took into account the request for parity of
treatment with respect to satisfaction of the physical manufacturing
test and the substantial contribution test in reaching this conclusion,
as well as with respect to other aspects of the temporary regulations,
as discussed further in Parts C and D of this preamble.
8. Documentation
Some commentators requested guidance on how taxpayers should
document their activities for application of the substantial
contribution test. Because the necessary documentation will vary by
industry and by taxpayer, the IRS and the Treasury Department believe
that creating general rules of documentation would prove impracticable
and would not allow for enough flexibility in application of the
substantial contribution test. Accordingly, the final regulations do
not include documentation rules.
9. Automated Manufacturing
Several comments were received concerning Prop. Reg. Sec. 1.954-
3(a)(4)(iv)(c) Example 4. In Example 4, a CFC owns software and network
systems that remotely and automatically (without human involvement)
order raw materials for use by the contract manufacturer, take customer
orders and route them to the contract manufacturer, and perform quality
control. Although the CFC has a small number of computer technicians
monitoring the software and network systems, the software and network
systems were developed by employees of DP, the CFC's domestic parent
corporation. Those DP employees supervise the CFC's computer
technicians, evaluate the results of the automated manufacturing
business, make ongoing operational decisions related to the performance
of the manufacturing process, redesign and update the products and the
manufacturing process, and develop all of the upgrades and patches for
the software and network systems owned by the CFC. The example
concludes that the CFC does not provide a substantial contribution to
the manufacture of Product X.
Commentators expressed concern that Prop. Reg. Sec. 1.954-
3(a)(4)(iv)(c) Example 4 did not recognize the importance of automated
manufacturing in modern business practices. These commentators noted
that manufacturing processes are increasingly automated and explained
that in some high technology industries, automated manufacturing
processes are the only way to manufacture and test the quality of
certain products. In such industries, commentators noted that human
involvement in various parts of the manufacturing process could be
counterproductive. Some commentators were concerned that Prop. Reg.
Sec. 1.954-3(a)(4)(iv)(c) Example 4 penalized such automated
manufacturing processes under the substantial contribution test.
The IRS and the Treasury Department agree that a CFC may provide a
substantial contribution to a largely automated manufacturing process
through its employees. Section 1.954-3(a)(4)(iv)(d) Example 5 contains
the same facts as Prop. Reg. Sec. 1.954-3(a)(4)(iv)(c) Example 4.
Under those particular facts, substantial operational responsibilities
and decision making by humans are required for the manufacturing
process; however, they are not performed by the CFC. To provide
additional guidance, the final regulations include an additional
example, Sec. 1.954-3(a)(4)(iv)(d) Example 6, which illustrates that a
CFC whose employees perform most of the functions that DP's employees
perform in Sec. 1.954-3(a)(4)(iv)(d) Example 5 makes a substantial
contribution to the manufacturing process. This result applies even
though DP's employees also contribute to the manufacturing process.
Section 1.954-3(a)(4)(iv)(d) Example 7 further illustrates that the CFC
can make a substantial contribution through the activities of its
employees regardless of whether the software and network systems were
purchased by the CFC. These examples illustrate that the evaluation of
whether a CFC makes a substantial contribution through its employees is
determined based on whether industry-sufficient substantial
contribution activities are conducted by employees of the CFC.
B. The ``Its'' Argument
The proposed regulations clarify that for purposes of determining
FBCSI a CFC qualifies for the manufacturing exception only if the CFC,
acting through its employees, manufactured, produced, or constructed
the relevant personal property within the meaning of Sec. 1.954-
3(a)(4)(i). In response to the proposed regulations, some commentators
maintained that a CFC need not satisfy the physical manufacturing test
or the substantial contribution test to exclude a sale from FBCSI as
long as the personal property sold is not the same as the property
originally purchased by the CFC.
The IRS and the Treasury Department believe, as described in the
preamble to the proposed regulations, that this position, commonly
referred to as the ``its'' argument, is contrary to existing law, and
represents an incorrect reading of section 954(d)(1). The final
regulations accordingly maintain the rules provided in the proposed
regulations regarding when personal property sold by a CFC will be
considered to be other than the property purchased by the CFC.
C. Same Country Manufacture Exception
Commentators requested that the regulations incorporate the
substantial contribution test in the same country manufacture
exception. The IRS and the Treasury Department generally agree with
commentators that if the substantial contribution test is sufficient to
constitute the manufacture of the personal property where a CFC
substantially contributes to the manufacture, production, or
construction of that property, then it
[[Page 79340]]
should be equally sufficient if those activities are performed by a
related person (as defined in section 954(d)(3)) in the CFC's country
of organization. However, the IRS and the Treasury Department concluded
that the same country manufacture exception would be difficult to
administer and enforce in the case of a substantial contribution
performed by an unrelated third party. Commentators suggested that
these concerns could be ameliorated if taxpayers were required to
maintain documentation with respect to a third party's substantial
contribution. The IRS and the Treasury Department do not believe a
documentation requirement adequately addresses these concerns because
the IRS may be unable to audit the third party to verify if those
substantial contribution activities in fact took place. Therefore, the
final regulations provide that the same country manufacture exception
is available to taxpayers in cases when a related person provides a
substantial contribution to the manufacture of the personal property in
the CFC's country of organization. The final regulations also retain
the rule provided in the proposed regulations modifying the application
of the principles of Sec. 1.954-3(a)(4)(ii) and (a)(4)(iii) to reflect
that the personal property manufactured, produced, or constructed in
the country of organization of the selling corporation under the
principles of Sec. 1.954-3(a)(4)(ii) and (a)(4)(iii) will qualify for
the same country exception regardless of whose employees engage in
qualifying manufacturing activities in that country.
D. Branch Rule
In addition to the amendments to Sec. 1.954-3(a), the proposed
regulations also proposed amendments to the rules of Sec. 1.954-3(b)
dealing with the application of the FBCSI rules to CFCs with branches
or similar establishments (the branch rule), particularly the rules
dealing with manufacturing branches. For the remainder of this
preamble, the word ``branch'' will be used to refer to a ``branch or
similar establishment.''
1. Branch Definition
Some commentators requested that the regulations define the term
``branch'' for purposes of the branch rule. These commentators
suggested various definitions for the IRS and the Treasury Department
to consider. Commentators suggested, for instance, that a branch be
defined as a permanent establishment, as a business activity in a
jurisdiction outside a CFC's country of organization that has separate
books and records, or as a trade or business outside a CFC's country of
organization. Commentators pointed to precedents in the section 367 and
987 regulations. Alternatively, some commentators requested that the
regulations make clear that a de minimis amount of activity outside of
a CFC's country of organization (for example, traveling employees) does
not constitute a branch. Other commentators warned that requiring too
high a level of activity outside of a CFC's country of organization
before a CFC was treated as having a ``branch'' would make it possible
for a CFC organized in a lower-tax jurisdiction to contribute
substantially to manufacturing activities in a higher-tax jurisdiction
without causing the CFC to operate through a branch. Still other
commentators suggested that courts have concluded that the IRS and the
Treasury Department lack the regulatory authority to determine what
constitutes a branch, and they may only address the consequences
flowing from the existence of a branch.
The IRS and the Treasury Department determined that defining a
branch was beyond the scope of this regulatory project. However, the
temporary regulations retain an example similar to Prop. Reg. Sec.
1.954-3(b)(1)(ii)(c)(3)(f) Example 3, which illustrates that employees
of a CFC that travel to a contract manufacturer's location outside the
CFC's country of organization do not necessarily give rise to a branch
in that location. See Sec. 1.954-3T(b)(1)(ii)(c)(3)(v) Example 6. See
also Part D.3.b of this preamble.
2. Determination of Hypothetical Effective Tax Rate
Commentators requested that the regulations clarify that the tax
rate disparity tests contained in Sec. Sec. 1.954-3(b)(1)(i)(b) and
(b)(1)(ii)(b) take into account incentive tax rates and other similar
foreign tax relief available to a CFC in calculating the hypothetical
effective tax rate of tax.
The IRS and the Treasury Department recognize that the tax rate
disparity tests should take into account the actual tax rate paid with
respect to the sales income by the selling branch or remainder and the
hypothetical effective tax rate that would be paid by the manufacturing
branch (or remainder) on that sales income under the laws of the
country in which the manufacturing branch is located (or, in the case
of a remainder, the country of organization of the CFC) if it were
derived from sources within that country. Thus, the IRS and the
Treasury Department agree that uniformly available tax incentives are
to be considered in determining the hypothetical effective tax rate to
be used in applying the tax rate disparity tests. In contrast, if a
sales affiliate in the country of manufacturing can theoretically
receive certain tax relief by taking certain actions, for example, by
applying for special treatment pursuant to a ruling process, but the
taxpayer has not affirmatively obtained such tax relief for the
manufacturing branch (or remainder), then the hypothetical effective
tax rate that would be paid by the manufacturing branch (or remainder)
were it to derive the sales income should be the effective tax rate
that would be applicable in that jurisdiction without such tax relief.
The IRS and the Treasury Department believe that no change to the text
of the existing regulations is necessary to address these points.
However, Sec. 1.954-3T(b)(4) Example (8) is included in the temporary
regulations to illustrate that uniformly applicable incentive tax rates
are taken into account in determining the hypothetical effective tax
rate.
The IRS and the Treasury Department concluded that other questions
and requests in this area, including further clarification of the
methodology for calculation of hypothetical tax rates, and for changes
to the assumptions used in applying the tax rate disparity tests and
determining the hypothetical effective tax rate, are beyond the scope
of this regulatory project. However, the IRS and the Treasury
Department continue to study these questions and welcome comments.
3. Multiple Manufacturing Branch Rules
a. Determination of the Location of Manufacturing
Under Prop. Reg. Sec. 1.954-3(b)(1)(ii)(c)(3), the relevant tax
rate disparity test is applied by giving satisfaction of the physical
manufacturing test precedence over satisfaction of the substantial
contribution test when multiple branches, or one or more branches and
the remainder of the CFC, perform manufacturing activities with respect
to the same item of personal property. If more than one branch (or one
or more branches and the remainder of the CFC) each independently
satisfies the physical manufacturing test, then the branch or the
remainder of the CFC located or organized in the jurisdiction that
would impose the lowest effective rate of tax is treated as the
location of manufacturing, producing, or constructing of the personal
property for purposes of applying the tax rate disparity test (lowest-
of-all-rates rule). If only one branch (or only the remainder of a CFC)
independently satisfies the physical manufacturing test, then that
[[Page 79341]]
branch (or remainder) is treated as the location of manufacturing,
producing, or constructing of the personal property (location of
manufacturing) for purposes of the tax rate disparity test.
If none of the branches or the remainder of the CFC independently
satisfies the physical manufacturing test, but the CFC as a whole
satisfies the substantial contribution test, then the location of
manufacturing under the proposed regulations is the location of the
branch or the remainder of the CFC that provides the predominant amount
of the CFC's substantial contribution to the manufacture of the
personal property (predominant place rule). If a predominant amount of
the CFC's contribution to the manufacture of the personal property is
not provided by any one location, then the location of manufacturing
for purposes of applying the manufacturing branch tax rate disparity
test under the proposed regulations is that place (either the remainder
of the CFC or one of its branches) where manufacturing activity with
respect to that property is performed and which would impose the
highest effective rate of tax (highest-of-all-rates rule) when applying
either Sec. 1.954-3(b)(1)(i)(b) or (b)(1)(ii)(b).
The IRS and the Treasury Department received multiple comments
comparing and contrasting the highest- and lowest-of-all-rates rules.
For example, commentators asked why the lowest-of-all-rates rule should
apply when more than one branch (or one or more branches and the
remainder of the CFC) independently satisfy the physical manufacturing
test, whereas the highest-of-all-rates rule should apply when none of
the branches or the remainder of the CFC independently satisfies the
physical manufacturing test but the CFC as a whole satisfies the
substantial contribution test. Commentators suggested that satisfaction
of the physical manufacturing test and the substantial contribution
test should be treated equally under the regulations, and therefore
suggested having the same rule in both circumstances. These
commentators proposed a lowest-of-all-rates rule or the use of a
weighted average of the tax rate of each branch or remainder of the CFC
in both instances.
The IRS and the Treasury Department generally agreed with these
comments. The IRS and the Treasury Department adopted taxpayers'
comment that the same rule should apply consistently when a branch (or
remainder) independently satisfies Sec. 1.954-3(a)(4)(i), regardless
of whether it satisfies the physical manufacturing test or the
substantial contribution test. Therefore the rules set forth in the
proposed regulations are modified in the temporary regulations to
provide that the lowest-of-all-rates rule will apply whenever a branch
(or remainder) independently satisfies Sec. 1.954-3(a)(4)(ii), (iii),
or (iv). However, providing parity of treatment for satisfaction of the
physical manufacturing test and the substantial contribution test in
respect of the lowest-of-all-rates rule is not sufficient to determine
the location of manufacturing in cases where a CFC satisfies the
substantial contribution test, yet no branch (or remainder)
independently satisfies Sec. 1.954-3(a)(4)(iv).
Commentators questioned how to treat branches making contributions
to the manufacture of the personal property through the activities of
employees when no branch independently satisfies Sec. 1.954-
3(a)(4)(iv). Some commentators expressed concern that it would be
difficult to compare the relative contributions of various locations to
determine which branch or remainder of the CFC made a predominant
contribution under the predominant place rule. Other commentators
requested greater guidance regarding the meaning of predominant
contribution. Many commentators suggested that the highest-of-all-rates
rule in the proposed regulations could lead to arbitrary results when
no predominant contributor could be identified.
The IRS and the Treasury Department generally agreed with these
comments. Consequently, the temporary regulations revise the rules for
determining the location of manufacture of the personal property when
more than one branch (or one or more branches and the remainder)
contributes to the manufacture of the personal property but no branch
(or remainder) independently satisfies the physical manufacturing test
or the substantial contribution test. The revised rules are based on
the principle that the branch rule should apply in situations where
purchase or sale activities with respect to the personal property are
separated from manufacturing activities conducted by the CFC such that
a demonstrably greater amount of manufacturing activity with respect to
that property occurs in jurisdictions with tax rate disparity relative
to the sales or purchase branch (or, in the case of a purchasing or
selling remainder, the demonstrably greater amount of manufacturing
activity with respect to the personal property occurs in jurisdictions
with tax rate disparity relative to the purchasing or selling
remainder).
Under the temporary regulations, if a demonstrably greater amount
of manufacturing activity with respect to the personal property occurs
in jurisdictions without tax rate disparity relative to the sales or
purchase branch, the location of the sales or purchase branch will be
deemed to be the location of manufacture of the personal property. In
that case, the purchase or sales activities with respect to the
property purchased or sold by or through the sales or purchase branch
of the CFC will not, for purposes of determining FBCSI in connection
with the sale of that property, be deemed to have substantially the
same tax effect as if a branch were a wholly owned subsidiary
corporation of the CFC. Otherwise, the location of manufacture of the
personal property will be deemed to be the location of a manufacturing
branch (or remainder) that has tax rate disparity relative to the sales
or purchase branch. In that case, the purchase or sales activities with
respect to the property purchased or sold by or through the sales or
purchase branch of the CFC will be deemed to have substantially the
same tax effect as if a branch were a wholly owned subsidiary
corporation of the CFC, and that branch will be treated as a separate
corporation for purposes of applying the regulations.
The temporary regulations apply analogous rules in the case of
purchase or sales activity being conducted through the jurisdiction
under the laws of which the CFC is organized. In such cases, however,
the analysis focuses on whether the demonstrably greater amount of
manufacturing activity with respect to the personal property occurs in
jurisdictions that do or do not have tax rate disparity relative to the
jurisdiction under the laws of which the CFC is organized. The
temporary regulations incorporate examples under Sec. 1.954-
3T(b)(1)(ii)(c)(3)(v) to illustrate the application of these rules.
b. Location of Activities
The proposed regulations provide that for purposes of the multiple
manufacturing branch rules the location of any activity with respect to
the manufacture of the personal property is where the CFC's employees
engage in such activity. Commentators suggested that in some cases the
proposed regulations left it unclear, for purposes of determining the
location of manufacturing, which jurisdiction was accorded credit for
activities performed by an employee who is traveling temporarily to a
foreign jurisdiction. Some commentators suggested that the location of
activity rule should be removed or that the regulations should
[[Page 79342]]
clarify that, for instance, the activities of employees of a CFC based
in the jurisdiction under the laws of which the CFC is organized, even
while traveling outside the CFC's country of organization, would
generally be credited toward establishing that the jurisdiction under
the laws of which the CFC is organized provided a predominant amount of
a CFC's substantial contribution. The IRS and the Treasury Department
believe the text of Sec. 1.954-3T(b)(1)(ii)(c)(3)(iv) makes clear that
when an employee travels to perform activities, those activities are
credited to the location in which the activities are conducted if there
is a branch or remainder of the CFC in that jurisdiction. Section
1.954-3T(b)(1)(ii)(c)(3)(v) provides examples to further clarify this
result.
Other commentators asked which location was accorded credit, if
any, for activities performed by traveling employees of the CFC while
located in a country in which there is no branch or remainder of the
CFC. The temporary regulations provide that the location of any
manufacturing activity is where the employees of the CFC perform that
activity. Thus, the activities of employees while traveling to a
country where the CFC does not maintain a branch or remainder are not
credited to the branch or remainder where the traveling employees are
regularly employed for purposes of determining the location of
manufacture of the personal property under the branch rule. Such
activities, however, can be taken into account for purposes of
satisfying the manufacturing exception and the substantial contribution
test. See Sec. 1.954-3T(b)(1)(ii)(c)(3)(v) Example 6.
c. Clarifying Application of the Rule for Determining the Remainder of
the CFC When Activities Are Performed in Multiple Locations
Prop Reg. Sec. 1.954-3(b)(2)(ii)(a) provides that when treating
the location of sales or purchase income as a separate corporation for
purposes of determining whether FBCSI is realized, that separate
corporation will exclude any branch or the remainder of the CFC that
would be treated as a separate corporation, if the hypothetical tax
rate imposed by the jurisdiction of each such branch or the remainder
of the CFC were separately tested against the effective rate of tax
imposed on the sales or purchase income under the relevant tax rate
disparity test. Commentators suggested that the application of this
rule for determining the remainder of the CFC when activities are
preformed in multiple locations is unclear. To clarify, the language
from the proposed regulations is revised in the temporary regulations
to describe what is included in the remainder, rather than what is
excluded from the remainder, for purposes of determining whether there
is FBCSI, after it is determined that a manufacturing branch should
receive treatment as a separate corporation for purposes of applying
the regulations. See Sec. 1.954-3T(b)(2)(ii)(a).
As with the rule provided in the proposed regulations, this rule is
intended to provide that the activities of all branch locations (or, in
the case of a remainder, the activities in the jurisdiction under the
laws of which the CFC is organized) that do not have tax rate disparity
relative to the sales or purchase branch location (or, in the case of a
purchasing or selling remainder, the jurisdiction under the laws of
which the CFC is organized) may be taken into account together with the
activities of the sales or purchase branch (or, in the case of a
purchasing or selling remainder, activities of the remainder of the CFC
in the jurisdiction under the laws of which the CFC is organized) for
purposes of applying the separate corporation analysis required under
the regulations and determining whether the sales income of the sales
or purchase branch (or remainder) is FBCSI. Such determination will
depend on whether the substantial contribution test is satisfied by the
combined activities of the sales or purchase branch (or remainder) and
the other locations aggregated with the sales or purchase branch (or
remainder).
4. Coordination of Sales and Manufacturing Branch Rules
Commentators requested guidance on how the sales or purchase branch
rules interact with the manufacturing branch rules. The current
manufacturing branch rules contemplate the existence of a sales or
purchase branch and a manufacturing branch. The rules provide that in
such an instance the sales or purchase branch is treated as the
remainder of the CFC for purposes of applying the tax rate disparity
test. However, the sales or purchase branch rules of Sec. 1.954-
3(b)(1)(i) of the existing regulations do not indicate that those rules
do not apply in cases where the manufacturing branch rules are applied.
Commentators were concerned that the manufacturing branch rules would
be applied in addition to, rather than in lieu of, the sales or
purchase branch rules.
The IRS and the Treasury Department agree that if one or more sales
or purchase branches are used in addition to a manufacturing branch and
Sec. 1.954-3T(b)(1)(ii)(c)(1) (use of one or more sales or purchases
branches in addition to a manufacturing branch) is applied with respect
to income from the sale of an item of personal property, then the sales
or purchasing branch rules do not also apply to determine whether that
income is FBCSI. Therefore, the temporary regulations clarify this
point. See Sec. 1.954-3(b)(1)(i)(c).
5. Unrelated to Unrelated Transactions
Commentators suggested that there was uncertainty as to whether a
substantial contribution to the manufacture, production, or
construction of personal property by a CFC could cause the CFC to earn
FBCSI in cases where, in the absence of the substantial contribution
test, some taxpayers had taken the position that they were outside the
scope of the FBCSI rules. Some commentators expressed concern that
transactions that are not currently subject to the existing regulations
may become subject to the regulations as a result of the interaction of
the substantial contribution test and the manufacturing branch rule.
Other commentators suggested more generally that it was unclear if the
substantial contribution test might create a branch through which a CFC
carries on activities in a contract manufacturer's jurisdiction.
Commentators suggested that taxpayers should be exempted from the
branch consequences of the regulations by providing that the
manufacturing branch rule only apply if the CFC was relying on the
manufacturing exception for purposes of section 954(d)(1), or
alternatively that the substantial contribution test should be
elective. In this context, commentators noted that placing a CFC's
substantial contribution activities, which are performed outside the
country where the sales activities are performed, in a separately
incorporated entity could prevent the CFC from having a branch that is
subject to the manufacturing branch rule as a result of such
activities.
The IRS and the Treasury Department agree that taxpayers may be
subject to the FBCSI rules as a result of CFC employees performing
indicia of manufacturing activities through a branch outside the
country of organization of a CFC. The IRS and the Treasury Department
believe this result is clear in the proposed regulations, and therefore
no modifications are made to the text of the temporary regulations to
clarify further this result. The IRS and the Treasury Department note
that many commentators criticized the proposed regulations for drawing
inappropriate distinctions between satisfaction of the
[[Page 79343]]
physical manufacturing test and satisfaction of the substantial
contribution test, and argued that updating the manufacturing exception
in the context of modern business enterprise models required treating
with equal importance and weight physical manufacturing and activities
satisfying the substantial contribution test. The IRS and the Treasury
Department adopted this comment in both the final regulations and the
temporary regulations and, accordingly, did not incorporate in the
temporary regulations an exception regarding activities performed
through a branch located outside the country of organization of a CFC
for cases in which, in the absence of the substantial contribution
test, some taxpayers had taken the position that they were outside the
scope of the FBCSI rules.
One commentator noted that while there are strong policy reasons
for the substantial contribution test and the branch rules to apply in
the case of ``unrelated to unrelated'' transactions, the IRS and the
Treasury Department should consider a special delayed effective date to
allow taxpayers in this position time to restructure their operations
in light of the regulations. The commentator argued that such taxpayers
had been outside the scope of the FBCSI rules prior to these
regulations and should be provided reasonable time to restructure. For
a discussion of the effective date of the final and temporary
regulations, see Part F of this preamble.
6. Branch Rule Examples
Commentators expressed concern that the facts of Prop. Reg. Sec.
1.954-3(b)(1)(ii)(c)(3)(f) Example 4 ascribed most substantial
contribution activities to the remainder, but determined that the
remainder had not met the substantial contribution test. In the
example, the remainder performs seven activities listed in the indicia
of manufacturing of the proposed regulations, whereas Branch A performs
only one activity (design) and Branch B performs only two activities.
The example was intended to show that in a CFC's particular industry,
the weight accorded to the activities performed by each branch can be
comparable, even though a different number of activities occur in
different locations, because the economic significance of the
activities conducted in each location is comparable. However, the IRS
and the Treasury Department recognize that the example may have caused
confusion for taxpayers. Therefore, the allocation of activities in
Example 4 of Prop. Reg. Sec. 1.954-3(b)(1)(ii)(c)(3)(f) has been
revised in Sec. 1.954-3T(b)(1)(ii)(c)(3)(v) Example 3. Moreover,
Examples 4, 5, and 6 of Prop. Reg. Sec. 1.954-3(b)(1)(ii)(c)(3)(f)
have been restructured in the temporary regulations to be consistent
with the revisions to the branch rules.
Commentators also noted that Example 4 and Example 5 of Prop. Reg.
Sec. 1.954-3(b)(1)(ii)(c)(3)(f) suggest that income other than sales
or purchasing income may be FBCSI. These examples are amended in the
temporary regulations to be consistent with section 954(d)(2), which
provides that income attributable to the carrying on of purchase or
sales activities by a branch may be FBCSI.
Commentators requested that the IRS and the Treasury Department add
an example to the regulations to illustrate how the substantial
contribution test and the branch rules operate in cases involving
multiple manufacturing branches and multiple sales branches. The
temporary regulations include such an example. See Sec. 1.954-
3T(b)(1)(ii)(c)(3)(v) Example 5.
The temporary regulations also include an example illustrating the
operation of the location of manufacture rules under Sec. 1.954-
3T(b)(1)(ii)(c)(3) and the application of the substantial contribution
test when a tested manufacturing location has been determined to have
tax rate disparity with a tested sales location. See Sec. 1.954-
3T(b)(4) Example (9). Example (9) illustrates that a tested sales
location can satisfy the substantial contribution test for purposes of
determining FBCSI once it has been determined that a tested
manufacturing location should be treated as a separate corporation for
purposes of determining FBCSI. Although a branch that has tax rate
disparity with the tested sales location is the tested manufacturing
location, Example (9) concludes that the CFC does not have FBCSI from
the sale of the personal property because, after applying the
aggregation rules of Sec. 1.954-3T(b)(2)(ii)(a), the tested sales
location satisfies Sec. 1.954-3(a)(4)(iv).
E. Conforming Amendments
Sections 1.954-3(a)(1)(i) and (c) of the existing regulations
contain cross-references to foreign base company shipping income under
Sec. 1.954-6. Section 954 was amended by Public Law 108-357 in 2004,
and foreign base company shipping income was removed as a separate
category of foreign base company income. The final regulations are
amended by deleting both references to foreign base company shipping
income to reflect the 2004 amendment to section 954.
Section 1.954-3(a)(1)(i) of the existing regulations defines
``related person'' and ``unrelated person'' by an obsolete cross
reference to Sec. 1.954-1(e). The final regulations are amended to
define ``related person'' and ``unrelated person'' with reference to
Sec. 1.954-1(f).
F. Effective Date
Several commentators requested that the new regulations provide for
a delayed effective date to allow taxpayers to implement supply chain
and structural changes that may be required to satisfy the substantial
contribution test and the branch rules. The IRS and the Treasury
Department agree that a delayed effective date is appropriate for
taxpayers whose structures require modification to accommodate the new
regulations. Accordingly, these final and temporary regulations will
apply to taxable years of CFCs beginning after June 30, 2009, and for
taxable years of United States shareholders in which or with which such
taxable years of the CFCs end. Thus, the final and temporary
regulations will become applicable January 1, 2010, for CFCs whose
taxable year is the calendar year. The temporary regulations will
expire on or before December 23, 2011. In addition, a taxpayer may
choose to apply these final and temporary regulations retroactively
with respect to its open taxable years. The taxpayer may so choose if
and only if the taxpayer and all members of the taxpayer's affiliated
group apply both the final and temporary regulations, in their
entirety, to the earliest taxable year of each controlled foreign
corporation that ends with or within an open taxable year of the
taxpayer and to all subsequent taxable years. A taxpayer that chose,
prior to December 24, 2008, to apply Prop. Reg. Sec. 1.954-3 (73 FR
10716 as corrected at 73 FR 20201) in its entirety to all of the
taxpayer's open taxable years in which or with which a taxable year of
a controlled foreign corporation of the taxpayer ended, may continue to
apply Prop. Reg. Sec. 1.954-3 (73 FR 10716 as corrected at 73 FR
20201) in its entirety with respect to all of the taxpayer's open
taxable years that begin prior to July 1, 2009.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It has also been
determined that section 553(b) of the Administrative Procedure Act (5
U.S.C. chapter 5) does not apply to these regulations and because the
regulations do not impose a collection
[[Page 79344]]
of information on small entities, the Regulatory Flexibility Act (5
U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the
Code, the notice of proposed rulemaking that preceded these final and
temporary regulations was submitted to the Chief Counsel for Advocacy
of the Small Business Administration for comment on its impact on small
business.
Drafting Information
The principal author of these regulations is Ethan Atticks of the
Office of Associate Chief Counsel (International). However, other
personnel from the IRS and the Treasury Department participated in
their development.
List of Subjects in 26 CFR Part 1
Income Taxes, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
0
Accordingly, 26 CFR part 1 is amended as follows:
PART 1--INCOME TAXES
0
Paragraph 1. The authority citation for 26 CFR part 1 continues to read
in part as follows:
Authority: 26 U.S.C. 7805 * * *
0
Par. 2. Section 1.954-3 is amended by:
0
1. Revising paragraphs (a)(1)(i), (a)(1)(iii) Examples 1 and 2, (a)(2),
(a)(4)(i), (a)(4)(ii), (a)(4)(iii), (a)(6)(i), and (c).
0
2. Adding paragraphs (a)(4)(iv) and (d).
0
3. Removing and reserving paragraphs (b)(1)(i)(c), (b)(1)(ii)(a),
(b)(1)(ii)(c), (b)(2)(i)(b), (b)(2)(i)(d), (b)(2)(ii)(a),
(b)(2)(ii)(b), (b)(2)(ii)(e) and (b)(4) Example (3).
The additions and revisions read as follows:
Sec. 1.954-3 Foreign base company sales income.
(a) * * *
(1) In general--(i) General rules. Foreign base company sales
income of a controlled foreign corporation shall, except as provided in
paragraphs (a)(2), (a)(3) and (a)(4) of this section, consist of gross
income (whether in the form of profits, commissions, fees or otherwise)
derived in connection with the purchase of personal property from a
related person and its sale to any person, the sale of personal
property to any person on behalf of a related person, the purchase of
personal property from any person and its sale to a related person, or
the purchase of personal property from any person on behalf of a
related person. See section 954(d)(1). For purposes of the preceding
sentence, except as provided in paragraphs (a)(2) and (a)(4) of this
section, personal property sold by a controlled foreign corporation
will be considered to be the same property that was purchased by the
controlled foreign corporation regardless of whether the personal
property is sold in the same form in which it was purchased, in a
different form than the form in which it was purchased, or as a
component part of a manufactured product. This section shall apply to
the purchase and/or sale of personal property, whether or not such
property was purchased and/or sold in the ordinary course of trade or
business, except that income derived in connection with the sale of
tangible personal property will not be considered to be foreign base
company sales income if such property is sold to a person that is not a
related person, as defined in Sec. 1.954-1(f), after substantial use
has been made of the property by the controlled foreign corporation in
its trade or business. This section shall not apply to the excess of
gains over losses from sales or exchanges of securities or from futures
transactions, to the extent such excess gains are includible in foreign
personal holding company income of the controlled foreign corporation
under Sec. 1.954-2; nor shall it apply to the sale of the controlled
foreign corporation's property (other than its stock in trade or other
property of a kind which would properly be included in its inventory if
on hand at the close of the taxable year, or property held primarily
for sale to customers in the ordinary course of its business) if
substantially all the property of such corporation is sold pursuant to
the discontinuation of the trade or business previously carried on by
such corporation. The term ``any person'' as used in this paragraph
(a)(1)(i) includes a related person as defined in Sec. 1.954-1(f).
* * * * *
(iii) * * *
Example 1. Controlled foreign corporation A, incorporated under
the laws of foreign country X, is a wholly owned subsidiary of
domestic corporation M. Corporation A purchases from M Corporation,
a related person, articles manufactured in the United States and
sells the articles to P, an unrelated person, for delivery and use
in foreign country Y. Gross income of A Corporation derived from the
purchase and sale of the personal property is foreign base company
sales income.
Example 2. Corporation A in Example 1 also purchases from P, an
unrelated person, articles manufactured in country Y and sells the
articles to foreign corporation B, a related person, for use in
foreign country Z. Gross income of A Corporation derived from the
purchase and sale of the personal property is foreign base company
sales income.
* * * * *
(2) Property manufactured, produced, constructed, grown, or
extracted within the country in which the controlled foreign
corporation is created or organized. Foreign base company sales income
does not include income derived in connection with the purchase and
sale of personal property (or purchase or sale of personal property on
behalf of a related person) in a transaction described in paragraph
(a)(1) of this section if the property is manufactured, produced,
constructed, grown, or extracted in the country under the laws of which
the controlled foreign corporation which purchases and sells the
property (or acts on behalf of a related person) is created or
organized. See section 954(d)(1)(A). The principles set forth in
paragraphs (a)(4)(ii) and (a)(4)(iii) of this section apply under this
paragraph (a)(2) in determining what constitutes the manufacture,
production, or construction of personal property, excluding the
requirement set forth in paragraph (a)(4)(i) of this section that the
provisions of paragraphs (a)(4)(ii) and (a)(4)(iii) of this section may
only be satisfied through the activities of employees of the
corporation manufacturing, producing, or constructing the personal
property. The principles of paragraph (a)(4)(iv) of this section apply
under this paragraph (a)(2) in determining what constitutes the
manufacture, production, or construction of personal property but only
when the personal property is manufactured, produced, or constructed by
a person related to the controlled foreign corporation within the
meaning of Sec. 1.954-1(f). The application of this paragraph (a)(2)
may be illustrated by the following examples:
* * * * *
(4) Property manufactured, produced, or constructed by the
controlled foreign corporation--(i) In general. Foreign base company
sales income does not include income of a controlled foreign
corporation derived in connection with the sale of personal property
manufactured, produced, or constructed by such corporation. A
controlled foreign corporation will have manufactured, produced, or
constructed personal property which the corporation sells only if such
corporation satisfies the provisions of paragraph (a)(4)(ii),
(a)(4)(iii), or (a)(4)(iv) of this section through the activities of
its employees (as defined in Sec. 31.3121(d)-1(c) of this chapter)
with respect to such property.
[[Page 79345]]
A controlled foreign corporation will not be treated as having
manufactured, produced, or constructed personal property which the
corporation sells merely because the property is sold in a different
form than the form in which it was purchased. For rules of
apportionment in determining foreign base company sales income derived
from the sale of personal property purchased and used as a component
part of property which is not manufactured, produced, or constructed,
see paragraph (a)(5) of this section.
(ii) Substantial transformation of property. If personal property
purchased by a foreign corporation is substantially transformed by such
foreign corporation prior to sale, the property sold by the selling
corporation is manufactured, produced, or constructed by such selling
corporation. The application of this paragraph (a)(4)(ii) may be
illustrated by the following examples:
* * * * *
(iii) Manufacture of a product when purchased components constitute
part of the property sold. If purchased property is used as a component
part of personal property which is sold, the sale of the property will
be treated as the sale of a manufactured product, rather than the sale
of component parts, if the assembly or conversion of the component
parts into the final product by the selling corporation involves
activities that are substantial in nature and generally considered to
constitute the manufacture, production, or construction of property.
Without limiting this substantive test, which is dependent on the facts
and circumstances of each case, the operations of the selling
corporation in connection with the use of the purchased property as a
component part of the personal property which is sold will be
considered to constitute the manufacture of a product if in connection
with such property conversion costs (direct labor and factory burden)
of such corporation account for 20 percent or more of the total cost of
goods sold. In no event, however, will packaging, repackaging,
labeling, or minor assembly operations constitute the manufacture,
production, or construction of property for purposes of section
954(d)(1). The application of this paragraph (a)(4)(iii) may be
illustrated by the following examples:
* * * * *
(iv) Substantial contribution to manufacturing of personal
property--(a) In general. If an item of personal property would be
considered manufactured, produced, or constructed (under the principles
of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) prior to sale
by the controlled foreign corporation had all of the manufacturing,
producing, and constructing activities undertaken with respect to that
property prior to sale been undertaken by the controlled foreign
corporation through the activities of its employees, then this
paragraph (a)(4)(iv) applies. If this paragraph (a)(4)(iv) applies and
if the facts and circumstances evince that the controlled foreign
corporation makes a substantial contribution through the activities of
its employees to the manufacture, production, or construction of the
personal property sold, then the personal property sold by the
controlled foreign corporation is manufactured, produced, or
constructed by such controlled foreign corporation.
(b) Activities. The determination of whether a controlled foreign
corporation makes a substantial contribution through the activities of
its employees to the manufacture, production, or construction of the
personal property sold involves, but will not necessarily be limited
to, consideration of the following activities:
(1) Oversight and direction of the activities or process pursuant
to which the property is manufactured, produced, or constructed (under
the principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section).
(2) Activities that are considered in, but that are insufficient to
satisfy, the tests provided in paragraphs (a)(4)(ii) and (a)(4)(iii) of
this section.
(3) Material selection, vendor selection, or control of the raw
materials, work-in-process or finished goods.
(4) Management of manufacturing costs or capacities (for example,
managing the risk of loss, cost reduction or efficiency initiatives
associated with the manufacturing process, demand planning, production
scheduling, or hedging raw material costs).
(5) Control of manufacturing related logistics.
(6) Quality control (for example, sample testing or establishment
of quality control standards).
(7) 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.
(c) Application of substantial contribution test. When considering
whether a controlled foreign corporation makes a substantial
contribution to the manufacture, production, or construction of the
personal property, the performance of any activity in paragraph
(a)(4)(iv)(b) of this section will be taken into account. The
performance or lack of performance of any particular activity in
paragraph (a)(4)(iv)(b) of this section, or of a particular number of
activities in (a)(4)(iv)(b) of this section, is not determinative. The
weight accorded to the performance of any quantum of any activity
(whether or not specified in paragraph (a)(4)(iv)(b) of this section)
will vary with the facts and circumstances of the particular business.
See paragraph (a)(4)(iv)(d) Examples 8, 10 and 11 of this section. In
determining whether the activities of the controlled foreign
corporation constitute a substantial contribution, there is no minimum
performance threshold before an activity can be considered. The fact
that other persons make a substantial contribution to the manufacture,
production, or construction of the personal property prior to sale does
not preclude the controlled foreign corporation from making a
substantial contribution to the manufacture, construction, or
production of that property through the activities of its employees.
See paragraph (a)(4)(iv)(d) Example 9 of this section.
(d) Examples. The rules of this paragraph (a)(4)(iv) are
illustrated by the following examples:
Example 1. No substantial contribution to manufacturing. (i)
Facts. FS, a controlled foreign corporation, purchases raw materials
from a related person. The raw materials are manufactured (under the
principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section)
into Product X by CM, an unrelated corporation, pursuant to a
contract manufacturing arrangement. CM physically performs the
substantial transformation, assembly, or conversion outside of FS's
country of organization. Product X is sold by FS for use outside of
FS's country of organization. Under the terms of the contract, FS
retains the right to control the raw materials, work-in-process, and
finished goods, and the right to oversee and direct the activities
or process pursuant to which Product X is manufactured by CM. FS
owns the intellectual property used in the manufacturing process.
However, FS does not exercise, through its employees, its powers to
control the raw materials, work-in-process, or finished goods, and
FS does not exercise its powers of oversight and direction.
Likewise, FS does not, through its employees, develop or direct the
use or development of the intellectual property for the purpose of
manufacturing Product X.
(ii) Result. If the manufacturing activities undertaken with
respect to Product X prior to sale were undertaken by FS through the
activities of its employees, FS would have satisfied the
manufacturing exception contained in paragraph (a)(4)(ii) or
(a)(4)(iii)
[[Page 79346]]
of this section with respect to Product X. Therefore, this paragraph
(a)(4)(iv) applies. FS does not satisfy the test under this
paragraph (a)(4)(iv) because it does not make a substantial
contribution through the activities of its employees to the
manufacture of Product X. Mere contractual rights to control
materials, contractual rights to oversee and direct the
manufacturing activities or process pursuant to which the property
is manufactured, and ownership of intellectual property are not
sufficient to satisfy this paragraph (a)(4)(iv). Therefore, under
the facts and circumstances of the business, FS is not considered to
have manufactured Product X under paragraph (a)(4)(i) of this
section.
Example 2. Substantial contribution to manufacturing. (i) Facts.
Assume the same facts as in Example 1, except for the following. FS,
through its employees, engages in product design and quality control
and controls manufacturing related logistics. Employees of FS
exercise the right to oversee and direct the activities of CM in the
manufacture of Product X.
(ii) Result. If the manufacturing activities undertaken with
respect to Product X prior to sale were undertaken by FS through the
activities of its employees, FS would have satisfied the
manufacturing exception contained in paragraph (a)(4)(ii) or
(a)(4)(iii) of this section with respect to Product X. Therefore,
this paragraph (a)(4)(iv) applies. Under the facts and circumstances
of the business, FS satisfies the test under this paragraph
(a)(4)(iv) because it makes a substantial contribution through the
activities of its employees to the manufacture of Product X.
Therefore, FS is considered to have manufactured Product X under
paragraph (a)(4)(i) of this section. The analysis and conclusion
would be the same if CM were related to FS because the relationship
between CM and FS is irrelevant for purposes of applying paragraph
(a)(4) of this section.
Example 3. Raw materials procured by contract manufacturer. (i)
Facts. FS, a controlled foreign corporation, enters into a contract
with CM to manufacture (under the principles of paragraph (a)(4)(ii)
or (a)(4)(iii) of this section) Product X. CM physically performs
the substantial transformation, assembly, or conversion required to
manufacture Product X outside of FS's country of organization.
Product X is sold by FS for use outside of FS's country of
organization. Employees of FS select the materials that will be used
to manufacture Product X. FS does not own the materials or work-in-
process during the manufacturing process. FS, through its employees,
exercises oversight and direction of the manufacturing process and
provides quality control. FS manages the manufacturing costs and
capacities with respect to Product X by managing the risk of loss
and engaging in demand planning and production scheduling.
(ii) Result. If the manufacturing activities undertaken with
respect to Product X prior to sale were undertaken by FS through the
activities of its employees, FS would have satisfied the
manufacturing exception contained in paragraph (a)(4)(ii) or
(a)(4)(iii) of this section with respect to Product X. Therefore,
this paragraph (a)(4)(iv) applies. Under the facts and circumstances
of the business, FS satisfies the test under this paragraph
(a)(4)(iv) because it makes a substantial contribution through the
activities of its employees to the manufacture of Product X.
Therefore, FS is considered to have manufactured Product X under
paragraph (a)(4)(i) of this section.
Example 4. Physical conversion by employees of a person other
than the contract manufacturer. (i) Facts. FS, a controlled foreign
corporation organized in Country M, purchases raw materials from a
related person. The raw materials are manufactured (under the
principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section)
into Product X by CM, an unrelated corporation, pursuant to a
contract manufacturing arrangement. CM physically performs the
substantial transformation, assembly, or conversion required to
manufacture Product X outside of FS's country of organization.
Product X is sold by FS for use outside of FS's country of
organization. CM contracts with another corporation for its
employees in order to operate CM's manufacturing plant and
transform, assemble, or convert the raw materials into Product X.
Apart from the physical performance of the substantial
transformation, assembly, or conversion of the raw materials into
Product X, employees of FS perform all of the other manufacturing
activities required in connection with the manufacture of Product X
(for example, oversight and direction of the manufacturing process;
vendor selection; control of raw materials, work-in-process, and
finished goods; control of manufacturing related logistics; and
quality control).
(ii) Result. If the manufacturing activities undertaken with
respect to Product X prior to sale were undertaken by FS through the
activities of its employees, FS would have satisfied the
manufacturing exception contained in paragraph (a)(4)(ii) or
(a)(4)(iii) of this section with respect to Product X. Therefore,
this paragraph (a)(4)(iv) applies. Under the facts and circumstances
of the business, FS satisfies the test under this paragraph
(a)(4)(iv) because it makes a substantial contribution through the
activities of its employees to the manufacture of Product X.
Therefore, FS is considered to have manufactured Product X under
paragraph (a)(4)(i) of this section.
Example 5. Automated manufacturing supervised by another person.
(i) Facts. FS, a controlled foreign corporation, purchases raw
materials from a related person. The raw materials are manufactured
(under the principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this
section) into Product X by CM, an unrelated corporation selected by
FS, pursuant to a contract manufacturing arrangement. CM physically
performs the substantial transformation, assembly, or conversion
outside of FS's country of organization. Product X is sold by FS to
related and unrelated persons for use outside of FS's country of
organization. At all times, FS retains ownership of the raw
materials, work-in-process, and finished goods. FS retains the right
to oversee and direct the activities or process pursuant to which
Product X is manufactured by CM, but does not exercise, through its
employees, its powers of oversight and direction. FS is the owner of
sophisticated software and network systems that remotely and
automatically (without human involvement) take orders, route them to
CM, order raw materials, and perform quality control. FS has a small
number of computer technicians who monitor the software and network
systems to ensure that they are running smoothly and apply any
necessary patches or fixes. The software and network systems were
developed by employees of DP, the U.S. corporate parent of FS. DP's
employees supervise the computer technicians, evaluate the results
of the automated manufacturing business, and make ongoing
operational decisions, including decisions related to acceptable
performance of the manufacturing process, stoppages of that process,
and decisions related to product and manufacturing process design.
DP's employees develop and provide to FS all of the upgrades to the
software and network systems. DP also has employees who direct and
control other aspects of the manufacturing process such as vendor
and material selection, management of the manufacturing costs and
capacities, and the selection of CM. The need for DP's employees to
direct the activities of the FS employees and otherwise contribute
to the manufacturing process evinces that substantial operational
responsibilities and decision making are required to be exercised by
parties other than CM in order to manufacture Product X.
(ii) Result. If the manufacturing activities undertaken with
respect to Product X prior to sale were undertaken by FS through the
activities of its employees, FS would have satisfied the
manufacturing exception contained in paragraph (a)(4)(ii) or
(a)(4)(iii) of this section with respect to Product X. Therefore,
this paragraph (a)(4)(iv) applies. Under the facts and circumstance
of the business, FS does not satisfy the test under this paragraph
(a)(4)(iv) because it does not make a substantial contribution
through the activities of its employees to the manufacture of
Product X. Mere ownership of materials and intellectual property
along with contractual rights to exercise powers of direction and
control are not sufficient to satisfy this paragraph (a)(4)(iv). The
employees of FS do not perform the amount of activity necessary to
constitute a substantial contribution. FS is not considered to have
manufactured Product X under paragraph (a)(4)(i) of this section.
Example 6. Automated manufacturing supervised by FS. (i) Facts.
Assume the same facts as in Example 5, except for the following. FS,
through its employees, engages in the activities undertaken by DP's
employees in Example 5. DP's employees also contribute to product
and manufacturing process design, and provide support and oversight
to FS in connection with functions performed by FS through its
employees.
(ii) Result. If the manufacturing activities undertaken with
respect to Product X prior to sale were undertaken by FS through the
activities of its employees, FS would have
[[Page 79347]]
satisfied the manufacturing exception contained in paragraph
(a)(4)(ii) or (a)(4)(iii) of this section with respect to Product X.
Therefore, this paragraph (a)(4)(iv) applies. Under the facts and
circumstances of the business, FS satisfies the test under this
paragraph (a)(4)(iv) because it makes a substantial contribution
through the activities of its employees to the manufacture of
Product X. This determination does not require a comparison between
the activities of FS and the activities of DP. Selection of the
contract manufacturer, even though not specifically identified in
paragraph (a)(4)(iv)(b) of this section, is considered under
paragraph (a)(4)(iv)(c) of this section in determining whether FS
makes a substantial contribution to the manufacture of Product X
through its employees. FS is considered to have manufactured Product
X under paragraph (a)(4)(i) of this section.
Example 7. Automated manufacturing supervised by FS with
purchased intellectual property. (i) Facts. Assume the same facts as
in Example 6, except for the following. The software and network
systems, and the upgrades to those systems, were purchased by FS
rather than developed by employees of FS.
(ii) Result. If the manufacturing activities undertaken with
respect to Product X prior to sale were undertaken by FS through the
activities of its employees, FS would have satisfied the
manufacturing exception contained in paragraph (a)(4)(ii) or
(a)(4)(iii) of this section with respect to Product X. Therefore,
this paragraph (a)(4)(iv) applies. The lack of performance of
software and network system development activities is not
determinative under the facts and circumstances of the business.
Therefore, FS satisfies the test under this paragraph (a)(4)(iv)
because it makes a substantial contribution through the activities
of its employees to the manufacture of Product X. This determination
does not require a comparison between the activities of FS and the
activities of DP. FS is considered to have manufactured Product X
under paragraph (a)(4)(i) of this section.
Example 8. Manufacture without intellectual property. (i) Facts.
FS, a controlled foreign corporation, purchases raw materials from a
related person. The raw materials are manufactured (under the
principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section)
into Product X by CM, an unrelated corporation, pursuant to a
contract manufacturing arrangement. CM physically performs the
substantial transformation, assembly, or conversion outside of FS's
country of organization. Product X is sold by FS for use outside of
FS's country of organization. At all times, FS controls the raw
materials, work-in-process, and finished goods. FS controls the
manufacturing related logistics, manages the manufacturing costs and
capacities, and provides quality control with respect to CM's
manufacturing process and product. No intellectual property of
significant value is required to manufacture Product X. FS does not
own any intellectual property underlying Product X, or hold an
exclusive or non-exclusive right to manufacture Product X.
(ii) Result. If the manufacturing activities undertaken with
respect to Product X prior to sale were undertaken by FS through the
activities of its employees, FS would have satisfied the
manufacturing exception contained in paragraph (a)(4)(ii) or
(a)(4)(iii) of this section with respect to Product X. Therefore,
this paragraph (a)(4)(iv) applies. Because use of intellectual
property plays little or no role in the manufacture of Product X, it
is irrelevant to the substantial contribution analysis under
paragraph (a)(4)(iv) of this section. Under the facts and
circumstances of the business, FS satisfies the test under this
paragraph (a)(4)(iv) because it makes a substantial contribution
through the activities of its employees to the manufacture of
Product X. Therefore, FS is considered to have manufactured Product
X under paragraph (a)(4)(i) of this section.
Example 9. Substantial contribution by more than one CFC. (i)
Facts. FS1 and FS2, unrelated controlled foreign corporations,
contract with CM, an unrelated corporation, to manufacture (under
the principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this
section) Product X. CM physically performs the substantial
transformation, assembly, or conversion required to manufacture
Product X outside of FS1's and FS2's respective countries of
organization. Neither FS1 nor FS2 owns the materials or work-in-
process during the manufacturing process. Product X is sold by FS1
and FS2 to persons related to FS1 and FS2, respectively, for
disposition outside of FS1's and FS2's respective countries of
organization. FS1, through its employees, designs Product X. FS1
directs the use of the product design and design specifications, and
other intellectual property, for the purpose of manufacturing
Product X. Employees of FS1 also select the materials that will be
used to manufacture Product X, and the vendors that provide those
materials. FS2, through its employees, designs the process for
manufacturing Product X. FS2, through its employees, manages the
manufacturing costs and capacities with respect to Product X. FS1
and FS2 each provide quality control and oversight and direction of
CM's manufacturing activities with respect to different aspects of
the manufacture of Product X.
(ii) Result. If the manufacturing activities undertaken with
respect to Product X prior to sale were undertaken by FS1 or FS2
through the activities of their employees, FS1 or FS2 would have
satisfied the manufacturing exception contained in paragraph
(a)(4)(ii) or (a)(4)(iii) of this section with respect to Product X.
Therefore, this paragraph (a)(4)(iv) applies. The fact that other
persons make a substantial contribution to the manufacture of
personal property does not preclude a controlled foreign corporation
from making a substantial contribution to the manufacture of
personal property through the activities of its employees. In the
analysis of whether FS1 or FS2 make a substantial contribution to
the manufacture of Product X, each company takes into account its
individual activities, including those of providing quality control
and oversight and direction of the manufacture of Product X. In
addition, no threshold level of activity is required, including with
respect to providing quality control or oversight and direction of
the activities or process pursuant to which Product X is
manufactured, before FS1 and FS2 can take into account their
respective activities. Under the facts and circumstances of the
business, both FS1 and FS2 satisfy the test under this paragraph
(a)(4)(iv) because each independently makes a substantial
contribution through the activities of its employees to the
manufacture of Product X. Therefore, FS1 and FS2 are each considered
to have manufactured Product X under paragraph (a)(4)(i) of this
section.
Example 10. Manufacture of products designed by CFC. (i) Facts.
FS, a controlled foreign corporation, purchases raw materials from a
related person. The raw materials are manufactured (under the
principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section)
into Product X by CM, an unrelated corporation, pursuant to a
contract manufacturing arrangement. CM physically performs the
substantial transformation, assembly, or conversion outside of FS's
country of organization. Product X is sold by FS for use outside of
FS's country of organization. Products in the X industry are
distinguished (and vary widely in value) based on the raw materials
used to make the product and the product design. FS designs the
product and selects the materials that CM will use to manufacture
Product X. FS also manages the manufacturing costs and capacities.
Product X can be manufactured from the raw materials to FS's design
specifications without significant oversight and direction, quality
control, or control of manufacturing related logistics. The
activities most relevant to the substantial contribution analysis
under these facts are material selection, product design and
management of the manufacturing costs and capacities.
(ii) Result. If the manufacturing activities undertaken with
respect to Product X prior to sale were undertaken by FS through the
activities of its employees, FS would have satisfied the
manufacturing exception contained in paragraph (a)(4)(ii) or
(a)(4)(iii) of this section with respect to Product X. Therefore,
this paragraph (a)(4)(iv) applies. Under the facts and circumstances
of the business, FS makes a substantial contribution through the
activities of its employees to the manufacture of Product X. FS
satisfies the test under this paragraph (a)(4)(iv) because it makes
a substantial contribution through the activities of its employees
to the manufacture of Product X. Therefore, FS is considered to have
manufactured Product X under paragraph (a)(4)(i) of this section.
Example 11. Direction and oversight of manufacturing and quality
control through periodic visits. (i) Facts. FS, a controlled foreign
corporation, purchases raw materials from a related person. The raw
materials are manufactured (under the principles of paragraph
(a)(4)(ii) or (a)(4)(iii) of this section) into Product X by CM, an
unrelated corporation, pursuant to a contract manufacturing
arrangement. CM physically performs the substantial transformation,
assembly, or conversion outside of FS's country of organization.
Product X is sold by FS for use outside of FS's country of
organization. FS controls the raw material, work-in-process, and
finished goods, manages the manufacturing costs and
[[Page 79348]]
capacities, and provides oversight and direction of the manufacture
of Product X. Employees of FS visit CM's manufacturing facility for
one week each quarter and perform quality control tests on a random
sample of the units of Product X produced during the week. In the X
industry, quarterly visits to a manufacturing facility by qualified
persons are sufficient to control the quality of manufacturing.
(ii) Result. If the manufacturing activities undertaken with
respect to Product X prior to sale were undertaken by FS through the
activities of its employees, FS would have satisfied the
manufacturing exception contained in paragraph (a)(4)(ii) or
(a)(4)(iii) of this section with respect to Product X. Therefore,
this paragraph (a)(4)(iv) applies. Under the facts and circumstances
of the business, FS satisfies the test under this paragraph
(a)(4)(iv) with respect to Product X because it makes a substantial
contribution through the activities of its employees to the
manufacture of Product X. Therefore, FS is considered to have
manufactured Product X under paragraph (a)(4)(i) of this section.
* * * * *
(6) Special rule applicable to distributive share of partnership
income--(i) In general. To determine the extent to which a controlled
foreign corporation's distributive share of any item of gross income of
a partnership would have been foreign base company sales income if
received by it directly, under Sec. 1.952-1(g), the property sold will
be considered to be manufactured, produced, or constructed by the
controlled foreign corporation, within the meaning of paragraph
(a)(4)(i) of this section, only if the manufacturing exception of
paragraph (a)(4)(i) of this section would have applied to exclude the
income from foreign base company sales income if the controlled foreign
corporation had earned the income directly, determined by taking into
account only the activities of the employees of, and property owned by,
the partnership.
* * * * *
(b) * * *
(1) * * *
(i) * * *
(c) [Reserved]. For further guidance, see Sec. 1.954-
3T(b)(1)(i)(c).
(ii) * * *
(a) [Reserved]. For further guidance, see Sec. 1.954-
3T(b)(1)(ii)(a).
* * * * *
(c) [Reserved]. For further guidance, see Sec. 1.954-
3T(b)(1)(ii)(c).
(2) * * *
(i) * * *
(b) [Reserved]. For further guidance, see Sec. 1.954-
3T(b)(2)(i)(b).
* * * * *
(d) [Reserved]. For further guidance, see Sec. 1.954-
3T(b)(2)(i)(d).
* * * * *
(ii) * * *
(a) [Reserved]. For further guidance, see Sec. 1.954-
3T(b)(2)(ii)(a).
(b) [Reserved]. For further guidance, see Sec. 1.954-
3T(b)(2)(ii)(b).
* * * * *
(e) [Reserved]. For further guidance, see Sec. 1.954-
3T(b)(2)(ii)(e).
* * * * *
(4) * * *
Example (3). [Reserved]. For further guidance, see Sec. 1.954-
3T(b)(4) Example (3).
* * * * *
(c) Effective/applicability date. Paragraphs (a)(1)(i), (a)(1)(iii)
Example 1, (a)(1)(iii) Example 2, (a)(2), (a)(4)(i), (a)(4)(ii),
(a)(4)(iii), (a)(4)(iv) and (a)(6)(i) shall apply to taxable years of
controlled foreign corporations beginning after June 30, 2009, and for
taxable years of United States shareholders in which or with which such
taxable years of the controlled foreign corporations end.
(d) Application of regulations to earlier taxable years. A taxpayer
may choose to apply these regulations and the regulations under Sec.
1.954-3T retroactively with respect to its open taxable years. The
taxpayer may so choose if and only if the taxpayer and all members of
the taxpayer's affiliated group (within the meaning of Sec. 1504(a))
apply both these regulations and the regulations under Sec. 1.954-3T,
in their entirety, to the earliest taxable year of each controlled
foreign corporation that ends with or within an open taxable year of
the taxpayer and to all subsequent taxable years of the taxpayer.
0
Par. 3. Section 1.954-3T is added to read as follows:
Sec. 1.954-3T Foreign base company sales income (temporary).
(a) Through (b)(1)(i)(b) [Reserved]. For further guidance, see
Sec. 1.954-3(a) through (b)(1)(i)(b).
(c) Use of more than one branch. If a controlled foreign
corporation carries on purchasing or selling activities by or through
more than one branch or similar establishment located outside the
country under the laws of which such corporation is created or
organized, then Sec. 1.954-3(b)(1)(i)(b) shall be applied separately
to the income derived by each such branch or similar establishment (by
treating such purchasing or selling branch or similar establishment as
if it were the only branch or similar establishment of the controlled
foreign corporation and as if any such other branches or similar
establishments were separate corporations) in determining whether the
use of such branch or similar establishment has substantially the same
tax effect as if such branch or similar establishment were a wholly
owned subsidiary corporation of the controlled foreign corporation. See
paragraph (b)(1)(ii)(c)(1) of this section for rules applicable to a
controlled foreign corporation that carries on purchase or sales
activities by or through one or more branches or similar establishments
in addition to carrying on manufacturing activities by or through one
or more branches or similar establishments.
(ii) Manufacturing branch--(a) In general. If a controlled foreign
corporation carries on manufacturing, producing, constructing, growing,
or extracting activities by or through a branch or similar
establishment located outside the country under the laws of which such
corporation is created or organized and the use of the branch or
similar establishment for such activities with respect to personal
property purchased or sold by or through the remainder of the
controlled foreign corporation has substantially the same tax effect as
if the branch or similar establishment were a wholly owned subsidiary
corporation of such controlled foreign corporation, the branch or
similar establishment and the remainder of the controlled foreign
corporation will be treated as separate corporations for purposes of
determining foreign base company sales income of such corporation. See
section 954(d)(2). The provisions of this paragraph (b)(1)(ii) and
Sec. 1.954-3(b)(1)(ii)(b) will apply only if the controlled foreign
corporation (including any branches or similar establishments of such
controlled foreign corporation) manufactures, produces, or constructs
such personal property within the meaning of Sec. 1.954-3(a)(4)(i), or
carries on growing or extracting activities with respect to such
personal property.
(b) [Reserved]. For further guidance, see Sec. 1.954-
3(b)(1)(ii)(b).
(c) Use of more than one branch--(1) Use of one or more sales or
purchase branches in addition to a manufacturing branch. If, with
respect to personal property manufactured, produced, constructed,
grown, or extracted by or through a branch or similar establishment
located outside the country under the laws of which the controlled
foreign corporation is created or organized, purchasing or selling
activities are carried on by or through more than one branch or similar
establishment, or by or through one or more branches or similar
establishments located outside such country, of such corporation, then
Sec. 1.954-3(b)(1)(ii)(b)
[[Page 79349]]
shall be applied separately to the income derived by each such
purchasing or selling branch or similar establishment (by treating such
purchasing or selling branch or similar establishment as though it
alone were the remainder of the controlled foreign corporation) for
purposes of determining whether the use of such manufacturing,
producing, constructing, growing, or extracting branch or similar
establishment has substantially the same tax effect as if such branch
or similar establishment were a wholly owned subsidiary corporation of
the controlled foreign corporation. If this rule applies, the sales or
purchase branch rules contained in paragraph (b)(1)(i)(c) of this
section and Sec. 1.954-3(b)(1)(i) do not apply. The application of
this paragraph (b)(1)(ii)(c)(1) is illustrated by the following
example:
Example. All activities of controlled foreign corporation
conducted through sales branches and manufacturing branch. (i)
Facts. FS, a controlled foreign corporation organized under the laws
of country M, operates three branches. Branch A, located in country
A, manufactures Product X under the principles of Sec. 1.954-
3(a)(4)(i). Branch B, located in Country B, sells Product X
manufactured by Branch A to customers for use outside of Country B.
Branch C, located in Country C sells Product X manufactured by
Branch A to customers for use outside of Country C. FS does not
conduct any manufacturing or selling activities apart from the
activities of Branches A, B and C. Country M imposes an effective
rate of tax on sales income of 0%. Country A imposes an effective
rate of tax on sales income of 20%. Country B imposes an effective
rate of tax on sales income of 20%. Country C imposes an effective
rate of tax on sales income of 18%.
(ii) Result. Pursuant to this paragraph (b)(1)(ii)(c)(1), Sec.
1.954-3(b)(1)(ii)(b) is applied to the sales income derived by
Branch B by treating Branch B as though it alone were the remainder
of the controlled foreign corporation. The use of Branch B does not
have the same tax effect as if Branch B were a wholly owned
subsidiary of FS because the tax rate applicable to the income
allocated to Branch B under Sec. 1.954-3(b)(1)(ii)(b) (20%) is not
less than 90 percent of, and at least 5 percentage points less than,
the effective rate of tax which would apply to such income under the
laws of Country A (20%), the country in which Branch A is located.
Section 1.954-3(b)(1)(ii)(b) is applied separately to the sales
income derived by Branch C by treating Branch C as though it alone
were the remainder of the controlled foreign corporation. The use of
Branch C does not have the same tax effect as if Branch C were a
wholly owned subsidiary of FS because the tax rate applicable to the
income allocated to Branch C under Sec. 1.954-3(b)(1)(ii)(b) (18%)
is not less than 90 percent of, and at least 5 percentage points
less than, the effective rate of tax which would apply to such
income under the laws of Country A (20%), the country in which
Branch A is located. Pursuant to this paragraph (b)(1)(ii)(c)(1),
the rules under paragraph (b)(1)(i)(c) of this section and Sec.
1.954-3(b)(1)(i) for determining whether a sales or purchase branch
is treated as a separate corporation from the remainder of the
controlled foreign corporation do not apply.
(2) Use of more than one branch to manufacture, produce, construct,
grow, or extract separate items of personal property. If a controlled
foreign corporation carries on manufacturing, producing, constructing,
growing, or extracting activities with respect to separate items of
personal property by or through more than one branch or similar
establishment located outside the country under the laws of which such
corporation is created or organized, then paragraph (b)(1)(ii)(c) of
this section and Sec. 1.954-3(b)(1)(ii)(b) will be applied separately
to each such branch or similar establishment (by treating such
manufacturing branch or similar establishment as if it were the only
such branch or similar establishment of the controlled foreign
corporation and as if any other such branches or similar establishments
were separate corporations) for purposes of determining whether the use
of such branch or similar establishment has substantially the same tax
effect as if such branch or similar establishment were a wholly owned
subsidiary corporation of the controlled foreign corporation. The
application of this paragraph (b)(1)(ii)(c)(2) is illustrated by the
following example:
Example. Multiple branches that satisfy Sec. 1.954-3(a)(4)(i).
(i) Facts. FS is a controlled foreign corporation organized in
Country M. FS operates two branches, Branch A and Branch B located
in Country A and Country B, respectively. Branch A and Branch B each
manufacture separate items of personal property (Product X and
Product Y, respectively) within the meaning of Sec. 1.954-
3(a)(4)(ii) or (iii). Raw materials used in the manufacture of
Product X and Product Y are purchased by FS from an unrelated
person. FS engages in activities in Country M to sell Product X and
Product Y to a related person for use, disposition or consumption
outside of Country M. Employees of FS located in Country M perform
only sales functions. The effective rate imposed in Country M on the
income from the sales of Product X and Product Y is 10%. Country A
imposes an effective rate of tax on sales income of 20%. Country B
imposes an effective rate of tax on sales income of 12%.
(ii) Result. Pursuant to this paragraph (b)(1)(ii)(c)(2), Sec.
1.954-3(b)(1)(ii)(b) is applied separately to Branch A and Branch B
with respect to the sales income of FS attributable to Product X
(manufactured by Branch A) and Product Y (manufactured by Branch B).
Because the effective rate of tax on FS's sales income from the sale
of Product X in Country M (10%) is less than 90% of, and at least 5
percentage points less than, the effective rate of tax that would
apply to such income in the country in which Branch A is located
(20%), the use of Branch A to manufacture Product X has
substantially the same tax effect as if Branch A were a wholly owned
subsidiary corporation of FS. Because the effective rate of tax on
FS's sales income from the sale of Product Y in Country M (10%) is
not less than 90% of, and at least 5 percentage points less than,
the effective rate of tax that would apply to such income in the
country in which Branch B is located (12%), the use of Branch B to
manufacture Product Y does not have substantially the same tax
effect as if Branch B were a wholly owned subsidiary corporation of
FS. Consequently, only Branch A is treated as a separate corporation
apart from the remainder of FS for purposes of determining foreign
base company sales income from the sales of Product X.
(3) Use of more than one manufacturing branch, or one or more
manufacturing branches and the remainder of the controlled foreign
corporation, to manufacture, produce, or construct the same item of
personal property--(i) In general. This paragraph (b)(1)(ii)(c)(3)
applies to determine the location of manufacture, production, or
construction of personal property for purposes of applying Sec. 1.954-
3(b)(1)(i)(b) or (b)(1)(ii)(b) where more than one branch (or similar
establishment) of a controlled foreign corporation, or one or more
branches (or similar establishments) of a controlled foreign
corporation and the remainder of the controlled foreign corporation,
each engage in manufacturing, producing, or constructing activities
with respect to the same item of personal property which is then sold
by the controlled foreign corporation. The location of manufacture,
production, or construction is determined under paragraph
(b)(1)(ii)(c)(3)(ii) of this section if one or more branches (or
similar establishments), or the remainder of the controlled foreign
corporation, independently satisfies Sec. 1.954-3(a)(4)(i) with
respect to an item of personal property. The location of manufacture,
production, or construction is determined under paragraph
(b)(1)(ii)(c)(3)(iii) of this section if none of the branches (or
similar establishments), or the remainder of the controlled foreign
corporation, independently satisfies Sec. 1.954-3(a)(4)(i) with
respect to an item of personal property, but the controlled foreign
corporation as a whole makes a substantial contribution to the
manufacture, production or construction of that property within the
meaning of Sec. 1.954-3(a)(4)(iv). For purposes of this paragraph
(b)(1)(ii)(c)(3), the location of any activity with respect to the
manufacture, production, or construction of an item
[[Page 79350]]
of personal property is determined under paragraph (b)(1)(ii)(c)(3)(iv)
of this section. For purposes of this paragraph (b)(1)(ii)(c)(3), if
multiple branches (or similar establishments) are located in a single
jurisdiction, then the activities of those branches will be aggregated
for purposes of determining whether a branch or remainder of the
controlled foreign corporation satisfies Sec. 1.954-3(a)(4)(i).
(ii) Manufacture, production, or construction in one or more
locations. If only one branch (or similar establishment), or only the
remainder of a controlled foreign corporation, independently satisfies
Sec. 1.954-3(a)(4)(i) with respect to an item of personal property,
then that branch (or similar establishment) or the remainder of the
controlled foreign corporation will be the location of manufacture,
production, or construction of that property for purposes of applying
Sec. 1.954-3(b)(1)(i)(b) or (b)(1)(ii)(b) to the income from the sale
of that property. See paragraph (b)(1)(ii)(c)(3)(v) Example 1 of this
section. If more than one branch (or similar establishment), or one or
more branches (or similar establishments) and the remainder of the
controlled foreign corporation, each independently satisfy Sec. 1.954-
3(a)(4)(i) with respect to an item of personal property, then the
location of manufacture, production, or construction of that property
for purposes of applying Sec. 1.954-3(b)(1)(i)(b) or (b)(1)(ii)(b)
will be the location of that branch (or similar establishment) or the
jurisdiction under the laws of which the remainder of the controlled
foreign corporation is organized that satisfies Sec. 1.954-3(a)(4)(i)
and that would, after applying Sec. 1.954-3(b)(1)(ii)(b) to such
branch (or similar establishment) or Sec. 1.954-3(b)(1)(i)(b) to the
remainder of the controlled foreign corporation, impose the lowest
effective rate of tax on the income allocated to such branch or the
remainder of the controlled foreign corporation under such section
(that is, either Sec. 1.954-3(b)(1)(i)(b) or (b)(1)(ii)(b)). See
paragraph (b)(1)(ii)(c)(3)(v) Example 2 of this section.
(iii) No location independently satisfies manufacturing test. If
none of the branches (or similar establishments) or the remainder of
the controlled foreign corporation independently satisfies Sec. 1.954-
3(a)(4)(i) with respect to an item of personal property but the
controlled foreign corporation as a whole makes a substantial
contribution to the manufacture, production, or construction of that
property within the meaning of Sec. 1.954-3(a)(4)(iv), then for
purposes of applying Sec. 1.954-3(b)(1)(i)(b) or (b)(1)(ii)(b), the
location of manufacture, production, or construction with respect to
that property will be the ``tested manufacturing location'' unless the
``tested sales location'' provides a demonstrably greater contribution
to the manufacture, production, or construction of the property. The
tested manufacturing location is the location of any branch (or similar
establishment) or remainder of the controlled foreign corporation that
contributes to the manufacture, production, or construction of the
personal property, if any, and that would, after applying Sec. 1.954-
3(b)(1)(ii)(b) to such branch (or similar establishment) or Sec.
1.954-3(b)(1)(i)(b) to the remainder of the controlled foreign
corporation, be treated as a separate corporation and would impose the
lowest effective rate of tax on the income allocated to such branch (or
similar establishment) or to the remainder of the controlled foreign
corporation under such section (that is, either Sec. 1.954-
3(b)(1)(ii)(b) or (b)(1)(i)(b)). The tested sales location is the
location where the branch (or similar establishment) or the remainder
of the controlled foreign corporation purchases or sells the personal
property. For purposes of this paragraph (b)(1)(ii)(c)(3)(iii), the
contribution to the manufacture, production, or construction of the
personal property by the tested sales location will be deemed to
include the activities of any branch (or similar establishment) or
remainder of the controlled foreign corporation that would not be
treated as a corporation separate from the tested sales location after
the application of Sec. 1.954-3(b)(1)(ii)(b) or (b)(1)(i)(b). For
purposes of this paragraph (b)(1)(ii)(c)(3)(iii), the contribution of
the tested manufacturing location to the manufacture, production, or
construction of the personal property will be deemed to include any
activities of any branch (or similar establishment) or remainder of the
controlled foreign corporation that would be treated as a corporation
separate from the tested sales location after the application of Sec.
1.954-3(b)(1)(ii)(b) or (b)(1)(i)(b). Whether the tested sales location
provides a demonstrably greater contribution to the manufacture,
production, or construction of the personal property is determined by
weighing the relative contributions to the manufacture, production, or
construction of that property by the tested sales location and the
tested manufacturing location under the facts and circumstances test
provided in Sec. 1.954-3(a)(4)(iv). See paragraph (b)(1)(ii)(c)(3)(v)
Examples 4, 5, and 6 of this section. If the tested sales location
provides a demonstrably greater contribution to the manufacture,
production, or construction of the personal property than the tested
manufacturing location or if there is no tested manufacturing location,
then the tested sales location is the location of manufacture,
production, or construction of that property and the rules of paragraph
(b)(1)(ii)(a) of this section and Sec. 1.954-3(b)(1)(i)(a) will not
apply with respect to the sales income related to that property and the
use of the purchasing or selling branch (or similar establishment) or
the purchasing or selling remainder will not result in a branch being
treated as a separate corporation for purposes of paragraph (b)(2)(ii)
of this section or Sec. 1.954-3(b)(2)(ii).
(iv) Location of activity. For purposes of paragraph
(b)(1)(ii)(c)(3) of this section, the location of any activity with
respect to the manufacture, production, or construction of an item of
personal property is the location where the employees of the controlled
foreign corporation perform such activity. For example, the location of
any activity concerning intellectual property is determined based on
where employees of the controlled foreign corporation develop, or
direct the use or development of, the intellectual property, not on the
formal assignment of that intellectual property.
(v) Examples. The following examples illustrate the application of
this paragraph (b)(1)(ii)(c)(3):
Example 1. Multiple branches contribute to the manufacture of a
single product, only one branch satisfies Sec. 1.954-3(a)(4)(i).
(i) Facts. FS is a controlled foreign corporation organized in
Country M. FS operates three branches, Branch A, Branch B, and
Branch C, located respectively in Country A, Country B, and Country
C. Branch A, Branch B, and Branch C each performs different
manufacturing activities with respect to the manufacture of Product
X. Branch A, through the activities of employees of FS located in
Country A, designs Product X. Branch B, through the activities of
employees of FS located in Country B, provides quality control and
oversight and direction. Branch C, through the activities of
employees of FS located in Country C, manufactures Product X (within
the meaning of Sec. 1.954-3(a)(4)(ii) or (a)(4)(iii)) using the
designs developed by Branch A and under the oversight of the quality
control personnel of Branch B. The activities of Branch A and Branch
B do not independently satisfy Sec. 1.954-3(a)(4)(i). Employees of
FS located in Country M purchase the raw materials used in the
manufacture of Product X from a related person and control the work-
in-process and finished goods throughout the manufacturing process.
Employees of FS located in Country M also manage the manufacturing
costs and
[[Page 79351]]
capacities related to Product X. Further, employees of FS located in
Country M oversee the coordination between the branches. Employees
of FS located in Country M sell Product X to unrelated persons for
use outside of Country M. The sales income from the sale of Product
X is taxed in Country M at an effective rate of tax of 10%. Country
C imposes an effective rate of tax of 20% on sales income.
(ii) Result. Country C is the location of manufacture for
purposes of applying Sec. 1.954-3(b)(1)(ii)(b) because only the
activities of Branch C independently satisfy Sec. 1.954-3(a)(4)(i).
The use of Branch C has substantially the same tax effect as if
Branch C were a wholly owned subsidiary corporation of FS because
the effective rate of tax on the sales income (10%) is less than 90%
of, and at least 5 percentage points less than, the effective rate
of tax that would apply to such income in the country in which
Branch C is located (20%). Therefore, sales of Product X by the
remainder of FS are treated as sales on behalf of Branch C. In
determining whether the remainder of FS will qualify for the
manufacturing exception under Sec. 1.954-3(a)(4)(iv), the
activities of FS will include the activities of Branch A or Branch
B, respectively, if each of those branches would not be treated as a
separate corporation under Sec. 1.954-3(b)(1)(ii)(b), if that
paragraph were applied independently to each of Branch A and Branch
B. See paragraph (b)(2)(ii)(a) of this section.
Example 2. Multiple branches satisfy Sec. 1.954-3(a)(4)(i) with
respect to the same product sold by the controlled foreign
corporation. (i) Facts. Assume the same facts as in Example 1,
except for the following. In addition to the design of Product X,
Branch A also performs in Country A other manufacturing activities,
including those ascribed to FS in Example 1, that are sufficient to
qualify as manufacturing under Sec. 1.954-3(a)(4)(iv) with respect
to Product X. Country A imposes an effective rate of tax of 12% on
sales income.
(ii) Result. Branch A and Branch C through their activities each
independently satisfy the requirements of Sec. 1.954-3(a)(4)(i).
Therefore, Sec. 1.954-3(b)(1)(ii)(b) is applied by comparing the
effective rate of tax imposed on the income from the sales of
Product X against the lowest effective rate of tax that would apply
to the sales income in either Country A or Country C if Sec. 1.954-
3(b)(1)(ii)(b) were applied separately to Branch A and Branch C.
Country A imposes the lower effective rate of tax, and therefore,
Branch A is treated as the location of manufacture for purposes of
applying Sec. 1.954-3(b)(1)(ii)(b). The effective rate of tax in
Country B is not considered because Branch B does not satisfy Sec.
1.954-3(a)(4)(i). Neither Branch A nor Branch C is treated as a
separate corporation because the effective rate of tax on the sales
income of FS from the sale of Product X (10%) is not less than 90%
of, and at least 5 percentage points less than, the effective rate
of tax that would apply to such income in the country in which
Branch A is located (12%). Sales of Product X by the remainder of
the controlled foreign corporation are not treated as made on behalf
of any branch.
Example 3. Determining the location of manufacture when
manufacturing activities performed by multiple branches and no
branch independently satisfies Sec. 1.954-3(a)(4)(i). (i) Facts.
FS, a controlled foreign corporation organized in Country M,
purchases raw materials from a related person. The raw materials are
manufactured (under the principles of Sec. 1.954-3(a)(4)(ii) or
(a)(4)(iii)) into Product X by CM, an unrelated corporation,
pursuant to a contract manufacturing arrangement. CM physically
performs the substantial transformation, assembly, or conversion of
the raw materials in Country C. FS has two branches, Branch A and
Branch B, located in Country A and Country B respectively. Branch A,
through the activities of employees of FS located in Country A,
designs Product X. Branch B, through the activities of employees of
FS located in Country B, controls manufacturing related logistics,
provides oversight and direction during the manufacturing process,
and controls the raw materials and work-in-process. FS manages the
manufacturing costs and capacities related to the manufacture of
Product X through employees located in Country M. Further, employees
of FS located in Country M oversee the coordination between the
branches. Employees of FS located in Country M also sell Product X
to unrelated persons for use outside of Country M. Country M imposes
an effective rate of tax on sales income of 10%. Country A imposes
an effective rate of tax on sales income of 20%, and Country B
imposes an effective rate of tax on sales income of 24%. Neither the
remainder of FS, nor any branch of FS independently satisfies Sec.
1.954-3(a)(4)(i). However, under the facts and circumstances of the
business, FS as a whole provides a substantial contribution to the
manufacture of Product X within the meaning of Sec. 1.954-
3(a)(4)(iv).
(ii) Result. Based on the facts, neither the remainder of FS
(through the activities of its employees in Country M) nor any
branch of FS independently satisfies Sec. 1.954-3(a)(4)(i) with
respect to Product X, but FS, as a whole, provides a substantial
contribution through the activities of its employees to the
manufacture of Product X. The remainder of FS, Branch A, and Branch
B each provides a contribution through the activities of employees
to the manufacture of Product X. Therefore, FS must determine the
location of manufacture under paragraph (b)(1)(ii)(c)(3)(iii) of
this section The tested sales location is Country M because the
remainder of FS performs the selling activities with respect to
Product X. The location of Branch A is the tested manufacturing
location because the effective rate of tax imposed on FS's sales
income by Country M (10%) is less than 90% of, and at least 5
percentage points less than, the effective rate of tax that would
apply to such income in Country A (20%), and Country A has the
lowest effective rate of tax among the manufacturing branches that
would, after applying Sec. 1.954-3(b)(1)(ii)(b), be treated as a
separate corporation. The activities of Branch B will be included in
the contribution of Branch A for purposes of determining the
location of manufacture of Product X because the effective rate of
tax imposed on the sales income by Country M (10%) is less than 90%
of, and at least 5 percentage points less than, the effective rate
of tax that would apply to such income in Country B (24%). Under the
facts and circumstances of the business, the activities of the
remainder of FS would not provide a demonstrably greater
contribution to the manufacture of Product X than the activities of
Branch A and Branch B, considered together. Therefore, the location
of manufacture is Country A, the location of Branch A.
Example 4. Manufacturing activities performed by multiple
branches, no branch independently satisfies Sec. 1.954-3(a)(4)(i),
selling activities performed by remainder of the controlled foreign
corporation, remainder contribution includes branch manufacturing
activities. (i) Facts. The facts are the same as Example 3, except
that the effective rate of tax on sales income in Country B is 12%.
In addition, under the facts of the particular business, the
activities of employees of FS located in Country B and Country M, if
considered together, would provide a demonstrably greater
contribution to the manufacture of Product X than the activities of
employees of FS located in Country A.
(ii) Result. Based on the facts, neither the remainder of FS
(through activities of its employees in Country M) nor any branch of
FS independently satisfies Sec. 1.954-3(a)(4)(i) with respect to
Product X, but FS, as a whole, provides a substantial contribution
through the activities of its employees to the manufacture of
Product X. The remainder of FS, Branch A, and Branch B each provide
a contribution through the activities of their employees to the
manufacture of Product X. Therefore, FS must determine the location
of manufacture under paragraph (b)(1)(ii)(c)(3)(iii) of this
section. The tested sales location is Country M because the
remainder of FS performs the selling activities with respect to
Product X. The location of Branch A is the tested manufacturing
location because the effective rate of tax imposed on FS's sales
income by Country M (10%) is less than 90% of, and at least 5
percentage points less than, the effective rate of tax that would
apply to such income in Country A (20%), and Branch A is the only
branch that would, after applying Sec. 1.954-3(b)(1)(ii)(b), be
treated as a separate corporation. The activities of Branch B will
be included in the contribution of the remainder of FS for purposes
of determining the location of manufacture of Product X because the
effective rate of tax imposed on the sales income by Country M (10%)
is not less than 90% of, and at least 5 percentage points less than,
the effective rate of tax that would apply to such income in Country
B (12%). Under a facts and circumstances analysis, considered
together, the activities of Branch B and the remainder of FS would
provide a demonstrably greater contribution to the manufacture of
Product X than the activities of Branch A. Therefore, the rules of
paragraph (b)(1)(ii)(a) of this section will not apply and neither
Branch A nor Branch B will be treated as a separate corporation for
purposes of paragraph (b)(2)(ii) of this section and Sec. 1.954-
3(b)(2)(ii).
Example 5. Manufacturing activities performed by multiple
branches, no branch independently satisfies Sec. 1.954-3(a)(4)(i),
selling activities performed by remainder of
[[Page 79352]]
the controlled foreign corporation and a sales branch. (i) Facts.
The facts are the same as Example 3, except that selling activities
are also performed by Branch D in Country D, and Country D imposes a
16% effective rate of tax on sales income. In addition, under the
facts and circumstances of the business, the activities of employees
of FS located in Country A and Country M, considered together, would
provide a demonstrably greater contribution to the manufacture of
Product X than the activities of employees of FS located in Country
B.
(ii) Result. Based on the facts, neither the remainder of FS nor
any branch of FS independently satisfies Sec. 1.954-3(a)(4)(i) with
respect to Product X, but FS, as a whole, provides a substantial
contribution through the activities of its employees to the
manufacture of Product X. The remainder of FS, Branch A, and Branch
B each provide a contribution through the activities of their
employees to the manufacture of Product X. Therefore, FS must
determine the location of manufacture under paragraph
(b)(1)(ii)(c)(3)(iii) of this section. Further, pursuant to
paragraph (b)(1)(ii)(c)(1) of this section, paragraph
(b)(1)(ii)(c)(3)(iii) of this section must be applied separately to
the sales income derived by the remainder of FS and Branch D
respectively. The results with respect to the remainder of FS in
this Example 6 are the same as in Example 3. However, paragraph
(b)(1)(ii)(c)(3)(iii) of this section must also be applied with
respect to Branch D because Branch D performs selling activities
with respect to Product X. Thus, for purposes of that sales income,
the location of Branch D is the tested sales location. The location
of Branch B is the tested manufacturing location because the
effective rate of tax imposed on the Branch D's sales income by
Country D (16%) is less than 90% of, and at least 5 percentage
points less than, the effective rate of tax that would apply to such
income in Country B (24%), and Branch B is the only branch that
would, after applying Sec. 1.954-3(b)(1)(ii)(b), be treated as a
separate corporation. The manufacturing activities performed in
Country M by the remainder of FS and the manufacturing activities
performed in Country A by Branch A will be included in Branch D's
contribution to the manufacture of Product X for purposes of
determining the location of manufacture of Product X with respect to
Branch D's sales income because the effective rate of tax imposed on
the sales income by Country D (16%) is not less than 90% of, and at
least 5 percentage points less than, the effective rate of tax that
would apply to such income in Country M (10%) and Country A (20%).
Under the facts and circumstances of the business, the activities of
Branch D, Branch A, and the remainder of FS, considered together,
would provide a demonstrably greater contribution to the manufacture
of Product X than the activities of Branch B. Therefore, the rules
of paragraph (b)(1)(ii)(a) of this section will not apply to Branch
D and neither Branch A nor Branch D will be treated as a separate
corporation for purposes of paragraph (b)(2)(ii) of this section and
Sec. 1.954-3(b)(2)(ii).
Example 6. Determining the location of manufacture when
employees of remainder of controlled foreign corporation travel to
location of unrelated contract manufacturer to perform manufacturing
activities. (i) Facts. FS, a controlled foreign corporation
organized in Country M, purchases raw materials from a related
person. The raw materials are manufactured (under the principles of
Sec. 1.954-3(a)(4)(ii) or (a)(4)(iii)) into Product X by CM, an
unrelated corporation, pursuant to a contract manufacturing
arrangement. CM physically performs the substantial transformation,
assembly, or conversion of the raw materials in Country C. Employees
of FS located in Country M sell Product X to unrelated persons for
use outside of Country M. Employees of FS located in Country M
engage in product design, manage the manufacturing costs and
capacities with respect to Product X, and direct the use of
intellectual property for the purpose of manufacturing Product X.
Quality control and oversight and direction of the manufacturing
process are conducted in Country C by employees of FS who are
employed in Country M but who regularly travel to Country C. Branch
A, located in Country A, is the only branch of FS. Product design
with respect to Product X conducted by employees of FS located in
Country A is supplemental to the bulk of the design work, which is
done by employees of FS located in Country M. At all times,
employees of Branch A control the raw materials, work-in-process and
finished goods. Employees of FS located in Country A also control
manufacturing related logistics with respect to Product X. Country M
imposes an effective rate of tax on sales income of 10%. Country A
imposes an effective rate of tax on sales income of 20%. Neither the
remainder of FS nor Branch A independently satisfies Sec. 1.954-
3(a)(4)(i). However, under the facts and circumstance of the
business, FS as a whole (including Branch A) provides a substantial
contribution to the manufacture of Product X within the meaning of
Sec. 1.954-3(a)(4)(iv).
(ii) Result. Based on the facts, neither the remainder of FS nor
Branch A independently satisfies Sec. 1.954-3(a)(4)(i) with respect
to Product X, but FS, as a whole, provides a substantial
contribution through the activities of its employees to the
manufacture of Product X. The remainder of FS and Branch A each
provide a contribution through the activities of employees to the
manufacture of Product X. Therefore, FS must determine the location
of manufacture under paragraph (b)(1)(ii)(c)(3)(iii) of this
section. The tested sales location is Country M because the
remainder of FS performs the selling activities with respect to
Product X. The tested manufacturing location is the location of
Branch A because the effective rate of tax imposed on the remainder
of FS's sales income by Country M (10%) is less than 90% of, and at
least 5 percentage points less than, the effective rate of tax that
would apply to such income in Country A (20%), and Branch A is the
only branch that would, after applying Sec. 1.954-3(b)(1)(ii)(b),
be treated as a separate corporation. Although the activities of
traveling employees are considered in determining whether FS, as a
whole, makes a substantial contribution to the manufacture of
Product X under Sec. 1.954-3(a)(4)(iv), the activities of the
employees of FS that are performed in Country C are not taken into
consideration in determining whether Country M, the jurisdiction
under the laws of which FS is organized, is the location of
manufacture under paragraph (b)(1)(ii)(c)(3)(iii) of this section.
Activities of employees performed outside the jurisdiction in which
the controlled foreign corporation is organized and outside a
location in which the controlled foreign corporation maintains a
branch or similar establishment, are not considered in determining
the location of manufacture. Under the facts and circumstances of
the business, the activities of employees of FS performed in Country
M do not provide a demonstrably greater contribution to the
manufacture of Product X than the activities of employees of FS
performed in Country A. Therefore, the location of manufacture is
Country A, the location of Branch A.
(4) Use of more than one branch to manufacture, produce, construct,
grow, or extract separate items of personal property. For purposes of
paragraphs (b)(1)(ii)(c)(2) and (b)(1)(ii)(c)(3) of this section, an
item of personal property refers to an individual unit of personal
property rather than a type or class of personal property.
(2) [Reserved]. For further guidance, see Sec. 1.954-3(b)(2).
(i) [Reserved]. For further guidance, see Sec. 1.954-3(b)(2)(i).
(a) Treatment as separate corporations. [Reserved]. For further
guidance, see Sec. 1.954-3(b)(2)(i)(a).
(b) Activities treated as performed on behalf of the remainder of
corporation. With respect to purchasing or selling activities performed
by or through the branch or similar establishment, such purchasing or
selling activities will--
(1) With respect to personal property manufactured, produced, or
constructed by the remainder of the controlled foreign corporation (or
any branch treated as the remainder of the controlled foreign
corporation); or
(2) With respect to personal property (other than property
described in paragraph (b)(2)(i)(b)(1) of this section) purchased or
sold, or purchased and sold, by the remainder of the controlled foreign
corporation (or any branch treated as the remainder of the controlled
foreign corporation), be treated on behalf of the remainder of the
controlled foreign corporation.
(c) [Reserved]. For further guidance, see Sec. 1.954-
3(b)(2)(i)(c).
(d) Determination of hypothetical tax. To the extent applicable,
the principles of Sec. 1.954-1(d)(2) shall be used in determining,
under paragraph (b)(1)(i) of this section and Sec. 1.954-3(b)(1)(i),
the effective rate of tax which would apply to the income of the branch
or similar establishment under the laws of the
[[Page 79353]]
country in which the controlled foreign corporation is created or
organized, or in determining, under paragraph (b)(1)(ii) of this
section and Sec. 1.954-3(b)(1)(ii), the effective rate of tax which
would apply to the income of the branch or similar establishment under
the laws of the country in which the manufacturing, producing,
constructing, growing, or extracting branch or similar establishment is
located.
(e) [Reserved]. For further guidance, see Sec. 1.954-
3(b)(2)(i)(e).
(ii) [Reserved]. For further guidance, see Sec. 1.954-3(b)(2)(ii).
(a) Treatment as separate corporations. The branch or similar
establishment will be treated as a wholly owned subsidiary corporation
of the controlled foreign corporation, and such branch or similar
establishment will be deemed to be incorporated in the country in which
it is located. For purposes of applying the rules of this paragraph
(b)(2)(ii) and Sec. 1.954-3(b)(2)(ii), a branch or similar
establishment of a controlled foreign corporation treated as a separate
corporation purchasing or selling on behalf of the remainder of the
controlled foreign corporation under paragraph (b)(2)(ii)(b) of this
section, or the remainder of the controlled foreign corporation treated
as a separate corporation purchasing or selling on behalf of a branch
or similar establishment of the controlled foreign corporation under
Sec. 1.954-3(b)(2)(ii)(c), will include any other branch or similar
establishment or remainder of the controlled foreign corporation that
would not be treated as a separate corporation (apart from the branch
or similar establishment of a controlled foreign corporation that is
treated as performing purchasing or selling activities on behalf of the
remainder of the controlled foreign corporation under paragraph
(b)(2)(ii)(b) of this section or the remainder of the controlled
foreign corporation that is treated as performing purchasing or selling
activities on behalf of the branch or similar establishment under Sec.
1.954-3(b)(2)(ii)(c)) if the effective rate of tax imposed on the
income of the purchasing or selling branch or similar establishment, or
purchasing or selling remainder of the controlled foreign corporation,
were tested under the principles of Sec. 1.954-3(b)(1)(i)(b) or
(b)(1)(ii)(b) against the effective rate of tax that would apply to
such income if it were considered derived by such other branch or
similar establishment or the remainder of the controlled foreign
corporation.
(b) Activities treated as performed on behalf of the remainder of
corporation. With respect to purchasing or selling activities performed
by or through the branch or similar establishment, such purchasing or
selling activities will--
(1) With respect to personal property manufactured, produced, or
constructed by the remainder of the controlled foreign corporation (or
any branch treated as the remainder of the controlled foreign
corporation); or
(2) With respect to personal property (other than property
described in paragraph (b)(2)(ii)(b)(1) of this section) purchased or
sold, or purchased and sold, by the remainder of the controlled foreign
corporation (or any branch treated as the remainder of the controlled
foreign corporation), be treated as performed on behalf of the
remainder of the controlled foreign corporation.
(c) and (d) [Reserved]. For further guidance, see Sec. 1.954-
3(b)(2)(ii)(c) and (d).
(e) Comparison with ordinary treatment. Income derived by a branch
or similar establishment, or by the remainder of the controlled foreign
corporation, shall not be determined to be foreign base company sales
income under paragraph (b) of this section or Sec. 1.954-3(b) if the
income would not be so considered if it were derived by a separate
controlled foreign corporation under like circumstances.
(f) [Reserved]. For further guidance, see Sec. 1.954-
3(b)(2)(ii)(f).
(3) [Reserved]. For further guidance, see Sec. 1.954-3(b)(3).
(4) Illustrations. The application of this paragraph (b)(4) may be
illustrated by the following examples:
Examples (1) and (2). [Reserved]. For further guidance, see Sec.
1.954-3(b)(4) Examples (1) and (2).
Example (3). (i) Facts. Corporation E, a controlled foreign
corporation incorporated under the laws of foreign Country X, is a
wholly owned subsidiary of Corporation D, also a controlled foreign
corporation incorporated under the laws of Country X. Corporation E
maintains Branch B in foreign Country Y. Both corporations use the
calendar year as the taxable year. In 1964, Corporation E's sole
activity, carried on through Branch B, consists of the purchase of
articles manufactured in Country X by Corporation D, a related
person, and the sale of the articles through Branch B to unrelated
persons. One hundred percent of the articles sold through Branch B
are sold for use outside Country X and 90 percent are also sold for
use outside of Country Y. The income of Corporation E derived by
Branch B from such transactions is taxed to Corporation E by Country
X only at the time Corporation E distributes such income to
Corporation D and is taxed on the basis of what the tax (a 40
percent effective rate) would have been if the income had been
derived in 1964 by Corporation E from sources within Country X from
doing business through a permanent establishment therein. Country Y
levies an income tax at an effective rate of 50 percent on income
derived from sources within such country, but the income of Branch B
for 1964 is effectively taxed by Country Y at a 5 percent rate since
under the laws of such country, only 10 percent of Branch B's income
is derived from sources within such country. Corporation E makes no
distributions to Corporation D in 1964.
(ii) Result. In determining foreign base company sales income of
Corporation E for 1964, Branch B is treated as a separate wholly
owned subsidiary corporation of Corporation E, the 5 percent rate of
tax being less than 90 percent of, and at least 5 percentage points
less than the 40 percent rate. Income derived by Branch B, treated
as a separate corporation, from the purchase from a related person
(Corporation D), of personal property manufactured outside of
Country Y and sold for use, disposition, or consumption outside of
Country Y constitutes foreign base company sales income. If,
instead, Corporation D were unrelated to Corporation E, none of the
income would be foreign base company sales income because
Corporation E would be purchasing from and selling to unrelated
persons and if Branch B were treated as a separate corporation it
would likewise be purchasing from and selling to unrelated persons.
Alternatively, if Corporation D were related to Corporation E, but
Branch B manufactured the articles prior to sale under the
principles of Sec. 1.954-3(a)(4)(iv), the income would not be
foreign base company sales income because Branch B, treated as a
separate corporation, would qualify for the manufacturing exception
under Sec. 1.954-3(a)(4).
Examples (4) through (7) [Reserved]. For further guidance, see
Sec. 1.954-3(b)(4) Examples (4) through (7).
Example (8). Uniformly applicable incentive tax rate in one
country. (i) Facts. FS is a controlled foreign corporation organized
in Country M. FS operates one branch, Branch A, located in Country
A. Branch A manufactures Product X within the meaning of Sec.
1.954-3(a)(4)(ii) or (a)(4)(iii). Raw materials used in the
manufacture of Product X are purchased by FS from an unrelated
person. FS engages in activities in Country M to sell Product X to a
related person for use outside of Country M. Employees of FS located
in Country M perform only sales functions. The effective rate
imposed in Country M on the income from the sale of Product X is
10%. Country A generally imposes an effective rate of tax on income
of 20%, but imposes a uniformly applicable incentive rate of tax of
10% on manufacturing income and related sales income.
(ii) Result. The use of Branch A to manufacture Product X does
not have substantially the same tax effect as if Branch A were a
wholly owned subsidiary corporation of FS because the effective rate
of tax on FS's sales income from the sale of Product X in Country M
(10%) is not less than 90% of, and at least 5 percentage points less
than, the effective rate of tax that would apply to such income in
the country in
[[Page 79354]]
which Branch A is located (10%). Consequently, pursuant to Sec.
1.954-3(b)(1)(ii)(b), Branch A is not treated as a separate
corporation apart from the remainder of FS for purposes of
determining foreign base company sales income.
Example (9). Manufacturing activities performed by multiple
branches, no branch independently satisfies Sec. 1.954-3(a)(4)(i),
selling activities performed by remainder of the controlled foreign
corporation, branch manufacturing activities included in remainder
contribution. (i) Facts. FS, a controlled foreign corporation
organized in Country M, has two branches, Branch A and Branch B,
located in Country A and Country B respectively. FS purchases raw
materials from a related person. The raw materials are manufactured
(under the principles of Sec. 1.954-3(a)(4)(ii) or (a)(4)(iii))
into Product X by CM, an unrelated corporation, pursuant to a
contract manufacturing arrangement. CM physically performs the
substantial transformation, assembly, or conversion required to
manufacture Product X outside of FS's country of organization. FS
manages the manufacturing costs and capacities with respect to the
manufacture of Product X through employees located in Country M.
Further, employees of FS located in Country M oversee the
coordination between the branches. Branch A, through the activities
of employees of FS located in Country A, designs Product X, controls
manufacturing related logistics, and controls the raw materials and
work-in-process during the manufacturing process. Branch B, through
the activities of employees of FS located in Country B, provides
quality control and oversight and direction during the manufacturing
process. Employees of FS located in Country M sell Product X to
unrelated persons for use outside of Country M. Country M imposes an
effective rate of tax on sales income of 10%. Country A imposes an
effective rate of tax on sales income of 12%, and Country B imposes
an effective rate of tax on sales income of 24%. None of the
remainder of FS, Branch A, or Branch B independently satisfies Sec.
1.954-3(a)(4)(i). However, under the facts and circumstances of the
business, FS, as a whole, provides a substantial contribution to the
manufacture of Product X within the meaning of Sec. 1.954-
3(a)(4)(iv). Under the facts and circumstances of the business, the
activities of the remainder of FS and Branch A, if considered
together, would not provide a demonstrably greater contribution to
the manufacture of Product X than the activities of Branch B. Under
the facts and circumstances of the business, however, the activities
of the employees of the remainder of FS and Branch A, if considered
together, would constitute a substantial contribution to the
manufacture of Product X.
(ii) Result. Based on the facts, neither the remainder of FS
(through activities of its employees in Country M) nor any branch of
FS independently satisfies Sec. 1.954-3(a)(4)(i) with respect to
Product X, but FS, as a whole, provides a substantial contribution
through the activities of its employees to the manufacture of
Product X. The remainder of FS, Branch A, and Branch B each provide
a contribution through the activities of employees to the
manufacture of Product X. Therefore, FS must determine the location
of manufacture under paragraph (b)(1)(ii)(c)(3)(iii) of this
section. The tested sales location is Country M because the
remainder of FS performs the selling activities with respect to
Product X. The location of Branch B is the tested manufacturing
location because the effective rate of tax imposed on FS's sales
income by Country M (10%) is less than 90% of, and at least 5
percentage points less than, the effective rate of tax that would
apply to such income in Country B (24%); and Branch B is the only
manufacturing branch that would, after applying Sec. 1.954-
3(b)(1)(ii)(b), be treated as a separate corporation. The
manufacturing activities performed in Country A will be included in
the contribution of the remainder of FS for purposes of determining
the location of manufacture of Product X because the effective rate
of tax imposed on the sales income by Country M (10%) is not less
than 90% of, and at least 5 percentage points less than, the
effective rate of tax that would apply to such income in Country A
(12%). Under the facts and circumstances of the business, the
manufacturing activities of the remainder of FS and Branch A,
considered together, would not provide a demonstrably greater
contribution to the manufacture of Product X than the activities of
Branch B. Therefore, the location of manufacture is Country B, the
location of Branch B. In determining that Country B is the location
of manufacture, it was determined that after applying Sec. 1.954-
3(b)(1)(ii)(b) Branch B would be treated as a separate corporation
under paragraph (b)(1)(ii)(a) of this section for purposes of
determining foreign base company sales income. To determine whether
income from the sale of Product X is foreign base company sales
income, the remainder of FS takes into account the activities of
Branch A because, under paragraph (b)(2)(ii)(a) of this section,
Branch A would not be treated as a separate corporation apart from
FS. The remainder of FS is considered to have manufactured Product X
under Sec. 1.954-3(a)(4)(i) because the manufacturing activities of
the remainder of FS and Branch A, considered together, would make a
substantial contribution to the manufacture of Product X within the
meaning of Sec. 1.954-3(a)(4)(iv). Therefore, income derived from
the sale of Product X by the remainder of FS does not constitute
foreign base company sales income.
(c) [Reserved]. For further guidance, see Sec. 1.954-3(c).
(d) [Reserved]. For further guidance, see Sec. 1.954-3(d).
(e) Effective/applicability date of temporary regulations.
Paragraphs (b)(1)(i)(c), (b)(1)(ii)(a), (b)(1)(ii)(c), (b)(2)(i)(b),
(b)(2)(ii)(a), (b)(2)(ii)(b), (b)(2)(ii)(e), and (b)(4) Example (3),
Example (8), and Example (9) of this section shall apply to taxable
years of controlled foreign corporations beginning after June 30, 2009,
and for taxable years of United States shareholders in which or with
which such taxable years of the controlled foreign corporations end.
(f) Application of temporary regulations to earlier taxable years.
For the application of these temporary regulations retroactively with
respect to taxable years of controlled foreign corporations and to open
taxable years of United States shareholders in which or with which such
taxable years of the controlled foreign corporations end, see Sec.
1.954-3(d).
(g) Expiration date. The applicability of this section expires on
or before December 23, 2011.
Linda E. Stiff,
Deputy Commissioner for Services and Enforcement.
Approved: December 18, 2008.
Eric Solomon,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. E8-30727 Filed 12-24-08; 8:45 am]
BILLING CODE 4830-01-P