[Federal Register Volume 73, Number 40 (Thursday, February 28, 2008)]
[Proposed Rules]
[Pages 10716-10730]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E8-3557]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-124590-07]
RIN 1545-BG11
Guidance Regarding Foreign Base Company Sales Income
AGENCY: Internal Revenue Service (IRS), Treasury Department.
ACTION: Notice of proposed rulemaking.
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SUMMARY: This document contains proposed regulations that provide
guidance relating to foreign base company sales income, as defined in
section 954(d), in cases in which personal property sold by a
controlled foreign corporation (CFC) is manufactured, produced, or
constructed pursuant to a contract manufacturing arrangement or by one
or more branches of the CFC. These regulations, in general, will affect
CFCs and their United States shareholders. Certain portions of these
proposed regulations restate changes to Sec. 1.954-3(a)(4) that were
contained in former proposed regulations.
DATES: Written or electronic comments and requests for a public hearing
must be received by May 28, 2008.
ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-124590-07), Internal
Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC
20044 or send electronically, via the Federal eRulemaking Portal at
www.regulations.gov (IRS REG-121509-00).
FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,
Ethan Atticks, (202) 622-3840; concerning submissions of comments,
Kelly Banks, (202) 622-0392 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
A. Foreign Base Company Sales Income
Under section 951(a)(1)(A)(i), a United States shareholder of a CFC
includes in gross income its pro rata share of the CFC's subpart F
income for the CFC's taxable year which ends with or within the taxable
year of the shareholder. Section 952(a)(2) defines the term ``subpart F
income'' to mean, in part, ``foreign base company income.'' Section
954(a)(2) defines ``foreign base company income'' to include foreign
base company sales income (FBCSI) for the taxable year. Section
954(d)(1) defines FBCSI to mean income derived by a 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 of these cases) that the property both 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 Treasury regulations further define FBCSI and the applicable
exceptions from FBCSI. These exceptions from FBCSI are contained in
Sec. 1.954-3(a)(2), which addresses personal property manufactured,
produced, constructed, grown, or extracted within the CFC's country of
organization (the same country manufacture exception), Sec. 1.954-
3(a)(3), which addresses personal property sold for use, consumption or
disposition within the CFC's country of organization, and Sec. 1.954-
3(a)(4) which addresses personal property manufactured, produced or
constructed by the CFC (the manufacturing exception).
Section 1.954-3(a)(4)(i) provides that FBCSI does not include
income of a CFC derived in connection with the sale of personal
property manufactured, produced, or constructed by such corporation in
whole or in part from personal property which it has purchased. It then
states generally that a foreign corporation is considered to have
manufactured, produced, or constructed personal property which it sells
if the property sold is in effect not the property which it purchased.
Specifically, Sec. 1.954-3(a)(4)(i) states that personal property sold
will be considered as not being the property purchased if the
provisions of Sec. 1.954-3(a)(4)(ii) or (iii) are satisfied.
Section 1.954-3(a)(4)(ii) and (iii) set forth two separate tests to
determine whether a CFC is considered to manufacture, produce, or
construct personal property that it sells. First, Sec. 1.954-
3(a)(4)(ii) sets forth a ``substantial transformation'' test, pursuant
to which if personal property is substantially transformed prior to
sale, the property sold will be treated as having been manufactured,
produced, or constructed by the selling corporation. Examples of
substantial transformation provided in the regulations include the
conversion of wood pulp to paper, steel rods to screws and bolts, and
tuna fish to canned tuna. Second, Sec. 1.954-
[[Page 10717]]
3(a)(4)(iii) sets forth a general ``substantive test'' and a safe
harbor that apply when purchased property is used by the CFC as a
component part of personal property that is sold by the CFC. Under the
substantive test, the sale of personal property will be treated as the
sale of a product manufactured by the CFC rather than the sale of
component parts if the operations conducted by the CFC in connection
with the property are substantial in nature and generally considered to
constitute the manufacture, production, or construction of the
property. The assembly of automobiles from component parts is provided
as an example of an activity considered to be substantial in nature and
generally considered to constitute the manufacture of a product. Under
the safe harbor, without limiting the application of the substantive
test, the operations of a selling corporation in connection with the
use of purchased property as a component part of the personal property
that 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. Section 1.954-3(a)(4)(iii) makes
clear that, in no event, however, will packaging, prepackaging,
labeling, or minor assembly operations constitute the manufacture,
production, or construction of property for purposes of section
954(d)(1). For purposes of this preamble, satisfaction of the
requirements of Sec. 1.954-3(a)(4)(ii) or (iii) will be referred to as
satisfaction of the ``physical manufacturing test.''
B. The Branch Rule
In addition to the general FBCSI rules of section 954(d)(1),
section 954(d)(2) provides a special rule for purposes of determining
FBCSI if a CFC carries on activities through a branch or similar
establishment outside its country of organization and the carrying on
of such activities has substantially the same effect as if such branch
or similar establishment were a wholly owned subsidiary corporation
(the branch rule). Under the branch rule, to the extent prescribed by
regulations, the income attributable to the carrying on of such
activities is treated as income derived by a wholly owned subsidiary of
the CFC and constitutes FBCSI of the CFC. Section 1.954-3(b)(1)(i)
(addressing sales or purchase branches) and (ii) (addressing
manufacturing branches) provide rules on the application of the branch
rule. The purpose of the branch rule is to prevent a CFC from using a
foreign branch to avoid the application of the FBCSI rules. Absent the
branch rule, a CFC could engage in purchasing or manufacturing
activities with respect to personal property in a high-tax jurisdiction
and selling activities with respect to the property in a low-tax
jurisdiction without incurring FBCSI. In such a case, the sales income
would not be FBCSI to the CFC because the same person would be
purchasing or manufacturing the personal property and selling the
personal property. The branch rule therefore treats a sales, purchase,
or manufacturing branch located outside of the country of organization
of the CFC as a separate corporation so as to create a related party
transaction between the branch and the remainder of the CFC for
purposes of determining FBCSI.
With respect to manufacturing branches, Sec. 1.954-3(b)(1)(ii)(a)
provides that if a CFC carries on manufacturing, producing,
constructing, growing, or extracting activities by or through a branch
or similar establishment located outside of its country of organization
and the use of that branch or similar establishment for such activities
with respect to personal property purchased or sold by or through the
remainder of the CFC has substantially the same tax effect as if that
branch or similar establishment were a wholly owned subsidiary
corporation of such CFC, that branch or similar establishment and the
remainder of the CFC will be treated as separate corporations for
purposes of determining FBCSI of such CFC. Section 1.954-3(b)(1)(ii)(b)
provides that the use of a manufacturing branch or similar
establishment will be considered to have substantially the same tax
effect as if it were a wholly owned subsidiary corporation of the CFC
if the tax imposed on the income derived by the remainder of the CFC
satisfies the test set forth in Sec. 1.954-3(b)(1)(ii)(b) (the
manufacturing branch tax rate disparity test). There is also a separate
tax rate disparity test which applies to sales or purchase branches
under Sec. 1.954-3(b)(1)(i)(b) (the sales branch tax rate disparity
test).
For purposes of the manufacturing branch tax rate disparity test,
the income considered to be derived by the remainder of the CFC is
determined first by applying the rules of Sec. 1.954-3(b)(2)(i) which
treat the CFC and the manufacturing branch as separate corporations,
and then by determining the income of the CFC that would be FBCSI under
section 954(d)(1) and Sec. 1.954-3(a)(1) if the CFC and the branch
were separate corporations (but without applying the exceptions
contained in Sec. 1.954-3(a)(2), (3), and (4)).
Specifically, Sec. 1.954-3(b)(2)(i)(a) treats the remainder of the
CFC and the manufacturing branch as separate corporations. In addition,
Sec. 1.954-3(b)(2)(i)(b) and (c) deem purchases or sales to be made
``on behalf of'' a related person to take into account that the
remainder of the CFC and the branch are treated as separate
corporations. Section 1.954-3(b)(2)(i)(b) addresses sales and purchase
branches by treating selling or purchasing activities conducted through
a branch or similar establishment with respect to personal property as
performed on behalf of the CFC if the CFC manufactures, produces,
constructs, grows, extracts, purchases, or sells that same property.
Section 1.954-3(b)(2)(i)(c) provides a corollary rule addressing
manufacturing branches, pursuant to which the purchase or sale of
personal property by the remainder of the CFC is treated as performed
on behalf of a branch that manufactures, produces, constructs, grows,
or extracts that property. The general rule of Sec. 1.954-3(a)(1) is
then applied to determine the income that would be FBCSI if the branch
and the remainder of the CFC were separate corporations subject to the
``on behalf of'' related party transactions described above.
Section 1.954-3(b)(1)(ii)(b) provides that the manufacturing branch
tax rate disparity test is satisfied if the income that would be FBCSI
after applying these special rules is taxed in the year when earned at
an effective rate of tax that is less than 90 percent of, and at least
5 percentage points less than, the hypothetical effective rate of tax.
The hypothetical effective rate of tax is the effective rate of tax
which would apply to such income under the laws of the country in which
the manufacturing branch is located, if, under the laws of such
country, the entire income of the CFC were considered derived by such
CFC from sources within such country from doing business through a
permanent establishment therein, received in such country, and
allocable to such permanent establishment, and the CFC were created or
organized under the laws of, and managed and controlled in, such
country.
If the manufacturing branch tax rate disparity test is satisfied,
Sec. 1.954-3(b)(1)(ii)(a) then treats the branch and the remainder of
the CFC as separate corporations and the special rules of Sec. 1.954-
3(b)(2)(ii) are applied for purposes of determining FBCSI. Section
1.954-3(b)(2)(ii)(a) through (c) provide separate CFC and related party
rules that mirror Sec. 1.954-3(b)(2)(i)(a) through
[[Page 10718]]
(c). Section 1.954-3(b)(2)(ii)(d) through (f) provide special rules to
prevent double counting of FBCSI and to align treatment of branches
with the treatment of separate CFCs. In particular, Sec. 1.954-
3(b)(2)(ii)(e) provides that income derived by a branch or similar
establishment, or by the remainder of the CFC, will not be FBCSI if the
income would not be so considered if it were derived by a separate CFC
under like circumstances.
C. Legal Developments
In Rev. Rul. 75-7 (1975-1 CB 244), revoked by Rev. Rul. 97-48
(1997-2 CB 89), the IRS considered a case in which a CFC purchased raw
material from related persons outside of its country of organization,
contracted with an unrelated manufacturer located outside of its
country of organization to process the raw material into a finished
product, and then sold the finished product to unrelated persons
outside of its country of organization. Under the terms of the
arrangement, the contract manufacturer was paid a conversion fee. The
raw material, work in process, and finished product remained the
property of the CFC at all times. The CFC alone had complete control
over the time and quantity of production as well as complete quality
control over the conversion process. The IRS ruled, under these facts,
that the performance of the operations by the contract manufacturer
whereby the raw material was processed into a finished good was
considered to be a performance by the CFC, and the CFC would therefore
be treated as having substantially transformed personal property. The
ruling further concluded that, because the CFC conducted the
manufacturing activity outside of its country of organization, it was
considered to do so through a branch or similar establishment. Because
the manufacturing branch tax rate disparity test was not satisfied,
however, the activities of the ``branch'' were not considered the
activities of a separate CFC and the CFC was therefore entitled to the
manufacturing exception from FBCSI. See Sec. 601.601(d)(2)(ii)(b).
In Ashland Oil, Inc. v. Commissioner, 95 TC 348 (1990), the Tax
Court held that an unrelated manufacturing corporation in a contract
manufacturing arrangement with a CFC cannot be treated as a branch or
similar establishment of the CFC. In Vetco, Inc. v. Commissioner, 95 TC
579 (1990), the Tax Court held that a wholly owned subsidiary of a CFC
in a contract manufacturing arrangement with the CFC also cannot be
treated as a branch or similar establishment of the CFC.
In Rev. Rul. 97-48 the IRS revoked Rev. Rul. 75-7. Rev. Rul. 97-48
states that the IRS will follow Ashland Oil, Inc. v. Commissioner and
Vetco, Inc. v. Commissioner, and therefore confirms that the IRS will
not treat a separate contract manufacturer as a branch for purposes of
section 954(d)(2). In addition, Rev. Rul. 97-48 rules that the
activities of a contract manufacturer cannot be attributed to a CFC for
purposes of either section 954(d)(1) or section 954(d)(2) to determine
whether the income of a CFC is FBCSI. However, the ruling does not
address the circumstances under which the activities of the CFC itself
may qualify as manufacturing when a contract manufacturing or similar
arrangement is in place. See Sec. 601.601(d)(2)(ii)(b).
D. Business Developments
Final regulations addressing FBCSI were first published in 1964 (TD
6734, 29 FR 6392). Since then, global economic expansion and
globalization have led to significant changes in manufacturing. Many
multinational groups have extensive manufacturing networks that
straddle geographic borders. These cross-border manufacturing networks
are created primarily to leverage expertise and cost efficiencies. In
addition, the use of contract manufacturing arrangements has become a
common way of manufacturing products because of the flexibility and
efficiencies it affords. Accordingly, updated rules in this area are
important to the continued competitiveness of U.S. businesses operating
abroad.
Explanation of Provisions
In response to the growing importance of contract manufacturing and
other manufacturing arrangements, the Treasury Department and the IRS
propose to modernize the FBCSI regulations in light of current business
structures and practices that are inadequately addressed by the current
regulations. Specifically, the proposed regulations address: (1) The
application of the manufacturing exception where the physical
manufacturing test is not satisfied by the CFC but where the CFC, and/
or a branch of the CFC, is involved in the manufacturing process; (2)
the application of the branch rule to business structures involving the
use of one or more branches engaged in manufacturing, producing,
constructing, growing, or extracting activities; and (3) other
miscellaneous branch rule issues. Certain portions of these proposed
regulations restate changes that were previously proposed in REG-
104537-97 (63 FR 14669) and withdrawn in REG-113909-98 (64 FR 37727).
A. Application of the Manufacturing Exception Where the Physical
Manufacturing Test Is Not Satisfied by the CFC but the CFC Is Involved
in the Manufacturing Process--Substantial Contribution to Manufacturing
Section 954(d)(1) includes, as FBCSI, income from the purchase of
personal property from any person and ``its'' sale to a related person.
Some taxpayers argue that use of the word ``its'' implies that the
property sold must be the same property that is purchased for the sales
income to be FBCSI. Accordingly, these taxpayers assert that where the
personal property purchased by the CFC is manufactured such that the
property purchased is not the same as the property sold by the CFC, the
property sold by the CFC is not the property purchased and therefore
the sale of such property does not generate FBCSI, even if the CFC
itself performs little or no part of the manufacture of that property.
They further argue that the manufacturing exception under Sec. 1.954-
3(a)(4)(i) provides a safe harbor but does not define the universe of
cases in which personal property sold by a CFC is considered to be
different from the property purchased by the CFC for purposes of
determining FBCSI. In addition, they argue that Sec. 1.954-3(a)(4)(i)
supports their view because it states, in part, that ``[a] foreign
corporation will be considered, for purposes of this subparagraph, to
have manufactured, produced, or constructed personal property which it
sells if the property sold is in effect not the property which it
purchased.''
The Treasury Department and the IRS believe that the position taken
by these taxpayers is contrary to existing law, and results from an
incorrect reading of section 954(d)(1) and Sec. 1.954-3(a)(4)(i).
Section 954(d)(1) requires only a purchase of personal property and the
sale of that personal property by the CFC with no indication as to
form. Moreover, section 954(d)(1)(A) limits FBCSI to income derived in
connection with the purchase (or sale) of personal property that is
manufactured, produced, grown, or extracted outside of the CFC's
country of organization, thereby indicating that section 954(d)(1) is
concerned with the segregation of purchase or sales and manufacturing
into different jurisdictions, not merely with whether the property was
manufactured.
Section 1.954-3(a)(4) provides the only set of rules under which a
change in form of personal property is considered relevant for purposes
of
[[Page 10719]]
determining FBCSI. The first sentence of Treas. Reg. Sec. 1.954-
3(a)(4) sets forth the general rule that ``foreign base company sales
income does not include income of a CFC derived in connection with the
sale of personal property manufactured, produced, or constructed by
such corporation in whole or in part from personal property which it
has purchased.'' The third sentence of that paragraph explains that
``the property sold will be considered, for purposes of this
subparagraph, as not being the property which is purchased if the
provisions of subdivision (ii) or (iii) of this subparagraph are
satisfied.'' The plain language of the regulation, as well as the
examples, clarify that in order to satisfy Sec. 1.954-3(a)(4)(ii) or
(iii) the relevant manufacturing activities must be performed by the
CFC itself. See, for example, Electronic Arts, Inc. v. Commissioner,
118 TC 226, 265 (2002) (stating that ``petitioner's focus on certain
language in section 1.954-3(a)(4), Income Tax Regs., overlooks the
regulation's requirement that various actions have been done `by' the
corporation being evaluated''). See also, Medchem v. Commissioner, 116
TC 308 (2001).
Further, this regulation was issued shortly after the statute
became effective, and is consistent with the legislative history, which
contemplates that property sold will be considered different from the
property purchased only when the CFC itself manufactures that property.
See S. Rep. No. 1881, 87th Cong., 2d Sess. (1962), 1962-3 C.B. 841, 949
(stating that ``[i]n a case in which a controlled foreign corporation
purchases parts or materials which it then transforms or incorporates
into a final product, income from the sale of the final product would
not be foreign base company sales income if the corporation
substantially transforms the parts or materials, so that, in effect,
the final product is not the property purchased.'')
The proposed regulations clarify that for purposes of determining
FBCSI personal property sold by a CFC will be considered to be the
property purchased by the CFC regardless of whether it 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, except as specifically provided by the same country
manufacture exception contained in Sec. 1.954-3(a)(2) and the
manufacturing exception contained in Sec. 1.954-3(a)(4). Therefore,
the only time that the manufacture of a product will affect whether
income is FBCSI is when the manufacture of the product is performed by
the CFC or performed in the country of organization of the CFC. With
respect to the manufacturing exception contained in Sec. 1.954-
3(a)(4), the proposed regulations clarify that a CFC qualifies for the
manufacturing exception from FBCSI only if the CFC, acting through its
employees, manufactured the relevant product within the meaning of
Sec. 1.954-3(a)(4)(i). The proposed regulations also further provide
rules to determine whether the activities of a branch or similar
establishment outside the country in which the CFC is incorporated have
substantially the same tax effect as if the branch or similar
establishment were a wholly owned subsidiary corporation, and thus
whether under section 954(d)(2) the income attributable to the branch
or similar establishment constitutes FBCSI of the CFC.
The Treasury Department and the IRS recognize, however, that due to
business considerations in the global marketplace, personal property
may be manufactured pursuant to a contract manufacturing arrangement
under which the CFC engages in activities related to the manufacture of
the property (for example, oversight, direction and control over the
contract manufacturer) but does not satisfy the physical manufacturing
test. In certain of these cases, the Treasury Department and the IRS
believe that the CFC should qualify for the manufacturing exception to
FBCSI. Accordingly, the proposed regulations modify Sec. 1.954-3(a)(4)
to provide that a CFC that provides a ``substantial contribution'' with
respect to the manufacture, production, or construction of personal
property, but that could not satisfy the physical manufacturing test,
may have manufactured such property for purposes of the manufacturing
exception. Specifically, proposed Sec. 1.954-3(a)(4)(i) provides that,
in addition to proposed Sec. 1.954-3(a)(4)(ii) and (iii), a taxpayer
may qualify for the manufacturing exception by satisfying the
``substantial contribution test'' in proposed Sec. 1.954-3(a)(4)(iv).
Pursuant to proposed Sec. 1.954-3(a)(4)(iv)(b), a CFC will satisfy the
substantial contribution test with respect to personal property only if
the facts and circumstances evidence that the controlled foreign
corporation makes a substantial contribution through the activities of
its employees to the manufacture of that property.
Factors to be considered in determining whether a CFC makes a
substantial contribution to the manufacture of personal property
include but are not limited to: (1) Oversight and direction of the
activities or process (including management of the risk of loss)
pursuant to which the property is manufactured under the principles of
Sec. 1.954-3(a)(4)(ii) and (iii); (2) performance of manufacturing
activities that are considered in, but insufficient to satisfy the
tests provided in Sec. 1.954-3(a)(4)(ii) or (iii); (3) control of the
raw materials, work-in-process and finished goods; (4) management of
the manufacturing profits; (5) material selection; (6) vendor
selection; (7) control of logistics; (8) quality control; and (9)
direction of the development, protection, and use of trade secrets,
technology, product design and design specifications, and other
intellectual property used in manufacturing the product.
In light of the addition of the new test contained in proposed
Sec. 1.954-3(a)(4)(iv), the interaction between several existing
regulation sections and the new test is clarified. First, the existing
manufacturing exceptions under Sec. 1.954-3(a)(4)(ii) and (iii) are
modified to clarify that the applicability of the tests under Sec.
1.954-3(a)(4)(ii) and (iii) are restricted to cases in which physical
transformation or physical assembly or conversion of component parts is
conducted by the selling corporation.
Second, the definition of manufacturing for purposes of the same
country manufacture exception contained in Sec. 1.954-3(a)(2) is
modified to exclude manufacturing as defined under the substantial
contribution test, and to ensure that the modifications to the existing
manufacturing exceptions under Sec. 1.954-3(a)(4)(ii) and (iii) do not
narrow the same country manufacture exception. The Treasury Department
and the IRS did not intend these regulations to change the scope of the
same country manufacture exception. Section 1.954-3(a)(2) excludes
manufacturing as defined under the substantial contribution test
because a rule that expanded the definition of manufacturing to include
Sec. 1.954-3(a)(4)(iv) activities for purposes of the same country
manufacture exception could prove difficult to administer. Such a rule
could require an assessment of activities other than physical
manufacturing conducted by an unrelated person. Modifying Sec. 1.954-
3(a)(2) ensures that the modifications to the existing manufacturing
exceptions under Sec. 1.954-3(a)(4)(ii) and (iii) do not narrow the
same country manufacture exception by clarifying that property
manufactured in the country of organization of the selling corporation
will qualify for the same country manufacture exception regardless of
whose employees engage in
[[Page 10720]]
manufacturing activities that satisfy the principles of Sec. 1.954-
3(a)(4)(ii) or (iii).
Third, the proposed regulations modify Sec. 1.954-3(a)(6), which
addresses the application of the manufacturing exception to a CFC's
distributive share of partnership income where the partnership
manufactures and sells personal property. The reference to ``the
separate activities or property of the controlled foreign corporation
or any other person,'' in Sec. 1.954-3(a)(6) was intended to clarify
that the activities of another person could not be attributed to the
partnership for purposes of applying the manufacturing exception.
Because these proposed regulations clarify that no attribution is
allowed for purposes of applying the manufacturing exception that
language is now unnecessary and is therefore removed. Section 1.954-
3(a)(6) is also modified consistent with the modifications to Sec.
1.954-3(a)(4) providing that a CFC may only qualify for the
manufacturing exception through the activities of its employees.
B. Application of the Branch Rule to Business Structures Involving the
Use of More Than One Branch Engaged in Manufacturing
Proposed Sec. 1.954-3(b)(2)(ii)(c)(2) creates a rebuttable
presumption with respect to the application of the substantial
contribution test where a CFC claims to satisfy the substantial
contribution test with respect to the activities of a branch of that
CFC that satisfies Sec. 1.954-3(a)(4)(ii) or (iii). Under this
rebuttable presumption, if a branch of a CFC satisfies the physical
manufacturing test with respect to personal property sold by the
remainder of the CFC, the remainder of the CFC will be presumed not to
make a substantial contribution to the manufacture of that personal
property unless the CFC can rebut that presumption to the satisfaction
of the Commissioner.
The Treasury Department and the IRS believe that these rules are
necessary as a backstop to the branch rule. In the absence of the
rebuttable presumption, a rule permitting a CFC to qualify for the
manufacturing exception based upon its contribution to the
manufacturing activities of a branch would prove difficult to
administer. Such a rule could encourage a CFC to elect classification
of its subsidiaries that engage in manufacturing activities as
disregarded entities, obfuscating the division of manufacturing labor
and income between the CFC and its branches. Of course, the presumption
may be rebutted and any adverse consequences alleviated by
incorporating the branch that satisfies the physical manufacturing
test.
Although Sec. 1.954-3(b)(1)(i)(c) provides a rule addressing the
use of multiple sales or purchase branches, Sec. 1.954-3(b)(1)(ii)
does not provide a corollary rule for the use of multiple manufacturing
branches. The Treasury Department and the IRS believe that the lack of
a specific rule addressing the use of more than one manufacturing
branch does not currently limit the general manufacturing branch rule
of Sec. 1.954-3(b)(1)(ii)(a) from applying to each manufacturing
branch of a CFC in a case where a CFC performs manufacturing activities
through more than one branch or similar establishment. Rather, such an
application is consistent with the rules regarding multiple sales or
purchase branches. Nonetheless, for clarity, the proposed regulations
set forth rules addressing the use of multiple manufacturing branches.
The proposed regulations set forth two rules addressing the
application of the manufacturing branch tax rate disparity test to
multiple manufacturing branches.
Proposed Sec. 1.954-3(b)(1)(ii)(c)(2) addresses situations in
which multiple branches each perform manufacturing activities with
respect to separate items of personal property that are then sold by
the CFC. Consistent with the rule for multiple sales branches, the
proposed regulations require the separate application of the
manufacturing branch tax rate disparity test to each branch that is
manufacturing a separate item of personal property.
Proposed Sec. 1.954-3(b)(1)(ii)(c)(3) addresses situations in
which 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 that is then sold by the CFC. 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, the manufacturing branch tax rate disparity test is applied
by giving satisfaction of the physical manufacturing test precedence
over other contributions to manufacturing. Therefore, if only one
branch, or only the remainder of the CFC, satisfies the physical
manufacturing test of Sec. 1.954-3(a)(4)(ii) or (iii), then the
location of that branch or the remainder of the CFC will be the
location of manufacturing of the personal property for purposes of
applying the manufacturing branch tax rate disparity test. If more than
one branch, or one or more branches and the remainder of the CFC, each
satisfy 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 will be the location of
manufacturing of the personal property for purposes of applying the
manufacturing branch tax rate disparity test.
If none of the branches nor the remainder of the CFC satisfies the
physical manufacturing test, but the CFC as a whole satisfies the
substantial contribution test contained in proposed Sec. 1.954-
3(a)(4)(iv), then the location of manufacturing of the personal
property will be the location of the branch or the remainder of the CFC
that provides the predominant amount of the CFC's substantial
contribution to manufacturing. Whether any branch or the remainder of
the CFC provides a predominant amount of the CFC's contribution to
manufacturing is determined by applying the facts and circumstances
test provided in Sec. 1.954-3(a)(4)(iv) to weigh the contribution to
manufacturing of each branch or the remainder of the CFC. If a
predominant amount of the CFC's contribution to manufacturing is not
provided by any one location, the location of manufacturing of the
personal property for purposes of applying the manufacturing branch tax
rate disparity test will be that place (either the remainder of the CFC
or one of its branches) where manufacturing activity is performed and
which would impose the highest effective rate of tax when applying
either Sec. 1.954-3(b)(1)(i)(b) or (ii)(b).
Because the proposed regulations address cases in which two or more
branches, or one or more branches and the remainder of the CFC, perform
manufacturing activities related to the manufacture of the same item of
property, Sec. 1.954-3(b)(2)(ii)(a) is modified to clarify the
application of the branch rule where manufacturing activities are
performed in more than one location. In such cases, proposed Sec.
1.954-3(b)(2)(ii)(a) provides that, for purposes of treating the
location of sales or purchase income as a separate corporation for
purposes of determining whether FBCSI is incurred, that separate
corporation will exclude any branch or the remainder of the CFC that
would be treated as a separate corporation, if the hypothetical 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.
[[Page 10721]]
C. Miscellaneous Branch Rule Issues
The Treasury Department and the IRS also propose to amend certain
other aspects of Sec. 1.954-3(b) as follows:
1. Definition of a Manufacturing Branch
While Sec. 1.954-3(b)(1)(ii)(a) defines a manufacturing branch as
a branch or similar establishment through which a CFC carries on
manufacturing activities, it does not explicitly require that Sec.
1.954-3(a)(4)(i) be satisfied by the CFC as a whole in order for the
manufacturing branch rule to apply. The Treasury Department and the IRS
believe that a manufacturing branch only exists with respect to
personal property sold by a CFC if the CFC (including any branch of
that CFC) has manufactured that property. Accordingly, proposed Sec.
1.954-3(b)(1)(ii)(a) clarifies this point by providing that the
manufacturing branch rule applies only where a CFC (including any
branch of the CFC) satisfies the manufacturing requirement under
proposed Sec. 1.954-3(a)(4).
2. Modification of Sec. 1.954-3(b)(2)(ii)(e)
Section 1.954-3(b)(2)(ii)(e) provides that income derived by a
branch or similar establishment, or by the remainder of the CFC, will
not be FBCSI if the income would not be so considered if it were
derived by a separate CFC under like circumstances. For example, if a
branch of a CFC purchases personal property from an unrelated person
and sells the property to an unrelated person without any involvement
by the remainder of the CFC, the branch rule will not apply to create a
related party transaction between the branch and the remainder of the
CFC. Therefore the purchase and sale of that personal property by the
branch will not generate FBCSI.
The proposed regulations provide that the substantial contribution
test generally applies to a CFC that sells personal property where
another person (for example, a second CFC) satisfies the physical
manufacturing test with respect to that property. However, a negative
presumption applies where a CFC claims to satisfy the substantial
contribution test with respect to income from the sale of personal
property where the physical manufacturing test is satisfied by a branch
of that CFC. The effect of these rules is that, where a CFC seeks to
rely on the substantial contribution test with respect to the income
from the sale of personal property manufactured (within the meaning of
Sec. 1.954-3(a)(4)(ii) or (iii)) by one or more of its branches, but
cannot rebut the negative presumption to the satisfaction of the
Commissioner, a branch or the remainder of a CFC may have FBCSI where a
separate CFC would not. Therefore, to integrate the rules regarding the
substantial contribution test and its application under the branch
rule, proposed Sec. 1.954-3(b)(2)(ii)(e) excepts from its general rule
cases in which a branch satisfies the physical manufacturing test with
respect to personal property and the remainder of the controlled
foreign corporation fails to rebut the presumption that it does not
satisfy the substantial contribution test with respect to the
activities of that manufacturing branch.
In addition, consistent with the clarification regarding the scope
of the branch rule contained in proposed Sec. 1.954-3(b)(1), Sec.
1.954-3(b)(2)(ii)(e) is modified to clarify that it applies only for
purposes of paragraph (b) of Sec. 1.954-3 (that is, the branch rule).
This clarifies that in no event will the branch rule cause income not
to be FBCSI if that income would otherwise be FBCSI under section
954(d)(1). For example, assume a CFC incorporated in Country Y
purchases personal property from a related party and has that property
manufactured by a contract manufacturer in Country Z. If the CFC does
not perform any other activity with respect to the manufacture of the
property, and if the CFC sells the manufactured property through a
branch located in Country Z for use, consumption, or disposition
outside of Country Y, the income from the sale of that property is
FBCSI under section 954(d)(1). If the branch located in Country Z were
a separate CFC the income would not be FBCSI because it would be
selling personal property manufactured in its country of organization,
Country Z. However, because the income would be FBCSI to the CFC under
section 954(d)(1), proposed Sec. 1.954-3(b)(2)(ii)(e) does not apply
to create a different result.
3. Modification of Sec. 1.954-3(b)(2)(i)(b), (b)(2)(ii)(b) and (b)(4),
Example 3
Commentators have noted that Sec. 1.954-3(b)(2)(i)(b) and (ii)(b)
can be read to cause a branch that purchases from unrelated persons and
sells to unrelated persons to have FBCSI even where the remainder of
the CFC has no connection with the personal property that is sold.
Although Sec. 1.954-3(b)(2)(ii)(e) should prevent such a result,
commentators note that a contrary reading is possible because the sales
branch rules of Sec. 1.954-3(b)(2)(i)(b) and (ii)(b) apply, in part,
with respect to personal property manufactured, produced, constructed,
grown, or extracted by, or personal property purchased or sold by the
``controlled foreign corporation'' (as opposed to by the ``remainder''
of the controlled foreign corporation). For example, in a case in which
a branch both manufactures and sells personal property, the branch
could be considered to sell on behalf of the remainder of the CFC
because the branch's manufacturing activities would be considered to be
manufacturing activities of the CFC, thereby triggering the application
of Sec. 1.954-3(b)(2)(ii)(b). Further, commentators note that Sec.
1.954-3(b)(4), Example 3 appears to support this reading because in
that example a branch of a corporation purchases from a related person
and sells to an unrelated person, and the branch is treated as selling
that property on behalf of the remainder of the CFC, even though the
remainder of the corporation does not manufacture, purchase, or sell
the personal property.
Section 1.954-3(b)(2)(i)(b) and (ii)(b) are intended to apply only
to purchasing or selling by a branch with respect to personal property
manufactured, purchased, or sold by ``the remainder of'' the CFC
(including any branch treated as the remainder of the CFC). For
example, the branch rule could apply in a case where personal property
is manufactured by the CFC in the country of organization of the CFC
and then sold by a branch of the CFC located outside of the country of
organization of the CFC. However, the branch rule does not apply where,
for example, a branch of the CFC purchases personal property from an
unrelated party and sells it to an unrelated party without any
involvement by the remainder of the CFC. Accordingly, the proposed
regulations amend Sec. 1.954-3(b)(2)(i)(b) and (ii)(b) by adding the
words ``remainder of'' before each place where the words ``controlled
foreign corporation'' appear in those paragraphs and by adding the
words ``(or by any branch treated as the remainder of the CFC)'' after
each place where the words ``controlled foreign corporation'' appear in
those paragraphs. Consistent with this change, the proposed regulations
revise the rationale for the result in Sec. 1.954-3(b)(4), Example 3
as described below.
In Sec. 1.954-3(b)(4), Example 3, a branch of a second-tier CFC
purchases finished goods from the first-tier CFC and sells 90 percent
of the product for use, consumption, or disposition outside of the
country in which the branch is located and the country of organization
of the second-tier CFC. The remainder of the second-tier CFC does not
engage in any manufacturing or
[[Page 10722]]
selling activities. The sales branch tax rate disparity test is met in
comparison to the effective tax rate of the second-tier CFC (the first-
tier CFC and second-tier CFC are organized in the same country). The
example concludes that since the sales branch tax disparity test is
met, the branch is treated as a separate CFC and is treated as selling
personal property on behalf of the second-tier CFC and therefore the 90
percent of sales made for use, consumption, or disposition outside of
the branch's country is FBCSI.
The rationale of the example is incorrect because the branch is not
selling on behalf of the second-tier CFC because the remainder of the
second-tier CFC (not including the branch) does not manufacture,
purchase, or sell the personal property. Therefore, Sec. 1.954-
3(b)(2)(i)(b) and (ii)(b) do not apply. However, the result is correct
because the branch, treated as a separate corporation, is purchasing
from a related person, the first-tier CFC, organized outside of the
branch's country and selling to persons outside the branch's country
and the branch is located in a jurisdiction that satisfies the sales
branch tax rate disparity test with respect to the income from the sale
of the personal property. Accordingly, the proposed regulations revise
Sec. 1.954-3(b)(4), Example 3 to provide the correct rationale for the
result. In addition, the result in Sec. 1.954-3(b)(4), Example 3 is
further revised to add two alternative factual scenarios (purchase from
an unrelated party, and manufacture within the meaning of proposed
Sec. 1.954-3(a)(4)(iv) by the selling branch) to illustrate the point
that, in general, a branch will not have FBCSI if a separate CFC would
not have FBCSI under like circumstances.
Proposed Effective/Applicability Date
These regulations will apply to taxable years of CFCs beginning on
or after the date they are published as final regulations in the
Federal Register, and for taxable years of United States shareholders
in which or with which such taxable years of the CFCs end.
Reliance on Proposed Regulations
Until these regulations are finalized, taxpayers may choose to
apply these regulations in their entirety to all open tax years as if
they were final regulations.
Request for Comments
The Treasury Department and the IRS request comments on all aspects
of these proposed regulations, including comments regarding the
substantial contribution test, and the activities listed in Sec.
1.954-3(a)(4)(iv)(b). In particular, comments are requested on whether
one or more safe harbors should be added to the substantial
contribution test. In drafting the proposed regulations, the Treasury
Department and the IRS considered a number of approaches to a safe
harbor but ultimately chose to request comments in this regard because
of difficulties in fashioning a safe harbor that would be flexible
enough to apply across various industries and across a range of
different types of manufacturing arrangements. Among the safe harbors
considered in drafting the proposed regulations were: (1) A list of
mandatory activities; (2) a cost based test; (3) a compensation based
test; (4) a value based test; (5) a tax rate disparity based test; and
(6) a percentage based test comparing the compensation paid to
employees of the CFC for performing activities related to the
manufacturing process vs. the total cost for all activities related to
the manufacturing process (that is, including costs paid to a contract
manufacturer but excluding the cost of raw materials and marketing
intangibles). In addition, the Treasury Department and the IRS request
comments as to whether the requirement, under the manufacturing
exception from foreign base company sales income, that the activities
of the CFC be performed by its employees, should permit commercial
arrangements where individuals performing services for the CFC, while
not on its payroll, are nevertheless controlled by employees of the
CFC.
Comments are also requested on whether it would be appropriate to
add an anti-abuse rule similar to the foreign base company services
substantial assistance test announced in Notice 2007-13 to prevent a
CFC from qualifying for the manufacturing exception based on the
application of the substantial contribution test in cases in which
substantially all of the direct or indirect contributions to the
manufacture of personal property provided collectively by the CFC and
any related United States person is provided by one or more related
United States persons. Such a rule might provide, for example, that
where (1) the United States parent of a CFC provides 45 percent of the
manufacturing contribution, (2) the CFC provides 5 percent of the
manufacturing contribution, and (3) an unrelated contract manufacturer
provides 50 percent of the manufacturing contribution to the personal
property, the CFC does not make a substantial contribution to the
manufacture of that property because a related United States person
provides 80 percent or more of the contribution to the manufacture of
the property (90 percent in this case, 45/50) provided collectively by
the CFC and any related United States person. Such a rule was
considered but ultimately not included in the proposed regulations and
comments are requested on whether or not such a rule should be added to
the final regulations. See Sec. 601.601(d)(2)(ii)(b).
In addition, comments are requested on the multiple manufacturing
branch rules. First, comments are requested on whether the negative
presumption rule concerning cases in which the selling branch or the
remainder of the CFC performs activities described in proposed Sec.
1.954-3(a)(4)(iv) is more appropriate than an alternative rule that
would deny the use of the test contained in proposed Sec. 1.954-
3(a)(4)(iv) in cases in which a branch of the CFC manufactures the
property within the meaning of proposed Sec. 1.954-3(a)(4)(ii) or
(iii). Second, comments are requested on the consequences of and
possible alternatives to proposed Sec. 1.954-3(b)(1)(ii)(c)(3)(e),
which provides that if a predominant amount of the CFC's substantial
contribution is not provided by any one location, the location of
manufacturing of the personal property will be considered to be that
location (either the remainder of the CFC or one of its branches) which
imposes the highest effective rate of tax that would be imposed on the
sales income, among those locations where manufacturing activity
related to the generation of that income is performed. The Treasury
Department and the IRS considered a rule that would allow taxpayers to
alternatively use the mean effective rate of tax among the locations
where manufacturing activity is performed, so long as that effective
rate of tax was within a set number of percentage points of the highest
effective tax rate that would be imposed by any jurisdiction in which a
manufacturing branch or the remainder of the CFC was located or
organized. However, the Treasury Department and the IRS were concerned
about the complexity of such a rule. The Treasury Department and the
IRS request comments on whether this or other alternatives to the
highest rate test would be appropriate. Finally, comments are requested
on whether any modifications to Sec. 1.954-3(b)(1)(i)(b) and
(b)(1)(ii)(b) should be adopted to make the rules concerning the
comparison of effective rates of tax easier to apply.
[[Page 10723]]
Special Analyses
It has been determined that this notice of proposed rulemaking 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 proposed regulation does not impose a collection of information on
small entities, the Regulatory Flexibility Act (5 U.S.C. Ch. 6) does
not apply. Pursuant to section 7805(f) of the Internal Revenue Code,
this notice of proposed rulemaking was submitted to the Chief Counsel
for Advocacy of the Small Business Administration for comment on its
impact on small business.
Comments and Requests for Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written (a signed original and eight
(8) copies) or electronic comments that are submitted timely to the
IRS. The Treasury Department and the IRS request comments on the
clarity of the proposed rules and how they can be made easier to
understand. All comments will be available for public inspection and
copying. A public hearing will be scheduled if requested in writing by
any person that timely submits written comments. If a public hearing is
scheduled, notice of the date, time, and place for the public hearing
will be published in the Federal Register.
Drafting Information
The principal author of these regulations is Ethan Atticks, Office
of Associate Chief Counsel (International). However, other personnel
from the Treasury Department and the IRS participated in their
development.
List of Subjects in 26 CFR Part 1
Income Taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for 26 CFR part 1 continues to
read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.954-3 is amended by:
1. Adding a new sentence after the first sentence of paragraph
(a)(1)(i), and by revising the second sentence of Example 1 in
paragraph (a)(1)(iii), and the first sentence of Example 2 in paragraph
(a)(1)(iii).
2. Revising the third sentence of paragraph (a)(2).
3. Revising paragraph (a)(4)(i), and the first sentences of
paragraphs (a)(4)(ii) and (iii), and by adding paragraph (a)(4)(iv).
4. Revising the text of paragraph (a)(6)(i).
5. Adding a new sentence to the end of paragraph (b)(1)(ii)(a).
6. Redesignating the text of paragraph (b)(1)(ii)(c) as paragraph
(b)(1)(ii)(c)(1), and adding a paragraph heading to newly designated
paragraph (b)(1)(ii)(c)(1).
7. Adding paragraphs (b)(1)(ii)(c)(2), and (c)(3).
8. Revising paragraph (b)(2)(i)(b).
9. Adding a new sentence to the end of paragraph (b)(2)(ii)(a), and
revising paragraph (b)(2)(ii)(b).
10. Redesignating the text of paragraph (b)(2)(ii)(c) as paragraph
(b)(2)(ii)(c)(1), adding a paragraph heading to newly redesignated
paragraph (b)(2)(ii)(c)(1), adding paragraph (b)(2)(ii)(c)(2), and
revising paragraph (b)(2)(ii)(e).
11. Revising Example 3 in paragraph (b)(4).
12. Adding paragraph (d).
The additions and revisions read as follows:
Sec. 1.954-3 Foreign base company sales income.
(a) * * *
(1) In general--(i) General rules. * * * 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. * * *
* * * * *
Example 1. * * * Corporation A purchases from M Corporation, a
related person, articles manufactured in the United States and sells
the articles to P, not a related person, for delivery and use in
foreign country Y. * * *
Example 2. Corporation A in Example 1 also purchases from P, not
a related person, articles manufactured in country Y and sells the
articles to foreign corporation B, a related person, for use in
foreign country Z. * * *
* * * * *
(2) * * * The principles set forth in paragraphs (a)(4)(i),
(a)(4)(ii), and (a)(4)(iii) of this section apply under this paragraph
(a)(2) in determining what constitutes manufacture, production, or
construction of personal property, excluding, in the case of
manufacture, production, or construction by a person other than the
controlled foreign corporation, 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 that person's employees. * * *
* * * * *
(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 in whole or
in part from personal property which it has purchased. A controlled
foreign corporation will have manufactured, produced, or constructed
personal property which the corporation sells only if such corporation
satisfies the provisions of paragraphs (a)(ii), (a)(iii), or (a)(iv) of
this section through the activities of its employees with respect to
such property. 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) * * * 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. * * *
(iii) * * * 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
[[Page 10724]]
manufacture, production, or construction of property. * * *
(iv) Substantial contribution to manufacturing of personal
property--(a)--In general. This paragraph (a)(4)(iv) applies only if a
controlled foreign corporation does not satisfy paragraph (a)(4)(ii) or
(a)(4)(iii) of this section, but the personal property purchased by a
controlled foreign corporation would be considered to be manufactured,
produced, or constructed prior to sale (under the principles of
paragraphs (a)(4)(ii) or (iii) of this section) by the controlled
foreign corporation if the manufacturing, producing, and constructing
activities undertaken with respect to the property prior to sale were
undertaken by the controlled foreign corporation through the activities
of its employees. If this paragraph (a)(4)(iv) applies, the personal
property sold by the controlled foreign corporation is manufactured,
produced, or constructed by such controlled foreign corporation only if
the facts and circumstances evidence 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. 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 will involve, but will not
necessarily be limited to, consideration of the activities set forth in
paragraph (a)(4)(iv)(b) of this section. The weight given to any
activity (whether or not set forth) will vary with the facts and
circumstances of the particular business. The presence or absence of
any activity, or of a particular number of activities, is not
determinative. Further, the fact that other persons make contributions
to the manufacture, production, or construction of personal property
prior to sale does not necessarily prevent the controlled foreign
corporation from making a substantial contribution to the manufacture,
construction, or production of that property through the activities of
its employees.
(b) Activities. Activities of a controlled foreign corporation's
employees to be considered in determining whether a controlled foreign
corporation makes a substantial contribution through the activities of
its employees to the manufacture, construction, or production of
personal property include but are not limited to--
(1) Oversight and direction of the activities or process (including
management of the risk of loss) pursuant to which the property is
manufactured, produced, or constructed under the principles of
paragraphs (a)(4)(ii) or (iii) of this section;
(2) Performance of 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) Control of the raw materials, work-in-process and finished
goods;
(4) Management of the manufacturing profits;
(5) Material selection;
(6) Vendor selection;
(7) Control of logistics;
(8) Quality control; and
(9) Direction of the development, protection, and use of trade
secrets, technology, product design and design specifications, and
other intellectual property used in manufacturing the product.
(c) The rules of this paragraph (a)(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 then manufactured
(under the principles of paragraph (a)(4)(iii)) of this section into
Product X by CM, an unrelated corporation that performs the physical
conversion outside of FS's country of organization, pursuant to a
contract manufacturing arrangement. Product X is then sold by FS for
use outside of FS's country of organization. At all times, FS
retains control of the raw material, work-in-process, and finished
goods, as well as the intangibles used in the conversion process. FS
retains the right to oversee and direct the physical conversion of
Product X by CM but does not regularly exercise, through its
employees, its powers of oversight or direction.
(ii) Result. FS does not satisfy paragraph (a)(4)(ii) or
(a)(4)(iii) of this section because FS does not, through the
activities of its employees, substantially transform, convert or
assemble personal property into Product X. However, Product X was
manufactured (by CM), and 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 ownership of materials and intellectual
property and contractual rights to exercise powers of direction and
control (without the exercise of those powers) are not sufficient to
satisfy this paragraph (a)(4)(iv). Therefore, FS is not considered
to have manufactured Product X under paragraph (a)(4)(i) of this
section.
Example 2. Substantial contribution to manufacturing, unrelated
manufacturer. (i) Facts. Assume the same facts as in Example 1,
except for the following. FS, through its employees, is engaged in
product design and quality control. Employees of FS regularly
exercise the right to oversee and direct the activities of CM in the
manufacture of Product X.
(ii) Result. FS does not satisfy paragraph (a)(4)(ii) or
(a)(4)(iii) of this section with respect to Product X because FS
does not, through the activities of its employees, substantially
transform, convert or assemble personal property into Product X.
However, Product X was manufactured (by CM), and therefore this
paragraph (a)(4)(iv) applies. 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. The analysis and conclusion in this Example 2 would be the same
if CM were a corporation that was related to FS.
Example 3. Employees of another person. (i) Facts. FS, a
controlled foreign corporation organized in Country M, purchases raw
materials from a related person. The raw materials are then
manufactured (under the principles of paragraph (a)(4)(iii) of this
section) into Product X by CM, an unrelated contract manufacturer
located in Country C. CM uses employees of another corporation to
operate its manufacturing plant and convert the raw materials into
Product X. Apart from the physical conversion of the raw materials
into Product X, employees of FS perform all of the other activities
with respect to the manufacture of Product X (for example, oversight
and direction of the manufacturing process, control of raw
materials, control of logistics, vendor selection, quality control).
FS sells Product X for use, consumption or disposition outside
Country M.
(ii) Result. If the manufacturing activities undertaken with
respect to Product X between the time the raw materials were
purchased and the time Product X was sold were undertaken by FS
through the activities of its employees, FS would have satisfied the
manufacturing exception contained in paragraph (a)(4)(iii) of this
section with respect to Product X. Therefore, this paragraph
(a)(4)(iv) applies. 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. If CM's
manufacturing plant were located in Country M, the test in paragraph
(a)(2) of this section could be satisfied even if CM did not
manufacture Product X through the activities of its employees.
Example 4. Automated manufacturing. (i) Facts. FS, a controlled
foreign corporation, purchases raw materials from a related person.
The raw materials are then manufactured (under the principles of
paragraph (a)(4)(ii) of this section) into Product X by CM, an
unrelated corporation located outside of FS's country of
organization, pursuant to a contract manufacturing arrangement.
Product X is then sold by FS to related and unrelated persons for
use outside of FS's country of organization. Under the contract
manufacturing arrangement, CM is responsible for the physical
transformation of the raw materials into Product X. At all times, FS
retains ownership of the raw material, work-in-process, and finished
goods. FS retains the right to oversee and
[[Page 10725]]
direct the physical conversion of Product X by CM but does not
regularly exercise, through its employees, its powers of oversight
or 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 to apply any necessary patches or fixes. The
software and network systems were developed by employees of DP, the
U.S. corporate parent of FS, pursuant to a cost sharing agreement
between DP and FS. DP employees regularly supervise the computer
technicians, evaluate the results of the automated manufacturing
business, and make ongoing operational decisions, including with
regard to acceptable performance of the manufacturing process,
stoppages of that process, and product and process redesign and
updates to meet the needs of the business and its customers. DP
employees develop and provide to FS all of the upgrades to the
software and network systems. DP also has employees who control the
other aspects of the manufacturing process such as product design,
vendor and material selection, management and retention of the
manufacturing profits, and the selection of CM.
(ii) Result. FS does not satisfy paragraph (a)(4)(ii) or
(a)(4)(iii) of this section with respect to Product X because FS
does not, through the activities of its employees, substantially
transform, convert or assemble personal property into Product X. If
the manufacturing activities undertaken with respect to Product X
between the time the raw materials were purchased and the time
Product X was sold were undertaken by FS through the activities of
its employees, FS would have satisfied the manufacturing exception
contained in paragraph (a)(4)(iii) 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
ownership of materials and intellectual property together with
contractual rights to exercise powers of direction and control and a
small number of technical employees are not sufficient to satisfy
this paragraph (a)(4)(iv). FS's primary contribution to the
manufacture of Product X is the provision of the software and
network systems to CM. Substantial operational responsibilities and
decision making are exercised by DP employees who direct the
activities of the FS employees. Therefore, FS is not considered to
have manufactured Product X.
* * * * *
(6) * * * (i) * * * 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)
of this section, only if the manufacturing exception of paragraph
(a)(4) 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 the
activities of the employees of, and property owned by, the partnership.
* * * * *
(b) * * *
(1) * * *
(ii) * * *
(a) * * * The provisions of this paragraph (b)(1)(ii)(a) will not
apply unless 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 paragraph (a)(4)(i) of this section.
* * * * *
(c) Use of more than one branch--(1) Use of one or more sales or
purchase branches in addition to a manufacturing branch. * * *
(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 paragraphs (b)(2)(ii)(b) and
(c) of this section will be applied separately to each such branch or
similar establishment (by treating such 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. The application of this paragraph
(b)(1)(ii)(c)(2) is illustrated by the following example:
Example. Multiple branches that satisfy paragraph (a)(4)(ii) or
(a)(4)(iii) of this section. (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 Y respectively) within the meaning of
paragraph (a)(4)(ii) or (iii) of this section. 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 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),
paragraph (b)(1)(ii)(b) of this section is separately applied 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 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 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.
(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, construct, grow, or extract the
same property--(a)--In general. This paragraph (b)(1)(ii)(c)(3) applies
to determine the location of manufacturing, producing, constructing,
growing or extracting of personal property for purposes of applying
paragraphs (b)(1)(i)(b) or (ii)(b) of this section where more than one
branch of a controlled foreign corporation, or one or more branches of
a controlled foreign corporation and the remainder of the controlled
foreign corporation, each engage in manufacturing, producing,
constructing, growing or extracting activities with respect to the same
item of personal property which is then sold by the controlled foreign
corporation.
(b) Physical manufacture, production, or construction in one or
more
[[Page 10726]]
locations. If only one branch or only the remainder of a controlled
foreign corporation satisfies either paragraph (a)(4)(ii) or
(a)(4)(iii) of this section with respect to an item of personal
property, then that branch or the remainder of the controlled foreign
corporation will be the location of manufacturing, producing, or
constructing of that property for purposes of applying paragraph
(b)(1)(i)(b) or (ii)(b) of this section to the income from the sale of
that property. See Sec. 1.954-3(b)(1)(ii)(c)(3)(f) Example 1. If more
than one branch, or one or more branches and the remainder of the
controlled foreign corporation, each independently satisfy either
paragraph (a)(4)(ii) or (a)(4)(iii) of this section with respect to an
item of property, then the location of manufacturing, producing, or
constructing of that property for purposes of applying paragraph
(b)(1)(i)(b) or (ii)(b) of this section will be that branch or the
remainder of the controlled foreign corporation that satisfies
paragraph (a)(4)(ii) or (a)(4)(iii) of this section and that is located
or organized in the jurisdiction that would, after applying paragraph
(b)(1)(ii)(b) of this section to such branch or paragraph (b)(1)(i)(b)
of this section 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 paragraph (that is, either paragraph (b)(1)(ii)(b) or (b)(1)(i)(b)
of this section), if, under the laws of such country, the entire income
of the controlled foreign corporation were considered derived by such
corporation from sources within such country from doing business
through a permanent establishment therein, received in such country,
and allocable to such permanent establishment, and the corporation were
created or organized under the laws of, and managed and controlled in,
such country. See Sec. 1.954-3(b)(1)(ii)(c)(3)(f) Example 2.
(c) Predominant contribution. If none of the branches nor the
remainder of a controlled foreign corporation satisfy paragraph
(a)(4)(ii) or (a)(4)(iii) of this section 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 paragraph
(a)(4)(iv) of this section, then for purposes of applying paragraph
(b)(1)(i)(b) or (ii)(b) or this section, the branch or the remainder of
the controlled foreign corporation that makes the predominant amount of
the controlled foreign corporation's substantial contribution with
respect to the manufacture, production, or construction of that
property will be the location of manufacturing, producing, or
constructing with respect to that property. See Sec. 1.954-
3(b)(1)(ii)(c)(3)(f) Example 3. Whether any branch or the remainder of
the controlled foreign corporation provides a predominant amount of the
controlled foreign corporation's substantial contribution is determined
by weighing each branch's or the remainder of the controlled foreign
corporation's relative contribution to the manufacture of the item of
property as determined by applying the facts and circumstances test
provided in paragraph (a)(4)(iv) of this section. If multiple branches
are located in a single jurisdiction, then the activities of those
branches will be aggregated for purposes of determining the branch or
the remainder of the controlled foreign corporation that makes the
predominant amount of the controlled foreign corporation's substantial
contribution with respect to the manufacture, production, or
construction of an item of property. For purposes of this paragraph
(b)(1)(ii)(c)(3)(c), a branch or the remainder of the controlled
foreign corporation makes a predominant amount of the controlled
foreign corporation's substantial contribution with respect to the
manufacture, production, or construction of an item of personal
property only if it makes a significantly greater contribution to the
manufacture, production, or construction of that property than any
other branch or the remainder of the controlled foreign corporation.
The location of any particular activity (that is, for purposes of
deciding whether that activity is conducted in a particular branch or
in the remainder of the controlled foreign corporation) will be
determined by applying the principles of paragraph (b)(1)(ii)(c)(3)(d)
of this section.
(d) Location of activity. The location of any activity with respect
to the manufacture, production, or construction of an item of personal
property is where the controlled foreign corporation makes a
contribution through its employees to such activity. For example, the
location of any activities concerning intangible property is not
determined based on the formal assignment of intangible property, but
on where employees of the controlled foreign corporation develop,
protect, and direct the use of the intangible.
(e) Where no branch or the remainder of the controlled foreign
corporation provides a predominant contribution. If neither a branch
nor the remainder of a controlled foreign corporation independently
satisfies paragraph (a)(4)(ii) or (iii) of this section and neither a
branch nor the remainder of the controlled foreign corporation provides
a predominant amount of the controlled foreign corporation's
contribution to the manufacture of an item of personal property, but
the controlled foreign corporation as a whole makes a substantial
contribution to the manufacture of that property within the meaning of
paragraph (a)(4)(iv) of this section, then for purposes of applying
paragraph (b)(1)(i)(b) or (ii)(b) of this section, the location of
manufacturing of that property will be that branch or remainder of the
controlled foreign corporation that provides a contribution to the
manufacture of the property and that is located or organized in the
jurisdiction that would, after applying paragraph (b)(1)(ii)(b) of this
section to such branch or (b)(1)(i)(b) of this section to such
remainder of the controlled foreign corporation, impose the highest
effective rate of tax on the income allocated to such branch or such
remainder of the controlled foreign corporation under that paragraph,
if, under the laws of such country, the entire income of the controlled
foreign corporation were considered derived by such corporation from
sources within such country from doing business through a permanent
establishment therein, received in such country, and allocable to such
permanent establishment, and the corporation were created or organized
under the laws of, and managed and controlled in, such country. See
Sec. 1.954-3(b)(1)(ii)(c)(3)(f) Example 4.
(f) Examples. The following examples illustrate the application of
this paragraph (b)(1)(ii)(c)(3):
Example 1. Multiple branches that contribute to the manufacture
of a single product, only one branch that satisfies paragraph
(a)(4)(ii) or (a)(4)(iii) of this section. (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 its employees, designs Product X. Branch
B, through the activities of its employees, provides quality control
and oversight. Branch C, through the activities of its employees,
manufactures Product X (within the meaning of paragraph (a)(4)(iii)
of this section) using the designs of Branch A and under the
oversight of the quality control personnel of Branch B. The
activities of
[[Page 10727]]
Branch A and B do not satisfy either paragraph (a)(4)(ii) or
(a)(4)(iii) of this section. 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 risk of loss from the manufacture of
Product X and the manufacturing profits from the sales of Product X.
Further, employees of FS located in Country M control logistics,
select vendors and raw materials, and oversee the coordination
between the branches. Employees of FS located in Country M sell
Product X to unrelated persons for use, consumption or disposition
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. Because only the activities of Branch C satisfy
paragraph (a)(4)(ii) or (a)(4)(iii) of this section, paragraph
(b)(1)(ii)(b) of this section is applied by considering only the
effective rate of tax that would apply in Country C. The effective
rates of tax in Country A and Country B are not considered, because
Branch A and Branch B do not satisfy either paragraph (a)(4)(ii) or
(a)(4)(iii) of this section. 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%), the use of Branch C has substantially the same tax effect as
if Branch C were a wholly owned subsidiary corporation of FS.
Therefore sales of Product X by the remainder of FS are treated as
sales on behalf of Branch C. Pursuant to paragraph (b)(2)(ii)(c)(2)
of this section, FS will only qualify for the manufacturing
exception under paragraph (a)(4)(iv) of this section if FS
successfully rebuts, to the satisfaction of the Commissioner, the
presumption that FS does not provide a substantial contribution to
the manufacture of Product X. For this purpose, the activities of FS
include the activities of Branch A or Branch B if either of those
branches would not be treated as a separate corporation under
paragraph (b)(1)(ii)(b) of this section, if that paragraph were
applied to each of Branch A and Branch B.
Example 2. Multiple branches satisfy paragraph (a)(4)(ii) or
(a)(4)(iii) of this section 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 manufactures (within the meaning of
paragraph (a)(4)(ii) of this section) a part of Product X. Branch C
then combines that part with other parts to complete Product X. The
activities of Branch C are sufficient to qualify as manufacturing
under paragraph (a)(4)(iii) of this section with respect to Product
X. Country A imposes an effective rate of tax of 12% on sales
income.
(ii) Result. Because the activities of Branch A and Branch C
satisfy the requirements of paragraph (a)(4)(ii) and (iii) of this
section respectively, paragraph (b)(1)(ii)(b) of this section 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 paragraph (b)(1)(ii)(b) of this section were applied separately
to Branch A and Branch C. The effective rate of tax in Country B is
not considered because Branch B does not satisfy either paragraph
(a)(4)(ii) or (a)(4)(iii) of this section. 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%), neither Branch A nor
Branch C is treated as a separate corporation and sales of Product X
by the remainder of the controlled foreign corporation are not
treated as made on behalf of any branch.
Example 3. Predominant contribution by employees located in the
country of organization of the controlled foreign corporation,
traveling employees, paragraph (a)(4)(iii) of this section satisfied
by an unrelated contract manufacturer. (i) Facts. FS, a controlled
foreign corporation organized in Country M, purchases raw materials
from a related person. The raw materials are then manufactured
(under the principles of paragraph (a)(4)(iii) of this section) into
Product X by CM, an unrelated corporation located in Country C that
performs the physical conversion pursuant to a contract
manufacturing arrangement. Employees of FS located in Country M sell
Product X to unrelated persons for use, consumption or disposition
outside of Country M. Employees of FS located in Country M engage in
design, testing, quality control and oversight with respect to the
manufacture of Product X. Employees of FS located in Country M also
direct the use of intellectual property used in the manufacture of
Product X from Country M. At all times, employees of FS located in
Country M control the raw material, work-in-process and finished
goods. Employees of FS located in Country M also control logistics,
select vendors, and manage the risk of loss from the manufacture of
Product X and the manufacturing profits from Product X. Quality
control and oversight of the manufacturing process is conducted 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. Design work with respect to Product X conducted by
Branch A is supplemental to the bulk of the design work, which is
done by employees of FS located in Country M. FS as a whole
(including Branch A) provides a substantial contribution to the
manufacture of Product X within the meaning of paragraph (a)(4)(iv)
of this section.
(ii) Result. FS qualifies for the exception to foreign base
company sales income contained in paragraph (a)(4) of this section
with respect to income from the sale of Product X because FS
satisfies the test contained in paragraph (a)(4)(iv) of this section
by providing a substantial contribution through the activities of
its employees to the manufacture of Product X. The fact that
employees of FS travel to the location of CM to perform some of the
activities considered in determining whether a controlled foreign
corporation makes a substantial contribution through the activities
of its employees to the manufacturing of an item of personal
property does not prevent activities of such employees while located
in Country M from being considered in determining the applicability
of paragraph (a)(4)(iv) of this section to FS. In addition,
paragraph (b) of this section does not apply to treat a branch of FS
as having substantially the same tax effect as if the branch were a
wholly owned subsidiary corporation, because FS, as opposed to
Branch A, provides the predominant contribution with respect to
Product X.
Example 4. Multiple branches perform manufacturing activities,
no branch makes a predominant contribution, paragraph (a)(4)(iii) of
this section is satisfied by an unrelated contract manufacturer. (i)
Facts. FS, a controlled foreign corporation organized in Country M,
purchases raw materials from a related person. The raw materials are
then manufactured (under the principles of paragraph (a)(4)(iii) of
this section) into Product X by CM, an unrelated corporation located
in Country C that performs the physical conversion pursuant to a
contract manufacturing arrangement. Employees of FS located in
Country M sell Product X to unrelated persons for use, consumption
or disposition outside of Country M. FS has two branches, Branch A
and Branch B, located in Country A and Country B respectively. FS
(including Branch A and Branch B) makes a substantial contribution
within the meaning of paragraph (a)(4)(iv) of this section with
respect to the manufacture of Product X. Branch A, through the
activities of its employees, designs Product X. Branch B, through
the activities of its employees, provides quality control and
oversight of the manufacturing process. At all times, FS controls
the raw materials, work-in-process and the finished Product X
through employees located in Country M. FS also manages the risk of
loss related to the manufacture of Product X and the manufacturing
profits from the sales of Product X through employees located in
Country M. Further, employees of FS located in Country M control
logistics, select vendors, and oversee the coordination between the
branches. 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%.
(ii) Result. Based on the facts, neither the remainder of FS
(through activities of its employees in Country M), nor Branch A,
nor Branch B, provide a predominant amount of the controlled foreign
corporation's substantial contribution to the manufacture of Product
X. FS, Branch A, and Branch B each provide a contribution through
the activities of their employees to the manufacture of Product X.
Accordingly, paragraph (b)(1)(ii)(b) of this section is applied by
comparing the effective rate of tax
[[Page 10728]]
imposed on the income from the sales of Product X against the
effective rate of tax that would apply to the sales income in Branch
B, which is located in the jurisdiction that would impose the
highest effective rate of tax on the sales income (24%). 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%) the remainder of FS is treated as selling on behalf of Branch
B. Further, for purposes of determining whether the remainder of FS
qualifies for any exception from foreign base company sales income,
applying paragraph (b)(2)(ii)(a) of this section, the remainder of
FS includes any branch of FS that would not, after the application
of paragraph (b)(1)(ii)(b) of this section to such branch, be
treated as a separate corporation. In this case, 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 A (20%).
Therefore, for purposes of determining foreign base company sales
income, the remainder of FS does not include the activities of
Branch A. The remainder of FS does not qualify for the manufacturing
exception from foreign base company sales income contained in
paragraph (a)(4)(iv) of this section. Because Product X is sold for
use, consumption, or disposition outside of Country M, the income
from the sale of Product X is foreign base company sales income.
Example 5. Multiple branches contribute to the manufacture of a
single product, one branch sells the product, the remainder of the
controlled foreign corporation does not participate. (i) Facts. FS
is a controlled foreign corporation organized in Country M, a
country that imposes a 0% effective rate of tax on sales income. FS
operates two branches, Branch A and Branch B, located respectively
in Country A, a country that imposes a 30% effective rate of tax on
income, and Country B, a country that imposes a 0% effective rate of
tax on income. Branch A and Branch B each perform different
activities with respect to the manufacture of Product X. Branch A,
through the activities of a large number of its employees working at
a state of the art facility, expends significant time and resources
to design a sophisticated product, Product X. Branch B, through the
activities of its employees, purchases raw materials from a related
person and contracts with CM, an unrelated corporation located in
Country C, to manufacture Product X. The raw materials are then
manufactured (under the principles of paragraph (a)(4)(iii) of this
section) into Product X by CM. Branch A, through the activities of
its employees, directs the use of intellectual property it
developed, including product designs, to provide quality control and
oversight to CM with respect to the manufacture of Product X. Branch
B controls the raw materials, work in process, and the finished
Product X. Branch B manages the risk of loss with respect to Product
X throughout the manufacturing process. Branch B also controls
logistics and selects vendors in connection with Product X. Branch B
then sells Product X to unrelated persons for use, consumption or
disposition outside of Country M. FS (including Branch A and Branch
B) provides a substantial contribution within the meaning of
paragraph (a)(4)(iv) of this section with respect to the manufacture
of Product X. FS does not provide a contribution to the manufacture
of Product X through employees located in Country M.
(ii) Result. Based on the facts, neither Branch A nor Branch B
provides the predominant amount of FS's contribution to the
manufacture of Product X. Further, Branch A and Branch B each
provide a contribution through the activities of its employees to
the manufacture of Product X. Accordingly, paragraph (b)(1)(ii)(b)
of this section is applied by comparing the effective rate of tax
imposed on the income from the sales of Product X against the
effective rate of tax that would apply to the sales income in Branch
A, which is located in the jurisdiction that would impose the
highest effective rate of tax on the sales income (30%). Because the
effective rate of tax in Country B with respect to the sales income
(0%) 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 (30%), the seller, Branch B, is treated as selling on
behalf of Branch A, which is treated as the remainder of FS pursuant
to paragraph (b)(1)(ii)(c) of this section. Further, for purposes of
determining whether the remainder of FS qualifies for any exception
from foreign base company sales income, Branch B, treated as the
remainder of FS, includes any branch or remainder of FS that would
not, after the application of paragraph (b)(1)(ii)(b) of this
section to such branch or (b)(1)(i)(b) of this section to such
remainder of FS, be treated as a separate corporation. In this case,
the effective rate of tax (0%) 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 (30%), but not country M (0%).
Therefore, for purposes of determining foreign base company sales
income, Branch B, treated as the remainder of FS, does not include
the activities of Branch A, but does include the activities of the
remainder of FS located in Country M. However, since the remainder
of FS in Country M does not perform any activities related to the
manufacture of Product X, the inclusion of the remainder of FS does
not qualify Branch B for any exception from foreign base company
sales income. Since the location of manufacturing of Product X is
considered to be the location of Branch A rather than Branch B,
Branch B, treated as the remainder of FS, does not qualify for the
manufacturing exception from foreign base company sales income
contained in paragraph (a)(4) of this section. Since the sale of
Product X is for use, consumption, or disposition outside of Country
B, the income from the sale of Product X is foreign base company
sales income.
Example 6. Multiple branches contribute to the manufacture of a
single product, the selling branch is located in the higher tax
jurisdiction, the remainder of the controlled foreign corporation
does not participate. (i) Facts. Assume the same facts as in Example
5 except that Branch B rather than Branch A is located in the
jurisdiction that would impose the higher effective rate of tax on
income from the sales of Product X.
(ii) Result. Based on the facts, neither Branch A nor Branch B
provides the predominant amount of FS's contribution to the
manufacture of Product X. Since Branch B is located in the
jurisdiction that would impose the higher effective rate of tax on
income from the sale of Product X, Branch B is considered to be the
location of manufacturing of Product X for purposes of applying
paragraph (b) of this section. Because all of the income from the
sale of Product X is already taxed in Country B, the use of Branch B
is not treated as having substantially the same tax effect as if
Branch B were a wholly owned subsidiary corporation of FS, and
therefore Branch B and the remainder of FS are not treated as
separate corporations under paragraph (b)(1)(ii)(a) of this section
for purposes of determining foreign base company sales income.
(2) * * *
(i) * * *
(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,
constructed, grown, or extracted 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 as performed on behalf of the
remainder of the controlled foreign corporation.
(ii) * * *
(a) Treatment as separate corporations. * * * For purposes of
applying the rules of this paragraph (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
paragraph (b)(2)(ii)(c) of this section, will exclude any other branch
or similar establishment or
[[Page 10729]]
remainder of the controlled foreign corporation that would be treated
as a separate corporation (apart from the branch or similar
establishment of a controlled foreign corporation that is treated as a
separate purchasing or selling corporation under paragraph
(b)(2)(ii)(b) of this section or the remainder of the controlled
foreign corporation that is treated as a separate purchasing or selling
corporation under paragraph (b)(2)(ii)(c) of this section) 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 against
the effective rate of tax that would apply to such income if it were
earned in the jurisdiction of such other branch or similar
establishment or the remainder of the controlled foreign corporation
under Sec. 1.954-3(b)(1)(i)(b) or (ii)(b) of this section.
(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,
constructed, grown, or extracted 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) Treatment of the use of a manufacturing branch by a controlled
foreign corporation--(1) Activities treated as performed on behalf of
branch. * * *
(2) Presumption where a controlled foreign corporation claims to
satisfy the substantial contribution test and its own branch satisfies
the physical manufacturing test. If a branch or similar establishment
is considered to manufacture, produce, or construct an item of personal
property under paragraph (a)(4)(ii) or (a)(4)(iii) of this section, the
remainder of the controlled foreign corporation (or any branch treated
as the remainder of the controlled foreign corporation) will be
presumed not to manufacture, produce, or construct that same item of
personal property under paragraph (a)(4)(iv) of this section (even if
it would have otherwise satisfied paragraph (a)(4)(iv) of this section
with respect to such property). However, if a controlled foreign
corporation demonstrates, to the satisfaction of the Commissioner, that
the remainder of the controlled foreign corporation (or any branch
treated as the remainder of the controlled foreign corporation) makes a
substantial contribution to the manufacture of that item of personal
property within the meaning of paragraph (a)(4)(iv) of this section,
then the remainder of the controlled foreign corporation (or any branch
treated as the remainder of the controlled foreign corporation), if
treated as a separate corporation apart from its manufacturing branch
under paragraph (b)(2)(ii)(a) of this section, will be considered to
manufacture, produce, or construct that item of personal property under
paragraph (a)(4)(iv) of this section. The application of this paragraph
(b)(2)(ii)(c)(2) may be illustrated by the following examples:
Example 1. Manufacturing branch, paragraph (b)(1)(ii)(b)
satisfied. (i) Facts. FS, a controlled foreign corporation organized
in Country M, a country that imposes a 0% effective rate of tax on
sales income, purchases raw materials from a related person. FS has
one branch, Branch A, organized in Country A, a country that imposes
a 30% effective rate of tax on sales income. The raw materials are
manufactured (within the meaning of paragraph (a)(4)(iii) of this
section) into Product X by Branch A. FS sells Product X for use,
consumption, or disposition outside of Country M. Absent the
application of paragraph (b)(2)(ii)(c)(2) of this section, the
remainder of FS would also be considered a manufacturer of Product X
under paragraph (a)(4)(iv) of this section. FS proves to the
satisfaction of the Commissioner that the remainder of FS makes a
substantial contribution to the manufacture of Product X.
(ii) Result. Since the effective rate of tax (0%) imposed on the
sales income 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 jurisdiction of Branch A (30%), the seller, the remainder of
FS is treated as a separate corporation selling on behalf of Branch
A. The remainder of FS (not including Branch A) does not satisfy
paragraph (a)(4)(ii) or (a)(4)(iii) of this section with respect to
Product X. If the manufacturing activities undertaken with respect
to Product X between the time the raw materials were purchased and
the time Product X was sold were undertaken by the remainder of FS
(not including Branch A) through the activities of its employees,
the remainder of FS would have satisfied the manufacturing exception
contained in paragraph (a)(4)(iii) of this section with respect to
Product X. Therefore, paragraph (a)(4)(iv) of this section applies.
Because FS has successfully rebutted the presumption of paragraph
(b)(2)(ii)(c)(2) of this section by proving to the satisfaction of
the Commissioner that the remainder of FS makes a substantial
contribution to the manufacture (within the meaning of paragraph
(a)(4)(iv) of this section) of Product X, it qualifies for the
exception in paragraph (a)(4)(iv) of this section with respect to
Product X. Therefore income from the sale of Product X, when treated
as sold by the remainder of FS on behalf of Branch A, is not
determined to be foreign base company sales income.
Example 2. Manufacturing branch, paragraph (b)(1)(ii)(b) is not
satisfied. (i) Facts. Assume the same facts as in Example 1, except
that Branch A is located in Country B, a country that imposes a 3%
rate of tax on sales income.
(ii) Result. Paragraph (b)(1)(ii)(b) of this section is not
satisfied, because the effective rate of tax imposed on the sales
income in Country M (0%) 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 jurisdiction of Branch A (3%).
Therefore, Branch A is not treated as a separate corporation for
purposes of determining foreign base company sales income. FS
qualifies for the manufacturing exception in paragraph (a)(4) of
this section because FS (including Branch A) satisfies paragraph
(a)(4)(iii) of this section with respect to income from the sales of
Product X.
* * * * *
(e) Comparison with ordinary treatment. With the exception of cases
in which a controlled foreign corporation seeks to rely on paragraph
(a)(4)(iv) of this section and is unsuccessful in rebutting the
presumption created by paragraph (b)(2)(ii)(c)(2) of this section,
income derived by a branch or similar establishment, or by the
remainder of the controlled foreign corporation, will not be determined
to be foreign base company sales income under paragraph (b) of this
section if the income would not be so considered if it were derived by
a separate controlled foreign corporation under like circumstances.
* * * * *
(4) * * *
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. 100 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
[[Page 10730]]
distributes such income to Corporation D and is then 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 paragraph (a)(4)(iv) of this section in conjunction
with the manufacture of the articles (within the meaning of
paragraph (a)(4)(ii) or (a)(4)(iii) of this section) by an unrelated
contract manufacturer, then 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
paragraph (a)(4)(i) of this section.
* * * * *
(d) Effective/applicability date. The second sentence of paragraph
(a)(1)(i), the second sentence of paragraph (a)(1)(iii) Example 1, the
first sentence of paragraph (a)(1)(iii) Example 2, the third sentence
of paragraph (a)(2), paragraph (a)(4)(i), the first sentence of
paragraph (a)(4)(ii), the first sentence of paragraph (a)(4)(iii),
paragraph (a)(4)(iv), the last sentence of paragraph (a)(6), the last
sentence of paragraph (b)(1)(ii)(a), paragraph (b)(1)(ii)(c)(2),
paragraph (b)(1)(ii)(c)(3), paragraph (b)(2)(i)(b), the last sentence
of paragraph (b)(2)(ii)(a), paragraph (b)(2)(ii)(b), paragraph
(b)(2)(ii)(c)(2), paragraph (b)(2)(ii)(e), and paragraph (b)(4) Example
3 shall apply to taxable years of controlled foreign corporations
beginning on or after the date these rules are published as final
regulations in the Federal Register, and for taxable years of United
States shareholders in which or with which such taxable years of the
controlled foreign corporations end.
Linda E. Stiff,
Deputy Commissioner for Services and Enforcement.
[FR Doc. E8-3557 Filed 2-27-08; 8:45 am]
BILLING CODE 4830-01-P