News Briefings - Federal Tax

The following article is from the 1/2/09 issue of Federal Taxes Weekly Alert.

1/2/09 -- New regs ease rules for foreign contract manufacturing arrangements

TD 9438, 12/24/2008; Reg § 1.954-3, Reg § 1.954-3T

IRS has issued final and temporary regs providing guidance relating to foreign base company sales income (FBCSA) where 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. The regs modify the foreign base company sales income regs to address current business structures and practices, particularly the growing importance of contract manufacturing and other manufacturing arrangements.

RIA observation: The final and temporary regs reflect numerous pro-taxpayer changes and clarifications to the proposed regs upon which they are based. This was the result of IRS's adoption of numerous suggestions made by commentators.

Background. Under Code Sec. 951(a)(1)(A)(i), a U.S. shareholder of a CFC includes in gross income its pro rata share of the CFC's subpart F income. Subpart F income means, in part, foreign base company income which includes foreign base company sales income (FBCSI). Code Sec. 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 preexisting regs further define FBCSI and the exceptions from it, including the exceptions for personal property that is: (1) manufactured, produced, constructed, grown, or extracted within the CFC's country of organization (same country manufacture exception); (2) sold for use, consumption or disposition within the CFC's country of organization; and (3) manufactured, produced, or constructed by the CFC (the manufacturing exception).

The preexisting regs have certain tests to determine whether a CFC satisfies the manufacturing exception. On Feb. 28, 2008, IRS issued proposed regs providing, among other changes, a third test for satisfying the manufacturing exception. In particular, they provide that a CFC would satisfy the manufacturing exception if the facts and circumstances evince that the CFC makes a substantial contribution through the activities of its employees to the manufacture, production, or construction of personal property (substantial contribution test). See Weekly Alert -- 3/6/2008 for additional background and details on the proposed regs. IRS is now adopting the proposed regs as final and temporary regs, with numerous revisions in response to many comments received.

Substantial contribution test. The final regs provide additional guidance relating to the application of the substantial contribution test. For example, Reg § 1.954-3(a)(4)(iv)(c) has been added to clarify that: (1) all CFC employee functions contributing to the manufacture of the personal property will be considered in the aggregate when determining whether a substantial contribution is made to the manufacture of the personal property through the activities of a CFC's employees; (2) there is no single activity that will be accorded more weight than any other activity in every case or that will be required to be performed in all cases; and (3) there is no minimum threshold with respect to functions performed by employees of a CFC before their functions with respect to a given activity may be taken into account as part of the substantial contribution test.

Another change clarifies that a CFC will not be precluded from making a substantial contribution to the manufacture of the personal property by the fact that other persons also make a substantial contribution to the manufacture, production, or construction of that property.

Examples have been changed to make clear that oversight and direction is not a prerequisite for satisfying the substantial contribution test and that in certain industries a substantial contribution could be made by a CFC without its employees engaging in oversight and direction of the activities or process pursuant to which personal property is manufactured, produced, or constructed.

The final regs group material selection, vendor selection, and control of the raw materials, work-in-process, and finished goods as a single activity in the indicia of manufacturing.

The regs have been modified to eliminate any inference that a CFC must own the raw materials that are used in the manufacturing process. Examples clarify that buy-sell or turnkey contract manufacturing arrangements may satisfy the substantial contribution test. (Reg § 1.954-3(a)(4)(iv)(d))

Another change makes clear that the CFC's employees' activities are considered regardless of whether the CFC's employees perform all or only some of the functions listed in any enumerated item in the indicia of manufacturing.

Under another clarification, developing, or directing the use or development of, trade secrets, technology, or other intellectual property, are considered under the substantial contribution test, but only when activities of this nature are undertaken for the purpose of the manufacture of the personal property.

The final regs provide that the term employee means any individual who, under Reg § 31.3121(d)-1(c), has the status of an employee for U.S. Federal tax purposes.

The regs have been modified to reflect that a CFC may provide a substantial contribution to a largely automated manufacturing process through its employees.

Branch rule. In February 2008, changes were also proposed to the preexisting reg dealing with the application of the FBCSI rules to CFCs with branches or similar establishments (the branch rule), particularly the rules dealing with manufacturing branches.

Commentators requested that the regs clarify that the tax rate disparity tests contained in the preexisting regs take into account incentive tax rates and other similar foreign tax relief available to a CFC in calculating the hypothetical effective tax rate of tax. IRS says it recognizes that the tax rate disparity tests should take into account the actual tax rate paid with respect to the sales income by the selling branch or remainder and the hypothetical effective tax rate that would be paid by the manufacturing branch (or remainder) on that sales income under the laws of the country in which the manufacturing branch is located (or, in the case of a remainder, the country of organization of the CFC) if it were derived from sources within that country. Thus, it agreed that uniformly available tax incentives are to be considered in determining the hypothetical effective tax rate to be used in applying the tax rate disparity tests. This is reflected in Reg § 1.954-3T(b)(4), Ex 8.

The temporary regs provide that the lowest-of-all-rates rule will apply whenever a branch (or remainder) independently satisfies Reg § 1.954-3(a)(4)(ii), Reg § 1.954-3(a)(4)(iii), or Reg § 1.954-3(a)(4)(iv).

The temporary regs revise the rules for determining the location of manufacture of the personal property when more than one branch (or one or more branches and the remainder) contributes to the manufacture of the personal property but no branch (or remainder) independently satisfies the physical manufacturing test or the substantial contribution test.

Effective date. IRS agreed with comments that a delayed effective date is appropriate for taxpayers whose structures require modification to accommodate the new regs. Accordingly, the final and temporary regs will apply to tax years of CFCs beginning after June 30, 2009, and for tax years of U.S shareholders in which or with which such tax years of the CFCs end. Thus, the regs will become applicable Jan. 1, 2010, for CFCs whose tax year is the calendar year.

References: For foreign base company sales income, see FTC 2d/FIN ¶ O-2481 et seq.; United States Tax Reporter Income ¶ 9544.03.

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