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The concept that matter consists of irreducible units, i.e., atoms, was proposed by an ancient Greek philosopher, Demokritos. The word “atom” comes from the Greek word atomos, which means “indivisible.” While, in the early 20th century, science came to acknowledge that the atom was made up of smaller particles (and, in August 1945, the whole world learned of a vivid demonstration of this fact), the ancient Greek concept of the irreducible atom dominated science and philosophy for many centuries.

Understanding the ancient Greek concept of matter may aid the international tax practitioner in understanding the concept of “property” as that word is interpreted by the new, proposed contract manufacturing regulations under Subpart F (“Proposed Regs”).¹ The Proposed Regs do many things that an observant, even mildly conservative, practitioner would have predicted. However, in their zeal to abolish the so-called “its defense” (described below), they adopt a view of what constitutes “property” that is somewhat unusual for tax law, but would be immediately recognizable to Demokritos. More seriously, it may be subject to challenge as inconsistent with the statute. The IRS might consider another approach, consistent with case law and legislative history, that might better withstand such a challenge.

Section 954(d)(1) defines foreign base company sales income (FBCSI) as, among other things, income from the purchase of property and itssale, from or to a related person. Looking exclusively at the statute, if the property sold is not the property purchased, arguably the income from the sale is not FBCSI. This is often referred to as the statutory “its defense”--the CFC buys property, consigns it to another to transform it into different property while the CFC does not relinquish ownership, and then the CFC sells that “different” property. As the Preamble to the Proposed Regs points out, however, “property” is not defined for this purpose. Perhaps more importantly, the legislative history can be read to imply that the transformation may only be done by the CFC.²

The Tax Court in the Electronic Artscase³ supports the idea that the transformation must be done by the CFC. Because the Electronic Arts court was dealing with §936(h)(5)(B)(ii)’s cross-reference to §954(d)(1)(A), however, it never dealt directly with the flush language of §954(d)(1)--the statutory its defense--and whether that defense exists as a matter separate from the manufacturing exception or the exception for “same country” manufacturing. One can only infer from Electronic Arts the idea that, however property purchased is changed into different property that is sold, for purposes of §954(d)(1) that change must be done “by such corporation,” i.e., by the CFC.⁴

So the legislative history and, by some extrapolation, Electronic Arts support the Proposed Regs' insistence that the transformation of the property into different property be accomplished only “by the CFC.” Unfortunately, the IRS and Treasury concluded it was necessary to drive an additional nail in the its defense's coffin by defining “property” for §954(d)(1) purposes in an extremely broad way, except within the manufacturing and “same country” exceptions. Instead of relying solely on the principle stated in the legislative history and arguably endorsed by the Electronic Artscourt--that the transformation of one property into another must be done by the CFC itself--the regulation authors appear to define property at the atomic level (except in the manufacturing and same country exceptions), thereby making the manufacturing and same country exceptions the only avenues by which a CFC's income related to the transformation of one property into another can avoid FBCSI.

The Proposed Regs accomplish this feat by adding the following sentence to Regs. §1.954-3(a)(1)(i):

For purposes of the preceding sentence [the purchase of property and itssale, from or to a related person], except as provided in paragraphs (a)(2) [same country manufacture] and (a)(4) [manufacturing exception], 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.

Under the Proposed Regs, a chassis is still the same property, even after it is assembled with other components into an automobile. A steel screw is not different property than the steel rod from which it was cut. More remarkably, a chemical compound, like acetylsalicylic acid (the active ingredient in aspirin), apparently is not different property from the separate chemicals which go into its synthesis, despite the fact that there are major changes in molecular structure between the inputs and the output. Apparently, under the Proposed Regs, so long as the same atoms (or at least some of the same atoms--there may be byproducts in the synthesis of aspirin) exist in the product purchased as exist in the product sold, that which was purchased is the same “product” as that which is sold unless the property is manufactured (within the meaning of the regulations) by the CFC. This approach may bend the concept of “property” to the breaking point. While perhaps understandable as a policy matter, it might not pass muster as a reasonable interpretation of the statute. It is hard to imagine that most courts would agree that different molecules are the same “property” simply because they contain some of the same atoms. This atomic theory of “property” also has important, taxpayer-favorable implications for purposes of §956.⁵

A more supportable approach might be to extend the concept, beyond the manufacturing exception, that property transformation must be done “by the CFC.” If this principle were applied generally to §954(d)(1), the its defense would be adequately corralled. Such an approach would also have support in the legislative history, unlike the atomic theory of “property” in the Proposed Regs.

Finally, whether the “by the CFC” principle is applied generally to §954(d)(1) or not, the “by the CFC” principle itself can be somewhat broadened from its narrow interpretation in the Proposed Regs and still accomplish that which the IRS desires. The Proposed Regs require that the CFC accomplish the manufacturing or the substantial contribution to the manufacturing “through the activities of its employees….”⁶ Instead, the “by the CFC” principle could be expanded to allow certain activities of the CFC's agents to count, provided the CFC, as principal, exercised sufficient control over that agent. Such an approach would be consistent with the part of the Electronic Arts case that the IRS lost, yet prevent CFCs from being considered to manufacture without adequate supervision of their contract manufacturer agents. It would also appear to be consistent with the substantial contribution rules of the Proposed Regs, which emphasize oversight and control by the CFC.

This commentary also will appear in the June 13, 2008, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Yoder, 928 T.M., CFCs -- Foreign Base Company Income (Other than FPHCI), and in Tax Practice Series, see ¶7130, U.S. Persons' Foreign Activities.