The Proposed Contract Manufacturing Regulations: A Journey of a
Thousand Miles Begins With a Single Step
By James J. Tobin, Esq.
Ernst & Young LLP, New York, NY
The ancient Chinese proverb that forms the second part of this
article's title is generally attributed to Lao-Tzu, a Chinese
philosopher who lived about 2,500 years ago, and who is also regarded
as the father of Taoism. Taoism posits that by understanding himself,
man may gain knowledge of the universe, and vice versa.
I must commend the IRS and the Treasury for taking on the very
difficult task of providing updated regulatory guidance addressing
contract manufacturing arrangements under the foreign base company
sales income rules. These have been long in coming and were much
anticipated by taxpayers who saw a major need for enhanced certainty
in this sometimes difficult area. The regulations acknowledge changes
in the way multinationals engage in manufacturing activity and make
significant advances towards clarifying the treatment of contract
manufacturing arrangements under the FBCSI rules.
As such, they are a step in the right direction. On the other hand,
while the regulation writers at the IRS and Treasury have made notable
strides in understanding the universe of contract manufacturing
arrangements, a Taoist might say that there's still a long way to
go--even though it may be less than a thousand miles--and that one
must also take care to make certain you keep going down the right
path.
Speaking of Philosophy
As I read the proposed regulations, I had to ask myself a question
about the philosophy underlying them. If, as the government decided
last year, it's okay for a CFC (and in many instances, a U.S. parent)
to provide substantial assistance to a related CFC in the course of
rendering services to a third party, why is it not okay for such a
related person to provide assistance to a CFC that is producing
something for sale to a third party? In this regard, under the revised
foreign base company services rules--which do not include branch
rules--services that are performed outside the United States for a
third party will not give rise to Subpart F income even though a
related person provided substantial assistance to the CFC service
company. Notwithstanding the enlightened approach of the proposed
regulations, this will not necessarily be the case for a CFC
manufacturing and sales company.
Yes, I'm well aware of the factual and operational differences
between selling a service and selling a product. But at a high level,
there's a common theme; a CFC has contracted to provide something to a
customer. If that something is a service, then related parties can
help out and the contracting CFC will still be considered to have
provided the service. But if that something is a product and a related
person helped out in its creation, the contracting CFC will often not
be considered to have provided the product. Perhaps a way can be found
to inject some additional flexibility into interpreting the statute,
particularly with regard to the manufacturing branch
rule.
So Much for Philosophy--How About Those New Substantial
Contribution Rules?
The proposed regulations would add a new manufacturing exception
for CFC that provides a “substantial contribution” with
respect to the manufacture of property but cannot satisfy the physical
manufacturing tests--that is, the substantial transformation or
component part tests--of Regs. §1.954-3(a)(4)(i) through
(iii).
Under Prop. Regs. §1.954-3(a)(4)(iv), a CFC would satisfy the
substantial contribution test only if, based on the facts and
circumstances, the CFC made a substantial contribution to the
manufacture of the property through the activities of its employees.
Under the proposed regulations, whether a CFC satisfies the
substantial contribution test will involve consideration of nine
listed activities (among others not listed, according to the IRS),
such as oversight and direction of the manufacturing activities or
manufacturing process--including management of risk of loss-control of
the raw materials, work-in-process and finished goods; material or
vendor selection; and quality control.
Whether or not this list of activities that may be considered
substantial contributions advances the cause of certainty may--shall
we say--be open to doubt, especially since the proposed regulations
say that “the weight given to any activity (whether or not set
forth) will vary with the facts and circumstances of the particular
business” and “the presence or absence of any activity, or
of a particular number of activities, is not determinative.” And
no account is taken of industry-related factors and, according to
government officials, none will be when the regulations are
finalized.
In any case, assume we have a Bermuda corporation with a Swiss
branch that sources product under a consignment arrangement from an
unrelated contract manufacturer and sells the product to a related
party. Now, along come the proposed regulations, which reject the
so-called “its” defense and the concept of manufacturing
attribution and introduce the new substantial contribution rules.
Assume further that the entity conducts the substantial contribution
activities in Switzerland. These new rules were intended by the IRS
and Treasury to provide a level of certainty as to whether the
activities undertaken by the CFC through its own employees are
sufficient to characterize it as a manufacturer for purposes of the
FBCSI rules, even though it doesn't actually “turn the
screws.”
The term “substantial” is left undefined and is, as
such, highly subjective. And, no, there's no safe harbor. So instead
of a level of certainty, to me what we have here is the perfect
foundation for a potential new area of
controversy.
And Then There Are the New Branch Rules
Also in need of further consideration, in my view, are the new
branch rules.
It's probably safe to say that the branch rules have been around
for longer than most of the readers of this publication, but it's also
probably safe to say that the amount of revenue they've raised over
the years might not even pay for a subscription. In this regard, the
Subpart F branch rules have to be among the most confusing and
difficult to apply set of measures in the law. Hardly anyone really
understands how to apply them. This may explain the regular and
continuing efforts on the part of tax advisors and corporate tax
departments to avoid having to deal with their application, which can
be done in the case of the sales branch rules by using a low- or
no-tax jurisdiction to hold the sales organization and in the case of
the manufacturing branch rules by organizing as a virtual, rather than
an actual, manufacturer.
Building on my previous example, for a Bermuda company with a Swiss
principal, the generally accepted outcome under the current rules
would be that the Bermuda CFC would not have Subpart F income; it
would be a virtual manufacturer under the Ashland and
Vetco cases and rely on the “its” defense such
that, under case law, the manufacturing activity should not be treated
as conducted through a branch. But under the proposed regulations,
virtual manufacturing becomes real manufacturing for purposes of
applying the branch rules as a result of the new substantial
contribution test.
As a consequence, it will become more difficult under the proposed
regulations to pinpoint the actual location of manufacturing activity.
The regulations acknowledge this and provide a hierarchy for
identifying the location (or locations) of manufacturing for purposes
of the branch rule. This is done through multiple, complex provisions
that address different factual situations. For example, where a CFC
has multiple branches and each performs manufacturing activities with
respect to separate items of property that the CFC then sells, the
proposed regulations would require that the rate disparity test be
applied separately to each branch that is manufacturing a separate
item of personal property in determining whether the branch or similar
establishment has substantially the same tax effect as if it were a
wholly-owned corporation of the CFC. On the other hand, where a CFC
has multiple branches and each performs manufacturing activities with
respect to the same item of property, the rate disparity test is
applied by giving precedence to the physical manufacturing test over
other contributions to manufacturing so that, if only one branch or
the remainder of the CFC satisfied the physical manufacturing test,
then the location of such branch or the remainder would be the
location of manufacturing for purposes of applying the rate disparity
test. If more than one branch or the remainder of the CFC satisfied
the physical manufacturing test, then the location of the branch or
remainder with the lowest effective tax rate would be the location of
manufacturing for purposes of applying the rate disparity test.
The rules go on (and on) to address situations in which none of the
branches or the remainder of the CFC satisfies the physical
manufacturing test, but the CFC as a whole satisfies the substantial
contribution test and in which multiple branches are located in a
single jurisdiction, as well as when no branch or the remainder of a
CFC provides a predominant amount of substantial contribution, but the
CFC as a whole provides substantial contribution. There, by the way,
the proposed regulations provide that the location of manufacturing
will be the location of the branch that is located in the jurisdiction
that would impose the highest effective tax rate.
After all of my years of success in avoiding dealing very much with
the branch rules, the proposed regulations virtually guarantee that
that's exactly where I will be spending time in the future, since many
of my clients carry on manufacturing through a foreign group of
entities, many of which are checked and in which more than one
“branch” is involved in the manufacturing process.
That raises some interesting questions that I've been avoiding
facing--like how to calculate the applicable tax rates for purposes of
applying the tax rate disparity test. My understanding is that, in
looking at a branch, I need to figure out the hypothetical rate of tax
applicable to income earned in the country in which the manufacturing
branch is located, using certain assumptions as to the branch's
“place of incorporation” and where its income is earned.
As to the “remainder” of the CFC, the relevant effective
rate of tax has to be determined based on the
actualcircumstances of the remainder of the CFC.
That makes me wonder: How do I overlay U.S. principles on this
calculation, since it is ultimately U.S. principles that will control
any actual Subpart F inclusion?
As far as I can tell, practitioners are still having this debate
and the matter is unresolved. For example, assume that the Swiss
manufacturing branch buys from a German manufacturing branch and sells
to a Dutch disregarded entity that functions as a warehouse and
on-sells to related customers. There are some who believe that the
Swiss purchase and sale are disregarded under the branch rule because
the transaction is disregarded for U.S. purposes. On this basis, they
say that Switzerland has no income under U.S. principles. Others think
the sale is not disregarded because the purpose of the test is to
determine whether income was shifted outside Germany and the test is
done using the foreign rules, not U.S. rules. It is not clear to me
that anyone really knows the answer to this question. While the latter
seems to make more sense from a policy perspective, do I then have to
analyze the transaction under the tax rules of each of the countries
involved in determining my hypothetical tax rate; that is, determine
how the Swiss would treat each of the transactions in Germany and the
Netherlands for purposes of foreign currency, inventory methods and
other tax accounting and local principles in calculating the
hypothetical tax that would be applied to that amount of income?
Further, what if another branch of a CFC lends money to multiple
manufacturing and non-manufacturing branches of the CFC located in
various European jurisdictions? For local tax purposes, the
“branches” would presumably be entitled to an interest
expense deduction in computing their actual taxes paid and, it seems
to me, this should also be taken into account in computing their
effective local tax rate under the rate comparison test. The
manufacturing branch may also have deductions for interest or
royalties that are disregarded for U.S. tax purposes, but presumably
these would not impact the hypothetical rate in the manufacturing
location. Query whether the disregarded deductions in the sales
branches would be taken into account if it came down to calculating
any Subpart F income. Since Subpart F income is calculated under U.S.
principles, there is a risk that the disregarded interest would be
ignored and the U.S. Subpart F inclusion would be substantially higher
than the amount of local sales profit considered to be
“offensive” under the FBCSI rules, which would not seem to
be consistent with the policy behind the Subpart F rules.
The real issue is whether a disregarded payment is taken into
account for purposes of calculating the effective rate of tax actually
paid by the CFC. Take a Dutch disregarded entity that buys from an
Irish manufacturing branch for resale and pays its Bermuda head office
a royalty of 80 of its 100 pre-royalty profits. As a result, it pays
Dutch tax of roughly 5 on its 20 of profits. (The Dutch statutory rate
is 25.5%.) For purposes of the rate comparison test and the amount of
Subpart F income, is the sales income of the Dutch branch
100--ignoring the royalty--or 20--taking into account the royalty, but
disregarding the Bermuda head office income of 80 on the basis that
its income is not sales income? (The difference between a 5% effective
rate and a 25% effective rate is likely to make a difference in
applying the rate comparison test.) If I believe that foreign rules
apply, it appears that the latter is the right answer; that is, the 20
of sales income recorded under Dutch law. I think this makes sense
because it would be the same answer if the manufacturing branch paid
the royalty instead of the sales branch.
Still, this is not how I want to be spending my time. Having now
seen where all this can lead, maybe it really is time to get rid of
the branch rule.
Conclusion
As already noted, the IRS and Treasury are to be commended for the
effort they've made to update the foreign base company sales income
rules to take into account business change in the realm of contract
manufacturing. It's a decent first step on what I see as a longer
journey toward resolving the treatment of contract manufacturing
arrangements in a way that makes sense for taxpayers and delivers the
enhanced certainty and consistency that the drafters had in mind when
they undertook this project.
Government officials have said that they intend to finalize the
regulations before the close of 2008. While such haste is generally
welcome (and electoral politics may be partly responsible for this
goal), in this case I would advise taking the time to revisit the
philosophy underlying the rules and to take a good, hard look at
application of the substantial contribution and branch rules as part
of a longer journey toward finalization of contract manufacturing
rules.
This commentary also will appear in the July 11, 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.
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