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The IRS and Treasury recently released proposed regulations that address the application of the foreign base company sales income (FBCSI) rules to contract manufacturing arrangements.¹ In particular, they provide a new non-physical definition of manufacturing for purposes of applying the manufacturing exception and the manufacturing branch rule. This commentary focuses on the rules in the proposed regulations that apply the manufacturing exception to contract manufacturing arrangements, which provide important and generally welcomed guidance for taxpayers.

Income derived by a controlled foreign corporation (CFC) from the purchase and sale of inventory generally is FBCSI if the product is either purchased from, or sold to, a related person, and the product is both manufactured and sold for use outside the CFC's country of organization.² Nevertheless, the regulations provide that income derived by a CFC from the sale of products that it manufactures is excluded from the definition of FBCSI (subject to a branch rule), regardless of where the product is manufactured or used and regardless of related person involvement.³

The current regulations define manufacturing as the physical transformation, conversion, or assembly of purchased property. Specifically, a CFC is considered as manufacturing the property it sells if:

• The property is substantially transformed (e.g., converting steel rods into screws);

• The production operations are substantial in nature and generally considered to constitute manufacturing (e.g., assembly of automobiles); or

• Conversion costs are 20% or more of costs of goods sold.

Minor assembly and packaging do not qualify as manufacturing.⁴

The Tax Court has broadly interpreted this definition of manufacturing. In Dave Fischbein Mfg. Co. v. Comr.,⁵ a Belgian CFC assembled component parts into a bag-closing machine in a six-hour, 58-step process. The Court found that assembly operations performed by the CFC were substantial in nature and generally considered to constitute manufacturing. Similarly, the Tax Court in Bausch & Lomb, Inc. v. Comr.⁶ held that sunglass assembly operations performed by Irish and Hong Kong CFCs satisfied the same definition of manufacturing. The IRS appears to have adopted this broad application of the definition of physical manufacturing, as illustrated by a recently issued LMSB directive instructing exam to consider assembly and test activities related to semiconductor production as manufacturing.⁷

The proposed regulations would not modify the definition of manufacturing contained in the current regulations (they refer to the definition in the current regulations as “physical manufacturing”). Accordingly, if a CFC satisfies the above broad definition of physical manufacturing, which includes assembly of component parts into products, then it qualifies for the manufacturing exception (subject to the branch rule).

A CFC may hire a contract manufacturer to physically manufacture, on its behalf, the property sold. For many years the IRS, based on general tax principles, treated a CFC principal that provides the intellectual property, has the risk of loss, and controls the manufacturing process as engaging in the manufacturing activities of the contract manufacturer (i.e., “attribution”).⁸ Although there were no changes to the Code or regulations, the IRS reversed itself in Rev. Rul. 97-48,⁹ asserting that the activities of a contract manufacturer cannot be attributed to a CFC principal for purposes of the manufacturing exception. Nevertheless, this is widely considered as an incorrect application of the relevant statute, regulations, and case law.¹⁰

The proposed regulations would require that only the activities of the employees of the CFC are taken into account in determining whether a CFC is considered as physically manufacturing the property it sells. Accordingly, unlike the current state of the law, the definition of physical manufacturing would not be satisfied by a CFC through attribution of the physical manufacturing activities of a contract manufacturer.¹¹

The proposed regulations, however, provide a new definition of manufacturing for purposes of applying the manufacturing exception to contract manufacturing arrangements. A CFC that does not satisfy the definition of physically manufacturing the property it sells will be considered as manufacturing the property if it “substantially contributes” to the manufacture of the product through activities engaged in by its employees. This new definition of manufacturing applies to both related and unrelated contract manufacturing arrangements.

A prerequisite for application of this new definition is that the raw materials and components purchased by a CFC must be physically manufactured into a finished product prior to the sale of the property. In each of the relevant examples, the contract manufacturer is considered as physically manufacturing the property after the CFC purchased the raw materials and components, and the CFC retains control of the raw materials, work-in-process, and finished goods at all times. The proposed regulations provide that, for purposes of applying this requirement, the CFC should be treated as if its employees performed the manufacturing with respect to the property prior to sale, i.e., the CFC is considered as engaging in the physical manufacturing activities of the contract manufacturer.

There is no requirement concerning whose employees actually perform the physical manufacturing, e.g., whether the contract manufacturer uses its own employees or the employees of another corporation.¹² There also is no specific requirement that the CFC exercise control over the parties engaged in the physical manufacturing. Moreover, the test appears to aggregate all activities that occur with respect to the property during the period the CFC has control over the property, including any physical manufacturing activities engaged in by the CFC principal.

Once it is determined that the product is physically manufactured by someone other than the CFC while the CFC controls the product, then a determination is made concerning whether the CFC satisfies the new non-physical definition of manufacturing. Specifically, a CFC principal will be considered as manufacturing the property it sells if it, acting through its own employees, makes a “substantial contribution” to the manufacture of the property sold. Relevant factors taken into account in determining whether a substantial contribution has been made include, but are not limited to:

1. Oversight and direction of the physical manufacturing activities or process (including management of risk of loss) with respect to the products sold;

2. Performance of physical manufacturing activities that are insufficient in extent to constitute full physical manufacturing in and of themselves;

3. Control of 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.

The weight given to any particular activity will vary based on the facts and circumstances of the particular business, and the presence or absence of any particular activity, or of a particular number of activities, will not be determinative. In addition, the fact that other persons make contributions to the manufacture of the property does not necessarily prevent the CFC from satisfying the substantial contribution test through the activities of its own employees. Furthermore, there may be other factors which contribute to the manufacture of the product that are not on the list that may be taken into account for purposes of satisfying the substantial contribution test for a particular business.¹³

A key focus of the new definition is activities of the CFC's employees. There is, however, no indication of a required minimum number of employees, and the employees necessary to satisfy the test should be based on the particular business circumstances of the CFC. Activities of independent contractors apparently are not taken into account.¹⁴ In addition, contractual ownership of materials and intellectual property, assumption of risk of loss and contractual rights to exercise powers of direction and control (without the regular exercise of those powers) are not sufficient to satisfy the substantial contribution test.¹⁵

The proposed regulations are commendable in departing from the analysis in FSA 200220005. In that FSA, the IRS identified 13 factors from Rev. Rul. 75-7 that “favor attribution” and found that the CFC principal only satisfied two of the factors and one required further development. The IRS concluded that attribution of the physical manufacturing activities of the consignment manufacturing affiliates to the CFC principal was not appropriate because the CFC “did not satisfy most of the significant factors set forth in the revenue ruling.” The proposed regulations clearly do not provide for such an approach with respect to the nine activities set forth in the regulations (e.g., four of nine factors can satisfy the substantial contribution test).¹⁶

For some taxpayers, however, the application of the substantial contribution test may be difficult. Some of the activities may be ambiguous under their circumstances, e.g., what does it mean to manage manufacturing profits, manage the risk of loss, and control the raw materials, work-in-process, and finished goods? How does a taxpayer know when, under the particular circumstances, a CFC has enough employee activity to satisfy the substantial contribution test? Additional definitions and examples would be helpful.

The regulations do not expressly state whether they apply where a contract manufacturer holds legal title to the product during the manufacturing process, and sells the finished product to the CFC. Nevertheless, the regulations are worded to accommodate such arrangements as qualifying for the manufacturing exception under the substantial contribution test, and the government has on a number of occasions publicly confirmed that buy-sell contract manufacturing arrangements may qualify for the new definition of manufacturing. Furthermore, it appears that it is not necessary in a buy-sell arrangement for the CFC to have the benefits and burdens of ownership with respect to the property while it is being physically manufactured by the contract manufacturer, but it is sufficient if the CFC “retains control” over the product during the manufacturing process.¹⁷

Once it is determined that a CFC satisfies the substantial contribution test, and accordingly is considered as manufacturing the property that it sells, a determination must be made concerning whether the branch rule applies. The branch rule can apply where the CFC conducts sales and manufacturing activities in more than one country. The application of the branch rule may deprive a portion of the CFC's income from qualifying for the manufacturing exception. I plan to address the provisions in the proposed regulations concerning the branch rule in a subsequent commentary.

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.