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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, which I addressed in a prior commentary.² The proposed regulations also would modify the manufacturing branch rule to take into account the new definition of manufacturing, and such is the subject of this commentary.

Under Subpart F, income derived by a controlled foreign corporation (CFC) from the sale of products is included in the gross income of its U.S. shareholders currently if such income falls within the definition of FBCSI.³ Generally, FBCSI does not include income derived by a CFC from the sale of products that it manufactured.⁴ Nevertheless, a CFC that qualifies for the manufacturing exception may have FBCSI under the manufacturing branch rule.⁵

The manufacturing branch rule applies where a CFC carries on manufacturing activities outside of its country of organization through a “branch or similar establishment,” and a tax rate disparity test is satisfied. The tax rate disparity test applies where the CFC's income derived from purchasing or selling activities is subject to a relatively low tax rate compared with the tax rate in the country where the CFC manufactures the property.⁶

A CFC may hire a contract manufacturer to physically manufacture, on its behalf, the property it sells. Under current law, a CFC principal that provides the intellectual property, has the risk of loss, and controls the manufacturing process should be treated as engaging in the manufacturing activities of the contract manufacturer. Accordingly, the CFC principal should qualify for the manufacturing exception to the definition of FBCSI. While the IRS has issued a revenue ruling asserting that a contract manufacturer's activities cannot be attributed to a CFC principal for this purpose,⁷ this view is widely considered as an incorrect application of the relevant statute, regulations, and case law.⁸

The IRS in the past also has asserted that a separate corporate contract manufacturer, whether related or unrelated, should be treated as a branch of the CFC principal for purposes of the manufacturing branch rule. The Tax Court rejected this position.⁹ Accordingly, under the current regulations as interpreted by the Tax Court, the manufacturing branch rule does not apply where a CFC principal is considered as manufacturing the products it sells as a result of attributing to such CFC the physical manufacturing activities of a contract manufacturer, because the CFC itself does not have a manufacturing branch.¹⁰

Under the new definition of manufacturing in the proposed regulations, a CFC principal in a contract manufacturing arrangement will be considered as manufacturing the property it sells if, acting through its own employees, it makes a “substantial contribution” to the manufacture of the property sold (“non-physical manufacturing”). Relevant factors taken into account include, but are not limited to: oversight and direction of the physical manufacturing activities or process (including management of risk of loss); control of raw materials, work-in-process, and finished goods; management of logistics; materials and vendor selection; quality control; and direction of the development, protection, and use of intellectual property used in manufacturing the product. Accordingly, under the proposed regulations, if a CFC hires a contract manufacturer to physically manufacture products on its behalf, and satisfies the new non-physical definition of manufacturing (which is similar to the analysis that supported attribution), the CFC qualifies for the manufacturing exception.

The new broader definition of manufacturing, however, would result in a broader application of the manufacturing branch rule. The proposed regulations provide that the non-physical manufacturing contribution activities of a CFC are considered as manufacturing activities for purposes of applying the branch rule. In contrast, the current regulations require physical manufacturing activities in a branch for it to be considered as a manufacturing branch. Accordingly, a CFC that hires a contract manufacturer to physically manufacture a product could be subject to the manufacturing branch rule under the proposed regulations where the CFC engages in activities in a foreign branch that are taken into account for purposes of the substantial contribution test.

Also, apparently any amount of manufacturing contribution activities can give rise to a manufacturing branch. For example, if a CFC performs logistics activities in a foreign branch, it may have a manufacturing branch in such country. This is in contrast to the current regulations, which apply the manufacturing branch rule only if a branch engages in physical manufacturing activities that rise to the level of satisfying the definition of the manufacturing exception.¹¹ This rule is carried over into the proposed regulations for purposes of applying the manufacturing branch rule to a CFC's physical manufacturing activities.¹²

The broader definition of a manufacturing branch could result in a CFC having multiple manufacturing branches, and the proposed regulations provide detailed rules addressing such circumstances. The current regulations generally do not contemplate more than one manufacturing branch, and seem to assume that manufacturing occurs only in one location. Under the proposed regulations, if a CFC has multiple manufacturing branches it will be treated as having only one “location of manufacturing” for each product for purposes of the tax rate disparity test. In relevant part, if the CFC does not engage in physical manufacturing, the location of manufacturing is the place where the CFC performs the predominant amount of the substantial contribution activities (i.e., a significantly greater contribution to the manufacture of the property). If there is no predominant location, then the location of manufacturing is the place (either the remainder of the CFC or one of its branches) where the CFC performs any manufacturing activity that has the highest effective tax rate.¹³

This new application of the manufacturing branch rule makes it critical that a CFC identify the activities of its employees that might be considered manufacturing contribution activities and the locations in which such activities are performed. The broader the definition of non-physical manufacturing, the broader the potential application of the branch rule. Under certain circumstances, a CFC may consider placing particular non-physical manufacturing activities conducted in a foreign branch in a separate CFC to avoid a possible risk of such activities giving rise to a manufacturing branch. The proposed regulations appear to provide that activities of employees of a separate affiliate that contribute to the manufacture of the product sold by the CFC are not taken into account for purposes of the branch rule.¹⁴

Nevertheless, like the current regulations, the proposed regulations apply the manufacturing branch rule only if the CFC satisfies the manufacturing exception.¹⁵ Accordingly, the performance of manufacturing activities in a branch will not result in the application of the manufacturing branch rule if the amount of manufacturing activities (including non-physical contribution activities) of the CFC as a whole does not qualify as manufacturing under the proposed regulations. While the CFC principal could not rely on the manufacturing exception under such circumstances, often the arrangements may be structured such that the CFC does not have a purchase from, or sale to, a related person, and accordingly the sales transaction falls outside the definition of FBCSI, regardless of whether the CFC manufactures the property.¹⁶

It is of particular concern that the broader application of the manufacturing branch rule under the proposed regulations may cause it to apply to a CFC principal that does not purchase from, or sell to, related parties. For example, a CFC may purchase products from unrelated contract manufacturers and sell the products to unrelated customers, and accordingly the transactions fall outside the general definition of FBCSI. Nevertheless, such CFC apparently has to analyze the manufacturing contribution activities performed by its employees and determine if, in the aggregate, they satisfy the substantial contribution test. If the CFC is considered as satisfying the non-physical definition of manufacturing, and some contribution activities are carried on in a foreign branch (e.g., in the contract manufacturer's country), then the branch rule might apply to cause a portion of the CFC's sales income to become FBCSI, even though it does not rely on the manufacturing exception.¹⁷ This risk is not present under the current regulations which limit the application of the branch rule to physical manufacturing activities.

The materially lower threshold for activities that can result in a manufacturing branch would cause the definition of a “branch or similar establishment” to become of much greater importance than under the current regulations. The manufacturing branch rule applies only if the manufacturing contribution activities are performed in a foreign branch; i.e., it does not apply if such activities occur in a foreign country where the CFC does not have a branch.¹⁸ The proposed regulations do not define a branch. They do, however, affirm the Tax Court decisions that the activities of a contract manufacturer's employees are irrelevant for purposes of applying the manufacturing branch rule.¹⁹

As the IRS considers providing guidance for determining whether a CFC has a branch for purposes of the manufacturing branch rule, it should follow the case law analysis that has addressed the definition of a branch for this purpose. The Tax Court stated that the phrase “branch or similar establishment” must be given its ordinary and customary meaning in a business and accounting sense, and the term “similar establishment” should not be construed more broadly than the definition of a branch. When rejecting the government's assertions that a contract manufacturer should be considered a branch of the CFC principal, the Tax Court determined that Congress did not give the Treasury specific regulatory authority to define a “branch.”²⁰ The Court also rejected the government's policy arguments, stating that the branch rule may not be used by the government as a “broad loop hole closing device.”²¹

Where it is determined that a CFC has a manufacturing branch, a tax rate disparity test is applied. The branch rule applies only if the income allocated to the remainder of the CFC is taxed at an effective rate that is both less than 90% of, and at least five percentage points less than, the effective rate which would apply to such income under the laws of the country of the manufacturing branch. If the tax rate disparity test is not satisfied, then the manufacturing branch rule does not apply. The proposed regulations do not change the basic operation of the tax rate disparity test.

If the manufacturing branch rule applies, then the manufacturing branch and the remainder are treated as separate CFCs for purposes of applying the FBCSI rules. Purchasing or sales income derived by the remainder of the CFC is considered as derived from purchasing or selling property on behalf of a related person, and therefore generally is FBCSI. Nevertheless, such income is not FBCSI if the product is either manufactured in, or sold for use in, the remainder's country of organization. Also, the remainder should qualify for the manufacturing exception if it satisfies the substantial contribution test without taking into account the activities performed in the manufacturing branch. In addition, the income of the manufacturing branch itself should never be FBCSI. These determinations become much more complex when the CFC has multiple branches, a discussion of which is beyond the scope of this commentary.

In sum, the proposed regulations would significantly broaden the application of the manufacturing branch rule, although proper structuring may minimize its impact in some cases. To avoid FBCSI under the proposed regulations, the CFC should derive its sales income in a country where its employees perform manufacturing contribution activities that are fully sufficient in and of themselves to satisfy the substantial contribution test.²² Also, a CFC relying on the unrelated-to-unrelated exception should consider steps to eliminate the performance of manufacturing contribution activities in branches to avoid the manufacturing branch rule (e.g., by transferring the activities to a separate subsidiary if feasible).

This commentary also will appear in the August 8, 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.