Federal Register: December 29, 2008 (Volume 73, Number 249)

DOCID: fr29de08-13 FR Doc E8-30727

Internal Revenue Service

CFR Citation: 26 CFR Part 1

RIN ID: RIN 1545-BI50

TD ID: [TD 9438]

NOTICE: RULES

DOCID: fr29de08-13

DOCUMENT ACTION: Final and temporary regulations.

SUBJECT CATEGORY:

Guidance Regarding Foreign Base Company Sales Income

DATES: Effective Date. These regulations are effective July 1, 2009.
Applicability Date. For dates of applicability, see Sec. 1.954 3(c) and Sec. 1.9543T(e). The final regulations shall apply to taxable years of controlled foreign corporations beginning after June 30, 2009, and for taxable years of United States shareholders in which or with which such taxable years of the controlled foreign corporations end. The temporary regulations shall apply to taxable years of controlled foreign corporations beginning after June 30, 2009, and for taxable years of United States shareholders in which or with which such taxable years of the controlled foreign corporations end.

DOCUMENT SUMMARY:

This document contains final and temporary regulations that provide guidance relating to foreign base company sales income in cases in which personal property sold by a controlled foreign corporation is manufactured,
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produced, or constructed pursuant to a contract manufacturing arrangement or by one or more branches of the controlled foreign corporation. These regulations modify the foreign base company sales income regulations to address current business structures and practices, particularly the growing importance of contract manufacturing and other manufacturing arrangements. These regulations, in general, will affect controlled foreign corporations and their United States shareholders. The text of the temporary regulations also serves as the text of the proposed regulations set forth in the notice of proposed rulemaking on this subject in the Proposed Rules section in this issue of the Federal Register.

SUMMARY:

Guidance Regarding Foreign Base Company Sales Income,

SUPPLEMENTAL INFORMATION

Background

On February 28, 2008, the IRS and the Treasury Department published in the Federal Register proposed regulations (REG12459007, 200816 IRB 801, 73 FR 10716, as corrected at 73 FR 20201), which provided proposed amendments to Sec. 1.9543, addressing the treatment of contract manufacturing arrangements under the foreign base company sales income (FBCSI) rules. Written comments were received in response to the notice of proposed rulemaking, and a public hearing on the proposed regulations was held on July 29, 2008.

Section 954(d)(1) defines FBCSI to mean income derived by a controlled foreign corporation (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 these cases) that the property 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 existing regulations further define FBCSI and the applicable exceptions from FBSCI, including the exceptions to the FBCSI rules 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). See Sec. 1.9543(a)(2)(4).

The existing regulations set forth certain tests to determine whether a CFC satisfies the manufacturing exception: The ``substantial transformation test'' of Sec. 1.9543(a)(4)(ii) and the ``substantive test'' and safe harbor of Sec. 1.9543(a)(4)(iii). For purposes of this preamble, the requirements of Sec. 1.9543(a)(4)(ii) and 1.954 3(a)(4)(iii) will be referred to collectively as the ``physical manufacturing test'' and the satisfaction of either test will be described as ``physical manufacturing.''

The proposed regulations provide a third test for satisfying the manufacturing exception, which may apply when a CFC is involved in the manufacturing process but does not satisfy the physical manufacturing test. In particular, the proposed regulations provide that a CFC will 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). The proposed regulations also propose other modifications to the existing regulations to address the treatment of contract manufacturing arrangements under the FBCSI rules.

Written comments were received in response to the notice of proposed rulemaking, and a public hearing was held on July 29, 2008. After consideration of all the comments, the proposed regulations, as revised by this Treasury decision, are adopted as final and temporary regulations.

Summary of Comments and Explanation of Provisions

This Treasury decision contains final and temporary regulations relating to FBCSI. The temporary regulations contained in this Treasury decision also serve as the text of proposed regulations set forth in a notice of proposed rulemaking on this subject in the Proposed Rules section in this issue of the Federal Register. The preamble to this Treasury decision will refer to the proposed regulations published in the Federal Register on February 28, 2008, as the proposed regulations. The preamble will refer to the regulations that are published simultaneously as temporary regulations in this Treasury decision and as proposed regulations in this issue of the Federal Register as the temporary regulations.

A. Substantial Contribution Test

The proposed regulations provide that a CFC will satisfy the substantial contribution test with respect to personal property only if all the facts and circumstances evince that the CFC makes a substantial contribution through the activities of its employees to the manufacture of the property. Prop. Reg. Sec. 1.9543(a)(4)(iv)(b) includes a non exclusive list of activities (collectively, ``indicia of
manufacturing'') to be considered in determining whether the CFC satisfies the substantial contribution test with respect to the manufacture, production, or construction of the personal property (manufacture of the personal property) under all the facts and circumstances.

1. General Operation of Substantial Contribution Test

In response to the proposed regulations, commentators requested further elaboration of the general operation of the substantial contribution test. For example, commentators requested guidance on the amount of activity performed by a CFC's employees that would be necessary to ``satisfy'' each individual activity listed among the indicia of manufacturing. Several commentators requested clarifications that suggested they believed that a certain threshold of employee activity was required before the activity would be considered in determining whether a CFC satisfied the substantial contribution test. Commentators requested, for example, clarification as to whether the ``vendor selection'' activity is satisfied if the CFC provides a contract manufacturer with an approved list of vendors but allows the contract manufacturer to make the final determination regarding the vendors to be used.

Commentators also requested guidance on how the indicia of manufacturing should be weighed in relation to one another and whether performing a certain minimum number of activities was required in order for
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the substantial contribution test to be satisfied. Others asked that the regulations explain whether a CFC must perform any particular activity in all cases to satisfy the substantial contribution test (for example, whether a CFC must always perform oversight and direction of the manufacturing process to satisfy the substantial contribution test). Some commentators requested that the regulations emphasize that the importance of each activity would vary by industry and by taxpayer. Commentators also requested that the regulations make clear that a CFC need not perform all of the indicia of manufacturing to establish a substantial contribution, and that the weight given to activities performed by employees of the CFC will depend on the economic significance of those activities to the business of the taxpayer with respect to the product being manufactured.

Although the proposed regulations provide guidance on many of these issues, the IRS and the Treasury Department believe that additional guidance with respect to the application of the substantial contribution test is warranted in light of the comments received. Consequently, Sec. 1.9543(a)(4)(iv)(c) is added to the final regulations to provide further clarification on the application of the substantial contribution test. First, Sec. 1.9543(a)(4)(iv)(c) clarifies that 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. Second, Sec. 1.9543(a)(4)(iv)(c) clarifies that 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. Third, it clarifies that 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. Therefore, all functions performed by a CFC's employees are considered (and given appropriate weight) under the substantial contribution test, even if the CFC's employees perform only some of the functions in connection with any one activity (for example, some, but not all, of the vendor selection) considered under that test. The weight given to any functions performed by employees of the CFC with respect to any activity will be based on the economic significance of those functions to the manufacture, production, or construction of the relevant personal property. Corresponding amendments and additional examples have been added to the final regulations to illustrate further the application of the substantial contribution test. See Sec. 1.9543(a)(4)(iv)(d).

Other commentators sought clarification as to the extent to which purely contractual assumptions of risk are considered in a substantial contribution analysis. The IRS and the Treasury Department believe that no further clarification in the final regulations is necessary to address this point. Both the proposed and final regulations provide that only activities of the CFC's employees are considered in the substantial contribution analysis and, consequently, purely contractual assumptions of risk are not considered in the substantial contribution analysis.

In addition, commentators requested that the regulations clarify that more than one person can provide a substantial contribution to the manufacturing process with respect to a given product. In response to this comment, the IRS and the Treasury Department amended the regulations to clarify 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. Further, Sec. 1.9543(a)(4)(iv)(d) Example 9 is added to the final regulations to illustrate that more than one person can provide a substantial contribution to the manufacture of the same property.

2. Indicia of Manufacturing

The IRS and the Treasury Department received numerous comments with respect to the specific activities listed in the proposed regulation that are considered in determining whether a CFC makes a substantial contribution through its employees to the manufacture, production, or construction of personal property.

a. Oversight and Direction of Manufacturing

Commentators requested that the IRS and the Treasury Department clarify certain issues related to the ``oversight and direction of the activities or process'' pursuant to which personal property is manufactured, produced, or constructed. Some commentators asked that the regulations provide that oversight and direction of the activities or process pursuant to which personal property is manufactured, produced, or constructed be a prerequisite for satisfying the substantial contribution test. Other commentators requested that the IRS and the Treasury Department clarify that in certain industries a substantial contribution can be made by a CFC without its employees engaging in significant oversight and direction of the activities or process pursuant to which personal property is manufactured, produced, or constructed. Some commentators focused on the fact that in an example in the proposed regulations the CFC was not treated as making a substantial contribution to the manufacture of personal property when the CFC did not ``regularly exercise'' oversight and direction with respect to the contract manufacturer. See Prop. Reg. Sec. 1.954 3(a)(4)(iv)(c) Example 1.

The importance of oversight and direction of the activities or process pursuant to which personal property is manufactured, produced, or constructed will vary based on the facts and circumstances associated with the specific manufacture, production, or construction at issue. The IRS and the Treasury Department acknowledge that oversight and direction of the activities or process pursuant to which personal property is manufactured, produced, or constructed is likely to be an important element in many, but not all, substantial contribution analyses. Thus, to address taxpayer comments, the examples in the final regulations are amended 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. Finally, the examples in the final regulations do not use the potentially confusing reference to ``regularly'' exercising oversight.
b. Material Selection, Vendor Selection, and Control of the Raw Materials, Workinprocess, and Finished Goods

Some commentators asked if other activities listed among the indicia of manufacturing also represented means of exercising control of the raw materials, workinprocess and finished goods. The IRS and the Treasury Department acknowledge that some of the activities in the indicia of manufacturing may overlap with other activities in that list. The final regulations require a substantial contribution to the manufacture of the personal property through the activities of the CFC's employees and not
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satisfaction of any specific activity in the indicia of manufacturing. Therefore, the IRS and the Treasury Department determined that it was not necessary to clarify whether any particular function might reasonably be included under more than one heading in the indicia of manufacturing. However, to provide further clarity, the final regulations group material selection, vendor selection, and control of the raw materials, workinprocess, and finished goods as a single activity in the indicia of manufacturing.

Commentators asked whether the control of the raw materials, work inprocess, and finished goods refers to the CFC having the contractual right to take possession of the personal property, to have title to the property, or to have economic risk of loss with respect to the property. These commentators requested clarification regarding whether tax ownership of raw materials, workinprocess and finished goods is required to have control of the raw materials, workinprocess, and finished goods. In connection with this question, commentators also asked whether a CFC can satisfy the substantial contribution test when the contract manufacturing arrangement is buysell or ``turnkey'' (that is, when the contract manufacturer purchases the raw materials).

Both the proposed and final regulations provide that only activities of the CFC's employees are considered in the substantial contribution analysis. Thus, mere contractual rights, legal title, tax ownership, or assumption of economic risk are not considered in the substantial contribution analysis. To provide greater clarity, the final regulations revise Prop. Reg. Sec. 1.9543(a)(4)(iv)(a), deleting the phrase ``purchased by a controlled foreign corporation'' in the first sentence of Prop. Reg. Sec. 1.9543(a)(4)(iv)(a) to eliminate any inference that a CFC needs to own the raw materials that are used in the manufacturing process. In addition, examples in the final regulations clarify that buysell or turnkey contract manufacturing arrangements may satisfy the substantial contribution test. See Sec. 1.9543(a)(4)(iv)(d) Examples 3 and 9.
c. Management of Manufacturing Profits and Management of Risk of Loss

Commentators requested clarification regarding which functions would qualify as ``management of the manufacturing profits'' or ``management of the risk of loss.'' Some commentators expressed concerns regarding the term ``management of the manufacturing profits.'' Other commentators suggested that it would add clarity if ``management of the risk of loss'' were deleted from Prop. Reg. Sec. 1.9543(a)(4)(iv)(b)(1) and included with ``management of manufacturing profits'' in a single item in the indicia of manufacturing. Some commentators expressed concern that the term ``management of the risk of loss'' implicitly excluded all other risk management functions. One commentator expressed the view that the indicia of manufacturing should include reference to management of enterprise risk, other than risks pertaining exclusively to sales and marketing functions. Some commentators suggested that management of the manufacturing profits might refer to such activities as the management of risks related to the raw materials and the utilization of plant capacity, but others thought it might encompass the finance function of a company.

The IRS and the Treasury Department agree that further clarification is needed as to the functions that are intended to be included within what was labeled ``management of the manufacturing profits'' and ``management of the risk of loss'' in the proposed regulations. The IRS and the Treasury Department intend that the substantial contribution test recognize contributions made by a CFC's employees to the manufacturing process through functions which help to ensure that a plant is run in an economically efficient manner, such as optimization of plant capacity and reduction of waste (for example, waste of raw materials). On the other hand, not all corporate managerial decisions are intended to be considered in the substantial contribution test, because many such decisions are not directly related to the manufacture of the personal property with respect to which the substantial contribution analysis is being performed. For example, the IRS and the Treasury Department do not intend that corporate finance decisions be considered in the substantial contribution test. Similarly, the IRS and the Treasury Department do not intend that the general management of enterprise risk be considered in the substantial contribution test.

The IRS and the Treasury Department concluded that the term ``management of the manufacturing costs or capacities'' more accurately reflects the type of functions originally contemplated by ``management of the manufacturing profits'' in the proposed regulations and is also related to the types of functions contemplated by the ``management of the risk of loss.'' Accordingly, the activity labeled ``management of the manufacturing profits'' in the proposed regulations is replaced in the final regulations with an activity entitled ``management of manufacturing costs or capacities.'' Further, the final regulations include a parenthetical list of functions (that is, managing the risk of loss, cost reduction or efficiency initiatives associated with the manufacturing process, demand planning, production scheduling, or hedging raw material costs) to elaborate on the meaning of the activity.

d. Control of Logistics

Commentators asked for clarification regarding the scope of logistical functions that will contribute towards a substantial contribution by a CFC. This activity is intended to include, for example, arranging for delivery of raw materials to a contract manufacturer, but to exclude, for example, delivery of finished goods to a customer. The final regulations provide further clarity on this issue by revising the activity to read ``control of manufacturing related logistics.''
e. 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

Commentators noted that the ``and'' in the description of this activity in the proposed regulations could be read to mean that directing the ``development, protection, and use'' of intellectual property are all required for this activity to be considered in the substantial contribution analysis. Commentators requested that these activities be stated in the disjunctive. The IRS and the Treasury Department adopted this comment, replacing ``and'' with ``or'' in the final regulations. This clarification is consistent with providing that all functions performed by a CFC's employees are considered (and given appropriate weight) under the substantial contribution test. Thus, 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.

The term ``protection'' is also deleted from the final regulations. The IRS and the Treasury Department were concerned that absent this clarification the final regulations could be read to provide that legal work performed by a CFC's inhouse legal staff was considered under the substantial contribution test, including in cases where, for example, litigation success could be heavily correlated to
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profitability or business failure with respect to a product. Further, the IRS and the Treasury Department modified the description of the activity in the final regulations to clarify that 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.

Commentators asked whether the intellectual property referred to in Prop. Reg. Sec. 1.9543(a)(4)(iv)(b)(9) included marketing intangibles. The activity as described in both the proposed and final regulations is with respect to intellectual property used in the manufacture of the personal property. Thus, developing, or directing the use or development of, marketing intangibles is not intended to be considered in the substantial contribution test.

3. Antiabuse Rule and Safe Harbor

The IRS and the Treasury Department requested comments on whether the substantial contribution test should include an antiabuse rule and safe harbor. In particular, comments were requested as to whether it would be appropriate to add an antiabuse rule to prevent a CFC from satisfying the substantial contribution test in cases in which a significant portion of the direct or indirect contributions to the manufacture of personal property provided collectively by the CFC and any related U.S. persons are provided by one or more related U.S. persons. Commentators recommended that in determining whether a CFC makes a substantial contribution it should not be relevant whether other persons (whether U.S. or foreign, related or unrelated) contribute to the manufacturing process. The IRS and the Treasury Department agree with commentators that the substantial contribution test should focus on whether the activities of the CFC itself are substantial without comparing those activities to those of other persons. Thus, the final regulations do not adopt such a rule. Examples in the final regulations also illustrate that the contributions of other persons to the manufacture of a product are not relevant to the analysis of whether a CFC makes a substantial contribution to the manufacturing process. See Sec. 1.9543(a)(4)(iv)(d) Examples 6, 7, and 9.

The IRS and the Treasury Department also requested comments as to whether one or more safe harbors should be added to the substantial contribution test of the proposed regulations. Some commentators suggested that a CFC that contributes at least twenty percent of the costs of manufacturing personal property should be deemed to have substantially contributed to its manufacture. Other commentators suggested that a safe harbor was only appropriate if it were made clear that such a safe harbor would not function as a minimum standard and would be flexible enough to accommodate multiple industries. Many other commentators recommended that the IRS and the Treasury Department not adopt a safe harbor. The IRS and the Treasury Department concluded that no safe harbor could fairly apply across the range of industries potentially subject to Sec. 1.9543, and therefore no safe harbor is provided in the final regulations.

4. Definition of Employee

The IRS and the Treasury Department requested comments as to whether the requirement in the proposed regulations that the activities of the CFC be performed by its employees should take into account commercial arrangements where individuals performing services for the CFC while not on its payroll are nevertheless controlled by employees of the CFC. Commentators requested that the regulations expand the definition of the term ``employee'' to include various commercial or economic arrangements where individuals who perform services for a CFC under the CFC's direction and control are not necessarily the CFC's employees under local law. In particular, commentators suggested that the term ``employee'' could be defined for purposes of the substantial contribution test using section 3121(d)(2). Other commentators asked that the term ``employee'' be defined more broadly to include anyone in an agency relationship with a CFC.

The IRS and the Treasury Department agree that clarification of the term ``employee'' will promote more effective application of these regulations. The IRS and the Treasury Department also agree that activities performed by certain nonpayroll workers should be considered in determining whether the CFC provides a substantial contribution through ``its employees.'' However, the IRS and the Treasury Department concluded that it would be inappropriate to broaden the definition of employee to include anyone in an agency relationship with a CFC, because it could create unintended branch rule issues for taxpayers (for example, as a result of employees of a contract manufacturer being treated as employees of the CFC under such a definition). Thus, the final regulations provide that the term employee means any individual who, under Sec. 31.3121(d)1(c), has the status of an employee for U.S. Federal tax purposes. This definition of the term ``employee'' may encompass certain seconded workers, parttime workers, workers on the payroll of a related employment company whose activities are directed and controlled by CFC employees, and contractors, so long as those individuals are deemed to be employees of the CFC under Sec. 31.3121(d)1(c). Consistent with commentators' request, this definition of the term employee may result in an individual being treated as an employee of two or more entities simultaneously.

5. Product Grouping

Commentators requested that the determination of whether a CFC provides a substantial contribution to the manufacture of the personal property be made on the basis of a group or line of related products rather than on a productbyproduct basis. The IRS and the Treasury Department believe that the substantial contribution test must be met with respect to each product. Whether manufactured goods are separate products or a single product for this purpose is determined by reference to the distinctions or lack thereof made by the CFC in its business operations and in its books and records, rather than by reference to a third party's definition of a product or an industry product classification system, such as the Standard Industrial Classification Code. The IRS and the Treasury Department recognize that some activities taken into account under the substantial contribution test are not performed with respect to each individual unit of a particular product manufactured under a contract manufacturing arrangement. Section 1.9543(a)(4)(iv)(d) Example 11 has been added to the final regulations to address these comments.

6. Treatment of Partnerships

Commentators requested that the regulations adopt principles to determine when the employees of a partnership should be treated as employees of the CFC for purposes of determining whether the CFC's relative economic interest in the partnership should be relevant in determining whether the CFC satisfies the substantial contribution test. The IRS and the Treasury Department concluded that this issue was beyond the scope of this regulatory project. However, the IRS and the Treasury Department continue to study this issue and welcome comments. [[Page 79339]]

7. Rebuttable Presumption

The proposed regulations provide a rebuttable presumption that the CFC does not satisfy the substantial contribution test when the activities of a branch of the CFC satisfy the physical manufacturing test. The presumption can only be rebutted if the taxpayer can prove to the satisfaction of the Commissioner that the CFC satisfied the substantial contribution test. Commentators suggested that satisfaction of the physical manufacturing test and satisfaction of the substantial contribution test should be treated equally under the regulations. Commentators also expressed the view that the standard required to rebut the presumption was either too subjective, imposed an improperly high standard, or both. They recommended that if a rebuttable presumption was retained, the standard required to rebut the presumption should be clear and convincing evidence.

In response to the comments received, the IRS and the Treasury Department reconsidered the ability to examine a CFC's claim that it substantially contributes to the manufacture of the personal property when the activities of its branch satisfy the physical manufacturing test. Upon further study, the IRS and the Treasury Department concluded that the substantial contribution test can be administered without the benefit of a rebuttable presumption that a CFC does not satisfy the substantial contribution test when the activities of a branch of the CFC satisfy the physical manufacturing test. Thus, these final and temporary regulations do not contain a rebuttable presumption. The IRS and the Treasury Department took into account the request for parity of treatment with respect to satisfaction of the physical manufacturing test and the substantial contribution test in reaching this conclusion, as well as with respect to other aspects of the temporary regulations, as discussed further in Parts C and D of this preamble.

8. Documentation

Some commentators requested guidance on how taxpayers should document their activities for application of the substantial contribution test. Because the necessary documentation will vary by industry and by taxpayer, the IRS and the Treasury Department believe that creating general rules of documentation would prove impracticable and would not allow for enough flexibility in application of the substantial contribution test. Accordingly, the final regulations do not include documentation rules.

9. Automated Manufacturing

Several comments were received concerning Prop. Reg. Sec. 1.954 3(a)(4)(iv)(c) Example 4. In Example 4, a CFC owns software and network systems that remotely and automatically (without human involvement) order raw materials for use by the contract manufacturer, take customer orders and route them to the contract manufacturer, and perform quality control. Although the CFC has a small number of computer technicians monitoring the software and network systems, the software and network systems were developed by employees of DP, the CFC's domestic parent corporation. Those DP employees supervise the CFC's computer technicians, evaluate the results of the automated manufacturing business, make ongoing operational decisions related to the performance of the manufacturing process, redesign and update the products and the manufacturing process, and develop all of the upgrades and patches for the software and network systems owned by the CFC. The example concludes that the CFC does not provide a substantial contribution to the manufacture of Product X.

Commentators expressed concern that Prop. Reg. Sec. 1.954 3(a)(4)(iv)(c) Example 4 did not recognize the importance of automated manufacturing in modern business practices. These commentators noted that manufacturing processes are increasingly automated and explained that in some high technology industries, automated manufacturing processes are the only way to manufacture and test the quality of certain products. In such industries, commentators noted that human involvement in various parts of the manufacturing process could be counterproductive. Some commentators were concerned that Prop. Reg. Sec. 1.9543(a)(4)(iv)(c) Example 4 penalized such automated manufacturing processes under the substantial contribution test.

The IRS and the Treasury Department agree that a CFC may provide a substantial contribution to a largely automated manufacturing process through its employees. Section 1.9543(a)(4)(iv)(d) Example 5 contains the same facts as Prop. Reg. Sec. 1.9543(a)(4)(iv)(c) Example 4. Under those particular facts, substantial operational responsibilities and decision making by humans are required for the manufacturing process; however, they are not performed by the CFC. To provide additional guidance, the final regulations include an additional example, Sec. 1.9543(a)(4)(iv)(d) Example 6, which illustrates that a CFC whose employees perform most of the functions that DP's employees perform in Sec. 1.9543(a)(4)(iv)(d) Example 5 makes a substantial contribution to the manufacturing process. This result applies even though DP's employees also contribute to the manufacturing process. Section 1.9543(a)(4)(iv)(d) Example 7 further illustrates that the CFC can make a substantial contribution through the activities of its employees regardless of whether the software and network systems were purchased by the CFC. These examples illustrate that the evaluation of whether a CFC makes a substantial contribution through its employees is determined based on whether industrysufficient substantial contribution activities are conducted by employees of the CFC. B. The ``Its'' Argument

The proposed regulations clarify that for purposes of determining FBCSI a CFC qualifies for the manufacturing exception only if the CFC, acting through its employees, manufactured, produced, or constructed the relevant personal property within the meaning of Sec. 1.954 3(a)(4)(i). In response to the proposed regulations, some commentators maintained that a CFC need not satisfy the physical manufacturing test or the substantial contribution test to exclude a sale from FBCSI as long as the personal property sold is not the same as the property originally purchased by the CFC.

The IRS and the Treasury Department believe, as described in the preamble to the proposed regulations, that this position, commonly referred to as the ``its'' argument, is contrary to existing law, and represents an incorrect reading of section 954(d)(1). The final regulations accordingly maintain the rules provided in the proposed regulations regarding when personal property sold by a CFC will be considered to be other than the property purchased by the CFC. C. Same Country Manufacture Exception

Commentators requested that the regulations incorporate the substantial contribution test in the same country manufacture exception. The IRS and the Treasury Department generally agree with commentators that if the substantial contribution test is sufficient to constitute the manufacture of the personal property where a CFC substantially contributes to the manufacture, production, or construction of that property, then it
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should be equally sufficient if those activities are performed by a related person (as defined in section 954(d)(3)) in the CFC's country of organization. However, the IRS and the Treasury Department concluded that the same country manufacture exception would be difficult to administer and enforce in the case of a substantial contribution performed by an unrelated third party. Commentators suggested that these concerns could be ameliorated if taxpayers were required to maintain documentation with respect to a third party's substantial contribution. The IRS and the Treasury Department do not believe a documentation requirement adequately addresses these concerns because the IRS may be unable to audit the third party to verify if those substantial contribution activities in fact took place. Therefore, the final regulations provide that the same country manufacture exception is available to taxpayers in cases when a related person provides a substantial contribution to the manufacture of the personal property in the CFC's country of organization. The final regulations also retain the rule provided in the proposed regulations modifying the application of the principles of Sec. 1.9543(a)(4)(ii) and (a)(4)(iii) to reflect that the personal property manufactured, produced, or constructed in the country of organization of the selling corporation under the principles of Sec. 1.9543(a)(4)(ii) and (a)(4)(iii) will qualify for the same country exception regardless of whose employees engage in qualifying manufacturing activities in that country.

D. Branch Rule

In addition to the amendments to Sec. 1.9543(a), the proposed regulations also proposed amendments to the rules of Sec. 1.9543(b) 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. For the remainder of this preamble, the word ``branch'' will be used to refer to a ``branch or similar establishment.''

1. Branch Definition

Some commentators requested that the regulations define the term ``branch'' for purposes of the branch rule. These commentators suggested various definitions for the IRS and the Treasury Department to consider. Commentators suggested, for instance, that a branch be defined as a permanent establishment, as a business activity in a jurisdiction outside a CFC's country of organization that has separate books and records, or as a trade or business outside a CFC's country of organization. Commentators pointed to precedents in the section 367 and 987 regulations. Alternatively, some commentators requested that the regulations make clear that a de minimis amount of activity outside of a CFC's country of organization (for example, traveling employees) does not constitute a branch. Other commentators warned that requiring too high a level of activity outside of a CFC's country of organization before a CFC was treated as having a ``branch'' would make it possible for a CFC organized in a lowertax jurisdiction to contribute substantially to manufacturing activities in a highertax jurisdiction without causing the CFC to operate through a branch. Still other commentators suggested that courts have concluded that the IRS and the Treasury Department lack the regulatory authority to determine what constitutes a branch, and they may only address the consequences flowing from the existence of a branch.

The IRS and the Treasury Department determined that defining a branch was beyond the scope of this regulatory project. However, the temporary regulations retain an example similar to Prop. Reg. Sec. 1.9543(b)(1)(ii)(c)(3)(f) Example 3, which illustrates that employees of a CFC that travel to a contract manufacturer's location outside the CFC's country of organization do not necessarily give rise to a branch in that location. See Sec. 1.9543T(b)(1)(ii)(c)(3)(v) Example 6. See also Part D.3.b of this preamble.

2. Determination of Hypothetical Effective Tax Rate

Commentators requested that the regulations clarify that the tax rate disparity tests contained in Sec. Sec. 1.9543(b)(1)(i)(b) and (b)(1)(ii)(b) 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.

The IRS and the Treasury Department recognize 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, the IRS and the Treasury Department agree 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. In contrast, if a sales affiliate in the country of manufacturing can theoretically receive certain tax relief by taking certain actions, for example, by applying for special treatment pursuant to a ruling process, but the taxpayer has not affirmatively obtained such tax relief for the manufacturing branch (or remainder), then the hypothetical effective tax rate that would be paid by the manufacturing branch (or remainder) were it to derive the sales income should be the effective tax rate that would be applicable in that jurisdiction without such tax relief. The IRS and the Treasury Department believe that no change to the text of the existing regulations is necessary to address these points. However, Sec. 1.9543T(b)(4) Example (8) is included in the temporary regulations to illustrate that uniformly applicable incentive tax rates are taken into account in determining the hypothetical effective tax rate.

The IRS and the Treasury Department concluded that other questions and requests in this area, including further clarification of the methodology for calculation of hypothetical tax rates, and for changes to the assumptions used in applying the tax rate disparity tests and determining the hypothetical effective tax rate, are beyond the scope of this regulatory project. However, the IRS and the Treasury Department continue to study these questions and welcome comments. 3. Multiple Manufacturing Branch Rules

a. Determination of the Location of Manufacturing

Under Prop. Reg. Sec. 1.9543(b)(1)(ii)(c)(3), the relevant tax rate disparity test is applied by giving satisfaction of the physical manufacturing test precedence over satisfaction of the substantial contribution test when multiple branches, or one or more branches and the remainder of the CFC, perform manufacturing activities with respect to the same item of personal property. If more than one branch (or one or more branches and the remainder of the CFC) each independently satisfies the physical manufacturing test, then the branch or the remainder of the CFC located or organized in the jurisdiction that would impose the lowest effective rate of tax is treated as the location of manufacturing, producing, or constructing of the personal property for purposes of applying the tax rate disparity test (lowest ofallrates rule). If only one branch (or only the remainder of a CFC) independently satisfies the physical manufacturing test, then that [[Page 79341]]
branch (or remainder) is treated as the location of manufacturing, producing, or constructing of the personal property (location of manufacturing) for purposes of the tax rate disparity test.

If none of the branches or the remainder of the CFC independently satisfies the physical manufacturing test, but the CFC as a whole satisfies the substantial contribution test, then the location of manufacturing under the proposed regulations is the location of the branch or the remainder of the CFC that provides the predominant amount of the CFC's substantial contribution to the manufacture of the personal property (predominant place rule). If a predominant amount of the CFC's contribution to the manufacture of the personal property is not provided by any one location, then the location of manufacturing for purposes of applying the manufacturing branch tax rate disparity test under the proposed regulations is that place (either the remainder of the CFC or one of its branches) where manufacturing activity with respect to that property is performed and which would impose the highest effective rate of tax (highestofallrates rule) when applying either Sec. 1.9543(b)(1)(i)(b) or (b)(1)(ii)(b).

The IRS and the Treasury Department received multiple comments comparing and contrasting the highest and lowestofallrates rules. For example, commentators asked why the lowestofallrates rule should apply when more than one branch (or one or more branches and the remainder of the CFC) independently satisfy the physical manufacturing test, whereas the highestofallrates rule should apply when none of the branches or the remainder of the CFC independently satisfies the physical manufacturing test but the CFC as a whole satisfies the substantial contribution test. Commentators suggested that satisfaction of the physical manufacturing test and the substantial contribution test should be treated equally under the regulations, and therefore suggested having the same rule in both circumstances. These commentators proposed a lowestofallrates rule or the use of a weighted average of the tax rate of each branch or remainder of the CFC in both instances.

The IRS and the Treasury Department generally agreed with these comments. The IRS and the Treasury Department adopted taxpayers' comment that the same rule should apply consistently when a branch (or remainder) independently satisfies Sec. 1.9543(a)(4)(i), regardless of whether it satisfies the physical manufacturing test or the substantial contribution test. Therefore the rules set forth in the proposed regulations are modified in the temporary regulations to provide that the lowestofallrates rule will apply whenever a branch (or remainder) independently satisfies Sec. 1.9543(a)(4)(ii), (iii), or (iv). However, providing parity of treatment for satisfaction of the physical manufacturing test and the substantial contribution test in respect of the lowestofallrates rule is not sufficient to determine the location of manufacturing in cases where a CFC satisfies the substantial contribution test, yet no branch (or remainder) independently satisfies Sec. 1.9543(a)(4)(iv).

Commentators questioned how to treat branches making contributions to the manufacture of the personal property through the activities of employees when no branch independently satisfies Sec. 1.954 3(a)(4)(iv). Some commentators expressed concern that it would be difficult to compare the relative contributions of various locations to determine which branch or remainder of the CFC made a predominant contribution under the predominant place rule. Other commentators requested greater guidance regarding the meaning of predominant contribution. Many commentators suggested that the highestofallrates rule in the proposed regulations could lead to arbitrary results when no predominant contributor could be identified.

The IRS and the Treasury Department generally agreed with these comments. Consequently, the temporary regulations 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. The revised rules are based on the principle that the branch rule should apply in situations where purchase or sale activities with respect to the personal property are separated from manufacturing activities conducted by the CFC such that a demonstrably greater amount of manufacturing activity with respect to that property occurs in jurisdictions with tax rate disparity relative to the sales or purchase branch (or, in the case of a purchasing or selling remainder, the demonstrably greater amount of manufacturing activity with respect to the personal property occurs in jurisdictions with tax rate disparity relative to the purchasing or selling remainder).

Under the temporary regulations, if a demonstrably greater amount of manufacturing activity with respect to the personal property occurs in jurisdictions without tax rate disparity relative to the sales or purchase branch, the location of the sales or purchase branch will be deemed to be the location of manufacture of the personal property. In that case, the purchase or sales activities with respect to the property purchased or sold by or through the sales or purchase branch of the CFC will not, for purposes of determining FBCSI in connection with the sale of that property, be deemed to have substantially the same tax effect as if a branch were a wholly owned subsidiary corporation of the CFC. Otherwise, the location of manufacture of the personal property will be deemed to be the location of a manufacturing branch (or remainder) that has tax rate disparity relative to the sales or purchase branch. In that case, the purchase or sales activities with respect to the property purchased or sold by or through the sales or purchase branch of the CFC will be deemed to have substantially the same tax effect as if a branch were a wholly owned subsidiary corporation of the CFC, and that branch will be treated as a separate corporation for purposes of applying the regulations.

The temporary regulations apply analogous rules in the case of purchase or sales activity being conducted through the jurisdiction under the laws of which the CFC is organized. In such cases, however, the analysis focuses on whether the demonstrably greater amount of manufacturing activity with respect to the personal property occurs in jurisdictions that do or do not have tax rate disparity relative to the jurisdiction under the laws of which the CFC is organized. The temporary regulations incorporate examples under Sec. 1.954 3T(b)(1)(ii)(c)(3)(v) to illustrate the application of these rules. b. Location of Activities

The proposed regulations provide that for purposes of the multiple manufacturing branch rules the location of any activity with respect to the manufacture of the personal property is where the CFC's employees engage in such activity. Commentators suggested that in some cases the proposed regulations left it unclear, for purposes of determining the location of manufacturing, which jurisdiction was accorded credit for activities performed by an employee who is traveling temporarily to a foreign jurisdiction. Some commentators suggested that the location of activity rule should be removed or that the regulations should [[Page 79342]]
clarify that, for instance, the activities of employees of a CFC based in the jurisdiction under the laws of which the CFC is organized, even while traveling outside the CFC's country of organization, would generally be credited toward establishing that the jurisdiction under the laws of which the CFC is organized provided a predominant amount of a CFC's substantial contribution. The IRS and the Treasury Department believe the text of Sec. 1.9543T(b)(1)(ii)(c)(3)(iv) makes clear that when an employee travels to perform activities, those activities are credited to the location in which the activities are conducted if there is a branch or remainder of the CFC in that jurisdiction. Section 1.9543T(b)(1)(ii)(c)(3)(v) provides examples to further clarify this result.

Other commentators asked which location was accorded credit, if any, for activities performed by traveling employees of the CFC while located in a country in which there is no branch or remainder of the CFC. The temporary regulations provide that the location of any manufacturing activity is where the employees of the CFC perform that activity. Thus, the activities of employees while traveling to a country where the CFC does not maintain a branch or remainder are not credited to the branch or remainder where the traveling employees are regularly employed for purposes of determining the location of manufacture of the personal property under the branch rule. Such activities, however, can be taken into account for purposes of satisfying the manufacturing exception and the substantial contribution test. See Sec. 1.9543T(b)(1)(ii)(c)(3)(v) Example 6.
c. Clarifying Application of the Rule for Determining the Remainder of the CFC When Activities Are Performed in Multiple Locations

Prop Reg. Sec. 1.9543(b)(2)(ii)(a) provides that when treating the location of sales or purchase income as a separate corporation for purposes of determining whether FBCSI is realized, that separate corporation will exclude any branch or the remainder of the CFC that would be treated as a separate corporation, if the hypothetical tax rate imposed by the jurisdiction of each such branch or the remainder of the CFC were separately tested against the effective rate of tax imposed on the sales or purchase income under the relevant tax rate disparity test. Commentators suggested that the application of this rule for determining the remainder of the CFC when activities are preformed in multiple locations is unclear. To clarify, the language from the proposed regulations is revised in the temporary regulations to describe what is included in the remainder, rather than what is excluded from the remainder, for purposes of determining whether there is FBCSI, after it is determined that a manufacturing branch should receive treatment as a separate corporation for purposes of applying the regulations. See Sec. 1.9543T(b)(2)(ii)(a).

As with the rule provided in the proposed regulations, this rule is intended to provide that the activities of all branch locations (or, in the case of a remainder, the activities in the jurisdiction under the laws of which the CFC is organized) that do not have tax rate disparity relative to the sales or purchase branch location (or, in the case of a purchasing or selling remainder, the jurisdiction under the laws of which the CFC is organized) may be taken into account together with the activities of the sales or purchase branch (or, in the case of a purchasing or selling remainder, activities of the remainder of the CFC in the jurisdiction under the laws of which the CFC is organized) for purposes of applying the separate corporation analysis required under the regulations and determining whether the sales income of the sales or purchase branch (or remainder) is FBCSI. Such determination will depend on whether the substantial contribution test is satisfied by the combined activities of the sales or purchase branch (or remainder) and the other locations aggregated with the sales or purchase branch (or remainder).

4. Coordination of Sales and Manufacturing Branch Rules

Commentators requested guidance on how the sales or purchase branch rules interact with the manufacturing branch rules. The current manufacturing branch rules contemplate the existence of a sales or purchase branch and a manufacturing branch. The rules provide that in such an instance the sales or purchase branch is treated as the remainder of the CFC for purposes of applying the tax rate disparity test. However, the sales or purchase branch rules of Sec. 1.954 3(b)(1)(i) of the existing regulations do not indicate that those rules do not apply in cases where the manufacturing branch rules are applied. Commentators were concerned that the manufacturing branch rules would be applied in addition to, rather than in lieu of, the sales or purchase branch rules.

The IRS and the Treasury Department agree that if one or more sales or purchase branches are used in addition to a manufacturing branch and Sec. 1.9543T(b)(1)(ii)(c)(1) (use of one or more sales or purchases branches in addition to a manufacturing branch) is applied with respect to income from the sale of an item of personal property, then the sales or purchasing branch rules do not also apply to determine whether that income is FBCSI. Therefore, the temporary regulations clarify this point. See Sec. 1.9543(b)(1)(i)(c).

5. Unrelated to Unrelated Transactions

Commentators suggested that there was uncertainty as to whether a substantial contribution to the manufacture, production, or construction of personal property by a CFC could cause the CFC to earn FBCSI in cases where, in the absence of the substantial contribution test, some taxpayers had taken the position that they were outside the scope of the FBCSI rules. Some commentators expressed concern that transactions that are not currently subject to the existing regulations may become subject to the regulations as a result of the interaction of the substantial contribution test and the manufacturing branch rule. Other commentators suggested more generally that it was unclear if the substantial contribution test might create a branch through which a CFC carries on activities in a contract manufacturer's jurisdiction. Commentators suggested that taxpayers should be exempted from the branch consequences of the regulations by providing that the manufacturing branch rule only apply if the CFC was relying on the manufacturing exception for purposes of section 954(d)(1), or alternatively that the substantial contribution test should be elective. In this context, commentators noted that placing a CFC's substantial contribution activities, which are performed outside the country where the sales activities are performed, in a separately incorporated entity could prevent the CFC from having a branch that is subject to the manufacturing branch rule as a result of such activities.

The IRS and the Treasury Department agree that taxpayers may be subject to the FBCSI rules as a result of CFC employees performing indicia of manufacturing activities through a branch outside the country of organization of a CFC. The IRS and the Treasury Department believe this result is clear in the proposed regulations, and therefore no modifications are made to the text of the temporary regulations to clarify further this result. The IRS and the Treasury Department note that many commentators criticized the proposed regulations for drawing inappropriate distinctions between satisfaction of the
[[Page 79343]]
physical manufacturing test and satisfaction of the substantial contribution test, and argued that updating the manufacturing exception in the context of modern business enterprise models required treating with equal importance and weight physical manufacturing and activities satisfying the substantial contribution test. The IRS and the Treasury Department adopted this comment in both the final regulations and the temporary regulations and, accordingly, did not incorporate in the temporary regulations an exception regarding activities performed through a branch located outside the country of organization of a CFC for cases in which, in the absence of the substantial contribution test, some taxpayers had taken the position that they were outside the scope of the FBCSI rules.

One commentator noted that while there are strong policy reasons for the substantial contribution test and the branch rules to apply in the case of ``unrelated to unrelated'' transactions, the IRS and the Treasury Department should consider a special delayed effective date to allow taxpayers in this position time to restructure their operations in light of the regulations. The commentator argued that such taxpayers had been outside the scope of the FBCSI rules prior to these regulations and should be provided reasonable time to restructure. For a discussion of the effective date of the final and temporary regulations, see Part F of this preamble.

6. Branch Rule Examples

Commentators expressed concern that the facts of Prop. Reg. Sec. 1.9543(b)(1)(ii)(c)(3)(f) Example 4 ascribed most substantial contribution activities to the remainder, but determined that the remainder had not met the substantial contribution test. In the example, the remainder performs seven activities listed in the indicia of manufacturing of the proposed regulations, whereas Branch A performs only one activity (design) and Branch B performs only two activities. The example was intended to show that in a CFC's particular industry, the weight accorded to the activities performed by each branch can be comparable, even though a different number of activities occur in different locations, because the economic significance of the activities conducted in each location is comparable. However, the IRS and the Treasury Department recognize that the example may have caused confusion for taxpayers. Therefore, the allocation of activities in Example 4 of Prop. Reg. Sec. 1.9543(b)(1)(ii)(c)(3)(f) has been revised in Sec. 1.9543T(b)(1)(ii)(c)(3)(v) Example 3. Moreover, Examples 4, 5, and 6 of Prop. Reg. Sec. 1.9543(b)(1)(ii)(c)(3)(f) have been restructured in the temporary regulations to be consistent with the revisions to the branch rules.

Commentators also noted that Example 4 and Example 5 of Prop. Reg. Sec. 1.9543(b)(1)(ii)(c)(3)(f) suggest that income other than sales or purchasing income may be FBCSI. These examples are amended in the temporary regulations to be consistent with section 954(d)(2), which provides that income attributable to the carrying on of purchase or sales activities by a branch may be FBCSI.

Commentators requested that the IRS and the Treasury Department add an example to the regulations to illustrate how the substantial contribution test and the branch rules operate in cases involving multiple manufacturing branches and multiple sales branches. The temporary regulations include such an example. See Sec. 1.954 3T(b)(1)(ii)(c)(3)(v) Example 5.

The temporary regulations also include an example illustrating the operation of the location of manufacture rules under Sec. 1.954 3T(b)(1)(ii)(c)(3) and the application of the substantial contribution test when a tested manufacturing location has been determined to have tax rate disparity with a tested sales location. See Sec. 1.954 3T(b)(4) Example (9). Example (9) illustrates that a tested sales location can satisfy the substantial contribution test for purposes of determining FBCSI once it has been determined that a tested manufacturing location should be treated as a separate corporation for purposes of determining FBCSI. Although a branch that has tax rate disparity with the tested sales location is the tested manufacturing location, Example (9) concludes that the CFC does not have FBCSI from the sale of the personal property because, after applying the aggregation rules of Sec. 1.9543T(b)(2)(ii)(a), the tested sales location satisfies Sec. 1.9543(a)(4)(iv).

E. Conforming Amendments

Sections 1.9543(a)(1)(i) and (c) of the existing regulations contain crossreferences to foreign base company shipping income under Sec. 1.9546. Section 954 was amended by Public Law 108357 in 2004, and foreign base company shipping income was removed as a separate category of foreign base company income. The final regulations are amended by deleting both references to foreign base company shipping income to reflect the 2004 amendment to section 954.

Section 1.9543(a)(1)(i) of the existing regulations defines ``related person'' and ``unrelated person'' by an obsolete cross reference to Sec. 1.9541(e). The final regulations are amended to define ``related person'' and ``unrelated person'' with reference to Sec. 1.9541(f).

F. Effective Date

Several commentators requested that the new regulations provide for a delayed effective date to allow taxpayers to implement supply chain and structural changes that may be required to satisfy the substantial contribution test and the branch rules. The IRS and the Treasury Department agree that a delayed effective date is appropriate for taxpayers whose structures require modification to accommodate the new regulations. Accordingly, these final and temporary regulations will apply to taxable years of CFCs beginning after June 30, 2009, and for taxable years of United States shareholders in which or with which such taxable years of the CFCs end. Thus, the final and temporary regulations will become applicable January 1, 2010, for CFCs whose taxable year is the calendar year. The temporary regulations will expire on or before December 23, 2011. In addition, a taxpayer may choose to apply these final and temporary regulations retroactively with respect to its open taxable years. The taxpayer may so choose if and only if the taxpayer and all members of the taxpayer's affiliated group apply both the final and temporary regulations, in their entirety, to the earliest taxable year of each controlled foreign corporation that ends with or within an open taxable year of the taxpayer and to all subsequent taxable years. A taxpayer that chose, prior to December 24, 2008, to apply

FOR FURTHER INFORMATION CONTACT

Ethan Atticks, (202) 622-3840 (not a tollfree number).

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