IRS revokes key Subpart F ruling.

• Author: Chip, Bill
• Position: Internal Revenue Code Subpart F

The IRS has revoked Rev. Rul. 75-7, which provided that a controlled foreign corporation (CFC) could employ a contract manufacturer without subjecting the income from sales of the manufactured product to current inclusion under subpart F. The revocation of Rev. Rul. 75-7 and the Service's rationale for its new policy are set forth in Rev. Rul. 97-48. Rev. Rul. 97-48 will force many U.S.-based multinational manufacturers to reconsider their overseas tax strategies.

Under subpart F, U.S. persons owning 10% or more of a CFC are taxed on the CFC's foreign base company sales income (FBCSI), whether or not such income is distributed. Under Sec. 954(d)(1), FBCSI includes income from the purchase and sale (to or from a related party) of personal property that is both produced and consumed outside the CFC's country of incorporation.

Regs. Sec. 1.954 provides that Sec. 954(d)(1) does not apply if the CFC manufactures the purchased property into something different before selling it. Rev. Rul. 75-7 reached the same result when the manufacturing was done by a contractor of the CFC, if the manufacturing process was closely controlled by the CFC. Unfortunately, Rev. Rul. 75-7 also treated a closely controlled contractor as a "branch" of the CFC, turning the CFC's income into FBCSI under Sec. 954(d)(2) if the CFC had a lower effective tax rate than the contract manufacturer.

In 1990, in both Ashland Oil Co., 95 TC 348, and Vetco, Inc., 95 TC 579, the Tax Court rejected the "branch" analysis of Rev. Rul. 75-7. Since then, many taxpayers with CFCs that use contract manufacturers have ignored the Sec. 954(d)(2) holding of Rev. Rul. 75-7 while relying on its Sec. 954(d)(1) holding. Feeling "whipsawed," the IRS declared in Rev. Rul. 97-48 that it would follow the 1990 court decisions but was revoking Rev. Rul. 75-7 for tax years beginning after Dec. 7, 1997. Rev. Rul. 97-48 allows taxpayers to rely on Rev. Rul. 75-7 for prior years only if they accept the "branch" holding...