New subpart F Regs. address manufacturing exception and branch rules.

• Author: Hawkins, Bert J.

On December 29, 2008, Treasury published final, temporary, and proposed regulations under Sec. 954 addressing the treatment of contract manufacturing arrangements and the branch rules applicable to foreign base company sales income (FBCSI), a type of subpart F income applicable to the sale of inventory (T.D. 9438, REG-150066-08). The new regulations leave the original regulations largely intact, provide an additional test for the "manufacturing exception" (the substantial contribution test), and provide a protocol for administering the branch rules. The new regulations also eliminate the "its defense," which is described in the preamble as being contrary to existing law and representing an incorrect reading of the FBCSI rules. These regulations are generally effective for tax years of controlled foreign corporations (CFCs) beginning after June 30, 2009, and the corresponding tax years of U.S. shareholders.

In general, the FBCSI rules impose U.S. tax on income derived by a CFC in connection with the sale of products purchased from a related party and sold outside the CFC's country of organization (Sec. 954(d)). Exceptions exist for products manufactured in the CFC's country of organization, de minimis transactions, and transactions subject to high rates of foreign tax. An additional exception exists for products that are manufactured by the CFC (the manufacturing exception). In many cases, the selling CFC may perform some but not all of the manufacturing functions in connection with the property it sells. These new regulations address the issue of what level of manufacturing activities a CFC must perform to become eligible for the manufacturing exception.

Two alternative tests are available under the existing regulations to determine if a CFC has performed sufficient manufacturing activities to satisfy the manufacturing exception. The first is the substantial transformation test, under which property is considered manufactured if it is substantially transformed prior to sale. The regulations give as illustrations of substantial transformation examples such as converting wood pulp into paper, steel rods into screws and bolts, and flesh fish into canned tuna (Regs. Sec. 1.9543(a)(4)(ii)). The second is the substantive test/safe harbor, under which property is considered manufactured if the CFC purchases components and performs substantial operations that are generally considered to be manufacturing activities (Regs. Sec. 1.954-3(a)(4)(iii)). A safe harbor is available if the conversion costs (direct labor and factory burden) incurred by the CFC in the integration process account for 20% or more of the total cost of goods sold. Packaging, repackaging, labeling, or minor assembly will in no event constitute manufacturing. The new regulations refer to these two tests collectively as the physical manufacturing tests.

Arguably, another basis for claiming the manufacturing exception is available under the statute, which provides that FBCSI is defined as "income ... derived in connection with the purchase of personal property from ... any person and its sale to a related...