TEI's comments on proposed contract manufacturing regulations.

PositionTax Executives Institute

On June 11, 2008, Tax Executives Institute filed the following comments on the proposed regulations relating to contract manufacturing arrangements under section 954(d) of the Internal Revenue Code. The comments were prepared under the aegis of TEI's International Tax Committee, whose chair is Brian C. Ugai of Starbucks Coffee Company. The following members of the Institute contributed significantly to the development of the Institute's comments: Daniel R. Goff and Peter Waterstreet of Xilinx, Inc.; Daniel J. Wenzel of S.C. Johnson & Son, Inc.; James P. Silvestri of Eisai, Inc.; Lester D. Ezrati of Hewlett Packard Co.; Dorothy C. Chao and Helena Klumpp of Baxter International Inc.; Alan Richer and Matthew O'Halloran of General Electric Company; John Lisi of Intersil Corporation; William Ramirez; Peter Hiltz and Rob Johnson of Cisco Systems Inc.; Anthony J. Blackburn of Goodyear Tire & Rubber Company; Howard Schneck and Susie Cheng of Atheros Communications, Inc.; Marc T. Hinch of Archer Daniels Midland Co.; and Jon Masunaga of FMC Technologies, Inc.

On February 27, 2008, the U.S. Department of Treasury and the Internal Revenue Service issued proposed regulations that provide guidance regarding the treatment of foreign base company sales income from property produced under contract manufacturing arrangements and sold by controlled foreign corporations under section 954(d) of the Internal Revenue Code. The proposed regulations were published in the April 21, 2008, issue of the Internal Revenue Bulletin (2008-16 I.R.B. 801), and the February 28, 2008, issue of the Federal Register (73 Fed. Reg. 10716).


Tax Executives Institute is the preeminent association of business tax executives in North America. Our 7,300 members represent 3,200 of the leading corporations in the United States, Canada, Europe, and Asia. TEI represents a cross-section of the business community, and is dedicated to developing and effectively implementing sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike.

As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply in a cost-efficient manner.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring a balanced and practical perspective to the proposed regulations regarding the treatment of foreign base company sales income from property produced under contract manufacturing arrangements and sold by controlled foreign corporations under section 954(d) of the Internal Revenue Code.


Under section 954(d) of the Code, "foreign base company sales income" (FBCSI) generally encompasses income derived by a controlled foreign corporation (CFC) from selling personal property that the CFC purchased from a related person (e.g., a domestic parent) or from buying personal property such as raw materials for sale to a related person if the property is both produced and sold for use outside the country in which the CFC is incorporated. Treas. Reg. [section] 1.954-3(a)(4)(i) provides that FBCSI excludes income of a CFC from the sale of property that was "manufactured, produced, of constructed by such corporation, in whole or in part, from personal property which it has purchased" (the "manufacturing exception'). The regulations set forth two separate tests--the substantial transformation and substantive tests--to determine whether a CFC is considered to manufacture, produce, or construct personal property that it sells. Under these tests, the personal property sold will not be considered the property purchased if the purchased property is either:

(1) substantially transformed prior to sale, or

(2) used as a component part of personal property that is sold, if the operations conducted by the selling corporation in connection with the property purchased and sold are substantial in nature and are generally considered to constitute the manufacture, production, or construction of property.

The two tests are collectively referred to in the preamble as "the physical manufacturing exception." 2008-16 I.R.B. at 802.

The proposed regulations relate primarily to the application of the FBCSI rules to a CFC's sale of property manufactured under a contract manufacturing arrangement. In the preamble, the Treasury Department and IRS recognize that, since the issuance of the current regulations in 1964, "the use of contract manufacturing arrangements has become a common way of manufacturing products because of the flexibility and efficiencies it affords. Accordingly, updated rules in this area are important to the continued competitiveness of U.S. businesses operating abroad." 2008-16 I.R.B. at 803.

TEI commends the Treasury Department and IRS for working to bring certainty to the treatment of contract manufacturing arrangements under the Subpart F rules. We also commend the government's willingness to consider changes to these rules. The proposed regulations expand the manufacturing exception by proposing a non-physical manufacturing test, seeking to clarify--

* the application of the manufacturing exception where the physical manufacturing test is not satisfied by the CFC but the CFC or its branch is involved in the manufacturing process; and

* the application of the branch rule to business structures involving the use of one or more branches engaged in manufacturing, producing, constructing, growing, of extracting activities.

Although the proposed regulations may provide more clarity for CFCs in contract manufacturing arrangements, TEI is concerned that the application of the new rules may (i) inappropriately increase taxpayers' exposure to permanent establishment claims by foreign jurisdictions, and (ii) harm some taxpayers' competitiveness by subjecting these companies to rules that currently do not apply to them.

For example, Prop. Reg. [section] 1.954-3(a)(4)(iv) (c), Example I posits that "mere" ownership of materials and intellectual property and rights to exercise powers of direction and control--without the actual exercise--are insufficient to qualify for the Subpart F exception. Not all oversight is physical, how ever, and many companies have adopted automated manufacturing processes that may not be recognized as manufacturing under these rules. Thus, the proposed regulations could actually penalize efficiency in contract manufacturing arrangements. Moreover, if companies are required to exercise more oversight over the manufacturing process, many more jurisdictions will likely conclude that a PE has been created. It is in the best interests of neither the government nor the taxpayer to expand the foreign jurisdictions in which a company's activities are taxable.

Moreover, a branch of a CFC that substantially contributes under (a)(4)(iv), but buys raw materials from unrelated parties and sells only to unrelated parties, may now be subject to Subpart F because of the branch rule. Such a result adversely affects the competitiveness of U.S. businesses operating abroad. See 2008-16 I.R.B at 803. (1) Finally, the administrative burden created by these rules would be substantial. Application of the substantial contribution test would require a detailed factual inquiry by taxpayers--especially in respect of branches, which may now be considered manufacturing branches in ways not previously anticipated. In the end, this qualitative facts-and-circumstances test would leave both taxpayers and IRS auditors with little certainty, potentially leading to expensive, time-consuming litigation. TEI's recommendations for improvement follow.

The Substantial Contribution Test

  1. In General. The proposed regulations would add an additional test for satisfying the manufacturing exception to Subpart F inclusion. Prop. Reg. [section] 1.954-3(a)(4)(iv)(a) sets forth a new "substantial contribution" test, which provides, in part, if the physical manufacturing tests are not met--

    [T]he personal property sold by the controlled foreign corporation is manufactured, produced, or constructed by such controlled foreign corporation only if the facts and circumstances evidence that the controlled foreign corporation makes a substantial contribution through the activities of its employees to the manufacture, production, of construction of the personal property sold. The determination of whether a controlled foreign corporation makes a substantial contribution through the activities of its employees to the manufacture, production, or construction of the personal property sold will involve, but will not necessarily be limited to, consideration of the activities set forth in paragraph (a)(4)(iv)(b) of this section. [Emphasis added.] The weight given to an activity varies with the facts and circumstances of the particular business. The presence (or absence) of one activity--or of several activities--is not determinative. Further, other persons making contributions to the manufacture, production, or construction of personal property before sale do not necessarily prevent the CFC from making a substantial contribution through the activities of its employees. The determination whether a CFC has made a substantial contribution is based only on the activities conducted by the CFC's employees--including employees of a branch or disregarded entity of the CFC, or employees of a center of excellence located in the same country operating under an intercompany administrative service agreement with the CFC--and not in comparison to the activities conducted by employees of any other entity.

    Subparagraph (a)(4)(iv)(b) sets forth a list of nine non-exclusive factors to be...

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