December 3, 2007
‘Manufacturing’ Foreign Base
Company Sales Income
by William W. Chip
Reprinted from Tax Notes Int’l, December 3, 2007, p. 975
(C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
Volume 48, Number 10
Special Reports
by William W. Chip
William W. Chip is a partner in the Washington office of Covington & Burling LLP.
Copyright © 2007 William W. Chip. All
rights reserved.
L
ess than two years after Congress enacted the
Revenue Act of 1962, the U.S. IRS succeeded in
writing a comprehensive set of final subpart F
regulations.1 The regulations were praised at the
time for their clarity and usefulness and for the most
part have stood the test of time. Why then, after
nearly half a century, are we still wondering
whether a controlled foreign corporation has foreign
base company sales income (FBCSI) when it sells
property produced by a contract manufacturer?
One reason why this important matter was not
settled sooner is that in 1997 the IRS felt obliged to
reverse two long-standing interpretations of the
FBCSI regulations. In Rev. Rul. 75-7, the IRS had
ruled that a CFC’s use of a contract manufacturer
could qualify the CFC for the manufacturing exception of section 954(d)(1) but could also create a
manufacturing branch for the CFC under section
954(d)(2).2 After its ruling on the manufacturing
branch was overturned by the courts,3 the IRS
reversed both of those positions in Rev. Rul. 97-48,
holding that the use of a contract manufacturer
would not give rise to a manufacturing branch but,
by the same token, would not qualify the CFC for the
manufacturing exception.4
Aware that taxpayers are receiving conflicting
advice from their lawyers and accountants on
whether and how to apply Rev. Rul. 97-48, IRS
officials have announced their intention to issue a
1
T.D. 6734, 1964-1 C.B. 237.
Rev. Rul. 75-7, 1975-1 C.B. 244.
3
Ashland Oil Co. v. Commissioner, 95 T.C. 348 (1990);
Vetco, Inc. v. Commissioner, 95 T.C. 579 (1990).
4
Rev. Rul. 97-48, 1997-2 C.B. 89, Doc 97-31487, 97 TNI
224-20.
new round of guidance.5 New guidance, however,
may not end the confusion and controversy if the
guidance follows the pattern of Rev. Ruls. 75-7 and
97-48 and asserts yet another interpretation of how
contract manufacturing relates to the manufacturing exception and a manufacturing branch. As argued in this report, section 954(d) recognizes neither
a manufacturing exception nor a manufacturing
branch, and an enforcement regime that is premised
on those concepts is inherently problematic and
exposed to challenge.
A more practical approach, more in keeping with
applicable legislative history, would be to define
FBCSI exclusively by reference to the degree of
transformation separating the property purchased
and the property sold by the CFC, without regard to
how the property was transformed. Any perceived
contract manufacturing abuses that might thereby
escape the rigors of subpart F may not be worth
pursuing.
Foreign Base Company Sales Income
Section 954(d)(1) defines four transactions of a
CFC that may create FBCSI. Each of them involves
a purchase, a sale, or a purchase and sale of personal
property. Two of the transactions are typical of
buy/sell distributors (‘‘the purchase of personal property from any person and its sale to any related
person’’ and ‘‘the purchase of personal property from
a related person and its sale to any person’’), while
two are typical of commission sales agents (‘‘the sale
of personal property to any person on behalf of a
related person’’ and ‘‘the purchase of personal property from any person on behalf of a related person’’).
Section 954(d) targets CFCs whose place of incorporation is unassociated with the origin or destination of the personal property that they purchase and
sell. Consequently, property purchased by a CFC
distributor or sold by a CFC sales agent is covered
only if the property was manufactured, produced,
grown, or extracted outside the CFC’s country of
2
Tax Notes International
5
Charles Gnaedinger, ‘‘IRS Official Provides More Details
on Contract Manufacturing Guidance,’’ Tax Notes Int’l, May
28, 2007, p. 909, Doc 2007-12286, 2007 WTD 99-2.
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‘Manufacturing’ Foreign Base Company
Sales Income
Special Reports
A practical rule is needed to draw
as bright a line as possible
between the sale of an assembled
product and a sale of its
component parts.
When in a process of transformation does it
become unnatural to speak of the transformed property as if it were still the property that had been
purchased? At one extreme on the scale of transformation, the purchased property may be labeled or
packaged before it is sold, in which case one says
naturally that the property sold is the property that
was purchased. Whether or not the shopkeeper puts
the groceries in a bag, and whether the bag is paper
or plastic, groceries are still being sold.
At the other extreme, the purchased property —
for example, olives — may be demolished in a
manufacturing process that produces entirely different property, such as olive oil. In that case it is quite
unnatural to say that the property sold is the
property that was purchased. In ordinary discourse,
no one would say that selling olive oil means the
same thing as selling olives.
Between the extremes are assembly operations —
for example, automobile assembly — in which an
6
Section 954(d)(1)(A).
Section 954(d)(1)(B).
8
Even more weighty matters than subpart F inclusions
have turned on the fact that English pronouns have a
referential function that must be respected by executive
agencies and courts when they interpret the law. For example, the federal statute authorizing the line-item veto was
held unconstitutional because the pronoun ‘‘it’’ in Article I’s
grant of presidential power to veto a bill (‘‘he shall sign it, but
if not he shall return it’’) had reference to the bill ‘‘in toto.’’ See
Clinton v. City of New York, 985 F. Supp. 168, Doc 98-6115, 98
TNT 30-11 (D.D.C. 1998), aff’d, 522 U.S. 1144.
7
976 • December 3, 2007
item of purchased property — say, a tire — is not
demolished, but instead becomes a component of the
final product. In those intermediate cases, the component retains some or all of its identity and may
even carry a separate warranty. A practical rule is
needed to draw as bright a line as possible between
the sale of an assembled product and a sale of its
component parts. Although the IRS has some linedrawing discretion, that discretion must be guided
by the applicable legislative history, which states
that ‘‘major assembling’’ is sufficient to remove purchased components from the purview of section
954(d)(1).9
The current FBCSI regulations deal with the two
extreme cases, as well as the intermediate case.
Income from selling personal property that was
merely packaged, repackaged, or labeled may constitute FBCSI.10 Income from selling purchased
property after it has been ‘‘substantially transformed’’ does not constitute FBCSI.11 In the intermediate case, when purchased property becomes a
component part of an assembled product, the line is
drawn between minor assembly, after which income
from selling the assembled product may be FBCSI,
and assembly that is ‘‘generally considered to constitute the manufacture, production, or construction
of property,’’ which cannot give rise to FBCSI.12
The Manufacturing Exception
The guidelines in the regulations for distinguishing the extreme and intermediate degrees of transformation, and the accompanying examples, are
reasonable and useful. However, the manner in
which the distinctions are drawn has caused some
confusion. Instead of using manufacturing as a
benchmark for whether sufficient transformation of
purchased property has occurred, the regulations
posit an exception to section 954(d)(1) for manufacturing (the manufacturing exception) and then use
the extent of transformation as a benchmark for
whether sufficient manufacturing has occurred:
Foreign base company sales income does not
include income of a [CFC] derived in connection with the sale of personal property manufactured . . . by such corporation in whole or in
part from personal property which it has purchased. A foreign corporation will be considered, for purposes of this paragraph, to have
manufactured . . . personal property which it
9
S. Rep. No. 1881, 87th Cong., 2d Sess., 84 (1962).
Reg. section 1.954-3(a)(4)(iii).
11
Reg. section 1.954-3(a)(4)(ii).
12
Reg. section 1.954-3(a)(4)(iii).
10
Tax Notes International
(C) Tax Analysts 2007. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
incorporation (the origin requirement).6 Property
that is sold by a CFC distributor or purchased by a
CFC sales agent is covered only if the property was
sold or purchased for use, consumption, or disposition outside that country (the destination requirement).7
When property that is purchased by a CFC is
transformed into, or becomes a part of, something
that is naturally considered to be a different kind of
property, it is reasonable to ask whether the sale of
that different kind of property would fall within the
scope of ‘‘the purchase of personal property . . . and
its sale.’’ The pronoun ‘‘its’’ in ‘‘its sale’’ cannot be
ignored, and, if it means anything, it is that the
property sold by the CFC must in some sense be the
same property that was purchased by the CFC.8
Special Reports
The Manufacturing Requirement
The Manufacturing Example
The manufacturing exception, as laid out in the
regulations, does not rule out an exception for other
situations in which the property sold is in effect not
the property that was purchased, such as when
purchased property is substantially transformed by
a contract manufacturer. However, in recent IRS
guidance, the manufacturing exception has become,
in effect, a manufacturing requirement. According to
FSA 200220005:
In any event, the legislative history does not,
when read in its entirety, appear to authorize a
manufacturing exception to section 954(d)(1), let
alone a manufacturing requirement. The operative
language of section 954(d)(1) was essentially the
same in both the House and Senate versions of the
act, and the reports of both the House Ways and
Means Committee and the Senate Finance Committee contain nearly identical descriptions of the rule:
The ‘‘foreign base company sales income’’ referred to here means income from the purchase
The regulations provide different rules for purchased property that is substantially transformed,
thereby losing its separate identity, and purchased
property that becomes a component part of an assembled product, without losing its separate identity. If raw materials are substantially transformed
before being sold, the sale of the final product will
qualify for the manufacturing exception, seemingly
without regard to the extent of manufacturing operations:
If purchased property is substantially transformed prior to sale, the property sold will be
treated as having been manufactured . . . by
the selling corporation.14
If, instead of being substantially transformed, the
purchased property becomes a component part of an
assembled product, qualification for the manufacturing exception depends not on the extent of transformation, but on the nature and extent of the
assembly operations:
The manufacturing exception contained in
Treas. Reg. [section] 1.954-3(a)(4) . . . carves
out sales income derived from purchases of raw
16
13
Reg. section 1.954-3(a)(4)(i).
Reg. section 1.954-3(a)(4)(ii).
15
Reg. section 1.954-3(a)(4)(iii).
14
Tax Notes International
FSA 200220005, Doc 2002-12025, 2002 WTD 98-27 (emphasis supplied).
17
See, e.g., sections 543(a)(1)(C), 864(c)(4)(B)(i), 865(f)(2),
901(l)(2)(A), 936(a)(1)(A)(i), 954(c)(2)(A), and 954(h)(2)(A)(i).
18
FSA 200220005, note 16 supra.
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If purchased property is used as a component
part of personal property which is sold, the sale
of the property will be treated as the sale of a
manufactured product, rather than the sale of
component parts, if the operations conducted
by the selling corporation in connection with
the property purchased and the property sold
are substantial in nature and are generally
considered to constitute the manufacture . . . of
property.15
materials and sales of finished products from
FBCSI only to the extent the CFC qualifies as a
manufacturer.16
A necessary condition of this manufacturing requirement is that the statutory phrase ‘‘purchase of
personal property . . . and its sale’’ can be read to
include ‘‘purchases of raw materials and sales of
finished products.’’ This strained and implausible
reading is easily reduced to an absurdity. For example, if a CFC supplies coal to power the factory of
a contract manufacturer that supplies it with tractors, is the CFC engaged in the ‘‘purchase of coal
. . . and its sale’’ when it sells the tractors?
This expansive reading of the statute raises important collateral issues. First, when Congress or
the IRS intend that an operation be conducted by
the taxpayer’s own employees or officers, as opposed
to independent contractors, it ordinarily prescribes
the ‘‘active’’ conduct of the operation,17 yet neither
section 954(d)(1) nor the FBCSI regulations contains
that prescription. Are we being told that ‘‘active’’ no
longer serves that prescriptive function?
Second, if the statutory definition of FBCSI really
does cover the purchase of raw materials and the
sale of a finished product, then on what authority
does the IRS carve out any manufacturing exception
at all? Section 954(d)(1) does not contain the word
‘‘except’’ and does not even contain the word ‘‘manufacture’’ (except as part of the origin requirement).
According to the IRS, the authority for the manufacturing exception is the discussion of CFC manufacturing in the legislative history of the Revenue Act of
1962.18 However, legislative history is questionable
authority for drafting exceptions to statutory rules
when, as in this case, Congress has not seen fit to
authorize legislative regulations.
sells if the property sold is in effect not the
property which it purchased.13
Special Reports
The Transformation Exception
What was the purpose and effect of the manufacturing example: (1) to authorize a manufacturing
exception to a general rule that treats the purchase
of raw materials and the sale of a finished product as
giving rise to FBCSI or (2) to illustrate a broader
transformation exception based on the commonsense principle that the sale of a finished product
does not constitute a sale of the raw materials? The
main texts of the committee report do not answer
this question because they offer the manufacturing
example without explaining its premise. Fortunately, the technical explanation that was appended
to the House report lays out that premise explicitly:
Since the definition of foreign base company
sales income covers only transactions involving
both a purchase and a sale, it does not apply to
income of a [CFC] from the sale of a product
which it manufactures. In a case in which a
[CFC] purchases parts or materials which it
then transforms or incorporates into a final
product, income from the sale of the final
product would not be foreign base company
sales income if the corporation substantially
transforms the parts or materials, so that, in
effect, the final product is not the product
purchased.20
There is only one way to read the first sentence:
Manufacturing income is not FBCSI because manufacturing does not entail ‘‘both a purchase and a
sale.’’ The first sentence would not be true if a
manufacturer could be regarded as having sold the
raw materials that it purchased or having purchased the final product that it sold. The necessary
premise of the technical explanation is that ‘‘the
purchase of personal property . . . and its sale’’ does
not include ‘‘purchases of raw materials and the sale
of finished products.’’
19
H.R. Rep. No. 1447, 87th Cong., 2d Sess., 62 (1962)
(emphasis added); S. Rep. No. 1881, note 9 supra, at 84
(emphasis added).
20
H.R. Rep. No. 1447, note 19 supra, A94 (emphasis
added).
978 • December 3, 2007
In summary, to justify the manufacturing exception described in FSA 200220005, the IRS (1) must
first expand the definition of FBCSI through a
strained reading of ‘‘its sale,’’ so that a sale of olive
oil is treated as a sale of olives, (2) must then carve
out from this unnaturally expanded definition a
statutorily unauthorized exception for ‘‘manufacturing’’ based on an example in the legislative history,
and (3) must then impose on this unauthorized
exception an ‘‘active’’ requirement that is not mentioned in the example. In comparison, a transformation exception is naturally construed from ‘‘the purchase of personal property . . . and its sale’’ and
follows directly from the technical explanation of the
manufacturing example.
Based on a plain but careful
reading of the statute and its
legislative history, the
transformation exception trumps
the manufacturing exception.
Based on a plain but careful reading of the statute
and its legislative history, the transformation exception trumps the manufacturing exception. If so, the
substantial transformation of raw materials purchased by a CFC, or the major assembly of component parts purchased by a CFC, should exclude from
FBCSI the CFC’s income from selling the final
product, without regard to how, or by whom, the
transformation or assembly was accomplished.
Contract Manufacturing
If a CFC actively manufactures the property that
it sells, it does not matter whether the sales income
is excluded from FBCSI by a transformation exception or a manufacturing exception. The same is true
when the CFC enters into a standard contract
manufacturing arrangement in which the manufacturer produces to the CFC’s specifications, but purchases and owns the raw materials and sells the
manufactured product to the CFC for an agreed
price. Given those arrangements, the CFC is regarded as having engaged in the purchase of personal property from the contract manufacturer, and
the pertinent questions are whether the contract
manufacturer is a related person and whether it
conducted its manufacturing activities outside the
CFC’s country of incorporation.
The difference between the manufacturing exception and the transformation exception becomes relevant when the manufacturing contract is a toll or
consignment contract in which some or all of the raw
materials belong to the CFC. In a pure tolling
arrangement, the CFC purchases all the raw materials and consigns them to the toll manufacturer
Tax Notes International
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and sale of property, without any appreciable
value being added to the product by the selling
corporation. This does not, for example, include
cases where any significant amount of manufacturing, installation [‘‘major assembling’’ in
the Senate version], or construction activity is
carried on with respect to the product by the
selling corporation.19
Thus, when one searches the committee reports for a
manufacturing exception to FBCSI, one finds instead a manufacturing example.
Special Reports
Toll manufacturing presents a different set of
questions than standard contract manufacturing.
Because the CFC is purchasing services, rather than
personal property, from the toll manufacturer, it is
not relevant to ask where the toll manufacturing
occurred or whether the toll manufacturer and the
CFC are related persons. Manufacturing in the
CFC’s country of incorporation does not avoid
FBCSI, nor does using an unrelated toll manufacturer. That the outsourcing of manufacturing functions to an unrelated toll manufacturer may convert
manufacturing income into FBCSI is a peculiar
consequence of the IRS’s manufacturing exception.
According to the 1962 committee reports, the income
that ‘‘primarily concerned’’ the taxwriting committees was ‘‘income of a selling subsidiary . . . which
has been separated from manufacturing activities of
a related corporation.’’21
To be sure, a CFC’s use of a related toll manufacturer’s services does entail a separation of CFC sales
income from related-person manufacturing income
that is economically identical to the arrangements
at which section 954(d)(1) is aimed. Indeed, after the
House had approved section 954(d)(1), which targeted intercompany purchases of manufactured
property, the Senate Finance Committee was
warned by the Treasury Department that intercompany purchases were not the only means by which a
multinational enterprise might separate sales and
manufacturing income.22 However, the committee
acted to close that potential loophole, not by expanding the scope of transactions that triggered section
954(d)(1), but by supplementing the intercompanypurchase rule of section 954(d)(1) with the branch
rule of section 954(d)(2). As noted at the outset of
this report, the IRS has already unsuccessfully tried
to use the branch rule to extend section 954(d) to
CFCs that use contract manufacturers.23 Having
failed to capture its quarry under the special rule
that Congress fashioned to cover de facto separations of sales and manufacturing income, the IRS
will not likely succeed under the general
intercompany-purchase rule.
21
Id. at 62 (emphasis added); S. Rep. No. 1881, note 9
supra, at 84.
22
Draft of statutory language, with accompanying explanation, of amendments proposed by the secretary of the
Treasury, Sen. Fin. Comm. Print, 87th Cong., 2d Sess., 2
(1962).
23
Ashland Oil, note 3 supra; Vetco, note 3 supra.
Tax Notes International
Practical Considerations
In casting the transformation exception as a
manufacturing exception, the IRS created an array
of complex interpretive problems. If a CFC outsources some manufacturing functions, what other
functions might the CFC perform and still qualify
for the manufacturing exception, and what quantum
of performance would be sufficient? Is outsourcing to
unrelated toll manufacturers to be placed on a better
footing than outsourcing to related contract manufacturers, as one might expect given the concerns of
Congress? If the CFC supplies some, but not all, of
the raw materials to its contract manufacturer, how
much of the sales profit is FBCSI?
This sort of line-drawing is challenging enough
when the statute itself requires active participation
by the taxpayer, but in those cases the IRS has no
choice and may turn at least to legislative intent for
guidance on where to draw the line. Unfortunately,
because neither section 954(d)(1) nor its legislative
history actually envisions a manufacturing exception, there is no standard to which the IRS may
resort to help define the scope of the exception it has
manufactured.
The Manufacturing Branch
The so-called branch rule of section 954(d)(2) was
not in the House version of the subpart F legislation.
It was one of several amendments to the House
version that were proposed by Treasury24 and added
by the Senate.25 Section 954(d)(2) provides:
For purposes of determining foreign base company sales income in situations in which the
carrying on of activities by a [CFC] through a
branch or similar establishment outside the
country of incorporation of the [CFC] has substantially the same effect as if such branch or
similar establishment were a wholly owned
subsidiary corporation deriving such income,
under regulations prescribed by the Secretary
the income attributable to the carrying on of
such activities of such branch or similar establishment shall be treated as income derived by
a wholly owned subsidiary of the [CFC] and
shall constitute foreign base company sales
income of the [CFC].
The current regulations apply the branch rule to
a manufacturing CFC that separates its selling
activities, its manufacturing activities, or both, into
24
Draft of statutory language, note 22 supra, at 2, 11.
S. Rep. No. 1881, note 9 supra, at 84.
25
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for processing into a finished or semifinished product. In that model, the purchase of personal property
that is relevant for section 954(d)(1) is the CFC’s
purchase of the raw materials; the final product is
not purchased from anyone.
Special Reports
FBCSI not the income of the manufacturing branch,
but the income of the remainder of the CFC.28
Conclusions
Admittedly, the interpretations of section 954(d)
advanced here would leave untouched by subpart F
several cross-border arrangements that present the
same ‘‘abuses’’ as the arrangements expressly targeted by the FBCSI rules. Nevertheless, statutory
rules from the early 1960s that targeted specific
business arrangements prevalent in the late 1950s
cannot be expected to cover every perceived deferral
abuse by a 21st-century super-entrepreneur in a
check-the-box world. Stretching the statute to reach
those cases may prolong the reign of confusion and
ultimately be rebuffed by the courts.
Even from the standpoint of policy, what is gained
by pushing section 954(d) to the edge of the interpretive envelope? According to the House report, the
foreign base company abuses that concerned Congress could be in part managed through improved
enforcement of the arm’s-length standard.29 Any
concern of the IRS that the 1962 foreign base company rules failed to contemplate every perceived
abuse of foreign sales subsidiaries is mitigated by
the subsequent enhancements in the Service’s
transfer pricing enforcement powers, including
statutory penalties and documentation requirements, not to mention the unfolding story of Financial Accounting Standards Board Interpretation No.
48 disclosures.
If modern transfer pricing enforcement effectively
limits a CFC’s income to arm’s-length compensation
of functions actually performed by the CFC, what
abuse is occasioned by toll manufacturing? Denying
to U.S. multinationals the privilege of deferring the
inclusion of arm’s-length profits from sales functions
located in low-taxed jurisdictions is a worse than
useless policy. The U.S. tax on profits from those
activities is not just deferred, it is lost forever,
because U.S. multinationals are eventually forced to
cede those activities to foreign competitors whose
governments permit them to reap the tax savings
and incorporate them into product prices. We have
learned a lot about globalization since 1962.
◆
26
Reg. section 1.954-3(a)(c).
See Charles I. Kingson, ‘‘IRS Premises on Contract
Manufacturing Are Wrong,’’ Tax Notes Int’l, June 25, 2007, p.
1331, Doc 2007-14385, 2007 WTD 123-9.
27
980 • December 3, 2007
28
Reg. section 1.954-3(b)(2)(ii)(c).
H.R. Rep. No. 1447, note 19 supra, at 58.
29
Tax Notes International
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one or more branches that result in a lower effective
tax rate for the sales income than for the manufacturing income.26
There is nothing to be said against application of
the branch rule to CFCs with low-taxed sales
branches, whether the manufacturing is performed
in the home country or in another branch. However,
application of the rule to a CFC with a manufacturing branch, but no sales branch, is simply invalid.
No doubt, a buy/sell CFC that operates a manufacturing branch, including in the form of a disregarded
subsidiary, presents a separation of selling and
manufacturing income within the same multinational group, which was the result with which the
taxwriting committees were ‘‘principally concerned.’’
Nevertheless, section 954(d)(2) simply cannot be
read under any canon of statutory interpretation as
extending to that set of facts.
In the first place, the predicate for the branch rule
is that the use of the branch have ‘‘substantially the
same effect’’ as if the branch were a subsidiary
corporation deriving ‘‘such income’’ — that is, a
subsidiary corporation deriving FBCSI, or a sales
subsidiary. Only by an interpretive leap could one
conclude that an incorporated branch deriving
manufacturing income has substantially the same
effect as a subsidiary deriving sales income.27
In the second place, after completing the interpretative leap, the interpreter comes face to face with a
bizarre consequence. If ‘‘the carrying on of activities
. . . through a branch or similar establishment’’ did
include the carrying on of manufacturing activities
through a manufacturing branch, the consequence
under section 954(d)(2) would be that the income
attributable to the carrying on of those activities —
that is, the manufacturing income of the manufacturing branch — is classified as FBCSI and is
includable in the income of the U.S. shareholders!
No one, to my knowledge, has ever claimed that
section 954(d)(2) converts manufacturing income
into sales income. The FBCSI regulations themselves avoid that absurd result only by ignoring the
express language of the statute and treating as