AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

COMMENTS ON

PROPOSED FOREIGN BASE COMPANY SALES INCOME REGULATIONS REGARDING CONTRACT MANUFACTURING ARRANGEMENTS

Approved by

International Tax Technical Resource Panel (TRP)

and

Tax Executive Committee

Developed by

Proposed Contract Manufacturing Regulations Task Force

Ron Dabrowski, Task Force Chair

Joseph M. Calianno

Karen Jacobs

Andy Mattson

Doug Poms

Paul Schmidt,International Tax TRP Chair

Eileen R. Sherr,AICPA Technical Manager

Submitted to the Department of Treasury and Internal Revenue Service

July23, 2008

AICPA COMMENTS ON

FOREIGN BASE COMPANY SALES INCOME REGULATIONS REGARDING CONTRACT MANUFACTURING ARRANGEMENTS

We thank the Internal Revenue Service (Service) and the Department of Treasury (Treasury) for their commendable efforts to undertake a comprehensive update of section 1.954-3 through proposed regulations (theproposed regulations or regulations) dealing with foreign base company sales income (FBCSI), as defined in section 954(d). The proposed regulations address situations in which personal property sold by a controlled foreign corporation (CFC) is manufactured, produced, or constructed under a contract manufacturing arrangement or by one or more branches of the CFC.[1]

The proposed regulations appropriately take note of the way in which multinational corporations structure manufacturing operations in a global economy and add a Substantial Contribution standard (Substantial Contribution) for determining when a CFC is considered to manufacture, produce or construct property. In addition, the proposed regulations attempt to clarify the application of the branch rules to sales transactions involving CFCs with one or more branches.

EXECUTIVE SUMMARY

Our comments make the following recommendations:

  1. The regulations should provide further guidance regarding the non-exclusive factors under the Substantial Contribution test, including what it means to manage the risk of manufacturing profits and to control raw materials, workforce in place, and finished products.
  1. The regulations should be explicit in noting that the application of the factors can vary by industry and that no one factor is per se more important than the others. The examples should be expanded to demonstrate how industry and product specific factors are taken intoaccount.
  1. We support the use of safe harbors on an industry specific basis. It would appear most efficient to develop the safe harbors outside of the regulations (e.g., through revenue rulings or revenue procedures) and upon consultation with taxpayers and industry groups.
  1. The regulations should expand the “employees-only” rule to contemplate the use of non-employee labor (perhaps through a concept of “controlled labor” discussed herein). More specific guidance with respect to the use of non-employees could be done on an industry-specific basis through the revenue ruling or revenue procedure process suggested above.
  1. We do not believe an anti-abuse rule with respect to excess U.S.contributions is necessary. If U.S.persons make excessive contributions, the CFC is unlikely to satisfy the Substantial Contribution test in any event.
  1. There should be affirmative guidance that more than one CFC can satisfy the Substantial Contribution standard with respect to the same item of property.
  1. The regulations should provide further guidance on whether and to what extent a CFC’s Substantial Contribution may create a branch.
  1. With respect to the negative presumption regarding the Substantial Contribution activity of the remainder vis-à-vis a physical manufacturing branch, werecommend doing away with the presumption. There does not appear to be any strong policy reason for imposing a higher standard and such standard would, in effect, penalize CFCs that have certain types of business and operational models.
  1. Regarding the default rule if there is no predominant contribution among non-physical manufacturing branches, we recommend that the determination of whether the branches in the aggregate have the effect of being a subsidiary corporation (under the manufacturing branch rule of section 954(d)(2) and Treas. Reg. sec. 1.954-3(b)(ii)) should be conducted by reference to the weighted average tax rate of all such branches.
  1. We request a clarification of the language in prop. reg. section 1.954-3(a)(4)(iv)(a).
  1. We provide suggested additional examples in three areas:

a.Applying the Substantial Contribution test to “buy/sell” arrangements;

b.Defining what constitutes an employee who may perform activities considered to be a Substantial Contribution to the manufacturing process; and

c.Clarifying that the Substantial Contribution test can be met by a branch of a CFC.

I.Comments Regarding the Substantial Contribution Test

A.Scope of the Substantial Contribution Test

Background

Under section 954(d)(1), FBCSI is defined as income derived by a 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 party, provided that the property is both 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. FBCSI does not include income derived in connection with the sale of personal property that is manufactured, produced or constructed in whole or in part from personal property purchased by the CFC (the “manufacturing exception”).[2] The current regulations provide tests to determine whether a CFC manufactures, produces, or constructs the property it sells and, hence, qualifies for the manufacturing exception.[3] The preamble to the proposed regulations refers to these tests collectively as the “physical manufacturing test.”[4]

The proposed regulations add the Substantial Contribution test to determine the applicability of the manufacturing exception. This test applies to situations in which a CFC does not itself physically manufacture the product but undertakes other activities associated with the physical manufacturing process that may be sufficient to qualify the CFC as a manufacturer.[5] Whether a CFC substantially contributes to the manufacture of a product will be determined on a facts and circumstances basis.[6] The proposed regulations provide a non-exclusive list of nine activities that may be considered in the determination, including “control of raw materials, work in process, and finished goods” and “management of manufacturing profits.[7]

We request clarification of “control of the raw materials, work-in-process and finished goods” and “management of the manufacturing profits.” These factors appear to be similar to those in now obsolete Rev. Rul. 75-7.[8] In that ruling, the Service determined, based on certain factors, that the activities of an unrelated contract manufacturer, Y, to process ore concentrate into a ferroalloy could be considered as performed by X, the contracting CFC.[9]

Control of the raw materials, work-in-process and finished goods

The Service cited the following determinative factors in Rev. Rul. 75-7 allowing for the attribution of the contract manufacturer’s activities to the CFC. These factors could potentially have the same meaning as “control of raw materials, work in process and finished goods” under the proposed regulations:

The ore concentrate, before and during processing, and the finished product remained the sole property of X at all times. X alone purchased all raw material and other ingredients necessary in the processing operation and bore the risk of loss at all times in connection with the operation. Complete control of the time and quantity of production was vested in X. Complete control of the quality of the product was also vested in X, and Y was at all times required to use such processes as were directed by X. X could, when the occasion warranted it, send engineers or technicians to Y's plant to inspect, correct, or advise with regard to the processing of the ore concentrate into the finished product.

In rulings and case law citing Rev. Rul. 75-7, one of the most important factors in determining which entity was the manufacturer for purposes of section 954 was who owned the raw materials, work-in-process and finished goods during the manufacturing process.[10] However, in other rulings applying Rev. Rul. 75-7, who bore the economic risk of loss seemed of greater importance.[11]

The view that control of the raw materials, work-in-process and finished goods does not necessarily mean ownership of such property was affirmed by the Service in a public comment and through the issuance of technical corrections to the proposed regulations.[12]The technical corrections revised Example 3 under prop.reg. section 1.954-3(a)(4)(iv)(c),which illustrates the Substantial Contribution exception. Example 3 is one of four examples in that section describing scenarios under which the CFC will be treated as having satisfied, or as not having satisfied, the Substantial Contribution exception.Under the "result" section of Example 3, the language, "If the manufacturing activities undertaken with respect to Product X between the time the raw materials were purchased and the time Product X was sold …" was changed to "If the manufacturing activities undertaken with respect to Product X prior to sale…." The change seems to suggest that the CFC does not need to purchase and own the raw materials during the manufacturing process in order to satisfy the Substantial Contribution exception. Thus, the change implies that the Substantial Contribution exception can be met by CFCs that enter into true contract manufacturing arrangements (as opposed to consignment manufacturing arrangements).[13]

We request that “control of the raw materials, work-in-process, and finished goods” be clarified to expressly provide that the phrase contemplates the purchase and ownership of raw materials, work-in-process and finished goods and/or bearing economic risk of loss for the property at all phases. We also recommend that the regulations affirmatively provide that holding title is not required in order for a CFC to be considered a manufacturer. This is consistent with rulings issued by the Service applying Rev. Rul. 75-7.[14]

Management of the manufacturing profits

As with “control of the raw materials, work-in-process, and finished goods”, Rev. Rul. 75-7 provides certain factors that may assist in interpreting the phrase “management of the manufacturing profits”:

The negotiation and consummation of the sale of the finished product were solely the responsibility of X. Profits or losses resulting from the sale of the finished product were solely X's. Y's only financial interest in the entire transaction was the fee paid by X for the conversion of the ore. The finished product was sold by X to unrelated parties in foreign countries, other than M, for use, consumption, or disposition in such other foreign countries.

Another commentator also cites to Rev. Rul. 75-7 and states that management of the manufacturing profits may mean that consummation of the sale of the finished product is the sole responsibility of the CFC.[15] In reported public comments, the Service explained the "management of the manufacturing profits," as “appear(ing) to include finance.”[16] On another date, Servicepersonnel were reported to explain that “It appears to be akin to assumption of the risk, though … in China, the principal does not usually own the raw materials that the contract manufacturer processes. Managing the manufacturing profits includes tasks such as hedging the raw materials costs, or guaranteeing the use of the contract manufacturer's plant capacity.”[17]

We recommend that Treasury and the Serviceprovide further guidance regarding the management of manufacturing profits to incorporate the explanations summarized above and the factors listed in Rev. Rul. 75-7.

B.Request for Guidance on Weighing the Section 1.954-3(b) Factors

We agree with the flexible approach of the regulations in making the Substantial Contribution determination a facts and circumstances test. Further, prop. reg. section 1.954-3(b)’s non-exclusivelist of activitiesconsidered in making the Substantial Contribution determination is necessary and helpful to focus taxpayers and Service examiners on the range of non-physical manufacturing activities relevant to such determination. Service and Treasury personnel have indicated that, within the context of the general facts and circumstances test, they view the first activity –oversight and direction – to be a “first-among-equals” factor.[18] While this view might be proven true as a general observation, we believe that the regulations should not depart from the current general facts and circumstances test and affirmatively tip the scale in favor of oversight and direction.

In addition to establishing what activities are relevant, we believe that the proposed regulations should provide explicit guidance on how to weigh the various factors. In particular, the regulations should make clear that the weighting of various activities will depend on the product being manufactured and the activities actually undertaken that contribute to the manufacture of such product. In this regard, certain industries may warrant weighing particular factors over and above the others. For example, in the manufacture of certain pharmaceuticals, quality control and oversight of the regulatory inspection and approval process may prove to be the primary non-physical manufacturing contributions with respect to such products. It may be appropriate to issue industry-specific factor weighting guidance through Revenue Rulings following the finalization of this regulation package.

It would also be useful for the proposed regulations to establish a more definite framework through which a taxpayer can demonstrate that it satisfies the Substantial Contribution standard. For example, the proposed regulations could provide that the determination of whether a CFC satisfies the Substantial Contribution standard is done pursuant to the following three-step process:

  • First, determine all manufacturing contributions that do not constitute physical manufacturing under prop.reg. Section 1.954-3(a)(4)(ii) or (iii) but that are part of the manufacture of a given product.
  • Second, determine the relative importance of the various contributions. This may be done by reference to the relative costs of the contributions, to the relative value-added by the contributions, and/or to any other metric indicative of the relative contributions of the contributing activities.
  • Third, determine the extent to which the CFC performs each of the contributions through its employees and controlled labor (discussed below).

The various examples in theproposed regulations should be revised to reflect this weighing process. As originally drafted, the examples discussed the presence or absence of certain factors and then reach conclusions as to whether the Substantial Contribution test is met. The April 15, 2008, Technical Correction softened this approachin certain examplesby not reaching specific conclusions on the general facts provided.[19] Nevertheless, more comprehensive revisions should be considered. In keeping with the current examples, the revised examples could be generic, reference the general factors that are absent or present, and then discuss the weighing of the factors in the context of the product being manufactured before reaching a conclusion. We have included below a sample revision to prop. reg. section 1.954-3(a)(4)(iv)(c), Example 1 for your consideration. (Revised language is in italics.)

Example 1. No substantial contribution to manufacturing. (i) Facts. FS, a controlled foreign corporation, purchases raw materials from a related person. The raw materials are then manufactured (under the principles of paragraph (a)(4)(iii) of this section) into Product X by CM, an unrelated corporation that performs the physical conversion outside of FS’s country of organization. At all times, FS retains control of the raw material, work-in-process, and finished goods, as well as the intangibles used in the conversion process. FS retains the right to oversee and direct the physical conversion of Product X by CM but does not regularly exercise, through its employees, its powers of oversight or direction.

(ii) Result. FS does not satisfy paragraph (a)(4)(ii) or (a)(4)(iii) of this section because FS does not, through the activities of its employees, substantially transform, convert or assemble personal property into Product X. However, Product X was manufactured (by CM), and therefore this paragraph (a)(4)(iv) applies. FS does not satisfy the test under this paragraph (a)(4)(iv) because, taking into consideration the facts and circumstances relevant to the manufacture of Product X, FS’s activities do not provide a substantial contribution to the manufacture of Product X. In this regard, in the context of the manufacturing process undertaken by FS and CM with regard to Product X, mere contractual ownership of materials and intellectual property and contractual rights to exercise powers of direction and control (without the exercise of those powers) are not sufficient to satisfy this paragraph (a)(4)(iv). Therefore, FS is not considered to have manufactured Product X under paragraph (a)(4)(i) of this section.

C.There Should Be No SafeHarbor for Applying the Substantial Contribution Test

With regard to a safe harbor, we do not believe the proposed regulations should contain one. Given the factually intensive nature of the Substantial Contribution determination and the diverse nature of manufacturing, there is no obvious formula for a safe harbor that would be applicable across industries and yet flexible enough to fairly treat divergent approaches to manufacturing a single product. For certain products or industries, there may be sufficient uniformity in the manufacturing process such that a Substantial Contribution safe harbor could be developed. We recommend that any such safe harbor be developed only with input from the affected manufacturers and their industry groups and outside of this regulation project. It may be appropriate to issue such safe harbor guidance through revenue rulings or revenue procedures following the finalization of this regulation package.

D.Definition of Employees for Purposes of Substantial Contribution

The proposed definition of Substantial Contribution depends on the activities undertaken by the “employees” of the CFC.[20] However, what constitutes an employee in that context is not defined in the proposed regulations.

Often, the definition of employee provided in Rev. Rul. 87-41 (which resembles the common law definition)[21] is the definition applicable under the Code. This definition generally applies for purposes of the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA), and the Collection of Income Tax at Source on Wages.[22] In addition, there are other definitions of employee provided under the Code, including for example, statutory employees such as officers of corporations and the industry specific definitions under section 3121(d)(3). The proposed regulations do not specify what it means to be an employee; without further guidance we believe it is likely over time that “employee” as used in the proposed regulations would be interpreted by IRS agents by reference to the common-law (Rev. Rul. 87-41) standard.