Company Sales

					                                                     LEWIS J. GREENWALD,
                                                   D O U G L A S S . S T R A N S K Y,
                                                         AND TENLEY OLDAK




                                                FOREIGN BASE
                                              COMPANY SALES
                                         THE FABULOUS INCOME
                                         NEW “SUBSTANTIAL
                                         CONTRIBUTION” TEST
                                             Assuming the requisite                 Since the IRS revoked Rev. Rul. 75-7,          company will be able to claim the man-
                                          “boots on the ground,” the
                                              key to success will be                1975-1 CB 244, with Rev. Rul. 97-48,           ufacturing exception to FBCSI if it can
                                               documentation,
                                                                                    1997-2 CB 89, abattlehasraged as to            demonstrate that it has made a“substan-
                                               documentation,
                                               documentation.                           whether a controlled foreign corporation   tial contribution” to the manufacturing

                                                                                        (CFC)/principal company can ever claim     process (“substantial contribution”test).

                                                                                        the manufacturing exception to foreign        This article first reviews the basics of

                                                                                        base company sales income (FBCSI) if it    FBCSI and the manufacturing exception

                                                                                        produces a product with the assistance     thereto, and then the Proposed Regula-

                                                                                        of one of more contract manufacturers.1    tions (the Preamble, the fabulous new

                                                                                           Mercifully, on February 27, 2008, the   “substantial contribution” test, and the

                                                                                    IRS and Treasury issued Proposed Reg-          four illustrative examples). The article

                                                                                    ulations, which, inter alia , answer that      concludes with some thoughts and

                                                                                    question in the affirmative.2 Under the        observations as to meeting the require-

                                                                                        Proposed Regulations, a CFC/principal      ments of the new test.




20   JOURNAL OF INTERNATIONAL TAXATION                                                                                                                 JOURNAL OF INTERNATIONAL TAXATION   21
     FBCSI                                                                Under the“substantial transformation”                                                                                                                                                      a finished good, was considered perform-
     In general, if a foreign corporation is a                        test of Reg. 1.954-3(a)(4)(ii), if personal                                                                                                                                                    ance by the CFC. The CFC would, there-
     CFC, a person who is a U.S. shareholder                          property is substantially transformed pri-                                                                                                                                                     fore, be treated as having substantially
     must include in gross income its pro rata                        or to sale, the property sold will be treat-                                                                                                                                                   transformed personal property. The Rul-
     share of the corporation’s Subpart F                             ed as having been manufactured by the                                                                                                                                                          ing further concluded that, because the
     income.3 For this purpose, “Subpart F                            selling corporation.Examples of substan-                                                                                                                                                       CFC conducted the manufacturing activ-
     income” includes, inter alia , foreign base                      tial transformation include the conversion                                                                                                                                                     ity outside its country of organization, it
     company income.4 Foreign base compa-                             of wood pulp into paper, steel rods into                                                                                                                                                       was considered to do so through a branch
     ny income includes, inter alia , FBCSI.5                         screws, and tuna fish into canned tuna.11                                                                                                                                                      or similar establishment. Because the
         FBCSI is income (whether in the form                             Under the “substantive” test and safe                                                                                                                                                      “manufacturing branch tax rate dispari-
     of profits, commissions, fees, or other-                         harbor of Reg. 1.954-3(a)(4)(iii), person-                                                                                                                                                     ty” test was not satisfied, however, the
     wise) derived in connection with one of                          al property will be treated as the sale of a                                                                                                                                                   activities of the “branch” were not con-
     the following:                                                   product manufactured by the CFC (rather                                                                                                                                                        sidered the activities of a separate CFC.
      • The purchase of personal property                             than the sale of component parts) if the                                                                                                                                                       The CFC was, therefore, entitled to the
         from a related person and its sale to                        operations conducted by the CFC in con-                                                                                                                                                        manufacturing exception from FBCSI.18
         any person.                                                  nection with the property are“substantial                                                                                                                                                          In Ashland Oil, Inc., 95 TC 348 (1990),
      • The sale of personal property to any                          in nature”and generally considered to con-                                                                                                                                                     the Tax Court held that an unrelated man-
         person on behalf of a related person.                        stitute the manufacture of the property.                                                                                                                                                       ufacturing corporation in a contract man-
      • The purchase of personal property                             Under the safe harbor,without limiting the                                                                                                                                                     ufacturing arrangement with a CFC
         from any person and its sale to a relat-                     application of the “substantive” test, the                                                                                                                                                     cannot be treated as the CFC’s branch or
         ed person.                                                   operations of a selling corporation in con-                                                                                                                                                    similar establishment.In Vetco, Inc.,95 TC
      • The purchase of personal property                             nection with the use of purchased proper-                                                                                                                                                      579 (1990), the Tax Court held that a
         from any person on behalf of a relat-                        ty as a component part of the personal                                                                                                                                                         wholly owned subsidiary of a CFC in a
         ed person where the purchased/sold                           property that is sold will be considered to                                                                                                                                                    contract manufacturing arrangement
         property is (1) manufactured outside                         constitute the manufacture of a product if,                                                                                                                                                    with the CFC also cannot be treated as the
         the CFC’s country of organization                            in connection with such property conver-                                                                                                                                                       CFC’s branch or similar establishment.19
         and (2) consumed outside the CFC’s                           sion costs (direct labor and factory bur-                                                                                                                                                          In Rev. Rul. 97-48, the IRS announced
         country of incorporation.6                                   den), the costs account for 20% or more                                                                                                                                                        that it would follow the Ashland Oil and
         Thus, FBCSI does not include income                          of the total cost of goods sold.12 In no                                                                                                                                                       Vetco decisions, although it concluded
     derived in connection with the purchase                          event, however, will mere packaging,                                                                                                                                                           that the activities of a contract manufac-
     and sale of personal property if that                            prepackaging,labeling,or minor assembly                                                                                                                                                        turer cannot be attributed to a CFC to
     property is manufactured in the CFC’s                            operations constitute the manufacture of                                                                                                                                                       determine whether the CFC’s income is
     country of incorporation.7 FBCSI also                            personal property.13 The assembly of auto-                                                                                                                                                     FBCSI. Thus, Rev. Rul. 75-7 was revoked.
     does not include income derived in con-                          mobiles from component parts is an             turing activities in a high-tax jurisdic-     subsidiary, the branch and the remain-         Rev. Rul. 75-7, Ashland                            Also, the IRS cautioned that it never
     nection with the purchase and sale of                            example of an activity considered “sub-        tion, and selling activities in a low-tax     der of the CFC will be treated as separate     Oil, Vetco, and Rev. Rul. 97-48                    viewed Rev. Rul. 75-7 as allowing a con-
     personal property if the property is man-                        stantial in nature”and generally constitutes   jurisdiction, without incurring FBCSI.        corporations for purposes of determin-         In Rev. Rul. 75-7, the IRS considered a            tract manufacturer’s activities performed
     ufactured, produced, or constructed by                           the manufacture of a product.14                In this situation, the sales income would     ing FBCSI of the CFC. Reg. 1.954-              case in which a CFC purchased raw mate-            outside the CFC’s country of organiza-
     the CFC in whole or in part from person-                                                                        not be FBCSI to the CFC because the           3(b)(1)(ii)(b) provides that the use of a      rial from related persons outside its coun-        tion to be attributed to the CFC without
     al property that it has purchased.8                                                                             same person would be purchasing or            manufacturing branch will be considered        try of organization, contracted with an            treating those activities as performed
                                                                      Branch Rule                                    manufacturing and selling. As such, the       to have substantially the same tax effect      unrelated manufacturer located outside             through a branch of the CFC.20 That said,
                                                                      In addition to the general FBCSI rules of      Branch Rule treats a sales, purchase, or      as if it were the CFC’s wholly owned sub-      its country of organization to process the         the Revenue Ruling does not address the
     Manufacturing Exception                                          Section 954(d)(1), Section 954(d)(2)           manufacturing branch that is located          sidiary if the tax imposed on the income       raw material into a finished product, and          circumstances under which the activities
     In general, a foreign corporation is con-                        provides a special rule for determining        outside the CFC’s country of organiza-        derived by the remainder of the CFC sat-       then sold the finished product to unre-            of the CFC (itself) may qualify as manu-
     sidered to have manufactured the per-                            FBCSI if a CFC carries on activities           tion as a separate corporation, so as to      isfies the“manufacturing branch tax rate       lated persons outside its country of               facturing when a contract manufacturing
     sonal property that it sells if the property                     through a branch (or similar establish-        create a related-party transaction            disparity” test.15                             organization. Under the terms of the               or similar arrangement is in place.
     sold is, in effect, not the personal proper-                     ment) outside its country of organization      between the branch and the remainder              In very general terms, the “manufac-       arrangement, the contract manufacturer
     ty that it purchased.9 Personal property                         and the carrying on of these activities has    of the CFC for purposes of determining        turing branch tax rate disparity” test is      was paid a conversion fee. The raw mate-
     sold will not be considered the property                         substantially the same effect as if the        FBCSI.                                        satisfied if the income earned by the          rial, work in process, and finished prod-          The Fabulous New
     purchased if the provisions of Reg. 1.954-                       branch (or similar establishment) were a           More specifically, with respect to        remainder of the CFC is less than 90%          uct remained the property of the CFC at            “Substantial Contribution” Test
     3(a)(4)(ii) or (iii) are satisfied.10                            wholly owned subsidiary of the CFC             manufacturing branches, Reg. 1.954-           of, and at least five percentage points less   all times. The CFC alone had complete              Since the promulgation of the first final
                                                                      (“Branch Rule”).                               3(b)(1)(ii)(a) provides that if a CFC car-    than, the “hypothetical effective tax          control over the time and quantity of pro-         Regulations under Section 954(d) in
     LEWIS J. GREENWALD and DOUGLAS S. STRAN-
     SKY are tax partners, and TENLEY OLDAK is a tax
                                                                         The purpose of the Branch Rule is to        ries on manufacturing activities by or        rate.”16 The “hypothetical effective tax       duction, as well as complete quality con-          1964, global economic expansion and
     associate, in the Boston office of Sullivan & Worcester          prevent a CFC from using a foreign             through a branch outside its country of       rate” is the effective tax rate that would     trol over the conversion process. The IRS          globalization have led to significant
     LLP. Mr. Greenwald and Mr. Stransky both practice                branch to avoid application of the FBC-        organization, and the use of that branch      apply to this income under the laws of         ruled that the performance of the opera-           changes in manufacturing. Many multi-
     exclusively in the area of international taxation. Mr.
     Greenwald is a member of the Board of Advisors of                SI rules. Absent the Branch Rule, a CFC        has substantially the same tax effect as if   the country where the manufacturing            tions by the contract manufacturer,                national groups have extensive manufac-
     the JOURNAL and a frequent contributor.                          could engage in purchasing or manufac-         the branch were the CFC’s wholly owned        branch is located.17                           whereby raw material was processed into            turing networks that straddle geographic
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     borders. These cross-border manufactur-                                                                                                                                                                                                                                                                                          agement of risk of loss) pursuant to
     ing networks are created primarily to                                                                                                                                                                                                                                                                                            which the property is manufactured,
     leverage expertise and cost efficiencies.                                                                                                                                                                                                                                                                                        produced, or constructed under the
     In addition, contract manufacturing                                                                                                                                                                                                                                                                                              principles of the“substantial transfor-
     arrangements have become a common                                                                                                                                                                                                                                                                                                mation” or “substantive” test.25
     way to manufacture products because of                                                                                                                                                                                                                                                                                        • Performance of activities that are con-
     the flexibility and efficiencies that they                                                                                                                                                                                                                                                                                       sidered in but are insufficient to sat-
     afford.Accordingly, Treasury and the IRS                                                                                                                                                                                                                                                                                         isfy the “substantial transformation”
     understood that updated rules were nec-                                                                                                                                                                                                                                                                                          and “substantive” tests.
     essary to assure the continuing compet-                                                                                                                                                                                                                                                                                       • Control of the raw materials, work-in-
     itiveness of U.S.-based multinationals.21                                                                                                                                                                                                                                                                                        process, and finished goods.
         More specifically, Treasury and the                                                                                                                                                                                                                                                                                       • Management of the manufacturing
     IRS recognized that, due to these busi-                                                                                                                                                                                                                                                                                          profits.26
     ness considerations in the global market-                                                                                                                                                                                                                                                                                     • Material selection.
     place, personal property can be                                                                                                                                                                                                                                                                                               • Vendor selection.
     manufactured pursuant to a contract                                                                                                                                                                                                                                                                                           • Control of logistics.
     manufacturing arrangement under                                                                                                                                                                                                                                                                                               • Quality control.
     which a CFC engages in activities related                                                                                                                                                                                                                                                                                     • Direction of the development, protec-
     to the manufacture of the property (e.g.,                                                                                                                                                                                                                                                                                        tion, and use of trade secrets, technol-
     oversight, direction and control over the                                                                                                                                                                                                                                                                                        ogy, product design, and design
     contract manufacturer), but does not sat-                                                                                                                                                                                                                                                                                        specification, and other intellectual
     isfy the “substantial transformation” or                                                                                                                                                                                                                                                                                         property used in the manufacturing
     “substantive” test. In some of these                                                                                                                                                                                                                                                                                             of the product.27
     instances, Treasury and the IRS now                                                                                                                                                                                                                                                                                              For purposes of the “substantial con-
     believe that the CFC should qualify for                                                                                                                                                                                                                                                                                      tribution” test:
     the manufacturing exception to FBCSI.22                                                                                                                                                                                                                                                                                       • The weight given to any activity will
         Prop. Reg. 1.954-3(a)(4)(i) provides                                                                                                                                                                                                                                                                                         vary with the facts and circumstances
     that, in addition to the“substantial trans-                                                                                                                                                                                                                                                                                      of the particular business.
     formation” and “substantive” tests, a tax-                                                                                                                                                                                                                                                                                    • The presence or absence of any activ-
     payer can now qualify for the                                                                                                                                                                                                                                                                                                    ity, or of a particular number of activ-
     manufacturing exception by satisfying                                                                                                                                                                                                                                                                                            ities, is not dispositive.
     the“substantial contribution”test of Prop.                                                                                                                                                                                                                                                                                    • Although other persons make contri-
     Reg. 1.954-3(a)(4)(iv). Thus, even where                                                                                                                                                                                                                                                                                         butions to the manufacture of person-
     the taxpayer cannot satisfy the “substan-                                                                                                                                                                                                                                                                                        al property prior to sale, the
     tial transformation” and “substantive”                                                                                                                                                                                                                                                                                           CFC/principal company can still
     tests, the taxpayer can be considered to                                                                                                                                                                                                                                                                                         make a substantial contribution to the
     have manufactured personal property for                                                                                                                                                                                                                                                                                          manufacture of that property through
     purposes of the manufacturing excep-                                                                                                                                                                                                                                                                                             the activities of its employees.28
     tion. 23 Pursuant to Prop. Reg. 1.954-                                                                                                                                                                                                                                                                                           “Substantial contribution” test
                                                                      1 Compare FSA 200220005 (February 5, 2002)                                    ”
                                                                                                                                     shareholders. Section 957(a). “United States            9 Id.                                                                     sunglasses; (6) inspected finished sunglasses
     3(a)(4)(iv)(b), a CFC/principal company                                                                                                                                                                                                                                                                                      examples.  The application of the “sub-
                                                                        with, e.g., Brewer, “Logic Does Not Resolve Rev.             shareholder” means, with respect to any foreign         10 Id.                                                                    for cosmetic and functional defects; and (7)
     will satisfy the“substantial contribution”                         Rul. 97-48 Controversy, 78 Tax Notes 121 (Janu-
                                                                                                  ”                                  corporation, a “United States person” (as defined                                                                                 cleaned and packaged sunglasses to prepare                 stantial contribution” test is illustrated
                                                                                                                                                                                             11 Id., Examples (1), (2), and (3).
     test with respect to personal property                             ary 5, 1998); Dolan, “Contract Manufacturing: Is             in Section 957(c)) who owns (under Section
                                                                                                                                                                                             12 Reg. 1.954-3(a)(4)(iii).
                                                                                                                                                                                                                                                                       them for distribution).                                    by four examples in Prop. Reg. 1.954-
                                                                        It Dead or Alive?” 26Tax Mgmt. Int’l J. 195 (1997);          958(a)) or is deemed to own (under Section                                                                                   15   The “sales branch tax rate disparity” test (which
     only if the facts and circumstances evi-                           Dolan, “Battle Over IRS Revocation of Rev. Rul.              958(b)), 10% or more of the voting power of all         13 Id.                                                                                                                               3(a)(4)(iv)(c).
                                                                                                                                                                                                                                                                       applies to sales or purchase branches) is under
     dence that the CFC/principal company                               75-7 Continues, 77Tax Notes 1177 (December 8,
                                                                                         ”                                           classes of shares of the foreign corporation. Sec-      14 Id., Example 2. See also Dave Fischbein Mfg.                           Reg. 1.954-3(b)(1)(i)(b).                                     Example 1: No substantial contribu-
                                                                        1997); Daub, “From the Editor, 8 JOIT 531
                                                                                                              ”                      tion 951(b).
     makes a substantial contribution through                                                                                                                                                   Co., 59 TC 338 (1972), acq. 1973-2 CB 2 (CFC’s                    16   Reg. 1.954-3(b)(1)(ii)(b).                                 tion to manufacturing. (1) Facts. FS, a
                                                                        (December 1997); Yoder, “New IRS Ruling Rocks            4   Section 952(a).                                            assembly of bag-closing machines was sub-                         17
     the activities of its employees to the man-                        the Contract Manufacturing Boat, 9 JOIT 6 (Feb-
                                                                                                            ”                    5   Section 954(a).                                            stantial in nature and generally considered to
                                                                                                                                                                                                                                                                       Id.                                                        CFC, purchases raw materials from a
                                                                        ruary 1998); and Yoder, “Contract Manufacturing                                                                                                                                           18   See Ltr. Rul. 8413062; TAM 8509004.
     ufacture of that property.                                                                                                  6   Section 954(d)(1). For this purpose, a person is a         constitute manufacturing); Bausch & Lomb,                                                                                         related person. CM, an unrelated corpo-
                                                                        Proposed Regs. Add Fuel to the Fire—What                                                                                Inc., TCM 1996-57 (assembly operations of                         19   See Yoder, supra note 1.
         Prop. Reg. 1.954-3(a)(4)(iv)(b) pro-                           Changed?, 9 JOIT 10 (May 1998). See also “TEI
                                                                                     ”                                               related person with respect to a CFC if (1) the
                                                                                                                                                                                                Irish and Hong Kong CFCs found to be sub-                         20
                                                                                                                                                                                                                                                                                                                                  ration that performs the physical conver-
                                                                                                                                     person is, inter alia, a corporation that controls or                                                                             In Rev. Rul. 97-48, the IRS also noted that, with
     vides that the activities of a CFC’s                               Roundtable on the Biggest Issues in Internation-                                                                        s t a n t i a l b e c a u s e t h e a s s e m b l y wo r ke r s                                                                   sion outside FS’s country of organization,
                                                                        al Tax, 19 JOIT 24 (March 2008).
                                                                              ”                                                      is controlled by the CFC; or (2) the person is, inter                                                                                                                  ,
                                                                                                                                                                                                                                                                       the revocation of Rev. Rul. 75-7 its positions on
     employees24 that are to be considered in                                                                                                                                                   received 13 weeks of training and, in each                             the treatment of contract manufacturing for pur-           manufactures the raw materials into
                                                                      2 Prop. Reg. 1.954-3 (REG-124590-07), 73 Fed. Reg.             alia, a corporation that is controlled by the same
                                                                                                                                                                                                location, the CFC (1) leased production facili-                        poses of Section 954(d) and Section 863(b) were
     determining whether the CFC/principal                              10716 (February 28, 2008).                                   person or persons that control the CFC. Section                                                                                                                                              Product X, pursuant to a contract manu-
                                                                                                                                                                                                ties to assemble sunglasses and warehouses                             now harmonized. Under Reg. 1.863-3(c), produc-
                                                                      3 Section 951(a)(1). For this purpose, “controlled             954(d)(3).
     company makes a substantial contribu-                                                                                       7   Reg. 1.954-3(a)(2).
                                                                                                                                                                                                to store finished goods; (2) employed manage-                          tion activity is limited to activity conducted direct-     facturing arrangement. FS then sells
                                                                        foreign corporation” (CFC) means any foreign cor-                                                                       ment teams to prepare production plans and                             ly by the taxpayer.
     tion to the manufacture of personal                                poration if more than 50% of (1) the voting pow-         8   Reg. 1.954-3(a)(4)(i). Hereinafter, “manufactured”         order parts from their suppliers; (3) hired and                   21
                                                                                                                                                                                                                                                                                                                                  Product X for use outside FS’s country of
                                                                                                                                                                                                                                                                       Preamble to Prop. Reg. 1.954-3, 73 Fed. Reg.
     property include, but are not limited to:                          er of all classes of shares of the corporation, or (2)       and “manufacturing” will include “produced” and            trained necessary personnel to carry out their
                                                                                                                                                                                                                                                                       10716 (February 28, 2008).                                 organization.At all times, FS retains con-
                                                                        the value of the stock of the corporation, is                             ”
                                                                                                                                     “producing, “constructed” and “constructing,        ”      operations; (4) inspected purchased parts for
      • Oversight and direction of the activ-                           owned (under Section 958(a)) or is deemed                    “grown” and “growing, and “extracted” and
                                                                                                                                                                 ”                              defects and prepared those parts for assem-
                                                                                                                                                                                                                                                                  22   Id.                                                        trol of the raw material, work-in-process,
         ities or process (including the man-                           owned (under Section 958(b)) by “United States               “extracting.”                                              bly; (5) assembled sunglass parts into finished                   23   Prop. Reg. 1.954-3(a)(4)(iv).                              and finished goods, as well as the intan-
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     gibles used in the conversion process. FS                        Product X. CM uses employees of anoth-                                                                                                                                                                              employees develop and provide to FS all
     retains the right to oversee and direct the                      er corporation to operate its manufactur-                                                                                                                                                                           upgrades to the software and network sys-
     physical conversion of Product X by CM,                          ing plant and convert the raw materials                                                                                                                                                                             tems. DP also has employees who control
     but does not regularly exercise, through                         into Product X. Apart from the physical                                                                                                                                                                             the other aspects of the manufacturing
     its employees, its powers of oversight or                        conversion of the raw materials into                                                                                                                                                                                process, such as product design, vendor
     direction. (2) Result. FS does not satisfy                       Product X, employees of FS perform all                                                                                                                                                                              and material selection, management and
     the“substantial transformation” or“sub-                          of the other activities with respect to the                                                                                                                                                                         retention of the manufacturing profits,
     stantive” test because FS does not,                              manufacture of Product X (for example,                                                                                                                                                                              and selection of the CM. (2) Result. FS
     through the activities of its employees,                         oversight and direction of the manufac-                                                                                                                                                                             does not satisfy the “substantial transfor-
     substantially transform, convert, or                             turing process, control of raw materials,                                                                                                                                                                           mation” or“substantive” test with respect
     assemble personal property into Product                          control of logistics, vendor selection,                                                                                                                                                                             to Product X because FS does not,
     X. However, Product X was manufac-                               quality control). FS sells Product X for                                                                                                                                                                            through its employees’activities,substan-
     tured (by CM), so the “substantial con-                          use, consumption, or disposition outside                                                                                                                                                                            tially transform, convert or assemble per-
     tribution” test applies. FS does not satisfy                     Country M. (2) Result. If the manufactur-                                                                                                                                                                           sonal property into Product X. If the
     the “substantial contribution” test in this                      ing activities undertaken with respect to                                                                                                                                                                           manufacturing activities undertaken with
     example because it does not make a sub-                          Product X between the time that the raw                                                                                                                                                                             respect to Product X between the time
     stantial contribution through the activi-                        materials were purchased and the time                                                                                                                                                                               that the raw materials were purchased and
     ties of its employees to the manufacture                         that Product X was sold were undertaken                                                                                                                                                                             the time that Product X was sold were
     of Product X. Mere contractual owner-                            by FS through its employees’ activities, FS                                                                                                                                                                         undertaken by FS through the activities
     ship of materials, intellectual property,                        would have satisfied the“substantive”test                                                                                                                                                                           of its employees, FS would have satisfied
     and contractual rights to exercise pow-                          with respect to Product X. Therefore, the                                                                                                                                                                           the“substantive”test with respect to Prod-
     ers of direction and control (without the                        “substantial contribution”test applies. FS                                                                                                                                                                          uct X. Therefore, the “substantial contri-
     exercise of those powers) are not suffi-                         satisfies this test because it makes a sub-                                                                                                                                                                         bution” test applies.FS does not satisfy the
     cient. Therefore, FS is not considered to                        stantial contribution through the activi-                                                                                                                                                                           “substantial contribution” test because it
     have manufactured Product X under the                            ties of its employees to the manufacture of                                                                                                                                                                         does not make a substantial contribution
     “substantial contribution” test.                                 Product X. Thus, FS is considered to have                                                                                                                                                                           through its employees’ activities to the
       Example 2: Substantial contribution to                         manufactured Product X. If CM’s manu-                                                                                                                                                                               manufacture of Product X.Mere contrac-
     manufacturing, unrelated manufacturer.                           facturing plant were located in Country                                                                                                                                                                             tual ownership of materials and intellectu-
     (1) Facts. Same as in Example 1, except                          M, the “substantial contribution” test                                                                                                                                                                              al property together with contractual
     that FS, through its employees, is engaged                       could still be satisfied even if CM did not                                                                                                                                                                         rights to exercise powers of direction and
     in product design and quality control.                           manufacture Product X through its                                                                                                                                                                                   control and a small number of technical
     FS’s employees regularly exercise the right                      employees’ activities.                                                                                                                                                                                              employees are not sufficient to satisfy the
     to oversee and direct CM’s activities in                              Example 4: Automated manufacturing.                                                                                                                                                                            “substantial contribution” test. FS’s pri-
     the manufacture of Product X. (2) Result.                        (1) Facts. FS, a CFC, purchases raw mate-                                                                                                                                                                           mary contribution to the manufacture of
     FS does not satisfy the“substantial trans-                       rials from a related person. CM, an unre-                                                                                                                                                                           Product X is the provision of the software
     formation” or “substantive” test with                            lated corporation located outside FS’s                                                       24 Taxpayers have raised concerns as to the defini-
                                                                                                                                                                                                                                                                                          and network systems to CM. Substantial
                                                                                                                                                                                                                                is not there. See Nadal, “Activities Listed in New
     respect to Product X because FS does not,                        country of organization,manufactures the       ment) take orders, route them to CM,             tion of “employee” for this purpose. At the Inter-        Substantial Contribution Test Not Exclusive, Offi-        operational responsibilities and decision-
     through its employees’activities, substan-                       raw materials (under the principles of the     order raw materials, and perform quality         national Tax Institute lunch in New York City on                    ”
                                                                                                                                                                                                                                cials Say, 2008 TNT 73-6 (April 14, 2008).                making are exercised by DP employees
                                                                                                                                                                      April 22, 2008, Michael DiFronzo, Deputy Associ-       26 At a conference sponsored by Boston University
     tially transform, convert, or assemble per-                      “substantial transformation” test) into        control. FS has a small number of com-           ate Chief Counsel (International), said that              School of Law, BNA, and DLA Piper in New York
                                                                                                                                                                                                                                                                                          who direct the activities of the FS employ-
     sonal property into Product X. However,                          Product X, pursuant to a contract manu-        puter technicians who monitor the soft-          “employees” means “somebody, not just some                City, Mr. DiFronzo indicated that “managing the           ees. Thus, FS is not considered to have
                                                                                                                                                                      binder on the shelf ... people clearly within the         manufacturing profits” includes tasks such as
     Product X was manufactured (by CM),                              facturing arrangement.FS then sells Prod-      ware and network systems to ensure that          control of the CFC, boots on the ground, perform-         hedging the raw materials costs, or guarantee-
                                                                                                                                                                                                                                                                                          manufactured Product X.
     so the “substantial contribution” test                           uct X to related and unrelated persons for     they are running smoothly and to apply           ing services at the direction of the CFC. Mr.  ”          ing the use of the contract manufacturer’s plant              Request for comments. In the Pream-
                                                                                                                                                                      DiFronzo also noted that many CFC/principal com-          capacity. See Sheppard, “‘Going Naked’: IRS Offi-
     applies.FS satisfies the“substantial contri-                     use outside FS’s country of organization.      any necessary patches or fixes.Employees         panies, which hold valuable intangibles, are in                                                                     ble to the Proposed Regulations, Treasury
                                                                                                                                                                                                                                cial Expands Contract Manufacturing Comments,      ”
     bution” test because it makes a substantial                      Under the contract manufacturing               of DP, the U.S. corporate parent of FS,          safe low-tax jurisdictions like Switzerland and Sin-      2008 TNT 102-14 (May 21, 2008).                           and the IRS requested comments, inter
                                                                                                                                                                      gapore that require employees in order for tax-
     contribution through the activities of its                       arrangement, CM is responsible for the         developed the software and network sys-          payers to be eligible for their lower tax rates. See
                                                                                                                                                                                                                             27 In light of the list, taxpayers have wondered if the      alia , with respect to the “substantial con-
                                                                                                                                                                                                                                concept of “substantial” is quantitative or quali-
     employees to the manufacture of Prod-                            physical transformation of the raw mate-       tems pursuant to a cost-sharing agree-           Sheppard, “Boots on the Ground: IRS Official
                                                                                                                                                                                                                                tative. Mr. DiFronzo stated (note 24, supra ):
                                                                                                                                                                                                                                                                                          tribution” test and the activities listed in
                                                                                                                                                                      Expands Contract Manufacturing Comments,           ”
     uct X. Therefore, FS is considered to have                       rials into Product X.At all times,FS retains   ment between DP and FS. DP employees             2008 TNT 79-1 (April 22, 2008).                           “Quantitative is not going to hurt you if you have        Prop. Reg. 1.954-3(a)(4)(iv)(b). In par-
                                                                                                                                                                                                                                eight or nine factors, but the key driver is qualita-
     manufactured Product X. This would be                            ownership of the raw material, work-in-        regularly supervise the computer techni-      25 Taxpayers have queried the IRS as to whether
                                                                                                                                                                                                                                tive—what’s the value added?... The weight is on
                                                                                                                                                                                                                                                                                          ticular, comments were requested on
     the same conclusion even if CM were a                            process,and finished goods.FS retains the      cians, evaluate the results of the automat-      this factor (“oversight and direction of activities                                                                 whether one or more safe harbors should
                                                                                                                                                                                                                                                                       ”
                                                                                                                                                                                                                                the value that comes to the process. See Shep-
                                                                                                                                                                      and process”) is the “super”/most important fac-
     corporation that was related to FS.                              right to oversee and direct the physical       ed manufacturing business, and make                                                                        pard, supra note 24. When pressed on this point           be added to the“substantial contribution”
                                                                                                                                                                      tor. At a luncheon sponsored by the District of
                                                                                                                                                                                                                                at the Boston conference, supra note 26, Mr.
                                                                                                                                                                      Columbia Bar Taxation Section’s International Tax
        Example 3: Employees of another per-                          conversion of Product X by CM, but does        ongoing operational decisions,including,         Committee in Washington on April 14, 2008,                DiFronzo noted that Prop. Reg. 1.954-3(a)(4)(iii)         test. In drafting the Proposed Regula-
     son. (1) Facts. FS, a CFC organized in                           not regularly exercise,through its employ-     with regard to acceptable performance of         Ethan Atticks, Senior Technical Reviewer, Branch          states that absorbing 20% of conversion costs             tions, Treasury and the IRS considered
                                                                                                                                                                      2, Office of Associated Chief Counsel (Interna-           is enough to make a CFC the physical manufac-
     Country M,purchases raw materials from                           ees, its powers of oversight or direction.     the manufacturing process, stoppages of          tional), explained that oversight is important and        turer of a product. See Sheppard, supra note 26.          several approaches to a safe harbor but
     a related person. CM, an unrelated con-                          FS is the owner of sophisticated software      that process and product and process             that the government was going to make it a                Query whether Mr. DiFronzo has identified the             ultimately requested comments because
                                                                                                                                                                      mandatory factor, but decided against that                safe harbor for purposes of Prop. Reg. 1.954-
     tract manufacturer located in Country C,                         and network systems that remotely and          redesign and updates to meet the needs of        because there could be situations where all of            3(a)(4)(iv).                                              of difficulties in fashioning a safe harbor
     manufactures the raw materials into                              automatically (without human involve-          the business and its customers. DP               the other activities are present but the oversight     28 Prop. Reg. 1.954-3(a)(4)(iv)(a).                          that would be (Continued on page 64)
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     JOURNAL OF INTERNATIONAL TAXATION OCTOBER 2008 FOREIGN BASE COMPANY SALES INCOME                                                                                                                                                                                                                  l              l
                                                                                                                                                                                                                                                                       FOREIGN BASE COMPANY SALES INCOME OCTOBER 2008 JOURNAL OF INTERNATIONAL TAXATION   27
     Foreign Base Company Sales Income
     (Continued from page 27) flexible                                80% or more of the manufacturing con-
     enough to apply across various industries                        tribution (90% here—45/50). Treasury
     and a range of different types of manu-                          and the IRS considered such a rule but
     facturing. Among the safe harbors con-                           ultimately did not include it in the Pro-
     sidered were (1) a list of mandatory                             posed Regulations. Comments were
     activities; (2) a cost-based test; (3) a com-                    requested on whether such a rule should
     pensation-based test; (4) a value-based                          be added to the final Regulations.32
     test; (5) a tax-rate-disparity-based test;                           Effective date. The Proposed Regula-
     and (6) a percentage-based test compar-                          tions will be effective for tax years of a
     ing the compensation paid to employees                           CFC/principal company that begin on
     of the CFC for performing activities relat-                      or after the date that the Proposed Reg-
     ed to the manufacturing process vs. the                          ulations are published as final Regula-
     total cost for all activities related to the                     tions.33 Until then, taxpayers have the
     manufacturing process (including cost                            option of applying them (in their entire-
     paid to a contract manufacturer but                              ty) to all open tax years as if they were         company has regularly exercised over-
     excluding the cost of raw materials and                          final Regulations.34                              sight and direction over the manufactur-
     marketing intangibles).29                                                                                          ing activities or process should be very
         In addition, Treasur y and IRS                                                                                 helpful. Similarly, even though IRS offi-
     requested comments on whether the                                Thoughts and Observations on                      cials have insisted that the “substantial
     requirement under the manufacturing                              Meeting the Fabulous New                          contribution”test is qualitative, not quan-
     exception (that the employees of the CFC                         ”Substantial Contribution” Test                   titative,37 a bundle of activities should
     perform its activities) should be expand-                        Now that we have the fabulous new “sub-           also be very helpful.38 And while there are
     ed to include individuals that are not on                        stantial contribution” test, the immediate        currently no safe harbors, the contribu-
     the CFC’s payroll but are controlled by                          question that arises is how to ensure suc-        tion by the CFC/principal company
     the CFC’s employees.30                                           cess. What activities and what amount of          should never fall below 20% of conver-
         Finally, comments were requested on                          activities will be enough to be“substantial”?     sion costs (the Prop. Reg. 1.954-
     whether it would be appropriate to add                               As Mr. DiFronzo rightly noted, 35             3(a)(4)(iii) test),39 and the contribution
     an anti-abuse rule (similar to the one in                        “boots on the ground,” coupled with the           by related U.S. persons should never
     Notice 2007-13, 2007-5 IRB 410)31 to                             exercise of significant decision making           exceed 80% of total conversion costs.40
     prevent a CFC/principal company from                             authority, is required to secure the tax              Finally, assuming the requisite“boots
     meeting the “substantial contribution”                           benefits in countries such as Ireland and         on the ground,” the key to success will be
     test where one or more related U.S. per-                         Switzerland. U.S. taxpayers that have             documentation, documentation, docu-
     sons supply substantially all of the direct                      established principal companies in those          mentation. Minuted board meetings,
     or indirect contributions to the manu-                           jurisdictions should be very familiar with        where the directors have made decisions
     facturing process. Such a rule might pro-                        these requirements. Having met the                with respect to vendor selection, contract
     vide, for example, that where (1) the U.S.                       local-country requirements, these U.S.            manufacturer selection, and the manu-
     parent of a CFC provides 45% of the                              taxpayers should already have gone a              facturing process, should be in the files.
     manufacturing contribution; (2) the CFC                          long way toward satisfying the“substan-           When applicable, logs/diaries of trips to
     provides 5% of the manufacturing con-                            tial contribution” test.                          the contract manufacturer (where over-
     tribution; and (3) an unrelated contract                             Further, although IRS officials have          sight and direction was exercised) should
     manufacturer provides 50% of the man-                            consistently denied that “oversight and           also be in the files.
     ufacturing contribution, the CFC does                            direction of the manufacturing activities
     not make a substantial contribution                              or process”is the most important/“super”
     because a related U.S. person provided                           factor,36 a showing that the CFC/principal        Conclusion
                                                                                                                        The fabulous new “substantial contribu-
     29 See note 21, supra.                                           32 See note 21, supra.
                                                                                                                        tion” test provides significant planning
     30 Id.                                                           33 Prop. Reg. 1.954-3(a)(4)(iv)(d).
     31 Under Notice 2007-13, a CFC will not be deemed                34 See note 21, supra.
                                                                                                                        opportunities for U.S.-based multina-
        to have received substantial assistance (from its             35 See note 24, supra.                            tionals. As with all U.S. tax planning, if
        U.S. parent or U.S. affiliates) if more than 20% of           36 See note 25, supra.                            getting it right is meaningful (i.e., if the
        the cost of the contract is attributable to servic-
        es furnished by related-party CFCs. See Rollinson,
                                                                      37 See note 27 supra.
                                                                                     ,                                  “substantial contribution” test must be
                                                                      38 Prop. Reg. 1.954-3(a)(4)(iv)(c), Example 3.
        O’Connor, Gordon, and Kilthau, “Notice 2007-13                                                                  met to avoid FBCSI), actions/tweaks to
                                                                      39 See note 27 supra.
                                                                                     ,
        and the Substantial Assistance Rules—A Good
                                                                                                                        existing structures/legal relationships
                                                                                                                        must be taken to ensure success. G
        Start but More Clarification Required, 19 JOIT
                                                  ”                   40 See discussion above under “Request for Com-
        18 (January 2008).                                                     ”
                                                                          ments.

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     JOURNAL OF INTERNATIONAL TAXATION OCTOBER 2008 FOREIGN BASE COMPANY SALES INCOME

				
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