International Tax Bulletin (January 1998)
Contract Manufacturing and Subpart F:
Revokes Revenue Ruling 75-7
By Kerne Matsubara,
now a tax partner in the
San Francisco office of Pillsbury Winthrop
Shaw Pittman LLP.
If you have or can obtain the
you may wish to
download our January 1998 International
Tax Bulletin (a 126K pdf file), containing the printed version of this article and also available
via ftp at ftp.pmstax.com/intl/bull9801.pdf.
This information is only of a general nature, intended simply as background
material, omits many details and special rules and cannot be regarded as legal or tax
One of the concepts underlying the anti-deferral regime of subpart F of the Internal Revenue Code is that U.S. taxpayers should be precluded from deferring U.S. tax on certain categories of income (so-called "subpart F income") earned by their foreign subsidiaries. Subpart F applies to controlled foreign corporations ("CFCs"); a CFC is any foreign corporation more than 50 percent of the stock of which, by vote or value, is owned by "United States shareholders," U.S. persons holding at least ten percent of the total voting power of the stock of the foreign corporation.[fn. 1] Among the categories of "subpart F income" is "foreign base company income," which in turn includes "foreign base company sales income."[fn. 2]
Foreign Base Company Sales Income
Foreign base company sales income is defined as income derived in connection with (i) the purchase of personal property from a related person and its sale to any person, (ii) the sale of personal property to any person on behalf of a related person, (iii) the purchase of personal property from any person and its sale to a related person or (iv) the purchase of personal property from any person on behalf of a related person where:
- "(A) the property which is purchased (or in the case of property sold on behalf of a related person, the property which is sold) is manufactured, produced, grown, or extracted outside the country under the laws of which the controlled foreign corporation is created or organized, and (B) the property is sold for use, consumption, or disposition outside such foreign country, or, in the case of property purchased on behalf of a related person, is purchased for use, consumption, or disposition outside such foreign country."[fn. 3]
The foreign base company sales rules are intended to prevent the artificial shifting of sales income among related parties. Sales income is not considered to have been shifted artificially where that income is earned by a CFC incorporated in the same country as the country in which the relevant property is either manufactured or consumed; hence the so-called "same country" exclusions from foreign base company sales income.
- The Manufacturing Exception
Consistent with the underlying rationale, the implementing regulations provide that foreign base company sales income does not include income from the sale of personal property manufactured, produced or constructed by a CFC in whole or in part from personal property which it has purchased, that is, if the property sold by the CFC is in effect not the property which it purchased.[fn. 4] A CFC is considered to manufacture, produce or construct property if the
purchased property is substantially transformed prior to its sale by the CFC.[fn. 5] This "manufacturing exception" is distinct from the "same country" exclusions described above and means that the U.S. parent of a CFC
can defer U.S. tax on the CFC's "manufacturing income," even if all the CFC's products are sold to related parties.
- The Branch Rule
Internal Revenue Code section 954(d)(2), the so-called "branch rule," contains a significant limitation on the manufacturing exception. It provides:
- "For purposes of determining foreign base company sales income in situations in which the carrying on of activities by a controlled foreign corporation through a branch or similar establishment outside the country of incorporation of the controlled foreign corporation has substantially the same effect as if such branch or similar establishment were a wholly owned subsidiary corporation deriving such income, under regulations prescribed by the Secretary, the income attributable to the carrying on of such activities of such branch or similar establishment shall be treated as income derived by a wholly owned subsidiary of the controlled foreign corporation and shall constitute foreign base company sales income of the controlled foreign corporation."
Without a branch rule, a manufacturing CFC could be incorporated in any tax haven jurisdiction and could in turn establish a branch in some other jurisdiction in which the actual manufacturing operations would be conducted. If the branch happens to be located in a high tax jurisdiction and recognized as a separate taxpayer in that jurisdiction, transfer pricing and other techniques could be utilized to shift income from the branch jurisdiction to the CFC's "home" jurisdiction. What the branch rule does in those types of situations is treat the CFC and its branch as if they were separate corporations; the CFC is then no longer a manufacturer and realizes foreign base company sales income from the purchase of property from a related person (its branch now treated as a wholly owned corporation).
Because the concern behind the branch rule is the shifting of income from a high tax branch jurisdiction to a low or non-tax CFC "home" jurisdiction, regulations provide that the branch rule does not apply where the tax rate in the CFC's "home" jurisdiction is 90 percent or more of (or no less than five percentage points below) the tax rate in the branch's jurisdiction.[fn. 6]
How are these rules applied when a CFC (the "Sponsor") itself does not conduct manufacturing activities, but instead engages a contract manufacturer (the "Contractor")? In a typical contract manufacturing arrangement:
- The Sponsor bears all risk of loss;
- The Sponsor controls the production (quality and quantity);
- The Sponsor owns and provides the raw materials;
- The Sponsor provides any trade secrets, technology or other intellectual property; and
- The Contractor receives a fee and does not share in any profits or losses.
The Service addressed the foreign base company sales income issues raised by contract manufacturing in Revenue Ruling
- Revenue Ruling 75-7
In Revenue Ruling 75-7, corporation X, a CFC, was incorporated in country M. X contracted with unrelated corporation Y, which was incorporated in country O. Under the contract, X paid Y a fee for processing ore into a metal alloy. X bore the risk of loss and completely controlled the time and quantity of production. X had the sole responsibility for arranging the sale of the finished product to third parties. Y was paid a conversion fee and did not share in profits or losses. The effective tax rate in country M was 46 percent and in country O was 38.5 percent.
The Service first ruled that the manufacturing exception applied to the arrangement, reasoning that the ore processing done by Y should be considered as performed by X. In general, under a contract manufacturing arrangement, Y's manufacturing activities can be attributed to X.
The Service also ruled that the activities of Y, the contract manufacturer, gave rise to a branch or similar establishment of X in country O. However, because the effective tax rate in Y's country O (38.5 percent) was actually less than the rate in X's county M (46 percent), the branch rule of Internal Revenue Code section 954(d)(2) did not apply.
- Ashland Oil and Vetco
The application of the branch rule to contract manufacturing arrangements was at issue in a pair of companion 1990 Tax Court cases, Ashland Oil, Inc. v. Commissioner[fn. 8] and Vetco, Inc. v. Commissioner.[fn. 9]
In Ashland Oil, a U.S. corporation organized a wholly owned Liberian subsidiary, which entered into a typical contract manufacturing arrangement with an unrelated Belgian corporation. The Belgian corporation would manufacture certain marine chemical products and the Liberian subsidiary would sell the products to third parties. At issue was whether the Belgian corporation should be treated as a "branch or similar establishment" of the Liberian corporation for purposes of the branch rule.
The Court held that the Belgian corporation was not a "branch" under the branch rule because the ordinary meaning of a "branch" does not include an unrelated corporation operating under an arm's-length contractual arrangement. In addition, the Court held that the Belgian corporation was not a "similar establishment." Here the Court looked to tax treaty concepts of "permanent establishment." The Court reasoned that a contract manufacturer could not be a "branch or similar establishment" of the contracting CFC, because an independent contractor cannot constitute a permanent establishment of its contracting party. The Court reached a similar result in Vetco, which involved a contract manufacturer that was related to the CFC (a wholly owned subsidiary).
The combination of Ashland Oil and particularly Vetco with the first holding in Revenue Ruling 75-7 (i.e., the Sponsor in a contract manufacturing arrangement is a manufacturer) created an extremely favorable planning opportunity: a CFC could be established in a tax haven jurisdiction and could arrange to have its products manufactured under contract by a related contract manufacturer in virtually any jurisdiction. The bulk of the profit from the overall activity could be, and indeed, under the transfer pricing rules of Internal Revenue Code section 482 would be required to be, allocated to the CFC.
- Revenue Ruling 97-48
As one would expect, the Service expressed dissatisfaction with the holdings in Ashland Oil and Vetco and indicated in its business plan that it intended to take action to limit the contract manufacturing exception. The Service was relatively quiet for seven years until November 1997 when it issued Revenue Ruling 97-48,[fn. 10] revoking Revenue Ruling 75-7 effective December 8, 1997. The Service, without much explanation, said that it was following the nonattribution principle established in Ashland Oil and Vetco. Because the Court refused to attribute activities of a contract manufacturer to a sponsoring CFC for branch rule purposes, the Service felt it was inappropriate to attribute such activities to a sponsoring CFC for manufacturing exception purposes. Revenue Ruling 97-48 also states that for taxable years beginning before December 8, 1997, a CFC may continue to rely on Revenue Ruling 75-7 to attribute contract manufacturer activities to the CFC, but only if the CFC treats the contract manufacturer as a "branch or similar establishment" of the CFC for purposes of the branch rule of Internal Revenue Code section 954(d)(2).
There is some surface logical appeal to the IRS proposition that if contract manufacturer activities cannot be attributed for branch purposes then they should not be attributed for manufacturing exception purposes. Unfortunately, this argument ignores one important factor: the reasons for and analysis behind "attribution" are fundamentally different in the two contexts. The reason a Sponsor in a contract manufacturing arrangement can be considered a manufacturer is that the Sponsor, and the Sponsor alone, bears all economic risk associated with the manufacturing endeavor. On the other hand, the branch analysis of Ashland Oil and Vetco turns on traditional income tax treaty notions of permanent establishment. As noted in Ashland Oil, an independent agent is ordinarily not considered a permanent establishment of an offshore party contracting with that independent agent. But it is equally true that the presence of a dependent agent can constitute a permanent establishment of the principal.
The branch analysis should turn on the nature of the relationship between the Sponsor and the Contractor. If that relationship is merely one of dependent agent and principal, then the contract manufacturer should be regarded as a "branch or similar establishment" of the Sponsor. But if the contract manufacturer is truly an independent agent, then it should not be so regarded. Perhaps this approach can offer a way out of the thicket; after all, a contract manufacturer may find it difficult to establish independent agent status in situations where it is related to the Sponsor and does not provide contract manufacturing services to others in the ordinary course of its business.[fn. 11]
- I.R.C. §§ 957(a), 951(b).[return to text]
- I.R.C. §§ 952, 954. Foreign base company income also includes "foreign personal holding company income," "foreign base company services income," "foreign base company shipping income" and "foreign base company oil related income." I.R.C. § 954(a).[return to text]
- I.R.C. § 954(d)(1).[return to text]
- Income Tax Regs. §
1.954-3(a)(4)(i).[return to text]
- Income Tax Regs. §
1.954-3(a)(4)(ii).[return to text]
- Income Tax Regs. §
1.954-3(b)(1)(ii)(b).[return to text]
- 1975-1 C.B. 244.[return to text]
- 95 T.C. 348 (1990).[return to text]
- 95 T.C. 579 (1990).[return to text]
- 1997-49 I.R.B. 5.[return to text]
- See InverWorld, Inc. v. Commissioner, T.C.Memo.
1996-301 (1996), supplemented T.C.Memo. 1997-226 (1997), where a foreign corporation was unable to insulate itself from U.S. effectively connected income because its U.S. affiliates were considered its agents.[return to text]
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