Guidance Regarding Foreign Base Company Sales Income, 10716-10730 [E8-3557]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 73, Number 40 (Thursday, February 28, 2008)]
[Proposed Rules]
[Pages 10716-10730]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E8-3557]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-124590-07]
RIN 1545-BG11


Guidance Regarding Foreign Base Company Sales Income

AGENCY: Internal Revenue Service (IRS), Treasury Department.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations that provide 
guidance relating to foreign base company sales income, as defined in 
section 954(d), in cases in which personal property sold by a 
controlled foreign corporation (CFC) is manufactured, produced, or 
constructed pursuant to a contract manufacturing arrangement or by one 
or more branches of the CFC. These regulations, in general, will affect 
CFCs and their United States shareholders. Certain portions of these 
proposed regulations restate changes to Sec.  1.954-3(a)(4) that were 
contained in former proposed regulations.

DATES: Written or electronic comments and requests for a public hearing 
must be received by May 28, 2008.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-124590-07), Internal 
Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 
20044 or send electronically, via the Federal eRulemaking Portal at 
www.regulations.gov (IRS REG-121509-00).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Ethan Atticks, (202) 622-3840; concerning submissions of comments, 
Kelly Banks, (202) 622-0392 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

A. Foreign Base Company Sales Income

    Under section 951(a)(1)(A)(i), a United States shareholder of a CFC 
includes in gross income its pro rata share of the CFC's subpart F 
income for the CFC's taxable year which ends with or within the taxable 
year of the shareholder. Section 952(a)(2) defines the term ``subpart F 
income'' to mean, in part, ``foreign base company income.'' Section 
954(a)(2) defines ``foreign base company income'' to include foreign 
base company sales income (FBCSI) for the taxable year. Section 
954(d)(1) defines FBCSI to mean income derived by a CFC in connection 
with (1) the purchase of personal property from a related person and 
its sale to any person, (2) the sale of personal property to any person 
on behalf of a related person, (3) the purchase of personal property 
from any person and its sale to a related person, or (4) the purchase 
of personal property from any person on behalf of a related person, 
provided (in all of these cases) that the property both is 
manufactured, produced, grown or extracted outside of the CFC's country 
of organization and is sold for use, consumption or disposition outside 
of such country.
    The Treasury regulations further define FBCSI and the applicable 
exceptions from FBCSI. These exceptions from FBCSI are contained in 
Sec.  1.954-3(a)(2), which addresses personal property manufactured, 
produced, constructed, grown, or extracted within the CFC's country of 
organization (the same country manufacture exception), Sec.  1.954-
3(a)(3), which addresses personal property sold for use, consumption or 
disposition within the CFC's country of organization, and Sec.  1.954-
3(a)(4) which addresses personal property manufactured, produced or 
constructed by the CFC (the manufacturing exception).
    Section 1.954-3(a)(4)(i) provides that FBCSI does not include 
income of a CFC derived in connection with the sale of personal 
property manufactured, produced, or constructed by such corporation in 
whole or in part from personal property which it has purchased. It then 
states generally that a foreign corporation is considered to have 
manufactured, produced, or constructed personal property which it sells 
if the property sold is in effect not the property which it purchased. 
Specifically, Sec.  1.954-3(a)(4)(i) states that personal property sold 
will be considered as not being the property purchased if the 
provisions of Sec.  1.954-3(a)(4)(ii) or (iii) are satisfied.
    Section 1.954-3(a)(4)(ii) and (iii) set forth two separate tests to 
determine whether a CFC is considered to manufacture, produce, or 
construct personal property that it sells. First, Sec.  1.954-
3(a)(4)(ii) sets forth a ``substantial transformation'' test, pursuant 
to which if personal property is substantially transformed prior to 
sale, the property sold will be treated as having been manufactured, 
produced, or constructed by the selling corporation. Examples of 
substantial transformation provided in the regulations include the 
conversion of wood pulp to paper, steel rods to screws and bolts, and 
tuna fish to canned tuna. Second, Sec.  1.954-

[[Page 10717]]

3(a)(4)(iii) sets forth a general ``substantive test'' and a safe 
harbor that apply when purchased property is used by the CFC as a 
component part of personal property that is sold by the CFC. Under the 
substantive test, the sale of personal property will be treated as the 
sale of a product manufactured by the CFC rather than the sale of 
component parts if the operations conducted by the CFC in connection 
with the property are substantial in nature and generally considered to 
constitute the manufacture, production, or construction of the 
property. The assembly of automobiles from component parts is provided 
as an example of an activity considered to be substantial in nature and 
generally considered to constitute the manufacture of a product. Under 
the safe harbor, without limiting the application of the substantive 
test, the operations of a selling corporation in connection with the 
use of purchased property as a component part of the personal property 
that is sold will be considered to constitute the manufacture of a 
product if in connection with such property conversion costs (direct 
labor and factory burden) of such corporation account for 20 percent or 
more of the total cost of goods sold. Section 1.954-3(a)(4)(iii) makes 
clear that, in no event, however, will packaging, prepackaging, 
labeling, or minor assembly operations constitute the manufacture, 
production, or construction of property for purposes of section 
954(d)(1). For purposes of this preamble, satisfaction of the 
requirements of Sec.  1.954-3(a)(4)(ii) or (iii) will be referred to as 
satisfaction of the ``physical manufacturing test.''

B. The Branch Rule

    In addition to the general FBCSI rules of section 954(d)(1), 
section 954(d)(2) provides a special rule for purposes of determining 
FBCSI if a CFC carries on activities through a branch or similar 
establishment outside its country of organization and the carrying on 
of such activities has substantially the same effect as if such branch 
or similar establishment were a wholly owned subsidiary corporation 
(the branch rule). Under the branch rule, to the extent prescribed by 
regulations, the income attributable to the carrying on of such 
activities is treated as income derived by a wholly owned subsidiary of 
the CFC and constitutes FBCSI of the CFC. Section 1.954-3(b)(1)(i) 
(addressing sales or purchase branches) and (ii) (addressing 
manufacturing branches) provide rules on the application of the branch 
rule. The purpose of the branch rule is to prevent a CFC from using a 
foreign branch to avoid the application of the FBCSI rules. Absent the 
branch rule, a CFC could engage in purchasing or manufacturing 
activities with respect to personal property in a high-tax jurisdiction 
and selling activities with respect to the property in a low-tax 
jurisdiction without incurring FBCSI. In such a case, the sales income 
would not be FBCSI to the CFC because the same person would be 
purchasing or manufacturing the personal property and selling the 
personal property. The branch rule therefore treats a sales, purchase, 
or manufacturing branch located outside of the country of organization 
of the CFC as a separate corporation so as to create a related party 
transaction between the branch and the remainder of the CFC for 
purposes of determining FBCSI.
    With respect to manufacturing branches, Sec.  1.954-3(b)(1)(ii)(a) 
provides that if a CFC carries on manufacturing, producing, 
constructing, growing, or extracting activities by or through a branch 
or similar establishment located outside of its country of organization 
and the use of that branch or similar establishment for such activities 
with respect to personal property purchased or sold by or through the 
remainder of the CFC has substantially the same tax effect as if that 
branch or similar establishment were a wholly owned subsidiary 
corporation of such CFC, that branch or similar establishment and the 
remainder of the CFC will be treated as separate corporations for 
purposes of determining FBCSI of such CFC. Section 1.954-3(b)(1)(ii)(b) 
provides that the use of a manufacturing branch or similar 
establishment will be considered to have substantially the same tax 
effect as if it were a wholly owned subsidiary corporation of the CFC 
if the tax imposed on the income derived by the remainder of the CFC 
satisfies the test set forth in Sec.  1.954-3(b)(1)(ii)(b) (the 
manufacturing branch tax rate disparity test). There is also a separate 
tax rate disparity test which applies to sales or purchase branches 
under Sec.  1.954-3(b)(1)(i)(b) (the sales branch tax rate disparity 
test).
    For purposes of the manufacturing branch tax rate disparity test, 
the income considered to be derived by the remainder of the CFC is 
determined first by applying the rules of Sec.  1.954-3(b)(2)(i) which 
treat the CFC and the manufacturing branch as separate corporations, 
and then by determining the income of the CFC that would be FBCSI under 
section 954(d)(1) and Sec.  1.954-3(a)(1) if the CFC and the branch 
were separate corporations (but without applying the exceptions 
contained in Sec.  1.954-3(a)(2), (3), and (4)).
    Specifically, Sec.  1.954-3(b)(2)(i)(a) treats the remainder of the 
CFC and the manufacturing branch as separate corporations. In addition, 
Sec.  1.954-3(b)(2)(i)(b) and (c) deem purchases or sales to be made 
``on behalf of'' a related person to take into account that the 
remainder of the CFC and the branch are treated as separate 
corporations. Section 1.954-3(b)(2)(i)(b) addresses sales and purchase 
branches by treating selling or purchasing activities conducted through 
a branch or similar establishment with respect to personal property as 
performed on behalf of the CFC if the CFC manufactures, produces, 
constructs, grows, extracts, purchases, or sells that same property. 
Section 1.954-3(b)(2)(i)(c) provides a corollary rule addressing 
manufacturing branches, pursuant to which the purchase or sale of 
personal property by the remainder of the CFC is treated as performed 
on behalf of a branch that manufactures, produces, constructs, grows, 
or extracts that property. The general rule of Sec.  1.954-3(a)(1) is 
then applied to determine the income that would be FBCSI if the branch 
and the remainder of the CFC were separate corporations subject to the 
``on behalf of'' related party transactions described above.
    Section 1.954-3(b)(1)(ii)(b) provides that the manufacturing branch 
tax rate disparity test is satisfied if the income that would be FBCSI 
after applying these special rules is taxed in the year when earned at 
an effective rate of tax that is less than 90 percent of, and at least 
5 percentage points less than, the hypothetical effective rate of tax. 
The hypothetical effective rate of tax is the effective rate of tax 
which would apply to such income under the laws of the country in which 
the manufacturing branch is located, if, under the laws of such 
country, the entire income of the CFC were considered derived by such 
CFC from sources within such country from doing business through a 
permanent establishment therein, received in such country, and 
allocable to such permanent establishment, and the CFC were created or 
organized under the laws of, and managed and controlled in, such 
country.
    If the manufacturing branch tax rate disparity test is satisfied, 
Sec.  1.954-3(b)(1)(ii)(a) then treats the branch and the remainder of 
the CFC as separate corporations and the special rules of Sec.  1.954-
3(b)(2)(ii) are applied for purposes of determining FBCSI. Section 
1.954-3(b)(2)(ii)(a) through (c) provide separate CFC and related party 
rules that mirror Sec.  1.954-3(b)(2)(i)(a) through

[[Page 10718]]

(c). Section 1.954-3(b)(2)(ii)(d) through (f) provide special rules to 
prevent double counting of FBCSI and to align treatment of branches 
with the treatment of separate CFCs. In particular, Sec.  1.954-
3(b)(2)(ii)(e) provides that income derived by a branch or similar 
establishment, or by the remainder of the CFC, will not be FBCSI if the 
income would not be so considered if it were derived by a separate CFC 
under like circumstances.

C. Legal Developments

    In Rev. Rul. 75-7 (1975-1 CB 244), revoked by Rev. Rul. 97-48 
(1997-2 CB 89), the IRS considered a case in which a CFC purchased raw 
material from related persons outside of its country of organization, 
contracted with an unrelated manufacturer located outside of its 
country of organization to process the raw material into a finished 
product, and then sold the finished product to unrelated persons 
outside of its country of organization. Under the terms of the 
arrangement, the contract manufacturer was paid a conversion fee. The 
raw material, work in process, and finished product remained the 
property of the CFC at all times. The CFC alone had complete control 
over the time and quantity of production as well as complete quality 
control over the conversion process. The IRS ruled, under these facts, 
that the performance of the operations by the contract manufacturer 
whereby the raw material was processed into a finished good was 
considered to be a performance by the CFC, and the CFC would therefore 
be treated as having substantially transformed personal property. The 
ruling further concluded that, because the CFC conducted the 
manufacturing activity outside of its country of organization, it was 
considered to do so through a branch or similar establishment. Because 
the manufacturing branch tax rate disparity test was not satisfied, 
however, the activities of the ``branch'' were not considered the 
activities of a separate CFC and the CFC was therefore entitled to the 
manufacturing exception from FBCSI. See Sec.  601.601(d)(2)(ii)(b).
    In Ashland Oil, Inc. v. Commissioner, 95 TC 348 (1990), the Tax 
Court held that an unrelated manufacturing corporation in a contract 
manufacturing arrangement with a CFC cannot be treated as a branch or 
similar establishment of the CFC. In Vetco, Inc. v. Commissioner, 95 TC 
579 (1990), the Tax Court held that a wholly owned subsidiary of a CFC 
in a contract manufacturing arrangement with the CFC also cannot be 
treated as a branch or similar establishment of the CFC.
    In Rev. Rul. 97-48 the IRS revoked Rev. Rul. 75-7. Rev. Rul. 97-48 
states that the IRS will follow Ashland Oil, Inc. v. Commissioner and 
Vetco, Inc. v. Commissioner, and therefore confirms that the IRS will 
not treat a separate contract manufacturer as a branch for purposes of 
section 954(d)(2). In addition, Rev. Rul. 97-48 rules that the 
activities of a contract manufacturer cannot be attributed to a CFC for 
purposes of either section 954(d)(1) or section 954(d)(2) to determine 
whether the income of a CFC is FBCSI. However, the ruling does not 
address the circumstances under which the activities of the CFC itself 
may qualify as manufacturing when a contract manufacturing or similar 
arrangement is in place. See Sec.  601.601(d)(2)(ii)(b).

D. Business Developments

    Final regulations addressing FBCSI were first published in 1964 (TD 
6734, 29 FR 6392). Since then, global economic expansion and 
globalization have led to significant changes in manufacturing. Many 
multinational groups have extensive manufacturing networks that 
straddle geographic borders. These cross-border manufacturing networks 
are created primarily to leverage expertise and cost efficiencies. In 
addition, the use of contract manufacturing arrangements has become a 
common way of manufacturing products because of the flexibility and 
efficiencies it affords. Accordingly, updated rules in this area are 
important to the continued competitiveness of U.S. businesses operating 
abroad.

Explanation of Provisions

    In response to the growing importance of contract manufacturing and 
other manufacturing arrangements, the Treasury Department and the IRS 
propose to modernize the FBCSI regulations in light of current business 
structures and practices that are inadequately addressed by the current 
regulations. Specifically, the proposed regulations address: (1) The 
application of the manufacturing exception where the physical 
manufacturing test is not satisfied by the CFC but where the CFC, and/
or a branch of the CFC, is involved in the manufacturing process; (2) 
the application of the branch rule to business structures involving the 
use of one or more branches engaged in manufacturing, producing, 
constructing, growing, or extracting activities; and (3) other 
miscellaneous branch rule issues. Certain portions of these proposed 
regulations restate changes that were previously proposed in REG-
104537-97 (63 FR 14669) and withdrawn in REG-113909-98 (64 FR 37727).

A. Application of the Manufacturing Exception Where the Physical 
Manufacturing Test Is Not Satisfied by the CFC but the CFC Is Involved 
in the Manufacturing Process--Substantial Contribution to Manufacturing

    Section 954(d)(1) includes, as FBCSI, income from the purchase of 
personal property from any person and ``its'' sale to a related person. 
Some taxpayers argue that use of the word ``its'' implies that the 
property sold must be the same property that is purchased for the sales 
income to be FBCSI. Accordingly, these taxpayers assert that where the 
personal property purchased by the CFC is manufactured such that the 
property purchased is not the same as the property sold by the CFC, the 
property sold by the CFC is not the property purchased and therefore 
the sale of such property does not generate FBCSI, even if the CFC 
itself performs little or no part of the manufacture of that property. 
They further argue that the manufacturing exception under Sec.  1.954-
3(a)(4)(i) provides a safe harbor but does not define the universe of 
cases in which personal property sold by a CFC is considered to be 
different from the property purchased by the CFC for purposes of 
determining FBCSI. In addition, they argue that Sec.  1.954-3(a)(4)(i) 
supports their view because it states, in part, that ``[a] foreign 
corporation will be considered, for purposes of this subparagraph, to 
have manufactured, produced, or constructed personal property which it 
sells if the property sold is in effect not the property which it 
purchased.''
    The Treasury Department and the IRS believe that the position taken 
by these taxpayers is contrary to existing law, and results from an 
incorrect reading of section 954(d)(1) and Sec.  1.954-3(a)(4)(i). 
Section 954(d)(1) requires only a purchase of personal property and the 
sale of that personal property by the CFC with no indication as to 
form. Moreover, section 954(d)(1)(A) limits FBCSI to income derived in 
connection with the purchase (or sale) of personal property that is 
manufactured, produced, grown, or extracted outside of the CFC's 
country of organization, thereby indicating that section 954(d)(1) is 
concerned with the segregation of purchase or sales and manufacturing 
into different jurisdictions, not merely with whether the property was 
manufactured.
    Section 1.954-3(a)(4) provides the only set of rules under which a 
change in form of personal property is considered relevant for purposes 
of

[[Page 10719]]

determining FBCSI. The first sentence of Treas. Reg. Sec.  1.954-
3(a)(4) sets forth the general rule that ``foreign base company sales 
income does not include income of a CFC derived in connection with the 
sale of personal property manufactured, produced, or constructed by 
such corporation in whole or in part from personal property which it 
has purchased.'' The third sentence of that paragraph explains that 
``the property sold will be considered, for purposes of this 
subparagraph, as not being the property which is purchased if the 
provisions of subdivision (ii) or (iii) of this subparagraph are 
satisfied.'' The plain language of the regulation, as well as the 
examples, clarify that in order to satisfy Sec.  1.954-3(a)(4)(ii) or 
(iii) the relevant manufacturing activities must be performed by the 
CFC itself. See, for example, Electronic Arts, Inc. v. Commissioner, 
118 TC 226, 265 (2002) (stating that ``petitioner's focus on certain 
language in section 1.954-3(a)(4), Income Tax Regs., overlooks the 
regulation's requirement that various actions have been done `by' the 
corporation being evaluated''). See also, Medchem v. Commissioner, 116 
TC 308 (2001).
    Further, this regulation was issued shortly after the statute 
became effective, and is consistent with the legislative history, which 
contemplates that property sold will be considered different from the 
property purchased only when the CFC itself manufactures that property. 
See S. Rep. No. 1881, 87th Cong., 2d Sess. (1962), 1962-3 C.B. 841, 949 
(stating that ``[i]n a case in which a controlled foreign corporation 
purchases parts or materials which it then transforms or incorporates 
into a final product, income from the sale of the final product would 
not be foreign base company sales income if the corporation 
substantially transforms the parts or materials, so that, in effect, 
the final product is not the property purchased.'')
    The proposed regulations clarify that for purposes of determining 
FBCSI personal property sold by a CFC will be considered to be the 
property purchased by the CFC regardless of whether it is sold in the 
same form in which it was purchased, in a different form than the form 
in which it was purchased, or as a component part of a manufactured 
product, except as specifically provided by the same country 
manufacture exception contained in Sec.  1.954-3(a)(2) and the 
manufacturing exception contained in Sec.  1.954-3(a)(4). Therefore, 
the only time that the manufacture of a product will affect whether 
income is FBCSI is when the manufacture of the product is performed by 
the CFC or performed in the country of organization of the CFC. With 
respect to the manufacturing exception contained in Sec.  1.954-
3(a)(4), the proposed regulations clarify that a CFC qualifies for the 
manufacturing exception from FBCSI only if the CFC, acting through its 
employees, manufactured the relevant product within the meaning of 
Sec.  1.954-3(a)(4)(i). The proposed regulations also further provide 
rules to determine whether the activities of a branch or similar 
establishment outside the country in which the CFC is incorporated have 
substantially the same tax effect as if the branch or similar 
establishment were a wholly owned subsidiary corporation, and thus 
whether under section 954(d)(2) the income attributable to the branch 
or similar establishment constitutes FBCSI of the CFC.
    The Treasury Department and the IRS recognize, however, that due to 
business considerations in the global marketplace, personal property 
may be manufactured pursuant to a contract manufacturing arrangement 
under which the CFC engages in activities related to the manufacture of 
the property (for example, oversight, direction and control over the 
contract manufacturer) but does not satisfy the physical manufacturing 
test. In certain of these cases, the Treasury Department and the IRS 
believe that the CFC should qualify for the manufacturing exception to 
FBCSI. Accordingly, the proposed regulations modify Sec.  1.954-3(a)(4) 
to provide that a CFC that provides a ``substantial contribution'' with 
respect to the manufacture, production, or construction of personal 
property, but that could not satisfy the physical manufacturing test, 
may have manufactured such property for purposes of the manufacturing 
exception. Specifically, proposed Sec.  1.954-3(a)(4)(i) provides that, 
in addition to proposed Sec.  1.954-3(a)(4)(ii) and (iii), a taxpayer 
may qualify for the manufacturing exception by satisfying the 
``substantial contribution test'' in proposed Sec.  1.954-3(a)(4)(iv). 
Pursuant to proposed Sec.  1.954-3(a)(4)(iv)(b), a CFC will satisfy the 
substantial contribution test with respect to personal property only if 
the facts and circumstances evidence that the controlled foreign 
corporation makes a substantial contribution through the activities of 
its employees to the manufacture of that property.
    Factors to be considered in determining whether a CFC makes a 
substantial contribution to the manufacture of personal property 
include but are not limited to: (1) Oversight and direction of the 
activities or process (including management of the risk of loss) 
pursuant to which the property is manufactured under the principles of 
Sec.  1.954-3(a)(4)(ii) and (iii); (2) performance of manufacturing 
activities that are considered in, but insufficient to satisfy the 
tests provided in Sec.  1.954-3(a)(4)(ii) or (iii); (3) control of the 
raw materials, work-in-process and finished goods; (4) management of 
the manufacturing profits; (5) material selection; (6) vendor 
selection; (7) control of logistics; (8) quality control; and (9) 
direction of the development, protection, and use of trade secrets, 
technology, product design and design specifications, and other 
intellectual property used in manufacturing the product.
    In light of the addition of the new test contained in proposed 
Sec.  1.954-3(a)(4)(iv), the interaction between several existing 
regulation sections and the new test is clarified. First, the existing 
manufacturing exceptions under Sec.  1.954-3(a)(4)(ii) and (iii) are 
modified to clarify that the applicability of the tests under Sec.  
1.954-3(a)(4)(ii) and (iii) are restricted to cases in which physical 
transformation or physical assembly or conversion of component parts is 
conducted by the selling corporation.
    Second, the definition of manufacturing for purposes of the same 
country manufacture exception contained in Sec.  1.954-3(a)(2) is 
modified to exclude manufacturing as defined under the substantial 
contribution test, and to ensure that the modifications to the existing 
manufacturing exceptions under Sec.  1.954-3(a)(4)(ii) and (iii) do not 
narrow the same country manufacture exception. The Treasury Department 
and the IRS did not intend these regulations to change the scope of the 
same country manufacture exception. Section 1.954-3(a)(2) excludes 
manufacturing as defined under the substantial contribution test 
because a rule that expanded the definition of manufacturing to include 
Sec.  1.954-3(a)(4)(iv) activities for purposes of the same country 
manufacture exception could prove difficult to administer. Such a rule 
could require an assessment of activities other than physical 
manufacturing conducted by an unrelated person. Modifying Sec.  1.954-
3(a)(2) ensures that the modifications to the existing manufacturing 
exceptions under Sec.  1.954-3(a)(4)(ii) and (iii) do not narrow the 
same country manufacture exception by clarifying that property 
manufactured in the country of organization of the selling corporation 
will qualify for the same country manufacture exception regardless of 
whose employees engage in

[[Page 10720]]

manufacturing activities that satisfy the principles of Sec.  1.954-
3(a)(4)(ii) or (iii).
    Third, the proposed regulations modify Sec.  1.954-3(a)(6), which 
addresses the application of the manufacturing exception to a CFC's 
distributive share of partnership income where the partnership 
manufactures and sells personal property. The reference to ``the 
separate activities or property of the controlled foreign corporation 
or any other person,'' in Sec.  1.954-3(a)(6) was intended to clarify 
that the activities of another person could not be attributed to the 
partnership for purposes of applying the manufacturing exception. 
Because these proposed regulations clarify that no attribution is 
allowed for purposes of applying the manufacturing exception that 
language is now unnecessary and is therefore removed. Section 1.954-
3(a)(6) is also modified consistent with the modifications to Sec.  
1.954-3(a)(4) providing that a CFC may only qualify for the 
manufacturing exception through the activities of its employees.

B. Application of the Branch Rule to Business Structures Involving the 
Use of More Than One Branch Engaged in Manufacturing

    Proposed Sec.  1.954-3(b)(2)(ii)(c)(2) creates a rebuttable 
presumption with respect to the application of the substantial 
contribution test where a CFC claims to satisfy the substantial 
contribution test with respect to the activities of a branch of that 
CFC that satisfies Sec.  1.954-3(a)(4)(ii) or (iii). Under this 
rebuttable presumption, if a branch of a CFC satisfies the physical 
manufacturing test with respect to personal property sold by the 
remainder of the CFC, the remainder of the CFC will be presumed not to 
make a substantial contribution to the manufacture of that personal 
property unless the CFC can rebut that presumption to the satisfaction 
of the Commissioner.
    The Treasury Department and the IRS believe that these rules are 
necessary as a backstop to the branch rule. In the absence of the 
rebuttable presumption, a rule permitting a CFC to qualify for the 
manufacturing exception based upon its contribution to the 
manufacturing activities of a branch would prove difficult to 
administer. Such a rule could encourage a CFC to elect classification 
of its subsidiaries that engage in manufacturing activities as 
disregarded entities, obfuscating the division of manufacturing labor 
and income between the CFC and its branches. Of course, the presumption 
may be rebutted and any adverse consequences alleviated by 
incorporating the branch that satisfies the physical manufacturing 
test.
    Although Sec.  1.954-3(b)(1)(i)(c) provides a rule addressing the 
use of multiple sales or purchase branches, Sec.  1.954-3(b)(1)(ii) 
does not provide a corollary rule for the use of multiple manufacturing 
branches. The Treasury Department and the IRS believe that the lack of 
a specific rule addressing the use of more than one manufacturing 
branch does not currently limit the general manufacturing branch rule 
of Sec.  1.954-3(b)(1)(ii)(a) from applying to each manufacturing 
branch of a CFC in a case where a CFC performs manufacturing activities 
through more than one branch or similar establishment. Rather, such an 
application is consistent with the rules regarding multiple sales or 
purchase branches. Nonetheless, for clarity, the proposed regulations 
set forth rules addressing the use of multiple manufacturing branches.
    The proposed regulations set forth two rules addressing the 
application of the manufacturing branch tax rate disparity test to 
multiple manufacturing branches.
    Proposed Sec.  1.954-3(b)(1)(ii)(c)(2) addresses situations in 
which multiple branches each perform manufacturing activities with 
respect to separate items of personal property that are then sold by 
the CFC. Consistent with the rule for multiple sales branches, the 
proposed regulations require the separate application of the 
manufacturing branch tax rate disparity test to each branch that is 
manufacturing a separate item of personal property.
    Proposed Sec.  1.954-3(b)(1)(ii)(c)(3) addresses situations in 
which multiple branches, or one or more branches and the remainder of 
the CFC, perform manufacturing activities with respect to the same item 
of personal property that is then sold by the CFC. When multiple 
branches, or one or more branches and the remainder of the CFC, perform 
manufacturing activities with respect to the same item of personal 
property, the manufacturing branch tax rate disparity test is applied 
by giving satisfaction of the physical manufacturing test precedence 
over other contributions to manufacturing. Therefore, if only one 
branch, or only the remainder of the CFC, satisfies the physical 
manufacturing test of Sec.  1.954-3(a)(4)(ii) or (iii), then the 
location of that branch or the remainder of the CFC will be the 
location of manufacturing of the personal property for purposes of 
applying the manufacturing branch tax rate disparity test. If more than 
one branch, or one or more branches and the remainder of the CFC, each 
satisfy the physical manufacturing test, then the branch or the 
remainder of the CFC located or organized in the jurisdiction that 
would impose the lowest effective rate of tax will be the location of 
manufacturing of the personal property for purposes of applying the 
manufacturing branch tax rate disparity test.
    If none of the branches nor the remainder of the CFC satisfies the 
physical manufacturing test, but the CFC as a whole satisfies the 
substantial contribution test contained in proposed Sec.  1.954-
3(a)(4)(iv), then the location of manufacturing of the personal 
property will be the location of the branch or the remainder of the CFC 
that provides the predominant amount of the CFC's substantial 
contribution to manufacturing. Whether any branch or the remainder of 
the CFC provides a predominant amount of the CFC's contribution to 
manufacturing is determined by applying the facts and circumstances 
test provided in Sec.  1.954-3(a)(4)(iv) to weigh the contribution to 
manufacturing of each branch or the remainder of the CFC. If a 
predominant amount of the CFC's contribution to manufacturing is not 
provided by any one location, the location of manufacturing of the 
personal property for purposes of applying the manufacturing branch tax 
rate disparity test will be that place (either the remainder of the CFC 
or one of its branches) where manufacturing activity is performed and 
which would impose the highest effective rate of tax when applying 
either Sec.  1.954-3(b)(1)(i)(b) or (ii)(b).
    Because the proposed regulations address cases in which two or more 
branches, or one or more branches and the remainder of the CFC, perform 
manufacturing activities related to the manufacture of the same item of 
property, Sec.  1.954-3(b)(2)(ii)(a) is modified to clarify the 
application of the branch rule where manufacturing activities are 
performed in more than one location. In such cases, proposed Sec.  
1.954-3(b)(2)(ii)(a) provides that, for purposes of treating the 
location of sales or purchase income as a separate corporation for 
purposes of determining whether FBCSI is incurred, that separate 
corporation will exclude any branch or the remainder of the CFC that 
would be treated as a separate corporation, if the hypothetical rate 
imposed by the jurisdiction of each such branch or the remainder of the 
CFC were separately tested against the effective rate of tax imposed on 
the sales or purchase income under the relevant tax rate disparity 
test.

[[Page 10721]]

C. Miscellaneous Branch Rule Issues

    The Treasury Department and the IRS also propose to amend certain 
other aspects of Sec.  1.954-3(b) as follows:
1. Definition of a Manufacturing Branch
    While Sec.  1.954-3(b)(1)(ii)(a) defines a manufacturing branch as 
a branch or similar establishment through which a CFC carries on 
manufacturing activities, it does not explicitly require that Sec.  
1.954-3(a)(4)(i) be satisfied by the CFC as a whole in order for the 
manufacturing branch rule to apply. The Treasury Department and the IRS 
believe that a manufacturing branch only exists with respect to 
personal property sold by a CFC if the CFC (including any branch of 
that CFC) has manufactured that property. Accordingly, proposed Sec.  
1.954-3(b)(1)(ii)(a) clarifies this point by providing that the 
manufacturing branch rule applies only where a CFC (including any 
branch of the CFC) satisfies the manufacturing requirement under 
proposed Sec.  1.954-3(a)(4).
2. Modification of Sec.  1.954-3(b)(2)(ii)(e)
    Section 1.954-3(b)(2)(ii)(e) provides that income derived by a 
branch or similar establishment, or by the remainder of the CFC, will 
not be FBCSI if the income would not be so considered if it were 
derived by a separate CFC under like circumstances. For example, if a 
branch of a CFC purchases personal property from an unrelated person 
and sells the property to an unrelated person without any involvement 
by the remainder of the CFC, the branch rule will not apply to create a 
related party transaction between the branch and the remainder of the 
CFC. Therefore the purchase and sale of that personal property by the 
branch will not generate FBCSI.
    The proposed regulations provide that the substantial contribution 
test generally applies to a CFC that sells personal property where 
another person (for example, a second CFC) satisfies the physical 
manufacturing test with respect to that property. However, a negative 
presumption applies where a CFC claims to satisfy the substantial 
contribution test with respect to income from the sale of personal 
property where the physical manufacturing test is satisfied by a branch 
of that CFC. The effect of these rules is that, where a CFC seeks to 
rely on the substantial contribution test with respect to the income 
from the sale of personal property manufactured (within the meaning of 
Sec.  1.954-3(a)(4)(ii) or (iii)) by one or more of its branches, but 
cannot rebut the negative presumption to the satisfaction of the 
Commissioner, a branch or the remainder of a CFC may have FBCSI where a 
separate CFC would not. Therefore, to integrate the rules regarding the 
substantial contribution test and its application under the branch 
rule, proposed Sec.  1.954-3(b)(2)(ii)(e) excepts from its general rule 
cases in which a branch satisfies the physical manufacturing test with 
respect to personal property and the remainder of the controlled 
foreign corporation fails to rebut the presumption that it does not 
satisfy the substantial contribution test with respect to the 
activities of that manufacturing branch.
    In addition, consistent with the clarification regarding the scope 
of the branch rule contained in proposed Sec.  1.954-3(b)(1), Sec.  
1.954-3(b)(2)(ii)(e) is modified to clarify that it applies only for 
purposes of paragraph (b) of Sec.  1.954-3 (that is, the branch rule). 
This clarifies that in no event will the branch rule cause income not 
to be FBCSI if that income would otherwise be FBCSI under section 
954(d)(1). For example, assume a CFC incorporated in Country Y 
purchases personal property from a related party and has that property 
manufactured by a contract manufacturer in Country Z. If the CFC does 
not perform any other activity with respect to the manufacture of the 
property, and if the CFC sells the manufactured property through a 
branch located in Country Z for use, consumption, or disposition 
outside of Country Y, the income from the sale of that property is 
FBCSI under section 954(d)(1). If the branch located in Country Z were 
a separate CFC the income would not be FBCSI because it would be 
selling personal property manufactured in its country of organization, 
Country Z. However, because the income would be FBCSI to the CFC under 
section 954(d)(1), proposed Sec.  1.954-3(b)(2)(ii)(e) does not apply 
to create a different result.
3. Modification of Sec.  1.954-3(b)(2)(i)(b), (b)(2)(ii)(b) and (b)(4), 
Example 3
    Commentators have noted that Sec.  1.954-3(b)(2)(i)(b) and (ii)(b) 
can be read to cause a branch that purchases from unrelated persons and 
sells to unrelated persons to have FBCSI even where the remainder of 
the CFC has no connection with the personal property that is sold. 
Although Sec.  1.954-3(b)(2)(ii)(e) should prevent such a result, 
commentators note that a contrary reading is possible because the sales 
branch rules of Sec.  1.954-3(b)(2)(i)(b) and (ii)(b) apply, in part, 
with respect to personal property manufactured, produced, constructed, 
grown, or extracted by, or personal property purchased or sold by the 
``controlled foreign corporation'' (as opposed to by the ``remainder'' 
of the controlled foreign corporation). For example, in a case in which 
a branch both manufactures and sells personal property, the branch 
could be considered to sell on behalf of the remainder of the CFC 
because the branch's manufacturing activities would be considered to be 
manufacturing activities of the CFC, thereby triggering the application 
of Sec.  1.954-3(b)(2)(ii)(b). Further, commentators note that Sec.  
1.954-3(b)(4), Example 3 appears to support this reading because in 
that example a branch of a corporation purchases from a related person 
and sells to an unrelated person, and the branch is treated as selling 
that property on behalf of the remainder of the CFC, even though the 
remainder of the corporation does not manufacture, purchase, or sell 
the personal property.
    Section 1.954-3(b)(2)(i)(b) and (ii)(b) are intended to apply only 
to purchasing or selling by a branch with respect to personal property 
manufactured, purchased, or sold by ``the remainder of'' the CFC 
(including any branch treated as the remainder of the CFC). For 
example, the branch rule could apply in a case where personal property 
is manufactured by the CFC in the country of organization of the CFC 
and then sold by a branch of the CFC located outside of the country of 
organization of the CFC. However, the branch rule does not apply where, 
for example, a branch of the CFC purchases personal property from an 
unrelated party and sells it to an unrelated party without any 
involvement by the remainder of the CFC. Accordingly, the proposed 
regulations amend Sec.  1.954-3(b)(2)(i)(b) and (ii)(b) by adding the 
words ``remainder of'' before each place where the words ``controlled 
foreign corporation'' appear in those paragraphs and by adding the 
words ``(or by any branch treated as the remainder of the CFC)'' after 
each place where the words ``controlled foreign corporation'' appear in 
those paragraphs. Consistent with this change, the proposed regulations 
revise the rationale for the result in Sec.  1.954-3(b)(4), Example 3 
as described below.
    In Sec.  1.954-3(b)(4), Example 3, a branch of a second-tier CFC 
purchases finished goods from the first-tier CFC and sells 90 percent 
of the product for use, consumption, or disposition outside of the 
country in which the branch is located and the country of organization 
of the second-tier CFC. The remainder of the second-tier CFC does not 
engage in any manufacturing or

[[Page 10722]]

selling activities. The sales branch tax rate disparity test is met in 
comparison to the effective tax rate of the second-tier CFC (the first-
tier CFC and second-tier CFC are organized in the same country). The 
example concludes that since the sales branch tax disparity test is 
met, the branch is treated as a separate CFC and is treated as selling 
personal property on behalf of the second-tier CFC and therefore the 90 
percent of sales made for use, consumption, or disposition outside of 
the branch's country is FBCSI.
    The rationale of the example is incorrect because the branch is not 
selling on behalf of the second-tier CFC because the remainder of the 
second-tier CFC (not including the branch) does not manufacture, 
purchase, or sell the personal property. Therefore, Sec.  1.954-
3(b)(2)(i)(b) and (ii)(b) do not apply. However, the result is correct 
because the branch, treated as a separate corporation, is purchasing 
from a related person, the first-tier CFC, organized outside of the 
branch's country and selling to persons outside the branch's country 
and the branch is located in a jurisdiction that satisfies the sales 
branch tax rate disparity test with respect to the income from the sale 
of the personal property. Accordingly, the proposed regulations revise 
Sec.  1.954-3(b)(4), Example 3 to provide the correct rationale for the 
result. In addition, the result in Sec.  1.954-3(b)(4), Example 3 is 
further revised to add two alternative factual scenarios (purchase from 
an unrelated party, and manufacture within the meaning of proposed 
Sec.  1.954-3(a)(4)(iv) by the selling branch) to illustrate the point 
that, in general, a branch will not have FBCSI if a separate CFC would 
not have FBCSI under like circumstances.

Proposed Effective/Applicability Date

    These regulations will apply to taxable years of CFCs beginning on 
or after the date they are published as final regulations in the 
Federal Register, and for taxable years of United States shareholders 
in which or with which such taxable years of the CFCs end.

Reliance on Proposed Regulations

    Until these regulations are finalized, taxpayers may choose to 
apply these regulations in their entirety to all open tax years as if 
they were final regulations.

Request for Comments

    The Treasury Department and the IRS request comments on all aspects 
of these proposed regulations, including comments regarding the 
substantial contribution test, and the activities listed in Sec.  
1.954-3(a)(4)(iv)(b). In particular, comments are requested on whether 
one or more safe harbors should be added to the substantial 
contribution test. In drafting the proposed regulations, the Treasury 
Department and the IRS considered a number of approaches to a safe 
harbor but ultimately chose to request comments in this regard because 
of difficulties in fashioning a safe harbor that would be flexible 
enough to apply across various industries and across a range of 
different types of manufacturing arrangements. Among the safe harbors 
considered in drafting the proposed regulations were: (1) A list of 
mandatory activities; (2) a cost based test; (3) a compensation based 
test; (4) a value based test; (5) a tax rate disparity based test; and 
(6) a percentage based test comparing the compensation paid to 
employees of the CFC for performing activities related to the 
manufacturing process vs. the total cost for all activities related to 
the manufacturing process (that is, including costs paid to a contract 
manufacturer but excluding the cost of raw materials and marketing 
intangibles). In addition, the Treasury Department and the IRS request 
comments as to whether the requirement, under the manufacturing 
exception from foreign base company sales income, that the activities 
of the CFC be performed by its employees, should permit commercial 
arrangements where individuals performing services for the CFC, while 
not on its payroll, are nevertheless controlled by employees of the 
CFC.
    Comments are also requested on whether it would be appropriate to 
add an anti-abuse rule similar to the foreign base company services 
substantial assistance test announced in Notice 2007-13 to prevent a 
CFC from qualifying for the manufacturing exception based on the 
application of the substantial contribution test in cases in which 
substantially all of the direct or indirect contributions to the 
manufacture of personal property provided collectively by the CFC and 
any related United States person is provided by one or more related 
United States persons. Such a rule might provide, for example, that 
where (1) the United States parent of a CFC provides 45 percent of the 
manufacturing contribution, (2) the CFC provides 5 percent of the 
manufacturing contribution, and (3) an unrelated contract manufacturer 
provides 50 percent of the manufacturing contribution to the personal 
property, the CFC does not make a substantial contribution to the 
manufacture of that property because a related United States person 
provides 80 percent or more of the contribution to the manufacture of 
the property (90 percent in this case, 45/50) provided collectively by 
the CFC and any related United States person. Such a rule was 
considered but ultimately not included in the proposed regulations and 
comments are requested on whether or not such a rule should be added to 
the final regulations. See Sec.  601.601(d)(2)(ii)(b).
    In addition, comments are requested on the multiple manufacturing 
branch rules. First, comments are requested on whether the negative 
presumption rule concerning cases in which the selling branch or the 
remainder of the CFC performs activities described in proposed Sec.  
1.954-3(a)(4)(iv) is more appropriate than an alternative rule that 
would deny the use of the test contained in proposed Sec.  1.954-
3(a)(4)(iv) in cases in which a branch of the CFC manufactures the 
property within the meaning of proposed Sec.  1.954-3(a)(4)(ii) or 
(iii). Second, comments are requested on the consequences of and 
possible alternatives to proposed Sec.  1.954-3(b)(1)(ii)(c)(3)(e), 
which provides that if a predominant amount of the CFC's substantial 
contribution is not provided by any one location, the location of 
manufacturing of the personal property will be considered to be that 
location (either the remainder of the CFC or one of its branches) which 
imposes the highest effective rate of tax that would be imposed on the 
sales income, among those locations where manufacturing activity 
related to the generation of that income is performed. The Treasury 
Department and the IRS considered a rule that would allow taxpayers to 
alternatively use the mean effective rate of tax among the locations 
where manufacturing activity is performed, so long as that effective 
rate of tax was within a set number of percentage points of the highest 
effective tax rate that would be imposed by any jurisdiction in which a 
manufacturing branch or the remainder of the CFC was located or 
organized. However, the Treasury Department and the IRS were concerned 
about the complexity of such a rule. The Treasury Department and the 
IRS request comments on whether this or other alternatives to the 
highest rate test would be appropriate. Finally, comments are requested 
on whether any modifications to Sec.  1.954-3(b)(1)(i)(b) and 
(b)(1)(ii)(b) should be adopted to make the rules concerning the 
comparison of effective rates of tax easier to apply.

[[Page 10723]]

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations and because 
the proposed regulation does not impose a collection of information on 
small entities, the Regulatory Flexibility Act (5 U.S.C. Ch. 6) does 
not apply. Pursuant to section 7805(f) of the Internal Revenue Code, 
this notice of proposed rulemaking was submitted to the Chief Counsel 
for Advocacy of the Small Business Administration for comment on its 
impact on small business.

Comments and Requests for Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The Treasury Department and the IRS request comments on the 
clarity of the proposed rules and how they can be made easier to 
understand. All comments will be available for public inspection and 
copying. A public hearing will be scheduled if requested in writing by 
any person that timely submits written comments. If a public hearing is 
scheduled, notice of the date, time, and place for the public hearing 
will be published in the Federal Register.

Drafting Information

    The principal author of these regulations is Ethan Atticks, Office 
of Associate Chief Counsel (International). However, other personnel 
from the Treasury Department and the IRS participated in their 
development.

List of Subjects in 26 CFR Part 1

    Income Taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for 26 CFR part 1 continues to 
read in part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.954-3 is amended by:
    1. Adding a new sentence after the first sentence of paragraph 
(a)(1)(i), and by revising the second sentence of Example 1 in 
paragraph (a)(1)(iii), and the first sentence of Example 2 in paragraph 
(a)(1)(iii).
    2. Revising the third sentence of paragraph (a)(2).
    3. Revising paragraph (a)(4)(i), and the first sentences of 
paragraphs (a)(4)(ii) and (iii), and by adding paragraph (a)(4)(iv).
    4. Revising the text of paragraph (a)(6)(i).
    5. Adding a new sentence to the end of paragraph (b)(1)(ii)(a).
    6. Redesignating the text of paragraph (b)(1)(ii)(c) as paragraph 
(b)(1)(ii)(c)(1), and adding a paragraph heading to newly designated 
paragraph (b)(1)(ii)(c)(1).
    7. Adding paragraphs (b)(1)(ii)(c)(2), and (c)(3).
    8. Revising paragraph (b)(2)(i)(b).
    9. Adding a new sentence to the end of paragraph (b)(2)(ii)(a), and 
revising paragraph (b)(2)(ii)(b).
    10. Redesignating the text of paragraph (b)(2)(ii)(c) as paragraph 
(b)(2)(ii)(c)(1), adding a paragraph heading to newly redesignated 
paragraph (b)(2)(ii)(c)(1), adding paragraph (b)(2)(ii)(c)(2), and 
revising paragraph (b)(2)(ii)(e).
    11. Revising Example 3 in paragraph (b)(4).
    12. Adding paragraph (d).
    The additions and revisions read as follows:


Sec.  1.954-3  Foreign base company sales income.

    (a) * * *
    (1) In general--(i) General rules. * * * For purposes of the 
preceding sentence, except as provided in paragraphs (a)(2) and (a)(4) 
of this section, personal property sold by a controlled foreign 
corporation will be considered to be the same property that was 
purchased by the controlled foreign corporation regardless of whether 
the personal property is sold in the same form in which it was 
purchased, in a different form than the form in which it was purchased, 
or as a component part of a manufactured product. * * *
* * * * *
    Example 1. * * * Corporation A purchases from M Corporation, a 
related person, articles manufactured in the United States and sells 
the articles to P, not a related person, for delivery and use in 
foreign country Y. * * *
    Example 2. Corporation A in Example 1 also purchases from P, not 
a related person, articles manufactured in country Y and sells the 
articles to foreign corporation B, a related person, for use in 
foreign country Z. * * *
* * * * *
    (2) * * * The principles set forth in paragraphs (a)(4)(i), 
(a)(4)(ii), and (a)(4)(iii) of this section apply under this paragraph 
(a)(2) in determining what constitutes manufacture, production, or 
construction of personal property, excluding, in the case of 
manufacture, production, or construction by a person other than the 
controlled foreign corporation, the requirement set forth in paragraph 
(a)(4)(i) of this section that the provisions of paragraphs (a)(4)(ii) 
and (a)(4)(iii) of this section may only be satisfied through the 
activities of that person's employees. * * *
* * * * *
    (4) Property manufactured, produced, or constructed by the 
controlled foreign corporation--(i)--In general. Foreign base company 
sales income does not include income of a controlled foreign 
corporation derived in connection with the sale of personal property 
manufactured, produced, or constructed by such corporation in whole or 
in part from personal property which it has purchased. A controlled 
foreign corporation will have manufactured, produced, or constructed 
personal property which the corporation sells only if such corporation 
satisfies the provisions of paragraphs (a)(ii), (a)(iii), or (a)(iv) of 
this section through the activities of its employees with respect to 
such property. A controlled foreign corporation will not be treated as 
having manufactured, produced, or constructed personal property which 
the corporation sells merely because the property is sold in a 
different form than the form in which it was purchased. For rules of 
apportionment in determining foreign base company sales income derived 
from the sale of personal property purchased and used as a component 
part of property which is not manufactured, produced, or constructed, 
see paragraph (a)(5) of this section.
    (ii) * * * If personal property purchased by a foreign corporation 
is substantially transformed by such foreign corporation prior to sale, 
the property sold by the selling corporation is manufactured, produced, 
or constructed by such selling corporation. * * *
    (iii) * * * If purchased property is used as a component part of 
personal property which is sold, the sale of the property will be 
treated as the sale of a manufactured product, rather than the sale of 
component parts, if the assembly or conversion of the component parts 
into the final product by the selling corporation involves activities 
that are substantial in nature and generally considered to constitute 
the

[[Page 10724]]

manufacture, production, or construction of property. * * *
    (iv) Substantial contribution to manufacturing of personal 
property--(a)--In general. This paragraph (a)(4)(iv) applies only if a 
controlled foreign corporation does not satisfy paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section, but the personal property purchased by a 
controlled foreign corporation would be considered to be manufactured, 
produced, or constructed prior to sale (under the principles of 
paragraphs (a)(4)(ii) or (iii) of this section) by the controlled 
foreign corporation if the manufacturing, producing, and constructing 
activities undertaken with respect to the property prior to sale were 
undertaken by the controlled foreign corporation through the activities 
of its employees. If this paragraph (a)(4)(iv) applies, the personal 
property sold by the controlled foreign corporation is manufactured, 
produced, or constructed by such controlled foreign corporation only if 
the facts and circumstances evidence that the controlled foreign 
corporation makes a substantial contribution through the activities of 
its employees to the manufacture, production, or construction of the 
personal property sold. The determination of whether a controlled 
foreign corporation makes a substantial contribution through the 
activities of its employees to the manufacture, production, or 
construction of the personal property sold will involve, but will not 
necessarily be limited to, consideration of the activities set forth in 
paragraph (a)(4)(iv)(b) of this section. The weight given to any 
activity (whether or not set forth) will vary with the facts and 
circumstances of the particular business. The presence or absence of 
any activity, or of a particular number of activities, is not 
determinative. Further, the fact that other persons make contributions 
to the manufacture, production, or construction of personal property 
prior to sale does not necessarily prevent the controlled foreign 
corporation from making a substantial contribution to the manufacture, 
construction, or production of that property through the activities of 
its employees.
    (b) Activities. Activities of a controlled foreign corporation's 
employees to be considered in determining whether a controlled foreign 
corporation makes a substantial contribution through the activities of 
its employees to the manufacture, construction, or production of 
personal property include but are not limited to--
    (1) Oversight and direction of the activities or process (including 
management of the risk of loss) pursuant to which the property is 
manufactured, produced, or constructed under the principles of 
paragraphs (a)(4)(ii) or (iii) of this section;
    (2) Performance of activities that are considered in but that are 
insufficient to satisfy the tests provided in paragraphs (a)(4)(ii) and 
(a)(4)(iii) of this section;
    (3) Control of the raw materials, work-in-process and finished 
goods;
    (4) Management of the manufacturing profits;
    (5) Material selection;
    (6) Vendor selection;
    (7) Control of logistics;
    (8) Quality control; and
    (9) Direction of the development, protection, and use of trade 
secrets, technology, product design and design specifications, and 
other intellectual property used in manufacturing the product.
    (c) The rules of this paragraph (a)(iv) are illustrated by the 
following examples:

    Example 1. No substantial contribution to manufacturing. (i) 
Facts. FS, a controlled foreign corporation, purchases raw materials 
from a related person. The raw materials are then manufactured 
(under the principles of paragraph (a)(4)(iii)) of this section into 
Product X by CM, an unrelated corporation that performs the physical 
conversion outside of FS's country of organization, pursuant to a 
contract manufacturing arrangement. Product X is then sold by FS for 
use outside of FS's country of organization. At all times, FS 
retains control of the raw material, work-in-process, and finished 
goods, as well as the intangibles used in the conversion process. FS 
retains the right to oversee and direct the physical conversion of 
Product X by CM but does not regularly exercise, through its 
employees, its powers of oversight or direction.
    (ii) Result. FS does not satisfy paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section because FS does not, through the 
activities of its employees, substantially transform, convert or 
assemble personal property into Product X. However, Product X was 
manufactured (by CM), and therefore this paragraph (a)(4)(iv) 
applies. FS does not satisfy the test under this paragraph 
(a)(4)(iv) because it does not make a substantial contribution 
through the activities of its employees to the manufacture of 
Product X. Mere contractual ownership of materials and intellectual 
property and contractual rights to exercise powers of direction and 
control (without the exercise of those powers) are not sufficient to 
satisfy this paragraph (a)(4)(iv). Therefore, FS is not considered 
to have manufactured Product X under paragraph (a)(4)(i) of this 
section.
    Example 2. Substantial contribution to manufacturing, unrelated 
manufacturer. (i) Facts. Assume the same facts as in Example 1, 
except for the following. FS, through its employees, is engaged in 
product design and quality control. Employees of FS regularly 
exercise the right to oversee and direct the activities of CM in the 
manufacture of Product X.
    (ii) Result. FS does not satisfy paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section with respect to Product X because FS 
does not, through the activities of its employees, substantially 
transform, convert or assemble personal property into Product X. 
However, Product X was manufactured (by CM), and therefore this 
paragraph (a)(4)(iv) applies. FS satisfies the test under this 
paragraph (a)(4)(iv) because it makes a substantial contribution 
through the activities of its employees to the manufacture of 
Product X. Therefore FS is considered to have manufactured Product 
X. The analysis and conclusion in this Example 2 would be the same 
if CM were a corporation that was related to FS.
    Example 3. Employees of another person. (i) Facts. FS, a 
controlled foreign corporation organized in Country M, purchases raw 
materials from a related person. The raw materials are then 
manufactured (under the principles of paragraph (a)(4)(iii) of this 
section) into Product X by CM, an unrelated contract manufacturer 
located in Country C. CM uses employees of another corporation to 
operate its manufacturing plant and convert the raw materials into 
Product X. Apart from the physical conversion of the raw materials 
into Product X, employees of FS perform all of the other activities 
with respect to the manufacture of Product X (for example, oversight 
and direction of the manufacturing process, control of raw 
materials, control of logistics, vendor selection, quality control). 
FS sells Product X for use, consumption or disposition outside 
Country M.
    (ii) Result. If the manufacturing activities undertaken with 
respect to Product X between the time the raw materials were 
purchased and the time Product X was sold were undertaken by F