Guidance Regarding Foreign Base Company Sales Income, 79334-79354 [E8-30727]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 73, Number 249 (Monday, December 29, 2008)]
[Rules and Regulations]
[Pages 79334-79354]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E8-30727]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9438]
RIN 1545-BI50


Guidance Regarding Foreign Base Company Sales Income

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains final and temporary regulations that 
provide guidance relating to foreign base company sales income in cases 
in which personal property sold by a controlled foreign corporation is 
manufactured,

[[Page 79335]]

produced, or constructed pursuant to a contract manufacturing 
arrangement or by one or more branches of the controlled foreign 
corporation. These regulations modify the foreign base company sales 
income regulations to address current business structures and 
practices, particularly the growing importance of contract 
manufacturing and other manufacturing arrangements. These regulations, 
in general, will affect controlled foreign corporations and their 
United States shareholders. The text of the temporary regulations also 
serves as the text of the proposed regulations set forth in the notice 
of proposed rulemaking on this subject in the Proposed Rules section in 
this issue of the Federal Register.

DATES: Effective Date. These regulations are effective July 1, 2009.
    Applicability Date. For dates of applicability, see Sec.  1.954-
3(c) and Sec.  1.954-3T(e). The final regulations shall apply to 
taxable years of controlled foreign corporations beginning after June 
30, 2009, and for taxable years of United States shareholders in which 
or with which such taxable years of the controlled foreign corporations 
end. The temporary regulations shall apply to taxable years of 
controlled foreign corporations beginning after June 30, 2009, and for 
taxable years of United States shareholders in which or with which such 
taxable years of the controlled foreign corporations end.

FOR FURTHER INFORMATION CONTACT: Ethan Atticks, (202) 622-3840 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    On February 28, 2008, the IRS and the Treasury Department published 
in the Federal Register proposed regulations (REG-124590-07, 2008-16 
IRB 801, 73 FR 10716, as corrected at 73 FR 20201), which provided 
proposed amendments to Sec.  1.954-3, addressing the treatment of 
contract manufacturing arrangements under the foreign base company 
sales income (FBCSI) rules. Written comments were received in response 
to the notice of proposed rulemaking, and a public hearing on the 
proposed regulations was held on July 29, 2008.
    Section 954(d)(1) defines FBCSI to mean income derived by a 
controlled foreign corporation (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 these cases) that the property 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 existing regulations further define FBCSI and the applicable 
exceptions from FBSCI, including the exceptions to the FBCSI rules for 
personal property that is: (1) Manufactured, produced, constructed, 
grown, or extracted within the CFC's country of organization (same 
country manufacture exception); (2) sold for use, consumption or 
disposition within the CFC's country of organization; and (3) 
manufactured, produced, or constructed by the CFC (the manufacturing 
exception). See Sec.  1.954-3(a)(2)-(4).
    The existing regulations set forth certain tests to determine 
whether a CFC satisfies the manufacturing exception: The ``substantial 
transformation test'' of Sec.  1.954-3(a)(4)(ii) and the ``substantive 
test'' and safe harbor of Sec.  1.954-3(a)(4)(iii). For purposes of 
this preamble, the requirements of Sec.  1.954-3(a)(4)(ii) and 1.954-
3(a)(4)(iii) will be referred to collectively as the ``physical 
manufacturing test'' and the satisfaction of either test will be 
described as ``physical manufacturing.''
    The proposed regulations provide a third test for satisfying the 
manufacturing exception, which may apply when a CFC is involved in the 
manufacturing process but does not satisfy the physical manufacturing 
test. In particular, the proposed regulations provide that a CFC will 
satisfy the manufacturing exception if the facts and circumstances 
evince that the CFC makes a substantial contribution through the 
activities of its employees to the manufacture, production, or 
construction of personal property (substantial contribution test). The 
proposed regulations also propose other modifications to the existing 
regulations to address the treatment of contract manufacturing 
arrangements under the FBCSI rules.
    Written comments were received in response to the notice of 
proposed rulemaking, and a public hearing was held on July 29, 2008. 
After consideration of all the comments, the proposed regulations, as 
revised by this Treasury decision, are adopted as final and temporary 
regulations.

Summary of Comments and Explanation of Provisions

    This Treasury decision contains final and temporary regulations 
relating to FBCSI. The temporary regulations contained in this Treasury 
decision also serve as the text of proposed regulations set forth in a 
notice of proposed rulemaking on this subject in the Proposed Rules 
section in this issue of the Federal Register. The preamble to this 
Treasury decision will refer to the proposed regulations published in 
the Federal Register on February 28, 2008, as the proposed regulations. 
The preamble will refer to the regulations that are published 
simultaneously as temporary regulations in this Treasury decision and 
as proposed regulations in this issue of the Federal Register as the 
temporary regulations.

A. Substantial Contribution Test

    The proposed regulations provide that a CFC will satisfy the 
substantial contribution test with respect to personal property only if 
all the facts and circumstances evince that the CFC makes a substantial 
contribution through the activities of its employees to the manufacture 
of the property. Prop. Reg. Sec.  1.954-3(a)(4)(iv)(b) includes a non-
exclusive list of activities (collectively, ``indicia of 
manufacturing'') to be considered in determining whether the CFC 
satisfies the substantial contribution test with respect to the 
manufacture, production, or construction of the personal property 
(manufacture of the personal property) under all the facts and 
circumstances.
1. General Operation of Substantial Contribution Test
    In response to the proposed regulations, commentators requested 
further elaboration of the general operation of the substantial 
contribution test. For example, commentators requested guidance on the 
amount of activity performed by a CFC's employees that would be 
necessary to ``satisfy'' each individual activity listed among the 
indicia of manufacturing. Several commentators requested clarifications 
that suggested they believed that a certain threshold of employee 
activity was required before the activity would be considered in 
determining whether a CFC satisfied the substantial contribution test. 
Commentators requested, for example, clarification as to whether the 
``vendor selection'' activity is satisfied if the CFC provides a 
contract manufacturer with an approved list of vendors but allows the 
contract manufacturer to make the final determination regarding the 
vendors to be used.
    Commentators also requested guidance on how the indicia of 
manufacturing should be weighed in relation to one another and whether 
performing a certain minimum number of activities was required in order 
for

[[Page 79336]]

the substantial contribution test to be satisfied. Others asked that 
the regulations explain whether a CFC must perform any particular 
activity in all cases to satisfy the substantial contribution test (for 
example, whether a CFC must always perform oversight and direction of 
the manufacturing process to satisfy the substantial contribution 
test). Some commentators requested that the regulations emphasize that 
the importance of each activity would vary by industry and by taxpayer. 
Commentators also requested that the regulations make clear that a CFC 
need not perform all of the indicia of manufacturing to establish a 
substantial contribution, and that the weight given to activities 
performed by employees of the CFC will depend on the economic 
significance of those activities to the business of the taxpayer with 
respect to the product being manufactured.
    Although the proposed regulations provide guidance on many of these 
issues, the IRS and the Treasury Department believe that additional 
guidance with respect to the application of the substantial 
contribution test is warranted in light of the comments received. 
Consequently, Sec.  1.954-3(a)(4)(iv)(c) is added to the final 
regulations to provide further clarification on the application of the 
substantial contribution test. First, Sec.  1.954-3(a)(4)(iv)(c) 
clarifies that all CFC employee functions contributing to the 
manufacture of the personal property will be considered in the 
aggregate when determining whether a substantial contribution is made 
to the manufacture of the personal property through the activities of a 
CFC's employees. Second, Sec.  1.954-3(a)(4)(iv)(c) clarifies that 
there is no single activity that will be accorded more weight than any 
other activity in every case or that will be required to be performed 
in all cases. Third, it clarifies that there is no minimum threshold 
with respect to functions performed by employees of a CFC before their 
functions with respect to a given activity may be taken into account as 
part of the substantial contribution test. Therefore, all functions 
performed by a CFC's employees are considered (and given appropriate 
weight) under the substantial contribution test, even if the CFC's 
employees perform only some of the functions in connection with any one 
activity (for example, some, but not all, of the vendor selection) 
considered under that test. The weight given to any functions performed 
by employees of the CFC with respect to any activity will be based on 
the economic significance of those functions to the manufacture, 
production, or construction of the relevant personal property. 
Corresponding amendments and additional examples have been added to the 
final regulations to illustrate further the application of the 
substantial contribution test. See Sec.  1.954-3(a)(4)(iv)(d).
    Other commentators sought clarification as to the extent to which 
purely contractual assumptions of risk are considered in a substantial 
contribution analysis. The IRS and the Treasury Department believe that 
no further clarification in the final regulations is necessary to 
address this point. Both the proposed and final regulations provide 
that only activities of the CFC's employees are considered in the 
substantial contribution analysis and, consequently, purely contractual 
assumptions of risk are not considered in the substantial contribution 
analysis.
    In addition, commentators requested that the regulations clarify 
that more than one person can provide a substantial contribution to the 
manufacturing process with respect to a given product. In response to 
this comment, the IRS and the Treasury Department amended the 
regulations to clarify that a CFC will not be precluded from making a 
substantial contribution to the manufacture of the personal property by 
the fact that other persons also make a substantial contribution to the 
manufacture, production, or construction of that property. Further, 
Sec.  1.954-3(a)(4)(iv)(d) Example 9 is added to the final regulations 
to illustrate that more than one person can provide a substantial 
contribution to the manufacture of the same property.
2. Indicia of Manufacturing
    The IRS and the Treasury Department received numerous comments with 
respect to the specific activities listed in the proposed regulation 
that are considered in determining whether a CFC makes a substantial 
contribution through its employees to the manufacture, production, or 
construction of personal property.
a. Oversight and Direction of Manufacturing
    Commentators requested that the IRS and the Treasury Department 
clarify certain issues related to the ``oversight and direction of the 
activities or process'' pursuant to which personal property is 
manufactured, produced, or constructed. Some commentators asked that 
the regulations provide that oversight and direction of the activities 
or process pursuant to which personal property is manufactured, 
produced, or constructed be a prerequisite for satisfying the 
substantial contribution test. Other commentators requested that the 
IRS and the Treasury Department clarify that in certain industries a 
substantial contribution can be made by a CFC without its employees 
engaging in significant oversight and direction of the activities or 
process pursuant to which personal property is manufactured, produced, 
or constructed. Some commentators focused on the fact that in an 
example in the proposed regulations the CFC was not treated as making a 
substantial contribution to the manufacture of personal property when 
the CFC did not ``regularly exercise'' oversight and direction with 
respect to the contract manufacturer. See Prop. Reg. Sec.  1.954-
3(a)(4)(iv)(c) Example 1.
    The importance of oversight and direction of the activities or 
process pursuant to which personal property is manufactured, produced, 
or constructed will vary based on the facts and circumstances 
associated with the specific manufacture, production, or construction 
at issue. The IRS and the Treasury Department acknowledge that 
oversight and direction of the activities or process pursuant to which 
personal property is manufactured, produced, or constructed is likely 
to be an important element in many, but not all, substantial 
contribution analyses. Thus, to address taxpayer comments, the examples 
in the final regulations are amended to make clear that oversight and 
direction is not a prerequisite for satisfying the substantial 
contribution test and that in certain industries a substantial 
contribution could be made by a CFC without its employees engaging in 
oversight and direction of the activities or process pursuant to which 
personal property is manufactured, produced, or constructed. Finally, 
the examples in the final regulations do not use the potentially 
confusing reference to ``regularly'' exercising oversight.
b. Material Selection, Vendor Selection, and Control of the Raw 
Materials, Work-in-process, and Finished Goods
    Some commentators asked if other activities listed among the 
indicia of manufacturing also represented means of exercising control 
of the raw materials, work-in-process and finished goods. The IRS and 
the Treasury Department acknowledge that some of the activities in the 
indicia of manufacturing may overlap with other activities in that 
list. The final regulations require a substantial contribution to the 
manufacture of the personal property through the activities of the 
CFC's employees and not

[[Page 79337]]

satisfaction of any specific activity in the indicia of manufacturing. 
Therefore, the IRS and the Treasury Department determined that it was 
not necessary to clarify whether any particular function might 
reasonably be included under more than one heading in the indicia of 
manufacturing. However, to provide further clarity, the final 
regulations group material selection, vendor selection, and control of 
the raw materials, work-in-process, and finished goods as a single 
activity in the indicia of manufacturing.
    Commentators asked whether the control of the raw materials, work-
in-process, and finished goods refers to the CFC having the contractual 
right to take possession of the personal property, to have title to the 
property, or to have economic risk of loss with respect to the 
property. These commentators requested clarification regarding whether 
tax ownership of raw materials, work-in-process and finished goods is 
required to have control of the raw materials, work-in-process, and 
finished goods. In connection with this question, commentators also 
asked whether a CFC can satisfy the substantial contribution test when 
the contract manufacturing arrangement is buy-sell or ``turnkey'' (that 
is, when the contract manufacturer purchases the raw materials).
    Both the proposed and final regulations provide that only 
activities of the CFC's employees are considered in the substantial 
contribution analysis. Thus, mere contractual rights, legal title, tax 
ownership, or assumption of economic risk are not considered in the 
substantial contribution analysis. To provide greater clarity, the 
final regulations revise Prop. Reg. Sec.  1.954-3(a)(4)(iv)(a), 
deleting the phrase ``purchased by a controlled foreign corporation'' 
in the first sentence of Prop. Reg. Sec.  1.954-3(a)(4)(iv)(a) to 
eliminate any inference that a CFC needs to own the raw materials that 
are used in the manufacturing process. In addition, examples in the 
final regulations clarify that buy-sell or turnkey contract 
manufacturing arrangements may satisfy the substantial contribution 
test. See Sec.  1.954-3(a)(4)(iv)(d) Examples 3 and 9.
c. Management of Manufacturing Profits and Management of Risk of Loss
    Commentators requested clarification regarding which functions 
would qualify as ``management of the manufacturing profits'' or 
``management of the risk of loss.'' Some commentators expressed 
concerns regarding the term ``management of the manufacturing 
profits.'' Other commentators suggested that it would add clarity if 
``management of the risk of loss'' were deleted from Prop. Reg. Sec.  
1.954-3(a)(4)(iv)(b)(1) and included with ``management of manufacturing 
profits'' in a single item in the indicia of manufacturing. Some 
commentators expressed concern that the term ``management of the risk 
of loss'' implicitly excluded all other risk management functions. One 
commentator expressed the view that the indicia of manufacturing should 
include reference to management of enterprise risk, other than risks 
pertaining exclusively to sales and marketing functions. Some 
commentators suggested that management of the manufacturing profits 
might refer to such activities as the management of risks related to 
the raw materials and the utilization of plant capacity, but others 
thought it might encompass the finance function of a company.
    The IRS and the Treasury Department agree that further 
clarification is needed as to the functions that are intended to be 
included within what was labeled ``management of the manufacturing 
profits'' and ``management of the risk of loss'' in the proposed 
regulations. The IRS and the Treasury Department intend that the 
substantial contribution test recognize contributions made by a CFC's 
employees to the manufacturing process through functions which help to 
ensure that a plant is run in an economically efficient manner, such as 
optimization of plant capacity and reduction of waste (for example, 
waste of raw materials). On the other hand, not all corporate 
managerial decisions are intended to be considered in the substantial 
contribution test, because many such decisions are not directly related 
to the manufacture of the personal property with respect to which the 
substantial contribution analysis is being performed. For example, the 
IRS and the Treasury Department do not intend that corporate finance 
decisions be considered in the substantial contribution test. 
Similarly, the IRS and the Treasury Department do not intend that the 
general management of enterprise risk be considered in the substantial 
contribution test.
    The IRS and the Treasury Department concluded that the term 
``management of the manufacturing costs or capacities'' more accurately 
reflects the type of functions originally contemplated by ``management 
of the manufacturing profits'' in the proposed regulations and is also 
related to the types of functions contemplated by the ``management of 
the risk of loss.'' Accordingly, the activity labeled ``management of 
the manufacturing profits'' in the proposed regulations is replaced in 
the final regulations with an activity entitled ``management of 
manufacturing costs or capacities.'' Further, the final regulations 
include a parenthetical list of functions (that is, managing the risk 
of loss, cost reduction or efficiency initiatives associated with the 
manufacturing process, demand planning, production scheduling, or 
hedging raw material costs) to elaborate on the meaning of the 
activity.
d. Control of Logistics
    Commentators asked for clarification regarding the scope of 
logistical functions that will contribute towards a substantial 
contribution by a CFC. This activity is intended to include, for 
example, arranging for delivery of raw materials to a contract 
manufacturer, but to exclude, for example, delivery of finished goods 
to a customer. The final regulations provide further clarity on this 
issue by revising the activity to read ``control of manufacturing 
related logistics.''
e. 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
    Commentators noted that the ``and'' in the description of this 
activity in the proposed regulations could be read to mean that 
directing the ``development, protection, and use'' of intellectual 
property are all required for this activity to be considered in the 
substantial contribution analysis. Commentators requested that these 
activities be stated in the disjunctive. The IRS and the Treasury 
Department adopted this comment, replacing ``and'' with ``or'' in the 
final regulations. This clarification is consistent with providing that 
all functions performed by a CFC's employees are considered (and given 
appropriate weight) under the substantial contribution test. Thus, the 
CFC's employees' activities are considered regardless of whether the 
CFC's employees perform all or only some of the functions listed in any 
enumerated item in the indicia of manufacturing.
    The term ``protection'' is also deleted from the final regulations. 
The IRS and the Treasury Department were concerned that absent this 
clarification the final regulations could be read to provide that legal 
work performed by a CFC's in-house legal staff was considered under the 
substantial contribution test, including in cases where, for example, 
litigation success could be heavily correlated to

[[Page 79338]]

profitability or business failure with respect to a product. Further, 
the IRS and the Treasury Department modified the description of the 
activity in the final regulations to clarify that developing, or 
directing the use or development of, trade secrets, technology, or 
other intellectual property, are considered under the substantial 
contribution test, but only when activities of this nature are 
undertaken for the purpose of the manufacture of the personal property.
    Commentators asked whether the intellectual property referred to in 
Prop. Reg. Sec.  1.954-3(a)(4)(iv)(b)(9) included marketing 
intangibles. The activity as described in both the proposed and final 
regulations is with respect to intellectual property used in the 
manufacture of the personal property. Thus, developing, or directing 
the use or development of, marketing intangibles is not intended to be 
considered in the substantial contribution test.
3. Anti-abuse Rule and Safe Harbor
    The IRS and the Treasury Department requested comments on whether 
the substantial contribution test should include an anti-abuse rule and 
safe harbor. In particular, comments were requested as to whether it 
would be appropriate to add an anti-abuse rule to prevent a CFC from 
satisfying the substantial contribution test in cases in which a 
significant portion of the direct or indirect contributions to the 
manufacture of personal property provided collectively by the CFC and 
any related U.S. persons are provided by one or more related U.S. 
persons. Commentators recommended that in determining whether a CFC 
makes a substantial contribution it should not be relevant whether 
other persons (whether U.S. or foreign, related or unrelated) 
contribute to the manufacturing process. The IRS and the Treasury 
Department agree with commentators that the substantial contribution 
test should focus on whether the activities of the CFC itself are 
substantial without comparing those activities to those of other 
persons. Thus, the final regulations do not adopt such a rule. Examples 
in the final regulations also illustrate that the contributions of 
other persons to the manufacture of a product are not relevant to the 
analysis of whether a CFC makes a substantial contribution to the 
manufacturing process. See Sec.  1.954-3(a)(4)(iv)(d) Examples 6, 7, 
and 9.
    The IRS and the Treasury Department also requested comments as to 
whether one or more safe harbors should be added to the substantial 
contribution test of the proposed regulations. Some commentators 
suggested that a CFC that contributes at least twenty percent of the 
costs of manufacturing personal property should be deemed to have 
substantially contributed to its manufacture. Other commentators 
suggested that a safe harbor was only appropriate if it were made clear 
that such a safe harbor would not function as a minimum standard and 
would be flexible enough to accommodate multiple industries. Many other 
commentators recommended that the IRS and the Treasury Department not 
adopt a safe harbor. The IRS and the Treasury Department concluded that 
no safe harbor could fairly apply across the range of industries 
potentially subject to Sec.  1.954-3, and therefore no safe harbor is 
provided in the final regulations.
4. Definition of Employee
    The IRS and the Treasury Department requested comments as to 
whether the requirement in the proposed regulations that the activities 
of the CFC be performed by its employees should take into account 
commercial arrangements where individuals performing services for the 
CFC while not on its payroll are nevertheless controlled by employees 
of the CFC. Commentators requested that the regulations expand the 
definition of the term ``employee'' to include various commercial or 
economic arrangements where individuals who perform services for a CFC 
under the CFC's direction and control are not necessarily the CFC's 
employees under local law. In particular, commentators suggested that 
the term ``employee'' could be defined for purposes of the substantial 
contribution test using section 3121(d)(2). Other commentators asked 
that the term ``employee'' be defined more broadly to include anyone in 
an agency relationship with a CFC.
    The IRS and the Treasury Department agree that clarification of the 
term ``employee'' will promote more effective application of these 
regulations. The IRS and the Treasury Department also agree that 
activities performed by certain non-payroll workers should be 
considered in determining whether the CFC provides a substantial 
contribution through ``its employees.'' However, the IRS and the 
Treasury Department concluded that it would be inappropriate to broaden 
the definition of employee to include anyone in an agency relationship 
with a CFC, because it could create unintended branch rule issues for 
taxpayers (for example, as a result of employees of a contract 
manufacturer being treated as employees of the CFC under such a 
definition). Thus, the final regulations provide that the term employee 
means any individual who, under Sec.  31.3121(d)-1(c), has the status 
of an employee for U.S. Federal tax purposes. This definition of the 
term ``employee'' may encompass certain seconded workers, part-time 
workers, workers on the payroll of a related employment company whose 
activities are directed and controlled by CFC employees, and 
contractors, so long as those individuals are deemed to be employees of 
the CFC under Sec.  31.3121(d)-1(c). Consistent with commentators' 
request, this definition of the term employee may result in an 
individual being treated as an employee of two or more entities 
simultaneously.
5. Product Grouping
    Commentators requested that the determination of whether a CFC 
provides a substantial contribution to the manufacture of the personal 
property be made on the basis of a group or line of related products 
rather than on a product-by-product basis. The IRS and the Treasury 
Department believe that the substantial contribution test must be met 
with respect to each product. Whether manufactured goods are separate 
products or a single product for this purpose is determined by 
reference to the distinctions or lack thereof made by the CFC in its 
business operations and in its books and records, rather than by 
reference to a third party's definition of a product or an industry 
product classification system, such as the Standard Industrial 
Classification Code. The IRS and the Treasury Department recognize that 
some activities taken into account under the substantial contribution 
test are not performed with respect to each individual unit of a 
particular product manufactured under a contract manufacturing 
arrangement. Section 1.954-3(a)(4)(iv)(d) Example 11 has been added to 
the final regulations to address these comments.
6. Treatment of Partnerships
    Commentators requested that the regulations adopt principles to 
determine when the employees of a partnership should be treated as 
employees of the CFC for purposes of determining whether the CFC's 
relative economic interest in the partnership should be relevant in 
determining whether the CFC satisfies the substantial contribution 
test. The IRS and the Treasury Department concluded that this issue was 
beyond the scope of this regulatory project. However, the IRS and the 
Treasury Department continue to study this issue and welcome comments.

[[Page 79339]]

7. Rebuttable Presumption
    The proposed regulations provide a rebuttable presumption that the 
CFC does not satisfy the substantial contribution test when the 
activities of a branch of the CFC satisfy the physical manufacturing 
test. The presumption can only be rebutted if the taxpayer can prove to 
the satisfaction of the Commissioner that the CFC satisfied the 
substantial contribution test. Commentators suggested that satisfaction 
of the physical manufacturing test and satisfaction of the substantial 
contribution test should be treated equally under the regulations. 
Commentators also expressed the view that the standard required to 
rebut the presumption was either too subjective, imposed an improperly 
high standard, or both. They recommended that if a rebuttable 
presumption was retained, the standard required to rebut the 
presumption should be clear and convincing evidence.
    In response to the comments received, the IRS and the Treasury 
Department reconsidered the ability to examine a CFC's claim that it 
substantially contributes to the manufacture of the personal property 
when the activities of its branch satisfy the physical manufacturing 
test. Upon further study, the IRS and the Treasury Department concluded 
that the substantial contribution test can be administered without the 
benefit of a rebuttable presumption that a CFC does not satisfy the 
substantial contribution test when the activities of a branch of the 
CFC satisfy the physical manufacturing test. Thus, these final and 
temporary regulations do not contain a rebuttable presumption. The IRS 
and the Treasury Department took into account the request for parity of 
treatment with respect to satisfaction of the physical manufacturing 
test and the substantial contribution test in reaching this conclusion, 
as well as with respect to other aspects of the temporary regulations, 
as discussed further in Parts C and D of this preamble.
8. Documentation
    Some commentators requested guidance on how taxpayers should 
document their activities for application of the substantial 
contribution test. Because the necessary documentation will vary by 
industry and by taxpayer, the IRS and the Treasury Department believe 
that creating general rules of documentation would prove impracticable 
and would not allow for enough flexibility in application of the 
substantial contribution test. Accordingly, the final regulations do 
not include documentation rules.
9. Automated Manufacturing
    Several comments were received concerning Prop. Reg. Sec.  1.954-
3(a)(4)(iv)(c) Example 4. In Example 4, a CFC owns software and network 
systems that remotely and automatically (without human involvement) 
order raw materials for use by the contract manufacturer, take customer 
orders and route them to the contract manufacturer, and perform quality 
control. Although the CFC has a small number of computer technicians 
monitoring the software and network systems, the software and network 
systems were developed by employees of DP, the CFC's domestic parent 
corporation. Those DP employees supervise the CFC's computer 
technicians, evaluate the results of the automated manufacturing 
business, make ongoing operational decisions related to the performance 
of the manufacturing process, redesign and update the products and the 
manufacturing process, and develop all of the upgrades and patches for 
the software and network systems owned by the CFC. The example 
concludes that the CFC does not provide a substantial contribution to 
the manufacture of Product X.
    Commentators expressed concern that Prop. Reg. Sec.  1.954-
3(a)(4)(iv)(c) Example 4 did not recognize the importance of automated 
manufacturing in modern business practices. These commentators noted 
that manufacturing processes are increasingly automated and explained 
that in some high technology industries, automated manufacturing 
processes are the only way to manufacture and test the quality of 
certain products. In such industries, commentators noted that human 
involvement in various parts of the manufacturing process could be 
counterproductive. Some commentators were concerned that Prop. Reg. 
Sec.  1.954-3(a)(4)(iv)(c) Example 4 penalized such automated 
manufacturing processes under the substantial contribution test.
    The IRS and the Treasury Department agree that a CFC may provide a 
substantial contribution to a largely automated manufacturing process 
through its employees. Section 1.954-3(a)(4)(iv)(d) Example 5 contains 
the same facts as Prop. Reg. Sec.  1.954-3(a)(4)(iv)(c) Example 4. 
Under those particular facts, substantial operational responsibilities 
and decision making by humans are required for the manufacturing 
process; however, they are not performed by the CFC. To provide 
additional guidance, the final regulations include an additional 
example, Sec.  1.954-3(a)(4)(iv)(d) Example 6, which illustrates that a 
CFC whose employees perform most of the functions that DP's employees 
perform in Sec.  1.954-3(a)(4)(iv)(d) Example 5 makes a substantial 
contribution to the manufacturing process. This result applies even 
though DP's employees also contribute to the manufacturing process. 
Section 1.954-3(a)(4)(iv)(d) Example 7 further illustrates that the CFC 
can make a substantial contribution through the activities of its 
employees regardless of whether the software and network systems were 
purchased by the CFC. These examples illustrate that the evaluation of 
whether a CFC makes a substantial contribution through its employees is 
determined based on whether industry-sufficient substantial 
contribution activities are conducted by employees of the CFC.

B. The ``Its'' Argument

    The proposed regulations clarify that for purposes of determining 
FBCSI a CFC qualifies for the manufacturing exception only if the CFC, 
acting through its employees, manufactured, produced, or constructed 
the relevant personal property within the meaning of Sec.  1.954-
3(a)(4)(i). In response to the proposed regulations, some commentators 
maintained that a CFC need not satisfy the physical manufacturing test 
or the substantial contribution test to exclude a sale from FBCSI as 
long as the personal property sold is not the same as the property 
originally purchased by the CFC.
    The IRS and the Treasury Department believe, as described in the 
preamble to the proposed regulations, that this position, commonly 
referred to as the ``its'' argument, is contrary to existing law, and 
represents an incorrect reading of section 954(d)(1). The final 
regulations accordingly maintain the rules provided in the proposed 
regulations regarding when personal property sold by a CFC will be 
considered to be other than the property purchased by the CFC.

C. Same Country Manufacture Exception

    Commentators requested that the regulations incorporate the 
substantial contribution test in the same country manufacture 
exception. The IRS and the Treasury Department generally agree with 
commentators that if the substantial contribution test is sufficient to 
constitute the manufacture of the personal property where a CFC 
substantially contributes to the manufacture, production, or 
construction of that property, then it

[[Page 79340]]

should be equally sufficient if those activities are performed by a 
related person (as defined in section 954(d)(3)) in the CFC's country 
of organization. However, the IRS and the Treasury Department concluded 
that the same country manufacture exception would be difficult to 
administer and enforce in the case of a substantial contribution 
performed by an unrelated third party. Commentators suggested that 
these concerns could be ameliorated if taxpayers were required to 
maintain documentation with respect to a third party's substantial 
contribution. The IRS and the Treasury Department do not believe a 
documentation requirement adequately addresses these concerns because 
the IRS may be unable to audit the third party to verify if those 
substantial contribution activities in fact took place. Therefore, the 
final regulations provide that the same country manufacture exception 
is available to taxpayers in cases when a related person provides a 
substantial contribution to the manufacture of the personal property in 
the CFC's country of organization. The final regulations also retain 
the rule provided in the proposed regulations modifying the application 
of the principles of Sec.  1.954-3(a)(4)(ii) and (a)(4)(iii) to reflect 
that the personal property manufactured, produced, or constructed in 
the country of organization of the selling corporation under the 
principles of Sec.  1.954-3(a)(4)(ii) and (a)(4)(iii) will qualify for 
the same country exception regardless of whose employees engage in 
qualifying manufacturing activities in that country.

D. Branch Rule

    In addition to the amendments to Sec.  1.954-3(a), the proposed 
regulations also proposed amendments to the rules of Sec.  1.954-3(b) 
dealing with the application of the FBCSI rules to CFCs with branches 
or similar establishments (the branch rule), particularly the rules 
dealing with manufacturing branches. For the remainder of this 
preamble, the word ``branch'' will be used to refer to a ``branch or 
similar establishment.''
1. Branch Definition
    Some commentators requested that the regulations define the term 
``branch'' for purposes of the branch rule. These commentators 
suggested various definitions for the IRS and the Treasury Department 
to consider. Commentators suggested, for instance, that a branch be 
defined as a permanent establishment, as a business activity in a 
jurisdiction outside a CFC's country of organization that has separate 
books and records, or as a trade or business outside a CFC's country of 
organization. Commentators pointed to precedents in the section 367 and 
987 regulations. Alternatively, some commentators requested that the 
regulations make clear that a de minimis amount of activity outside of 
a CFC's country of organization (for example, traveling employees) does 
not constitute a branch. Other commentators warned that requiring too 
high a level of activity outside of a CFC's country of organization 
before a CFC was treated as having a ``branch'' would make it possible 
for a CFC organized in a lower-tax jurisdiction to contribute 
substantially to manufacturing activities in a higher-tax jurisdiction 
without causing the CFC to operate through a branch. Still other 
commentators suggested that courts have concluded that the IRS and the 
Treasury Department lack the regulatory authority to determine what 
constitutes a branch, and they may only address the consequences 
flowing from the existence of a branch.
    The IRS and the Treasury Department determined that defining a 
branch was beyond the scope of this regulatory project. However, the 
temporary regulations retain an example similar to Prop. Reg. Sec.  
1.954-3(b)(1)(ii)(c)(3)(f) Example 3, which illustrates that employees 
of a CFC that travel to a contract manufacturer's location outside the 
CFC's country of organization do not necessarily give rise to a branch 
in that location. See Sec.  1.954-3T(b)(1)(ii)(c)(3)(v) Example 6. See 
also Part D.3.b of this preamble.
2. Determination of Hypothetical Effective Tax Rate
    Commentators requested that the regulations clarify that the tax 
rate disparity tests contained in Sec. Sec.  1.954-3(b)(1)(i)(b) and 
(b)(1)(ii)(b) take into account incentive tax rates and other similar 
foreign tax relief available to a CFC in calculating the hypothetical 
effective tax rate of tax.
    The IRS and the Treasury Department recognize that the tax rate 
disparity tests should take into account the actual tax rate paid with 
respect to the sales income by the selling branch or remainder and the 
hypothetical effective tax rate that would be paid by the manufacturing 
branch (or remainder) on that sales income under the laws of the 
country in which the manufacturing branch is located (or, in the case 
of a remainder, the country of organization of the CFC) if it were 
derived from sources within that country. Thus, the IRS and the 
Treasury Department agree that uniformly available tax incentives are 
to be considered in determining the hypothetical effective tax rate to 
be used in applying the tax rate disparity tests. In contrast, if a 
sales affiliate in the country of manufacturing can theoretically 
receive certain tax relief by taking certain actions, for example, by 
applying for special treatment pursuant to a ruling process, but the 
taxpayer has not affirmatively obtained such tax relief for the 
manufacturing branch (or remainder), then the hypothetical effective 
tax rate that would be paid by the manufacturing branch (or remainder) 
were it to derive the sales income should be the effective tax rate 
that would be applicable in that jurisdiction without such tax relief. 
The IRS and the Treasury Department believe that no change to the text 
of the existing regulations is necessary to address these points. 
However, Sec.  1.954-3T(b)(4) Example (8) is included in the temporary 
regulations to illustrate that uniformly applicable incentive tax rates 
are taken into account in determining the hypothetical effective tax 
rate.
    The IRS and the Treasury Department concluded that other questions 
and requests in this area, including further clarification of the 
methodology for calculation of hypothetical tax rates, and for changes 
to the assumptions used in applying the tax rate disparity tests and 
determining the hypothetical effective tax rate, are beyond the scope 
of this regulatory project. However, the IRS and the Treasury 
Department continue to study these questions and welcome comments.
3. Multiple Manufacturing Branch Rules
a. Determination of the Location of Manufacturing
    Under Prop. Reg. Sec.  1.954-3(b)(1)(ii)(c)(3), the relevant tax 
rate disparity test is applied by giving satisfaction of the physical 
manufacturing test precedence over satisfaction of the substantial 
contribution test 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. If more than one branch (or one 
or more branches and the remainder of the CFC) each independently 
satisfies 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 is treated as the 
location of manufacturing, producing, or constructing of the personal 
property for purposes of applying the tax rate disparity test (lowest-
of-all-rates rule). If only one branch (or only the remainder of a CFC) 
independently satisfies the physical manufacturing test, then that

[[Page 79341]]

branch (or remainder) is treated as the location of manufacturing, 
producing, or constructing of the personal property (location of 
manufacturing) for purposes of the tax rate disparity test.
    If none of the branches or the remainder of the CFC independently 
satisfies the physical manufacturing test, but the CFC as a whole 
satisfies the substantial contribution test, then the location of 
manufacturing under the proposed regulations is the location of the 
branch or the remainder of the CFC that provides the predominant amount 
of the CFC's substantial contribution to the manufacture of the 
personal property (predominant place rule). If a predominant amount of 
the CFC's contribution to the manufacture of the personal property is 
not provided by any one location, then the location of manufacturing 
for purposes of applying the manufacturing branch tax rate disparity 
test under the proposed regulations is that place (either the remainder 
of the CFC or one of its branches) where manufacturing activity with 
respect to that property is performed and which would impose the 
highest effective rate of tax (highest-of-all-rates rule) when applying 
either Sec.  1.954-3(b)(1)(i)(b) or (b)(1)(ii)(b).
    The IRS and the Treasury Department received multiple comments 
comparing and contrasting the highest- and lowest-of-all-rates rules. 
For example, commentators asked why the lowest-of-all-rates rule should 
apply when more than one branch (or one or more branches and the 
remainder of the CFC) independently satisfy the physical manufacturing 
test, whereas the highest-of-all-rates rule should apply when none of 
the branches or the remainder of the CFC independently satisfies the 
physical manufacturing test but the CFC as a whole satisfies the 
substantial contribution test. Commentators suggested that satisfaction 
of the physical manufacturing test and the substantial contribution 
test should be treated equally under the regulations, and therefore 
suggested having the same rule in both circumstances. These 
commentators proposed a lowest-of-all-rates rule or the use of a 
weighted average of the tax rate of each branch or remainder of the CFC 
in both instances.
    The IRS and the Treasury Department generally agreed with these 
comments. The IRS and the Treasury Department adopted taxpayers' 
comment that the same rule should apply consistently when a branch (or 
remainder) independently satisfies Sec.  1.954-3(a)(4)(i), regardless 
of whether it satisfies the physical manufacturing test or the 
substantial contribution test. Therefore the rules set forth in the 
proposed regulations are modified in the temporary regulations to 
provide that the lowest-of-all-rates rule will apply whenever a branch 
(or remainder) independently satisfies Sec.  1.954-3(a)(4)(ii), (iii), 
or (iv). However, providing parity of treatment for satisfaction of the 
physical manufacturing test and the substantial contribution test in 
respect of the lowest-of-all-rates rule is not sufficient to determine 
the location of manufacturing in cases where a CFC satisfies the 
substantial contribution test, yet no branch (or remainder) 
independently satisfies Sec.  1.954-3(a)(4)(iv).
    Commentators questioned how to treat branches making contributions 
to the manufacture of the personal property through the activities of 
employees when no branch independently satisfies Sec.  1.954-
3(a)(4)(iv). Some commentators expressed concern that it would be 
difficult to compare the relative contributions of various locations to 
determine which branch or remainder of the CFC made a predominant 
contribution under the predominant place rule. Other commentators 
requested greater guidance regarding the meaning of predominant 
contribution. Many commentators suggested that the highest-of-all-rates 
rule in the proposed regulations could lead to arbitrary results when 
no predominant contributor could be identified.
    The IRS and the Treasury Department generally agreed with these 
comments. Consequently, the temporary regulations revise the rules for 
determining the location of manufacture of the personal property when 
more than one branch (or one or more branches and the remainder) 
contributes to the manufacture of the personal property but no branch 
(or remainder) independently satisfies the physical manufacturing test 
or the substantial contribution test. The revised rules are based on 
the principle that the branch rule should apply in situations where 
purchase or sale activities with respect to the personal property are 
separated from manufacturing activities conducted by the CFC such that 
a demonstrably greater amount of manufacturing activity with respect to 
that property occurs in jurisdictions with tax rate disparity relative 
to the sales or purchase branch (or, in the case of a purchasing or 
selling remainder, the demonstrably greater amount of manufacturing 
activity with respect to the personal property occurs in jurisdictions 
with tax rate disparity relative to the purchasing or selling 
remainder).
    Under the temporary regulations, if a demonstrably greater amount 
of manufacturing activity with respect to the personal property occurs 
in jurisdictions without tax rate disparity relative to the sales or 
purchase branch, the location of the sales or purchase branch will be 
deemed to be the location of manufacture of the personal property. In 
that case, the purchase or sales activities with respect to the 
property purchased or sold by or through the sales or purchase branch 
of the CFC will not, for purposes of determining FBCSI in connection 
with the sale of that property, be deemed to have substantially the 
same tax effect as if a branch were a wholly owned subsidiary 
corporation of the CFC. Otherwise, the location of manufacture of the 
personal property will be deemed to be the location of a manufacturing 
branch (or remainder) that has tax rate disparity relative to the sales 
or purchase branch. In that case, the purchase or sales activities with 
respect to the property purchased or sold by or through the sales or 
purchase branch of the CFC will be deemed to have substantially the 
same tax effect as if a branch were a wholly owned subsidiary 
corporation of the CFC, and that branch will be treated as a separate 
corporation for purposes of applying the regulations.
    The temporary regulations apply analogous rules in the case of 
purchase or sales activity being conducted through the jurisdiction 
under the laws of which the CFC is organized. In such cases, however, 
the analysis focuses on whether the demonstrably greater amount of 
manufacturing activity with respect to the personal property occurs in 
jurisdictions that do or do not have tax rate disparity relative to the 
jurisdiction under the laws of which the CFC is organized. The 
temporary regulations incorporate examples under Sec.  1.954-
3T(b)(1)(ii)(c)(3)(v) to illustrate the application of these rules.
b. Location of Activities
    The proposed regulations provide that for purposes of the multiple 
manufacturing branch rules the location of any activity with respect to 
the manufacture of the personal property is where the CFC's employees 
engage in such activity. Commentators suggested that in some cases the 
proposed regulations left it unclear, for purposes of determining the 
location of manufacturing, which jurisdiction was accorded credit for 
activities performed by an employee who is traveling temporarily to a 
foreign jurisdiction. Some commentators suggested that the location of 
activity rule should be removed or that the regulations should

[[Page 79342]]

clarify that, for instance, the activities of employees of a CFC based 
in the jurisdiction under the laws of which the CFC is organized, even 
while traveling outside the CFC's country of organization, would 
generally be credited toward establishing that the jurisdiction under 
the laws of which the CFC is organized provided a predominant amount of 
a CFC's substantial contribution. The IRS and the Treasury Department 
believe the text of Sec.  1.954-3T(b)(1)(ii)(c)(3)(iv) makes clear that 
when an employee travels to perform activities, those activities are 
credited to the location in which the activities are conducted if there 
is a branch or remainder of the CFC in that jurisdiction. Section 
1.954-3T(b)(1)(ii)(c)(3)(v) provides examples to further clarify this 
result.
    Other commentators asked which location was accorded credit, if 
any, for activities performed by traveling employees of the CFC while 
located in a country in which there is no branch or remainder of the 
CFC. The temporary regulations provide that the location of any 
manufacturing activity is where the employees of the CFC perform that 
activity. Thus, the activities of employees while traveling to a 
country where the CFC does not maintain a branch or remainder are not 
credited to the branch or remainder where the traveling employees are 
regularly employed for purposes of determining the location of 
manufacture of the personal property under the branch rule. Such 
activities, however, can be taken into account for purposes of 
satisfying the manufacturing exception and the substantial contribution 
test. See Sec.  1.954-3T(b)(1)(ii)(c)(3)(v) Example 6.
c. Clarifying Application of the Rule for Determining the Remainder of 
the CFC When Activities Are Performed in Multiple Locations
    Prop Reg. Sec.  1.954-3(b)(2)(ii)(a) provides that when treating 
the location of sales or purchase income as a separate corporation for 
purposes of determining whether FBCSI is realized, that separate 
corporation will exclude any branch or the remainder of the CFC that 
would be treated as a separate corporation, if the hypothetical tax 
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. Commentators suggested that the application of this 
rule for determining the remainder of the CFC when activities are 
preformed in multiple locations is unclear. To clarify, the language 
from the proposed regulations is revised in the temporary regulations 
to describe what is included in the remainder, rather than what is 
excluded from the remainder, for purposes of determining whether there 
is FBCSI, after it is determined that a manufacturing branch should 
receive treatment as a separate corporation for purposes of applying 
the regulations. See Sec.  1.954-3T(b)(2)(ii)(a).
    As with the rule provided in the proposed regulations, this rule is 
intended to provide that the activities of all branch locations (or, in 
the case of a remainder, the activities in the jurisdiction under the 
laws of which the CFC is organized) that do not have tax rate disparity 
relative to the sales or purchase branch location (or, in the case of a 
purchasing or selling remainder, the jurisdiction under the laws of 
which the CFC is organized) may be taken into account together with the 
activities of the sales or purchase branch (or, in the case of a 
purchasing or selling remainder, activities of the remainder of the CFC 
in the jurisdiction under the laws of which the CFC is organized) for 
purposes of applying the separate corporation analysis required under 
the regulations and determining whether the sales income of the sales 
or purchase branch (or remainder) is FBCSI. Such determination will 
depend on whether the substantial contribution test is satisfied by the 
combined activities of the sales or purchase branch (or remainder) and 
the other locations aggregated with the sales or purchase branch (or 
remainder).
4. Coordination of Sales and Manufacturing Branch Rules
    Commentators requested guidance on how the sales or purchase branch 
rules interact with the manufacturing branch rules. The current 
manufacturing branch rules contemplate the existence of a sales or 
purchase branch and a manufacturing branch. The rules provide that in 
such an instance the sales or purchase branch is treated as the 
remainder of the CFC for purposes of applying the tax rate disparity 
test. However, the sales or purchase branch rules of Sec.  1.954-
3(b)(1)(i) of the existing regulations do not indicate that those rules 
do not apply in cases where the manufacturing branch rules are applied. 
Commentators were concerned that the manufacturing branch rules would 
be applied in addition to, rather than in lieu of, the sales or 
purchase branch rules.
    The IRS and the Treasury Department agree that if one or more sales 
or purchase branches are used in addition to a manufacturing branch and 
Sec.  1.954-3T(b)(1)(ii)(c)(1) (use of one or more sales or purchases 
branches in addition to a manufacturing branch) is applied with respect 
to income from the sale of an item of personal property, then the sales 
or purchasing branch rules do not also apply to determine whether that 
income is FBCSI. Therefore, the temporary regulations clarify this 
point. See Sec.  1.954-3(b)(1)(i)(c).
5. Unrelated to Unrelated Transactions
    Commentators suggested that there was uncertainty as to whether a 
substantial contribution to the manufacture, production, or 
construction of personal property by a CFC could cause the CFC to earn 
FBCSI in cases where, in the absence of the substantial contribution 
test, some taxpayers had taken the position that they were outside the 
scope of the FBCSI rules. Some commentators expressed concern that 
transactions that are not currently subject to the existing regulations 
may become subject to the regulations as a result of the interaction of 
the substantial contribution test and the manufacturing branch rule. 
Other commentators suggested more generally that it was unclear if the 
substantial contribution test might create a branch through which a CFC 
carries on activities in a contract manufacturer's jurisdiction. 
Commentators suggested that taxpayers should be exempted from the 
branch consequences of the regulations by providing that the 
manufacturing branch rule only apply if the CFC was relying on the 
manufacturing exception for purposes of section 954(d)(1), or 
alternatively that the substantial contribution test should be 
elective. In this context, commentators noted that placing a CFC's 
substantial contribution activities, which are performed outside the 
country where the sales activities are performed, in a separately 
incorporated entity could prevent the CFC from having a branch that is 
subject to the manufacturing branch rule as a result of such 
activities.
    The IRS and the Treasury Department agree that taxpayers may be 
subject to the FBCSI rules as a result of CFC employees performing 
indicia of manufacturing activities through a branch outside the 
country of organization of a CFC. The IRS and the Treasury Department 
believe this result is clear in the proposed regulations, and therefore 
no modifications are made to the text of the temporary regulations to 
clarify further this result. The IRS and the Treasury Department note 
that many commentators criticized the proposed regulations for drawing 
inappropriate distinctions between satisfaction of the

[[Page 79343]]

physical manufacturing test and satisfaction of the substantial 
contribution test, and argued that updating the manufacturing exception 
in the context of modern business enterprise models required treating 
with equal importance and weight physical manufacturing and activities 
satisfying the substantial contribution test. The IRS and the Treasury 
Department adopted this comment in both the final regulations and the 
temporary regulations and, accordingly, did not incorporate in the 
temporary regulations an exception regarding activities performed 
through a branch located outside the country of organization of a CFC 
for cases in which, in the absence of the substantial contribution 
test, some taxpayers had taken the position that they were outside the 
scope of the FBCSI rules.
    One commentator noted that while there are strong policy reasons 
for the substantial contribution test and the branch rules to apply in 
the case of ``unrelated to unrelated'' transactions, the IRS and the 
Treasury Department should consider a special delayed effective date to 
allow taxpayers in this position time to restructure their operations 
in light of the regulations. The commentator argued that such taxpayers 
had been outside the scope of the FBCSI rules prior to these 
regulations and should be provided reasonable time to restructure. For 
a discussion of the effective date of the final and temporary 
regulations, see Part F of this preamble.
6. Branch Rule Examples
    Commentators expressed concern that the facts of Prop. Reg. Sec.  
1.954-3(b)(1)(ii)(c)(3)(f) Example 4 ascribed most substantial 
contribution activities to the remainder, but determined that the 
remainder had not met the substantial contribution test. In the 
example, the remainder performs seven activities listed in the indicia 
of manufacturing of the proposed regulations, whereas Branch A performs 
only one activity (design) and Branch B performs only two activities. 
The example was intended to show that in a CFC's particular industry, 
the weight accorded to the activities performed by each branch can be 
comparable, even though a different number of activities occur in 
different locations, because the economic significance of the 
activities conducted in each location is comparable. However, the IRS 
and the Treasury Department recognize that the example may have caused 
confusion for taxpayers. Therefore, the allocation of activities in 
Example 4 of Prop. Reg. Sec.  1.954-3(b)(1)(ii)(c)(3)(f) has been 
revised in Sec.  1.954-3T(b)(1)(ii)(c)(3)(v) Example 3. Moreover, 
Examples 4, 5, and 6 of Prop. Reg. Sec.  1.954-3(b)(1)(ii)(c)(3)(f) 
have been restructured in the temporary regulations to be consistent 
with the revisions to the branch rules.
    Commentators also noted that Example 4 and Example 5 of Prop. Reg. 
Sec.  1.954-3(b)(1)(ii)(c)(3)(f) suggest that income other than sales 
or purchasing income may be FBCSI. These examples are amended in the 
temporary regulations to be consistent with section 954(d)(2), which 
provides that income attributable to the carrying on of purchase or 
sales activities by a branch may be FBCSI.
    Commentators requested that the IRS and the Treasury Department add 
an example to the regulations to illustrate how the substantial 
contribution test and the branch rules operate in cases involving 
multiple manufacturing branches and multiple sales branches. The 
temporary regulations include such an example. See Sec.  1.954-
3T(b)(1)(ii)(c)(3)(v) Example 5.
    The temporary regulations also include an example illustrating the 
operation of the location of manufacture rules under Sec.  1.954-
3T(b)(1)(ii)(c)(3) and the application of the substantial contribution 
test when a tested manufacturing location has been determined to have 
tax rate disparity with a tested sales location. See Sec.  1.954-
3T(b)(4) Example (9). Example (9) illustrates that a tested sales 
location can satisfy the substantial contribution test for purposes of 
determining FBCSI once it has been determined that a t