AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

COMMENTS ONPROPOSED FOREIGN BASE COMPANY SALES INCOME

REGULATIONS REGARDING CONTRACT MANUFACTURING ARRANGEMENTS

Approved byInternational Tax Technical Resource Panel (TRP)

andTax Executive Committee

Developed byProposed Contract Manufacturing Regulations Task Force

Ron Dabrowski, Task Force ChairJoseph M. Calianno

Karen JacobsAndy Mattson

Doug PomsPaul Schmidt, International Tax TRP ChairEileen R. Sherr, AICPA Technical Manager

Submitted to the Department of Treasury and Internal Revenue Service

July 23, 2008

AICPA COMMENTS ON FOREIGN BASE COMPANY SALES INCOME REGULATIONS

REGARDING CONTRACT MANUFACTURING ARRANGEMENTS

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

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

EXECUTIVE SUMMARY

Our comments make the following recommendations:

1. The regulations should provide further guidance regarding the non-exclusive factors under the Substantial Contribution test, including what it means to manage the risk of manufacturing profits and to control raw materials, workforce in place, and finished products.

2. The regulations should be explicit in noting that the application of the factors can vary by industry and that no one factor is per se more important than the others. The examples should be expanded to demonstrate how industry and product specific factors are taken into account.

3. We support the use of safe harbors on an industry specific basis. It would appear most efficient to develop the safe harbors outside of the regulations (e.g., through revenue rulings or revenue procedures) and upon consultation with taxpayers and industry groups.

4. The regulations should expand the “employees-only” rule to contemplate the use of non-employee labor (perhaps through a concept of “controlled labor” discussed herein). More specific guidance with respect to the use of non-employees could be done on an industry-specific basis through the revenue ruling or revenue procedure process suggested above.

5. We do not believe an anti-abuse rule with respect to excess U.S. contributions is necessary. If U.S. persons make excessive contributions, the CFC is unlikely to satisfy the Substantial Contribution test in any event.

6. There should be affirmative guidance that more than one CFC can satisfy the Substantial Contribution standard with respect to the same item of property.

1 See 73 F.R. 10716-01 (February 28, 2008); 73 F.R. 20201-01 (April 15, 2008) (technical correction); 73 F.R. 24186-01 (May 2, 2008) (technical correction).

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7. The regulations should provide further guidance on whether and to what extent a CFC’s Substantial Contribution may create a branch.

8. With respect to the negative presumption regarding the Substantial Contribution activity of the remainder vis-à-vis a physical manufacturing branch, we recommend doing away with the presumption. There does not appear to be any strong policy reason for imposing a higher standard and such standard would, in effect, penalize CFCs that have certain types of business and operational models.

9. Regarding the default rule if there is no predominant contribution among non-physical manufacturing branches, we recommend that the determination of whether the branches in the aggregate have the effect of being a subsidiary corporation (under the manufacturing branch rule of section 954(d)(2) and Treas. Reg. sec. 1.954-3(b)(ii)) should be conducted by reference to the weighted average tax rate of all such branches.

10. We request a clarification of the language in prop. reg. section 1.954-3(a)(4)(iv)(a).

11. We provide suggested additional examples in three areas:a. Applying the Substantial Contribution test to “buy/sell” arrangements;b. Defining what constitutes an employee who may perform activities considered to be a

Substantial Contribution to the manufacturing process; andc. Clarifying that the Substantial Contribution test can be met by a branch of a CFC.

I. Comments Regarding the Substantial Contribution Test

A. Scope of the Substantial Contribution Test

Background

Under section 954(d)(1), FBCSI is defined as income derived by a CFC in connection with (1) the purchase of personal property from a related person and its sale to any person (2) the sale of personal property to any person on behalf of a related person, (3) the purchase of personal property from any person and its sale to a related person or (4) the purchase of personal property from any person on behalf of a related party, provided that the property is both manufactured, produced, grown, or extracted outside of the CFC’s country of organization and is sold for use, consumption or disposition outside of such country. FBCSI does not include income derived in connection with the sale of personal property that is manufactured, produced or constructed in whole or in part from personal property purchased by the CFC (the “manufacturing exception”).2 The current regulations provide tests to determine whether a CFC manufactures, produces, or constructs the property it sells and, hence, qualifies for the manufacturing exception.3 The preamble to the proposed regulations refers to these tests collectively as the “physical manufacturing test.”4

The proposed regulations add the Substantial Contribution test to determine the applicability of the manufacturing exception. This test applies to situations in which a CFC does not itself physically

2 Reg. §1.954-3(a)(4)(i).3 See Reg. §1.954-3(a)(4)(ii) and (iii).4 See preamble to proposed regulations at 73 FR 10716 (February 28, 2008).

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manufacture the product but undertakes other activities associated with the physical manufacturing process that may be sufficient to qualify the CFC as a manufacturer.5 Whether a CFC substantially contributes to the manufacture of a product will be determined on a facts and circumstances basis.6 The proposed regulations provide a non-exclusive list of nine activities that may be considered in the determination, including “control of raw materials, work in process, and finished goods” and “management of manufacturing profits.7

We request clarification of “control of the raw materials, work-in-process and finished goods” and “management of the manufacturing profits.” These factors appear to be similar to those in now obsolete Rev. Rul. 75-7.8 In that ruling, the Service determined, based on certain factors, that the activities of an unrelated contract manufacturer, Y, to process ore concentrate into a ferroalloy could be considered as performed by X, the contracting CFC.9

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

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

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

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

The view that control of the raw materials, work-in-process and finished goods does not necessarily mean ownership of such property was affirmed by the Service in a public comment and through the issuance of technical corrections to the proposed regulations.12 The technical corrections revised Example 3 under

5 Prop. Reg. §1.954-3(a)(4)(iv).6 Id.7 Prop. Reg. §1.954-3(a)(4)(iv)(b).8 Rev. Rul. 75-7, 1975-1 C.B. 244. Rev. Rul. 97-48, 1997-2 C.B. 89, revoked Rev. Rul. 75-7. See also Fuller, James P., 49 Tax Notes Int’l 1149 (March 31, 2008). 9 Rev. Rul. 75-7, 1975-1 C.B. 244.10 See FSA 200220005; 2002 FSA LEXIS 24 (February 5, 2002); Ashland Oil, Inc. v. Commissioner, 95 T.C. 348 (1990); 1996 FSA LEXIS 463 (April 30, 1996), and PLR 7809003, 1977 PLR LEXIS 3105 (November 18, 1977).11 See PLR 8749060, 1987 PLR LEXIS 1413 (September 8, 1987) and PLR 8739003, 1987 PLR LEXIS 2251 (June 17, 1987).12 RIN 1545-BG11, 73 F.R. 73, 20201 — 20203 (2008). Sheppard, Lee A, 49 Tax Notes Int'l 834 - NEWS ANALYSIS: TREASURY OFFICIALS DISCUSS REFORM, CONTRACT MANUFACTURING. (Section 954 -- Foreign Base Company Income) (Release Date: MARCH 05, 2008) (Doc 2008-4795).

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prop. reg. section 1.954-3(a)(4)(iv)(c), which illustrates the Substantial Contribution exception. Example 3 is one of four examples in that section describing scenarios under which the CFC will be treated as having satisfied, or as not having satisfied, the Substantial Contribution exception. Under the "result" section of Example 3, the language, "If the manufacturing activities undertaken with respect to Product X between the time the raw materials were purchased and the time Product X was sold …" was changed to "If the manufacturing activities undertaken with respect to Product X prior to sale…." The change seems to suggest that the CFC does not need to purchase and own the raw materials during the manufacturing process in order to satisfy the Substantial Contribution exception. Thus, the change implies that the Substantial Contribution exception can be met by CFCs that enter into true contract manufacturing arrangements (as opposed to consignment manufacturing arrangements).13

We request that “control of the raw materials, work-in-process, and finished goods” be clarified to expressly provide that the phrase contemplates the purchase and ownership of raw materials, work-in-process and finished goods and/or bearing economic risk of loss for the property at all phases. We also recommend that the regulations affirmatively provide that holding title is not required in order for a CFC to be considered a manufacturer. This is consistent with rulings issued by the Service applying Rev. Rul. 75-7.14

Management of the manufacturing profits

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

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

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

13 See Rollinson, O’Connor, Pirozek, and Karasek, Treasury Issues Technical Corrections to Contract Manufacturing Proposed Regulations, Ernst & Young LLP International Tax Alert (April 17, 2008). The technical corrections did not entirely clear up the ambiguity. For example, the technical corrections did not change the facts of Example 3, which indicates that FS, which is the CFC, purchases raw materials. See also Bates and Kirkwood, Contract Manufacturing: Is the War Over?, 50 Tax Notes Int'l 61 (Apr. 7, 2008).14 See PLR 7809003; 1977 PLR LEXIS 3105 (November 18, 1977).15 See also Fuller, James P., Fenwick & West, 49 Tax Notes Int’l 1149 (March 31, 2008).16 Sheppard, Lee A, 49 Tax Notes Int'l 834 - NEWS ANALYSIS: TREASURY OFFICIALS DISCUSS REFORM, CONTRACT MANUFACTURING. (Section 954 -- Foreign Base Company Income) (Release Date: MARCH 05, 2008) (Doc 2008-4795).17 2008 WTD 97-5 GOING NAKED: Service OFFICIAL EXPANDS CONTRACT MANUFACTURING COMMENTS. (Section 954 -- Foreign Base Company Income) (Release Date: MAY 16, 2008) (Doc 2008-10978).

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

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

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

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

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

First, determine all manufacturing contributions that do not constitute physical manufacturing under prop. reg. Section 1.954-3(a)(4)(ii) or (iii) but that are part of the manufacture of a given product.

Second, determine the relative importance of the various contributions. This may be done by reference to the relative costs of the contributions, to the relative value-added by the contributions, and/or to any other metric indicative of the relative contributions of the contributing activities.

Third, determine the extent to which the CFC performs each of the contributions through its employees and controlled labor (discussed below).

The various examples in the proposed regulations should be revised to reflect this weighing process. As originally drafted, the examples discussed the presence or absence of certain factors and then reach

18 2008 TNT 79-1 BOOTS ON THE GROUND: Service OFFICIAL EXPANDS CONTRACT MANUFACTURING COMMENTS. (Section 954 -- Foreign Base Company Income) (Release Date: APRIL 22, 2008) (Doc 2008-8952).

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

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

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

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

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

D. Definition of Employees for Purposes of Substantial Contribution

19 See prop. reg. section 1.954-3(b)(1)(ii)(f) Example 4, Example 5.

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

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

We believe that limiting the activities by which a CFC can be viewed as satisfying the Substantial Contribution test to those activities conducted by “employees” is too narrow. There are often instances where a CFC uses other contractual arrangements and relationships that, while not typical, or even common law, employer-employee relationships, should be considered as being performed on behalf of the CFC in the same manner as if those activities had been conducted directly by common-law employees of the CFC. Such arrangements might include, for example, secondment arrangements or contractual arrangements under which the contractor performs services under the direct control of the CFC’s employees but nevertheless does not satisfy some of the factors for being an employee included in Rev. Rul. 87-41, such as the presence of a continuing relationship, working full-time, working on the CFC’s premises, the furnishing of tools and materials, and working for only one firm at a time. There may be scenarios where a CFC uses a combination of these relationships and employees of its own and has a substantial amount of control over the individuals and the manufacturing process generally. The courts in both Electronic Arts v. Commissioner23 and MedChem, Inc. v. Commissioner24 indicated that it is not the employer-employee relationship that is important in the determination of which party manufactures in a contract manufacturing relationship, but rather the control over the process, including the amount of control over the individuals performing certain roles (often times managerial or supervisory roles). Thus, requiring a strict employer-employee relationship arguably is narrower than existing law.

In our view, the Substantial Contribution standard should not depend on whether the qualifying activities are performed by persons who are narrowly defined as “employees” of the CFC under existing guidance. Rather, the test for whether the CFC provides a Substantial Contribution should include activities performed both by common-law employees of the CFC and by individuals that have a contractual relationship with the CFC and are under the direct control of the employees of the CFC. (Treasury and the Service may find it expedient to identify such qualifying non-employees through a defined term such as “controlled labor.”) Such a definition requires that a CFC has employees itself, but allows a CFC, for example, to utilize seconded employees or certain supervised contractors ( i.e., that do not satisfy the Rev. Rul. 87-41 definition of employee) to perform quality control, or to contract for logistics or information technology services, so long as the service providers are under the direct control of the CFC. Indicia of direct control include, for example, decision making authority, signatory authority, and establishment of

20 Proposed reg. section 1.954-3(a)(4)(iv).21 Section 3401(a).22 These persons are commonly described as those individuals that would receive a Form W-2, as opposed to a independent contractor, which would generally receive a Form 1099, for reporting earnings.23 118 TC 226 (2002).24 116 TC 308 (2001).

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procedures and guidelines.25 Examples can be used to demonstrate when there is an amount of employee staffing necessary in the CFC to give it sufficient substance and to illustrate what type of control the CFC must exert over the process. (We have provided one such example in the last section of this letter.) However, the arrangements utilized by multinational corporations often vary from industry to industry and certain industries may utilize independent contractors more frequently than others. We recommend that industry specific clarifications be addressed through revenue rulings and private letter rulings in the future as concerns are raised by taxpayers in those specific industries.

E. Anti-Abuse Rule for US Contribution

The preamble to the proposed regulations requests comments on whether it would be appropriate to add an anti-abuse rule similar to the foreign base company services income substantial assistance test announced in Notice 2007-13.26 Such an anti-abuse rule may 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 collectively by the CFC and related United States persons is provided by one or more related United States persons. We believe that such an anti-abuse rule is inappropriate because the Substantial Contribution test purports to determine whether the CFC’s activities are substantial, and does not focus on the CFC’s relative contribution to the manufacturing process. The test inherently protects against excess US contribution because a CFC will not be able to satisfy the Substantial Contribution test if the facts and circumstances demonstrate that the CFC does not make a Substantial Contribution to the manufacture of property through the activities of its employees. The automated manufacturing example in the proposed regulations, Example 4 of prop. reg. Section 1.954-3(a)(4)(iv)(c), illustrates this point. In that example, the substantial operational responsibilities and decision-making over the manufacturing process exercised by the CFC’s domestic parent did not allow the CFC to satisfy the Substantial Contribution test.

In addition, the proposed regulations clearly provide that more than one party can make a Substantial Contribution to the manufacture of an item of property and, indeed, that more than one branch of a CFC may make a contribution to the manufacture of property.27 In our view, this focus on the substantiality of the activities of the CFC, and not its comparative contribution relative to the activities of others, is appropriate.

F. Multiple CFCs May Make Substantial Contribution to Manufacturing

As noted above, the proposed regulations clearly provide that more than one party can contribute to the manufacture of an item of property and, indeed, that more than one branch of a CFC can contribute to the manufacture of property.28 However, none of the examples nor the proposed regulations themselves expressly address whether more than one CFC can satisfy the Substantial Contribution standard with respect to the same item of property. The ability of more than one CFC to satisfy the Substantial Contribution standard with respect to the same item of property seems implied by the proposed

25 Although there would be some overlap with Rev. Rul. 87-41, the standard for controlled labor in this context would be broader and focus primarily on the control element.26 Under Notice 2007-13, the substantial assistance rules contained in the reg. section 1.954-4 regulations for determining whether a CFC has foreign base company services income apply only if the cost to the CFC of the services furnished by the related U.S. person(s) equals or exceeds 80 percent of the total cost to the CFC of performing those services.27 See, e.g., prop. reg. section 1.954-3(b)(1)(ii)(c)(3)(f), Examples 4 and 5.28 See, e.g., prop. reg. section 1.954-3(b)(1)(ii)(c)(3)(f), Examples 4 and 5.

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regulations and the examples, but it is not clear. There should be affirmative guidance in the proposed regulations to that effect.

II. Comments Regarding the Branch Rule

A. Defining a Manufacturing Branch

The current regulations generally define a manufacturing branch as a branch or similar establishment through which a CFC carries on manufacturing activities.29 Treasury and the Service have specifically requested comments on the definition of branch due to the fact that the proposed “rules are under pressure” to include such definition “because the new rules allow nonphysical activity to constitute manufacturing.”30 Practitioners have also considered whether the Substantial Contribution test, while helpful in allowing the manufacturing exception to apply in contract manufacturing situations, may be harmful if such rule causes application of the branch rule. Specifically, it is unclear if the Substantial Contribution activities might create a branch or similar establishment through which a CFC carries on manufacturing activities in the unrelated manufacturer’s jurisdiction. If a CFC conducts manufacturing activities through such branch or similar establishment located outside the CFC’s country of creation or organization and “the use of the 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 the branch or similar establishment were a wholly owned subsidiary corporation of such [CFC], the branch or similar establishment and the remainder of the [CFC] will be treated as separate corporations for purposes of determining the [FBCSI] of such corporation” (i.e., the “manufacturing branch rule”).31

The interpretation that a manufacturing branch may be created under the Substantial Contribution test may be limited under legislative history, case law and the proposed regulations. In Ashland Oil v. Commissioner,32 the Tax Court determined, among other things, that according to the legislative history the term “branch” as used under the branch rule should have the “customary business meaning” absent a technical definition in the statute.33 In addition, the Tax Court found the term "similar establishment" “to serve a fine-tuning purpose rather than an expansionary one … We read "similar establishment," however, to mean an establishment that bears the typical characteristics of an ordinary-usage branch, yet goes by another name for accounting, financial reporting, local law, or other purposes.34” The Tax Court went on further to assert that, according to legislative history, section 954(d)(2) does not grant the Secretary of Treasury the statutory authority to define what a branch or similar establishment is but rather grants it the authority to “address certain consequences flowing from the existence of a branch or similar establishment.”35 The Tax Court rejected the Service argument that the branch rule was a broad “loophole closing provision” that was intended to apply to any arrangement that had a specific tax effect. 36 In Rev. Rul. 97-48, the Service acknowledged that it would follow Ashland Oil.37

29 See preamble to proposed regulations at 73 FR 10716 (February 28, 2008) and reg. section 1.954-3(b)(1)(ii)(a).30 50 Tax Notes Int'l 557 (May 19, 2008).31 Reg. section 1.954-3(b)(1)(ii)(b).32 Ashland Oil, Inc. v. Commissioner, 95 T.C. 348 (1990).33 Id. at 356. 34 Id. at 357 and 360.35 Id. at 357.36 Id. at 354 and 360.37 See Rev. Rul. 97-48, 1997-2 C.B. 89; see also 2008 TNT 49-5 at 3.

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In addition, the proposed regulations themselves indicate that a broad definition of branch and similar establishment is not the intention of the Service. Specifically, according to prop. reg. section 1.954-3(f), Example 3, a branch operation is not established simply by employees of a CFC traveling to a contract manufacturer’s location. In this regard, reg. section 1.954-3(f), Example 3 states that the activities of FS’s employees while they travel to the contract manufacturer outside County M do not prevent FS from making a Substantial Contribution. This statement is puzzling given that the activities of FS’s employees, even while temporarily outside Country M, would seem to be a positive factor and not a negative one. Furthermore, if the Service does not intend for such activities to create a branch, it would be helpful for the example (or accompanying regulations) to affirmatively state so.

Keeping in mind the limitations on regulatory authority in defining a branch as outlined in Ashland Oil, we recommend that Treasury and the Service provide clarification of whether and when CFCs satisfying the Substantial Contribution test may create a manufacturing branch. Treasury and the Service may consider referencing other Code or regulation sections, for example, section 367(a)(3)(C), reg. section 1.367(a)-6T(g) or reg. sections 1.987-5 and 1.989-1(b). However, the definition should not be overly expansive so as to create branches in situations where there is a minimal level of activity in a foreign jurisdiction.

B. Negative Presumption Regarding Activity of the Remainder with respect to a Physical Manufacturing Branch

The proposed regulations include a rebuttable presumption with respect to the application of the Substantial Contribution test where a CFC seeks to satisfy that test through the activities of a branch that undertakes physical manufacturing.

Under this rebuttable presumption, if a branch of a CFC satisfies the physical manufacturing test (i.e., the requirements of Reg. §1.954-3(a)(4)(ii) or (iii)) with respect to personal property sold by the remainder of the CFC, the remainder of the CFC or any branch treated as the remainder of the CFC will be presumed not to make a Substantial Contribution to the manufacture of that personal property unless the CFC canrebut that presumption to the satisfaction of the Commissioner.38

In the preamble, the Service and Treasury state that they believe this rule is necessary as a backstop to the branch rule under section 954(d)(2), and, in the absence of the rebuttable presumption, a rule permitting a CFC to qualify for the manufacturing exception based upon its contribution to the physical manufacturing activities of a branch would prove difficult to administer. The Service and Treasury further indicated that 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.

It is not entirely clear why a rebuttable presumption in these specific instances is necessary, despite the articulated reasons discussed above. As a preliminary matter, a taxpayer seeking to qualify for benefits under a regulatory provision generally has the burden of proving that it satisfies the specific regulatory requirements (e.g., the requirements for avoiding a subpart F income inclusion). It would seem that the type of documentation necessary to qualify for the Substantial Contribution test for a CFC that engages in a contract manufacturing arrangement with an unrelated party or a related CFC and a CFC that undertakes

38 For an example that illustrates the application of prop. reg. section 1.954-3(b)(2)(ii)(c)(2), see prop. reg. section 1.954-3(b)(2)(ii)(c)(2), Example 1.

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a similar arrangement with one of its branches (e.g., a foreign disregarded entity of the CFC) should be the same. In both instances, the CFC must adequately document that it has satisfied the Substantial Contribution test; otherwise the benefits of the exception will be lost.

We are concerned that, by including the rebuttable presumption rule in the proposed regulations, the Service and Treasury are intending to hold to a higher standard (and perhaps a greater documentation requirement) a CFC seeking to satisfy the Substantial Contribution test through the remainder of the CFC (or any branch treated as the remainder of the CFC) when physical manufacturing occurs through one of its branches. There does not appear to be any strong policy reason for imposing a higher standard and such standard would, in effect, penalize CFCs that have this type of business and operational model. We further note that the standard for rebuttal is inherently vague and may invite controversies between taxpayers and the Service and/or between taxpayers and their auditors.

Therefore, we strongly recommend that the rebuttable presumption rule be removed when the regulations are finalized.

C. “Predominant Contribution” and the Highest Tax Rate Default Due to Lack of “Predominant Contribution”

Under prop. reg. section 1.954-3(b)(1)(ii)(c)(3), a CFC with multiple branches that does not itself physically manufacture will be deemed to manufacture in the branch location where “the predominant amount” of manufacturing activities take place. If no such predominant manufacturing location exists, the location of manufacturing-related activities with the highest tax rate is deemed to be the location of the manufacturing.

Due to the importance placed upon the standard of predominant contribution, guidance and/or elaboration is needed with respect to its definition. Absent such guidance, multinational taxpayers would be in the position of lacking any certainty as to where the Service might deem their manufacturing to take place. As with the rebuttable presumption addressed above, we note that the predominant contribution standard in the regulations is also inherently vague and may give rise to controversies between taxpayers and the Service or its auditors.

In situations where no location provides a predominant contribution, merely looking to the location of manufacturing-related activities with the highest tax rate can lead to unfair results. The following example illustrates the problem.

A CFC is incorporated in the Netherlands (25 percent rate) that conducts sales. The CFC has a) a Taiwanese check-the-box (“CTB”) branch that handles manufacturing coordination and selection (20 percent rate); b) a Hong Kong CTB branch that handles logistics (12 percent rate); c) a Chinese CTB WOFE that performs part of the CFC’s R&D (25 percent rate); and d) a single logistics employee in Japan (30 percent rate). There are no related party purchases or sales. An unrelated third-party manufacturer in Taiwan performs the manufacturing.

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If the taxpayer or the Service is unable to determine which location of manufacturing-related activities provides a predominant contribution, then, as the result of a single logistics employee, Japan would be the location tested as a manufacturing branch. Due to the relatively high Japanese tax rate, the Japanese branch will satisfy the rate disparity test, resulting in the application of the manufacturing branch rule. This result applies regardless of the number of employees at the non-Japanese branches or the materiality of their operations relative to the single employee in Japan.39

Furthermore, as the above example illustrates, using the highest tax rate as the standard to determine the default manufacturing location (where no location provides a predominant contribution) could lead to arbitrary results. For example, where there are two locations that conduct manufacturing activities and 50 percent of the manufacturing activities occur in a high tax jurisdiction and the other 50 percent occur in a low tax jurisdiction, the application of the manufacturing branch rules may be significantly different than if 49 percent of the manufacturing activities occur in a high tax jurisdiction while 51 percent occur in a low tax jurisdiction.

Accordingly, we recommend that if multiple branches exist and no location of manufacturing-related activities provides a predominant contribution, then the weighted average tax rate of all such branches should be used. The weighting should be accomplished by reference to the relative size of the manufacturing-related activities carried on in each branch. It would be reasonable for the weighting to follow the same methodology used to determine if there is a predominant contribution.

III. Proposed Revisions to the Language of the Proposed Regulations

In addition to the general comments above, we recommend the following change to the proposed regulations.

In prop. reg. section 1.954-3(a)(4)(iv)(a), consider changing the term “purchased” to “sold” in the phrase “but the personal property purchased by a controlled foreign corporation would considered to be manufactured”. The current language is awkward in that it suggests that the CFC must have manufactured the property that it purchased. We believe the use of the term “sold” instead of “purchased” more accurately reflects the statutory requirements. We further believe this change is consistent with the language in prop. reg. section 1.954-3(a)(4)(i), (ii), and (iii).

IV. Additional Examples

The current regulations do not contain an example of an arrangement in which the contract manufacturer is responsible for purchasing raw materials, owns the work-in-process, and sells the goods to the principal (a so-called “buy/sell” arrangement). Accordingly, we recommend the following example be included in the regulations:

New Example 1. Raw Materials Procured by Contract Manufacturer. FS, a controlled foreign corporation, is located in Country X. FS employs a significant number of employees in country X, including senior management, treasury personnel, and administrative personnel. All decision-makers with respect to manufacturing and

39 Even though the manufacturing activities of Taiwan, Hong Kong and China may be considered when applying the Substantial Contribution test to the activities of the remainder, there is a higher burden to satisfy the Substantial Contribution test.

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processing activities are employed by FS and located in Country X. The intellectual property in connection with processing operations is owned by FS. FS engages CM, a related controlled foreign corporation located in Country Y, to manufacture Product Z (under the principles of paragraph (a)(4)(iii) of this section) pursuant to a contract manufacturing arrangement. Under the agreement, FS is responsible for quality control and oversight of the processing activities. FS manages risk of loss with respect to the raw materials, work-in-process, and finished goods by hedging price and currency risk. FS is responsible for all logistics and shipping functions. Under Country Y law, certain incentives are available to manufacturers and processors. To qualify for these incentives, CM must be considered the manufacturer under country Y law. This requires CM to acquire raw materials, own the work-in-process and sell finished goods. The contract between CM and FS provides that CM will procure the raw materials in its name and will own title to the work in process. When CM contracts to procure the raw materials, it is required to notify FS so that FS can hedge any risk of loss in connection with acquisition. All of the manufacturing is done according to specifications provided by FS. FS has the right pursuant to the contract, and exercises its right, to inspect the process and ensure quality control. FS guarantees CM that is would purchase all of its production, and compensates CM on a cost-plus basis, ensuring that CM has very limited risk of loss. FS agrees to compensate CM for any losses or damages to CM’s inventory while at CM’s plant and obtains insurance on CM’s behalf in connection with such inventory. In form, CM sells finished goods to FS.

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 and controlled labor, substantially transform, convert, or assemble personal property into finished goods. However, Product Z is manufactured by CM and therefore paragraph (a)(4)(iv) applies. FS satisfies the test under this paragraph (a)(4)(iv) because, taking into consideration the facts and circumstances relevant to the manufacture of Product Z, FS makes a Substantial Contribution through the activities of its employees and controlled labor to the manufacture of Product Z. Therefore FS is considered to have manufactured the finished goods.

As noted above, the current regulations do not define what constitutes an employee who may perform activities considered to be a Substantial Contribution to the manufacturing process. In conjunction with our recommendation on this issue, we offer the following example:

New Example 2. Direct Control of Contracted Employees. FS is a controlled foreign corporation incorporated and located in Country X. FS employs its senior management, engineering, and supervisory staff in Country X. All decision makers with respect to manufacturing and processing activities are employed by FS and located in Country X. The intellectual property in connection with processing operations is owned by FS. FS engages CM, a related controlled foreign corporation located in Country Y, to manufacture Product Z (under the principles of paragraph (a)(4)(iii) of this section) pursuant to a contract manufacturing arrangement. Under the agreement, FS is responsible for arranging logistics related to shipped finished goods from CM. Supervisors employed by FS located in Country X manage contract personnel located at CM that are responsible for quality control and logistics related to raw materials shipped to CM pursuant to guidelines established by the supervisors employed by FS. FS is obligated to purchase all of the output produced by CM. CM owns the raw materials and

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work in process, but an insurance policy provided by FS insures CM for risk of loss on these goods. FS has risk of loss on finished goods, which generally are shipped on F.O.B. terms. FS engineers are responsible for all research and development activities related to Product Z and technologies developed by FS engineers are licensed to CM.

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 finished goods. However, Product Z is manufactured by CM and therefore paragraph (a)(4)(iv) applies. FS is responsible for quality control and logistics because FS, with its own employees, directly manages the contract personnel located at CM that perform logistics and quality control activities. Moreover, because the contract personnel located at CM are under the direct control of FS supervisors, such contract personnel, although not rising to the level of employees under common law, should also be considered controlled labor of FS for purposes of applying the Substantial Contribution test. FS satisfies the test under this paragraph (a)(4)(iv) because, taking into consideration the facts and circumstances relevant to the manufacture of Product Z, it makes a Substantial Contributions through the activities of its employees and controlled labor to the manufacturing and processing operations. Therefore FS is considered to have manufactured the finished goods.

The proposed regulations contain no examples demonstrating that the Substantial Contribution test can be met by a branch of a CFC. Accordingly, we recommend that the following example be included in the regulations:

New Example 3. Substantial Contribution by a Branch. FS, a controlled foreign corporation, is located in Country X. FS owns and operates Branch A located in Country Y. Branch A procures raw materials that are then manufactured (under the principles of paragraph (a)(4)(iii) of this section) into Product X by CM, a related corporation incorporated in Country Z, that performs the physical transformation pursuant to a contract manufacturing arrangement. Product X is then sold by Branch A outside of Country X. Under the contract manufacturing arrangement, Branch A is responsible for oversight and quality control of the manufacturing processes. Employees of Branch A regularly exercise this authority by providing oversight and decision making in connection with the manufacturing operations in Country Y, and by traveling to CM plants in Country Z. Branch A is responsible for all logistics and shipping. Branch A maintains ownership of all raw materials during processing and maintains ownership of the finished goods. Branch A has ownership of all intellectual property used in the manufacturing process and licenses the technology to CM, but CM has the right to use the intellectual property for manufacturing for unrelated third parties who may also enter into contract manufacturing arrangements with CM and, thus, has some ownership of the intellectual property. No other branches are involved in the manufacturing process and FS is not a party to the contract manufacturing arrangement.

Result. Neither FS nor Branch A satisfy paragraph (a)(4)(ii) or (a)(4)(iii) of this section with respect to Product X because FS and Branch A do not, through the activities of their own employees, substantially transform, convert or assemble personal property into Product X. However, Product X was manufactured (by CM), and therefore paragraph (a)(4)(iv) applies. Branch A satisfies the test under this paragraph (a)(4)(iv) because, taking into consideration the facts and circumstances relevant to the manufacture of Product X,

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it makes a Substantial Contribution through the activities of its employees to the manufacture of Product X. Therefore, Branch A is considered to have manufactured Product X under paragraph (a)(4)(i) of this section.

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