Branching Out: The Subpart F Contract Manufacturing Regulations
v2.0
By James J. Tobin, Esq.
Ernst & Young LLP, New York, NY
I suppose I should be embarrassed to admit it, but almost every
time over the years that I've had to deal with the Subpart F sales or
manufacturing branch rules, I've had to open the regulations and read
through the rules -- yet again -- to get myself back up to speed on
the details. And in the case of these branch rules, as much as
anything, the devil really is in the details. So when the IRS issued
the proposed Subpart F contract manufacturing rules in February of
2008, I was less than thrilled to see yet another set of branch rules
and yet another layer of dazzling complication.
Oh, and some of the proposed rules didn't exactly make sense, even
after I carefully parsed my way through them.
I made my thoughts about the early-2008 proposed regulations pretty
clear on these pages in the wake of the issuance of those
rules.1 In short, while I gave the
government a modest attaboyfor taking on such a daunting task
and making a credible first effort, I concluded that the proposed
regulations were just that -- a first effort -- indicating that a good
deal more thoughtful consideration was needed. I also spent some time
carping about the lack of guidance provided for purposes of
calculating the effective tax rate of a branch around which you're
made to “draw a box” under the branch rules, as well as
for purposes of figuring out how much income is attributable to such a
“branch.”
So, now that the IRS has had time to think about it -- and sift
through what were probably a record number of comments -- what have
they wrought with version two of the contract manufacturing
regulations?
Overall, the Service has done a pretty good job of addressing many
of the concerns raised by taxpayers and practitioners about the
proposed regulations. So, for example, they've now refined the list of
“substantial contribution” activities and clarified
certain aspects of the list, as well as the manner in which it is to
be applied in practice. They've also provided a definition for the
term “employee,” which was a big sticking point in the
proposed regulations.
All in all, a decent day's work. And all very constructive in the
recognition of the economic reality of the world we live in today,
where physical manufacturing is often outsourced but direction and
control of the manufacturing process is often the true value-added
economic activity that should not, in principle, be viewed as
“foreign base company”-type activity.
As to the branch rules, though, in my view what we have remains a
work very much still in progress. While the progress does seem to be
going in the right direction in my view, the progress is only
incremental. In fact, the changes to the proposed branch rules are so
extensive that this portion of the rules, unlike most of the
remainder, has been issued in proposed and temporary form. Which makes
one pause and wonder whether the manufacturing branch rule really is
worth all this blood, sweat, and tears.
The Branch Rules: Some Answers but Many More Questions
By way of quick background, recall that if a controlled foreign
corporation (CFC) conducts its manufacturing or sales activities
outside its country of incorporation through a branch, a special set
of rules applies for purposes of determining whether the CFC has
foreign base company sales income (FBCSI).
Also recall that the branch rule is specifically authorized by the
statute (§954(d)(2)) as enacted in 1962. The statutory language
is centered on a sales branch paradigm, rather than on a manufacturing
branch paradigm (although the legislative history provides some
support for the latter). I'll also point out that in 1962, which was a
good bit before my time as a tax guy, it appears there was little
thought of virtual outsourced manufacturing, few if any regional or
global business models as the operating philosophy of multinationals,
and no formal transfer pricing documentation or penalty rules to
ensure that profit wasn't shifted inappropriately from one foreign
branch to another. Oh yeah, and it was also pre-check-the-box by about
35 years and operating in true branch form was pretty rare.
So now, almost 50 years after the legislative authority was
provided for the branch rules, at a time when they will actually be
relevant to a majority of U.S. multinationals, we are finally given
somewhat detailed and very complex guidance for the first time since
1962. What does the guidance cover and, more importantly, what does it
not cover?
The primary driver of the regulations has always been the so-called
rate disparity test (RDT), which determines whether you have a branch
that you have to worry about. In the good news category, the
regulations recognize that there can be more than one substantial
contributor to the manufacturing process eligible for the
manufacturing exception to FBCSI; in the bad news category, this means
that multiple locations within a CFC could be considered to have
substantially contributed, which could give rise to multiple
manufacturing branches. Likewise, a CFC can have multiple sales
branches because it sells different products from different offices,
it purchases a particular component or raw material in one location
and sells the finished product in another (note that purchasing
activities can also create a “sales” branch), or perhaps
even where multiple offices contribute to the marketing or sale of a
single product. To their credit, having created greater potential for
multiple manufacturing branches through the operation of the new
substantial contribution concept, the drafters did include in these
regulations rules for prioritizing among multiple manufacturing
branches in order to focus the analysis on one such branch. The
drafters also helpfully included rules for coordinating the
manufacturing branch rule and the sales branch rule. These are both
areas where guidance had been lacking for years.
The new regulations include a complicated scheme for determining
which manufacturing branch (or aggregation of branches) must be
examined under the RDT. Once you determine the manufacturing branch
that will be the focus of the analysis, the RDT is then applied by
comparing the actual effective tax rate incurred in a sales branch
with the hypothetical tax rate that would have been incurred had that
income been earned in the appropriate manufacturing branch; if the
actual tax rate is too disparate (less than 90% of and more than 5%
points lower than the hypothetical tax rate), then a box is to be
drawn around the sales branch and Subpart F consequences are analyzed
as if there were two separate CFCs. If there are multiple sales
branches, this analysis is repeated for each sales branch.
In my view, the basic conceptual approach used in these new branch
rules is fairly well thought-out and recognizes the realities of
complex global or regional business models, as far as it goes. Of
course, the rules will also be incredibly complex to apply in practice
for all but the most simple fact patterns.
My biggest concerns, however, are still with respect to the issues
the regulations do not address, as well as a potential trap for the
unwary created by the regulations in cases where a virtual
manufacturer is purchasing and selling from and to unrelated
parties.
Areas that are not addressed in the regulations include the
definition of what is a branch, details as to how to compute the
effective tax rate of a sales branch or the hypothetical tax rate of
the manufacturing branch, and details on how to compute the amount of
Subpart F income if the RDT is failed and the deemed existence of a
second CFC could result in the creation of Subpart F income. Not
exactly minor details!
The Preamble to the regulations does indeed acknowledge the lack of
guidance on these issues in stating, “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.” The Preamble similarly states that defining the term
“branch” is outside the regulations' scope.
My reaction to all this was going to be to say that, in my view,
this is unacceptable from a tax policy standpoint. I was then going to
go on to note that if these detailed calculation issues are too tough
for the IRS national office to figure out for inclusion in the
regulations, how can it be acceptable to toss these unanswered
questions over the fence for taxpayers and IRS agents to figure out?
Admittedly, we have lived without any real guidance on these issues
since 1962. However, under existing law, based on the Ashland
and Vetco cases (and notwithstanding the questionable position
espoused in Rev. Rul. 97-48, which revoked Rev. Rul. 75-7), a virtual
manufacturer should not be considered to have a manufacturing branch,
so the issue of the RDT has only infrequently had application.
However, the way the new substantial contribution concept is
structured in these regulations now will result in many companies
needing to grapple with the manufacturing branch rule, only to find
themselves on their own in attempting to interpret how to do the most
fundamental of calculations.
Then, on March 20, the IRS issued “technical
corrections” to the regulations, portions of which seem to go
way beyond the usual meaning of that term. For example, the Preamble
was revised to provide that uniformly available tax incentives should
be considered in determining the hypothetical effective tax rate used
in applying the RED; if a ruling is available and the manufacturing
branch does not obtain one, then the hypothetical effective tax rate
that would be paid by that branch (or remainder of the CFC), were it
to derive the sales income, should be the jurisdiction's effective
rate not taking into account the “forgone” relief. It is
thus clear that the manufacturing branch (not the sales branch) must
affirmatively obtain a ruling that includes sales income. In addition,
the Preamble removed the portion of the regulations that said the
principles of the §954 regulations addressing the high-tax
exception were to be used in determining the effective rate of tax
when applying the RDT. The technical corrections also revise the rules
to be applied when no location independently satisfies the
manufacturing test in such a way that one can now have multiple tested
sales locations for the same item of property.
Perhaps my planned carping was not quite strong enough, because,
among other things, this last change will likely result in a greater
amount of foreign base company sales income and add even more
draconian compliance burdens, and very little has been clarified (or
“corrected”).
In any case, notwithstanding these so-called technical corrections
-- or, to some degree, because of them -- companies will really have
their hands full in attempting to comply with the new rules.
Consider a simple fact pattern. A CFC European holding company, CFC
Holdco, owns a Swiss checked subsidiary that substantially contributes
to the manufacturing of a product. Swiss “branch” sells to
Belgian sales company, which is also a checked subsidiary of CFC
Holdco. Belgian “branch” sells to non-Belgian customers.
Assume Belgian “branch” buys for 100 and resells for 175
and deducts 20 for local marketing costs, 25 for interest to CFC
Holdco, 10 for royalties to Swiss branch, and 15 in NOL carryovers,
which results in net taxable income in Belgium of 5 and Belgian tax of
2. Questions that one might ask -- in determining how to apply the RDT
-- include:
•
Do I use local Belgian taxable income rules or U.S. rules to compute
the effective tax rate?
•
Do I regard disregarded payments in the calculation?
•
Do I take into account NOL deductions?
-
Does that answer depend on whether the NOL relates to the sales
activity?
•
Do I respect the terms of sale for the purchase from Swiss branch and
thus the gross margin that the sales branch records?
•
How should U.S. or Belgian or Swiss transfer pricing concepts or
adjustments enter into the calculation?
•
How do I deal with forex issues, in this case between the Euro and the
Swiss Franc?
•
If I do conclude that the RDT is flunked, how do I compute Subpart F
income -- which raises all the same questions as above?
•
After I have done all that, do I follow the same principles I use
above for purposes of §987 in considering what constitutes a
branch remittance?
Again, not exactly minor details.
My last whine relates to the trap for the unwary. Assume CFC Holdco
in the above example is purchasing all raw materials from unrelated
parties and selling all finished products to unrelated parties, albeit
through branches. And assume it doesn't fail the sales branch rule
RDT, so it only could have Subpart F income if the manufacturing
branch rules apply. Under Ashland/Vetco and other
existing authority, there would not seem to be a concern about Subpart
F in such a case; after all, the CFC is not doing either related party
sales or related party purchases. And indeed, if the Swiss
“branch” is not a substantial contributor, the
manufacturing branch rule would not apply and there would still be no
Subpart F risk. However, if the Swiss branch were found to be
substantially contributing, all of the calculation headaches above
would apply and some Subpart F income could well exist. The irony, of
course, is that now the IRS will have an incentive in some cases to
assert a CFC is a manufacturer and the taxpayer will need to argue why
its alleged contribution is not substantial.
Going back to one of my opening comments, the world in 1962 was
very different from the world today. The substantial contribution
rules provide appropriate guidance on when activities of a CFC are
substantial enough to not be considered tainted base company
activities. But we still can't figure out how to apply the branch rule
income test. At this point, it is appropriate to remember that the
authority for the manufacturing branch rule is vague and exists only
in the legislative history and not in the statute. I suggest some
bolder policy thinking is in order and ask why not just drop the
manufacturing branch rule altogether? The policy underlying the branch
rule is rooted in concern about the potential for inappropriate
shifting of a multinational's foreign tax base from a high-tax
location to a low-tax location. The vigilance of foreign tax
authorities, the proliferation of transfer pricing documentation and
penalty regimes, and the intense focus on the tax implications of
“business restructurings” as evidenced by the recent OECD
report on this subject should all provide the IRS with comfort that
the complexity and burden required to police this concern are no
longer needed. We all have too many other things to worry about these
days!
This commentary also will appear in the May 2009 issue of
the Tax Management International Journal. For more information,
in the Tax Management Portfolios, see Yoder, 928 T.M.,
CFCs--Foreign Base Company Income (Other than FPHCI), and in Tax
Practice Series, see ¶7130, U.S. Persons' Foreign
Activities.
1
Tobin, “The Proposed Contract Manufacturing Regulations: A Journey of a Thousand Miles Begins With a Single Step,” 37 Tax Mgmt. Intl J. 407 (7/11/08).
|
