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Under Subpart F, income derived by a controlled foreign corporation (“CFC”) from the sale of products is included in the gross income of its U.S. shareholders currently if such income falls within the definition of foreign base company sales income (“FBCSI”).¹ FBCSI does not include income from the sale of products manufactured in a CFC's country of organization.² The IRS and Treasury recently issued final regulations (“2008 Regulations”) that address this exception.³

The same-country-of-manufacture exception requires that the products sold have been manufactured in the CFC's country of organization. The exception applies, however, regardless of who manufactures the property. The product may be manufactured by an unrelated or related person. The exception contemplates that the CFC itself is not involved with the manufacture of the property but engages in selling the property.

For example, CFC1 imports into Country X rough diamonds mined in Country Y. CFC1 cuts, polishes, and shapes the diamonds in a process that constitutes manufacturing. CFC1 sells the finished diamonds to CFC2, a related person organized in Country X. CFC2 sells the diamonds for use in Country Z. CFC2's sales income is not FBCSI because the finished diamonds are manufactured in Country X.⁴

The current regulations (“1964 Regulations”) define manufacturing as the transformation, conversion, or assembly of purchased property (“physical manufacturing”). Specifically, purchased property is considered as manufactured if:

• The property is substantially transformed (e.g., steel rods converted into screws); or

• The production operations are substantial in nature and generally considered to constitute manufacturing (e.g., assembly of automobiles).

Under the second definition, a safe harbor is provided where labor and factory burden costs are 20% or more of costs of goods sold. Minor assembly and packaging do not qualify as manufacturing.⁵ The Tax Court, however, has broadly interpreted this definition of manufacturing (e.g., assembly of sunglasses qualified as manufacturing).⁶

The above definition of manufacturing is specifically provided for purposes of the exception to FBCSI for income from the sale of property that is manufactured by a CFC (“manufacturing exception”). The 1964 Regulations cross-reference that definition for purposes of determining what constitutes the manufacture of property under the same-country-of-manufacture exception.

The 2008 Regulations add a new definition of manufacturing to determine whether a CFC principal will be considered as manufacturing the product it sells for purposes of the manufacturing exception. Under those regulations, a CFC principal that has a contract manufacturer produce products on its behalf will be considered as manufacturing the property it sells if, acting through its own employees, the CFC makes a “substantial contribution” to the manufacture of the property sold (“non-physical manufacturing”).⁷ Relevant activities taken into account include: oversight and direction of the physical manufacturing activities; material selection, vendor selection, or control of raw materials, work-in-process, or finished goods; management of manufacturing costs or capacities; control of manufacturing related logistics; quality control; and developing, or directing the use or development of, intellectual property for the purpose of manufacturing property. The manufacturing definition must be satisfied on a product-by-product basis.

Other indicia of manufacturing are relevant and the weight given to any particular activity will depend on the economic significance of those functions to the manufacture of the relevant property. The presence or absence of any particular activity (e.g., oversight and direction), or of a particular number of activities, will not be determinative, and more than one company may satisfy the substantial contribution definition with respect to the same product. The new definition may be satisfied when the manufacturing is largely automated where the employees conduct “industry-sufficient” substantial contribution activities. The 2008 Regulations make clear that the new definition is available for both consignment and buy-sell contract manufacturing arrangements.

The 2008 Regulations provide that the new non-physical definition of manufacturing applies for purposes of the same-country-of-manufacture exception, but only where the manufacturing activities are performed by a related person. Accordingly, a CFC will qualify for the same-country-of-manufacture exception where a related person substantially contributes to the manufacture of a product through the activities of its own employees performed in the CFC's country of organization. On the other hand, this exception cannot be applied based on substantial contribution activities of an unrelated person.⁸ Nevertheless, the same-country-of-manufacture exception continues to apply where the product is physically manufactured (by anyone) in the CFC's country of organization.

For example, an Irish CFC distributor (“CFC-D”) purchases products from an Irish related person (“CFC-M”). CFC-M hires a French unrelated company to physically manufacture the products in France. CFC-M satisfies the substantial contribution definition of manufacturing based on the activities of its employees that are performed in Ireland. CFC-D's income from the sale of the products should qualify for the same-country-of-manufacture exception because CFC-M, a related person, is considered as manufacturing the property in Ireland.

The 2008 Regulations require that the activities of the CFC's own employees satisfy the definition of manufacturing to qualify for the manufacturing exception. Nevertheless, the 2008 Regulations make clear that such requirement does not apply for purposes of the same-country-of-manufacture exception (nor could it apply under the statute). For example, if a CFC hires a contract manufacturer to physically manufacture a product in the CFC's country of organization and the CFC does not satisfy the substantial contribution definition of manufacturing, its sales income nevertheless will qualify for the same-country-of-manufacture exception.⁹

No rule is provided for determining the location of manufacturing for purposes of the same-country-of-manufacture exception. While location rules are provided in new temporary branch regulations that accompanied the 2008 Regulations, there is no cross-reference to those rules, and the location rules expressly state that they apply only for purposes of the branch rules. Nevertheless, certain principles contained in those rules might be considered in determining the location of manufacturing for purposes of the same-country-of-manufacture exception.

The temporary branch regulations provide that a CFC generally is considered as manufacturing products in the location where the activities of the CFC's employees independently satisfy the physical or non-physical definition of manufacturing.¹⁰ For this purpose, the location of any activity with respect to the manufacture of an item of personal property is the location where the employees of the CFC perform such activity.¹¹ If multiple branches are located in one country, the activities of the branches are aggregated.¹² Accordingly, if sufficient manufacturing activities occur in a country such that the product is considered as manufactured in that country, then the product should be considered as manufactured in such country for purposes of the same-country-of-manufacture exception. For purposes of the same-country-of-manufacture exception, physical manufacturing activities performed by any person, and non-physical manufacturing activities performed by the CFC or a related person, should be taken into account (and aggregated) in determining whether a product is manufactured in a particular country.

Under the temporary regulations, a product may be considered as independently manufactured in more than one country. For purpose of applying the branch rules, such product is considered as manufactured only in the country with the lowest tax rate. On the other hand, for purposes of applying the same-country-of-manufacture exception, the product should be considered as manufactured in all countries where there are sufficient activities that independently satisfy the definition of manufacturing.

For example, the manufacture of a product may entail several stages of manufacturing processes. Assume an unrelated company manufactures components in Country A and assembles the components into a finished product in Country B. The operations in both Country A and in Country B independently satisfy the definition of manufacturing. Income derived by a Country B CFC that sells the finished products to a related distributor should qualify for the same-country-of-manufacture exception. In addition, it appears that income derived by a Country A CFC that sells the finished products to related distributors likewise should qualify for the exception.

Under the temporary regulations, under certain circumstances a sales location that does not otherwise satisfy the definition of manufacturing may be deemed to satisfy such definition as a result of the attribution of manufacturing activities that take place in a different country that does not have a materially higher tax rate.¹³ It would seem unlikely that such rule would apply for purposes of the same-country-of-manufacture exception.

The same-country-of-manufacture exception applies regardless of whether the CFC is subject to tax in its country of organization. For example, CFC1 manufactures a product in Country A. CFC2 is organized under the laws of Country A, but is not tax resident in such country, so its income is not subject to tax in Country A (e.g., CFC2 is not managed and controlled in Country A). CFC1 sells products to CFC2 for resale. CFC2's sales income should not be FBCSI because it satisfies the same-country-of-manufacture exception.¹⁴

The FBCSI branch rule may cause a CFC to lose the same-country-of-manufacture exception. For example, CFCX is organized in Country X. CFCX purchases products from a related company that manufactures the products in Country X. CFCX sells the products through Branch Y in Country Y to unrelated customers for use outside of Country Y. The Country X tax rate is 30% and the Country Y tax rate is 5%. For purposes of applying the FBCSI rules, the branch rules require that Branch Y be treated as a separate CFC organized in Country Y and, as a result, its sales income would not qualify for the same-country-of-manufacture exception.¹⁵ On the other hand, if the branch rule did not apply (e.g., the tax rates in Country X and Country Y are similar), the same-country-of-manufacture exception should apply to the sales income derived by Branch Y.¹⁶

If a branch is treated as a separate CFC under the branch rule and the products sold by the branch are manufactured in the country where the branch is located (as discussed above), the branch's sales income should qualify for the same-country-of-manufacture exception.¹⁷ For instance, assume in the above example that CFCX purchased the products from an unrelated manufacturer that manufactured the products in Country Y. If Branch Y is treated as a separate CFC under the branch rule, the sales income derived by Branch Y should qualify for the same-country-of-manufacture exception.

The branch rule, however, may not be used affirmatively (the final regulations add clarifying language to this effect).¹⁸ Accordingly, one must be cautious in electing disregarded entity status for a CFC. For example, assume in the first illustration above that CFC2, a Country X corporation, became a disregarded entity owned by CFC3, a Country R corporation. Under the general rule, CFC3's income (derived through the disregarded CFC2) would be FBCSI, because the products are purchased from a related person and are manufactured in Country X (not Country R). Since CFC3's income is FBCSI under the general rule, the branch rule would not apply to treat CFC2 as a separate CFC. Therefore, CFC3's income derived through its branch in Country X from the sale of finished diamonds manufactured in Country X would not qualify for the same-country-of-manufacture exception.¹⁹

In sum, the 2008 Regulations affirm the application of the same-country-of-manufacture exception to modern business structures, taking into account the broad application of the definition of manufacturing in the 1964 Regulations. In addition, the 2008 Regulations expand the application of the same-country-of-manufacture exception to apply where a related person is considered as satisfying the new non-physical definition of manufacturing in the CFC's country of organization. One must be cautious, however, to consider the possible application of the branch rule, which can result in losing the ability to rely on the same-country-of-manufacture exception.

This commentary also will appear in the April 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.