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Subpart F Income: Navigating the Revised Branch and Contract Manufacturing Rules

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1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific Robert J. Misey, Jr., Shareholder, Reinhart Boerner Van Deuren, Milwaukee y, , , , Frederick Chilton, Partner, McDermott Will & Emery, Silicon Valley, Calif. James Sams, Principal, KPMG, McLean, Va.

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Subpart F Income: Navigating the R i d B h d C t t Revised Branch and Contract Manufacturing Rules Seminar

June 20, 2012 Frederick Chilton, McDermott Will & Emery

fchilton@ mwe.com

Robert J. Misey Jr. Reinhart Boerner Van Deuren

rmisey@reinhartlaw.com

James Sams, KPMG

jksams@ kpmg.com

Today’s Program

Origin Of Branch, Contract Manufacturing Regulations [Robert J. Misey Jr.] Slide 7 – Slide 17 Contract Manufacturing Regulations [Robert . J. Misey Jr., Frederick Chilt on] Slide 18 – Slide 42 Branch Office Regulations [James S ams and Frederick Chilt on] Slide 43 – Slide 64

ORIGIN OF BRANCH

Robert J. Misey Jr., Reinhart Boerner Van Deuren

ORIGIN OF BRANCH, CONTRACT MANUFACTURING REGULATIONS

Foreign‐Based Company Sales Income

• 1. CFC buys from or sells to a related person.
• 2. Property manufactured outside the CFC’s country by someone
• t her t han t he CFC
• 3. Sold for use outside the CFC’s country

8

Th FBCSI S i The FBCSI Scenario

USCo

d t

US F

product

CFC

3rd-Country Customer

product

9

The Branch Rule: Manufacturing Branch

USCo

US

CFC

F

CFC Sales

4th-Country

product

4 Country Customers 3rd-Country Manufacturing Branch

p

10 10

Th B h R l S l B h The Branch Rule: Sales Branch

USCo

US

CFC

F

CFC Manufacturing

4th-Country

product

4 Country Customer 3rd-Country Sales Branch

product

11

Branch

11

H W G H R R l How We Got Here: Rev. Rul. 75‐7

USCo

US US F

Unrelated CFC

Conversion process

4th-Country

Title to metal ore concentrate – control over conversion process

Unrelated ForCo

4th-Country Customers

ferroalloy

— CFC manufactures — CFC has a branch

12 12

How We Got Here: P R R l Pl i Post‐Rev. Rul. 75‐7 Planning

— Taxpayers claimed contract manufacturers resulted in the CFC manufacturing. — Taxpayers claimed the contract manufacturers were not branches of the CFC.

13 13

H W G H A hl d Oil How We Got Here: Ashland Oil

USCo

US US F

Unrelated CFC

conversion process

4th-Country

Unrelated ForCo

4th Country Customers

product

Tax Court: Unrelated contract manufacturer wasn’t a branch of the CFC.

14 14

H W G H V How We Got Here: Vetco

USCo

US

CFC

F 4th-Country Customers 3rd-Country

product

y CFC

Conversion process

Tax Court: Wholly owned manufacturing subsidiary of a CFC isn’t a branch

15 15

Tax Court: Wholly owned manufacturing subsidiary of a CFC isn t a branch.

l How We Got Here: Rev. Rul. 97‐48

— Revoked Rev. Rul. 75-7 St t d th t t t f t ’ ti iti ’t b — Stated that a contract manufacturer’s activities can’t be attributed to a CFC unless a branch exists

16 16

How We Got Here: P R R l 8 Pl i Post‐Rev. Rul. 97‐48 Planning

• The it s argument:

― FBCSI is "income derived in connection with the purchase

• f property from a related purchaser and it s sale to any
• f property from a related purchaser and it s sale to any

person."

17 17

R b J Mi J R i h B V D

CONTRACT MANUFACTURING

Robert J. Misey Jr., Reinhart Boerner Van Deuren Frederick Chilton, McDermott Will & Emery

CONTRACT MANUFACTURING REGULATIONS

Th R R l i The Recent Regulations

— Eliminate the "it s" defense E d th f t i ti ith

b t t i l

— Expand the manufacturing exception with subst ant ial

cont ribut ion t o manufact uring

— Substantially reinvigorate the branch rule

19 19

F T F M f i Four Tests For Manufacturing

• 1. Substantial transformation

2 G ll id d f t i i th i d t

• 2. Generally considered manufacturing in the industry

3 Safe harbor of conversion costs constituting 20% of the cost of

• 3. Safe harbor of conversion costs constituting 20% of the cost of

goods sold

• 4. Substantial contribution to manufacturing

20 20

S b i l T f i Substantial Transformation

USCo

US F

fresh tuna

CFC

3rd-Country Customers

canned tuna

21 21

Generally Considered To C i M f i Constitute Manufacturing

USCo

sunglass

US F

sunglass components

CFC

3rd-Country Customer

sunglasses

22 22

Safe Harbor Of 20% Of Cost Of Goods Sold

USCo

US F

WIP

CFC

$30,000 direct material costs $10,000 conversion costs

3rd-Country Customer

completed products

23 23

Substantial Contribution To Manufacturing

— Results in manufacturing without what is traditionally considered manufacturing — Facts-and-circumstances test — No minimum performance threshold — Require that activities be conducted by employees

24

— Deals with automated manufacturing

24

Seven Factors Of S b i l C ib i Substantial Contribution

• 1. Oversight of physical manufacturing
• 2. Physical activities are less than full physical manufacturing.

3 C t l f t i l

• 3. Control of raw materials
• 4. Managing manufacturing costs or capacities

5 Control of manufacturing logistics

• 5. Control of manufacturing logistics
• 6. Quality control
• 7. Development of manufacturing intangibles
• 7. Development of manufacturing intangibles

25 25

Contract Manufacturing: L F Th E l Lessons From The Examples

— Mere contractual rights, legal title, tax ownership or assumption of risk of loss are not considered in determining whether the CFC has substantially contributed. — Contractual claims to oversight without actual oversight mean nothing nothing.

26 26

Contract Manufacturing: h l ( ) Lessons From The Examples (Cont.)

USCo

US US F

3rd Country CFC

Substantial transformation

4th-Country Customer

product

3 Country KM

Power to control

No substantial contribution

and oversee is not exercised.

27

No substantial contribution

27

Contract Manufacturing: h l ( ) Lessons From The Examples (Cont.)

The actual exercise of direction and oversight of the manufacturing activities constitute a substantial contribution.

28 28

Contract Manufacturing: h l ( ) Lessons From The Examples (Cont.)

A CFC must consider the activities of its employees in determining whether the CFC manufactures the property sold.

29 29

Contract Manufacturing: h l ( ) Lessons From The Examples (Cont.)

USCo

US US F

3rd-Country CFC

Substantial transformation

4th-Country Customer

product

3 Country KM

Employees conduct

Substantial contribution

R&D, QC and logistics.

30

Substantial contribution

30

Contract Manufacturing: h l ( ) Lessons From The Examples (Cont.)

USCo

US US F

3rd-Country CFC

Substantial transformation buys raw materials

4th-Country Customer

3 Country KM

Employees select buys raw materials

Substantial contribution

materials, oversee mfg. process, and schedule.

31

Substantial contribution

31

Contract Manufacturing: h l ( ) Lessons From The Examples (Cont.)

USCo

US US F

3rd-Country CFC

Substantial transformation with contract employees

4th-Country Customer

3 Country KM

Employees control product contract employees

Substantial transformation

• mfg. process, raw

materials, WIP, QC and finished goods.

32

Substantial transformation

32

Contract Manufacturing: h l ( ) Lessons From The Examples (Cont.)

Application of substantial contribution Test (Treas. Reg. Sect. 1.954-3(a)(4)(iv)(c)) 1 The performance of any of the enumerated seven activities

• 1. The performance of any of the enumerated seven activities

is to be taken into account.

• 2. Lack of performance of such activities, and the number of

activities actually performed, are not determinative.

• 3. The fact that other persons make a substantial contribution

to manufacture does not preclude the CFC from making a to manufacture does not preclude the CFC from making a substantial contribution to manufacture.

33 33

Contract Manufacturing: h l ( ) Lessons From The Examples (Cont.)

Automated manufacturing examples Example 5: Automated manufacturing not supervised by CFC

Facts: CFC owns raw materials. CFC has legal right to oversee manufacturing but

does not do so through its employees CFC owns sophisticated software that does not do so through its employees. CFC owns sophisticated software that remotely and automatically (without human involvement) takes orders, routes them to CM, orders raw materials and performs quality control.

CFC activities: CFC has a small staff of computer technicians who monitor the

p software and network systems to make sure that they are running smoothly.

DP activities: The automated systems were designed by DP

. DP employees supervise the CFC computer technicians and make ongoing operational decisions, i l di d i i l d d d f i d i DP including decisions related to product and manufacturing process design. DP employees direct and control vendor and material selection, management of the manufacturing costs and capacities, and selection of the CM. Substantial operational responsibilities and decision-making are required but are

34

Substantial operational responsibilities and decision making are required but are not carried out by the CFC to manufacture the product.

34

Contract Manufacturing: h l ( ) Lessons From The Examples (Cont.)

Automated manufacturing examples (Cont.) E l 5 A t t d f t i i d b th Example 5: Automated manufacturing supervised by another person

Result:

The activities of the CFC constitute manufacture. However, the CFC does not make a substantial contribution to manufacturing through its employees. Mere ownership of raw materials and IP , along with contractual rights to oversee manufacturing (compare examples 1 and 2)

35

rights to oversee manufacturing (compare examples 1 and 2), are not sufficient to constitute substantial contribution to manufacturing.

35

Contract Manufacturing: h l ( ) Lessons From The Examples (Cont.)

Automated manufacturing examples (Cont.) Example 6: Automated manufacturing supervised by FS Example 6: Automated manufacturing supervised by FS

Facts: Are the same as in 5, except that FS employees carry out

the activities of the DP employees.

Result: FS makes a substantial contribution through the activities

• f its employees to the manufacture of the product. This

determination does not require a comparison of the activities

• f the employees of FS and DP

. Activities that are not among the enumerated seven activities: Selection of the CM, even though not one of the enumerated

36

, g seven activities, is taken into account in determining whether FS makes a substantial contribution to manufacturing.

36

Contract Manufacturing: h l ( ) Lessons From The Examples (Cont.)

Automated manufacturing examples (Cont.) E l 7 A t t d f t i i d b FS ith Example 7: Automated manufacturing supervised by FS with purchased intellectual property

Facts: The facts are the same as in Example 6, except that the

p , p software and network systems were purchased by FS rather than developed by FS.

Result: The fact that FS did not develop the software and Result: The fact that FS did not develop the software and

network systems is not determinative. The other activities of its employees make a substantial contribution to the f f h d

37

manufacture of the product.

37

Contract Manufacturing: h l ( ) Lessons From The Examples (Cont.)

Example 8: Manufacturing without intellectual property

Facts: FS purchases raw materials from a related party, and they are

manufactured into a product by CM. At all times, FS controls the raw materials, work-in-process and finished goods. FS controls the manufacturing-related logistics, manages the manufacturing costs and capacities, and provides quality control with respect to CM’s manufacturing process and product. No intellectual property is required to manufacture the product, and FS does not own any IP relating to the product.

Result: Because intellectual property is irrelevant to the manufacture of

the product, it is not important to the substantial contribution

• analysis. FS employees make a substantial contribution to the

38

manufacture of the product.

38

Contract Manufacturing: h l ( ) Lessons From The Examples (Cont.)

More than one party makes a contribution to manufacturing More than one party makes a contribution to manufacturing. Example 9: Substantial contribution by more than one CFC

Facts: Both FS1 and FS2 contract with CM for the manufacture of Product

• X. Neither FS1 nor FS2 owns the materials or work-in-process during

the manufacturing process. FS1, through its employees: Designs Product X; directs the use of the product design and design specifications, and other intellectual property, for the purpose of manufacturing Product X; and selects the materials that will be used to manufacture product X. FS2, through its employees: Designs the process for manufacturing Product X. FS1 and FS2 each provide quality control and oversight and direction

39

FS1 and FS2 each provide quality control and oversight and direction

• f the CM’s manufacturing activities, with respect to different

aspects of the manufacturing process.

39

Contract Manufacturing: h l ( ) Lessons From The Examples (Cont.)

More than one party makes a contribution to manufacturing (Cont.) Example 9: Substantial contribution by more than one CFC Example 9: Substantial contribution by more than one CFC

Result: The fact that other persons make a substantial contribution to

manufacturing the product does not preclude a CFC from making a substantial contribution to manufacture of the property Each CFC substantial contribution to manufacture of the property. Each CFC takes account only of its activities if performing the analysis. No threshold of activity is required. Under the facts and circumstances, both FS1 and FS2 make substantial contributions to the manufacture both FS1 and FS2 make substantial contributions to the manufacture

• f Product X.

Compare with Example 5, in which USP’s activities demonstrated that

substantial contributions to manufacture were required but that the

40

substantial contributions to manufacture were required, but that the CFC did not make them.

40

Contract Manufacturing: h l ( ) Lessons From The Examples (Cont.)

Example 10: Value-added activities are most important in substantial contribution analysis.

Facts: FS designs the product selects the materials that CM will Facts: FS designs the product, selects the materials that CM will

use to manufacture Product X, and manages manufacturing costs and capacities. These are the activities that add value to the X product FS does not oversee manufacturing and quality the X product. FS does not oversee manufacturing and quality control, because it is not required.

Result: FS makes a substantial contribution through the activities

• f its employees.

41 41

Contract Manufacturing: h l ( ) Lessons From The Examples (Cont.)

Example 11: Direction and oversight of manufacturing and quality control p g g q y through periodic visits

Facts: FS controls the raw material, work-in-process and finished goods;

manages the manufacturing costs and capacities; and provides manages the manufacturing costs and capacities; and provides

• versight and direction of the manufacture of Product X. Employees
• f FS visit CM’s manufacturing facility for one week each quarter and

perform quality control tests on a random sample of the units of p q y p Product X produced.

Result: FS makes a substantial contribution through its employees to the

manufacture of Product X. manufacture of Product X.

Compare: Automated manufacturing examples in which software, among

• ther things, was responsible for quality control. Quality control,

whether carried out automatically or by CFC employees can qualify

42

whether carried out automatically or by CFC employees, can qualify as a substantial contribution activity depending upon the level of CFC employee involvement.

42

James Sams, KPMG

BRANCH OFFICE

James Sams, KPMG Frederick Chilton, McDermott Will & Emery

REGULATIONS

Agenda For This Section

• Statute and regulation terms of art
• Mechanics for application of rules
• Complexities with multiple branches
• Practical issues and examples
• Practical issues and examples

44

• Sect. 954(d)(2): The Branch Rule

The Statute. Prerequisite: When the “carrying on of activities by a

.

q

y g y controlled foreign corporation through a branch … (outside the country

• f incorporation of the controlled foreign corporation) has substantially

the same effect as if such branch … were a wholly owned subsidiary corporation deriving such income corporation deriving such income, …,

Effect: (1) The income attributable to the carrying on of such activities of

such branch shall be treated as income derived by a wholly owned such branch … shall be treated as income derived by a wholly owned subsidiary of the controlled foreign corporation. and (2) shall constitute foreign base company sales income of the controlled foreign corporation.”

45

Regs Provide Rules For Determining When To Treat CFC Sales Branch Separately

Sales or purchase branch -

To Treat CFC, Sales Branch Separately

Sales or purchase branch Prerequisites: (1) If a CFC carries on purchasing or selling

activities through a branch (located outside the country under the laws of which such corporation is organized), and the use of the branch for such activities has substantially the same tax effect as if branch for such activities has substantially the same tax effect as if the branch or similar establishment were a wholly owned subsidiary corporation of such controlled foreign corporation (see next slide);

Effect: The branch and the remainder of the CFC will be treated as

t ti f f d t i i f i b separate corporations, for purposes of determining foreign base company sales income of such corporation. Treas. Reg. §1.954- 3(b)(1)(a)

46

Regs For Allocating Income And Comparing Effective Tax Rates (Tax Rate Disparity) In Effective Tax Rates (Tax Rate Disparity), In Situation Involving Sales Branch

The use of the branch, for purchasing or sales activities, will be considered to have substantially the same tax effect as if it were a wholly owned subsidiary corporation of the CFC, if the income allocated to the branch … is … taxed in the year when earned at an

effective rate of tax that is less than 90% of, and at least 5 percentage

points less than, the effective rate of tax which would apply to such p pp y income under the laws of the country in which the CFC is created or

• rganized. Treas. Reg. §1.954-3(b)(1)(b)

47

Application Of Tax Rate Disparity Test To Sales Branch Test To Sales Branch

.

CFC Country X Tax rate: 20% C t Y Sales Branch Country Y Tax rate: 0% Analysis: Because the tax rate in Y (the branch country) is less than 90% of, and at least 5 percentage points less than, the effective rate of tax in X, the use of the sales branch for sales activities has substantially the same tax effect as if the branch were a y wholly owned subsidiary corporation of the CFC.

48

Application Of Tax Rate Disparity Test In Sales Branch Situation In Sales Branch Situation

Advantage of using a low-taxed CFC to avoid the sales branch rule CFC Country X Tax rate: 0% C t Y Sales Branch Country Y Tax rate: 10% Analysis: Because the tax rate in Y (the branch country) is more than 90% of, and within 5 percentage points of (in fact, more than) the effective rate of tax in X, the use of the sales branch for sales activities does not have substantially the same tax effect as if the branch were a wholly owned subsidiary corporation of the CFC.

49

Regs Provide Rules For Determining When To Apply Separate Treatment to Manufacturing pp y p g Branch And CFC

If a CFC carries on manufacturing, producing, constructing, growing, or extracting If a CFC carries on manufacturing, producing, constructing, growing, or extracting activities by a branch (located outside the country under the laws of which such corporation is organized), and The use of the branch 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 sa e ta e ect as t e b a c o s la establ s e t we e a w olly ow ed subsidiary corporation of such CFC, Then the branch or similar establishment and the remainder of the CFC will be Then the branch or similar establishment and the remainder of the CFC will be treated as separate corporations, for purposes of determining foreign base company sales income of such corporations. Temp. Treas. Reg. §1.954- 3(b)(1)(ii)(a) ( )( )( )( )

50

Regs Provide Rules For Determining When To Apply Separate Treatment To Manufacturing pp y p g Branch And CFC (Cont.)

The manufacturing branch rules will apply only if the CFC (including any branches or similar establishments of such CFC) manufactures, branches or similar establishments of such CFC) manufactures, produces or constructs such personal property within the meaning of

• Treas. Reg. §1.954-3(a)(4)(i), or carries on growing or extracting

activities with respect to such personal property Temp Treas Reg activities with respect to such personal property. Temp. Treas. Reg. §1.954-3(b)(1)(ii)(a)

51

Mechanics Of Application

“Substantially the same tax effect” is a four-step process:

Mechanics Of Application

y p p 1. Allocate income to the “selling party.” This is the “remainder” of the CFC for the manufacturing branch test, and the selling branch for the sales branch test. test.

• The term “remainder” of the CFC denotes the CFC’s activities apart

from those performed within its branches. 2 D i h l ETR f h lli ’ j i di i 2. Determine the actual ETR of the selling party’s jurisdiction 3. Determine the hypothetical ETR that would apply in the manufacturing jurisdiction 4. Apply rate disparity test * Additi l t l h th lti l b h (di

d l t

) * Additional steps apply when there are multiple branches (discussed lat er).

52

Step 1: Allocation Of Income To Selling Party

The income allocated to the selling branch or the CFC remainder is the

Step 1: Allocation Of Income To Selling Party

The income allocated to the selling branch or the CFC remainder is the amount that would constitute FBCSI to the selling party under the following assumptions: 1 The branches are wholly owned subsidiaries of the CFC incorporated 1. The branches are wholly owned subsidiaries of the CFC, incorporated in the country where they are located. 2. Purchasing and selling activities of the selling party are performed on behalf of the manufacturing party. 3. The exceptions for FBCSI do not apply to: a) Property manufactured in selling party’s country a) Property manufactured in selling party s country b) Property sold for use in selling party’s country c) Property manufactured by CFC

53

Step 2: Determination Of Actual ETR Of Selling Party

• Actual ETR takes into account all income-like taxes in the selling party’s

ETR Of Selling Party

Actual ETR takes into account all income like taxes in the selling party s country of organization. T h lid d h ib f h lli h i h

• Tax holidays, and the tax attributes of the selling party that it uses when

computing its taxes, will be taken into account for this calculation.

• For example, if the selling party reduces its tax liability within its

country of organization to zero through the use of net operating loss carryforwards, then its ETR will be 0%.

54

Step 3: Hypothetical ETR Calculation

• Determine hypothetical ETR as if income allocated to the selling party

Step 3: Hypothetical ETR Calculation

Determine hypothetical ETR as if income allocated to the selling party was earned by a corporation organized in the manufacturing party’s tax jurisdiction, with all of its income attributed to that country.

• Hypothetical ETR takes into account all income-like taxes in the

manufacturing party’s country of organization.

• Tax holidays and other available tax incentives of manufacturing

jurisdiction will be applied jurisdiction will be applied.

• It is unclear whether tax attributes specific to the selling party, such as

net operating losses and capital loss carryforwards, can be used.

55

Hypothetical ETR Examples

E l f l ETR FS

CFC: S ll P d t X t id f

FS

CFC: S ll P d t X t id

Example of simple ETR Example of complex ETR FS

(Country M)

• Sells Product X outside of

Country M

• Country M statutory tax rate

= 10%

• ETR = 10%

FS

(Country M)

• Sells Product X outside

Country M

• Country M statutory tax rate

= 10%

• ETR = 10%

Branch A

(Country A)

Manufacturing Branch:

• Manufactures Product X
• Country A statutory tax rate

Branch A

(Country A)

Manufacturing Branch:

• Manufactures Product X
• Country A statutory tax rate

( y )

= 20%

• ETR = 20%

( y )

= 20%

• ETR = 8%
• Remainder of FS earns $100k on sales of Product X outside of

Country M.

• Remainder of FS earns $100k on sales of Product X outside of

Country M. Country M.

• $100k taxed at 10% in Country M is $10k, for an ETR of 10%.
• $100k taxed at 20% in Country A is $20k, for an ETR of 20%.
• There is a rate disparity.
• $100k taxed at 10% in Country M is $10k, for an ETR of 10%.
• In Country A, sales income of Product X gets a tax incentive,

and only 40% of the $100k sales income would be taxed.

• $40k (40% * 100k) taxed at 20% in Country A is $8k, for an

$ $ p y ETR of 8% ($8k / $100k).

• There is no rate disparity.

56

Step 4: Rate Disparity Test

Rate disparity test

Step 4: Rate Disparity Test

Rate disparity test Sales branch

• Actual sales branch ETR less than 90% of and at least five
• Actual sales branch ETR less than 90% of, and at least five

percentage points lower than, hypothetical ETR in CFC’s country.

Manufacturing branch g

• Actual CFC remainder ETR is less than 90% of, and at least five

percentage points lower than, hypothetical ETR in manufacturing branch’s country branch’s country

57

Structural And Operational Complexities

• If there are multiple sales branches, and no manufacturing branches,

Structural And Operational Complexities

If there are multiple sales branches, and no manufacturing branches, then test each sales branch independently using the sales branch rules If th lti l l b h d t l t f t i

• If there are multiple sales branches and at least one manufacturing

branch, then test each sales branch independently using the manufacturing branch rules, as if the sales branch were the remainder C C CFC.

• May require use of multiple manufacturing branch rules
• If, after application of the rules, the manufacturing entities are

, a te appl cat o o t e ules, t e a u actu g e t t es a e considered separate entities from the sales branch, then the sales branch income will be FBCSI and vice versa.

58

Structural And Operational Complexities (Cont )

• Apply rate disparity test between selling party and the “location of

Complexities (Cont.)

Apply rate disparity test between selling party and the location of manufacture”

• If only one branch independently satisfies a manufacturing test, then
• ly o e b a c

depe de tly sat s es a a u actu g test, t e that branch is treated as the “location of manufacture.”

• If more than one branch independently satisfies a manufacturing test,

p y g , then the “location of manufacture” is the branch with the lowest effective rate of tax.

• If none of the branches independently satisfies a manufacturing test,

but the CFC as a whole does, apply a “greater contribution” test (see

next slide) next slide).

59

Structural And Operational Complexities (Cont )

What if no one entity meets manufacturing test, but the CFC’s operations as a whole do?

Complexities (Cont.)

1. Determine the “tested sales location” 2. Determine the “tested manufacturing location” 3. Apply the “greater contribution test” to determine “location of manufacture” 3. Apply the greater contribution test to determine location of manufacture i. Attribute activities of rate disparate entities to the tested manufacturing location ii. Attribute activities of non-rate disparate entities to the tested sales location iii Determine which tested location after attrib tion contrib tes more to the iii. Determine which tested location, after attribution, contributes more to the manufacturing process. If they are equal, the tested manufacturing location has the “greater contribution.” A If the tested manufacturing location has the “greater contribution ” then it is A. If the tested manufacturing location has the greater contribution, then it is the location of manufacture, and the branches will be considered separate entities. B If the tested sales location has the “greater contribution ” then it is the location B. If the tested sales location has the greater contribution, then it is the location

• f manufacture, and the branches will continue to be treated as branches.

60

• Treas. Reg. §1.954‐3(b)(1)(ii)(c)(3)(v), Ex. 2:

Multiple Manufacturing Branches Multiple Manufacturing Branches

FS

Raw Materials Product X Sales

Related Unrelated

FS

(Country M) Materials Sales

• ETR = 10%

Related Supplier Customers

(Outside M)

Branch A

(Country A)

• Product design
• Manages manufacturing costs

Branch C

(Country C)

• Physically manufactures

Product X

Branch B

(Country B)

• QC
• Oversight and direction

g g and capacities

• Oversees coordination

between branches

• Controls raw materials, WIP,

risk of loss Product X

• ETR = 20%

Oversight and direction

• ETR = 12%

Result:

• Both Branch A and Branch C independently qualify as manufacturers through the activities of their employees.
• Branch A is treated as the location of manufacture, because Country A imposes the lower effective rate of tax.

Branch C is not tested separately.

• ETR = 12%

Branch C is not tested separately.

• Therefore, none of the branches is considered a separate entity from FS, because Country A does not have a rate

disparity with Country M.

61

• Treas. Reg. §1.954‐3(b)(1)(ii)(c)(3)(v), Ex. 4:

Manufacturing Function Divided Among f g g Multiple Branches

FS

Raw Materials Product X Sales FS:

Related Unrelated

FS

(Country M) Materials Sales FS:

• Manages manufacturing

costs and capacities

• Oversees coordination

between branches

• ETR = 10%

Related Supplier Customers

(Outside M)

• ETR = 10%

Branch A

(Country A)

• Product design
• ETR = 20%

Unrelated Contract Mfg

( ) Branch B

(Country B)

• Controls raw materials, WIP, risk
• f loss

Result:

• Neither the remainder of FS, nor Branch A, nor Branch B independently satisfies §1.954-3(a)(4)(i). But, FS, as a whole, provides a substantial

contribution through the activities of its employees to the manufacture of Product X.

(Country C)

• Contract mfg oversight and

direction; control logistics

• ETR = 12%

contribution through the activities of its employees to the manufacture of Product X.

• The tested sales location is Country M, because the remainder performs the selling activities with respect to Product X.
• The location of Branch A is the tested manufacturing location, because Country A has the lowest effective rate of tax among the

manufacturing branches that would be treated as a separate corporation (20% of Country A vs. 10% of Country M).

• The activities of Branch B will be included in the contribution of FS for purposes of determining the location of manufacture of Product X, because

it does not have a rate disparity with Country M (12% vs. 10%).

• The activities of FS and Branch B combined would provide a greater contribution to the manufacture of Product X than the activities of

Branch A. Therefore, the location of manufacture is Country M, and neither Branch A nor Branch B would be considered a separate entity from FS. 62

Issues With Affirmative Use Of Branch Rules

FS:

FS

(Country M) Product X Product X

• Does not provide manufacturing
• r sales services outside of its

branch ownership

• ETR = 18%

Product X Intercompany Sale Product X Sales

Branch A

(Country A) Branch A:

Related Supplier

(Country R)

Unrelated Customers

(Country A only)

• Does not provide manufacturing

services

• ETR = 10%
• Be aware that there is a concern whether the affirmative use of the branch rules to create a favorable outcome for the

taxpayer would be allowed.

• In this example, if Branch A is treated as a separate corporation, it would avoid FBCSI on its sales income of Product X

(because of the same country exception).

• A taxpayer’s claim that Branch A should be a separate corporation because of Branch A’s rate disparity with FS would be

an affirmative use of the branch rules, since it would be favorable to the taxpayer.

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Future Guidance

The Service has stated that it plans to issue future guidance regarding:

Future Guidance

The Service has stated that it plans to issue future guidance regarding:

• When a branch should be treated as a separate corporation under

IRC Sect. 954(d)(2)

• The coordination of the foreign base company sales and services
• rules. Presumably, this guidance will address open issues regarding

whether the Service can recast a service relationship as a sales whether the Service can recast a service relationship as a sales

• relationship. This question arises most commonly in the following two

scenarios:

• CFC makes unrelated purchases and sales, and engages a contract

manufacturer to provide manufacturing services. CFC engages a commission agent to provide marketing and sales

• CFC engages a commission agent to provide marketing and sales

support services.

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