Code §954(d)(1) defines foreign base company sales as follows:

[T]he term "foreign base company sales income" means income (whether in the form of profits, commissions, fees, or otherwise) derived in connection with the purchase of personal property from a related person and its sale to any person, the sale of personal property to any person on behalf of a related person, the purchase of personal property from any person and its sale to a related person, or the purchase of personal property from any person on behalf of a related person where --

(A) the property which is purchased (or in the case of property sold on behalf of a related person, the property which is sold) is manufactured, produced, grown, or extracted outside the country under the laws of which the controlled foreign corporation is created or organized, and

(B) the property is sold for use, consumption, or disposition outside such foreign country, or, in the case of property purchased on behalf of a related person, is purchased for use, consumption, or disposition outside such foreign country.

Code §954(d)(2) provides special rules for controlled foreign corporations that carry on activities through a branch or similar establishment outside the country of incorporation of the controlled foreign corporation.  This posting does not deal with the special branch rules of Code §954(d)(2).  Instead, here the focus is on a controlled foreign corporation that carries on all of its activities in one country.

Treas. Reg. §1.954-3(a)(1) generally defines foreign base company sales income (“FBCSI”).  Treas. Reg. §1.954-(a)(2) goes on to provide that FBCSI:

does not include income derived in connection with the purchase and sale of personal property . . . if the property is manufactured . . . in the country under the laws of which the controlled foreign corporation . . . is created or organized.  See section 954(d)(1)(A).

Treas. Reg. §1.954-(a)(3) further provides that FBCSI:

does not include income derived in connection with the purchase and sale of personal property . . .  if the property is sold for use, consumption, or disposition in the country under the laws of which the controlled foreign corporation . . . is created or organized . . . See section 954(d)(1)(B).

The exceptions in Treas. Reg. §1.954-3(a)(2) and (a)(3) directly mirror the statute in Code §954(d)(1)(A) and (d)(1)(B).  It is interesting to note that Code § 954(d)(1)(B) and Treas. Reg. §1.954-3(a)(3) have no relation to where the personal property was manufactured or by whom it was manufactured.  Further, Code §954(d)(1)(A) and Treas. Reg. §1.954-3(a)(2) only refer to where the personal property was manufactured.  Under these rules, there is no need to determine who manufactured the personal property.

Up to this point, the statute and the regulations are parallel to each other.  However, Treas. Reg. §1.954-3(a)(4) provides an exception to FBCSI that is not explicitly provided for in the statute.  Treas. Reg. §1.954-3(a)(4)(i) provides that FBCSI:

does not include income of a controlled foreign corporation derived in connection with the sale of personal property manufactured . . . by such corporation . . . .

As mentioned above, the statute has no explicit parallel to this rule in the regulations.  Nowhere in Code §954(d) does it state that property manufactured by a corporation will be excluded from FBCSI.  The legislative history of Code §954(d) does, however, refer to an exception for property manufactured “by the selling corporation.”  Thus, Treas. Reg. §1.954-3(a)(4) would appear to be consistent with the intent of Congress.

If one attempts to discern where in the language of the statute this “manufacturing” exception could be embodied, it makes sense to focus on the language “income . . . derived in connection with the purchase of personal property . . . and its sale . . . .”  This reliance appears to be supported by Treas. Reg. §1.954-3(a)(4)(i), which provides that:

A foreign corporation will be considered . . . to have manufactured . . . personal property which it sells if the property sold is in effect not the property which it purchased.  In the case of the manufacture . . . of personal property, the property sold will be considered . . . as not being the property which is purchased if the provisions of subdivision (ii) or (iii) of this subparagraph are satisfied.

Thus, under certain circumstances, a foreign corporation is considered to have manufactured.  If a foreign corporation is considered to have manufactured, it would seem to follow that the manufacturing would be considered done “by the corporation.”  It would be a non sequitur to state that a foreign corporation is considered to have manufactured a product, but that the product was not considered manufactured by the corporation.

The Internal Revenue Service and the Treasury Department recently published proposed regulations (see here) which would amend Treas. Reg. §1.954-3.  The following is an excerpt from the preamble to those proposed regulations:

Section 954(d)(1) includes, as FBCSI, income from the purchase of personal property from any person and “its” sale to a related person.  Some taxpayers argue that use of the word “its” implies that the property sold must be the same property that is purchased for the sales income to be FBCSI.  Accordingly, these taxpayers assert that where the personal property purchased by the CFC is manufactured such that the property purchased is not the same as the property sold by the CFC, the property sold by the CFC is not the property purchased and therefore the sale of such property does not generate FBCSI, even if the CFC itself performs little or no part of the manufacture of that property.

The preamble to the regulations goes on to state that “[t]he Treasury Department and the IRS believe that the position taken by these taxpayers is contrary to existing law, and results from an incorrect reading of section 954(d)(1) and Sec.  1.954-3(a)(4)(i).”

It is submitted here that the Treasury Department, when drafting the original regulations under Code §954(d), themselves relied on the use of the word “its” (in the same manner as taxpayers may be relying on the use of the word "its") to arrive at the manufacturing exception provided in Treas. Reg. §1.954-3(a)(4).  Otherwise, it is unclear what language in the statute the Treasury Department relied upon to allow for the manufacturing exception in Treas. Reg. §1.954-3(a)(4).