Andrew Mitchel LLC

International Tax Blog - New and Interesting International Tax Issues

Three Manufacturing Tests Under Code § 954(d) & the Manufacturing Branch Rules


In December 2008, the I.R.S. and the Treasury Department published T.D. 9438, which included new regulations under Code § 954(d).  These regulations became effective on July 1, 2009, and are generally applicable to tax years of controlled foreign corporations (“C.F.C.s”) beginning after June 30, 2009.

As with the prior regulations, foreign base company sales income (“FBCSI” or “subpart F income”) generally does not include income of a C.F.C. derived in connection with the sale of personal property manufactured, produced, or constructed (“manufactured”) by such corporation.  Under the new regulations, a C.F.C. will have manufactured personal property which the corporation sells only if the corporation satisfies one of the following tests through the activities of its own employees:

--- 1.954-3(a)(4)(ii) - Substantial Transformation Test (“STT”),

--- 1.954-3(a)(4)(iii) - Substantive Manufacturing Test (“SMT”), or

--- 1.954-3(a)(4)(iv) - Substantial Contribution Test (“SCT”).

When a C.F.C. purchases product from related parties or sells product to related parties, the C.F.C. may be able to avoid FBCSI under one of the above noted manufacturing tests (often referred to as the “manufacturing exception”).  Consequently, manufacturing activities are generally useful in avoiding subpart F income.

Manufacturing Branch Rules

However, if the C.F.C. performs the manufacturing activities through a branch (or similar establishment) in a country other than the country in which it is created or organized, the manufacturing activities can create subpart F income under complex manufacturing branch rules.  Under these rules, subpart F income can occur even if there are no related party purchases and no related party sales.  If the branch rules apply, certain activities are deemed to have occurred on behalf of deemed related parties.

Deemed Activities & Deemed Entities

With regard to the deemed activities, certain purchasing and selling activities are deemed to occur on behalf of a related manufacturing entity.  With regard to the deemed related parties, the manufacturing branch is deemed to be a separate entity and the location of the sales activities (the home office of the C.F.C. or a sales branch) is also deemed to be a separate entity.  This fictional construct may or may not create FBCSI, depending upon the circumstances.

Manufacturing Activities Not Treated As Manufacturing

The manufacturing branch rules do not apply if the C.F.C. as a whole does not meet one of the manufacturing tests noted above (STT, SMT, or SCT).  Thus, where a C.F.C. is engaged in some manufacturing activities (see the indicia of manufacturing in Treas. Reg. § 1.954-3(a)(4)(iv)(b)(1) - (7)) within or outside its country of formation, but not enough to be meet the manufacturing tests, the manufacturing branch rules do not apply.  If a C.F.C. does not have related party purchases and does not have related party sales, but does have some manufacturing activities outside its country of formation, and if the C.F.C. can limit those manufacturing activities to avoid meeting the manufacturing tests, the C.F.C. can avoid FBCSI under the manufacturing branch rules.

Of course, if purchasing and/or selling activities occur outside the C.F.C.’s country of formation, then the sales branch rules must be applied to determine whether FBCSI exists.  Similar to the manufacturing branch rules, subpart F income can be triggered under the sales branch rules even if there are no related party purchases and no related party sales.

Tags: 951 Subpart F Income