New Subpart F Regs. Address Manufacturing Exception and Branch Rules

By From Bert J. Hawkins, CPA, MST, and Cari A. Koval, CPA, Los Angeles, CA

Editor: Mindy Cozewith, CPA, M. Tax.

On December 29, 2008, Treasury published final, temporary, and proposed regulations under Sec. 954 addressing the treatment of contract manufacturing arrangements and the branch rules applicable to foreign base company sales income (FBCSI), a type of subpart F income applicable to the sale of inventory (T.D. 9438, REG-150066-08). The new regulations leave the original regulations largely intact, provide an additional test for the “manufacturing exception” (the substantial contribution test), and provide a protocol for administering the branch rules. The new regulations also eliminate the “its defense,” which is described in the preamble as being contrary to existing law and representing an incorrect reading of the FBCSI rules. These regulations are generally effective for tax years of controlled foreign corporations (CFCs) beginning after June 30, 2009, and the corresponding tax years of U.S. shareholders.

In general, the FBCSI rules impose U.S. tax on income derived by a CFC in connection with the sale of products purchased from a related party and sold outside the CFC’s country of organization (Sec. 954(d)). Exceptions exist for products manufactured in the CFC’s country of organization, de minimis transactions, and transactions subject to high rates of foreign tax. An additional exception exists for products that are manufactured by the CFC (the manufacturing exception). In many cases, the selling CFC may perform some but not all of the manufacturing functions in connection with the property it sells. These new regulations address the issue of what level of manufacturing activities a CFC must perform to become eligible for the manufacturing exception.

Two alternative tests are available under the existing regulations to determine if a CFC has performed sufficient manufacturing activities to satisfy the manufacturing exception. The first is the substantial transformation test, under which property is considered manufactured if it is substantially transformed prior to sale. The regulations give as illustrations of substantial transformation examples such as converting wood pulp into paper, steel rods into screws and bolts, and fresh fish into canned tuna (Regs. Sec. 1.954- 3(a)(4)(ii)). The second is the substantive test/safe harbor, under which property is considered manufactured if the CFC purchases components and performs substantial operations that are generally considered to be manufacturing activities (Regs. Sec. 1.954-3(a)(4)(iii)). A safe harbor is available if the conversion costs (direct labor and factory burden) incurred by the CFC in the integration process account for 20% or more of the total cost of goods sold. Packaging, repackaging, labeling, or minor assembly will in no event constitute manufacturing. The new regulations refer to these two tests collectively as the physical manufacturing tests.

Arguably, another basis for claiming the manufacturing exception is available under the statute, which provides that FBCSI is defined as “income . . . derived in connection with the purchase of personal property from . . . any person and its sale to a related person” (Sec. 954(d)(1); emphasis added). Taxpayers have taken the position, commonly referred to as the “its defense,” that as long as the property purchased and the property sold by the CFC is not the same property, its sale does not give rise to FBCSI. CFCs relying on this defense take and hold title to raw materials, work in process, and finished goods inventories, while a related third party performs the manufacturing processes on a contract fee basis..

Branch Rules

The branch rules are intended to prevent circumvention of the FBCSI rules by taxpayers that conduct business through a branch, thereby eliminating the intercompany sale that would otherwise give rise to FBCSI.

Example: H is a CFC based in Hong Kong, which in turn owns C, a manufacturing CFC based in the People’s Republic of China (PRC). H purchases products from C and resells them to customers outside Hong Kong.

Such sales would give rise to FBCSI. However, if C were instead structured as a branch of H (either as a branch in fact or as a disregarded entity), the intercompany sale of products from C to H would be a mere transfer from a branch to the remainder of the CFC (remainder). Absent the branch rules, FBCSI would be avoided. However, if the branch rules apply, the branch is treated as a CFC separate from the remainder, and the branch transfer becomes an intercompany sale resulting in FBCSI.

The branch rules are triggered based on the disparity in tax rates between the branch and the remainder of the CFC. The manufacturing branch rule applies if the sales or procurement function attributed to the remainder is subject to tax at an effective rate that is less than 90% of, and at least five percentage points less than, the tax rate that would apply to that income if it were subject to tax in the manufacturing branch’s home country (Regs. Sec. 1.954- 3(b)(1)(ii)(b)).

Returning to the example, if the effective tax rate in Hong Kong is 17.5% and the effective tax rate in the PRC is 25%, the Hong Kong rate is less than 90% of the PRC rate (90% × 25% = 22.5%) and less than the PRC rate minus five percentage points (25% – 5% = 20%). Accordingly, the manufacturing branch rule applies.

Similarly, the sales or procurement branch rule applies if the branch’s income is subject to tax at an effective rate less than 90% of, and at least five percentage points less than, the tax rate that would apply to such income if it were subject to tax in the remainder’s home country (Regs. Sec. 1.954-3(b)(1)(i)(b)). In both tests, the branch rule is triggered by the sales or procurement function being subject to a lesser tax rate than the manufacturing function, with the presumption being that the purpose of separating the relatively mobile sales or procurement function from the relatively fixed manufacturing function is to gain the advantage of the lower tax rate.

The branch rules have grown increasingly unwieldy as a result of globalization, segmentation of manufacturing practices, and the proliferation of foreign branches resulting from U.S. check-thebox elections. Today it is not uncommon for multinational corporations to employ multiple manufacturing facilities around the world, each manufacturing different components or performing final product assembly and test functions. At the same time, modern multinational corporations employ procurement, sales, and distribution entities in many countries. Checkthe-box elections are often made to treat some or all of these entities as either disregarded entities or branches of one or more foreign holding companies.

These new and complex structures, which were not envisioned when the original regulations were published, have raised important questions with respect to the application of the branch rules. For example, if multiple entities are involved in the manufacture of a product, which entity is deemed to be the manufacturer, and where is the location of manufacture? If a CFC has multiple sales and manufacturing branches, how is the tax rate disparity test administered? The new FBCSI regulations attempt to address such issues.

New Regs.: Substantial Contribution Test

If a CFC does not meet one of the physical manufacturing tests, the new regulations provide a new test, the substantial contribution test, whereby the CFC may qualify for the manufacturing exception if it makes a substantial contribution through the activities of its employees to the manufacture, production, or construction of personal property (Regs. Sec. 1.954-3(a)(4)(iv)).

Only the activities performed by the CFC’s employees are considered. The regulations provide a nonexclusive list of activities to be considered in determining whether the substantial contribution test is met based on the facts and circumstances:

  • Oversight and direction of manufacturing activities or processes. Although the regulations single out this activity as being important in most cases, the regulations qualify that the performance of this activity may not be required in every case, depending on the facts.
  • Activities considered in, but insufficient to satisfy, the physical manufacturing tests
  • Material selection, vendor selection, or control of the raw materials, work in process, or finished goods.
  • Management of manufacturing costs or capacities. This includes activities that help ensure that a plant is run in an economically efficient manner, such as optimizing plant capacity, reducing waste, managing the risk of loss, working on cost reduction or efficiency initiatives associated with the manufacturing process, demand planning, production scheduling, or hedging raw material costs. Not all corporate managerial decisions are intended to be considered in the test because many decisions are not “directly related to the manufacture of the personal property.”
  • Control of manufacturing-related logistics. This includes, for example, arranging for delivery of raw materials to a contract manufacturer but excludes, for example, delivery of finished goods to a customer.
  • Quality control; for example, sample testing or establishment of quality control standards
  • Developing, or directing the use or development of, product design and design specifications, as well as trade secrets, technology, or other intellectual property for the purpose of manufacturing, producing, or constructing the personal property. Only manufacturing- related activities are considered.

The location of manufacture is based on where the employees perform the activities, rather than where the CFC is located. For this purpose, the definition of an employee generally includes certain nonpayroll workers (such as certain seconded workers, part-time workers, and contractors) who are considered common-law employees under Regs. Sec. 31.3121(d)-1(c). The definition does not go so far as to include anyone in an agency relationship, as this may create unintended branch rule issues.

In connection with the substantial contribution test analysis, all CFC employee functions that contribute to the manufacture of the personal property are considered in the aggregate and are weighted based on the economic significance of such functions to the manufacturing activities. The performance (or lack thereof) of any particular activity is not determinative, and there is neither one activity that must be performed in all cases nor any minimum number of activities or a performance threshold (Regs. Sec. 1.954-3(a)(4)(iv)(c)). (Note that eleven examples in the regulations in which the test is satisfied involve at least three, and often four, of the factors listed above.)

The fact that other persons make a substantial contribution to the manufacturing activities does not preclude the CFC from making a substantial contribution of the same activities through its employees. Therefore, in applying the test, each CFC takes into account its own employees’ individual activities, considers all functions performed by the employees, and weights the functions based on the facts and circumstances of the particular business in order to determine if sufficient activity has been performed.

The mere right to perform these activities is not sufficient; the CFC’s employees must actually exercise their right and perform the activities. Thus, contractual rights, legal title, tax ownership, or assumption of economic risk are not determinative. The substantial contribution test is administered on a productby- product basis. For this purpose, a product is defined by reference to the distinctions made by the CFC in its business operations and in its books and records, not by a third-party definition or industry classification (e.g., SIC code). There is no special documentation required in connection with the substantial contribution test.

New Branch Rules

The new regulations provide a protocol for applying the branch rules to modern multinational business models. This protocol may be best addressed by way of a summary of its principles:

  • Each branch’s functions stand on their own for purposes of determining if a manufacturing test is met. (An exception applies to multiple branches in the same country, which are considered in aggregate.)
  • The location of a manufacturing activity is determined based on where employees perform such activity
  • The functions of branches not treated as separate CFCs under the tax rate disparity tests are attributed back to the remainder.
  • The hypothetical effective tax rate, for purposes of the tax rate disparity test, takes into account any uniformly available tax incentives available in the foreign jurisdiction.
  • In a case in which sales, procurement, and manufacturing functions are performed through branches (e.g., the remainder is a pure holding company), the tax rate disparity test is applied on a branch-to-branch basis.
  • In a case in which sales, procurement, and manufacturing functions are performed through branches (e.g., the remainder is a pure holding company), the tax rate disparity test is applied on a branch-to-branch basis.
  • If the CFC as a whole is determined to satisfy the substantial contribution test, but no branch individually satisfies a manufacturing test, the manufacturing location is determined using an approach that employs both a functional analysis and a comparison of effective tax rates.

Effective Date

These regulations are generally effective for tax years of CFCs beginning after June 30, 2009, and for tax years of U.S. shareholders in which or with which such tax years of the CFC end (e.g., 2010 for calendar-year taxpayers). Taxpayers may elect retroactive application to all open tax years, and the regulations expire in three years.


The new FBCSI regulations largely succeed in updating the regulations to address modern business models. The new substantial contribution test provides a welcome third alternative to the existing physical manufacturing tests. The revised branch rules also provide a greater degree of clarity and certainty, albeit at the cost of additional complexity. Taxpayers that may be adversely affected by these regulations include those that have relied on the “its defense” and those employing foreign holding company/check-thebox structures. All taxpayers involved in cross-border trade should revisit their structures in light of these new regulations and be mindful of permanent establishment, transfer pricing, and other foreign implications arising from any operating modifications made to comply with the new regulations.


Mindy Cozewith is director, National Tax, at RSM McGladrey, Inc., in New York City.

Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.

For additional information about these items, contact Ms. Cozewith at (908) 233-2577 or

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