Source: https://www.bna.com/subpart-manufacturing-exception-n17179881957/
Timestamp: 2017-04-26 19:30:53
Document Index: 636431187

Matched Legal Cases: ['§951', '§954', '§1', '§1', '§1', '§954', '§1', '§1', '§954', '§1', '§1', '§1', '§993', '§927', '§941', '§199']

Subpart F Manufacturing Exception Applied to Products That Are Grown | Bloomberg BNA
The IRS recently issued a ruling1 concluding that, undercertain circumstances, the "Subpart F"2 manufacturingexception can apply to products that are grown (e.g., crops). TheIRS further ruled that growing activities that also are productionactivities are taken into account for purposes of determiningwhether products sold are manufactured or produced by a controlledforeign corporation (CFC).
Under the facts of the ruling, a U.S. corporation (USP)indirectly wholly owns a CFC formed under the laws of Country X.CFC wholly owns another Country X entity, which is disregarded(DE1). DE1 wholly owns a third Country X entity which isdisregarded (DE2), collectively the "CFC Group" or the "CFC."
CFC Group produces final stage products (the Final StageProducts) in four phases. During the initial phase, CFC makesdecisions as to the types of product traits that are needed to meetdemand and provide market opportunities. CFC enters into cost-plusarrangements with related and unrelated persons for research anddevelopment, as a result of which intellectual property isdeveloped for the risk and account of CFC, and ultimately the StageA products are developed.
During the second phase, the Stage A Products are planted, andthe Stage B Products are harvested from the resulting crop grownfrom the Stage A Products. During the third phase, the Stage BProducts are planted, and the Stage C Products are harvested fromthe resulting crop grown from the Stage B Products.
CFC Group directly produces some of the Stage B and Stage CProducts in Country X or in jurisdictions outside of Country X. CFCGroup also contracts with related persons or unrelated personspursuant to contract manufacturing or toll manufacturingarrangements to produce the Stage B and Stage C Products injurisdictions outside of Country X. If a contract manufacturingarrangement is used, CFC Group may transfer title of the Stage A orStage B Products to the contracting party in exchange for a nominalamount. Thus, during the growing and harvesting processes, legaltitle to the Stage B or Stage C Products is held either by CFCGroup or by the contracting party. In cases where title istransferred to the contracting party, title to the Stage B or StageC Products is subsequently transferred for a nominal amount to CFCGroup, and the contracting party is remunerated by CFC Groupthrough a fee.
During the fourth phase, the Stage C Products are organized atprocessing facilities for final cleaning, quality assessment, andpackaging based on relevant marketing requirements. CFC Groupeither performs these activities directly, or contracts with arelated person to perform these activities in a jurisdictionoutside of Country X in exchange for a fee. At the conclusion ofthe fourth phase, the Stage C Products are in their final form. CFCGroup sells the Final Stage Products to related persons andunrelated persons for use in jurisdictions inside and outside ofCountry X.
"Subpart F income" generally includes income derived by a CFCfrom selling to any person products purchased from related persons,or selling products to related persons that were purchased from anyperson, i.e., foreign base company sales income (FBCSI).3 Nevertheless, incomederived by a CFC from the sale of products that it manufactures orproduces is excluded from the definition of FBCSI, subject to thebranch rule.
More specifically, FBCSI generally does not include income of aCFC derived in connection with personal property "manufactured,produced, or constructed by such corporation." A CFC will havemanufactured or produced such property if it meets either aphysical manufacturing or production test, or the CFC substantiallycontributes to the physical manufacture or production of theproperty. Only the activities of the CFC's employees are taken intoaccount for this purpose.4
The regulations provide that property is considered asphysically manufactured if:
The property is substantially transformed (e.g., steelrods converted into screws);
The production operations are substantial in nature andare generally considered to constitute manufacturing (e.g.,assembly of automobiles); or
Conversion costs are 20% or more of costs of goodssold.
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 regulations further provide that property physically"manufactured, produced or constructed" taking into accountactivities of a contract manufacturer on behalf of a CFC will beconsidered as manufactured by the CFC if the facts andcircumstances evince that the CFC makes a substantial contributionthrough the activities of its employees to the manufacture orproduction of the personal property sold. The regulations list anumber of factors that are taken into account for this purpose,including quality control, oversight and direction, vendorselection, physical manufacturing activities, demand planning,management of manufacturing costs and capacities, and control ofmanufacturing-related logistics. 7
The IRS ruling states that certain income the CFC derives fromselling Final Stage Products meets the definition of FBCSI "becausethe income is derived in connection with the purchase of personalproperty from a related person, or a sale of personal property to arelated person." Nevertheless, income derived from the sale ofFinal Stage Products would not be FBCSI to the extent themanufacturing exception applies (subject to the branch rule).8
The manufacturing exception would apply if the activities of theemployees of CFC and its disregarded entities satisfy the physicalmanufacturing definition with respect to Final Stage Products thatare sold. In addition, the manufacturing exception would apply ifthe physical manufacturing definition is satisfied taking intoaccount the activities of the contract manufacturers hired by CFCGroup and CFC Group substantially contributes to the manufacture orproduction of the Final Stage Products.
The ruling addressed whether the manufacturing exception isavailable for products that are grown and, if so, how to determinewhether such products are considered as physically "manufactured orproduced" by CFC Group or the contract manufacturers.
The issues particularly require analysis because other FBCSIrules expressly refer to products that are grown, while no suchreference is contained in the rules providing the manufacturingexception. For example, FBCSI does not include income from the saleof property that "is manufactured, produced, constructed,grown or extracted" in the CFC's country oforganization.9
In addition, the manufacturing branch rule refers to productsthat are grown. That rule can apply with respect to "personalproperty manufactured, produced, constructed,grown or extracted by or through a foreignbranch."10 Thus, a CFCthat grows products in a foreign branch can have a "manufacturingbranch."11
The ruling first notes that the regulations do not specificallyaddress whether income derived from the sale of products grown by aCFC is excluded from FBCSI pursuant to the manufacturing exception.Nevertheless, the ruling states that property that is grown mayalso be considered as manufactured or produced and thus income fromthe sale of such property can qualify for the manufacturingexception.
The ruling points out, however, that the terms "produced" and"grown" are not interchangeable. The mere fact that property is"grown" does not mean that it will be considered as "produced" forpurpose of the manufacturing exception. The ruling further states that the terms "grow" and "produce"are not mutually exclusive. The use of the term "grow" to describea process or part of a process is not determinative of whether theprocess constitutes a production activity. Rather, growingactivities that also are producing activities are taken intoaccount for purposes of applying the manufacturing exception.
In sum, for products that are grown, in applying themanufacturing exception the determination is whether the productsare also considered as manufactured or produced within the meaningof the manufacturing exception. This is a facts and circumstancestest. If a particular activity is a producing activity, it is takeninto account, even if such activity may also be considered as agrowing activity.
The ruling specifically states that activities-of CFC Group andcontract manufacturers-related to the physical growing of the StageB and Stage C Products that constitute production activities aretaken into account in determining whether CFC produced the FinalStage Products for purposes of the manufacturing exception. Thus, taking into account such activities performed by the CFCitself may cause the CFC to satisfy the physical manufacturing orproducing definition. In addition, taking into account suchactivities performed by the contract manufacturers may cause theFinal Stage Products to be considered as physically manufactured orproduced for purposes of qualifying for the substantialcontribution definition of manufacturing.
The taxpayer represented that CFC Group's activities withrespect to the Final Stage Products constituted production ifactivities that are both growing and production activities aretaken into account in determining whether a CFC has "produced"property for purposes of the manufacturing exception.
Based on the information submitted and the representations made,the ruling concluded that income derived by CFC Group from the saleof Final Stage Products produced by CFC Group that otherwise isFBCSI is excluded from FBCSI pursuant to the manufacturing andproducing exception.
The ruling did not address the types of growing activities thatalso are considered as producing activities. It would seem thatproduction activities in this context should be broadly defined.This would be consistent with the same-country-of-manufacturingexception as well as the manufacturing branch rule, which bothtreat growing itself as equivalent to manufacturing orproducing.12 Aninclusive definition of "production activities" would also beconsistent with case law, which has broadly defined physicalmanufacturing and production for purposes of the Subpart Fmanufacturing exception.13 Thus, itwould seem appropriate that where a CFC engages in substantialactivities (directly or through contract manufacturers) related togrowing and preparing products for sale, that the CFC should beconsidered as producing the property sold.14
The ruling appears to analyze the application of themanufacturing exception to the sale of the Final Stage Products byaggregating activities undertaken at all four phases. Thus, allproduction activities performed by CFC Group and by all contractmanufacturers, and all substantial contribution activitiesperformed by CFC Group during all four phases of producing theFinal Stage Products, should be taken into account for purposes ofdetermining whether the Final Stage Products were manufactured orproduced. This is the case whether or not different stage productsare sold and repurchased from contract manufacturers for nominalamounts, and whether the products undergo transformation during aparticular phase of production. All phases are considered as theprocess of producing the Final Stage Products for purposes of themanufacturing exception.
In sum, income from the sale of products that are grown canqualify for the manufacturing exception. For purposes of satisfyingthe physical manufacturing and producing definition, all productionactivities are taken into account, even if such activities mightalso be considered as growing activities.
This commentary also will appear in the February 2014 issueof the Tax Management International Journal. For more information, in the Tax Management Portfolios,see Yoder, 928 T.M., CFCs - Foreign Base Company Income (Otherthan FPHCI), and in Tax Practice Series, see ¶7150, U.S.Persons - Worldwide Taxation.
1 PLR 201340010.
2 §§951-964.
3 §954(d); Regs. §1.954-3(a)(1).
5 Regs. §1.954-3(a)(4)(ii) and (iii).
6 Bausch & Lomb, Inc. v. Commissioner,71 T.C.M. 2031 (1996); see also Dave Fischbein Mfg. Co. v.Commissioner, 59 T.C. 338 (1972) (assembly of bag-closingmachine in six-hour, 58-step process met definition ofmanufacturing).
7 Regs. §1.954-3(a)(4)(iv). See Yoder, "Subpart F: Indicia of Manufacturing," 38Tax Mgmt. Int'l J. 526 (8/14/09).
8 The ruling does not address the branch rule.§954(d)(2); Regs. §1.954-3(b).
9 Regs. §1.954-3(a)(2) (emphasis added). Thisphrase is also in §954(d)(1)(A).
10 Regs. §1.954-3(b)(1)(ii)(a) (emphasisadded); see also Regs.§1.954-3(b)(1)(ii)(c). The Code does not containthis language because it does not provide a manufacturing branchrule.
11 See also Regs. §1.954-3(a)(1)(ii)(special rule for agricultural commodities). Other rules of theCode that have provided an export or domestic manufacturingincentive referring to manufacturing and production also haveincluded a reference to products that are grown. See§993(c) (Domestic International Sales Corporation (DISC) rules);§927(a)(1)(C) (Foreign Sales Corporation rules); §941(a)(1)(A)(Extraterritorial Income rules); §199(c)(4)(A) (deduction fordomestic production activities).
12 Indeed, it would seem odd if a CFC is consideredas having a manufacturing branch based on growing products in abranch, but then for that branch not to qualify for themanufacturing exception with respect to its own income from thesale of the products.
13 See Yoder, "Subpart F: LMSB ProvidesGuidance Concerning the Definition of Manufacturing," 35 TaxMgmt. Int'l J. 360 (7/14/06); Yoder, "The Subpart F PhysicalManufacturing Exception," 34 Int'l Tax J. 3 (Nov.-Dec.2008); Yoder, "Bausch & Lomb: The `Manufacturing' Exception toForeign Base Company Sales Income," 25 Tax Mgmt. Int'lJ. 427 (4/29/96).
14 For application of a similar manufacturing orproducing test under the DISC rules to products that are grown, seeWebb Export Corp. v. Commissioner, 91 T.C. 131 (1988);Garnac Grain Co. v. Commissioner, 95 T.C. 7 (1990); Rev.Rul. 75-394, 1975-2 C.B. 311.