Firm Suggests Changes to Proposed Contract Manufacturing Rules

Dear Sirs:

This letter provides public comments on the proposed section 954(d) regulations regarding foreign base company sales income in cases in which personal property sold by a controlled foreign corporation ("CFC") is manufactured, produced, or constructed pursuant to a contract manufacturing arrangement or by one or more branches of a CFC (the "Proposed Regulations")¹

We would like to thank Treasury and the IRS for the Proposed Regulations, which, when finalized, should provide taxpayers and their advisers with much greater certainty for CFCs that have entered into contract manufacturing arrangements with respect to personal property that is sold by a CFC.

The preamble to the Proposed Regulations requests comments on all aspects of the Proposed Regulations, including, among other things: (1) The activities listed in Prop. Treas. Reg. § 1.954-3(a)(4)(iv)(b) under the substantial contribution test; (2) "[W]hether the requirement, under the manufacturing exception from foreign base company sales income, that the activities of a CFC be performed by its employees, should permit commercial arrangements where individuals performing services for the CFC, while not on its payroll, are nevertheless controlled by employees of the CFC"; and (3) Several specific issues under the manufacturing branch rule.

Our comments and recommendations will address the following issues: (1) Factor nine under the substantial contribution test relating to direction of the development, protection, and use of intellectual property; (2) The treatment of employees of a person related (or unrelated) to a CFC who are under the control and direction of the CFC's own employees; and (3) The treatment of the CFC's employees (and/or employees of a person related (or unrelated) to a CFC who are under the control and direction of the CFC) who regularly travel to the location where a contract manufacturer has its manufacturing facilities to perform quality control and oversight for purposes of applying the predominant contribution test to the manufacturing branch rule.

The ninth listed activity in Prop. Treas. Reg. § 1.954-3(a)(4)(iv)(b) is: "Direction of the development, protection, and use of trade secrets, technology, product design and design specifications, and other intellectual property used in manufacturing the product." Under certain circumstances, because of the nature of the intellectual property involved in the manufacturing process, a CFC may have minimal or even no involvement in the direction, development, or use of the intellectual property. For example, the relevant intellectual property may be an older and less valuable "off-patent" technology that the CFC either owns or licenses from a third party. In such cases, whether a CFC is involved in the development, protection, and use of the intellectual property, or whether it owns the intellectual property should not be a relevant factor, as the intellectual property is far less important to the manufacturing process as compared with other aspects of the manufacturing process, such as quality control or oversight and direction of the manufacturing process. This is in contrast to other situations, for example, where the relevant intellectual property is a highly valuable patented process, in which case the CFC's involvement in the development, protection, use, or ownership of the intellectual property should properly be considered to be a relevant factor in determining whether the CFC satisfies the substantial contribution test.

Accordingly, we recommend that the Proposed Regulations be amended to explicitly clarify that a CFC's direction of the development, protection, use, or ownership of intellectual property is not a relevant factor under all circumstances. This recommendation could be accomplished by adding an example to Prop. Treas. Reg. § 1.954-3(a)(4)(iv)(c) that involves a situation where the intellectual property used in the manufacturing process is an older, off-patent technology with respect to which the CFC has little or no involvement in directing the development, protection, or use of the intellectual property, although the CFC could either own or license the relevant intellectual property. The CFC would otherwise substantially contribute to the manufacturing process (e.g., by overseeing and directing the activities of the contract manufacturer (including management of the risk of loss), controlling the raw materials, work-in-process and finished goods, selecting vendors and materials, controlling logistics, and engaging in quality control) such that it would satisfy the substantial contribution test.

Notably, the Proposed Regulations do not define the term "employee," for example, by reference to the common law meaning of the term or otherwise (e.g., a statutorily defined employee under section 3121(d)(1)).⁵ We generally believe that it is appropriate for the Proposed Regulations to not restrict the definition of "employee" to persons who are on the CFC's payroll. Indeed, there are many situations where employees of a CFC (e.g., persons who actually are on the CFC's payroll) will control and direct the activities of other persons who are involved in the manufacturing process. For example, a CFC that is otherwise heavily involved in the manufacturing process through the activities of persons that are on its payroll will often hire the services of persons who are on the payroll of another company, which may be related or unrelated to the CFC, to assist the CFC in its performance of certain activities relating to the manufacturing process, such as quality control.⁶ In these circumstances, the persons on the CFC's payroll will often perform more of a management role (e.g., by establishing guidelines for the quality control and by regularly visiting a contract manufacturer's facilities to perform spot checks of the contract manufacturer and to ensure that the persons hired out to the CFC are adhering to the standards established by the CFC). Frequently, the contract for services between the CFC and the related or unrelated person whose employees are being hired out to the CFC will specify that the CFC has the right to control and direct such persons in the performance of their activities, and the CFC, through persons on its payroll, will in fact exercise such control and direction over the employees of the other party.

In the circumstances described above, we believe that it is appropriate for the activities of persons who are not on the CFC's payroll but who are otherwise under the control and direction of the CFC to be taken into account for purposes of determining whether the CFC satisfies the substantial contribution test. Accordingly, we respectfully request that the final regulations define the term "employee" for purposes of the substantial contribution test in Prop. Treas. Reg. § 1.954-3(a)(4)(iv) and the predominant contribution test in Prop. Treas. Reg. § 1.954-3(b)(l)(ii)(c)(3) to include an individual who, although not on the payroll of the CFC, is, under the facts and circumstances, under the control and direction of one or more persons who are on the payroll of the CFC. At a minimum, the rule should be extended to cover employees of persons related to the CFC over whom the CFC, acting through its own employees, exercises control and direction, regardless of whether the related person is incorporated or resident in the same country as the CFC.⁷

Example 3 in Prop. Treas. Reg. § 1.954-3(b)(l)(ii)(c)(3)(f) applies the predominant contribution test to a situation where the CFC (including through its only branch, which performs certain supplemental design work) makes a substantial contribution to the manufacture of the product (Product X) that it sells to unrelated persons for use, consumption, or disposition outside the CFC's country of incorporation. Among the activities that the CFC performs, through its employees, that make a substantial contribution with respect to the manufacture of Product X, are quality control and oversight. Such activities are conducted by employees of the CFC who are employed in Country M (the CFC's country of incorporation) but who regularly travel to Country C (the country where the unrelated contract manufacturer (CM) physically manufactures Product X pursuant to a contract manufacturing arrangement with the CFC). The example concludes that the CFC qualifies for the manufacturing exception to foreign base company sales income by virtue of the substantial contribution test. In so doing, the example adds: "The fact that employees of FS travel to the location of CM to perform some of the activities considered in determining whether a [CFC] makes a substantial contribution through the activities of its employees to the manufacturing of an item of personal property does not prevent activities of such employees while located in Country M from being considered in determining the applicability of [Prop. Treas. Reg. § 1.954-3(a)(4)(iv)] of this section to [the CFC]."¹² According to the facts of Example 3, the only activities of the CFC's employees that make a substantial contribution to the manufacture of Product X and that are conducted in Country C are quality control and supervision. The remainder of the activities performed by the CFC's employees that make a substantial contribution to the manufacture of Product M are conducted in Country M and in Country A. The example also concludes that the branch rule is not applicable because the CFC (as opposed to Branch A, the CFC's "only branch") provides the predominant contribution with respect to Product X.

It is not clear from the above quoted language of Example 3 how the quality control and oversight activities of the CFC's employees while they are in Country C (or outside Country M) are treated for purposes of applying the substantial contribution test and the predominant contribution test. One possible reading of Example 3 is that such activities are taken into account solely for purposes of determining whether the CFC satisfies the substantial contribution test. Under the substantial contribution test, the location where particular activities are conducted is not relevant, so the above does not appear to be the correct reading of Example 3.¹³ Another possible reading of Example 3 is that the quality control and oversight activities of the CFC's employees while they are in Country C (or are otherwise outside Country M) are relevant both for purposes of determining whether the CFC satisfies the substantial contribution test and for purposes of applying the predominant contribution test. However, in applying the predominant contribution test, it is not clear whether the quality control and oversight activities of the CFC's employees carried on in Country C (or otherwise outside Country M) are taken into account for purposes of determining whether the remainder of the CFC (i.e., excluding its only branch, Branch A) makes a predominant contribution to the manufacture of Product X, or whether such activities are entirely excluded from the analysis.

We believe that the better reading of Example 3 is that the activities of the CFC's employees while they are in Country C (or otherwise outside Country M) should be taken into account for purposes applying the predominant contribution test with respect to the remainder of the CFC. Under Prop. Treas. Reg. § 1.954-3(b)(l)(ii)(c)(3)(d), the location of the quality control and oversight activities of the CFC's employees is determined by reference to where the CFC carries on those activities through its employees. In this case, that location is Country C. Nonetheless, the CFC's employees who perform the quality control and oversight activities are "employed in Country M" and are otherwise involved in the performance of activities in Country M that make a substantial contribution to the manufacture of Product X. Accordingly, if the quality control and oversight activities of the CFC's employees performed in Country C (or otherwise outside Country M) do not constitute a branch of the CFC, or are otherwise not attributable to a branch of the CFC, outside Country M (which is apparently the case under Example 3, as Branch A is stated as being the CFC's "only branch"), then their activities should be taken into account for purposes of determining whether the remainder of the CFC or a branch of the CFC makes a predominant contribution to the manufacture of property.¹⁴ Such a rule would give credit to the remainder of the CFC for the activities of its employees that are properly viewed as being within its purview (i.e., because the employees are employed in Country M and otherwise do not constitute a branch of the CFC outside country M), especially in a case where such employees are otherwise involved in activities that make a substantial contribution to the manufacture of Product X from Country M. In this regard, taking into account the activities of employees while in Country M (or otherwise outside Country C) is consistent with one of the main purposes underlying the substantial contribution test: ensuring that the CFC is sufficiently involved in the manufacturing process even if its own activities do not rise to the level of physical manufacturing. One way in which a CFC can be involved in the manufacturing process -- which is explictly encouraged by several of the factors in the substantial contribution test -- is for the CFC to engage in oversight and direction of the contract manufacturer's activities. To be sure, a CFC will often insist on having (and exercising) the right to oversee and direct certain aspects of the contract manufacturer's activities for reasons wholly unrelated to tax, such as to ensure a quality product (e.g., to maintain a good reputation and to protect from possible product liability). Thus, allowing activities of a branch or the remainder of the CFC that take place outside the country of the branch or the remainder of the CFC to count for purposes of the predominant contribution test further encourages a CFC to engage in substantial contribution.

Moreover, it is common for a contract manufacturer with whom the CFC has contracted to perform physical manufacturing of products that are sold by the CFC to be located in a country other than the CFC's country of incorporation (or a country where the CFC has a branch). Nonetheless, the quality control and related activities that the employees of the CFC perform in the location where the contract manufacturer has its manufacturing facilities form an integral part of the CFC's operations, for which the CFC should be given credit in applying the predominant contribution test.

Thank you for your consideration of the above. Please let either of us know if you have any questions regarding the above.

² Prop. Treas. Reg. § 1.954-3(a)(4)(iv)(a).

³Id.

⁴Id. (emphasis added).

⁵ Section 3121(d)(1) defines "employee" for purposes of Chapter 21 (Federal Insurance Contributions Act) of Subtitle C (Employment Taxes) of the Internal Revenue Code as including any officer of a corporation. Other sections of the Code also define "employee" for various other purposes.

⁶ The CFC would pay the other company an arm's length fee for the services of its employees that are hired out to the CFC.

⁷ For these purposes, the definition of a "related person" in section 954(d)(3) may be used.

⁸ Prop. Treas. Reg. § 1.954-3(b)(1)(ii)(c)(3)(c).

⁹Id.

¹⁰Id.

¹¹ Prop. Treas. Reg. § 1.954-3(b)(l)(ii)(c)(3)(d).

¹² Emphasis added.

¹³See Prop. Treas. Reg. § 1.954-3(a)(4)(iv).

¹⁴ In this regard, the Proposed Regulations, as originally drafted, included language which suggested that, in applying the predominant contribution test, the location of activities of a CFC's employees would be considered to occur either in a particular branch or in the remainder of the CFC, regardless of whether they were in fact performed in a place other than a branch of the CFC or the remainder of the CFC (i.e., the CFC's country of incorporation): "The location of any particular activity (that is, for purposes of determining whether that activity is conducted in a particular branch or in the remainder of the [CFC]) will be determined by applying the principles of [Prop. Treas. Reg. § 1.954-3(b)(1)(ii)(c)(3)(d)]." 73 Fed. Reg. 10,716, at 10,726 (emphasis added). Treasury and the IRS subsequently made corrections to the Proposed Regulations, which deleted the above quoted language. 73 Fed. Reg. 20,201, at 20,202. No explanation was provided for the deletion of the: language other than a general explanation that the Proposed Regulations, as originally drafted, "contain[ed] errors that may be misleading and are in need of clarification." It is possible that Treasury and the IRS considered the deleted language to be potentially inconsistent with the location of activity rule of Prop. Treas. Reg. § 1.954-3(b)(1)(ii)(c)(3)(d) because the latter determines the location of an activity by reference to where it is actually performed, whereas the deleted language from Prop. Treas. Reg. § 1.954-3(b)(1)(ii)(c)(3)(c) might be read to deem the location of are activity to be either in a branch of a CFC or in the remainder of the CFC even if it is actually performed in neither one of the those locations (e.g., in the country where a contract manufacturer performs physical manufacturing and where the CFC's activities do not rise to the level of a branch).