Cisco Seeks Withdrawal of Proposed Contract Manufacturing Regs

This submission is in response to your request for public comments on proposed contract manufacturing regulations issued under § 954(d) of the Internal Revenue Code of 1986, as amended (the "Code"), REG-124590-07, 73 Fed. Reg. 10716 (February 28, 2008).

Cisco Systems, Inc. and its affiliates ("Cisco") commends Treasury and the IRS for attempting to update the § 954(d) regulations to take modern contract manufacturing practices into account. Unfortunately, the proposed regulations do this in a way that is not supported by the statute or legislative history. Cisco hereby requests a public hearing in connection with the proposed regulations.

Cisco designs, manufactures, and sells Internet Protocol (IP)-based networking and other products related to the communications and information technology industry, and provides services associated with these products and their use. The networking products that Cisco designs and sells are among the most sophisticated technological products commercially available worldwide. Cisco uses unrelated contract manufacturers to fabricate products that Cisco sells worldwide. Although contract manufacturing certainly existed in 1964,¹ when regulations were first promulgated under § 954(d), it was not as commonplace then as it is today.

B. The proposed regulations are contrary to § 954(d)(1) and the legislative history, and should be withdrawn

Congress was explicit that CFC manufacturing was a safe harbor -- an example of how FBCSI could be avoided. The existing regulations are consistent with this approach. They consider a CFC that sells property different than it buys to have manufactured the property sold. Thus, the existing regulations have assumed for some 44 years that the determination of whether property sold differs from property purchased can be made The proposed regulations, however, are contrary to the statute and legislative history because they create a manufacturing-through-employees requirement, not contained in the statute, that must be met for a CFC to avoid FBCSI.⁴

Existing Treas. Reg. § 1.954-3(a)(4) deems a CFC to meet a manufacturing safe harbor, thereby avoiding FBCSI, if either (i) the CFC sells property different than it purchases (thereby fully conforming the safe harbor to the plain language of the statute); (ii) the property the CFC sells has been substantially transformed from property purchased by the CFC; or (iii) the CFC's activities in connection with the property purchased and sold are substantial in nature and generally considered to constitute manufacturing. This safe harbor under the existing regulation is consistent with CFC manufacturing examples and instances in the legislative history. It does not prescribe the sole way to avoid FBCSI, nor does it require the CFC to meet any of the tests through activities of its own employees.

C. The proposed regulations should be withdrawn and re-proposed with substantial changes to align them with modern manufacturing practices

Notwithstanding the above criticisms of the proposed regulations, Cisco applauds Treasury and the Service for initiating a project whereby the realities of modem manufacturing practices might be considered in the FBCSI rules. But the substantial contribution test in the proposed regulations suffers serious shortcomings. It is Imprecise, is ultimately subjective, adds no clarity, and will likely lead to litigation.

The substantial contribution test in the proposed regulations should be withdrawn and replaced by a simple manufacturing safe harbor. The determination of whether the manufacturing safe harbor is met should involve consideration of all relevant CFC assets and manufacturing supply chain activities (including attributed activities). This rule should be complemented with a manufacturing branch safe harbor, pursuant to which the branch (if any, for a particular product) that has agreements with contract manufacturers, intellectual property rights needed to manufacture, economic ownership of work in process, and industry-sufficient employee manufacturing oversight is treated as the only manufacturing branch for § 954(d)(2) purposes.

In withdrawing and re-proposing the regulations, the Service should make explicit in both substantive provisions and examples that ownership of title to raw materials used in the manufacturing process is not controlling for purposes of FBCSI determination.

While the best solution would be to withdraw the substantial contribution test and replace it with a simple manufacturing safe harbor based on modern manufacturing practices, if the Service adheres to the substantial contribution test it should be substantially revised to address its shortcomings. The substantial contribution rules should be crafted to comport with the trend toward automation in modern manufacturing processes.

The substantial contribution rules require CFC employee activity in the face of a trend -- at least in the case of the manufacture of high tech products -- towards more automation of manufacturing and quality control and assurance processes, and less employee involvement. The determination of whether a CFC makes a substantial contribution to the manufacture of products should be based both on the CFC's assets (including intangible property needed for manufacturing) and activities.

Taxpayers should be allowed to elect out of application of the substantial contribution rule for unrelated-to-unrelated product flows. Without such an election, U.S. multinational corporations with only unrelated-to-unrelated product flows -- who do not rely on the manufacturing safe harbor to avoid application of § 954(d)(1) -- could inappropriately have FBCSI under the manufacturing branch rule as a result of the liberalization of what constitutes manufacturing under the proposed regulations. Without such an election, such taxpayers will be forced to incur costs and operational disruption in restructuring to avoid application of the branch rule.

D. The proposed regulations are contrary to the plain language of § 954(d)(2) and to this extent they should be amended

Paragraph 954(d)(2) specifies that when the branch rule applies the income attributable to the carrying on of sales activities by a branch shall be treated as income derived by a wholly owned subsidiary of the CFC. The proposed regulations ignore this by treating a "remainder" -- not necessarily just the sales or purchasing branch -- as selling or purchasing on behalf of the manufacturing branch (treated as a foreign corporation). This is contrary to the statute. The natural reading of the statute is that, if the conditions are met, the relevant sales (or purchasing) branch outside the CFC's home country is treated as the wholly-owned subsidiary earning FBCSI.

The language of § 954(d)(2) is also clear that only sales or purchasing incomes -- not other types of income -- can be characterized as FBCSI under the paragraph. Re-proposed regulations should clarify this. It is not reasonable to propose regulations under § 954(d)(2) that do not conform with the statute in these two respects.

E. The anti-abuse rule

The anti-abuse rule contemplated in the preamble to the proposed regulations is impractical, would be difficult to apply, and would penalize companies whose U.S. manufacturing activities contribute to global supply chain operations. No such rule should be adopted.

F. The substantial contribution rules add uncertainty, administrative burdens, and economic costs for U.S. multinational corporation;

Industries and taxpayers vary and the Service is quite right to believe that determining whether a "substantial contribution" to manufacturing has been achieved is a facts-and-circumstances test. However, the proposed regulations fail to provide adequate guidance as to what constitutes a "substantial contribution." The lack of clarity is compounded when attempting to apply the substantial contribution rules in the branch context. While application of the substantial contribution test may be clearer for a taxpayer with centralized foreign operations, many taxpayers have de-centralized operations. In the case of de-centralized operations, the determination of whether a single CFC or a single branch or combination of branches makes a substantial contribution is plagued with difficulty. This will create substantial uncertainties, administrative burdens, and costs for taxpayers as they move employees and restructure U.S. and foreign operations simply to meet a subjective new U.S. tax test.

G. Other specific suggestions

The proposed regulations then overlay an exception to this statutory language: FBCSI arises unless the CFC, using its own employees, manufactures the property it sells from the property it purchased. Under the proposed regulations, unless otherwise demonstrated, a CFC consumer electronics company is presumed to sell copper and solder, a CFC publishing company is presumed to sell ink, and a CFC whiskey company is presumed to sell water. The presumption is rebutted only through sufficient CFC employee activity in connection with the transformation of raw materials to finished goods. The Service apparently believes either that (i) this requirement follows from the statute; or (ii) that the statute is ambiguous, but that this is a reasonable or permissible interpretation of the text of the statute. Neither is correct.

The proposed regulations expand the scope of § 954(d)(1) by finding FBCSI where none would arise under a plain reading of the statute. The proposed regulations cannot do this.⁹

The interpretation in the proposed regulations of "the purchase of personal property from any person and its sale to a related person" is that this condition is met whenever property is sold by a CFC to a related person because the property sold is always just property purchased by the CFC in a different form. In essence, the proposed regulations suppose that if the property sold in any way comprises the raw materials, then it is the same property. What the proposed regulations try to do is define the sole means of determining when property sold differs from property purchased. Under the proposed regulations, property sold will be considered the same as the raw materials used to make the property sold unless the CFC, through activities of its employees, manufacture, or make a substantial contribution 10 the manufacture of, the finished product. This, for example, is the sole means of determining when a book sold by a CFC is different than the ink, paper, and thread used to make it.

In contemplating manufacturing in connection with FBCSI, Congress saw fit to put in a same-country manufacturing exception for property purchased. Congress could easily have included a fourth requirement that, for FBCSI to arise in a transaction involving a purchase from or a sale to a related party, "the property sold is not manufactured by the controlled foreign corporation through activities of its employees." But Congress did not do that. The natural reading of the statute is that the only manufacturing requirement is found in the same-country manufacturing exception in § 954(d)(1)(A) -- which applies only to property purchased by the CFC -- and that CFC manufacturing (whether or not through is employees) is but one means for a CFC to sell personal property different than it purchases.¹¹ There is no requirement that a CFC manufacture property to avoid FBCSI under the statute.

Congress has clearly specified in the Code when Congress required corporations to conduct business activities. Congress has also specified in the Code when it required corporations to actively conduct business activities -- i.e., those situations generally in which only the activities of a corporation's officers and employees are relevant. A good example is the foreign personal holding company income ("FPHCI") regime in § 954(c), enacted in 1962 along with § 954(d). As enacted, § 954(c)(3)(A) (which became § 954(c)(2)(A)) provided that FPHCI does not include "rents and royalties which are derived in the active conduct of a trade or business and which are received from a person other than a related person. . . ." The proposed regulations effectively interpret § 954(d)(1) to define FBCSI as arising from "the purchase of personal property from any person and its sale to a related person, where the CFC does not actively conduct manufacturing activities with respect to the. property sold." The presence of "active conduct" language in subsection (c) but not subsection (d) supports the conclusion, consistent with the legislative history discussed below, that CFC activities other than sales activities are irrelevant in defining FBCSI.

But this interpretation of "its sale" would mean that FBCSI arises under § 954(d)(1) whether a CFC acts as a buy-sell distributor or a CFC buys raw materials used to make finished products sold by the CFC. Significantly, under the interpretation of "its sale" advocated in the proposed regulations, § 954(d)(1) by its terms would create FBCSI from the sale by a CFC of products manufactured by the CFC through activities of its employees. That is, the proposed regulations advocate an interpretation of "its sale" that would give rise to FBCSI from a wide variety of transactions. Where property is manufactured from components, the Service would say that the CFC sold the same property that it bought. In effect, the proposed regulations advocate a broad, unnatural reading of "its sale" -- claiming that the "its sale" condition is met if the CFC buys personal property and sells it in a different form ¹³ The proposed regulations then claim authority to carve out income from certain transactions that would otherwise be FBCSI under the statute. Yet, under this interpretation, there is no support in the statute for this carve out. Our criticism is not of the result per se -- where a CFC's employees manufacture property, the CFC should not have FBCSI. Our criticism is that the proposed regulations' inclusion of income from manufactured products is overly broad, based on a flawed interpretation of § 954(d)(1), which is then overridden by the proposed regulation. This is unnecessary if one adopts a common sense meaning of the statute.

The Service cannot avoid the plain text of § 954(d)(1). The "its" condition in "its sale" is not met, so FBCSI doesn't arise, if property sold has a different commercial identity, form, and function from property purchased. The proposed regulations argue that the "its" condition in "its sale" is met, so FBCSI may arise, if the property sold is in a different form than property purchased. What is beyond dispute is that the condition "the purchase of personal property from any person and its sale to a related person" involves in relevant part a comparison only of the property sold and the property purchased. The statute neither has nor suggests any inquiry as to how property sold may have come to differ from the property purchased -- it simply asks whether the property purchased and the property sold differ. The statute neither has nor suggests any inquiry as to who may have made the property sold different than the property purchased. What the proposed regulations do is advocate a definition of "its" broad enough so that the flush language condition is met by essentially all CFC related party sales. The proposed regulations distort a plain statutory inquiry into the characteristics of property sold and purchased and instead impose a requirement on who may cause those two properties to differ. This is not a permissible construction of the statute; it is an attempt to rewrite it.

The plain meaning interpretation of "its sale" in the statute and the existing regulations does not have this shortcoming. Under this interpretation, property sold differs from property purchased if it is determined that property sold has a different commercial identity, form, and function from property purchased. This is a commonly understood meaning of what causes two pieces of personal property to be different. The existing regulations are simply a manufacturing safe harbor: in making the determination of whether property sold is different from property purchased, the existing regulations do not "occupy the field."

The safe harbor in the existing regulations at first blush seems to require the CFC to manufacture the property sold, but the CFC is deemed to meet this requirement (that property be manufactured) in situations in which CFC employee activities are irrelevant. CFCs that sell property different than they purchase are deemed to qualify for the manufacturing safe harbor, thereby insuring consistency between the statute and the regulatory safe harbor. CFCs that sell property that is substantially transformed from property purchased are deemed to qualify for the manufacturing safe harbor. CFCs that conduct operations in connection with the property purchased and sold that are substantial in nature and are generally considered to constitute manufacturing are deemed to qualify for the manufacturing safe harbor. The existing regulations are in harmony with the "its sale" provision of the statute.

The interpretation of "its sale" advocated in the proposed regulations also defies common sense in everyday commercial situations. It is unnatural, for example, to think of a sale of a book as a sale of the ink, paper, and thread used to make the book. The Service's interpretation is based on an uncommon, curious reading of the statute.¹⁴

The preamble to the proposed regulations suggests that the Service would interpret these paragraphs as they do the flush language. That is, the Service would presumably assert that "the property . . . sold" is the same as "the property which is purchased" whenever a CFC sells a product incorporating raw materials or components it has bought. The same objections raised above apply to this assertion.

But other language in the same-country use exception in § 954(d)(1)(B) further supports the plain-meaning interpretation of "its" in the flush language. An inquiry into the use of the property sold must be made to determine if this condition for FBCSI is met. The common understanding of "use" relates to the intended use of property. The common understanding of the inquiry in § 954(d)(1)(B) is that "the property" whose use must be examined is the final product, not the components. By way of example, the subparagraph requires examination of the intended use of a book sold by a CFC, not the intended use of paper, ink, and thread used to make the book; likewise, examination must be made of the intended use of a computer sold by a CFC, not the intended use of copper wire, capacitors, inductors, resistors, silicon chips, memory, and power supply used to make the computer. To argue otherwise defies common sense. This again supports the conclusion that "the property . . . sold" will not be the same as "the property which is purchased" if the property sold has a different commercial identity, form, and function than the property purchased.

B. The proposed regulations are contrary to the legislative history of § 954(d)(1)

If a statute is ambiguous, a court may use the legislative history to determine the intent of Congress in adopting the statute.¹⁶ As has been discussed above, the statute is not ambiguous and therefore reference need not be made to the legislative history. The proposed regulations appear to acknowledge that the statute is clear. The preamble to the proposed regulations mentions the legislative history once, to the effect that the existing regulation "was issued shortly after the statute became effective, and is consistent with the legislative history."¹⁷ The preamble does not claim any consistency between the legislative history of § 954(d) and the Proposed Regulations. We provide a discussion of the legislative history of § 954(d) below: (1) to show it does not support the proposed regulations; and (2) because such legislative history is relevant to the later discussion of attribution.

The Reports of the House Committee on Ways and Means and the Senate Finance Committee each state:

Yet, oddly enough, this thinking is asserted in the preamble to the proposed regulations. In alleged support of the proposition that the legislative history "contemplates that property sold will be considered different than the property purchased only when the CFC itself manufactures that property,"²¹ the preamble cites as support the following passage:

Furthermore, nowhere in the legislative history does Congress discuss CFC manufacturing solely through activities of its employees. Congress in every instance simply referred to manufacturing being carried on by a CFC. Congress can be presumed to know that corporations only act through officers, employees, and agents (each of whose acts are attributed to the legal person that is the corporation). Nothing in the legislative history even hints that only activities of employees should be taken into account. Contrast this with language in the legislative history used in describing a sister provision to § 954(d) -- the FPHCI regime in § 954(c) -- where Congress in the legislative history (on the page of the Senate Report preceding discussion of FBCSI) clearly signaled the "active conduct of a trade or business requirement" statutory exception, explaining that

As discussed above, there is no "manufacturing" requirement in § 954(d)(1) imposed on the CFC in order that it escape FBCSI. But there is a requirement that for FBCSI to arise the property purchased must have been manufactured outside the CFC's home country. The legislative history repeatedly and explicitly discusses manufacturing outside the CFC's home-country as a requirement for FBCSI to arise.²⁴ The same-country manufacturing exception for property purchased was codified in § 954(d)(1)(A). If Congress had likewise intended CFC manufacturing as a requirement to avoid FBCSI from related-party property sales, why did it not codify the requirement? The only sensible answer is that CFC manufacturing -- whether or not through CFC employee activities -- is but an example of how FBCSI can be avoided.

This distinction is contrary to the legislative history of § 954(d)(1). In describing CFC manufacturing as a way (a safe harbor) to avoid FBCSI, and in describing the same-country manufacturing exception, Congress did not signal any intent that it was using "manufactured" or "manufacturing" in different senses. For example, in explaining the same-country manufacturing exception for property purchased by the CFC, the House Ways and Means Committee wrote that the FBCSI provision "is made inapplicable to the extent the property is manufactured, produced, grown, or extracted in the country where the corporation is organized . . .;"²⁵ and in describing the manufacturing safe harbor the same Committee wrote that FBCSI "does not, for example, include cases where any significant amount of manufacturing, installation, or construction activity is carried on with respect to the product by the selling corporation."²⁶ The Senate Finance Committee, likewise, in explaining the same-country manufacturing exception wrote that FBCSI "applies only where the property purchased is manufactured, produced, grown, or extracted outside of the country where the controlled foreign corporation is organized . . .;"²⁷ and in describing the manufacturing safe harbor the same Committee paraphrased language from the House Ways and Means Committee Report, to the effect that FBCSI "does not, for example, include cases where any significant amount of manufacturing, major assembling, or construction activity is carried on with respect to the product by the selling corporation."²⁸

The preamble to the proposed regulations states that the Service "did not intend these regulations to change the scope of the same country manufacturing exception."²⁹ In effect, the proposed regulations posit that two different notions of manufacture are used in the legislative history. There is no support for such an interpretation. Any expansion in the scope of what constitutes manufacturing should apply for purposes of the same-country manufacturing exception in § 954(d)(1)(A).

C. The proposed regulations should not disallow attribution of manufacturing activities

While the asserted manufacturing requirement is clearly absent from § 954(d)(1), one can at least point to misinterpretation of the CFC manufacturing examples in the legislative history as the source of error. The "clarification" that only activities of CFC employees is taken into account does not share this ready explanation for the error; it is simply without foundation. Nothing in the legislative history, and certainly nothing in the statute, signals intent that only one category of activities performed by a CFC be singled out for purposes of deciding whether a CFC manufactures personal property. Language in the CFC manufacturing examples in the legislative history -- discussing, e.g., manufacturing activities carried on "by the selling corporation" -- certainly does not support the "clarification." A corporation only "acts" through activities of others, and absent clear expression of intent to the contrary, all such activities must be attributed.

Common law agency principles should apply to the FBCSI provisions of the Code and regulations.³³ Rev. Rul. 75-7 implicitly acknowledged this point. Under common law agency principles, the activities of a contract manufacturer acting under agreement with a CFC should be attributed to the CFC if the contract manufacturer is a common law agent of the CFC.

Courts have recognized that common-law agency attribution of activities applies under the Code. For example, an agent's activities have been attributed to a principal for purposes of finding unrelated business taxable income of tax-exempt organizations;³⁴ and an agent's activities have been attributed for purposes of characterizing gain from the sale of real property, based on whether the property is held primarily for sale to customers in the ordinary course of trade or business.³⁵

Rev. Rul. 75-7 concludes simply that a CFC may be considered to perform the activities performed by a contract manufacturer. This legal conclusion appeared, from the ruling's history, to be based in part on common law agency principles. But with no legal analysis the ruling also concluded that the contract manufacturer will be considered to be a branch of the CFC for purposes of applying the branch rule. While the legal foundation of the first holding in Rev. Rul. 75-7 has remained intact, the second (unsupported) holding was swept away by the Tax Court in 1990, based on the ordinary or plain reading of § 954(d)(2) in light of the legislative history.

Rev. Rul. 97-48,⁴¹ revoking Rev. Rul. 75-7, stated:

Electronic Arts dealt with, in relevant part, the issue of whether products are, under § 936(h)(5)(B)(ii), "manufactured or produced in the possession by the electing corporation within the meaning of subsection (d)(1)(A) of section 954." Electronic Arts dealt with the credit under § 936, and it is well understood that income tax deductions and credits are matters of legislative grace. Subpart F, by contrast, imposes a tax (in the sense of imputing gross income), and should be interpreted liberally in favor of the taxpayer.⁴³

Against this backdrop, the Tax Court focused on the "by the corporation" language in § 936, and stated that its examination of the legislative history of §§ 936 and 954 "convinces us that there is not an absolute requirement that only the activities actually performed by a corporation's employees or officers are to be taken into account in determining whether the corporations manufactured or produced a product in a possession." 118 T.C. at 265. The Tax Court also explained that "corporations pay persons (individuals or other entities) to actually do things. . . ." 118 T.C. at 277. Thus a requirement that activities be performed "by the CFC itself" does not override common law and restrict the inquiry to CFC employee activity.

D. The proposed regulations impermissibly expand the scope of § 954(d)(2)

The branch rule in § 954(d)(2) provides that if (i) a CFC is carrying on sales activities through a branch outside the CFC's home country, and (ii) this has "substantially the same effect as if such branch (or similar establishment) were a wholly-owned subsidiary corporation deriving such income" (i.e., if the tax rate disparity test is triggered), then "the income attributable to the carrying on of such activities of such branch shall be treated as income derived by a wholly-owned subsidiary of the controlled foreign corporation."

The consequence of conditions (i) and (ii) being met is that the income attributable to the sales activities carried on by the sales branch (or purchasing activities of a purchasing branch) shall be treated as income derived by a wholly-owned subsidiary of the CFC. The proposed regulations run contrary to this plain directive in the statute. They provide, for example, in the case of the manufacturing branch rule, that the "remainder" of the CFC is treated as selling on behalf of the manufacturing branch (treated as a separate foreign corporation). This is impermissible under the statute. The plain language of the statute precludes roping the entire remainder of the CFC into the deemed subsidiary having FBCSI from selling on behalf of a manufacturing branch (treated as a corporation). The obvious choice for the deemed wholly-owned subsidiary treated as having FBCSI is the branch carrying on the selling activities (or the branch carrying on purchasing activities), treated as a corporation. The proposed regulations should be withdrawn and re-proposed to endorse this statutory consequence of the branch rule.

The language of § 954(d)(2) also makes clear that only sales or purchasing income -- not manufacturing income or any other type of income -- may be FBCSI. Re-proposed regulations should clarify that other types of income earned by branches is excluded from FBCSI under the branch rule.

E. Specific comments on the proposed regulations

This test is imprecise and does not provide clarity.⁴⁴ Taxpayers attempting to comply with it will incur significant expense and inconvenience with no certainty of end result. The test is at bottom subjective -- in effect suggesting a "we'll know it when we see it" rule. The test does not add clarity, and it will undoubtedly lead to litigation that could otherwise be avoided. In the following section we expand on some of the shortcomings of the substantial contribution test.

The substantial contribution test in the proposed regulations should be withdrawn and replaced by a manufacturing safe harbor. The determination of whether the safe harbor is met should involve consideration of all relevant CFC assets and manufacturing supply chain activities (including attributed activities), including but not limited to (i) product and process intangibles owned by the CFC; (ii) legal rights held by the CFC, in connection with third-party contract manufacturing arrangements, relating to control of raw materials, work in process, and finished goods; (iii) the CFC's economic ownership of work in process; and (iv) CFC employee regular or periodic (as required under the facts) oversight activities and responsibilities.

Such a manufacturing safe harbor rule should be complemented with a branch safe harbor rule. Under this rule, the manufacturing branch for § 954(d)(2) purposes would be the branch (if any, for a particular product) that makes the largest contribution to manufacturing. A branch that contracts with contract manufacturers, has intellectual proper:y rights needed to manufacture, has economic ownership of work in process, and has industry-sufficient employee manufacturing oversight activities would be deemed to make the largest contribution. Alternatively, determination of the largest contribution could be made by reference to costs. Taxpayers with branches meeting these safe harbor criteria would have the certainty they need in structuring international operations.

U.S. multinational corporations will incur significant cost and disruption burdens in restructuring to comply with the "substantial contribution" standard. The lack of precision in defining "substantial", and the absence of an objective test, add to the uncertainty and will likely result in heightened controversy. Taxpayers are entitled to know whether they meet the substantial contribution test and a combined subjective-objective approach will provide that certainty. Taxpayers and the Service alike will be better served with such an approach.

In conjunction with this, the Service should define certain of the listed factors used in making the substantial contribution determination. For example, it is unclear precisely what "management of the risk of loss" means in connection with oversight and direction of manufacturing activities or processes. Further clarification should be given on what "management of the manufacturing profits" would entail, and greater clarity is needed on what is meant by "control of the raw materials, work-in-process and finished goods."

The proposed regulations expand the definition of what constitutes manufacturing (i.e., by adding those activities that are considered to make a "substantial contribution" to manufacturing). Absent relief, the proposed regulation's lowering of the threshold for what activities constitute manufacturing could create FBCSI under the manufacturing branch rule for taxpayers who have never before had FBCSI (because their CFC does not conduct physical manufacturing or engage in related party purchases or sales). To address this inappropriate result, the proposed regulations should be modified to allow taxpayers to elect out of application of the substantial contribution test for unrelated-to-unrelated product flows.

The view of paramountcy of oversight and direction of manufacturing activities is antithetical to the trend in manufacturing practices in high technology. In many, if not most, cases of high tech products the overwhelming majority of steps; in the fabrication process are automated. Human oversight and direction would for most purposes be either inadequate, inefficient, or redundant. Further, the microscopic tolerances: and complex functionality of components and products force key quality control and quality assurance decision making to be automated. Again, human involvement with such decision making would be inadequate, inefficient, or redundant. The trend towards less human intervention in high tech manufacturing process is in tension with the focus on CFC employee activities in the proposed regulations.

A concrete instance of this arises in Example 4 under the substantial contribution rules. In this example, a CFC that owns "sophisticated software and network systems that remotely and automatically (without human involvement) take orders, route them to [a] CM, order raw materials, and perform quality control," is nonetheless found not to make a substantial contribution to manufacturing apparently because of its reliance on manufacturing activities performed by employees of its domestic parent. The result reached erroneously places undue emphasis on human activity in a manufacturing situation where, if it involves high technology products, most meaningful oversight is likely performed by he CFC's software. This example should be substantially revised to remove this emphasis.

As more manufacturing supply chain operations become automated, the proposed regulations inflexibly shift the focus to the remaining manufacturing supply chain activities performed by CFC employees. The decision about whether the CFC makes a substantial contribution to manufacturing is made by looking at a shrinking pool of activities that may only loosely be related to manufacturing. This rule is contrived. The determination of whether a CFC makes a substantial contribution to manufacturing should be made by looking at assets owned by the CFC (such as product and manufacturing intangibles) as well as manufacturing activities performed by the CFC. If a substantial contribution test survives, it should include an objective cost-based test based in part on costs of manufacturing-related assets, including manufacturing intangibles.⁴⁵

If the Service proceeds with a subjective contribution test, it should provide an expedited ruling process for taxpayers. This process should provide applying taxpayers with rulings, based on represented facts and circumstances, on the following: (i) whether the IRS would consider a CFC to make a substantial contribution to manufacturing personal property; (ii) if the IRS would not consider a CFC to make a substantial contribution to manufacturing personal property, what changes would be needed to make a favorable ruling; and (iii) what branch, if any, the IRS considers to be the manufacturing branch under § 954(d)(2). This process would allow taxpayers to make quick, focused, and cost-efficient changes to their foreign manufacturing operations to comply with changes in the regulations. Taxpayers who apply for such a ruling should be given at least until the beginning of the second year following the issuance of a ruling to comply with recommended changes.

If a substantial contribution test is retained, for taxpayers who choose not to apply for such a ruling the effective date of any final regulations should be the beginning of the third full taxable year following publication of the regulations. This will give taxpayers time to restructure international operations to try to comply with hopefully more focused rules.

The proposed regulations should be withdrawn and re-proposed with far more examples relating to substantial contribution. These examples should be nontrivial. Fact patterns such as in Example 3 -- where "employees of FS perform all of the other activities with respect to the manufacture of Product X" -- are hardly informative. Taxpayers are not meaningfully helped by being told that a CFC that performs all non-physical manufacturing activities with respect to products made by a contract manufacturer makes a substantial contribution to the manufacture of the product. Taxpayers would be helped by fact patterns where a substantial contribution conclusion flows from less than all non-physical manufacturing activities being performed by CFC employees. To be helpful, these examples should give nontrivial fact patterns resulting in substantial contribution or not, and then vary the facts to show what would yield the opposite result. The examples should also explain why conclusions followed from presence or absence of substantial contribution factors, and the reasons for particular weightings of the factors.

The Service, if it proceeds with a subjective substantial contribution test, has a responsibility to provide taxpayers with substantial and meaningful guidance with this sea change in the government's position on manufacturing under § 954(d). As discussed, U.S. multinationals will likely spend large sums of money and incur disruption in their business processes in an effort to comply with the provisions. Black and white fact patterns in examples are unhelpful in this regard; more fact patterns involving "gray areas" are needed. It is respectfully submitted that it is not responsible for the Service to promulgate such important regulations that contain so much uncertainty. What taxpayers need is help in eliminating the guesswork as to the contours of what constitutes a substantial contribution in a particular industry. In providing this help, the Service may find it of value to consult with representative U.S. multinational companies and manufacturing experts, nationwide, across a spectrum of industries.

This rule is arbitrary. In many cases the multi-jurisdiction dispersion of employees performing activities related to the manufacturing supply chain is driven by business exigencies, not tax motivation. If a CFC makes a substantial contribution to the manufacture of personal property but no single branch makes a predominant contribution, then one or more branches must make roughly equal contributions to the overall substantial contribution. In this situation, choosing the manufacturing branch as the manufacturing location where the highest effective rate of tax would be imposed is without foundation. Suppose two branches each provide 45 percent of the contribution to a CFC's substantial contribution, but a third branch with the highest effective tax rate provides 10 percent of the contribution. What rational justification is there for treating the third branch as the manufacturing branch?

In situations in which a CFC, though more than one branch, makes a substantial contribution to the manufacture of a product, the manufacturing branch should be chosen as the branch providing the largest contribution, measured by an objective standard, to the CFC's substantial contribution (also measured by an objective standard). The largest contribution could, for example, be determined by the branch, for each product, with the preponderance of the following factors: (i) contracts with contract manufacturers; (ii) intellectual property rights needed to manufacture; (iii) economic ownership of work in process; and (iv) industry-sufficient employee manufacturing oversight activities. Alternatively, the contribution of different branches might be weighed according to the costs incurred by such branches with respect to specified assets and activities. Such a principled rule would allow taxpayers to mitigate branch rule risks through an objective determination of what constitutes a manufacturing branch, based not on effective tax rates -- which should play no role in choosing a manufacturing branch -- but rather on manufacturing assets and activities.

Such a rule would be difficult to apply. The proposed regulations explain that the determination of whether a CFC makes a substantial contribution to the manufacture of property sold is based on all of the facts and circumstances, and that the weight given to any activity will vary with the facts and circumstances of the particular business.⁵³ In the event a CFC makes a substantial contribution through employee activities in more than one branch, the proposed regulations call for a determination of whether one branch makes a "predominant contribution" to the CFC's substantial contribution, in the sense of making "a significantly greater contribution" to the manufacture than any other branch. These large-scale qualitative determinations will be difficult enough to make objectively, but the numerical percentage determinations called for in the anti-abuse provision would be even harder to make objectively. It is difficult to see how they could be made with any reasonable degree of reliability.

Only activities conducted and costs borne by the CFC should be relevant to the determination of whether the CFC has FBCSI The implementation of an anti-abuse rule would tend to erode U.S. manufacturing strength. Effects of the proposed anti-abuse rule would be either inefficient duplication (U.S. and abroad) of manufacturing activities, or worse, loss of U.S. domestic manufacturing jobs and expertise. The Service should not foster erosion of U.S. manufacturing strength.

Thank you for your consideration of these comments.

² REG-124590-07, 73 Fed. Reg. 10716, 10718 ("Section 954(d)(1) requires only a purchase of personal property and a sale of that personal property by the CFC with no indication as to form." (emphasis added))

³ If the IRS interpretation of the statute is correct (i.e., form has no importance), there is no statutory basis for creating a carve-out for CFC manufacturing or a substantial contribution to manufacturing.

⁴ REG--124590--07, 73 Fed. Reg. 10716, 10719 ("With respect to the manufacturing exception contained in § 1.954-3(a)(4), the proposed regulations clarify that a CFC qualifies for the manufacturing exception from FBCSI only if the CFC, acting through its employees, manufactured die relevant product within the meaning of § 1.954-3(a)(4)(i).")

⁵Richardson v. U.S., 526 U.S. 813, 818 (1999); U.S. v. Ron Pair Enterprises, 489 U.S. 235, 240-242 (1989); The Limited, Inc. v. Commissioner, 286 F.3d 324, 332 (6th Cir. 2002).

⁶U.S. v. Ron Pair Enterprises, 489 U.S. 235, 241 (1989).

⁷Hanover Bank v. Commissioner, 369 U.S. 672 (1962); Crane v. Commissioner, 331 U.S. 1 (1947); Old Colony R. Co. v. Commissioner, 284 U.S. 552 (1932); Fed. Dep. Ins. Corp. v. Meyer, 510 U.S. 471, 476 (1994) ("In the absence of [statutory definitions of words used in statutes], we construe a statutory term in accordance with its ordinary or natural meaning." (citing Smith v. United States, 508 U.S. 223, 228 (1993))); Ashland Oil, Inc. v. Commissioner, 95 T.C. 348, 356 (1990) ("In the absence of a specified technical definition, a statutory term should be given its normal and customary meaning.")

⁸Old Colony R. Co. v. Commissioner, 284 U.S. 552, 560 (1932) (citing, DeGanay v. Lederer, 250 U.S. 376, 381 (1919)).

⁹See, e.g., Gould v. Gould, 245 151,153 (1917) ("In the interpretation of statutes levying taxes it is the established rule not to extend their provisions, by implication, beyond the clear import of the language used, or to enlarge their operations so as to embrace matters not specifically pointed out."); Miller v. Standard Nut Margerine Co., 284 U.S. 498, 508 (1932) (In striking down application of a tax regulation interpreting a statute, the Supreme Court held that "the words defining things to be taxed may not be extended beyond their clear import."); Estate of Lovett v. U.S., 621 F.2d 1130 (Ct. Cl. 1980) (In striking down Treas. Reg. § 1.951-3 as contrary to the plain meaning of the statute and legislative history of subpart F, the Court of Claims overrode the government's argument that its regulation was necessary "to avoid the 'absurd' results which flow from the literal reading of [the statute]," explaining that "[n]either we nor the Commissioner may rewrite the statute simply because we may feel that the scheme it creates could be improved upon" (citing U.S. v. Calamaro, 354 U.S. 351, 357(1957)).

¹⁰ It is important to note that the phrase "manufactured . . . outside the country under the laws of which the [CFC] is created or organized" in § 954(d)(1)(A) refers solely to the property purchased by the CFC, and does not purport to change the natural interpretation of the flush language in § 954(d)(1) or the requirement in that paragraph relating to the nature of the property sold. Also, because the phrase refers solely to property purchased by the CFC, there is no "manufacturing" requirement or "same country manufacturing" requirement placed on the CFC under the statute in order to avoid FBCSI. Thus, the statutory test for FBCSI under the flush language of § 954(d)(1) does not depend on who manufactured the product that is sold or where the product sold was manufactured -- it simply requires a determination of whether the property sold was the same as the property purchased.

¹¹ As noted below, this natural reading of the statute is consistent with the legislative history, which clearly indicates that CFC manufacturing -- not necessarily through activities of its employees -- is just an example of how a CFC can avoid FBCSI.

¹² REG-124590-07, 73 Fed. Reg. 10716, 10718 ("Section 954(d)(1) requires only a purchase of personal property and a sale of that personal property by the CFC with no indication as to form." (emphasis added))

¹³ As we describe below, this interpretation of § 954(d)(1) would be contrary to the legislative history -- which makes it clear that income from the sale of products made from purchased raw materials escapes FBCSI -- but for now we focus solely on interpreting the statutory language.

¹⁴ As discussed below, such a reading is also inconsistent with the legislative history.

¹⁵ The second sentence of Treas. Reg. § 1.954-3(a)(4)(i) provides that "[a] foreign corporation will be considered, or purposes of this subparagraph, to have manufactured, produced, or constructed personal property which it sells if the property sold is in effect not the property which it purchased." Thus a CFC that sells property different than it purchases is deemed to have manufactured the products sold, thereby qualifying for the safe harbor. Taxpayers who cannot demonstrate this can still avoid FBCSI by qualifying for either the "substantial transformation" or "substantial operations" tests in Treas. Reg. §§ 1.954-3 (a)(4)(ii) or (iii), respectively. The Preamble to the proposed regulations acknowledges this deeming sentence, but effectively has no retort other than the claim that "its sale" means the sale of property purchased in any form. Under the Service's interpretation of "its sale" proffered in the proposed regulations, there is no reasonable interpretation of the second sentence in Treas. Reg. § 1.954-3(a)(4)(i).

¹⁶The Limited, Inc. v. Commissioner, 286 F.3d 324, 332 (6th Cir. 2002); AMP, Inc. v. United States, 820 F.2d 612, 615-16 (3rd Cir. 1987); Snap-On Tools, Inc. v. United States, 26 Cl. Ct. 1045, 1070 (1992), aff'd, 26 F.3d 137 (Fed. Cir. 1994).

¹⁷ REG-124590-07, 73 Fed. Reg. 10716,10719.

¹⁸ H. Rept. 1447, 87th Cong., 2d. Sess., (1962), 1962-3 C.B. 402, 462.

¹⁹ H. Rept. 1447, 87th Cong., 2d. Sess., (1962), 1962-3 C.B. 402, 463.

²⁰ H. Rept. 1447, 87th Cong., 2d Sess. (1962), 1962-3 C.B. 402, 466-467 S. Rept. 1881, 87th Cong. 2d Sess., (1962), 1962-3 C.B. 707, 790 (emphasis added).

²¹ REG-124590-07, 73 Fed. Reg. at 10719.

²² S. Rept. 1881, 87th Cong., 2d Sess. (1962), 1962-3 C.B. 841, 949.

²³ S. Rept. 1881, 87th Cong., 2d Sess. (1962), 1962-3 C.B. 707, 789 (emphasis added).

²⁴See, e.g., H. Rept. 1447, 87th Cong., 2d Sess. (1962), 1962-3 C.B. 402, 467 ("[T]he [FBCSI] provision is made inapplicable to the extent the property is manufactured . . . in the country where the corporation is organized . . . .")

²⁵ H. Rept. 1447, 87th Cong., 2d Sess. (1962), 1962-3 C.B. 402, 467.

²⁶ H. Rept. 1447, 87th Cong., 2d Sess. (1962), 1962-3 C.B. 402, 466.

²⁷ S. Rept. 1881, 87th Cong., 2d Sess. (1962), 1962-3 C.B. 707, 790.

²⁸Ibid.

²⁹ REG-124590-07, 73 Fed. Reg. at 10719.

³⁰ REG-124590-07, 73 Fed. Reg. at 10719.

³¹See, e.g., Commissioner v. Consolidated Premium Iron Ores, Ltd., 265 F.2d 320, 322 (6th Cir. 1959); accord, Bugaboo Timber v. Commissioner, 101 T.C. 474, 486 (1993).

³²See, e.g., Dussouy v. Gulf Coast Investment Corporation, 660 F.2d 594, 603 (5th Cir. 1981) ("[A]gency principles attribute the acts of agents of a corporation to the corporation, so that all of their acts are considered to be those of a single actor. . . . The original purposes of the rule attributing agents' acts to a corporation were to enable corporations to act.")

³³ Application of these common law principles should follow either from the general silence in § 954(d)(1) and the legislative history (i.e., common law principles should apply by default), or from the specific reference by Congress to a principle of agency law. To abrogate a common-law principle (such as attribution of an agent's activities), a statute must speak directly to the question addressed by the common law. There is nothing in § 954(d)(1), or in its legislative history, abrogating attribution of an agent's activities. Accordingly, the common-law agency principle of attribution of activities should apply for purposes of subpart F.

³⁴Common Cause v. Commissioner, 112 T.C. 332,347 (1999); State Police Association of Massachusetts v. Commissioner, 72 T.C.M 582 (1996), aff'd, 125 F.3d 1 (1st Cir. 1997); NCAA v. Commissioner, 92 T.C. 456, 466-467 (1989); rev'd on other grounds, 914 F.2d 1417 (10th Cir. 199C).

³⁵Pointer v. Commissioner, 419 F.2d 213 (9th Cir. 1969), aff'g, 48 T.C. 906 (1967); James H. Merritt, Sr. v. Commissioner, 47 T.C. 519 (1967), aff'd, 400 F.2d 417 (5th Cir. 1969)]; William E. Urick v. Commissioner, 45 T.C.M. 624 (1983).

³⁶ 1975-1 C.B. 244.

³⁷ LTR 6412105700A (December 10, 1964).

³⁸ G.C.M. 33357 (October 24, 1966).

³⁹ G.C.M. 35961 (August 23, 1974).

⁴⁰ In explaining that no caselaw interpreted manufacturing under § 954(d)(1) in a contract manufacturing situation, the Tax Court quoted from Vetco, as an example, to the effect that the Tax Court did '"not address whether . . . [the subsidiary corporation] was engaged in manufacturing' because our determination under sec. 954(d)(2) made it unnecessary to answer the manufacturing question." 118 T.C. at 1267, n. 14 (citation omitted).

⁴¹ 1997-2 C.B. 89.

⁴² When Congress was drafting the 2004 Jumpstart Our Business Strength ("JOBS") bill, the Senate specifically considered and rejected an attempt to modify the § 954(d)(1) provisions to prevent CFCs from attributing the activities of non-employees for purposes of determining whether it has FBCSI. According to the a release issued by the Senate Finance Committee Staff, the proposed amendment (Section 662 of the Revised Manager's Amendment to the JOBS Bill) was stricken from the final bill because "the IRS position is under review and may not be sustained under current case law." Senate Amendment Number 3143, reprinted in 2004 TNT 93-42 (May 12, 2004). At the same time, the office of Senator Grassley (then the Chairman of the Senate Finance Committee) issued a statement stating in relevant part:

⁴³See, e.g., Vetco, 95 T.C. at 590-591 (Tax Court construes the phrase "branch or similar establishment" narrowly, in favor of the taxpayer); The Limited, Inc. v. Commissioner, 286 F.3d 324, 335 (6th Cir. 2002) (citing Weingarden v. Commissioner, 825 F.2d 1027,1029 (6th Cir. 1987)) (in criticizing Tax Court's failing to interpret the plain language of § 956 -- another subpart F provision -- the Sixth Circuit Court of Appeals stated that the Tax Court "should have instead relied on another principle of statutory interpretation -- statutes imposing tax should be interpreted liberally in favor of the taxpayer.")

⁴⁴ While application of the substantial contribution test may be clearer for a taxpayer with centralized foreign operations, many taxpayers have de-centralized operations. In the case of de-centralized operations, the determination of whether a single CFC or a single branch or combination of branches makes a substantial contribution is plagued with difficulty. This will create substantial uncertainties, administrative burdens, and costs for taxpayers as they move employees and restructure U.S. and foreign operations simply to meet a subjective new U.S. tax test.

⁴⁵ Manufacturing intangibles include quality control, assurance, test, process control, and oversight software.

⁴⁶ REG-124590-07,73 Fed. Reg. at 10718.

⁴⁷Id.

⁴⁸See, e.g., Kristen A. Parillo, "Treasury, IRS Officials Clarity Proposed Contract Manufacturing Regs," Tax Notes, 2008 TNT 47-4 (March 10, 2008).

⁴⁹ Treas. Reg. § 1.954-3(b)(1)(i)(b).

⁵⁰ Treas. Reg. § 1.954-3(b)(1)(ii)(b).

⁵¹ Treas. Reg. § 1.954-3(b)(2)(i)(e).

⁵² REG-124590-07, 73 Fed. Reg. at 10722.

⁵³ Prop. Treas. Reg. § 1.954-3(a)(4)(iv)(a).