Accessing the Manufacturing Exception to Subpart F Through Contract Manufacturing Arrangements
Many U.S.-based multinational corporations do not, in fact, directly manufacture their own goods. Instead, they commission unrelated manufacturers ("contract manufacturers") operating offshore to convert raw materials into a finished product for a conversion fee ("contract manufacturing").
For many years, the Internal Revenue Service (the "IRS") took the view, set forth in a published revenue ruling, that a foreign corporation using an unrelated contract manufacturer would be treated as the manufacturer for certain purposes of "Subpart F" (defined below), provided that the contract manufacturing arrangement satisfied certain requirements. The effect of this holding was to permit U.S. corporations to defer U.S. tax on sales by their foreign subsidiaries of goods manufactured through certain (properly structured) contract manufacturing arrangements.
In 1997, the IRS reversed its long-held position, refusing to treat a foreign corporation that commissioned a contract manufacturer as the manufacturer for purposes of Subpart F. The IRS' new position is not particularly persuasive, however, and there continues to be a strong position for relying on the IRS' prior ruling.
To put the contract manufacturing issue in perspective, it is first necessary to understand the general rules applicable to foreign corporations and their shareholders, as well as the anti-deferral rules set forth in "Subpart F." These rules are summarized immediately below.
Taxation of Foreign Corporations and Their Shareholders
Generally Applicable Deferral Regime
As a general rule, to which various exceptions apply, foreign corporations are not subject to U.S. tax on their business income unless they are engaged in a trade or business within the United States (a "U.S. trade or business"),(1) and their U.S. shareholders are not subject to U.S. tax until they (1) receive (or are treated as receiving) dividends from the corporation or (2) dispose of their shares of the corporation.(2) Thus, as a general rule a U.S. shareholder of a foreign corporation can defer U.S. tax on its proportionate share of the profits of the foreign corporation, even if the corporation pays little or no corporate tax in the U.S. or abroad.
Various "anti-deferral" regimes, however, preclude such deferral in certain situations. Of particular interest here are the anti-deferral rules set forth in Subpart F of the Code.
Subpart F sets forth special rules applicable to "United States shareholders" of a "controlled foreign corporation" ("CFC"). For this purpose, a United States shareholder is a United States person that, directly, indirectly, or by application of certain attribution rules, owns at least 10% of the voting stock of a foreign corporation.(3) A CFC is a foreign corporation a majority of the shares of which (measured by either vote or value) are owned by United States shareholders.(4)
Pursuant to Subpart F, each United States shareholder who, directly or indirectly, owns stock of the CFC generally must include in his income each year his proportionate share of the CFC's "Subpart F income."(5) The term "Subpart F income" includes, among other things, most passive income (e.g., interest, dividends, and capital gains) and "foreign base company sales income" ("FBCSI"), described below.
Definition of FBCSI
Pursuant to the general rule set forth in Section 954(d)(1), an item of income is FBCSI only if it is derived in connection with (i) the purchase of personal property from a related person and its sale to any person, (ii) the sale of personal property to any person on behalf of a related person, (iii) the purchase of personal property from any person and its sale to a related person, or (iv) the purchase of personal property from any person on behalf of a related person, where:
(A) the personal property purchased (or sold, if on behalf of a related person) is manufactured, produced, grown or extracted outside the foreign country in which the CFC is created or organized (the "CFC Country"); and
(B) the personal property is sold for use, consumption or disposition outside the CFC Country.
Thus, the general rule set forth by Section 954(d)(1) does not apply where, for example, the personal property sold is manufactured within the CFC Country. This exception (the "Same Country Exception") applies regardless of whether the CFC or another entity performs the manufacturing activity.
An additional exception (the "Manufacturing Exception"), not expressly set forth in Section 954(d)(1), applies where the CFC manufactures (or otherwise adds appreciable value to) the personal property, regardless of whether this is done in the CFC Country. Treasury Regulations Section 1.954-3(a)(4)(i) provides in part that FBCSI does not include income derived in connection with the sale of personal property manufactured by the CFC in whole or in part from personal property which it has purchased.(6) The Manufacturing Exception only has relevance where the manufacturing activity is performed outside the CFC Country, inasmuch as the Same Country Exception already exempts from FBCSI any income from personal property manufactured within the CFC Country.
A special rule (the "Branch Rule"), however, limits a CFC's ability to take advantage of the Manufacturing Exception. Pursuant to Section 954(d)(2), if a CFC carries out activities through a "branch or similar establishment" located outside the CFC Country, and the carrying out of such activities has "substantially the same effect" as if the branch or similar establishment were a wholly-owned subsidiary of the CFC,(7) the income attributable to the activities of the branch or similar establishment is treated as earned by a wholly-owned subsidiary of the CFC incorporated in the jurisdiction in which the branch is located.(8) The income of the CFC and of its deemed subsidiary, as separately determined, are both tested for FBCSI status.
The effect of the Branch Rule is to separate the CFC's manufacturing income (which should continue to qualify for an exception to FBCSI) from its income from sales and other operations (which may constitute FBCSI).(9) Notably, the result under the Branch Rule should not be worse than it would have been if the branch actually had been incorporated as a separate subsidiary in the country in which it conducts its activities.(10)
Treatment of Contract Manufacturing
For many years, the IRS held that, on appropriate facts, the activities of a contract manufacturer are attributed to a CFC to treat the CFC as the manufacturer for purposes of the Manufacturing Exception.(11) In 1997, the IRS revoked its prior ruling, holding instead that such attribution is not permissible.(12) Despite the IRS' new position, taxpayers appear to have a strong position for relying on the approach of the prior ruling.(13)
Revenue Ruling 75-7
In Revenue Ruling 75-7, the IRS addressed the interaction of the Manufacturing Exception and the Branch Rule in the context of manufacturing performed on behalf of a CFC by an unrelated party outside the CFC Country.(14) In that ruling, the CFC purchased metal ore concentrate from unrelated persons and entered into an arm's-length contract with an unrelated manufacturer ("M") to convert the concentrate outside the CFC Country.
Under the terms of the contract, the CFC remained the owner of the concentrate at all times and "bore the risk of loss at all times in connection with the operation." The CFC had complete control of the time and quantity of production and of the quality of the product. Complete control of the quality of the product was also vested in the CFC, and M was at all times required to use such processes as were directed by the CFC. The CFC could, when the occasion warranted it, send engineers or technicians to M's plant to inspect, correct, or advise with regard to the processing of the concentrate into the finished product. The CFC paid a fee to M for conversion of the ore, sold the finished product to unrelated parties outside the CFC Country, and was entitled to all profits from such sales. M had no other relationship or affiliation with the CFC.
Based upon the contractual arrangement between the CFC and M, the IRS attributed M's manufacturing activities to the CFC:
"Under the contractual arrangement between [the CFC] and [M], the performance by [M] of the operations whereby the ore concentrate is processed into a ferroalloy is considered to be a performance by [the CFC]. Therefore, [the CFC] will be treated as having 'substantially transformed personal property' within the meaning of section 1.954-3(a)(4) of the regulations."
Notably, the ruling did not specify which elements of the contract were essential to its conclusion.
The ruling then addressed the Branch Rule. Taking the view that any manufacturing activity conducted by a CFC outside the CFC Country must be considered conducted through a branch or similar establishment, the ruling found the Branch Rule to be inapplicable, solely because the "substantially the same effect test" was not satisfied.(15)
The Treasury Regulations do not define the term "branch or similar establishment" for this purpose, and the ruling offers no analysis in support of its assertion that any manufacturing activity conducted by a CFC outside the CFC Country must be considered to have been conducted through a branch or similar establishment.
Interestingly, at least two prior drafts of the ruling did not address the Branch Rule. This discussion was added pursuant to recommendations set forth in two General Counsel Memoranda prepared in connection with the ruling.(16) Undoubtedly, the IRS was concerned that it could be whipsawed if attribution (or agency) principles were applied to treat the CFC as the manufacturer for purposes of the Manufacturing Exception but not for purposes of treating the CFC as having a branch (or similar establishment) outside the CFC Country for purposes of the Branch Rule.
In this regard, it is especially noteworthy that the GCMs chose to avoid such perceived whipsaw by clarifying the desired treatment under the Branch Rule, rather than by contending that the CFC should not be considered the manufacturer for purposes of the Manufacturing Exception. Moreover, the first GCM considered it "obvious" that the contract manufacturer should be considered an instrumentality of the CFC:
"You have concluded that the [CFC] does not realize foreign base company sales income upon the sales of the ferroalloy inasmuch as there has been a substantial transformation of the property sold within the meaning of the manufacturing exception set forth in regulations section 1.954-3(a)(4)(ii). In so doing, you have applied the laws of agency to treat the contractor as an agent of the [CFC] and therefore consider the processing activities as having been performed by the [CFC].
Under the facts presented, the contractor is obviously an instrumentality of the [CFC]. However, while it may be that the [CFC] has not realized foreign base company sales income, this determination can only be made after consideration of the branch rule set forth in section 954(d)(2) and the regulations thereunder." [Emphasis added.]
As stated later in the first GCM, and quoted approvingly in the second:
"In our opinion, it was not within the contemplation of Congress to permit the avoidance of the operation of the branch rule and thus insulate selling income in a tax haven status by the simple device of having the manufacturing activity performed by an instrumentality of [the CFC], such as [M], rather than through a more conventional branch operation. Accordingly, the branch rule must be applied to the CFC herein even though the manufacturing activities are performed by a so-called unrelated agent."
The second GCM added the following:
"We are not bothered by the fact that in the typical case involving an application of the branch rule the manufacturing activity is conducted by a permanent establishment of the CFC rather than by an unrelated corporation on behalf of the CFC. In either case, the CFC will be incurring a separate tax on the manufacturing, either directly, or indirectly as a cost of the manufacturing, and thereby separating the taxation of its manufacturing and selling activities."
This application of the Branch Rule appears to be a bit of a stretch, and it seems a fair inference that the IRS considered such stretch necessary, because it was even less comfortable with the argument that attribution principles should not apply for purposes of the Manufacturing Exception. As noted above, the author of the first GCM considered it "obvious" that the contract manufacturer was an instrumentality of the CFC.
Ashland and Vetco
In Ashland Oil, Inc. v. Commissioner,(17) the Tax Court severely undercut the position of the IRS, by refusing to treat an unrelated contract manufacturer as a branch or similar establishment of a CFC. The contract in Ashland was similar to the contract in Revenue Ruling 75-7 except that the contract manufacturer owned the raw materials, work-in-progress, and finished products until they were purchased by the CFC. Holding that the term "branch" should be given its customary meaning (and that a "similar establishment" refers solely to a branch given another label, e.g., for financial reporting purposes), the Tax Court held, as a matter of law, that, regardless of the degree of control exercised by the CFC or the level of risk assumed by the CFC, an unrelated contract manufacturer operating under an arm's-length contractual arrangement cannot constitute a branch (or similar establishment) under the Branch Rule.
Similarly, in Vetco, Inc. v. Commissioner,(18) the Tax Court held that a contract-manufacturer subsidiary cannot be considered a branch (or similar establishment) of its parent CFC for purposes of the Branch Rule. Accordingly, the Tax Court reaffirmed, and extended, its holding in Ashland.
Thus, the perceived whipsaw that the IRS had sought to avoid came to pass. The IRS had conceded the availability of the Manufacturing Exception under Section 954(d)(1) and suffered two adverse decisions with respect to the Branch Rule.
What was the IRS to do?
Revenue Ruling 97-48
Short of a legislative change, there was little the IRS could do about the Branch Rule issue, since it had lost twice in the Tax Court.(19) The Manufacturing Exception, however, had never been litigated.
Accordingly, the IRS issued Revenue Ruling 97-48, which revoked Revenue Ruling 75-7 and concluded, somewhat summarily, that "[t]he activities of a contract manufacturer cannot be attributed to a controlled foreign corporation for purposes of either section 954(d)(1) or section 954(d)(2) of the Code to determine whether the income of a controlled foreign corporation is foreign base company sales income."(20)
Revenue Ruling 97-48 offers no analysis supporting its revocation of the twenty-two year old prior ruling. Instead, Revenue Ruling 97-48 admits simply that:
"The Service has never been of the opinion that Rev. Rul. 75-7 allows the activities of a contract manufacturer performed outside the controlled foreign corporations country of incorporation to be attributed to the controlled foreign corporation without treating those activities as performed through a branch or similar establishment of the controlled foreign corporation.
With the revocation of Rev. Rul. 75-7, the Service's position on the treatment of contract manufacturing for purposes of Section 954(d) is harmonized with its position on the treatment of contract manufacturing for purposes of section 863(b) (see section 1.863-3(c) of the Income Tax Regulations (production activity limited to activity directly conducted by the taxpayer))."(21)
In 1998, the IRS' position in Revenue Ruling 97-48 was adopted in proposed regulations.(22) These regulations, however, which also included other controversial provisions, were subsequently withdrawn and have not been reproposed.(23)
Authorities Supporting Attribution of Manufacturing Activities in other Contexts
Despite the revocation of Revenue Ruling 75-7, numerous authorities bear favorably on the contract manufacturing issue. In at least four other contexts, the case law supports attributing activities conducted by one person to another, even where the two persons are not related to one another.
U.S. trade or business
First, it is well established that the activities of a U.S. service provider may in certain circumstances be attributed to a foreign taxpayer, thereby causing the foreign taxpayer to be considered engaged in a U.S. trade or business.
These cases offer little guidance as to the circumstances in which such attribution of activities will be deemed to occur, but the cases suggest that activities of persons who are subject to a high degree of control by a foreign person will be attributed to the foreign person.(24) The courts and the IRS have on occasion even imputed the activities of an independent service provider to such a foreign person.(25)
Under these cases, if a foreign corporation were to utilize a contract manufacturer within the U.S. the IRS could argue that the foreign corporation was engaged, through an agent, in the conduct of a trade or business within the United States.(26) There appears to be no compelling reason why a CFC should not be able to invoke similar principles for purposes of applying the Manufacturing Exception.
Excise tax cases
Second, the IRS and the courts have on other occasions attributed the manufacturing activity of a contract manufacturer to the other contracting party for the purpose of subjecting the latter party to an excise tax.
For example, in Carbon Steel Co. v. Lewellyn,(27) the taxpayer had contracted with the British government for the manufacture and delivery of high explosive shells. The manufacturing process involved nine operations, only one of which was performed by the taxpayer. The remaining operations were carried out by an independent contract manufacturer. In holding that the taxpayer was a "person manufacturing," for the purposes of a Pennsylvania excise tax on "every person manufacturing . . . projectiles, shells, or torpedoes of any kind," the Supreme Court rejected the contention that in order for a person to be considered the manufacturer, he must himself perform the various operations. The Court considered it to be understood that a manufacturer would use "other aid and instrumentalities, machinery, servants, and general agents." The Court considered it significant that the taxpayer kept control of the manufacturing process and retained ownership of all materials furnished by it until the final product was delivered to the British government, but it is not clear how material these factors were to the Court's decision.
Similarly, in Charles Peckat Mfg. Co. v. Jarecki,(28) the taxpayer owned the patent, tools and dies utilized by an independent contract manufacturer to manufacture sun visors for automobiles. The contract provided that the contract manufacturer technically retained title to the raw materials during the manufacturing process, but generally placed the risk of loss in this respect on the taxpayer. The contract manufacturer could ship the visors only as directed by the taxpayer and had no proprietary interest in the completed product.
Based upon the foregoing, the court had little trouble concluding that the taxpayer should be considered the manufacturer for purposes of an excise tax imposed on manufacturers of automobile accessories.(29) The court also observed that "[i]t is not unusual in taxing statutes for the term 'manufacturer' to include one who has contracted with others to actually fabricate the product."
A third useful analogy is to Section 263A, which provides for the capitalization of inventory costs in the case of property "produced by the taxpayer."(30) The IRS recently argued -- successfully -- that a taxpayer utilizing a contract manufacturing arrangement should be considered the manufacturer for these purposes.
In Suzy's Zoo v. Commissioner,(31) a domestic corporation sold greeting cards and other paper products bearing the image of one or more licensed cartoon characters. The corporation argued that it merely resold those products after purchasing them from the printers. The IRS argued successfully, however, that the taxpayer was the true manufacturer.
The court observed that the printers' reproduction of the taxpayer's characters onto paper is merely one small step in the taxpayer's process of exploiting its characters as sellable images, and that the reproduction process is mechanical in nature in that it involves little independence on the printers' part and is subject to the taxpayer's control, close scrutiny and approval. Furthermore, the printers acquired no proprietary interest in the cartoon drawings which would have permitted them to sell a drawing either separately or as part of a paper product. Accordingly, the court concluded that only the taxpayer, and not the putative manufacturer, could be considered the true manufacturer, citing Peckat Manufacturing.(32) The court did not consider it dispositive that the printers bore the risk of loss during the printing process.
As noted below, however, Suzy's Zoo may be distinguished on the ground that activities of the printers were ministerial and relatively insignificant in comparison with those of the taxpayer. Nevertheless, the court's willingness to treat the taxpayer as the manufacturer of goods physically produced by an unrelated party pursuant to an arm's-length contractual arrangement appears to provide support to corporations that utilize contract manufacturers and seek to take advantage of the Manufacturing Exception.
Possession Tax Credit
A final analogy could be drawn from Section 936, which provides a tax credit to electing domestic corporations that earn foreign-source income from "the active conduct of a trade or business within a possession of the United States."(33) In Medchem, Inc. v. Commissioner, 116 T.C. No. 25 (2001), the question arose as to whether a domestic corporation (MedChem) that used a contract manufacturer based in Puerto Rico (Alcon) to manufacture a blood-clotting drug (Avitene) could be considered engaged in "the active conduct of a trade or business" in Puerto Rico.
After reviewing definitions of the phrase "active trade or business" applicable in various other contexts, and the legislative history to Section 936 (and its predecessor), the Tax Court concluded as follows:
"In light of Congress' intent for section 936, the Secretary's interpretations of the subject phrase for purposes of other provisions of the Code, and the Supreme Court's interpretation of the phrase 'trade or business' in section 162(a), we believe that, for purposes of section 936(a), a taxpayer actively conducts a trade or business in a U.S. possession only if it participates regularly, continually, extensively, and actively in management and operation of its profit-motivated activity in that possession. We also believe that, for purposes of this participation requirement, the services underlying a manufacturing contract may be imputed to a taxpayer only to the extent that the performance of those services is adequately supervised by the taxpayer's own employees." (Citations omitted.)
Observing that MedChem "lacked any operational or directional control over the Avitene business[,]" and that all of the business activities connected to Avitene were directed and controlled by Alcon and MedChem's parent corporation (from the U.S.), the Tax Court declined to attribute the manufacturing activities of Alcon to MedChem. The Tax Court did not consider it particularly significant that MedChem supplied the raw materials and equipment necessary to manufacture the drug.
The Tax Court also rejected MedChem's attempt to draw support for its position from Suzy's Zoo.
"In contrast with the situation there, where the thrust of the work as to the finished product was performed by the taxpayer, the thrust of the work here as to the manufacturing of Avitene was performed by [Alcon]. The Avitene manufacturing process was not ministerial but required specialized skill and expertise, unlike the reproduction process in Suzy's Zoo."
The impact of Medchem on the Manufacturing Exception is difficult to assess, however, because the issue ultimately addressed there was whether MedChem had an "active trade or business" within Puerto Rico for purposes of Section 936, not the "who is the manufacturer?" question arising under Subpart F.
Nevertheless, the Tax Court's standard for determining whether the activities of a contract manufacturer should be attributed to its principal has no clear source in Section 936, or its legislative history, and appears to have been drawn, at least in significant part, from the court's view of general tax principles. Consequently, although not determinative, Medchem appears to be relevant to the contract manufacturing issue arising under Subpart F.
Notwithstanding that the Tax Court found attribution of Alcon's manufacturing activity to MedChem to be unwarranted on the facts presented in that case, Medchem suggests attribution of the activities of a contract manufacturer to its principal, at least where the principal exercises a sufficient degree of control over the manufacturing process.
In addition, Medchem should serve as a warning to U.S.-based multinational corporations that have not carefully structured, or properly implemented, their contract manufacturing arrangements. After Medchem, a CFC that fails to supervise and control its contract manufacturer may be less likely to satisfy the Manufacturing Exception.
Notwithstanding continuing uncertainty arising from the IRS' reversal of its long-held position in 1997, practitioners can remain optimistic that contract manufacturing arrangements conforming to the fact pattern described in the IRS' prior ruling should remain viable.
Recent developments, on balance, support such optimism, but suggest the need for great care in structuring -- and monitoring -- contract manufacturing arrangements to present the most favorable fact pattern possible.
1. In the case of a foreign corporation engaged in a U.S. trade or business, only the business income that is considered to be "effectively connected" with such U.S. trade or business is subject to U.S. tax. Such effectively connected income generally is subject to a "branch profits tax" as well as a corporate tax.
2. For this purpose, any income arising form a disposition of a "United states real property interest" is treated as effectively connected with a U.S. trade or business. Internal Revenue Code ("Code") Sec. 897. Except as otherwise indicated, all "Section" references herein are to the Code.
3. Sec. 951(b).
4. Sec. 957(a).
5. Sec. 951(a).
6. Treasury Regulations Section 1.954-3(a)(4)(ii) provides that, if purchased property is "substantially transformed" prior to sale, the property sold will be treated as having been manufactured (or produced or constructed) by the selling CFC.
7. Treasury Regulations Section 1.954-3(b)(1)(ii)(b) interprets the "substantially the same effect" test as a comparison of effective tax rates:
"The use of the branch or similar establishment for such activities will be considered to have substantially the same tax effect as if it were a wholly owned subsidiary corporation of the controlled foreign corporation if the income allocated to the branch or similar establishment . . . is, by statute, treaty obligation, or otherwise, taxed in the year when earned at an effective rate of tax that is less than 90 percent of, and at least 5 percentage points less than, the effective rate of tax which would apply to such income under the laws of the country in which the controlled foreign corporation is created or organized, if, under the laws of such country, the entire income of the controlled foreign corporation were considered derived by the corporation from sources within such country from doing business through a permanent establishment therein, received in such country, and allocable to such permanent establishment, and the corporation were managed and controlled in such country."
8. See also Treas. Reg. Sec. 1.954-3(b)(1).
9. For example, suppose that a CFC in Country A has a manufacturing branch in Country B, and all sales activities are carried out by the home office in Country A. If the Branch Rule applies, so that the Country B branch is treated as a separate corporation, the sales activities of the home office could generate FBCSI, since it would be treated as purchasing its goods from a related person (i.e., the branch which is deemed to have incorporated) and the Same Country Exception would not apply.
10. See Treas. Reg. Sec. 1.954-3(b)(2)(ii)(e).
11. Rev. Rul. 75-7, 1975-1 C.B. 244.
12. Rev. Rul. 97-48, 1997-2 C.B. 89.
13. Pursuant to Section 6662, a 20% penalty is imposed on the portion of an underpayment of tax that is attributable to (i) negligence or disregard of rules or regulations ("negligence penalty") or (ii) a substantial understatement of income tax ("substantial understatement penalty"). In the case of a position that is contrary to a revenue ruling (but not a regulation) the negligence penalty will not apply if the position has a "realistic possibility of being sustained on the merits." Treas. Reg. Sec. 1.6662-3(b)(2). The substantial understatement penalty generally will not apply if the taxpayer either (a) has substantial authority for its position or (b) makes adequate disclosure of the facts affecting the item's tax treatment on its tax return and has a reasonable basis for its position. Sec. 6662(d)(2)(B). In appropriate circumstances, a taxpayer relying on the approach of the prior ruling should have both a realistic possibility of being sustained on the merits and substantial authority. Accordingly, if such a taxpayer were to litigate this issue unsuccessfully, neither the negligence penalty nor the substantial understatement penalty should be imposed. Disclosure on such taxpayer's return should not be required.
14. For an analysis of Revenue Ruling 75-7 prior to its revocation, see Levine and Littman, "Contracting Out, Not Branching Out: Manufacturing Revisited," 22 Tax Mgmt. Int'l J. 343 (1993).
15. "Furthermore, since [the CFC] is conducting a manufacturing activity outside [the CFC Country] it will be considered to do so through a branch or similar establishment within the meaning of section 1.954-3(b)(1)(ii) of the regulations. However, since the effective rate of tax in [the CFC Country] is higher than the rate of tax in [the non-CFC Country], the manufacturing activity of [the CFC] conducted in [the non-CFC Country] will not be considered to have substantially the same tax effect as a wholly-owned subsidiary corporation of [the CFC] within the meaning of section 1.954-3(b)(1)(ii)."
16. GCM 35961 (Aug. 23, 1974); GCM 33357 (Oct. 24, 1966).
17. 95 T.C. 348 (1990).
18. 95 T.C. 580 (1990).
19. Query whether regulations issued to reverse the result in those cases would be given effect by the Tax Court. Notably, there is at least some authority to the effect that such regulations might simply be ignored by the Tax Court on stare decisis grounds. See Bankers Trust New York Corp. v. United States, 225 F.3d 1368 (Fed. Cir. 2000), 2000 US App. Lexis 23503, rev'g 36 Fed. Cl. 30 (1996) (disregarding a regulation that would have disallowed certain foreign tax credits, because, prior to the promulgation of the regulation, the court's predecessor had held comparable payments to be creditable).
20. Alternatively, it appears that the IRS could have amended the regulations to restrict the Manufacturing Exception or to condition its availability, in the case of contract manufacturing arrangements, upon an election to have the Branch Rule apply. The IRS may have deemed such a substantial amendment to be inappropriate, however, since the Manufacturing Exception set forth in the regulations has remained unchanged since 1964.
21. As indicated in the passage quoted above, the ruling does express the view that its new position with regard to Subpart F "is harmonized with its position on the treatment of contract manufacturing for purposes of section 863(b)[.]"
Section 863(b) provides in pertinent part that income from the sale of inventory (i) produced (in whole or in part) by the taxpayer within the U.S. and sold outside the U.S. or (ii) produced (in whole or in part) by the taxpayer outside the U.S. and sold within the U.S. "shall be treated as derived partly from sources within and partly from sources without the United States." The details of such allocation are left to the Section 863(b) regulations. These regulations allocate income attributable to the taxpayer's production activity based upon the location of the taxpayer's production assets, and only take into account activities directly conducted (and assets directly owned) by the taxpayer for this purpose. The ruling does not contend, and indeed it would be difficult to demonstrate, that the very specific rules set forth in such regulations provide material support for the proposition that an offshore corporation using a contract manufacturer cannot be considered the manufacturer under general tax principles.
22. Former Prop. Treas. Reg. Sec. 1.954-3(a)(4), REG-104537-97, 63 Fed. Reg. 14669 (March 26, 1998).
23. REG-113909-98, 64 Fed. Reg. 37727 (July 13, 1999).
24. See, e.g., Lewenhaupt v. Commissioner, 20 T.C. 151 (1953) (management of rental real estate through agent subject to taxpayer's control), aff'd, 221 F.2d 227 (9th Cir. 1955); Adda v. Commissioner, 10 T.C. 273 (1948) (trading in commodities futures through the taxpayer's brother), aff'd, 171 F.2d 457 (4th Cir. 1948); Rev. Rul. 70-424, 1970-2 C.B. 150 (sales of products in United States through exclusive agency arrangement); J. Isenbergh, International Taxation: U.S. Taxation of Foreign Persons and Foreign Income 20.17, 20.19 (2d ed.) (Rel. No. 4, Apr. 1999).
25. See de Amodio v. Commissioner, 34 T.C. 894, 906 (1960), aff'd, 299 F.2d 623 (1962) (nonresident alien owning U.S. real property treated as engaged in a U.S. trade or business through independent agents acting in the ordinary course of business); Handfield v. Commissioner, 23 T.C. 633 (1955) (substantial sales by an independent U.S. distributor attributed to the nonresident alien on whose behalf such sales were made); Rev. Rul. 55-617 (sales through an (apparently) independent commission agent acting in the ordinary course of business attributed to Belgian corporation); TAM 8029005 (Mar. 27, 1980) (activities of an operator of working interests in oil properties attributed to the owner of those interests, seemingly solely on the basis of the owner's direct ownership of the assets and without regard to whether the operator was an independent contractor or an agent of the owner).
26. This example assumes that the foreign corporation is not entitled to the benefits of an income tax treaty with the U.S. conditioning source-state taxation of business profits upon the presence of a permanent establishment.
27. 251 U.S. 501 (1920).
28. 196 F.2d 849 (7th Cir. 1952).
29. See also, e.g., Polaroid Corp. v. United States, 235 F.2d 276 (1st Cir. 1956) (for purposes of excise tax imposed on the manufacturer of photographic apparatus, a taxpayer who used a contract manufacturer to fabricate cameras was considered a manufacturer).
30. Section 263A(a).
31. 114 T.C. No. 1 (2000).
32. Interestingly, the court did not consider the case to fall within the ambit of Section 263A(g)(2) which provides as follows: "The taxpayer shall be treated as producing any property produced for the taxpayer under a contract with the taxpayer, except that only costs paid or incurred by the taxpayer (whether under such contract or otherwise) shall be taken into account in applying subsection (a) to the taxpayer." Apparently, the court took the view that this provision has no relevance where the contract manufacturer is not, as a threshold matter, considered the manufacturer under general tax principles.
33. Sec. 936(a)(1). For this purpose, the Commonwealth of Puerto Rico is considered a possession. Sec. 936(d)(1).