November 23, 1984
Taxpayer's Name: * * *
Taxpayer's Address: * * *
Taxpayer's Identification No: * * *
Years Involved: * * *
No conference held
Parent = * * *
Sub = * * *
F1 = * * *
F2 = * * *
F3 = * * *
Country X = * * *
Country Y = * * *
Product Z = * * *
This is in reply to a request for Technical Advice dated April 11, 1984.
ISSUE:
Whether F1 has foreign base company sales income as defined in section 954(d)(1) of the Internal Revenue Code by reason of the application of section 954(d)(2).
FACTS:
Parent is a domestic corporation engaged principally in the manufacture and sale of * * * machinery, including Product Z. The stock of Parent is publicly traded. Sub is a domestic corporation, all of the stock of which is owned by Parent. F1 is a Country X corporation which was created to undertake the production and distribution of Product Z. All of the stock of F1 is owned by Sub. F2 is a Country Y corporation which manufactures Product Z. All of the stock of F2 is owned by Sub.
Parent manufactured Product Z for a number of years at a domestic plant and sold the machine in domestic and international markets. During the early 1970's, the management of Parent became convinced that its ability to continue the production of Product Z depended upon concentrating its production in one location abroad, closer to the principal markets for the product, which had shifted from the United States to Europe, Africa and the Middle East. To implement this decision, Parent established F1 to assume the responsibility for the production and marketing of Product Z.
Consistent with the foregoing purposes, F1 established a branch (the branch) in Country Y and entered into a subcontract manufacturing agreement with F2. Pursuant to the agreement, F1 retained the services of F2 to contract manufacture Product Z pursuant to the direction and control of F1.
The branch supplied all materials necessary for the manufacture of Product Z. The materials were purchased from unrelated suppliers which recognized and accepted that they were dealing with the branch. The branch was responsible for the collection and provision of data, technical engineering and information necessary in the manufacturing process. Upon completion of the manufacture of Product Z the branch conducted product testing, inspection and quality control procedures to assure that the machines conformed with its standards. All goods in process, as well as finished products awaiting delivery, were situated in designated areas clearly demarcated as belonging to the branch and were kept separate and apart from any goods belonging to F2. Title to, and ownership of, all work in process, as well as finished goods, was clearly in the branch. All risk of loss remained in the branch from the time of submission of raw materials to delivery of finished products. Also, export financing provided by the Country Y Credit Guarantee Department, an arm of the Country Y government, was furnished in the name of the branch. In consideration for the service performed by F2, the branch paid F2 compensation calculated on the cost plus profit method.
Except for sales of Product Z and parts to Parent for subsequent resale in the United States, F1 sells all of its Product Z production directly to unrelated third party customers. The actual sales activities with respect to Product Z and parts is undertaken either by locally established sales subsidiaries of Parent which, pursuant to agency agreements, act as commission agents for F1, or by a network of approximately 60 independent sales agents, which also act as commission agents for F1, pursuant to agency agreements. Sales of Product Z are made F.O.B. the plant of manufacture in Country Y. Orders for Product Z are accepted by F3, a foreign corporation related to F1 and F2 through common ownership.
Pursuant to its Articles of Association, F1's home office (the home office) in Country X is precluded from undertaking sales or sales activities in Country X. Accordingly, while the home office staff assumes supervisory responsibility for Parent's locally established sales subsidiaries and independent agents which function as commission agents for F1, it does not perform any sales or selling activities. The home office's staff consists solely of management personnel charged with the responsibility of supervising the various aspects of F1's business. In addition, the home office undertakes market research activities, such as forecasting demand of new markets and analysis of methods of financing export sales.
It has been determined that both the manufacturing and sales of Product Z were conducted by the branch in Country Y.
APPLICABLE LAW:
Section 954(d)(1) of the Code provides, in general, that the term "foreign base company sales income" means income (whether in the form of profits, commissions, fees, or otherwise) derived in connection with the purchase of personal property from a related person and its sale to any person, the sale of personal property to any person on behalf of a related person, the purchase of personal property from any person and its sale to a related person, or the purchase of personal property from any person on behalf of a related person where:
(A) the property which is purchased (or in the case of property sold on behalf of a related person, the property which is sold) is manufactured, produced, grown, or extracted outside the country under the laws of which the controlled foreign corporation is created or organized; and
(B) the property is sold for use, consumption, or disposition outside such foreign country, or, in the case of property purchased on behalf of a related person, is purchased for use, consumption, or disposition outside such foreign country.
Section 954(d)(2) of the Code provides that for purposes of determining foreign base company sales income in situations in which the carrying on of activities by a controlled foreign corporation through a branch or similar establishment outside the country of incorporation of the controlled foreign corporation has substantially the same effect as if such branch or similar establishment were a wholly owned subsidiary corporation deriving such income, under regulations prescribed by the Secretary the income attributable to the carrying on of such activities of such branch or similar establishment shall be treated as income derived by a wholly owned subsidiary of the controlled foreign corporation and shall constitute foreign base company sales income of the controlled foreign corporation.
Section 1.954-3(b)(1)(ii)(a) of the Income Tax Regulations provides, in general, that if a controlled foreign corporation carries on manufacturing, producing, constructing, growing, or extracting activities by or through a branch or similar establishment located outside the country under the laws of which such corporation is created or organized and the use of the branch or similar establishment for such activities with respect to personal property purchased or sold by or through the remainder of the controlled foreign corporation has substantially the same tax effect as if the branch or similar establishment were a wholly owned subsidiary corporation of such controlled foreign corporation, the branch or similar establishment and the remainder of the controlled foreign corporation will be treated as separate corporations for purposes of determining foreign base company sales income of such corporation. (Emphasis added.)
Section 1.954-3(b)(2)(ii)(a) of the regulations provides, in part, that once it has been determined that a branch and the remainder of the controlled foreign corporation are to be treated as separate corporations, the branch will be treated as a wholly owned subsidiary corporation of the controlled foreign corporation and such branch will be deemed to be incorporated in the country in which it is located.
Section 1.954-3(b)(2)(ii)(e) of the regulations provides that income derived by the branch or similar establishment, or by the remainder of the controlled foreign corporation shall not be considered foreign base company sales income if the income would not be so considered if it were derived by a separate controlled foreign corporation under like circumstances.
Section 1.954-3(a)(4)(i) of the regulations provides, in part, that foreign base company sales income does not include income of a controlled foreign corporation derived in connection with the sale of personal property manufactured by such corporation in whole or in part from personal property which it has purchased.
Section 1.954-3(a)(2) of the regulations provides, in part, that foreign base company sales income does not include income derived in connection with the purchase and sale of purchased property (or purchase or sale of personal property on behalf of a related person) if the property is manufactured in the country under laws of which the controlled foreign corporation which purchases and sells the property is organized.
Section 957(a) of the Code provides, in general, that the term "controlled foreign corporation" means any foreign corporation of which more than 50 percent of the total combined voting power of all classes of stock entitled to vote is owned by United States shareholders on any day during the taxable year of such corporation.
Section 957(d) of the Code provides, in part, that the term "United States person" has the meaning assigned to it by section 7701(a)(30). Section 7701(a)(30)(c) provides that the term "United States person" means a domestic corporation.
Rev. Rul. 75-7, 1975-1 C.B. 244, involves a situation where X, a controlled foreign corporation within the meaning of section 957(a) of the Code, was incorporated in Country M. X purchased specific metal ore concentrate in the United States and Canada from related persons, within the meaning of section 954(d)(3).
Conversion of the ore concentrate into a ferroalloy was accomplished by X, pursuant to an arm's length contract through Y, an unrelated foreign corporation incorporated in Country O. The conversion of the ore concentrate required intricate chemical and metallurgical processing involving highly skilled labor working in accordance with scientific controls. Y's plant in Country O was one of the few plants in the world equipped to accomplish the conversion.
Under the terms of the contract, X paid Y a conversion fee. The ore concentrate, before and during processing, and the finished product remained the sole property of X at all times. X alone purchased all raw material and other ingredients necessary in the processing operation and bore the risk of loss at all times in connection with the operation. Complete control of the time and quantity of production was vested in X. Complete control of the quality of the product was also vested in X, and Y was at all times required to use such processes as were directed by X. X could, when the occasion warranted it, send engineers or technicians to Y's plant to inspect, correct, or advise with regard to the processing of the ore concentrate into the finished product.
The negotiation and consummation of the sale of the finished product were solely the responsibility of X. Profits or losses resulting from the sale of the finished product were solely X's. Y's only financial interest in the entire transaction was the fee paid by X for the conversion of the ore. The finished product was sold by X to unrelated parties in foreign countries, other than Country M, for use, consumption, or disposition in such other foreign countries. The effective tax rate in Country M was 46 percent while the effective tax rate in Country O was 38.5 percent.
The issue in Rev. Rul. 75-7 is whether X has "foreign base company income" within the meaning of section 954(a) of the Code. Rev. Rul. 75-7 holds that under the contractual arrangement between X and Y, the performance by Y is considered to be a performance by X. Furthermore, since X is conducting such manufacturing activity outside Country M, it will be considered to do so through a branch or similar establishment. However, since the effective rate of tax in Country M is higher than the rate of tax in Country O, the manufacturing activity of X in Country O is not considered to have substantially the same tax effect as a wholly-owned subsidiary of X, and accordingly, X does not have foreign base company sales income within the meaning of section 954(a).
DISCUSSION:
Section 954(d)(2) of the Code was enacted to prevent circumvention of the foreign base company sales income rules set forth in section 954(d)(1) through the use of a branch carrying on the activities of a controlled foreign corporation (CFC) located outside of the CFC's country of incorporation, so as to separate sales operations from manufacturing activity. See, Sen.Rep. No. 1881, 87th Cong., 2d Sess. 85, 246 (1962). Pursuant to section 957(a) and (d), F1 is a CFC.
Section 954(d)(2) of the Code gives the Secretary of the Treasury the authority to prescribe regulations to determine when the income attributable to the carrying on of activities of a branch of a CFC shall be treated as income derived by a wholly owned subsidiary of the CFC and shall constitute foreign base company sales income of the CFC. Accordingly, section 1.954-3(b)(1)(ii) of the regulations was promulgated to apply to situations where a branch of a CFC located outside the CFC's country of incorporation manufactures personal property which is "purchased or sold by or through" the remainder of the CFC.
In the case at hand, the home office of F1 in Country X is the "remainder" of F1.
The International Examiner determined, pursuant to Rev. Rul. 75-7, that the branch is the manufacturer of Product Z for purposes of section 1.954-3(b)(1)(ii) of the regulations. As previously noted, the home office (or "remainder") of F1 performs no selling or sales activities with respect to Product Z. F1's Country Y branch sold all of its Product Z production directly to unrelated third parties, except for Product Z and parts sold to Parent for subsequent resale in the United States. Since none of the Product Z manufactured by the branch is purchased or sold by or through the remainder of F1, section 1.954-3(b)(1)(ii) does not apply.
Even assuming that section 1.954-3(b)(1)(ii) of the regulations could be applied to F1 and the branch, the manufacture and sale of Product Z would not give rise to foreign base company sales income. In accordance with section 1.954-3(b)(2)(ii)(a), once it has been determined that F1 and the branch are to be treated as separate corporations, the branch will be treated as a wholly owned subsidiary of F1 and it will be deemed to be incorporated in Country Y. Pursuant to section 1.954-3(b)(2)(ii)(e), income derived by the branch or the remainder of F1 will not be considered foreign base company sales income if such income would not be so considered if it were derived by a separate CFC under like circumstances.
Under section 1.954-3(a)(4)(i) of the regulations, income derived by the branch in connection with the sale of Product Z would not constitute foreign base company sales income since the branch manufactured and sold Product Z.
Even if the branch was determined not to be the manufacturer of Product Z, but was simply a purchaser and reseller, income derived from the sale of Product Z would not constitute foreign base company sales income under section 1.954-3(a)(2) of the regulations since Product Z is manufactured in Country Y, the same country under the laws of which the branch would be deemed to be incorporated. In addition, section 1.954-3(a)(2) makes it clear that this exclusion from foreign base company sales income would apply even if the sales of Product Z were considered to have been made on behalf of F1's home office, the remainder of F1.
CONCLUSION:
F1 does not have foreign base company sales income as defined in section 954(d)(1) of the Code by reason of the application of section 954(d)(2) and the regulations thereunder.
A copy of this Technical Advice Memorandum is to be given to the taxpayer. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.
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