Certain growing activities qualify as production activities for purposes of foreign base company sales income rules

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1 23 October 2013 International Tax Alert Certain growing activities qualify as production activities for purposes of foreign base company sales income rules Executive summary On 21 October 2013, the Internal Revenue Service (the IRS) released Private Letter Ruling (the PLR), ruling that production activities that also constitute growing activities are taken into account to determine whether a controlled foreign corporation (a CFC) has satisfied the CFC manufacturing exception to foreign base company sales income (FBCSaI). By the terms of the applicable Treasury regulations section, that exception pertains to personal property manufactured, produced, or constructed by a CFC but does not indicate whether or not the exception applies to personal property grown by a CFC. The ruling indicates that a production activity that is also a growing activity remains relevant for purposes of determining whether the exception applies. The PLR is significant to taxpayers that engage in agricultural production and, more generally, provides interpretative guidance as to the scope of the CFC manufacturing exception. Detailed discussion Facts The requesting taxpayer was the United States shareholder of a CFC 1 that was engaged in the production and sale of certain agricultural products. The activities to develop, grow, and harvest the products undertaken both by the CFC, through its employees, and by related and unrelated service providers surpassed traditional farming activities. Instead, the CFC generated the products pursuant to a sophisticated, multi-phase process. 2 Some of the relevant activities were performed within the CFC s country of organization, and others were performed outside of it.

2 Law In general, a United States shareholder of a CFC must include currently in gross income amounts of FBCSaI earned by the CFC, notwithstanding that the CFC did not actually distribute the income. 3 Section 954(d)(1) defines FBCSaI as income that a CFC derives in connection with certain purchases from, and/or sales to, related persons of personal property. More specifically, FBCSaI includes income derived in connection with a CFC s sale of personal property only if the CFC purchased the property from another person, and the property was manufactured, produced, grown, or extracted outside of the CFC s country of organization. Accordingly, FBCSaI excludes income derived in connection with the sale of personal property that is considered to have been manufactured, produced, grown, or extracted either (i) by the CFC itself (the CFC manufacturing exception) 4 or (ii) by another person, but in the CFC s country of organization (the samecountry manufacturing exception). 5 Treas. Reg. Section (a)(4) describes the CFC manufacturing exception. 6 By its terms, it pertains only to personal property manufactured, produced, or constructed by a CFC. Thus, unlike Section 954(d)(1) 7 and the regulations sections implementing the same-country manufacturing exception 8 and the so-called manufacturing branch rule, 9 Treas. Reg. Section (a)(4) does not refer to growing activities. Thus, the regulations suggest that growing activities, by themselves, create a manufacturing branch but do not satisfy the CFC manufacturing exception an incongruous result. The question arose, then, whether a CFC s growing activities may be taken into account for purposes of the CFC manufacturing exception to FBCSaI. Posed differently, to the extent that production activities also constitute growing activities, can they be considered for purposes of the CFC manufacturing exception? Analysis and implications The IRS ruled in the PLR that production activities that also are growing activities are properly taken into account for purposes of the CFC manufacturing exception. The PLR noted that, although the terms produced and grown are not interchangeable, neither are they mutually exclusive. Certain growing activities, based on facts and circumstances, also may constitute production activities. The ruling applied equally to activities undertaken by the CFC itself and to those undertaken by contract manufacturers hired by the CFC. The taxpayer in the PLR had represented to the IRS that, if activities that are both growing and production activities were taken into account for purposes of the CFC manufacturing exception, the CFC s activities with respect to the products at issue would be sufficient to satisfy the exception. Accordingly, the PLR did not express an opinion as to whether the CFC s activities constituted production activities or were sufficient to satisfy the CFC manufacturing exception. The ruling in the PLR is significant to United States persons owning CFCs and other foreign entities that are engaged in similarly sophisticated agricultural production activities. More generally, however, the PLR indicates the IRS s willingness to interpret the multi-varied provisions of the FBCSaI rules in a commonsense fashion that takes into account the complexity of the activities involved in the development of a product. 10 Thus, merely because an activity may be described as growing does not mean that it cannot be considered for purposes of the CFC manufacturing exception. The complexity of the process was undoubtedly significant to the IRS; not all growing activities will constitute production activities for purposes of the CFC manufacturing exception. 2 International Tax Alert

3 Endnotes 1. The CFC owned, and conducted certain activities through, two wholly-owned entities that were disregarded for US federal income tax purposes. For simplicity, references to the activities of the CFC in this summary include the activities conducted by both disregarded entities. 2. During the initial phase, the CFC makes decisions about product attributes and contracts with related and unrelated persons to undertake research and development on a cost-plus basis. The resulting intellectual property is for the risk and account of the CFC. Ultimately, Stage A products are developed. During the second phase, the Stage A products are planted and the resulting Stage B products are harvested. The CFC in some cases undertakes these activities itself through its employees; in others it enters into toll manufacturing or contract manufacturing arrangements with related and unrelated persons to do so. During the third phase, the Stage B products are planted and the resulting Stage C products are harvested. Similarly to the second phase, the CFC both undertakes these activities itself and enters into toll manufacturing or contract manufacturing arrangements with related and unrelated persons to do so. During the fourth phase, Stage C products are organized at processing facilities for cleaning, quality assessment, and packaging either by the CFC itself or by a related person pursuant to a contract with the CFC and then sold to related and unrelated persons. 3. See generally Sections 951(a)(1)(A); 952(a)(2); 954(c). References to section are to that section of the Internal Revenue Code of 1986, as amended (the Code). References to Treas. Reg. Section are to that section of the Treasury regulations promulgated under the Code. 4. See Treas. Reg. Section (a)(4)(i). 5. See Treas. Reg. Section (a)(2). 6. The Treasury regulations set forth three ways by which a CFC may be treated as manufacturing, producing, or constructing the relevant personal property (and thus as satisfying the CFC manufacturing exception): two physical manufacturing tests and the substantial contribution test (when another person is the physical manufacturer). Treas. Reg. Section (a)(4)(ii), (iii), and (iv). 7. Section 954(d)(1) does not, however, refer to personal property constructed outside of a CFC s country of organization. 8. Treas. Reg. Section (a)(2). 9. Treas. Reg. Section (b)(1)(ii)(a). Pursuant to the rule, a CFC branch through which a CFC carries on manufacturing, producing, constructing, growing, or extracting activities is treated in certain circumstances as a separate CFC frequently, with adverse US federal income tax consequences. 10. For example, it is possible that that production activities that are also extracting activities are properly taken into account for purposes of the CFC manufacturing exception despite the omission of the word extracted in Treas. Reg. Section (a)(4). International Tax Alert 3

4 For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, International Tax Services, United States Stephen Bates, San Francisco Peg O Connor, Washington, DC margaret.oconnor@ey.com Allen Stenger, Washington, DC allen.stenger@ey.com David Macall, Washington, DC david.macall@ey.com International Tax Services Global ITS, Alex Postma, London ITS Director, Americas, Jeffrey Michalak, Detroit Member Firm Contacts, Ernst & Young LLP (US) Northeast Craig Hillier, Boston East Central Johnny Lindroos, McLean, VA Financial Services Phil Green, New York Midwest Simon Moore, Chicago Southeast Scott Shell, Charlotte, NC Southwest Amy Ritchie, Austin West Frederick Round, San Jose, CA Canada - Ernst & Young LLP (Canada) Albert Anelli, Montreal Kost Forer Gabbay & Kasierer (Israel) Sharon Shulman, Tel Aviv Mancera, S.C. (Mexico) Koen Van t Hek, Mexico City South America Alberto Lopez, New York 4 International Tax Alert

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