Subpart F Income: Navigating the Revised Branch and Contract Manufacturing Rules

Transcription

1 Presenting a live 110 minute teleconference with interactive Q&A Subpart F Income: Navigating the Revised Branch and Contract Manufacturing Rules WEDNESDAY, JUNE 20, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Robert J. Misey, Jr., Shareholder, Reinhart Boerner Van Deuren,, Milwaukee Frederick Chilton, Partner, McDermott Will & Emery, Silicon Valley, Calif. James Sams, Principal, KPMG, McLean, Va. For this program, attendees must listen to the audio over the telephone. Please refer to the instructions ed to the registrant for the dial-in information. Attendees can still view the presentation slides online. If you have any questions, please contact Customer Service at ext. 10.

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5 Subpart F Income: Navigating the Revised Branch and Contract t Manufacturing Rules Seminar June 20, 2012 Robert J. Misey Jr. Reinhart Boerner Van Deuren rmisey@reinhartlaw.com Frederick Chilton, McDermott Will & Emery fchilton@mwe.com James Sams, KPMG jksams@kpmg.com

6 Today s Program Origin Of Branch, Contract Manufacturing Regulations [Robert J. Misey Jr.] Slide 7 Slide 17 Contract Manufacturing Regulations [Robert. J. Misey Jr., Frederick Chilton] Slide 18 Slide 42 Branch Office Regulations [James Sams and Frederick Chilton] Slide 43 Slide 64

7 Robert J. Misey Jr., Reinhart Boerner Van Deuren ORIGIN OF BRANCH, CONTRACT MANUFACTURING REGULATIONS

8 Foreign Based Company Sales Income 1. CFC buys from or sells to a related person. 2. Property manufactured outside the CFC s country by someone other than the CFC 3. Sold for use outside the CFC s country 8

9 The FBCSI Scenario USCo US product F CFC product 3 rd- Country Customer 9

10 The Branch Rule: Manufacturing Branch USCo US F CFC Sales 3 rd- Country Manufacturing Branch product 4 th- Country Customers 10

11 The Branch Rule: Sales Branch USCo US F CFC Manufacturing 3 rd- Country Sales Branch product 4 th- Country Customer 11

12 How We Got Here: Rev. Rul USCo US F Unrelated ForCo Conversion process CFC manufactures CFC has a branch CFC Title to metal ore concentrate control over conversion process ferroalloy 4 th- Country Customers 12

13 How We Got Here: Post Rev. Rul Planning Taxpayers claimed contract manufacturers resulted in the CFC manufacturing. Taxpayers claimed the contract manufacturers were not branches of the CFC. 13

14 How We Got Here: Ashland Oil USCo US F Unrelated ForCo conversion process CFC product 4 th- Country Customers Tax Court: Unrelated contract manufacturer wasn t a branch of the CFC. 14

15 How We Got Here: Vetco USCo US F CFC 3 rd- Country CFC Conversion process product 4 th- Country Customers Tax Court: Wholly owned manufacturing subsidiary of a CFC isn t a branch. 15

16 How We Got Here: Rev. Rul Revoked Rev. Rul Stated t that t a contract t manufacturer s activities iti can t be attributed to a CFC unless a branch exists 16

17 How We Got Here: Post Rev. Rul Planning The its argument: FBCSI is "income derived in connection with the purchase of property from a related purchaser and its sale to any person." 17

18 Robert J. Misey Jr., Reinhart ih Boerner Van Deuren Frederick Chilton, McDermott Will & Emery CONTRACT MANUFACTURING REGULATIONS

19 The Recent Regulations Eliminate the "its" defense Expand the manufacturing exception with substantial bt til contribution to manufacturing Substantially reinvigorate the branch rule 19

20 Four Tests For Manufacturing 1. Substantial transformation 2. Generally considered d manufacturing in the industry 3. Safe harbor of conversion costs constituting 20% of the cost of goods sold 4. Substantial contribution to manufacturing 20

21 Substantial Transformation USCo US fresh tuna F CFC canned tuna 3 rd- Country Customers 21

22 Generally Considered To Constitute Manufacturing USCo US F sunglass components CFC sunglasses 3 rd- Country Customer 22

23 Safe Harbor Of 20% Of Cost Of Goods Sold USCo US WIP F CFC $30,000 direct material costs $10,000 conversion costs completed products 3 rd- Country Customer 23

24 Substantial Contribution To Manufacturing Results in manufacturing without what is traditionally considered manufacturing Facts-and-circumstances test No minimum performance threshold Require that activities be conducted by employees Deals with automated manufacturing 24

25 Seven Factors Of Substantial Contribution i 1. Oversight of physical manufacturing 2. Physical activities are less than full physical manufacturing. 3. Control of raw materials 4. Managing manufacturing costs or capacities 5. Control of manufacturing logistics 6. Quality control 7. Development of manufacturing intangibles 25

26 Contract Manufacturing: Lessons From The Examples Mere contractual rights, legal title, tax ownership or assumption of risk of loss are not considered in determining whether the CFC has substantially contributed. Contractual claims to oversight without actual oversight mean nothing. 26

27 Contract Manufacturing: Lessons From The Examples (Cont.) USCo US F 3 rd Country KM CFC Substantial transformation Power to control and oversee is not exercised. product 4 th- Country Customer No substantial contribution 27

28 Contract Manufacturing: Lessons From The Examples (Cont.) The actual exercise of direction and oversight of the manufacturing activities constitute a substantial contribution. 28

29 Contract Manufacturing: Lessons From The Examples (Cont.) A CFC must consider the activities of its employees in determining whether the CFC manufactures the property sold. 29

30 Contract Manufacturing: Lessons From The Examples (Cont.) USCo US F 3 rd- Country KM CFC Substantial transformation Employees conduct R&D, QC and logistics. product 4 th- Country Customer Substantial contribution 30

31 Contract Manufacturing: Lessons From The Examples (Cont.) USCo US F 3 rd- Country KM Substantial transformation buys raw materials CFC Employees select materials, oversee mfg. process, and schedule. 4 th- Country Customer Substantial contribution 31

32 Contract Manufacturing: Lessons From The Examples (Cont.) USCo US F 3 rd- Country KM CFC Substantial transformation with contract employees Employees control mfg. process, raw materials, WIP, QC and finished goods. product 4 th- Country Customer Substantial transformation 32

33 Contract Manufacturing: Lessons From The Examples (Cont.) Application of substantial contribution Test (Treas. Reg. Sect (a)(4)(iv)(c)) 1. The performance of any of the enumerated seven activities is to be taken into account. 2. Lack of performance of such activities, and the number of activities actually performed, are not determinative. 3. The fact that other persons make a substantial contribution to manufacture does not preclude the CFC from making a substantial contribution to manufacture. 33

34 Contract Manufacturing: Lessons From The Examples (Cont.) Automated manufacturing examples Example 5: Automated manufacturing not supervised by CFC Facts: CFC owns raw materials. CFC has legal right to oversee manufacturing but does not do so through its employees. CFC owns sophisticated software that remotely and automatically (without human involvement) takes orders, routes them to CM, orders raw materials and performs quality control. CFC activities: CFC has a small staff of computer technicians who monitor the software and network systems to make sure that they are running smoothly. DP activities: The automated systems were designed by DP. DP employees supervise the CFC computer technicians and make ongoing operational decisions, including decisions i related to product and manufacturing process design. DP employees direct and control vendor and material selection, management of the manufacturing costs and capacities, and selection of the CM. Substantial operational responsibilities and decision-making are required but are not carried out by the CFC to manufacture the product. 34

35 Contract Manufacturing: Lessons From The Examples (Cont.) Automated manufacturing examples (Cont.) Example 5: Automated t manufacturing supervised by another person Result: The activities of the CFC constitute manufacture. However, the CFC does not make a substantial contribution to manufacturing through its employees. Mere ownership of raw materials and IP, along with contractual rights to oversee manufacturing (compare examples 1 and 2), are not sufficient to constitute substantial contribution to manufacturing. 35

36 Contract Manufacturing: Lessons From The Examples (Cont.) Automated manufacturing examples (Cont.) Example 6: Automated manufacturing supervised by FS Facts: Are the same as in 5, except that FS employees carry out the activities of the DP employees. Result: FS makes a substantial contribution through the activities of its employees to the manufacture of the product. This determination does not require a comparison of the activities of the employees of FS and DP. 36 Activities that are not among the enumerated seven activities: Selection of the CM, even though not one of the enumerated seven activities, is taken into account in determining whether FS makes a substantial contribution to manufacturing.

37 Contract Manufacturing: Lessons From The Examples (Cont.) Automated manufacturing examples (Cont.) Example 7: Automated t manufacturing supervised by FS with purchased intellectual property Facts: The facts are the same as in Example 6, except that the software and network systems were purchased by FS rather than developed by FS. Result: The fact that FS did not develop the software and network systems is not determinative. The other activities of its employees make a substantial contribution to the manufacture of the product. 37

38 Contract Manufacturing: Lessons From The Examples (Cont.) Example 8: Manufacturing without intellectual property Facts: FS purchases raw materials from a related party, and they are manufactured into a product by CM. At all times, FS controls the raw materials, work-in-process and finished goods. FS controls the manufacturing-related logistics, manages the manufacturing costs and capacities, and provides quality control with respect to CM s manufacturing process and product. No intellectual property is required to manufacture the product, and FS does not own any IP relating to the product. Result: Because intellectual property is irrelevant to the manufacture of the product, it is not important to the substantial contribution analysis. FS employees make a substantial contribution to the manufacture of the product. 38

39 Contract Manufacturing: Lessons From The Examples (Cont.) More than one party makes a contribution to manufacturing. Example 9: Substantial contribution by more than one CFC Facts: Both FS1 and FS2 contract with CM for the manufacture of Product X. Neither FS1 nor FS2 owns the materials or work-in-process during the manufacturing process. 39 FS1, through its employees: Designs Product X; directs the use of the product design and design specifications, and other intellectual property, for the purpose of manufacturing Product X; and selects the materials that will be used to manufacture product X. FS2, through its employees: Designs the process for manufacturing Product X. FS1 and FS2 each provide quality control and oversight and direction of the CM s manufacturing activities, with respect to different aspects of the manufacturing process.

40 Contract Manufacturing: Lessons From The Examples (Cont.) More than one party makes a contribution to manufacturing (Cont.) Example 9: Substantial contribution by more than one CFC Result: The fact that other persons make a substantial contribution to manufacturing the product does not preclude a CFC from making a substantial contribution to manufacture of the property. Each CFC takes account only of its activities if performing the analysis. No threshold of activity is required. Under the facts and circumstances, both FS1 and FS2 make substantial contributions to the manufacture of Product X. Compare with Example 5, in which USP s activities demonstrated that substantial contributions to manufacture were required, but that the CFC did not make them. 40

41 Contract Manufacturing: Lessons From The Examples (Cont.) Example 10: Value-added activities are most important in substantial contribution analysis. Facts: FS designs the product, selects the materials that CM will use to manufacture Product X, and manages manufacturing costs and capacities. These are the activities that add value to the X product. FS does not oversee manufacturing and quality control, because it is not required. Result: FS makes a substantial contribution through the activities of its employees. 41

42 Contract Manufacturing: Lessons From The Examples (Cont.) Example 11: Direction and oversight of manufacturing and quality control through periodic visits Facts: FS controls the raw material, work-in-process and finished goods; manages the manufacturing costs and capacities; and provides oversight and direction of the manufacture of Product X. Employees of FS visit CM s manufacturing facility for one week each quarter and perform quality control tests on a random sample of the units of Product X produced. Result: FS makes a substantial contribution through its employees to the manufacture of Product X. Compare: Automated manufacturing examples in which software, among other things, was responsible for quality control. Quality control, whether carried out automatically or by CFC employees, can qualify as a substantial contribution activity depending upon the level of CFC employee involvement. 42

43 James Sams, KPMG Frederick Chilton, McDermott Will & Emery BRANCH OFFICE REGULATIONS

44 Agenda For This Section Statute and regulation terms of art Mechanics for application of rules Complexities with multiple branches Practical issues and examples 44

45 Sect. 954(d)(2): The Branch Rule The Statute. Prerequisite: When the carrying on of activities by a controlled. foreign corporation through a branch (outside the country of incorporation of the controlled foreign corporation) has substantially the same effect as if such branch were a wholly owned subsidiary corporation deriving such income,, Effect: (1) 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. and (2) shall constitute foreign base company sales income of the controlled foreign corporation. 45

46 Regs Provide Rules For Determining When To Treat CFC, Sales Branch Separately Sales or purchase branch - Prerequisites: (1) If a CFC carries on purchasing or selling activities through a branch (located outside the country under the laws of which such corporation is organized), and the use of the branch for such activities has substantially the same tax effect as if the branch or similar establishment were a wholly owned subsidiary corporation of such controlled foreign corporation (see next slide); Effect: The branch and the remainder of the CFC will be treated as separate corporations, for purposes of determining i foreign base company sales income of such corporation. Treas. Reg (b)(1)(a) 46

47 Regs For Allocating Income And Comparing Effective Tax Rates (Tax Rate Disparity), In Situation Involving Sales Branch The use of the branch, for purchasing or sales activities, will be considered to have substantially the same tax effect as if it were a wholly owned subsidiary corporation of the CFC, if the income allocated to the branch is taxed in the year when earned at an effective rate of tax that is less than 90% 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 CFC is created or organized. Treas. Reg (b)(1)(b) 47

48 Application Of Tax Rate Disparity Test To Sales Branch. CFC Country X Tax rate: 20% Sales Branch Country Y Tax rate: 0% Analysis: Because the tax rate in Y (the branch country) is less than 90% of, and at least 5 percentage points less than, the effective rate of tax in X, the use of the sales branch for sales activities has substantially the same tax effect as if the branch were a wholly owned subsidiary corporation of the CFC. 48

49 Application Of Tax Rate Disparity Test In Sales Branch Situation Advantage of using a low-taxed CFC to avoid the sales branch rule CFC Country X Tax rate: 0% Sales Branch Country Y Tax rate: 10% Analysis: Because the tax rate in Y (the branch country) is more than 90% of, and within 5 percentage points of (in fact, more than) the effective rate of tax in X, the use of the sales branch for sales activities does not have substantially the same tax effect as if the branch were a wholly owned subsidiary corporation of the CFC. 49

50 Regs Provide Rules For Determining When To Apply Separate Treatment to Manufacturing Branch And CFC If a CFC carries on manufacturing, producing, constructing, growing, or extracting activities by a branch (located outside the country under the laws of which such corporation is organized), and The use of the branch for such activities with respect to personal property purchased or sold by or through the remainder of the CFC has substantially the same tax effect ect as if the branch or similar establishment s e t were e a wholly owned subsidiary corporation of such CFC, Then the branch or similar establishment and the remainder of the CFC will be treated as separate corporations, for purposes of determining foreign base company sales income of such corporations. Temp. Treas. Reg (b)(1)(ii)(a) ) 50

51 Regs Provide Rules For Determining When To Apply Separate Treatment To Manufacturing Branch And CFC (Cont.) The manufacturing branch rules will apply only if the CFC (including any branches or similar establishments of such CFC) manufactures, produces or constructs such personal property within the meaning of Treas. Reg (a)(4)(i), or carries on growing or extracting activities with respect to such personal property. Temp. Treas. Reg (b)(1)(ii)(a) 51

52 Mechanics Of Application Substantially the same tax effect is a four-step pprocess: 1. Allocate income to the selling party. This is the remainder of the CFC for the manufacturing branch test, and the selling branch for the sales branch test. The term remainder of the CFC denotes the CFC s activities apart from those performed within its branches. 2. Determine the actual ETR of the selling party s jurisdiction 3. Determine the hypothetical ETR that would apply in the manufacturing jurisdiction 4. Apply rate disparity test * Additional steps apply when there are multiple l branches (discussed d later). ) 52

53 Step 1: Allocation Of Income To Selling Party The income allocated to the selling branch or the CFC remainder is the amount that would constitute FBCSI to the selling party under the following assumptions: 1. The branches are wholly owned subsidiaries of the CFC, incorporated in the country where they are located. 2. Purchasing and selling activities of the selling party are performed on behalf of the manufacturing party. 3. The exceptions for FBCSI do not apply to: a) Property manufactured in selling party s country b) Property sold for use in selling party s country c) Property manufactured by CFC 53

54 Step 2: Determination Of Actual ETR Of Selling Party Actual ETR takes into account all income-like taxes in the selling party s country of organization. Tax holidays, and the tax attributes of the selling party that it uses when computing its taxes, will be taken into account for this calculation. For example, if the selling party reduces its tax liability within its country of organization to zero through the use of net operating loss carryforwards, then its ETR will be 0%. 54

55 Step 3: Hypothetical ETR Calculation Determine hypothetical ETR as if income allocated to the selling party was earned by a corporation organized in the manufacturing party s tax jurisdiction, with all of its income attributed to that country. Hypothetical ETR takes into account all income-like taxes in the manufacturing party s country of organization. Tax holidays and other available tax incentives of manufacturing jurisdiction will be applied. It is unclear whether tax attributes specific to the selling party, such as net operating losses and capital loss carryforwards, can be used. 55

56 Hypothetical ETR Examples Example of simple ETR Example of complex ETR FS (Country M) CFC: Sells Product X outside of FS Country M (Country M) Country M statutory tax rate = 10% ETR = 10% CFC: Sells Product X outside Country M Country M statutory tax rate = 10% ETR = 10% Branch A (Country y A) ) Manufacturing Branch: Manufactures Product X Country A statutory tax rate = 20% ETR = 20% Branch A (Country y A) ) Manufacturing Branch: Manufactures Product X Country A statutory tax rate = 20% ETR = 8% Remainder of FS earns $100k on sales of Product X outside of Country M. $100k taxed at 10% in Country M is $10k, for an ETR of 10%. $100k taxed at 20% in Country A is $20k, for an ETR of 20%. There is a rate disparity. Remainder of FS earns $100k on sales of Product X outside of Country M. $100k taxed at 10% in Country M is $10k, for an ETR of 10%. In Country A, sales income of Product X gets a tax incentive, and only 40% of the $100k sales income would be taxed. $40k (40% * 100k) taxed at 20% in Country A is $8k, for an ETR of 8% ($8k / $100k). There is no rate disparity. 56

57 Step 4: Rate Disparity Test Rate disparity test Sales branch Actual sales branch ETR less than 90% of, and at least five percentage points lower than, hypothetical ETR in CFC s country. Manufacturing branch Actual CFC remainder ETR is less than 90% of, and at least five percentage points lower than, hypothetical ETR in manufacturing branch s country 57

58 Structural And Operational Complexities If there are multiple sales branches, and no manufacturing branches, then test each sales branch independently using the sales branch rules If there are multiple l sales branches and at least one manufacturing branch, then test each sales branch independently using the manufacturing branch rules, as if the sales branch were the remainder CFC. May require use of multiple manufacturing branch rules If, after ate applcato application of the rules, the manufacturing uactu entities ttes ae are considered separate entities from the sales branch, then the sales branch income will be FBCSI and vice versa. 58

59 Structural And Operational Complexities (Cont.) Apply rate disparity test between selling party and the location of manufacture If only one branch ba independently satisfies s a manufacturing actu test, then that branch is treated as the location of manufacture. If more than one branch independently satisfies a manufacturing test, then the location of manufacture is the branch with the lowest effective rate of tax. If none of the branches independently satisfies a manufacturing test, but the CFC as a whole does, apply a greater contribution test (see next slide). 59

60 Structural And Operational Complexities (Cont.) What if no one entity meets manufacturing test, but the CFC s operations as a whole do? 1. Determine the tested sales location 2. Determine the tested manufacturing location 3. Apply the greater contribution test to determine location of manufacture i. Attribute activities of rate disparate entities to the tested manufacturing location ii. iii. Attribute activities of non-rate disparate entities to the tested sales location Determine which tested location, after attribution, tion contributes tes more to the manufacturing process. If they are equal, the tested manufacturing location has the greater contribution. A. If the tested manufacturing location has the greater contribution, then it is the location of manufacture, and the branches will be considered separate entities. B. If the tested sales location has the greater contribution, then it is the location of manufacture, and the branches will continue to be treated as branches. 60

61 Treas. Reg (b)(1)(ii)(c)(3)(v), Ex. 2: Multiple Manufacturing Branches Related Supplier Raw Materials FS (Country M) Product X Sales ETR = 10% Unrelated Customers (Outside M) Branch A (Country A) Branch B (Country B) Branch C (Country C) Product design QC Physically manufactures Manages manufacturing costs Oversight and direction Product X and capacities ETR = 12% ETR = 20% Oversees coordination between branches Controls raw materials, WIP, risk of loss ETR = 12% Result: Both Branch A and Branch C independently qualify as manufacturers through the activities of their employees. Branch A is treated as the location of manufacture, because Country A imposes the lower effective rate of tax. Branch C is not tested separately. Therefore, none of the branches is considered a separate entity from FS, because Country A does not have a rate disparity with Country M. 61

62 Treas. Reg (b)(1)(ii)(c)(3)(v), Ex. 4: Manufacturing Function Divided Among Multiple Branches FS: Manages manufacturing costs and capacities Oversees coordination between branches ETR = 10% Related Supplier Raw Materials Branch A (Country A) FS (Country M) Product X Sales Branch B (Country B) Unrelated Customers (Outside M) Unrelated Product design Controls raw materials, WIP, risk Contract Mfg ETR = 20% of loss (Country C) ) Contract mfg oversight and direction; control logistics ETR = 12% Result: Neither the remainder of FS, nor Branch A, nor Branch B independently satisfies (a)(4)(i). But, FS, as a whole, provides a substantial contribution through the activities of its employees to the manufacture of Product X. The tested sales location is Country M, because the remainder performs the selling activities with respect to Product X. The location of Branch A is the tested manufacturing location, because Country A has the lowest effective rate of tax among the manufacturing branches that would be treated as a separate corporation (20% of Country A vs. 10% of Country M). The activities of Branch B will be included in the contribution of FS for purposes of determining the location of manufacture of Product X, because it does not have a rate disparity with Country M (12% vs. 10%). The activities of FS and Branch B combined would provide a greater contribution to the manufacture of Product X than the activities of Branch A. Therefore, the location of manufacture is Country M, and neither Branch A nor Branch B would be considered a separate entity from FS. 62

63 Issues With Affirmative Use Of Branch Rules FS (Country M) FS: Does not provide manufacturing or sales services outside of its branch ownership ETR = 18% Related Supplier (Country R) Product X Intercompany Sale Branch A (Country A) Product X Sales Branch A: Does not provide manufacturing services ETR = 10% Unrelated Customers (Country A only) Be aware that there is a concern whether the affirmative use of the branch rules to create a favorable outcome for the taxpayer would be allowed. In this example, if Branch A is treated as a separate corporation, it would avoid FBCSI on its sales income of Product X (because of the same country exception). A taxpayer s claim that Branch A should be a separate corporation because of Branch A s rate disparity with FS would be an affirmative use of the branch rules, since it would be favorable to the taxpayer. 63

64 Future Guidance The Service has stated that it plans to issue future guidance regarding: When a branch should be treated as a separate corporation under IRC Sect. 954(d)(2) The coordination of the foreign base company sales and services rules. Presumably, this guidance will address open issues regarding whether the Service can recast a service relationship as a sales relationship. This question arises most commonly in the following two scenarios: CFC makes unrelated purchases and sales, and engages a contract manufacturer to provide manufacturing services. CFC engages a commission agent to provide marketing and sales support services. 64