tax notes international - Tuck School of Business - Dartmouth College

SPECIAL REPORTS
create unintended branch rule issues for taxpayers (for
example, as a result of employees of a contract manufacturer
being treated as employees of the CFC under
such a definition). 1
Thus, the final regulations, the preamble states, provide
that employee means any individual who under
Treas. reg. section 31.3121(d)-1(c) has the status of an
employee for U.S. federal income tax purposes. This
definition of the term ‘‘employee’’ may encompass
some seconded workers, part-time workers, workers on
the payroll of a related employment company whose
activities are directed and controlled by CFC employees,
and contractors, so long as those individuals
are deemed to be employees of the CFC under Treas.
reg. section 31.3121(d)-1(c).
The preamble notes that this definition may result in
an individual being treated as an employee of two or
more entities simultaneously.
Substantial Contribution Activities
The substantial contribution activities, that is, the
nonexclusive list of activities that will be considered in
determining whether manufacturing takes place, are at
the heart of the new regulation. They were reworded
somewhat and are set forth below:
1. Oversight and direction of the activities or
processes pursuant to which the property is
manufactured, produced, or constructed (under
the ‘‘physical manufacturing’’ rules).
2. Activities that are considered in, but that are
insufficient to satisfy, the tests for ‘‘physical
manufacturing.’’
3. Material selection, vendor selection, or control
of the raw materials, work-in-process, or finished
goods.
4. Management of manufacturing costs or capabilities
(for example, managing the risk of loss,
cost reduction, or efficiency initiatives associated
with the manufacturing process, demand planning,
production scheduling, or hedging raw material
costs).
5. Control of manufacturing-related logistics.
6. Quality control (for example, sample testing or
establishment of quality control standards).
7. Developing, or directing the use or development
of, product design and design specifications,
as well as trade secrets, technology, or other intellectual
property for the purpose of manufacturing,
producing, or constructing the personal property.
1 See below for a discussion of the possible effects of this new
rule under the temporary branch rule regulations.
Under Treas. reg. section 1.954-3(a)(4)(iv)(c), all
CFC employee functions contributing to the manufacture
of the personal property will be considered in the
aggregate when determining whether a substantial contribution
is made to the manufacture of the personal
property through the activities of the CFC’s employees.
There is no single activity that will be accorded more
weight than any other activity in every case or that will
be required to be performed in all cases. There is no
minimum threshold for functions performed by employees
of a CFC before the functions regarding a
given activity may be taken into account as part of the
substantial contribution test. Therefore, all functions
performed by a CFC’s employees are considered (and
given appropriate weight) under the substantial contribution
test, even if the CFC’s employees perform only
some of the functions in connection with any one activity
(for example, some of the vendor selection) considered
under that test.
The weight given to any functions performed by employees
of the CFC regarding any activity will be
based on the economic significance of those functions
to the manufacture, production, or construction of the
relevant personal property and will vary with the facts
and circumstances. Only activities of the CFC’s employees
are considered in the substantial contribution
analysis, and, consequently, purely contractual assumptions
of risk are not considered in the substantial contribution
analysis. A CFC will not be precluded from
making a substantial contribution simply because other
persons make a substantial contribution to the manufacture,
production, or construction of that property.
The importance of oversight and direction of the
activities or processes under which personal property is
manufactured, produced, or constructed will vary
based on the facts and circumstances associated with
the manufacture, production, or construction at issue.
The preamble states that oversight and direction of the
activities or process under which personal property is
manufactured are likely to be important elements in
many substantial contribution analyses. In some industries,
a substantial contribution could be made by a
CFC without its employees engaging in oversight and
direction of the activities or process under which personal
property is manufactured.
Since the regulations provide that only activities of
the CFC’s employees are considered in the analysis,
mere contractual rights, legal title, tax ownership, or
assumption of economic risk are not considered in the
substantial contribution analysis. The CFC does not
need to own the raw materials that are used in the
manufacturing process.
The proposed regulations used the term ‘‘management
of the manufacturing profits.’’ The IRS and Treasury
intend that the substantial contribution test recognize
contributions made by a CFC’s employees to the
manufacturing process through functions that help ensure
a plant is run in an economically efficient manner,
448 • FEBRUARY 2, 2009 TAX NOTES INTERNATIONAL
(C) Tax Analysts 2009. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.