[Federal Register Volume 73, Number 249 (Monday, December 29, 2008)]
[Rules and Regulations]
[Pages 79334-79354]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E8-30727]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9438]
RIN 1545-BI50


Guidance Regarding Foreign Base Company Sales Income

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains final and temporary regulations that 
provide guidance relating to foreign base company sales income in cases 
in which personal property sold by a controlled foreign corporation is 
manufactured,

[[Page 79335]]

produced, or constructed pursuant to a contract manufacturing 
arrangement or by one or more branches of the controlled foreign 
corporation. These regulations modify the foreign base company sales 
income regulations to address current business structures and 
practices, particularly the growing importance of contract 
manufacturing and other manufacturing arrangements. These regulations, 
in general, will affect controlled foreign corporations and their 
United States shareholders. The text of the temporary regulations also 
serves as the text of the proposed regulations set forth in the notice 
of proposed rulemaking on this subject in the Proposed Rules section in 
this issue of the Federal Register.

DATES: Effective Date. These regulations are effective July 1, 2009.
    Applicability Date. For dates of applicability, see Sec.  1.954-
3(c) and Sec.  1.954-3T(e). The final regulations shall apply to 
taxable years of controlled foreign corporations beginning after June 
30, 2009, and for taxable years of United States shareholders in which 
or with which such taxable years of the controlled foreign corporations 
end. The temporary regulations shall apply to taxable years of 
controlled foreign corporations beginning after June 30, 2009, and for 
taxable years of United States shareholders in which or with which such 
taxable years of the controlled foreign corporations end.

FOR FURTHER INFORMATION CONTACT: Ethan Atticks, (202) 622-3840 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    On February 28, 2008, the IRS and the Treasury Department published 
in the Federal Register proposed regulations (REG-124590-07, 2008-16 
IRB 801, 73 FR 10716, as corrected at 73 FR 20201), which provided 
proposed amendments to Sec.  1.954-3, addressing the treatment of 
contract manufacturing arrangements under the foreign base company 
sales income (FBCSI) rules. Written comments were received in response 
to the notice of proposed rulemaking, and a public hearing on the 
proposed regulations was held on July 29, 2008.
    Section 954(d)(1) defines FBCSI to mean income derived by a 
controlled foreign corporation (CFC) in connection with: (1) The 
purchase of personal property from a related person and its sale to any 
person, (2) the sale of personal property to any person on behalf of a 
related person, (3) the purchase of personal property from any person 
and its sale to a related person or (4) the purchase of personal 
property from any person on behalf of a related person, provided (in 
all these cases) that the property is manufactured, produced, grown or 
extracted outside of the CFC's country of organization and is sold for 
use, consumption or disposition outside of such country.
    The existing regulations further define FBCSI and the applicable 
exceptions from FBSCI, including the exceptions to the FBCSI rules for 
personal property that is: (1) Manufactured, produced, constructed, 
grown, or extracted within the CFC's country of organization (same 
country manufacture exception); (2) sold for use, consumption or 
disposition within the CFC's country of organization; and (3) 
manufactured, produced, or constructed by the CFC (the manufacturing 
exception). See Sec.  1.954-3(a)(2)-(4).
    The existing regulations set forth certain tests to determine 
whether a CFC satisfies the manufacturing exception: The ``substantial 
transformation test'' of Sec.  1.954-3(a)(4)(ii) and the ``substantive 
test'' and safe harbor of Sec.  1.954-3(a)(4)(iii). For purposes of 
this preamble, the requirements of Sec.  1.954-3(a)(4)(ii) and 1.954-
3(a)(4)(iii) will be referred to collectively as the ``physical 
manufacturing test'' and the satisfaction of either test will be 
described as ``physical manufacturing.''
    The proposed regulations provide a third test for satisfying the 
manufacturing exception, which may apply when a CFC is involved in the 
manufacturing process but does not satisfy the physical manufacturing 
test. In particular, the proposed regulations provide that a CFC will 
satisfy the manufacturing exception if the facts and circumstances 
evince that the CFC makes a substantial contribution through the 
activities of its employees to the manufacture, production, or 
construction of personal property (substantial contribution test). The 
proposed regulations also propose other modifications to the existing 
regulations to address the treatment of contract manufacturing 
arrangements under the FBCSI rules.
    Written comments were received in response to the notice of 
proposed rulemaking, and a public hearing was held on July 29, 2008. 
After consideration of all the comments, the proposed regulations, as 
revised by this Treasury decision, are adopted as final and temporary 
regulations.

Summary of Comments and Explanation of Provisions

    This Treasury decision contains final and temporary regulations 
relating to FBCSI. The temporary regulations contained in this Treasury 
decision also serve as the text of proposed regulations set forth in a 
notice of proposed rulemaking on this subject in the Proposed Rules 
section in this issue of the Federal Register. The preamble to this 
Treasury decision will refer to the proposed regulations published in 
the Federal Register on February 28, 2008, as the proposed regulations. 
The preamble will refer to the regulations that are published 
simultaneously as temporary regulations in this Treasury decision and 
as proposed regulations in this issue of the Federal Register as the 
temporary regulations.

A. Substantial Contribution Test

    The proposed regulations provide that a CFC will satisfy the 
substantial contribution test with respect to personal property only if 
all the facts and circumstances evince that the CFC makes a substantial 
contribution through the activities of its employees to the manufacture 
of the property. Prop. Reg. Sec.  1.954-3(a)(4)(iv)(b) includes a non-
exclusive list of activities (collectively, ``indicia of 
manufacturing'') to be considered in determining whether the CFC 
satisfies the substantial contribution test with respect to the 
manufacture, production, or construction of the personal property 
(manufacture of the personal property) under all the facts and 
circumstances.
1. General Operation of Substantial Contribution Test
    In response to the proposed regulations, commentators requested 
further elaboration of the general operation of the substantial 
contribution test. For example, commentators requested guidance on the 
amount of activity performed by a CFC's employees that would be 
necessary to ``satisfy'' each individual activity listed among the 
indicia of manufacturing. Several commentators requested clarifications 
that suggested they believed that a certain threshold of employee 
activity was required before the activity would be considered in 
determining whether a CFC satisfied the substantial contribution test. 
Commentators requested, for example, clarification as to whether the 
``vendor selection'' activity is satisfied if the CFC provides a 
contract manufacturer with an approved list of vendors but allows the 
contract manufacturer to make the final determination regarding the 
vendors to be used.
    Commentators also requested guidance on how the indicia of 
manufacturing should be weighed in relation to one another and whether 
performing a certain minimum number of activities was required in order 
for

[[Page 79336]]

the substantial contribution test to be satisfied. Others asked that 
the regulations explain whether a CFC must perform any particular 
activity in all cases to satisfy the substantial contribution test (for 
example, whether a CFC must always perform oversight and direction of 
the manufacturing process to satisfy the substantial contribution 
test). Some commentators requested that the regulations emphasize that 
the importance of each activity would vary by industry and by taxpayer. 
Commentators also requested that the regulations make clear that a CFC 
need not perform all of the indicia of manufacturing to establish a 
substantial contribution, and that the weight given to activities 
performed by employees of the CFC will depend on the economic 
significance of those activities to the business of the taxpayer with 
respect to the product being manufactured.
    Although the proposed regulations provide guidance on many of these 
issues, the IRS and the Treasury Department believe that additional 
guidance with respect to the application of the substantial 
contribution test is warranted in light of the comments received. 
Consequently, Sec.  1.954-3(a)(4)(iv)(c) is added to the final 
regulations to provide further clarification on the application of the 
substantial contribution test. First, Sec.  1.954-3(a)(4)(iv)(c) 
clarifies that 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 a 
CFC's employees. Second, Sec.  1.954-3(a)(4)(iv)(c) clarifies that 
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. Third, it clarifies that there is no minimum threshold 
with respect to functions performed by employees of a CFC before their 
functions with respect to 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, but not all, of the vendor selection) 
considered under that test. The weight given to any functions performed 
by employees of the CFC with respect to any activity will be based on 
the economic significance of those functions to the manufacture, 
production, or construction of the relevant personal property. 
Corresponding amendments and additional examples have been added to the 
final regulations to illustrate further the application of the 
substantial contribution test. See Sec.  1.954-3(a)(4)(iv)(d).
    Other commentators sought clarification as to the extent to which 
purely contractual assumptions of risk are considered in a substantial 
contribution analysis. The IRS and the Treasury Department believe that 
no further clarification in the final regulations is necessary to 
address this point. Both the proposed and final regulations provide 
that 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.
    In addition, commentators requested that the regulations clarify 
that more than one person can provide a substantial contribution to the 
manufacturing process with respect to a given product. In response to 
this comment, the IRS and the Treasury Department amended the 
regulations to clarify that a CFC will not be precluded from making a 
substantial contribution to the manufacture of the personal property by 
the fact that other persons also make a substantial contribution to the 
manufacture, production, or construction of that property. Further, 
Sec.  1.954-3(a)(4)(iv)(d) Example 9 is added to the final regulations 
to illustrate that more than one person can provide a substantial 
contribution to the manufacture of the same property.
2. Indicia of Manufacturing
    The IRS and the Treasury Department received numerous comments with 
respect to the specific activities listed in the proposed regulation 
that are considered in determining whether a CFC makes a substantial 
contribution through its employees to the manufacture, production, or 
construction of personal property.
a. Oversight and Direction of Manufacturing
    Commentators requested that the IRS and the Treasury Department 
clarify certain issues related to the ``oversight and direction of the 
activities or process'' pursuant to which personal property is 
manufactured, produced, or constructed. Some commentators asked that 
the regulations provide that oversight and direction of the activities 
or process pursuant to which personal property is manufactured, 
produced, or constructed be a prerequisite for satisfying the 
substantial contribution test. Other commentators requested that the 
IRS and the Treasury Department clarify that in certain industries a 
substantial contribution can be made by a CFC without its employees 
engaging in significant oversight and direction of the activities or 
process pursuant to which personal property is manufactured, produced, 
or constructed. Some commentators focused on the fact that in an 
example in the proposed regulations the CFC was not treated as making a 
substantial contribution to the manufacture of personal property when 
the CFC did not ``regularly exercise'' oversight and direction with 
respect to the contract manufacturer. See Prop. Reg. Sec.  1.954-
3(a)(4)(iv)(c) Example 1.
    The importance of oversight and direction of the activities or 
process pursuant to which personal property is manufactured, produced, 
or constructed will vary based on the facts and circumstances 
associated with the specific manufacture, production, or construction 
at issue. The IRS and the Treasury Department acknowledge that 
oversight and direction of the activities or process pursuant to which 
personal property is manufactured, produced, or constructed is likely 
to be an important element in many, but not all, substantial 
contribution analyses. Thus, to address taxpayer comments, the examples 
in the final regulations are amended to make clear that oversight and 
direction is not a prerequisite for satisfying the substantial 
contribution test and that in certain industries a substantial 
contribution could be made by a CFC without its employees engaging in 
oversight and direction of the activities or process pursuant to which 
personal property is manufactured, produced, or constructed. Finally, 
the examples in the final regulations do not use the potentially 
confusing reference to ``regularly'' exercising oversight.
b. Material Selection, Vendor Selection, and Control of the Raw 
Materials, Work-in-process, and Finished Goods
    Some commentators asked if other activities listed among the 
indicia of manufacturing also represented means of exercising control 
of the raw materials, work-in-process and finished goods. The IRS and 
the Treasury Department acknowledge that some of the activities in the 
indicia of manufacturing may overlap with other activities in that 
list. The final regulations require a substantial contribution to the 
manufacture of the personal property through the activities of the 
CFC's employees and not

[[Page 79337]]

satisfaction of any specific activity in the indicia of manufacturing. 
Therefore, the IRS and the Treasury Department determined that it was 
not necessary to clarify whether any particular function might 
reasonably be included under more than one heading in the indicia of 
manufacturing. However, to provide further clarity, the final 
regulations group material selection, vendor selection, and control of 
the raw materials, work-in-process, and finished goods as a single 
activity in the indicia of manufacturing.
    Commentators asked whether the control of the raw materials, work-
in-process, and finished goods refers to the CFC having the contractual 
right to take possession of the personal property, to have title to the 
property, or to have economic risk of loss with respect to the 
property. These commentators requested clarification regarding whether 
tax ownership of raw materials, work-in-process and finished goods is 
required to have control of the raw materials, work-in-process, and 
finished goods. In connection with this question, commentators also 
asked whether a CFC can satisfy the substantial contribution test when 
the contract manufacturing arrangement is buy-sell or ``turnkey'' (that 
is, when the contract manufacturer purchases the raw materials).
    Both the proposed and final regulations provide that only 
activities of the CFC's employees are considered in the substantial 
contribution analysis. Thus, mere contractual rights, legal title, tax 
ownership, or assumption of economic risk are not considered in the 
substantial contribution analysis. To provide greater clarity, the 
final regulations revise Prop. Reg. Sec.  1.954-3(a)(4)(iv)(a), 
deleting the phrase ``purchased by a controlled foreign corporation'' 
in the first sentence of Prop. Reg. Sec.  1.954-3(a)(4)(iv)(a) to 
eliminate any inference that a CFC needs to own the raw materials that 
are used in the manufacturing process. In addition, examples in the 
final regulations clarify that buy-sell or turnkey contract 
manufacturing arrangements may satisfy the substantial contribution 
test. See Sec.  1.954-3(a)(4)(iv)(d) Examples 3 and 9.
c. Management of Manufacturing Profits and Management of Risk of Loss
    Commentators requested clarification regarding which functions 
would qualify as ``management of the manufacturing profits'' or 
``management of the risk of loss.'' Some commentators expressed 
concerns regarding the term ``management of the manufacturing 
profits.'' Other commentators suggested that it would add clarity if 
``management of the risk of loss'' were deleted from Prop. Reg. Sec.  
1.954-3(a)(4)(iv)(b)(1) and included with ``management of manufacturing 
profits'' in a single item in the indicia of manufacturing. Some 
commentators expressed concern that the term ``management of the risk 
of loss'' implicitly excluded all other risk management functions. One 
commentator expressed the view that the indicia of manufacturing should 
include reference to management of enterprise risk, other than risks 
pertaining exclusively to sales and marketing functions. Some 
commentators suggested that management of the manufacturing profits 
might refer to such activities as the management of risks related to 
the raw materials and the utilization of plant capacity, but others 
thought it might encompass the finance function of a company.
    The IRS and the Treasury Department agree that further 
clarification is needed as to the functions that are intended to be 
included within what was labeled ``management of the manufacturing 
profits'' and ``management of the risk of loss'' in the proposed 
regulations. The IRS and the Treasury Department intend that the 
substantial contribution test recognize contributions made by a CFC's 
employees to the manufacturing process through functions which help to 
ensure that a plant is run in an economically efficient manner, such as 
optimization of plant capacity and reduction of waste (for example, 
waste of raw materials). On the other hand, not all corporate 
managerial decisions are intended to be considered in the substantial 
contribution test, because many such decisions are not directly related 
to the manufacture of the personal property with respect to which the 
substantial contribution analysis is being performed. For example, the 
IRS and the Treasury Department do not intend that corporate finance 
decisions be considered in the substantial contribution test. 
Similarly, the IRS and the Treasury Department do not intend that the 
general management of enterprise risk be considered in the substantial 
contribution test.
    The IRS and the Treasury Department concluded that the term 
``management of the manufacturing costs or capacities'' more accurately 
reflects the type of functions originally contemplated by ``management 
of the manufacturing profits'' in the proposed regulations and is also 
related to the types of functions contemplated by the ``management of 
the risk of loss.'' Accordingly, the activity labeled ``management of 
the manufacturing profits'' in the proposed regulations is replaced in 
the final regulations with an activity entitled ``management of 
manufacturing costs or capacities.'' Further, the final regulations 
include a parenthetical list of functions (that is, managing the risk 
of loss, cost reduction or efficiency initiatives associated with the 
manufacturing process, demand planning, production scheduling, or 
hedging raw material costs) to elaborate on the meaning of the 
activity.
d. Control of Logistics
    Commentators asked for clarification regarding the scope of 
logistical functions that will contribute towards a substantial 
contribution by a CFC. This activity is intended to include, for 
example, arranging for delivery of raw materials to a contract 
manufacturer, but to exclude, for example, delivery of finished goods 
to a customer. The final regulations provide further clarity on this 
issue by revising the activity to read ``control of manufacturing 
related logistics.''
e. Direction of the Development, Protection, and Use of Trade Secrets, 
Technology, Product Design, and Design Specifications, and Other 
Intellectual Property Used in Manufacturing the Product
    Commentators noted that the ``and'' in the description of this 
activity in the proposed regulations could be read to mean that 
directing the ``development, protection, and use'' of intellectual 
property are all required for this activity to be considered in the 
substantial contribution analysis. Commentators requested that these 
activities be stated in the disjunctive. The IRS and the Treasury 
Department adopted this comment, replacing ``and'' with ``or'' in the 
final regulations. This clarification is consistent with providing that 
all functions performed by a CFC's employees are considered (and given 
appropriate weight) under the substantial contribution test. Thus, the 
CFC's employees' activities are considered regardless of whether the 
CFC's employees perform all or only some of the functions listed in any 
enumerated item in the indicia of manufacturing.
    The term ``protection'' is also deleted from the final regulations. 
The IRS and the Treasury Department were concerned that absent this 
clarification the final regulations could be read to provide that legal 
work performed by a CFC's in-house legal staff was considered under the 
substantial contribution test, including in cases where, for example, 
litigation success could be heavily correlated to

[[Page 79338]]

profitability or business failure with respect to a product. Further, 
the IRS and the Treasury Department modified the description of the 
activity in the final regulations to clarify that developing, or 
directing the use or development of, trade secrets, technology, or 
other intellectual property, are considered under the substantial 
contribution test, but only when activities of this nature are 
undertaken for the purpose of the manufacture of the personal property.
    Commentators asked whether the intellectual property referred to in 
Prop. Reg. Sec.  1.954-3(a)(4)(iv)(b)(9) included marketing 
intangibles. The activity as described in both the proposed and final 
regulations is with respect to intellectual property used in the 
manufacture of the personal property. Thus, developing, or directing 
the use or development of, marketing intangibles is not intended to be 
considered in the substantial contribution test.
3. Anti-abuse Rule and Safe Harbor
    The IRS and the Treasury Department requested comments on whether 
the substantial contribution test should include an anti-abuse rule and 
safe harbor. In particular, comments were requested as to whether it 
would be appropriate to add an anti-abuse rule to prevent a CFC from 
satisfying the substantial contribution test in cases in which a 
significant portion of the direct or indirect contributions to the 
manufacture of personal property provided collectively by the CFC and 
any related U.S. persons are provided by one or more related U.S. 
persons. Commentators recommended that in determining whether a CFC 
makes a substantial contribution it should not be relevant whether 
other persons (whether U.S. or foreign, related or unrelated) 
contribute to the manufacturing process. The IRS and the Treasury 
Department agree with commentators that the substantial contribution 
test should focus on whether the activities of the CFC itself are 
substantial without comparing those activities to those of other 
persons. Thus, the final regulations do not adopt such a rule. Examples 
in the final regulations also illustrate that the contributions of 
other persons to the manufacture of a product are not relevant to the 
analysis of whether a CFC makes a substantial contribution to the 
manufacturing process. See Sec.  1.954-3(a)(4)(iv)(d) Examples 6, 7, 
and 9.
    The IRS and the Treasury Department also requested comments as to 
whether one or more safe harbors should be added to the substantial 
contribution test of the proposed regulations. Some commentators 
suggested that a CFC that contributes at least twenty percent of the 
costs of manufacturing personal property should be deemed to have 
substantially contributed to its manufacture. Other commentators 
suggested that a safe harbor was only appropriate if it were made clear 
that such a safe harbor would not function as a minimum standard and 
would be flexible enough to accommodate multiple industries. Many other 
commentators recommended that the IRS and the Treasury Department not 
adopt a safe harbor. The IRS and the Treasury Department concluded that 
no safe harbor could fairly apply across the range of industries 
potentially subject to Sec.  1.954-3, and therefore no safe harbor is 
provided in the final regulations.
4. Definition of Employee
    The IRS and the Treasury Department requested comments as to 
whether the requirement in the proposed regulations that the activities 
of the CFC be performed by its employees should take into account 
commercial arrangements where individuals performing services for the 
CFC while not on its payroll are nevertheless controlled by employees 
of the CFC. Commentators requested that the regulations expand the 
definition of the term ``employee'' to include various commercial or 
economic arrangements where individuals who perform services for a CFC 
under the CFC's direction and control are not necessarily the CFC's 
employees under local law. In particular, commentators suggested that 
the term ``employee'' could be defined for purposes of the substantial 
contribution test using section 3121(d)(2). Other commentators asked 
that the term ``employee'' be defined more broadly to include anyone in 
an agency relationship with a CFC.
    The IRS and the Treasury Department agree that clarification of the 
term ``employee'' will promote more effective application of these 
regulations. The IRS and the Treasury Department also agree that 
activities performed by certain non-payroll workers should be 
considered in determining whether the CFC provides a substantial 
contribution through ``its employees.'' However, the IRS and the 
Treasury Department concluded that it would be inappropriate to broaden 
the definition of employee to include anyone in an agency relationship 
with a CFC, because it could 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). Thus, the final regulations provide that the term employee 
means any individual who, under Sec.  31.3121(d)-1(c), has the status 
of an employee for U.S. Federal tax purposes. This definition of the 
term ``employee'' may encompass certain 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 Sec.  31.3121(d)-1(c). Consistent with commentators' 
request, this definition of the term employee may result in an 
individual being treated as an employee of two or more entities 
simultaneously.
5. Product Grouping
    Commentators requested that the determination of whether a CFC 
provides a substantial contribution to the manufacture of the personal 
property be made on the basis of a group or line of related products 
rather than on a product-by-product basis. The IRS and the Treasury 
Department believe that the substantial contribution test must be met 
with respect to each product. Whether manufactured goods are separate 
products or a single product for this purpose is determined by 
reference to the distinctions or lack thereof made by the CFC in its 
business operations and in its books and records, rather than by 
reference to a third party's definition of a product or an industry 
product classification system, such as the Standard Industrial 
Classification Code. The IRS and the Treasury Department recognize that 
some activities taken into account under the substantial contribution 
test are not performed with respect to each individual unit of a 
particular product manufactured under a contract manufacturing 
arrangement. Section 1.954-3(a)(4)(iv)(d) Example 11 has been added to 
the final regulations to address these comments.
6. Treatment of Partnerships
    Commentators requested that the regulations adopt principles to 
determine when the employees of a partnership should be treated as 
employees of the CFC for purposes of determining whether the CFC's 
relative economic interest in the partnership should be relevant in 
determining whether the CFC satisfies the substantial contribution 
test. The IRS and the Treasury Department concluded that this issue was 
beyond the scope of this regulatory project. However, the IRS and the 
Treasury Department continue to study this issue and welcome comments.

[[Page 79339]]

7. Rebuttable Presumption
    The proposed regulations provide a rebuttable presumption that the 
CFC does not satisfy the substantial contribution test when the 
activities of a branch of the CFC satisfy the physical manufacturing 
test. The presumption can only be rebutted if the taxpayer can prove to 
the satisfaction of the Commissioner that the CFC satisfied the 
substantial contribution test. Commentators suggested that satisfaction 
of the physical manufacturing test and satisfaction of the substantial 
contribution test should be treated equally under the regulations. 
Commentators also expressed the view that the standard required to 
rebut the presumption was either too subjective, imposed an improperly 
high standard, or both. They recommended that if a rebuttable 
presumption was retained, the standard required to rebut the 
presumption should be clear and convincing evidence.
    In response to the comments received, the IRS and the Treasury 
Department reconsidered the ability to examine a CFC's claim that it 
substantially contributes to the manufacture of the personal property 
when the activities of its branch satisfy the physical manufacturing 
test. Upon further study, the IRS and the Treasury Department concluded 
that the substantial contribution test can be administered without the 
benefit of a rebuttable presumption that a CFC does not satisfy the 
substantial contribution test when the activities of a branch of the 
CFC satisfy the physical manufacturing test. Thus, these final and 
temporary regulations do not contain a rebuttable presumption. The IRS 
and the Treasury Department took into account the request for parity of 
treatment with respect to satisfaction of the physical manufacturing 
test and the substantial contribution test in reaching this conclusion, 
as well as with respect to other aspects of the temporary regulations, 
as discussed further in Parts C and D of this preamble.
8. Documentation
    Some commentators requested guidance on how taxpayers should 
document their activities for application of the substantial 
contribution test. Because the necessary documentation will vary by 
industry and by taxpayer, the IRS and the Treasury Department believe 
that creating general rules of documentation would prove impracticable 
and would not allow for enough flexibility in application of the 
substantial contribution test. Accordingly, the final regulations do 
not include documentation rules.
9. Automated Manufacturing
    Several comments were received concerning Prop. Reg. Sec.  1.954-
3(a)(4)(iv)(c) Example 4. In Example 4, a CFC owns software and network 
systems that remotely and automatically (without human involvement) 
order raw materials for use by the contract manufacturer, take customer 
orders and route them to the contract manufacturer, and perform quality 
control. Although the CFC has a small number of computer technicians 
monitoring the software and network systems, the software and network 
systems were developed by employees of DP, the CFC's domestic parent 
corporation. Those DP employees supervise the CFC's computer 
technicians, evaluate the results of the automated manufacturing 
business, make ongoing operational decisions related to the performance 
of the manufacturing process, redesign and update the products and the 
manufacturing process, and develop all of the upgrades and patches for 
the software and network systems owned by the CFC. The example 
concludes that the CFC does not provide a substantial contribution to 
the manufacture of Product X.
    Commentators expressed concern that Prop. Reg. Sec.  1.954-
3(a)(4)(iv)(c) Example 4 did not recognize the importance of automated 
manufacturing in modern business practices. These commentators noted 
that manufacturing processes are increasingly automated and explained 
that in some high technology industries, automated manufacturing 
processes are the only way to manufacture and test the quality of 
certain products. In such industries, commentators noted that human 
involvement in various parts of the manufacturing process could be 
counterproductive. Some commentators were concerned that Prop. Reg. 
Sec.  1.954-3(a)(4)(iv)(c) Example 4 penalized such automated 
manufacturing processes under the substantial contribution test.
    The IRS and the Treasury Department agree that a CFC may provide a 
substantial contribution to a largely automated manufacturing process 
through its employees. Section 1.954-3(a)(4)(iv)(d) Example 5 contains 
the same facts as Prop. Reg. Sec.  1.954-3(a)(4)(iv)(c) Example 4. 
Under those particular facts, substantial operational responsibilities 
and decision making by humans are required for the manufacturing 
process; however, they are not performed by the CFC. To provide 
additional guidance, the final regulations include an additional 
example, Sec.  1.954-3(a)(4)(iv)(d) Example 6, which illustrates that a 
CFC whose employees perform most of the functions that DP's employees 
perform in Sec.  1.954-3(a)(4)(iv)(d) Example 5 makes a substantial 
contribution to the manufacturing process. This result applies even 
though DP's employees also contribute to the manufacturing process. 
Section 1.954-3(a)(4)(iv)(d) Example 7 further illustrates that the CFC 
can make a substantial contribution through the activities of its 
employees regardless of whether the software and network systems were 
purchased by the CFC. These examples illustrate that the evaluation of 
whether a CFC makes a substantial contribution through its employees is 
determined based on whether industry-sufficient substantial 
contribution activities are conducted by employees of the CFC.

B. The ``Its'' Argument

    The proposed regulations clarify that for purposes of determining 
FBCSI a CFC qualifies for the manufacturing exception only if the CFC, 
acting through its employees, manufactured, produced, or constructed 
the relevant personal property within the meaning of Sec.  1.954-
3(a)(4)(i). In response to the proposed regulations, some commentators 
maintained that a CFC need not satisfy the physical manufacturing test 
or the substantial contribution test to exclude a sale from FBCSI as 
long as the personal property sold is not the same as the property 
originally purchased by the CFC.
    The IRS and the Treasury Department believe, as described in the 
preamble to the proposed regulations, that this position, commonly 
referred to as the ``its'' argument, is contrary to existing law, and 
represents an incorrect reading of section 954(d)(1). The final 
regulations accordingly maintain the rules provided in the proposed 
regulations regarding when personal property sold by a CFC will be 
considered to be other than the property purchased by the CFC.

C. Same Country Manufacture Exception

    Commentators requested that the regulations incorporate the 
substantial contribution test in the same country manufacture 
exception. The IRS and the Treasury Department generally agree with 
commentators that if the substantial contribution test is sufficient to 
constitute the manufacture of the personal property where a CFC 
substantially contributes to the manufacture, production, or 
construction of that property, then it

[[Page 79340]]

should be equally sufficient if those activities are performed by a 
related person (as defined in section 954(d)(3)) in the CFC's country 
of organization. However, the IRS and the Treasury Department concluded 
that the same country manufacture exception would be difficult to 
administer and enforce in the case of a substantial contribution 
performed by an unrelated third party. Commentators suggested that 
these concerns could be ameliorated if taxpayers were required to 
maintain documentation with respect to a third party's substantial 
contribution. The IRS and the Treasury Department do not believe a 
documentation requirement adequately addresses these concerns because 
the IRS may be unable to audit the third party to verify if those 
substantial contribution activities in fact took place. Therefore, the 
final regulations provide that the same country manufacture exception 
is available to taxpayers in cases when a related person provides a 
substantial contribution to the manufacture of the personal property in 
the CFC's country of organization. The final regulations also retain 
the rule provided in the proposed regulations modifying the application 
of the principles of Sec.  1.954-3(a)(4)(ii) and (a)(4)(iii) to reflect 
that the personal property manufactured, produced, or constructed in 
the country of organization of the selling corporation under the 
principles of Sec.  1.954-3(a)(4)(ii) and (a)(4)(iii) will qualify for 
the same country exception regardless of whose employees engage in 
qualifying manufacturing activities in that country.

D. Branch Rule

    In addition to the amendments to Sec.  1.954-3(a), the proposed 
regulations also proposed amendments to the rules of Sec.  1.954-3(b) 
dealing with the application of the FBCSI rules to CFCs with branches 
or similar establishments (the branch rule), particularly the rules 
dealing with manufacturing branches. For the remainder of this 
preamble, the word ``branch'' will be used to refer to a ``branch or 
similar establishment.''
1. Branch Definition
    Some commentators requested that the regulations define the term 
``branch'' for purposes of the branch rule. These commentators 
suggested various definitions for the IRS and the Treasury Department 
to consider. Commentators suggested, for instance, that a branch be 
defined as a permanent establishment, as a business activity in a 
jurisdiction outside a CFC's country of organization that has separate 
books and records, or as a trade or business outside a CFC's country of 
organization. Commentators pointed to precedents in the section 367 and 
987 regulations. Alternatively, some commentators requested that the 
regulations make clear that a de minimis amount of activity outside of 
a CFC's country of organization (for example, traveling employees) does 
not constitute a branch. Other commentators warned that requiring too 
high a level of activity outside of a CFC's country of organization 
before a CFC was treated as having a ``branch'' would make it possible 
for a CFC organized in a lower-tax jurisdiction to contribute 
substantially to manufacturing activities in a higher-tax jurisdiction 
without causing the CFC to operate through a branch. Still other 
commentators suggested that courts have concluded that the IRS and the 
Treasury Department lack the regulatory authority to determine what 
constitutes a branch, and they may only address the consequences 
flowing from the existence of a branch.
    The IRS and the Treasury Department determined that defining a 
branch was beyond the scope of this regulatory project. However, the 
temporary regulations retain an example similar to Prop. Reg. Sec.  
1.954-3(b)(1)(ii)(c)(3)(f) Example 3, which illustrates that employees 
of a CFC that travel to a contract manufacturer's location outside the 
CFC's country of organization do not necessarily give rise to a branch 
in that location. See Sec.  1.954-3T(b)(1)(ii)(c)(3)(v) Example 6. See 
also Part D.3.b of this preamble.
2. Determination of Hypothetical Effective Tax Rate
    Commentators requested that the regulations clarify that the tax 
rate disparity tests contained in Sec. Sec.  1.954-3(b)(1)(i)(b) and 
(b)(1)(ii)(b) take into account incentive tax rates and other similar 
foreign tax relief available to a CFC in calculating the hypothetical 
effective tax rate of tax.
    The IRS and the Treasury Department recognize that the tax rate 
disparity tests should take into account the actual tax rate paid with 
respect to the sales income by the selling branch or remainder and the 
hypothetical effective tax rate that would be paid by the manufacturing 
branch (or remainder) on that sales income under the laws of the 
country in which the manufacturing branch is located (or, in the case 
of a remainder, the country of organization of the CFC) if it were 
derived from sources within that country. Thus, the IRS and the 
Treasury Department agree that uniformly available tax incentives are 
to be considered in determining the hypothetical effective tax rate to 
be used in applying the tax rate disparity tests. In contrast, if a 
sales affiliate in the country of manufacturing can theoretically 
receive certain tax relief by taking certain actions, for example, by 
applying for special treatment pursuant to a ruling process, but the 
taxpayer has not affirmatively obtained such tax relief for the 
manufacturing branch (or remainder), then the hypothetical effective 
tax rate that would be paid by the manufacturing branch (or remainder) 
were it to derive the sales income should be the effective tax rate 
that would be applicable in that jurisdiction without such tax relief. 
The IRS and the Treasury Department believe that no change to the text 
of the existing regulations is necessary to address these points. 
However, Sec.  1.954-3T(b)(4) Example (8) is included in the temporary 
regulations to illustrate that uniformly applicable incentive tax rates 
are taken into account in determining the hypothetical effective tax 
rate.
    The IRS and the Treasury Department concluded that other questions 
and requests in this area, including further clarification of the 
methodology for calculation of hypothetical tax rates, and for changes 
to the assumptions used in applying the tax rate disparity tests and 
determining the hypothetical effective tax rate, are beyond the scope 
of this regulatory project. However, the IRS and the Treasury 
Department continue to study these questions and welcome comments.
3. Multiple Manufacturing Branch Rules
a. Determination of the Location of Manufacturing
    Under Prop. Reg. Sec.  1.954-3(b)(1)(ii)(c)(3), the relevant tax 
rate disparity test is applied by giving satisfaction of the physical 
manufacturing test precedence over satisfaction of the substantial 
contribution test when multiple branches, or one or more branches and 
the remainder of the CFC, perform manufacturing activities with respect 
to the same item of personal property. If more than one branch (or one 
or more branches and the remainder of the CFC) each independently 
satisfies the physical manufacturing test, then the branch or the 
remainder of the CFC located or organized in the jurisdiction that 
would impose the lowest effective rate of tax is treated as the 
location of manufacturing, producing, or constructing of the personal 
property for purposes of applying the tax rate disparity test (lowest-
of-all-rates rule). If only one branch (or only the remainder of a CFC) 
independently satisfies the physical manufacturing test, then that

[[Page 79341]]

branch (or remainder) is treated as the location of manufacturing, 
producing, or constructing of the personal property (location of 
manufacturing) for purposes of the tax rate disparity test.
    If none of the branches or the remainder of the CFC independently 
satisfies the physical manufacturing test, but the CFC as a whole 
satisfies the substantial contribution test, then the location of 
manufacturing under the proposed regulations is the location of the 
branch or the remainder of the CFC that provides the predominant amount 
of the CFC's substantial contribution to the manufacture of the 
personal property (predominant place rule). If a predominant amount of 
the CFC's contribution to the manufacture of the personal property is 
not provided by any one location, then the location of manufacturing 
for purposes of applying the manufacturing branch tax rate disparity 
test under the proposed regulations is that place (either the remainder 
of the CFC or one of its branches) where manufacturing activity with 
respect to that property is performed and which would impose the 
highest effective rate of tax (highest-of-all-rates rule) when applying 
either Sec.  1.954-3(b)(1)(i)(b) or (b)(1)(ii)(b).
    The IRS and the Treasury Department received multiple comments 
comparing and contrasting the highest- and lowest-of-all-rates rules. 
For example, commentators asked why the lowest-of-all-rates rule should 
apply when more than one branch (or one or more branches and the 
remainder of the CFC) independently satisfy the physical manufacturing 
test, whereas the highest-of-all-rates rule should apply when none of 
the branches or the remainder of the CFC independently satisfies the 
physical manufacturing test but the CFC as a whole satisfies the 
substantial contribution test. Commentators suggested that satisfaction 
of the physical manufacturing test and the substantial contribution 
test should be treated equally under the regulations, and therefore 
suggested having the same rule in both circumstances. These 
commentators proposed a lowest-of-all-rates rule or the use of a 
weighted average of the tax rate of each branch or remainder of the CFC 
in both instances.
    The IRS and the Treasury Department generally agreed with these 
comments. The IRS and the Treasury Department adopted taxpayers' 
comment that the same rule should apply consistently when a branch (or 
remainder) independently satisfies Sec.  1.954-3(a)(4)(i), regardless 
of whether it satisfies the physical manufacturing test or the 
substantial contribution test. Therefore the rules set forth in the 
proposed regulations are modified in the temporary regulations to 
provide that the lowest-of-all-rates rule will apply whenever a branch 
(or remainder) independently satisfies Sec.  1.954-3(a)(4)(ii), (iii), 
or (iv). However, providing parity of treatment for satisfaction of the 
physical manufacturing test and the substantial contribution test in 
respect of the lowest-of-all-rates rule is not sufficient to determine 
the location of manufacturing in cases where a CFC satisfies the 
substantial contribution test, yet no branch (or remainder) 
independently satisfies Sec.  1.954-3(a)(4)(iv).
    Commentators questioned how to treat branches making contributions 
to the manufacture of the personal property through the activities of 
employees when no branch independently satisfies Sec.  1.954-
3(a)(4)(iv). Some commentators expressed concern that it would be 
difficult to compare the relative contributions of various locations to 
determine which branch or remainder of the CFC made a predominant 
contribution under the predominant place rule. Other commentators 
requested greater guidance regarding the meaning of predominant 
contribution. Many commentators suggested that the highest-of-all-rates 
rule in the proposed regulations could lead to arbitrary results when 
no predominant contributor could be identified.
    The IRS and the Treasury Department generally agreed with these 
comments. Consequently, the temporary regulations revise the rules for 
determining the location of manufacture of the personal property when 
more than one branch (or one or more branches and the remainder) 
contributes to the manufacture of the personal property but no branch 
(or remainder) independently satisfies the physical manufacturing test 
or the substantial contribution test. The revised rules are based on 
the principle that the branch rule should apply in situations where 
purchase or sale activities with respect to the personal property are 
separated from manufacturing activities conducted by the CFC such that 
a demonstrably greater amount of manufacturing activity with respect to 
that property occurs in jurisdictions with tax rate disparity relative 
to the sales or purchase branch (or, in the case of a purchasing or 
selling remainder, the demonstrably greater amount of manufacturing 
activity with respect to the personal property occurs in jurisdictions 
with tax rate disparity relative to the purchasing or selling 
remainder).
    Under the temporary regulations, if a demonstrably greater amount 
of manufacturing activity with respect to the personal property occurs 
in jurisdictions without tax rate disparity relative to the sales or 
purchase branch, the location of the sales or purchase branch will be 
deemed to be the location of manufacture of the personal property. In 
that case, the purchase or sales activities with respect to the 
property purchased or sold by or through the sales or purchase branch 
of the CFC will not, for purposes of determining FBCSI in connection 
with the sale of that property, be deemed to have substantially the 
same tax effect as if a branch were a wholly owned subsidiary 
corporation of the CFC. Otherwise, the location of manufacture of the 
personal property will be deemed to be the location of a manufacturing 
branch (or remainder) that has tax rate disparity relative to the sales 
or purchase branch. In that case, the purchase or sales activities with 
respect to the property purchased or sold by or through the sales or 
purchase branch of the CFC will be deemed to have substantially the 
same tax effect as if a branch were a wholly owned subsidiary 
corporation of the CFC, and that branch will be treated as a separate 
corporation for purposes of applying the regulations.
    The temporary regulations apply analogous rules in the case of 
purchase or sales activity being conducted through the jurisdiction 
under the laws of which the CFC is organized. In such cases, however, 
the analysis focuses on whether the demonstrably greater amount of 
manufacturing activity with respect to the personal property occurs in 
jurisdictions that do or do not have tax rate disparity relative to the 
jurisdiction under the laws of which the CFC is organized. The 
temporary regulations incorporate examples under Sec.  1.954-
3T(b)(1)(ii)(c)(3)(v) to illustrate the application of these rules.
b. Location of Activities
    The proposed regulations provide that for purposes of the multiple 
manufacturing branch rules the location of any activity with respect to 
the manufacture of the personal property is where the CFC's employees 
engage in such activity. Commentators suggested that in some cases the 
proposed regulations left it unclear, for purposes of determining the 
location of manufacturing, which jurisdiction was accorded credit for 
activities performed by an employee who is traveling temporarily to a 
foreign jurisdiction. Some commentators suggested that the location of 
activity rule should be removed or that the regulations should

[[Page 79342]]

clarify that, for instance, the activities of employees of a CFC based 
in the jurisdiction under the laws of which the CFC is organized, even 
while traveling outside the CFC's country of organization, would 
generally be credited toward establishing that the jurisdiction under 
the laws of which the CFC is organized provided a predominant amount of 
a CFC's substantial contribution. The IRS and the Treasury Department 
believe the text of Sec.  1.954-3T(b)(1)(ii)(c)(3)(iv) makes clear that 
when an employee travels to perform activities, those activities are 
credited to the location in which the activities are conducted if there 
is a branch or remainder of the CFC in that jurisdiction. Section 
1.954-3T(b)(1)(ii)(c)(3)(v) provides examples to further clarify this 
result.
    Other commentators asked which location was accorded credit, if 
any, for activities performed by traveling employees of the CFC while 
located in a country in which there is no branch or remainder of the 
CFC. The temporary regulations provide that the location of any 
manufacturing activity is where the employees of the CFC perform that 
activity. Thus, the activities of employees while traveling to a 
country where the CFC does not maintain a branch or remainder are not 
credited to the branch or remainder where the traveling employees are 
regularly employed for purposes of determining the location of 
manufacture of the personal property under the branch rule. Such 
activities, however, can be taken into account for purposes of 
satisfying the manufacturing exception and the substantial contribution 
test. See Sec.  1.954-3T(b)(1)(ii)(c)(3)(v) Example 6.
c. Clarifying Application of the Rule for Determining the Remainder of 
the CFC When Activities Are Performed in Multiple Locations
    Prop Reg. Sec.  1.954-3(b)(2)(ii)(a) provides that when treating 
the location of sales or purchase income as a separate corporation for 
purposes of determining whether FBCSI is realized, that separate 
corporation will exclude any branch or the remainder of the CFC that 
would be treated as a separate corporation, if the hypothetical tax 
rate imposed by the jurisdiction of each such branch or the remainder 
of the CFC were separately tested against the effective rate of tax 
imposed on the sales or purchase income under the relevant tax rate 
disparity test. Commentators suggested that the application of this 
rule for determining the remainder of the CFC when activities are 
preformed in multiple locations is unclear. To clarify, the language 
from the proposed regulations is revised in the temporary regulations 
to describe what is included in the remainder, rather than what is 
excluded from the remainder, for purposes of determining whether there 
is FBCSI, after it is determined that a manufacturing branch should 
receive treatment as a separate corporation for purposes of applying 
the regulations. See Sec.  1.954-3T(b)(2)(ii)(a).
    As with the rule provided in the proposed regulations, this rule is 
intended to provide that the activities of all branch locations (or, in 
the case of a remainder, the activities in the jurisdiction under the 
laws of which the CFC is organized) that do not have tax rate disparity 
relative to the sales or purchase branch location (or, in the case of a 
purchasing or selling remainder, the jurisdiction under the laws of 
which the CFC is organized) may be taken into account together with the 
activities of the sales or purchase branch (or, in the case of a 
purchasing or selling remainder, activities of the remainder of the CFC 
in the jurisdiction under the laws of which the CFC is organized) for 
purposes of applying the separate corporation analysis required under 
the regulations and determining whether the sales income of the sales 
or purchase branch (or remainder) is FBCSI. Such determination will 
depend on whether the substantial contribution test is satisfied by the 
combined activities of the sales or purchase branch (or remainder) and 
the other locations aggregated with the sales or purchase branch (or 
remainder).
4. Coordination of Sales and Manufacturing Branch Rules
    Commentators requested guidance on how the sales or purchase branch 
rules interact with the manufacturing branch rules. The current 
manufacturing branch rules contemplate the existence of a sales or 
purchase branch and a manufacturing branch. The rules provide that in 
such an instance the sales or purchase branch is treated as the 
remainder of the CFC for purposes of applying the tax rate disparity 
test. However, the sales or purchase branch rules of Sec.  1.954-
3(b)(1)(i) of the existing regulations do not indicate that those rules 
do not apply in cases where the manufacturing branch rules are applied. 
Commentators were concerned that the manufacturing branch rules would 
be applied in addition to, rather than in lieu of, the sales or 
purchase branch rules.
    The IRS and the Treasury Department agree that if one or more sales 
or purchase branches are used in addition to a manufacturing branch and 
Sec.  1.954-3T(b)(1)(ii)(c)(1) (use of one or more sales or purchases 
branches in addition to a manufacturing branch) is applied with respect 
to income from the sale of an item of personal property, then the sales 
or purchasing branch rules do not also apply to determine whether that 
income is FBCSI. Therefore, the temporary regulations clarify this 
point. See Sec.  1.954-3(b)(1)(i)(c).
5. Unrelated to Unrelated Transactions
    Commentators suggested that there was uncertainty as to whether a 
substantial contribution to the manufacture, production, or 
construction of personal property by a CFC could cause the CFC to earn 
FBCSI in cases where, in the absence of the substantial contribution 
test, some taxpayers had taken the position that they were outside the 
scope of the FBCSI rules. Some commentators expressed concern that 
transactions that are not currently subject to the existing regulations 
may become subject to the regulations as a result of the interaction of 
the substantial contribution test and the manufacturing branch rule. 
Other commentators suggested more generally that it was unclear if the 
substantial contribution test might create a branch through which a CFC 
carries on activities in a contract manufacturer's jurisdiction. 
Commentators suggested that taxpayers should be exempted from the 
branch consequences of the regulations by providing that the 
manufacturing branch rule only apply if the CFC was relying on the 
manufacturing exception for purposes of section 954(d)(1), or 
alternatively that the substantial contribution test should be 
elective. In this context, commentators noted that placing a CFC's 
substantial contribution activities, which are performed outside the 
country where the sales activities are performed, in a separately 
incorporated entity could prevent the CFC from having a branch that is 
subject to the manufacturing branch rule as a result of such 
activities.
    The IRS and the Treasury Department agree that taxpayers may be 
subject to the FBCSI rules as a result of CFC employees performing 
indicia of manufacturing activities through a branch outside the 
country of organization of a CFC. The IRS and the Treasury Department 
believe this result is clear in the proposed regulations, and therefore 
no modifications are made to the text of the temporary regulations to 
clarify further this result. The IRS and the Treasury Department note 
that many commentators criticized the proposed regulations for drawing 
inappropriate distinctions between satisfaction of the

[[Page 79343]]

physical manufacturing test and satisfaction of the substantial 
contribution test, and argued that updating the manufacturing exception 
in the context of modern business enterprise models required treating 
with equal importance and weight physical manufacturing and activities 
satisfying the substantial contribution test. The IRS and the Treasury 
Department adopted this comment in both the final regulations and the 
temporary regulations and, accordingly, did not incorporate in the 
temporary regulations an exception regarding activities performed 
through a branch located outside the country of organization of a CFC 
for cases in which, in the absence of the substantial contribution 
test, some taxpayers had taken the position that they were outside the 
scope of the FBCSI rules.
    One commentator noted that while there are strong policy reasons 
for the substantial contribution test and the branch rules to apply in 
the case of ``unrelated to unrelated'' transactions, the IRS and the 
Treasury Department should consider a special delayed effective date to 
allow taxpayers in this position time to restructure their operations 
in light of the regulations. The commentator argued that such taxpayers 
had been outside the scope of the FBCSI rules prior to these 
regulations and should be provided reasonable time to restructure. For 
a discussion of the effective date of the final and temporary 
regulations, see Part F of this preamble.
6. Branch Rule Examples
    Commentators expressed concern that the facts of Prop. Reg. Sec.  
1.954-3(b)(1)(ii)(c)(3)(f) Example 4 ascribed most substantial 
contribution activities to the remainder, but determined that the 
remainder had not met the substantial contribution test. In the 
example, the remainder performs seven activities listed in the indicia 
of manufacturing of the proposed regulations, whereas Branch A performs 
only one activity (design) and Branch B performs only two activities. 
The example was intended to show that in a CFC's particular industry, 
the weight accorded to the activities performed by each branch can be 
comparable, even though a different number of activities occur in 
different locations, because the economic significance of the 
activities conducted in each location is comparable. However, the IRS 
and the Treasury Department recognize that the example may have caused 
confusion for taxpayers. Therefore, the allocation of activities in 
Example 4 of Prop. Reg. Sec.  1.954-3(b)(1)(ii)(c)(3)(f) has been 
revised in Sec.  1.954-3T(b)(1)(ii)(c)(3)(v) Example 3. Moreover, 
Examples 4, 5, and 6 of Prop. Reg. Sec.  1.954-3(b)(1)(ii)(c)(3)(f) 
have been restructured in the temporary regulations to be consistent 
with the revisions to the branch rules.
    Commentators also noted that Example 4 and Example 5 of Prop. Reg. 
Sec.  1.954-3(b)(1)(ii)(c)(3)(f) suggest that income other than sales 
or purchasing income may be FBCSI. These examples are amended in the 
temporary regulations to be consistent with section 954(d)(2), which 
provides that income attributable to the carrying on of purchase or 
sales activities by a branch may be FBCSI.
    Commentators requested that the IRS and the Treasury Department add 
an example to the regulations to illustrate how the substantial 
contribution test and the branch rules operate in cases involving 
multiple manufacturing branches and multiple sales branches. The 
temporary regulations include such an example. See Sec.  1.954-
3T(b)(1)(ii)(c)(3)(v) Example 5.
    The temporary regulations also include an example illustrating the 
operation of the location of manufacture rules under Sec.  1.954-
3T(b)(1)(ii)(c)(3) and the application of the substantial contribution 
test when a tested manufacturing location has been determined to have 
tax rate disparity with a tested sales location. See Sec.  1.954-
3T(b)(4) Example (9). Example (9) illustrates that a tested sales 
location can satisfy the substantial contribution test for purposes of 
determining FBCSI once it has been determined that a tested 
manufacturing location should be treated as a separate corporation for 
purposes of determining FBCSI. Although a branch that has tax rate 
disparity with the tested sales location is the tested manufacturing 
location, Example (9) concludes that the CFC does not have FBCSI from 
the sale of the personal property because, after applying the 
aggregation rules of Sec.  1.954-3T(b)(2)(ii)(a), the tested sales 
location satisfies Sec.  1.954-3(a)(4)(iv).

E. Conforming Amendments

    Sections 1.954-3(a)(1)(i) and (c) of the existing regulations 
contain cross-references to foreign base company shipping income under 
Sec.  1.954-6. Section 954 was amended by Public Law 108-357 in 2004, 
and foreign base company shipping income was removed as a separate 
category of foreign base company income. The final regulations are 
amended by deleting both references to foreign base company shipping 
income to reflect the 2004 amendment to section 954.
    Section 1.954-3(a)(1)(i) of the existing regulations defines 
``related person'' and ``unrelated person'' by an obsolete cross 
reference to Sec.  1.954-1(e). The final regulations are amended to 
define ``related person'' and ``unrelated person'' with reference to 
Sec.  1.954-1(f).

F. Effective Date

    Several commentators requested that the new regulations provide for 
a delayed effective date to allow taxpayers to implement supply chain 
and structural changes that may be required to satisfy the substantial 
contribution test and the branch rules. The IRS and the Treasury 
Department agree that a delayed effective date is appropriate for 
taxpayers whose structures require modification to accommodate the new 
regulations. Accordingly, these final and temporary regulations will 
apply to taxable years of CFCs beginning after June 30, 2009, and for 
taxable years of United States shareholders in which or with which such 
taxable years of the CFCs end. Thus, the final and temporary 
regulations will become applicable January 1, 2010, for CFCs whose 
taxable year is the calendar year. The temporary regulations will 
expire on or before December 23, 2011. In addition, a taxpayer may 
choose to apply these final and temporary regulations retroactively 
with respect to its open taxable years. The taxpayer may so choose if 
and only if the taxpayer and all members of the taxpayer's affiliated 
group apply both the final and temporary regulations, in their 
entirety, to the earliest taxable year of each controlled foreign 
corporation that ends with or within an open taxable year of the 
taxpayer and to all subsequent taxable years. A taxpayer that chose, 
prior to December 24, 2008, to apply Prop. Reg. Sec.  1.954-3 (73 FR 
10716 as corrected at 73 FR 20201) in its entirety to all of the 
taxpayer's open taxable years in which or with which a taxable year of 
a controlled foreign corporation of the taxpayer ended, may continue to 
apply Prop. Reg. Sec.  1.954-3 (73 FR 10716 as corrected at 73 FR 
20201) in its entirety with respect to all of the taxpayer's open 
taxable years that begin prior to July 1, 2009.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations and because the 
regulations do not impose a collection

[[Page 79344]]

of information on small entities, the Regulatory Flexibility Act (5 
U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the 
Code, the notice of proposed rulemaking that preceded these final and 
temporary regulations was submitted to the Chief Counsel for Advocacy 
of the Small Business Administration for comment on its impact on small 
business.

Drafting Information

    The principal author of these regulations is Ethan Atticks of the 
Office of Associate Chief Counsel (International). However, other 
personnel from the IRS and the Treasury Department participated in 
their development.

List of Subjects in 26 CFR Part 1

    Income Taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for 26 CFR part 1 continues to read 
in part as follows:

    Authority: 26 U.S.C. 7805 * * *


0
Par. 2. Section 1.954-3 is amended by:
0
1. Revising paragraphs (a)(1)(i), (a)(1)(iii) Examples 1 and 2, (a)(2), 
(a)(4)(i), (a)(4)(ii), (a)(4)(iii), (a)(6)(i), and (c).
0
2. Adding paragraphs (a)(4)(iv) and (d).
0
3. Removing and reserving paragraphs (b)(1)(i)(c), (b)(1)(ii)(a), 
(b)(1)(ii)(c), (b)(2)(i)(b), (b)(2)(i)(d), (b)(2)(ii)(a), 
(b)(2)(ii)(b), (b)(2)(ii)(e) and (b)(4) Example (3).
    The additions and revisions read as follows:


Sec.  1.954-3  Foreign base company sales income.

    (a) * * *
    (1) In general--(i) General rules. Foreign base company sales 
income of a controlled foreign corporation shall, except as provided in 
paragraphs (a)(2), (a)(3) and (a)(4) of this section, consist of gross 
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. See section 954(d)(1). For purposes of the preceding 
sentence, except as provided in paragraphs (a)(2) and (a)(4) of this 
section, personal property sold by a controlled foreign corporation 
will be considered to be the same property that was purchased by the 
controlled foreign corporation regardless of whether the personal 
property is sold in the same form in which it was purchased, in a 
different form than the form in which it was purchased, or as a 
component part of a manufactured product. This section shall apply to 
the purchase and/or sale of personal property, whether or not such 
property was purchased and/or sold in the ordinary course of trade or 
business, except that income derived in connection with the sale of 
tangible personal property will not be considered to be foreign base 
company sales income if such property is sold to a person that is not a 
related person, as defined in Sec.  1.954-1(f), after substantial use 
has been made of the property by the controlled foreign corporation in 
its trade or business. This section shall not apply to the excess of 
gains over losses from sales or exchanges of securities or from futures 
transactions, to the extent such excess gains are includible in foreign 
personal holding company income of the controlled foreign corporation 
under Sec.  1.954-2; nor shall it apply to the sale of the controlled 
foreign corporation's property (other than its stock in trade or other 
property of a kind which would properly be included in its inventory if 
on hand at the close of the taxable year, or property held primarily 
for sale to customers in the ordinary course of its business) if 
substantially all the property of such corporation is sold pursuant to 
the discontinuation of the trade or business previously carried on by 
such corporation. The term ``any person'' as used in this paragraph 
(a)(1)(i) includes a related person as defined in Sec.  1.954-1(f).
* * * * *
    (iii) * * *

    Example 1. Controlled foreign corporation A, incorporated under 
the laws of foreign country X, is a wholly owned subsidiary of 
domestic corporation M. Corporation A purchases from M Corporation, 
a related person, articles manufactured in the United States and 
sells the articles to P, an unrelated person, for delivery and use 
in foreign country Y. Gross income of A Corporation derived from the 
purchase and sale of the personal property is foreign base company 
sales income.
    Example 2. Corporation A in Example 1 also purchases from P, an 
unrelated person, articles manufactured in country Y and sells the 
articles to foreign corporation B, a related person, for use in 
foreign country Z. Gross income of A Corporation derived from the 
purchase and sale of the personal property is foreign base company 
sales income.

* * * * *
    (2) Property manufactured, produced, constructed, grown, or 
extracted within the country in which the controlled foreign 
corporation is created or organized. Foreign base company sales income 
does not include income derived in connection with the purchase and 
sale of personal property (or purchase or sale of personal property on 
behalf of a related person) in a transaction described in paragraph 
(a)(1) of this section if the property is manufactured, produced, 
constructed, grown, or extracted in the country under the laws of which 
the controlled foreign corporation which purchases and sells the 
property (or acts on behalf of a related person) is created or 
organized. See section 954(d)(1)(A). The principles set forth in 
paragraphs (a)(4)(ii) and (a)(4)(iii) of this section apply under this 
paragraph (a)(2) in determining what constitutes the manufacture, 
production, or construction of personal property, excluding the 
requirement set forth in paragraph (a)(4)(i) of this section that the 
provisions of paragraphs (a)(4)(ii) and (a)(4)(iii) of this section may 
only be satisfied through the activities of employees of the 
corporation manufacturing, producing, or constructing the personal 
property. The principles of paragraph (a)(4)(iv) of this section apply 
under this paragraph (a)(2) in determining what constitutes the 
manufacture, production, or construction of personal property but only 
when the personal property is manufactured, produced, or constructed by 
a person related to the controlled foreign corporation within the 
meaning of Sec.  1.954-1(f). The application of this paragraph (a)(2) 
may be illustrated by the following examples:
* * * * *
    (4) Property manufactured, produced, or constructed by the 
controlled foreign corporation--(i) In general. Foreign base company 
sales income does not include income of a controlled foreign 
corporation derived in connection with the sale of personal property 
manufactured, produced, or constructed by such corporation. A 
controlled foreign corporation will have manufactured, produced, or 
constructed personal property which the corporation sells only if such 
corporation satisfies the provisions of paragraph (a)(4)(ii), 
(a)(4)(iii), or (a)(4)(iv) of this section through the activities of 
its employees (as defined in Sec.  31.3121(d)-1(c) of this chapter) 
with respect to such property.

[[Page 79345]]

A controlled foreign corporation will not be treated as having 
manufactured, produced, or constructed personal property which the 
corporation sells merely because the property is sold in a different 
form than the form in which it was purchased. For rules of 
apportionment in determining foreign base company sales income derived 
from the sale of personal property purchased and used as a component 
part of property which is not manufactured, produced, or constructed, 
see paragraph (a)(5) of this section.
    (ii) Substantial transformation of property. If personal property 
purchased by a foreign corporation is substantially transformed by such 
foreign corporation prior to sale, the property sold by the selling 
corporation is manufactured, produced, or constructed by such selling 
corporation. The application of this paragraph (a)(4)(ii) may be 
illustrated by the following examples:
* * * * *
    (iii) Manufacture of a product when purchased components constitute 
part of the property sold. If purchased property is used as a component 
part of personal property which is sold, the sale of the property will 
be treated as the sale of a manufactured product, rather than the sale 
of component parts, if the assembly or conversion of the component 
parts into the final product by the selling corporation involves 
activities that are substantial in nature and generally considered to 
constitute the manufacture, production, or construction of property. 
Without limiting this substantive test, which is dependent on the facts 
and circumstances of each case, the operations of the selling 
corporation in connection with the use of the purchased property as a 
component part of the personal property which is sold will be 
considered to constitute the manufacture of a product if in connection 
with such property conversion costs (direct labor and factory burden) 
of such corporation account for 20 percent or more of the total cost of 
goods sold. In no event, however, will packaging, repackaging, 
labeling, or minor assembly operations constitute the manufacture, 
production, or construction of property for purposes of section 
954(d)(1). The application of this paragraph (a)(4)(iii) may be 
illustrated by the following examples:
* * * * *
    (iv) Substantial contribution to manufacturing of personal 
property--(a) In general. If an item of personal property would be 
considered manufactured, produced, or constructed (under the principles 
of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) prior to sale 
by the controlled foreign corporation had all of the manufacturing, 
producing, and constructing activities undertaken with respect to that 
property prior to sale been undertaken by the controlled foreign 
corporation through the activities of its employees, then this 
paragraph (a)(4)(iv) applies. If this paragraph (a)(4)(iv) applies and 
if the facts and circumstances evince that the controlled foreign 
corporation makes a substantial contribution through the activities of 
its employees to the manufacture, production, or construction of the 
personal property sold, then the personal property sold by the 
controlled foreign corporation is manufactured, produced, or 
constructed by such controlled foreign corporation.
    (b) Activities. The determination of whether a controlled foreign 
corporation makes a substantial contribution through the activities of 
its employees to the manufacture, production, or construction of the 
personal property sold involves, but will not necessarily be limited 
to, consideration of the following activities:
    (1) Oversight and direction of the activities or process pursuant 
to which the property is manufactured, produced, or constructed (under 
the principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section).
    (2) Activities that are considered in, but that are insufficient to 
satisfy, the tests provided in paragraphs (a)(4)(ii) and (a)(4)(iii) of 
this section.
    (3) Material selection, vendor selection, or control of the raw 
materials, work-in-process or finished goods.
    (4) Management of manufacturing costs or capacities (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.
    (c) Application of substantial contribution test. When considering 
whether a controlled foreign corporation makes a substantial 
contribution to the manufacture, production, or construction of the 
personal property, the performance of any activity in paragraph 
(a)(4)(iv)(b) of this section will be taken into account. The 
performance or lack of performance of any particular activity in 
paragraph (a)(4)(iv)(b) of this section, or of a particular number of 
activities in (a)(4)(iv)(b) of this section, is not determinative. The 
weight accorded to the performance of any quantum of any activity 
(whether or not specified in paragraph (a)(4)(iv)(b) of this section) 
will vary with the facts and circumstances of the particular business. 
See paragraph (a)(4)(iv)(d) Examples 8, 10 and 11 of this section. In 
determining whether the activities of the controlled foreign 
corporation constitute a substantial contribution, there is no minimum 
performance threshold before an activity can be considered. The fact 
that other persons make a substantial contribution to the manufacture, 
production, or construction of the personal property prior to sale does 
not preclude the controlled foreign corporation from making a 
substantial contribution to the manufacture, construction, or 
production of that property through the activities of its employees. 
See paragraph (a)(4)(iv)(d) Example 9 of this section.
    (d) Examples. The rules of this paragraph (a)(4)(iv) are 
illustrated by the following examples:

    Example 1. No substantial contribution to manufacturing. (i) 
Facts. FS, a controlled foreign corporation, purchases raw materials 
from a related person. The raw materials are manufactured (under the 
principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) 
into Product X by CM, an unrelated corporation, pursuant to a 
contract manufacturing arrangement. CM physically performs the 
substantial transformation, assembly, or conversion outside of FS's 
country of organization. Product X is sold by FS for use outside of 
FS's country of organization. Under the terms of the contract, FS 
retains the right to control the raw materials, work-in-process, and 
finished goods, and the right to oversee and direct the activities 
or process pursuant to which Product X is manufactured by CM. FS 
owns the intellectual property used in the manufacturing process. 
However, FS does not exercise, through its employees, its powers to 
control the raw materials, work-in-process, or finished goods, and 
FS does not exercise its powers of oversight and direction. 
Likewise, FS does not, through its employees, develop or direct the 
use or development of the intellectual property for the purpose of 
manufacturing Product X.
    (ii) Result. If the manufacturing activities undertaken with 
respect to Product X prior to sale were undertaken by FS through the 
activities of its employees, FS would have satisfied the 
manufacturing exception contained in paragraph (a)(4)(ii) or 
(a)(4)(iii)

[[Page 79346]]

of this section with respect to Product X. Therefore, this paragraph 
(a)(4)(iv) applies. FS does not satisfy the test under this 
paragraph (a)(4)(iv) because it does not make a substantial 
contribution through the activities of its employees to the 
manufacture of Product X. Mere contractual rights to control 
materials, contractual rights to oversee and direct the 
manufacturing activities or process pursuant to which the property 
is manufactured, and ownership of intellectual property are not 
sufficient to satisfy this paragraph (a)(4)(iv). Therefore, under 
the facts and circumstances of the business, FS is not considered to 
have manufactured Product X under paragraph (a)(4)(i) of this 
section.
    Example 2. Substantial contribution to manufacturing. (i) Facts. 
Assume the same facts as in Example 1, except for the following. FS, 
through its employees, engages in product design and quality control 
and controls manufacturing related logistics. Employees of FS 
exercise the right to oversee and direct the activities of CM in the 
manufacture of Product X.
    (ii) Result. If the manufacturing activities undertaken with 
respect to Product X prior to sale were undertaken by FS through the 
activities of its employees, FS would have satisfied the 
manufacturing exception contained in paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section with respect to Product X. Therefore, 
this paragraph (a)(4)(iv) applies. Under the facts and circumstances 
of the business, FS satisfies the test under this paragraph 
(a)(4)(iv) because it makes a substantial contribution through the 
activities of its employees to the manufacture of Product X. 
Therefore, FS is considered to have manufactured Product X under 
paragraph (a)(4)(i) of this section. The analysis and conclusion 
would be the same if CM were related to FS because the relationship 
between CM and FS is irrelevant for purposes of applying paragraph 
(a)(4) of this section.
    Example 3. Raw materials procured by contract manufacturer. (i) 
Facts. FS, a controlled foreign corporation, enters into a contract 
with CM to manufacture (under the principles of paragraph (a)(4)(ii) 
or (a)(4)(iii) of this section) Product X. CM physically performs 
the substantial transformation, assembly, or conversion required to 
manufacture Product X outside of FS's country of organization. 
Product X is sold by FS for use outside of FS's country of 
organization. Employees of FS select the materials that will be used 
to manufacture Product X. FS does not own the materials or work-in-
process during the manufacturing process. FS, through its employees, 
exercises oversight and direction of the manufacturing process and 
provides quality control. FS manages the manufacturing costs and 
capacities with respect to Product X by managing the risk of loss 
and engaging in demand planning and production scheduling.
    (ii) Result. If the manufacturing activities undertaken with 
respect to Product X prior to sale were undertaken by FS through the 
activities of its employees, FS would have satisfied the 
manufacturing exception contained in paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section with respect to Product X. Therefore, 
this paragraph (a)(4)(iv) applies. Under the facts and circumstances 
of the business, FS satisfies the test under this paragraph 
(a)(4)(iv) because it makes a substantial contribution through the 
activities of its employees to the manufacture of Product X. 
Therefore, FS is considered to have manufactured Product X under 
paragraph (a)(4)(i) of this section.
    Example 4. Physical conversion by employees of a person other 
than the contract manufacturer. (i) Facts. FS, a controlled foreign 
corporation organized in Country M, purchases raw materials from a 
related person. The raw materials are manufactured (under the 
principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) 
into Product X by CM, an unrelated corporation, pursuant to a 
contract manufacturing arrangement. CM physically performs the 
substantial transformation, assembly, or conversion required to 
manufacture Product X outside of FS's country of organization. 
Product X is sold by FS for use outside of FS's country of 
organization. CM contracts with another corporation for its 
employees in order to operate CM's manufacturing plant and 
transform, assemble, or convert the raw materials into Product X. 
Apart from the physical performance of the substantial 
transformation, assembly, or conversion of the raw materials into 
Product X, employees of FS perform all of the other manufacturing 
activities required in connection with the manufacture of Product X 
(for example, oversight and direction of the manufacturing process; 
vendor selection; control of raw materials, work-in-process, and 
finished goods; control of manufacturing related logistics; and 
quality control).
    (ii) Result. If the manufacturing activities undertaken with 
respect to Product X prior to sale were undertaken by FS through the 
activities of its employees, FS would have satisfied the 
manufacturing exception contained in paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section with respect to Product X. Therefore, 
this paragraph (a)(4)(iv) applies. Under the facts and circumstances 
of the business, FS satisfies the test under this paragraph 
(a)(4)(iv) because it makes a substantial contribution through the 
activities of its employees to the manufacture of Product X. 
Therefore, FS is considered to have manufactured Product X under 
paragraph (a)(4)(i) of this section.
    Example 5. Automated manufacturing supervised by another person. 
(i) Facts. FS, a controlled foreign corporation, purchases raw 
materials from a related person. The raw materials are manufactured 
(under the principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section) into Product X by CM, an unrelated corporation selected by 
FS, pursuant to a contract manufacturing arrangement. CM physically 
performs the substantial transformation, assembly, or conversion 
outside of FS's country of organization. Product X is sold by FS to 
related and unrelated persons for use outside of FS's country of 
organization. At all times, FS retains ownership of the raw 
materials, work-in-process, and finished goods. FS retains the right 
to oversee and direct the activities or process pursuant to which 
Product X is manufactured by CM, but does not exercise, through its 
employees, its powers of oversight and direction. FS is the owner of 
sophisticated software and network systems that remotely and 
automatically (without human involvement) take orders, route them to 
CM, order raw materials, and perform quality control. FS has a small 
number of computer technicians who monitor the software and network 
systems to ensure that they are running smoothly and apply any 
necessary patches or fixes. The software and network systems were 
developed by employees of DP, the U.S. corporate parent of FS. DP's 
employees supervise the computer technicians, evaluate the results 
of the automated manufacturing business, and make ongoing 
operational decisions, including decisions related to acceptable 
performance of the manufacturing process, stoppages of that process, 
and decisions related to product and manufacturing process design. 
DP's employees develop and provide to FS all of the upgrades to the 
software and network systems. DP also has employees who direct and 
control other aspects of the manufacturing process such as vendor 
and material selection, management of the manufacturing costs and 
capacities, and the selection of CM. The need for DP's employees to 
direct the activities of the FS employees and otherwise contribute 
to the manufacturing process evinces that substantial operational 
responsibilities and decision making are required to be exercised by 
parties other than CM in order to manufacture Product X.
    (ii) Result. If the manufacturing activities undertaken with 
respect to Product X prior to sale were undertaken by FS through the 
activities of its employees, FS would have satisfied the 
manufacturing exception contained in paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section with respect to Product X. Therefore, 
this paragraph (a)(4)(iv) applies. Under the facts and circumstance 
of the business, FS does not satisfy the test under this paragraph 
(a)(4)(iv) because it does not make a substantial contribution 
through the activities of its employees to the manufacture of 
Product X. Mere ownership of materials and intellectual property 
along with contractual rights to exercise powers of direction and 
control are not sufficient to satisfy this paragraph (a)(4)(iv). The 
employees of FS do not perform the amount of activity necessary to 
constitute a substantial contribution. FS is not considered to have 
manufactured Product X under paragraph (a)(4)(i) of this section.
    Example 6. Automated manufacturing supervised by FS. (i) Facts. 
Assume the same facts as in Example 5, except for the following. FS, 
through its employees, engages in the activities undertaken by DP's 
employees in Example 5. DP's employees also contribute to product 
and manufacturing process design, and provide support and oversight 
to FS in connection with functions performed by FS through its 
employees.
    (ii) Result. If the manufacturing activities undertaken with 
respect to Product X prior to sale were undertaken by FS through the 
activities of its employees, FS would have

[[Page 79347]]

satisfied the manufacturing exception contained in paragraph 
(a)(4)(ii) or (a)(4)(iii) of this section with respect to Product X. 
Therefore, this paragraph (a)(4)(iv) applies. Under the facts and 
circumstances of the business, FS satisfies the test under this 
paragraph (a)(4)(iv) because it makes a substantial contribution 
through the activities of its employees to the manufacture of 
Product X. This determination does not require a comparison between 
the activities of FS and the activities of DP. Selection of the 
contract manufacturer, even though not specifically identified in 
paragraph (a)(4)(iv)(b) of this section, is considered under 
paragraph (a)(4)(iv)(c) of this section in determining whether FS 
makes a substantial contribution to the manufacture of Product X 
through its employees. FS is considered to have manufactured Product 
X under paragraph (a)(4)(i) of this section.
    Example 7. Automated manufacturing supervised by FS with 
purchased intellectual property. (i) Facts. Assume the same facts as 
in Example 6, except for the following. The software and network 
systems, and the upgrades to those systems, were purchased by FS 
rather than developed by employees of FS.
    (ii) Result. If the manufacturing activities undertaken with 
respect to Product X prior to sale were undertaken by FS through the 
activities of its employees, FS would have satisfied the 
manufacturing exception contained in paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section with respect to Product X. Therefore, 
this paragraph (a)(4)(iv) applies. The lack of performance of 
software and network system development activities is not 
determinative under the facts and circumstances of the business. 
Therefore, FS satisfies the test under this paragraph (a)(4)(iv) 
because it makes a substantial contribution through the activities 
of its employees to the manufacture of Product X. This determination 
does not require a comparison between the activities of FS and the 
activities of DP. FS is considered to have manufactured Product X 
under paragraph (a)(4)(i) of this section.
    Example 8. Manufacture without intellectual property. (i) Facts. 
FS, a controlled foreign corporation, purchases raw materials from a 
related person. The raw materials are manufactured (under the 
principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) 
into Product X by CM, an unrelated corporation, pursuant to a 
contract manufacturing arrangement. CM physically performs the 
substantial transformation, assembly, or conversion outside of FS's 
country of organization. Product X is sold by FS for use outside of 
FS's country of organization. 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 of 
significant value is required to manufacture Product X. FS does not 
own any intellectual property underlying Product X, or hold an 
exclusive or non-exclusive right to manufacture Product X.
    (ii) Result. If the manufacturing activities undertaken with 
respect to Product X prior to sale were undertaken by FS through the 
activities of its employees, FS would have satisfied the 
manufacturing exception contained in paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section with respect to Product X. Therefore, 
this paragraph (a)(4)(iv) applies. Because use of intellectual 
property plays little or no role in the manufacture of Product X, it 
is irrelevant to the substantial contribution analysis under 
paragraph (a)(4)(iv) of this section. Under the facts and 
circumstances of the business, FS satisfies the test under this 
paragraph (a)(4)(iv) because it makes a substantial contribution 
through the activities of its employees to the manufacture of 
Product X. Therefore, FS is considered to have manufactured Product 
X under paragraph (a)(4)(i) of this section.
    Example 9. Substantial contribution by more than one CFC. (i) 
Facts. FS1 and FS2, unrelated controlled foreign corporations, 
contract with CM, an unrelated corporation, to manufacture (under 
the principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section) Product X. CM physically performs the substantial 
transformation, assembly, or conversion required to manufacture 
Product X outside of FS1's and FS2's respective countries of 
organization. Neither FS1 nor FS2 owns the materials or work-in-
process during the manufacturing process. Product X is sold by FS1 
and FS2 to persons related to FS1 and FS2, respectively, for 
disposition outside of FS1's and FS2's respective countries of 
organization. FS1, through its employees, designs Product X. FS1 
directs the use of the product design and design specifications, and 
other intellectual property, for the purpose of manufacturing 
Product X. Employees of FS1 also select the materials that will be 
used to manufacture Product X, and the vendors that provide those 
materials. FS2, through its employees, designs the process for 
manufacturing Product X. FS2, through its employees, manages the 
manufacturing costs and capacities with respect to Product X. FS1 
and FS2 each provide quality control and oversight and direction of 
CM's manufacturing activities with respect to different aspects of 
the manufacture of Product X.
    (ii) Result. If the manufacturing activities undertaken with 
respect to Product X prior to sale were undertaken by FS1 or FS2 
through the activities of their employees, FS1 or FS2 would have 
satisfied the manufacturing exception contained in paragraph 
(a)(4)(ii) or (a)(4)(iii) of this section with respect to Product X. 
Therefore, this paragraph (a)(4)(iv) applies. The fact that other 
persons make a substantial contribution to the manufacture of 
personal property does not preclude a controlled foreign corporation 
from making a substantial contribution to the manufacture of 
personal property through the activities of its employees. In the 
analysis of whether FS1 or FS2 make a substantial contribution to 
the manufacture of Product X, each company takes into account its 
individual activities, including those of providing quality control 
and oversight and direction of the manufacture of Product X. In 
addition, no threshold level of activity is required, including with 
respect to providing quality control or oversight and direction of 
the activities or process pursuant to which Product X is 
manufactured, before FS1 and FS2 can take into account their 
respective activities. Under the facts and circumstances of the 
business, both FS1 and FS2 satisfy the test under this paragraph 
(a)(4)(iv) because each independently makes a substantial 
contribution through the activities of its employees to the 
manufacture of Product X. Therefore, FS1 and FS2 are each considered 
to have manufactured Product X under paragraph (a)(4)(i) of this 
section.
    Example 10. Manufacture of products designed by CFC. (i) Facts. 
FS, a controlled foreign corporation, purchases raw materials from a 
related person. The raw materials are manufactured (under the 
principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) 
into Product X by CM, an unrelated corporation, pursuant to a 
contract manufacturing arrangement. CM physically performs the 
substantial transformation, assembly, or conversion outside of FS's 
country of organization. Product X is sold by FS for use outside of 
FS's country of organization. Products in the X industry are 
distinguished (and vary widely in value) based on the raw materials 
used to make the product and the product design. FS designs the 
product and selects the materials that CM will use to manufacture 
Product X. FS also manages the manufacturing costs and capacities. 
Product X can be manufactured from the raw materials to FS's design 
specifications without significant oversight and direction, quality 
control, or control of manufacturing related logistics. The 
activities most relevant to the substantial contribution analysis 
under these facts are material selection, product design and 
management of the manufacturing costs and capacities.
    (ii) Result. If the manufacturing activities undertaken with 
respect to Product X prior to sale were undertaken by FS through the 
activities of its employees, FS would have satisfied the 
manufacturing exception contained in paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section with respect to Product X. Therefore, 
this paragraph (a)(4)(iv) applies. Under the facts and circumstances 
of the business, FS makes a substantial contribution through the 
activities of its employees to the manufacture of Product X. FS 
satisfies the test under this paragraph (a)(4)(iv) because it makes 
a substantial contribution through the activities of its employees 
to the manufacture of Product X. Therefore, FS is considered to have 
manufactured Product X under paragraph (a)(4)(i) of this section.
    Example 11. Direction and oversight of manufacturing and quality 
control through periodic visits. (i) Facts. FS, a controlled foreign 
corporation, purchases raw materials from a related person. The raw 
materials are manufactured (under the principles of paragraph 
(a)(4)(ii) or (a)(4)(iii) of this section) into Product X by CM, an 
unrelated corporation, pursuant to a contract manufacturing 
arrangement. CM physically performs the substantial transformation, 
assembly, or conversion outside of FS's country of organization. 
Product X is sold by FS for use outside of FS's country of 
organization. FS controls the raw material, work-in-process, and 
finished goods, manages the manufacturing costs and

[[Page 79348]]

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 during the week. In the X 
industry, quarterly visits to a manufacturing facility by qualified 
persons are sufficient to control the quality of manufacturing.
    (ii) Result. If the manufacturing activities undertaken with 
respect to Product X prior to sale were undertaken by FS through the 
activities of its employees, FS would have satisfied the 
manufacturing exception contained in paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section with respect to Product X. Therefore, 
this paragraph (a)(4)(iv) applies. Under the facts and circumstances 
of the business, FS satisfies the test under this paragraph 
(a)(4)(iv) with respect to Product X because it makes a substantial 
contribution through the activities of its employees to the 
manufacture of Product X. Therefore, FS is considered to have 
manufactured Product X under paragraph (a)(4)(i) of this section.

* * * * *
    (6) Special rule applicable to distributive share of partnership 
income--(i) In general. To determine the extent to which a controlled 
foreign corporation's distributive share of any item of gross income of 
a partnership would have been foreign base company sales income if 
received by it directly, under Sec.  1.952-1(g), the property sold will 
be considered to be manufactured, produced, or constructed by the 
controlled foreign corporation, within the meaning of paragraph 
(a)(4)(i) of this section, only if the manufacturing exception of 
paragraph (a)(4)(i) of this section would have applied to exclude the 
income from foreign base company sales income if the controlled foreign 
corporation had earned the income directly, determined by taking into 
account only the activities of the employees of, and property owned by, 
the partnership.
* * * * *
    (b) * * *
    (1) * * *
    (i) * * *
    (c) [Reserved]. For further guidance, see Sec.  1.954-
3T(b)(1)(i)(c).
    (ii) * * *
    (a) [Reserved]. For further guidance, see Sec.  1.954-
3T(b)(1)(ii)(a).
* * * * *
    (c) [Reserved]. For further guidance, see Sec.  1.954-
3T(b)(1)(ii)(c).
    (2) * * *
    (i) * * *
    (b) [Reserved]. For further guidance, see Sec.  1.954-
3T(b)(2)(i)(b).
* * * * *
    (d) [Reserved]. For further guidance, see Sec.  1.954-
3T(b)(2)(i)(d).
* * * * *
    (ii) * * *
    (a) [Reserved]. For further guidance, see Sec.  1.954-
3T(b)(2)(ii)(a).
    (b) [Reserved]. For further guidance, see Sec.  1.954-
3T(b)(2)(ii)(b).
* * * * *
    (e) [Reserved]. For further guidance, see Sec.  1.954-
3T(b)(2)(ii)(e).
* * * * *
    (4) * * *
    Example (3). [Reserved]. For further guidance, see Sec.  1.954-
3T(b)(4) Example (3).
* * * * *
    (c) Effective/applicability date. Paragraphs (a)(1)(i), (a)(1)(iii) 
Example 1, (a)(1)(iii) Example 2, (a)(2), (a)(4)(i), (a)(4)(ii), 
(a)(4)(iii), (a)(4)(iv) and (a)(6)(i) shall apply to taxable years of 
controlled foreign corporations beginning after June 30, 2009, and for 
taxable years of United States shareholders in which or with which such 
taxable years of the controlled foreign corporations end.
    (d) Application of regulations to earlier taxable years. A taxpayer 
may choose to apply these regulations and the regulations under Sec.  
1.954-3T retroactively with respect to its open taxable years. The 
taxpayer may so choose if and only if the taxpayer and all members of 
the taxpayer's affiliated group (within the meaning of Sec.  1504(a)) 
apply both these regulations and the regulations under Sec.  1.954-3T, 
in their entirety, to the earliest taxable year of each controlled 
foreign corporation that ends with or within an open taxable year of 
the taxpayer and to all subsequent taxable years of the taxpayer.

0
Par. 3. Section 1.954-3T is added to read as follows:


Sec.  1.954-3T  Foreign base company sales income (temporary).

    (a) Through (b)(1)(i)(b) [Reserved]. For further guidance, see 
Sec.  1.954-3(a) through (b)(1)(i)(b).
    (c) Use of more than one branch. If a controlled foreign 
corporation carries on purchasing or selling activities by or through 
more than one branch or similar establishment located outside the 
country under the laws of which such corporation is created or 
organized, then Sec.  1.954-3(b)(1)(i)(b) shall be applied separately 
to the income derived by each such branch or similar establishment (by 
treating such purchasing or selling branch or similar establishment as 
if it were the only branch or similar establishment of the controlled 
foreign corporation and as if any such other branches or similar 
establishments were separate corporations) in determining whether the 
use of such branch or similar establishment has substantially the same 
tax effect as if such branch or similar establishment were a wholly 
owned subsidiary corporation of the controlled foreign corporation. See 
paragraph (b)(1)(ii)(c)(1) of this section for rules applicable to a 
controlled foreign corporation that carries on purchase or sales 
activities by or through one or more branches or similar establishments 
in addition to carrying on manufacturing activities by or through one 
or more branches or similar establishments.
    (ii) Manufacturing branch--(a) In general. 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. See 
section 954(d)(2). The provisions of this paragraph (b)(1)(ii) and 
Sec.  1.954-3(b)(1)(ii)(b) will apply only if the controlled foreign 
corporation (including any branches or similar establishments of such 
controlled foreign corporation) manufactures, produces, or constructs 
such personal property within the meaning of Sec.  1.954-3(a)(4)(i), or 
carries on growing or extracting activities with respect to such 
personal property.
    (b) [Reserved]. For further guidance, see Sec.  1.954-
3(b)(1)(ii)(b).
    (c) Use of more than one branch--(1) Use of one or more sales or 
purchase branches in addition to a manufacturing branch. If, with 
respect to personal property manufactured, produced, constructed, 
grown, or extracted by or through a branch or similar establishment 
located outside the country under the laws of which the controlled 
foreign corporation is created or organized, purchasing or selling 
activities are carried on by or through more than one branch or similar 
establishment, or by or through one or more branches or similar 
establishments located outside such country, of such corporation, then 
Sec.  1.954-3(b)(1)(ii)(b)

[[Page 79349]]

shall be applied separately to the income derived by each such 
purchasing or selling branch or similar establishment (by treating such 
purchasing or selling branch or similar establishment as though it 
alone were the remainder of the controlled foreign corporation) for 
purposes of determining whether the use of such manufacturing, 
producing, constructing, growing, or extracting branch or similar 
establishment has substantially the same tax effect as if such branch 
or similar establishment were a wholly owned subsidiary corporation of 
the controlled foreign corporation. If this rule applies, the sales or 
purchase branch rules contained in paragraph (b)(1)(i)(c) of this 
section and Sec.  1.954-3(b)(1)(i) do not apply. The application of 
this paragraph (b)(1)(ii)(c)(1) is illustrated by the following 
example:

    Example. All activities of controlled foreign corporation 
conducted through sales branches and manufacturing branch. (i) 
Facts. FS, a controlled foreign corporation organized under the laws 
of country M, operates three branches. Branch A, located in country 
A, manufactures Product X under the principles of Sec.  1.954-
3(a)(4)(i). Branch B, located in Country B, sells Product X 
manufactured by Branch A to customers for use outside of Country B. 
Branch C, located in Country C sells Product X manufactured by 
Branch A to customers for use outside of Country C. FS does not 
conduct any manufacturing or selling activities apart from the 
activities of Branches A, B and C. Country M imposes an effective 
rate of tax on sales income of 0%. Country A imposes an effective 
rate of tax on sales income of 20%. Country B imposes an effective 
rate of tax on sales income of 20%. Country C imposes an effective 
rate of tax on sales income of 18%.
    (ii) Result. Pursuant to this paragraph (b)(1)(ii)(c)(1), Sec.  
1.954-3(b)(1)(ii)(b) is applied to the sales income derived by 
Branch B by treating Branch B as though it alone were the remainder 
of the controlled foreign corporation. The use of Branch B does not 
have the same tax effect as if Branch B were a wholly owned 
subsidiary of FS because the tax rate applicable to the income 
allocated to Branch B under Sec.  1.954-3(b)(1)(ii)(b) (20%) is not 
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 Country A (20%), the country in which Branch A is located. 
Section 1.954-3(b)(1)(ii)(b) is applied separately to the sales 
income derived by Branch C by treating Branch C as though it alone 
were the remainder of the controlled foreign corporation. The use of 
Branch C does not have the same tax effect as if Branch C were a 
wholly owned subsidiary of FS because the tax rate applicable to the 
income allocated to Branch C under Sec.  1.954-3(b)(1)(ii)(b) (18%) 
is not 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 Country A (20%), the country in which 
Branch A is located. Pursuant to this paragraph (b)(1)(ii)(c)(1), 
the rules under paragraph (b)(1)(i)(c) of this section and Sec.  
1.954-3(b)(1)(i) for determining whether a sales or purchase branch 
is treated as a separate corporation from the remainder of the 
controlled foreign corporation do not apply.

    (2) Use of more than one branch to manufacture, produce, construct, 
grow, or extract separate items of personal property. If a controlled 
foreign corporation carries on manufacturing, producing, constructing, 
growing, or extracting activities with respect to separate items of 
personal property by or through more than one branch or similar 
establishment located outside the country under the laws of which such 
corporation is created or organized, then paragraph (b)(1)(ii)(c) of 
this section and Sec.  1.954-3(b)(1)(ii)(b) will be applied separately 
to each such branch or similar establishment (by treating such 
manufacturing branch or similar establishment as if it were the only 
such branch or similar establishment of the controlled foreign 
corporation and as if any other such branches or similar establishments 
were separate corporations) for purposes of determining whether the use 
of such branch or similar establishment has substantially the same tax 
effect as if such branch or similar establishment were a wholly owned 
subsidiary corporation of the controlled foreign corporation. The 
application of this paragraph (b)(1)(ii)(c)(2) is illustrated by the 
following example:

    Example. Multiple branches that satisfy Sec.  1.954-3(a)(4)(i). 
(i) Facts. FS is a controlled foreign corporation organized in 
Country M. FS operates two branches, Branch A and Branch B located 
in Country A and Country B, respectively. Branch A and Branch B each 
manufacture separate items of personal property (Product X and 
Product Y, respectively) within the meaning of Sec.  1.954-
3(a)(4)(ii) or (iii). Raw materials used in the manufacture of 
Product X and Product Y are purchased by FS from an unrelated 
person. FS engages in activities in Country M to sell Product X and 
Product Y to a related person for use, disposition or consumption 
outside of Country M. Employees of FS located in Country M perform 
only sales functions. The effective rate imposed in Country M on the 
income from the sales of Product X and Product Y is 10%. Country A 
imposes an effective rate of tax on sales income of 20%. Country B 
imposes an effective rate of tax on sales income of 12%.
    (ii) Result. Pursuant to this paragraph (b)(1)(ii)(c)(2), Sec.  
1.954-3(b)(1)(ii)(b) is applied separately to Branch A and Branch B 
with respect to the sales income of FS attributable to Product X 
(manufactured by Branch A) and Product Y (manufactured by Branch B). 
Because the effective rate of tax on FS's sales income from the sale 
of Product X in Country M (10%) is less than 90% of, and at least 5 
percentage points less than, the effective rate of tax that would 
apply to such income in the country in which Branch A is located 
(20%), the use of Branch A to manufacture Product X has 
substantially the same tax effect as if Branch A were a wholly owned 
subsidiary corporation of FS. Because the effective rate of tax on 
FS's sales income from the sale of Product Y in Country M (10%) is 
not less than 90% of, and at least 5 percentage points less than, 
the effective rate of tax that would apply to such income in the 
country in which Branch B is located (12%), the use of Branch B to 
manufacture Product Y does not have substantially the same tax 
effect as if Branch B were a wholly owned subsidiary corporation of 
FS. Consequently, only Branch A is treated as a separate corporation 
apart from the remainder of FS for purposes of determining foreign 
base company sales income from the sales of Product X.

    (3) Use of more than one manufacturing branch, or one or more 
manufacturing branches and the remainder of the controlled foreign 
corporation, to manufacture, produce, or construct the same item of 
personal property--(i) In general. This paragraph (b)(1)(ii)(c)(3) 
applies to determine the location of manufacture, production, or 
construction of personal property for purposes of applying Sec.  1.954-
3(b)(1)(i)(b) or (b)(1)(ii)(b) where more than one branch (or similar 
establishment) of a controlled foreign corporation, or one or more 
branches (or similar establishments) of a controlled foreign 
corporation and the remainder of the controlled foreign corporation, 
each engage in manufacturing, producing, or constructing activities 
with respect to the same item of personal property which is then sold 
by the controlled foreign corporation. The location of manufacture, 
production, or construction is determined under paragraph 
(b)(1)(ii)(c)(3)(ii) of this section if one or more branches (or 
similar establishments), or the remainder of the controlled foreign 
corporation, independently satisfies Sec.  1.954-3(a)(4)(i) with 
respect to an item of personal property. The location of manufacture, 
production, or construction is determined under paragraph 
(b)(1)(ii)(c)(3)(iii) of this section if none of the branches (or 
similar establishments), or the remainder of the controlled foreign 
corporation, independently satisfies Sec.  1.954-3(a)(4)(i) with 
respect to an item of personal property, but the controlled foreign 
corporation as a whole makes a substantial contribution to the 
manufacture, production or construction of that property within the 
meaning of Sec.  1.954-3(a)(4)(iv). For purposes of this paragraph 
(b)(1)(ii)(c)(3), the location of any activity with respect to the 
manufacture, production, or construction of an item

[[Page 79350]]

of personal property is determined under paragraph (b)(1)(ii)(c)(3)(iv) 
of this section. For purposes of this paragraph (b)(1)(ii)(c)(3), if 
multiple branches (or similar establishments) are located in a single 
jurisdiction, then the activities of those branches will be aggregated 
for purposes of determining whether a branch or remainder of the 
controlled foreign corporation satisfies Sec.  1.954-3(a)(4)(i).
    (ii) Manufacture, production, or construction in one or more 
locations. If only one branch (or similar establishment), or only the 
remainder of a controlled foreign corporation, independently satisfies 
Sec.  1.954-3(a)(4)(i) with respect to an item of personal property, 
then that branch (or similar establishment) or the remainder of the 
controlled foreign corporation will be the location of manufacture, 
production, or construction of that property for purposes of applying 
Sec.  1.954-3(b)(1)(i)(b) or (b)(1)(ii)(b) to the income from the sale 
of that property. See paragraph (b)(1)(ii)(c)(3)(v) Example 1 of this 
section. If more than one branch (or similar establishment), or one or 
more branches (or similar establishments) and the remainder of the 
controlled foreign corporation, each independently satisfy Sec.  1.954-
3(a)(4)(i) with respect to an item of personal property, then the 
location of manufacture, production, or construction of that property 
for purposes of applying Sec.  1.954-3(b)(1)(i)(b) or (b)(1)(ii)(b) 
will be the location of that branch (or similar establishment) or the 
jurisdiction under the laws of which the remainder of the controlled 
foreign corporation is organized that satisfies Sec.  1.954-3(a)(4)(i) 
and that would, after applying Sec.  1.954-3(b)(1)(ii)(b) to such 
branch (or similar establishment) or Sec.  1.954-3(b)(1)(i)(b) to the 
remainder of the controlled foreign corporation, impose the lowest 
effective rate of tax on the income allocated to such branch or the 
remainder of the controlled foreign corporation under such section 
(that is, either Sec.  1.954-3(b)(1)(i)(b) or (b)(1)(ii)(b)). See 
paragraph (b)(1)(ii)(c)(3)(v) Example 2 of this section.
    (iii) No location independently satisfies manufacturing test. If 
none of the branches (or similar establishments) or the remainder of 
the controlled foreign corporation independently satisfies Sec.  1.954-
3(a)(4)(i) with respect to an item of personal property but the 
controlled foreign corporation as a whole makes a substantial 
contribution to the manufacture, production, or construction of that 
property within the meaning of Sec.  1.954-3(a)(4)(iv), then for 
purposes of applying Sec.  1.954-3(b)(1)(i)(b) or (b)(1)(ii)(b), the 
location of manufacture, production, or construction with respect to 
that property will be the ``tested manufacturing location'' unless the 
``tested sales location'' provides a demonstrably greater contribution 
to the manufacture, production, or construction of the property. The 
tested manufacturing location is the location of any branch (or similar 
establishment) or remainder of the controlled foreign corporation that 
contributes to the manufacture, production, or construction of the 
personal property, if any, and that would, after applying Sec.  1.954-
3(b)(1)(ii)(b) to such branch (or similar establishment) or Sec.  
1.954-3(b)(1)(i)(b) to the remainder of the controlled foreign 
corporation, be treated as a separate corporation and would impose the 
lowest effective rate of tax on the income allocated to such branch (or 
similar establishment) or to the remainder of the controlled foreign 
corporation under such section (that is, either Sec.  1.954-
3(b)(1)(ii)(b) or (b)(1)(i)(b)). The tested sales location is the 
location where the branch (or similar establishment) or the remainder 
of the controlled foreign corporation purchases or sells the personal 
property. For purposes of this paragraph (b)(1)(ii)(c)(3)(iii), the 
contribution to the manufacture, production, or construction of the 
personal property by the tested sales location will be deemed to 
include the activities of any branch (or similar establishment) or 
remainder of the controlled foreign corporation that would not be 
treated as a corporation separate from the tested sales location after 
the application of Sec.  1.954-3(b)(1)(ii)(b) or (b)(1)(i)(b). For 
purposes of this paragraph (b)(1)(ii)(c)(3)(iii), the contribution of 
the tested manufacturing location to the manufacture, production, or 
construction of the personal property will be deemed to include any 
activities of any branch (or similar establishment) or remainder of the 
controlled foreign corporation that would be treated as a corporation 
separate from the tested sales location after the application of Sec.  
1.954-3(b)(1)(ii)(b) or (b)(1)(i)(b). Whether the tested sales location 
provides a demonstrably greater contribution to the manufacture, 
production, or construction of the personal property is determined by 
weighing the relative contributions to the manufacture, production, or 
construction of that property by the tested sales location and the 
tested manufacturing location under the facts and circumstances test 
provided in Sec.  1.954-3(a)(4)(iv). See paragraph (b)(1)(ii)(c)(3)(v) 
Examples 4, 5, and 6 of this section. If the tested sales location 
provides a demonstrably greater contribution to the manufacture, 
production, or construction of the personal property than the tested 
manufacturing location or if there is no tested manufacturing location, 
then the tested sales location is the location of manufacture, 
production, or construction of that property and the rules of paragraph 
(b)(1)(ii)(a) of this section and Sec.  1.954-3(b)(1)(i)(a) will not 
apply with respect to the sales income related to that property and the 
use of the purchasing or selling branch (or similar establishment) or 
the purchasing or selling remainder will not result in a branch being 
treated as a separate corporation for purposes of paragraph (b)(2)(ii) 
of this section or Sec.  1.954-3(b)(2)(ii).
    (iv) Location of activity. For purposes of paragraph 
(b)(1)(ii)(c)(3) of this section, the location of any activity with 
respect to the manufacture, production, or construction of an item of 
personal property is the location where the employees of the controlled 
foreign corporation perform such activity. For example, the location of 
any activity concerning intellectual property is determined based on 
where employees of the controlled foreign corporation develop, or 
direct the use or development of, the intellectual property, not on the 
formal assignment of that intellectual property.
    (v) Examples. The following examples illustrate the application of 
this paragraph (b)(1)(ii)(c)(3):

    Example 1. Multiple branches contribute to the manufacture of a 
single product, only one branch satisfies Sec.  1.954-3(a)(4)(i). 
(i) Facts. FS is a controlled foreign corporation organized in 
Country M. FS operates three branches, Branch A, Branch B, and 
Branch C, located respectively in Country A, Country B, and Country 
C. Branch A, Branch B, and Branch C each performs different 
manufacturing activities with respect to the manufacture of Product 
X. Branch A, through the activities of employees of FS located in 
Country A, designs Product X. Branch B, through the activities of 
employees of FS located in Country B, provides quality control and 
oversight and direction. Branch C, through the activities of 
employees of FS located in Country C, manufactures Product X (within 
the meaning of Sec.  1.954-3(a)(4)(ii) or (a)(4)(iii)) using the 
designs developed by Branch A and under the oversight of the quality 
control personnel of Branch B. The activities of Branch A and Branch 
B do not independently satisfy Sec.  1.954-3(a)(4)(i). Employees of 
FS located in Country M purchase the raw materials used in the 
manufacture of Product X from a related person and control the work-
in-process and finished goods throughout the manufacturing process. 
Employees of FS located in Country M also manage the manufacturing 
costs and

[[Page 79351]]

capacities related to Product X. Further, employees of FS located in 
Country M oversee the coordination between the branches. Employees 
of FS located in Country M sell Product X to unrelated persons for 
use outside of Country M. The sales income from the sale of Product 
X is taxed in Country M at an effective rate of tax of 10%. Country 
C imposes an effective rate of tax of 20% on sales income.
    (ii) Result. Country C is the location of manufacture for 
purposes of applying Sec.  1.954-3(b)(1)(ii)(b) because only the 
activities of Branch C independently satisfy Sec.  1.954-3(a)(4)(i). 
The use of Branch C has substantially the same tax effect as if 
Branch C were a wholly owned subsidiary corporation of FS because 
the effective rate of tax on the sales income (10%) is less than 90% 
of, and at least 5 percentage points less than, the effective rate 
of tax that would apply to such income in the country in which 
Branch C is located (20%). Therefore, sales of Product X by the 
remainder of FS are treated as sales on behalf of Branch C. In 
determining whether the remainder of FS will qualify for the 
manufacturing exception under Sec.  1.954-3(a)(4)(iv), the 
activities of FS will include the activities of Branch A or Branch 
B, respectively, if each of those branches would not be treated as a 
separate corporation under Sec.  1.954-3(b)(1)(ii)(b), if that 
paragraph were applied independently to each of Branch A and Branch 
B. See paragraph (b)(2)(ii)(a) of this section.
    Example 2. Multiple branches satisfy Sec.  1.954-3(a)(4)(i) with 
respect to the same product sold by the controlled foreign 
corporation. (i) Facts. Assume the same facts as in Example 1, 
except for the following. In addition to the design of Product X, 
Branch A also performs in Country A other manufacturing activities, 
including those ascribed to FS in Example 1, that are sufficient to 
qualify as manufacturing under Sec.  1.954-3(a)(4)(iv) with respect 
to Product X. Country A imposes an effective rate of tax of 12% on 
sales income.
    (ii) Result. Branch A and Branch C through their activities each 
independently satisfy the requirements of Sec.  1.954-3(a)(4)(i). 
Therefore, Sec.  1.954-3(b)(1)(ii)(b) is applied by comparing the 
effective rate of tax imposed on the income from the sales of 
Product X against the lowest effective rate of tax that would apply 
to the sales income in either Country A or Country C if Sec.  1.954-
3(b)(1)(ii)(b) were applied separately to Branch A and Branch C. 
Country A imposes the lower effective rate of tax, and therefore, 
Branch A is treated as the location of manufacture for purposes of 
applying Sec.  1.954-3(b)(1)(ii)(b). The effective rate of tax in 
Country B is not considered because Branch B does not satisfy Sec.  
1.954-3(a)(4)(i). Neither Branch A nor Branch C is treated as a 
separate corporation because the effective rate of tax on the sales 
income of FS from the sale of Product X (10%) is not less than 90% 
of, and at least 5 percentage points less than, the effective rate 
of tax that would apply to such income in the country in which 
Branch A is located (12%). Sales of Product X by the remainder of 
the controlled foreign corporation are not treated as made on behalf 
of any branch.
    Example 3. Determining the location of manufacture when 
manufacturing activities performed by multiple branches and no 
branch independently satisfies Sec.  1.954-3(a)(4)(i). (i) Facts. 
FS, a controlled foreign corporation organized in Country M, 
purchases raw materials from a related person. The raw materials are 
manufactured (under the principles of Sec.  1.954-3(a)(4)(ii) or 
(a)(4)(iii)) into Product X by CM, an unrelated corporation, 
pursuant to a contract manufacturing arrangement. CM physically 
performs the substantial transformation, assembly, or conversion of 
the raw materials in Country C. FS has two branches, Branch A and 
Branch B, located in Country A and Country B respectively. Branch A, 
through the activities of employees of FS located in Country A, 
designs Product X. Branch B, through the activities of employees of 
FS located in Country B, controls manufacturing related logistics, 
provides oversight and direction during the manufacturing process, 
and controls the raw materials and work-in-process. FS manages the 
manufacturing costs and capacities related to the manufacture of 
Product X through employees located in Country M. Further, employees 
of FS located in Country M oversee the coordination between the 
branches. Employees of FS located in Country M also sell Product X 
to unrelated persons for use outside of Country M. Country M imposes 
an effective rate of tax on sales income of 10%. Country A imposes 
an effective rate of tax on sales income of 20%, and Country B 
imposes an effective rate of tax on sales income of 24%. Neither the 
remainder of FS, nor any branch of FS independently satisfies Sec.  
1.954-3(a)(4)(i). However, under the facts and circumstances of the 
business, FS as a whole provides a substantial contribution to the 
manufacture of Product X within the meaning of Sec.  1.954-
3(a)(4)(iv).
    (ii) Result. Based on the facts, neither the remainder of FS 
(through the activities of its employees in Country M) nor any 
branch of FS independently satisfies Sec.  1.954-3(a)(4)(i) with 
respect to Product X, but FS, as a whole, provides a substantial 
contribution through the activities of its employees to the 
manufacture of Product X. The remainder of FS, Branch A, and Branch 
B each provides a contribution through the activities of employees 
to the manufacture of Product X. Therefore, FS must determine the 
location of manufacture under paragraph (b)(1)(ii)(c)(3)(iii) of 
this section The tested sales location is Country M because the 
remainder of FS performs the selling activities with respect to 
Product X. The location of Branch A is the tested manufacturing 
location because the effective rate of tax imposed on FS's sales 
income by Country M (10%) is less than 90% of, and at least 5 
percentage points less than, the effective rate of tax that would 
apply to such income in Country A (20%), and Country A has the 
lowest effective rate of tax among the manufacturing branches that 
would, after applying Sec.  1.954-3(b)(1)(ii)(b), be treated as a 
separate corporation. The activities of Branch B will be included in 
the contribution of Branch A for purposes of determining the 
location of manufacture of Product X because the effective rate of 
tax imposed on the sales income by Country M (10%) is less than 90% 
of, and at least 5 percentage points less than, the effective rate 
of tax that would apply to such income in Country B (24%). Under the 
facts and circumstances of the business, the activities of the 
remainder of FS would not provide a demonstrably greater 
contribution to the manufacture of Product X than the activities of 
Branch A and Branch B, considered together. Therefore, the location 
of manufacture is Country A, the location of Branch A.
    Example 4. Manufacturing activities performed by multiple 
branches, no branch independently satisfies Sec.  1.954-3(a)(4)(i), 
selling activities performed by remainder of the controlled foreign 
corporation, remainder contribution includes branch manufacturing 
activities. (i) Facts. The facts are the same as Example 3, except 
that the effective rate of tax on sales income in Country B is 12%. 
In addition, under the facts of the particular business, the 
activities of employees of FS located in Country B and Country M, if 
considered together, would provide a demonstrably greater 
contribution to the manufacture of Product X than the activities of 
employees of FS located in Country A.
    (ii) Result. Based on the facts, neither the remainder of FS 
(through activities of its employees in Country M) nor any branch of 
FS independently satisfies Sec.  1.954-3(a)(4)(i) with respect to 
Product X, but FS, as a whole, provides a substantial contribution 
through the activities of its employees to the manufacture of 
Product X. The remainder of FS, Branch A, and Branch B each provide 
a contribution through the activities of their employees to the 
manufacture of Product X. Therefore, FS must determine the location 
of manufacture under paragraph (b)(1)(ii)(c)(3)(iii) of this 
section. The tested sales location is Country M because the 
remainder of FS performs the selling activities with respect to 
Product X. The location of Branch A is the tested manufacturing 
location because the effective rate of tax imposed on FS's sales 
income by Country M (10%) is less than 90% of, and at least 5 
percentage points less than, the effective rate of tax that would 
apply to such income in Country A (20%), and Branch A is the only 
branch that would, after applying Sec.  1.954-3(b)(1)(ii)(b), be 
treated as a separate corporation. The activities of Branch B will 
be included in the contribution of the remainder of FS for purposes 
of determining the location of manufacture of Product X because the 
effective rate of tax imposed on the sales income by Country M (10%) 
is not less than 90% of, and at least 5 percentage points less than, 
the effective rate of tax that would apply to such income in Country 
B (12%). Under a facts and circumstances analysis, considered 
together, the activities of Branch B and the remainder of FS would 
provide a demonstrably greater contribution to the manufacture of 
Product X than the activities of Branch A. Therefore, the rules of 
paragraph (b)(1)(ii)(a) of this section will not apply and neither 
Branch A nor Branch B will be treated as a separate corporation for 
purposes of paragraph (b)(2)(ii) of this section and Sec.  1.954-
3(b)(2)(ii).
    Example 5. Manufacturing activities performed by multiple 
branches, no branch independently satisfies Sec.  1.954-3(a)(4)(i), 
selling activities performed by remainder of

[[Page 79352]]

the controlled foreign corporation and a sales branch. (i) Facts. 
The facts are the same as Example 3, except that selling activities 
are also performed by Branch D in Country D, and Country D imposes a 
16% effective rate of tax on sales income. In addition, under the 
facts and circumstances of the business, the activities of employees 
of FS located in Country A and Country M, considered together, would 
provide a demonstrably greater contribution to the manufacture of 
Product X than the activities of employees of FS located in Country 
B.
    (ii) Result. Based on the facts, neither the remainder of FS nor 
any branch of FS independently satisfies Sec.  1.954-3(a)(4)(i) with 
respect to Product X, but FS, as a whole, provides a substantial 
contribution through the activities of its employees to the 
manufacture of Product X. The remainder of FS, Branch A, and Branch 
B each provide a contribution through the activities of their 
employees to the manufacture of Product X. Therefore, FS must 
determine the location of manufacture under paragraph 
(b)(1)(ii)(c)(3)(iii) of this section. Further, pursuant to 
paragraph (b)(1)(ii)(c)(1) of this section, paragraph 
(b)(1)(ii)(c)(3)(iii) of this section must be applied separately to 
the sales income derived by the remainder of FS and Branch D 
respectively. The results with respect to the remainder of FS in 
this Example 6 are the same as in Example 3. However, paragraph 
(b)(1)(ii)(c)(3)(iii) of this section must also be applied with 
respect to Branch D because Branch D performs selling activities 
with respect to Product X. Thus, for purposes of that sales income, 
the location of Branch D is the tested sales location. The location 
of Branch B is the tested manufacturing location because the 
effective rate of tax imposed on the Branch D's sales income by 
Country D (16%) is less than 90% of, and at least 5 percentage 
points less than, the effective rate of tax that would apply to such 
income in Country B (24%), and Branch B is the only branch that 
would, after applying Sec.  1.954-3(b)(1)(ii)(b), be treated as a 
separate corporation. The manufacturing activities performed in 
Country M by the remainder of FS and the manufacturing activities 
performed in Country A by Branch A will be included in Branch D's 
contribution to the manufacture of Product X for purposes of 
determining the location of manufacture of Product X with respect to 
Branch D's sales income because the effective rate of tax imposed on 
the sales income by Country D (16%) is not less than 90% of, and at 
least 5 percentage points less than, the effective rate of tax that 
would apply to such income in Country M (10%) and Country A (20%). 
Under the facts and circumstances of the business, the activities of 
Branch D, Branch A, and the remainder of FS, considered together, 
would provide a demonstrably greater contribution to the manufacture 
of Product X than the activities of Branch B. Therefore, the rules 
of paragraph (b)(1)(ii)(a) of this section will not apply to Branch 
D and neither Branch A nor Branch D will be treated as a separate 
corporation for purposes of paragraph (b)(2)(ii) of this section and 
Sec.  1.954-3(b)(2)(ii).
    Example 6. Determining the location of manufacture when 
employees of remainder of controlled foreign corporation travel to 
location of unrelated contract manufacturer to perform manufacturing 
activities. (i) Facts. FS, a controlled foreign corporation 
organized in Country M, purchases raw materials from a related 
person. The raw materials are manufactured (under the principles of 
Sec.  1.954-3(a)(4)(ii) or (a)(4)(iii)) into Product X by CM, an 
unrelated corporation, pursuant to a contract manufacturing 
arrangement. CM physically performs the substantial transformation, 
assembly, or conversion of the raw materials in Country C. Employees 
of FS located in Country M sell Product X to unrelated persons for 
use outside of Country M. Employees of FS located in Country M 
engage in product design, manage the manufacturing costs and 
capacities with respect to Product X, and direct the use of 
intellectual property for the purpose of manufacturing Product X. 
Quality control and oversight and direction of the manufacturing 
process are conducted in Country C by employees of FS who are 
employed in Country M but who regularly travel to Country C. Branch 
A, located in Country A, is the only branch of FS. Product design 
with respect to Product X conducted by employees of FS located in 
Country A is supplemental to the bulk of the design work, which is 
done by employees of FS located in Country M. At all times, 
employees of Branch A control the raw materials, work-in-process and 
finished goods. Employees of FS located in Country A also control 
manufacturing related logistics with respect to Product X. Country M 
imposes an effective rate of tax on sales income of 10%. Country A 
imposes an effective rate of tax on sales income of 20%. Neither the 
remainder of FS nor Branch A independently satisfies Sec.  1.954-
3(a)(4)(i). However, under the facts and circumstance of the 
business, FS as a whole (including Branch A) provides a substantial 
contribution to the manufacture of Product X within the meaning of 
Sec.  1.954-3(a)(4)(iv).
    (ii) Result. Based on the facts, neither the remainder of FS nor 
Branch A independently satisfies Sec.  1.954-3(a)(4)(i) with respect 
to Product X, but FS, as a whole, provides a substantial 
contribution through the activities of its employees to the 
manufacture of Product X. The remainder of FS and Branch A each 
provide a contribution through the activities of employees to the 
manufacture of Product X. Therefore, FS must determine the location 
of manufacture under paragraph (b)(1)(ii)(c)(3)(iii) of this 
section. The tested sales location is Country M because the 
remainder of FS performs the selling activities with respect to 
Product X. The tested manufacturing location is the location of 
Branch A because the effective rate of tax imposed on the remainder 
of FS's sales income by Country M (10%) is less than 90% of, and at 
least 5 percentage points less than, the effective rate of tax that 
would apply to such income in Country A (20%), and Branch A is the 
only branch that would, after applying Sec.  1.954-3(b)(1)(ii)(b), 
be treated as a separate corporation. Although the activities of 
traveling employees are considered in determining whether FS, as a 
whole, makes a substantial contribution to the manufacture of 
Product X under Sec.  1.954-3(a)(4)(iv), the activities of the 
employees of FS that are performed in Country C are not taken into 
consideration in determining whether Country M, the jurisdiction 
under the laws of which FS is organized, is the location of 
manufacture under paragraph (b)(1)(ii)(c)(3)(iii) of this section. 
Activities of employees performed outside the jurisdiction in which 
the controlled foreign corporation is organized and outside a 
location in which the controlled foreign corporation maintains a 
branch or similar establishment, are not considered in determining 
the location of manufacture. Under the facts and circumstances of 
the business, the activities of employees of FS performed in Country 
M do not provide a demonstrably greater contribution to the 
manufacture of Product X than the activities of employees of FS 
performed in Country A. Therefore, the location of manufacture is 
Country A, the location of Branch A.

    (4) Use of more than one branch to manufacture, produce, construct, 
grow, or extract separate items of personal property. For purposes of 
paragraphs (b)(1)(ii)(c)(2) and (b)(1)(ii)(c)(3) of this section, an 
item of personal property refers to an individual unit of personal 
property rather than a type or class of personal property.
    (2) [Reserved]. For further guidance, see Sec.  1.954-3(b)(2).
    (i) [Reserved]. For further guidance, see Sec.  1.954-3(b)(2)(i).
    (a) Treatment as separate corporations. [Reserved]. For further 
guidance, see Sec.  1.954-3(b)(2)(i)(a).
    (b) Activities treated as performed on behalf of the remainder of 
corporation. With respect to purchasing or selling activities performed 
by or through the branch or similar establishment, such purchasing or 
selling activities will--
    (1) With respect to personal property manufactured, produced, or 
constructed by the remainder of the controlled foreign corporation (or 
any branch treated as the remainder of the controlled foreign 
corporation); or
    (2) With respect to personal property (other than property 
described in paragraph (b)(2)(i)(b)(1) of this section) purchased or 
sold, or purchased and sold, by the remainder of the controlled foreign 
corporation (or any branch treated as the remainder of the controlled 
foreign corporation), be treated on behalf of the remainder of the 
controlled foreign corporation.
    (c) [Reserved]. For further guidance, see Sec.  1.954-
3(b)(2)(i)(c).
    (d) Determination of hypothetical tax. To the extent applicable, 
the principles of Sec.  1.954-1(d)(2) shall be used in determining, 
under paragraph (b)(1)(i) of this section and Sec.  1.954-3(b)(1)(i), 
the effective rate of tax which would apply to the income of the branch 
or similar establishment under the laws of the

[[Page 79353]]

country in which the controlled foreign corporation is created or 
organized, or in determining, under paragraph (b)(1)(ii) of this 
section and Sec.  1.954-3(b)(1)(ii), the effective rate of tax which 
would apply to the income of the branch or similar establishment under 
the laws of the country in which the manufacturing, producing, 
constructing, growing, or extracting branch or similar establishment is 
located.
    (e) [Reserved]. For further guidance, see Sec.  1.954-
3(b)(2)(i)(e).
    (ii) [Reserved]. For further guidance, see Sec.  1.954-3(b)(2)(ii).
    (a) Treatment as separate corporations. The branch or similar 
establishment will be treated as a wholly owned subsidiary corporation 
of the controlled foreign corporation, and such branch or similar 
establishment will be deemed to be incorporated in the country in which 
it is located. For purposes of applying the rules of this paragraph 
(b)(2)(ii) and Sec.  1.954-3(b)(2)(ii), a branch or similar 
establishment of a controlled foreign corporation treated as a separate 
corporation purchasing or selling on behalf of the remainder of the 
controlled foreign corporation under paragraph (b)(2)(ii)(b) of this 
section, or the remainder of the controlled foreign corporation treated 
as a separate corporation purchasing or selling on behalf of a branch 
or similar establishment of the controlled foreign corporation under 
Sec.  1.954-3(b)(2)(ii)(c), will include any other branch or similar 
establishment or remainder of the controlled foreign corporation that 
would not be treated as a separate corporation (apart from the branch 
or similar establishment of a controlled foreign corporation that is 
treated as performing purchasing or selling activities on behalf of the 
remainder of the controlled foreign corporation under paragraph 
(b)(2)(ii)(b) of this section or the remainder of the controlled 
foreign corporation that is treated as performing purchasing or selling 
activities on behalf of the branch or similar establishment under Sec.  
1.954-3(b)(2)(ii)(c)) if the effective rate of tax imposed on the 
income of the purchasing or selling branch or similar establishment, or 
purchasing or selling remainder of the controlled foreign corporation, 
were tested under the principles of Sec.  1.954-3(b)(1)(i)(b) or 
(b)(1)(ii)(b) against the effective rate of tax that would apply to 
such income if it were considered derived by such other branch or 
similar establishment or the remainder of the controlled foreign 
corporation.
    (b) Activities treated as performed on behalf of the remainder of 
corporation. With respect to purchasing or selling activities performed 
by or through the branch or similar establishment, such purchasing or 
selling activities will--
    (1) With respect to personal property manufactured, produced, or 
constructed by the remainder of the controlled foreign corporation (or 
any branch treated as the remainder of the controlled foreign 
corporation); or
    (2) With respect to personal property (other than property 
described in paragraph (b)(2)(ii)(b)(1) of this section) purchased or 
sold, or purchased and sold, by the remainder of the controlled foreign 
corporation (or any branch treated as the remainder of the controlled 
foreign corporation), be treated as performed on behalf of the 
remainder of the controlled foreign corporation.
    (c) and (d) [Reserved]. For further guidance, see Sec.  1.954-
3(b)(2)(ii)(c) and (d).
    (e) Comparison with ordinary treatment. Income derived by a branch 
or similar establishment, or by the remainder of the controlled foreign 
corporation, shall not be determined to be foreign base company sales 
income under paragraph (b) of this section or Sec.  1.954-3(b) if the 
income would not be so considered if it were derived by a separate 
controlled foreign corporation under like circumstances.
    (f) [Reserved]. For further guidance, see Sec.  1.954-
3(b)(2)(ii)(f).
    (3) [Reserved]. For further guidance, see Sec.  1.954-3(b)(3).
    (4) Illustrations. The application of this paragraph (b)(4) may be 
illustrated by the following examples:
    Examples (1) and (2). [Reserved]. For further guidance, see Sec.  
1.954-3(b)(4) Examples (1) and (2).

    Example (3). (i) Facts. Corporation E, a controlled foreign 
corporation incorporated under the laws of foreign Country X, is a 
wholly owned subsidiary of Corporation D, also a controlled foreign 
corporation incorporated under the laws of Country X. Corporation E 
maintains Branch B in foreign Country Y. Both corporations use the 
calendar year as the taxable year. In 1964, Corporation E's sole 
activity, carried on through Branch B, consists of the purchase of 
articles manufactured in Country X by Corporation D, a related 
person, and the sale of the articles through Branch B to unrelated 
persons. One hundred percent of the articles sold through Branch B 
are sold for use outside Country X and 90 percent are also sold for 
use outside of Country Y. The income of Corporation E derived by 
Branch B from such transactions is taxed to Corporation E by Country 
X only at the time Corporation E distributes such income to 
Corporation D and is taxed on the basis of what the tax (a 40 
percent effective rate) would have been if the income had been 
derived in 1964 by Corporation E from sources within Country X from 
doing business through a permanent establishment therein. Country Y 
levies an income tax at an effective rate of 50 percent on income 
derived from sources within such country, but the income of Branch B 
for 1964 is effectively taxed by Country Y at a 5 percent rate since 
under the laws of such country, only 10 percent of Branch B's income 
is derived from sources within such country. Corporation E makes no 
distributions to Corporation D in 1964.
    (ii) Result. In determining foreign base company sales income of 
Corporation E for 1964, Branch B is treated as a separate wholly 
owned subsidiary corporation of Corporation E, the 5 percent rate of 
tax being less than 90 percent of, and at least 5 percentage points 
less than the 40 percent rate. Income derived by Branch B, treated 
as a separate corporation, from the purchase from a related person 
(Corporation D), of personal property manufactured outside of 
Country Y and sold for use, disposition, or consumption outside of 
Country Y constitutes foreign base company sales income. If, 
instead, Corporation D were unrelated to Corporation E, none of the 
income would be foreign base company sales income because 
Corporation E would be purchasing from and selling to unrelated 
persons and if Branch B were treated as a separate corporation it 
would likewise be purchasing from and selling to unrelated persons. 
Alternatively, if Corporation D were related to Corporation E, but 
Branch B manufactured the articles prior to sale under the 
principles of Sec.  1.954-3(a)(4)(iv), the income would not be 
foreign base company sales income because Branch B, treated as a 
separate corporation, would qualify for the manufacturing exception 
under Sec.  1.954-3(a)(4).
    Examples (4) through (7) [Reserved]. For further guidance, see 
Sec.  1.954-3(b)(4) Examples (4) through (7).
    Example (8). Uniformly applicable incentive tax rate in one 
country. (i) Facts. FS is a controlled foreign corporation organized 
in Country M. FS operates one branch, Branch A, located in Country 
A. Branch A manufactures Product X within the meaning of Sec.  
1.954-3(a)(4)(ii) or (a)(4)(iii). Raw materials used in the 
manufacture of Product X are purchased by FS from an unrelated 
person. FS engages in activities in Country M to sell Product X to a 
related person for use outside of Country M. Employees of FS located 
in Country M perform only sales functions. The effective rate 
imposed in Country M on the income from the sale of Product X is 
10%. Country A generally imposes an effective rate of tax on income 
of 20%, but imposes a uniformly applicable incentive rate of tax of 
10% on manufacturing income and related sales income.
    (ii) Result. The use of Branch A to manufacture Product X does 
not have substantially the same tax effect as if Branch A were a 
wholly owned subsidiary corporation of FS because the effective rate 
of tax on FS's sales income from the sale of Product X in Country M 
(10%) is not less than 90% of, and at least 5 percentage points less 
than, the effective rate of tax that would apply to such income in 
the country in

[[Page 79354]]

which Branch A is located (10%). Consequently, pursuant to Sec.  
1.954-3(b)(1)(ii)(b), Branch A is not treated as a separate 
corporation apart from the remainder of FS for purposes of 
determining foreign base company sales income.
    Example (9). Manufacturing activities performed by multiple 
branches, no branch independently satisfies Sec.  1.954-3(a)(4)(i), 
selling activities performed by remainder of the controlled foreign 
corporation, branch manufacturing activities included in remainder 
contribution. (i) Facts. FS, a controlled foreign corporation 
organized in Country M, has two branches, Branch A and Branch B, 
located in Country A and Country B respectively. FS purchases raw 
materials from a related person. The raw materials are manufactured 
(under the principles of Sec.  1.954-3(a)(4)(ii) or (a)(4)(iii)) 
into Product X by CM, an unrelated corporation, pursuant to a 
contract manufacturing arrangement. CM physically performs the 
substantial transformation, assembly, or conversion required to 
manufacture Product X outside of FS's country of organization. FS 
manages the manufacturing costs and capacities with respect to the 
manufacture of Product X through employees located in Country M. 
Further, employees of FS located in Country M oversee the 
coordination between the branches. Branch A, through the activities 
of employees of FS located in Country A, designs Product X, controls 
manufacturing related logistics, and controls the raw materials and 
work-in-process during the manufacturing process. Branch B, through 
the activities of employees of FS located in Country B, provides 
quality control and oversight and direction during the manufacturing 
process. Employees of FS located in Country M sell Product X to 
unrelated persons for use outside of Country M. Country M imposes an 
effective rate of tax on sales income of 10%. Country A imposes an 
effective rate of tax on sales income of 12%, and Country B imposes 
an effective rate of tax on sales income of 24%. None of the 
remainder of FS, Branch A, or Branch B independently satisfies Sec.  
1.954-3(a)(4)(i). However, under the facts and circumstances of the 
business, FS, as a whole, provides a substantial contribution to the 
manufacture of Product X within the meaning of Sec.  1.954-
3(a)(4)(iv). Under the facts and circumstances of the business, the 
activities of the remainder of FS and Branch A, if considered 
together, would not provide a demonstrably greater contribution to 
the manufacture of Product X than the activities of Branch B. Under 
the facts and circumstances of the business, however, the activities 
of the employees of the remainder of FS and Branch A, if considered 
together, would constitute a substantial contribution to the 
manufacture of Product X.
    (ii) Result. Based on the facts, neither the remainder of FS 
(through activities of its employees in Country M) nor any branch of 
FS independently satisfies Sec.  1.954-3(a)(4)(i) with respect to 
Product X, but FS, as a whole, provides a substantial contribution 
through the activities of its employees to the manufacture of 
Product X. The remainder of FS, Branch A, and Branch B each provide 
a contribution through the activities of employees to the 
manufacture of Product X. Therefore, FS must determine the location 
of manufacture under paragraph (b)(1)(ii)(c)(3)(iii) of this 
section. The tested sales location is Country M because the 
remainder of FS performs the selling activities with respect to 
Product X. The location of Branch B is the tested manufacturing 
location because the effective rate of tax imposed on FS's sales 
income by Country M (10%) is less than 90% of, and at least 5 
percentage points less than, the effective rate of tax that would 
apply to such income in Country B (24%); and Branch B is the only 
manufacturing branch that would, after applying Sec.  1.954-
3(b)(1)(ii)(b), be treated as a separate corporation. The 
manufacturing activities performed in Country A will be included in 
the contribution of the remainder of FS for purposes of determining 
the location of manufacture of Product X because the effective rate 
of tax imposed on the sales income by Country M (10%) is not less 
than 90% of, and at least 5 percentage points less than, the 
effective rate of tax that would apply to such income in Country A 
(12%). Under the facts and circumstances of the business, the 
manufacturing activities of the remainder of FS and Branch A, 
considered together, would not provide a demonstrably greater 
contribution to the manufacture of Product X than the activities of 
Branch B. Therefore, the location of manufacture is Country B, the 
location of Branch B. In determining that Country B is the location 
of manufacture, it was determined that after applying Sec.  1.954-
3(b)(1)(ii)(b) Branch B would be treated as a separate corporation 
under paragraph (b)(1)(ii)(a) of this section for purposes of 
determining foreign base company sales income. To determine whether 
income from the sale of Product X is foreign base company sales 
income, the remainder of FS takes into account the activities of 
Branch A because, under paragraph (b)(2)(ii)(a) of this section, 
Branch A would not be treated as a separate corporation apart from 
FS. The remainder of FS is considered to have manufactured Product X 
under Sec.  1.954-3(a)(4)(i) because the manufacturing activities of 
the remainder of FS and Branch A, considered together, would make a 
substantial contribution to the manufacture of Product X within the 
meaning of Sec.  1.954-3(a)(4)(iv). Therefore, income derived from 
the sale of Product X by the remainder of FS does not constitute 
foreign base company sales income.

    (c) [Reserved]. For further guidance, see Sec.  1.954-3(c).
    (d) [Reserved]. For further guidance, see Sec.  1.954-3(d).
    (e) Effective/applicability date of temporary regulations. 
Paragraphs (b)(1)(i)(c), (b)(1)(ii)(a), (b)(1)(ii)(c), (b)(2)(i)(b), 
(b)(2)(ii)(a), (b)(2)(ii)(b), (b)(2)(ii)(e), and (b)(4) Example (3), 
Example (8), and Example (9) of this section shall apply to taxable 
years of controlled foreign corporations beginning after June 30, 2009, 
and for taxable years of United States shareholders in which or with 
which such taxable years of the controlled foreign corporations end.
    (f) Application of temporary regulations to earlier taxable years. 
For the application of these temporary regulations retroactively with 
respect to taxable years of controlled foreign corporations and to open 
taxable years of United States shareholders in which or with which such 
taxable years of the controlled foreign corporations end, see Sec.  
1.954-3(d).
    (g) Expiration date. The applicability of this section expires on 
or before December 23, 2011.

Linda E. Stiff,
Deputy Commissioner for Services and Enforcement.
    Approved: December 18, 2008.
Eric Solomon,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. E8-30727 Filed 12-24-08; 8:45 am]
BILLING CODE 4830-01-P