United States Tax Alert - 16 December 2011
Temporary regulations under §954(d) branch rules finalized
By Tim Tuerff, Gretchen Sierra, Christopher Trump and Janet Elsbernd
On 15 December 2011, the U.S. Internal Revenue Service (IRS) and Treasury Department finalized regulations under the so-called “branch rules” of U.S. Internal Revenue Code §954(d)(2) (“Final Regulations”).1 The temporary regulations under §954(d)(2) (“Temporary Regulations,” discussed here)2 were issued on 24 December 2008, and were due to expire on 23 December 2011. The Final Regulations largely adopt the branch rules in the Temporary Regulations with very minor exceptions. Importantly, the Final Regulations do not amend any portion of the rules of Reg. §1.954-3(a), including the substantial contribution rules that were finalized in 2008.3
The Final Regulations provide rules for determining whether a controlled foreign corporation (CFC) will recognize foreign base company sales income (FBCSI) where it conducts selling, purchasing or manufacturing activities outside its country of incorporation. The Final Regulations make three key changes to the branch rules.
First, the Final Regulations make a minor amendment to the rules addressing multiple manufacturing locations under the manufacturing branch rules. The regulations delete the word “demonstrably” from Reg. §1.954-3(b)(1)(ii)(c)(3)(iii). As originally drafted, this provision provided that if none of the branches or the remainder of a CFC independently satisfies the substantial contribution test,4 but the CFC as a whole makes a substantial contribution to the physical manufacture of the property it purchases or sells, then the location of manufacturing is the tested manufacturing location5 unless the tested sales location6 provided a demonstrably greater contribution. As noted by the IRS and Treasury in the Preamble to the Final Regulations, this change was made to alleviate concern that the use of the term “demonstrably” was intended to set forth a standard of evidentiary proof. Accordingly, although the word was removed, no change was made to the application of the provision.
In addition, the Final Regulations clarify for purposes of certain branch grouping rules,7 which apply after it has been determined that a branch and the remainder of a CFC will be treated as a separate corporation, that only the activities of the branches (or remainder CFC) are grouped. As a result, the Final Regulations make clear that the income of the branches (or remainder CFC) is not combined for purposes of determining the FBSCI of the CFC.
Finally, the Final Regulations clarify the coordination of the sales or purchase branch rules and the manufacturing branch rules. The Final Regulations confirm, through the removal of Reg. §1.954-3(b)(1)(ii)(d), that the sales or purchase branch rules of Reg. §1.954-3(b)(1)(i) do not apply if the manufacturing branch rules apply.8
The Final Regulations are effective for CFC taxable years beginning after 30 June 2009 and for the taxable years of U.S. shareholders in which or within which such taxable year of the CFC ends. However, taxpayers can elect to apply the Final Regulations retroactively to all open taxable years that began prior to 1 July 2009.
2 T.D. 9438, 73 Fed. Reg. 79334 (29 December 2008), as corrected at 74 Fed. Reg. 11843 (20 March 2009).
4 Under the substantial contribution test, a CFC can qualify as the manufacturer of personal property, regardless of whether it engages in physical manufacturing, if two conditions are satisfied. First, the item of personal property must be physically manufactured prior to its sale. Second, the CFC must make a “substantial contribution” through the activity of its employees to the manufacture, production or construction of the personal property sold. See Reg. §1.954-3(a)(4)(iv).
5 The tested manufacturing location is the location of any branch (or similar establishment) or remainder of the CFC that contributes to the manufacture, production or construction of the personal property, if any, that would 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 CFC. Reg. §1.954-3(b)(1)(ii)(c)(3)(iii).
6 The tested sales location is the location of the purchasing or selling branch (or similar establishment) or the remainder of the CFC by or through which the purchasing or selling activities are carried on with respect to the personal property. Reg. §1.954-3(b)(1)(ii)(c)(3)(iii).
7 See Reg. §1.954-3(b)(2)(ii)(a).
8 Reg. §1.954-3(b)(1)(ii)(d) providing that income treated as FBSCI under the sales or purchase branch rule cannot also result in FBSCI under the manufacturing branch rules, preventing a double subpart F inclusion.