* * * * *

(i) Abandonment of securities—(1) In general. For purposes of section 165 and this section, a security that becomes wholly worthless includes a security described in paragraph (a) of this section that is abandoned and otherwise satisfies the requirements for a deductible loss under section 165. If the abandoned security is a capital asset and is not described in section 165(g)(3) and paragraph (d) of this section (concerning worthless securities of certain affiliated corporations), the resulting loss is treated as a loss from the sale or exchange, on the last day of the taxable year, of a capital asset. See section 165(g)(1) and paragraph (c) of this section. To abandon a security, a taxpayer must permanently surrender and relinquish all rights in the security and receive no consideration in exchange for the security. For purposes of this section, all the facts and circumstances determine whether the transaction is properly characterized as an abandonment or other type of transaction, such as an actual sale or exchange, contribution to capital, dividend, or gift.

(2) Effective/applicability date. This paragraph (i) applies to any abandonment of stock or other securities after March 12, 2008.

* * * * *

Linda E. Stiff,
Deputy Commissioner for
Services and Enforcement.

Approved March 3, 2008.

Eric Solomon,
Assistant Secretary of
the Treasury (Tax Policy).

* * * * *

(k) Treatment of accumulated deferred investment tax credits upon the deregulation of public utility property—(1) Scope—(i) In general. This paragraph (k) provides rules for the application of former sections 46(f)(1) and 46(f)(2) of the Internal Revenue Code to a taxpayer with respect to public utility property that ceases, whether by disposition, deregulation, or otherwise, to be public utility property with respect to the taxpayer and that is not described in paragraph (k)(1)(ii) of this section (deregulated public utility property).

(ii) Exception. This paragraph (k) does not apply to property that ceases to be public utility property with respect to the taxpayer on account of an ordinary retirement within the meaning of §1.167(a)-11(d)(3)(ii).

(2) Ratable amount—(i) Restoration of rate base reduction. A reduction in the taxpayer’s rate base on account of the credit with respect to public utility property that becomes deregulated public utility property is restored ratably during the period after the property becomes deregulated public utility property if the amount of the reduction remaining to be restored does not, at any time during the period, exceed the restoration percentage of the recoverable stranded cost of the property at such time.

For this purpose—

(A) The stranded cost of the property is the cost of the property reduced by the amount of such cost that the taxpayer has recovered through regulated depreciation expense during the period before the property becomes deregulated public utility property;

(B) The recoverable stranded cost of the property at any time is the stranded cost of the property that the taxpayer will be permitted to recover through rates after such time; and

(C) The restoration percentage for the property is determined by dividing the reduction in rate base remaining to be restored with respect to the property immediately before the property becomes deregulated public utility property by the stranded cost of the property.

(ii) Cost of service reduction. Reductions in the taxpayer’s cost of service on account of the credit with respect to public utility property that becomes deregulated public utility property are ratable during the period after the property becomes deregulated public utility property if the cumulative amount of the reduction during such period does not, at any time during the period, exceed the flowthrough percentage of the cumulative stranded cost recovery for the property at such time.

For this purpose—

(A) The stranded cost of the property is the cost of the property reduced by the amount of such cost that the taxpayer has recovered through regulated depreciation expense during the period before the property becomes deregulated public utility property;

(B) The cumulative stranded cost recovery for the property at any time is the stranded cost of the property that the taxpayer has been permitted to recover through rates on or before such time; and

(C) The flowthrough percentage for the property is determined by dividing the amount of credit with respect to the property remaining to be used to reduce cost of service immediately before the property becomes deregulated public utility property by the stranded cost of the property.

(3) Cross reference. See §1.168(i)-(3) for rules relating to the treatment of balances of excess deferred income taxes when public utility property becomes deregulated public utility property.

(4) Effective/applicability dates—(i) In general. Except as provided in paragraph (k)(4)(ii) of this section, this paragraph (k) applies to public utility property that becomes deregulated public utility property with respect to a taxpayer after December 21, 2005.

(ii) Property that becomes public utility property of the transferee. This paragraph (k) does not apply to property that becomes deregulated public utility property with respect to a taxpayer on account of a transfer on or before March 20, 2008, if after the transfer the property is public utility property of the transferee.

(iii) Application of regulation project (REG-104385-01). A reduction in the taxpayer’s cost of service will be treated as ratable if it is consistent with the proposed rules in regulation project (REG-104385-01) (68 FR 10190) March 4, 2003, and occurs during the period beginning on March 5, 2003, and ending on the earlier of—

(A) The last date on which the utility’s rates are determined under the rate order in effect on December 21, 2005; or

(B) December 21, 2007.

Par. 3. Section 1.168(i)-3 is added to read as follows:

(a) Scope—(1) In general. This section provides rules for the application of section 203(e) of the Tax Reform Act of 1986, Public Law 99-514 (100 Stat. 2146) to a taxpayer with respect to public utility property (within the meaning of section 168(i)(10)) that ceases, whether by disposition, deregulation, or otherwise, to be public utility property with respect to the taxpayer and that is not described in paragraph (a)(2) of this section (deregulated public utility property).

(2) Exceptions. This section does not apply to the following property:

(i) Property that ceases to be public utility property with respect to the taxpayer on account of an ordinary retirement within the meaning of §1.167(a)-11(d)(3)(ii).

(ii) Property transferred by the taxpayer if after the transfer the property is public utility property of the transferee and the taxpayer’s excess tax reserve with respect to the property (within the meaning of section 203(e) of the Tax Reform Act of 1986) is treated as an excess tax reserve of the transferee with respect to the property.

(b) Amount of reduction. If public utility property of a taxpayer becomes deregulated public utility property to which this section applies, the reduction in the taxpayer’s excess tax reserve permitted under section 203(e) of the Tax Reform Act of 1986 is equal to the amount by which the reserve could be reduced under that provision if all such property had remained public utility property of the taxpayer and the taxpayer had continued use of its normalization method of accounting with respect to such property.

(c) Cross reference. See §1.46-6(k) for rules relating to the treatment of accumulated deferred investment tax credits when utilities dispose of regulated public utility property.

(d) Effective/applicability dates—(1) In general. Except as provided in paragraph (d)(2) of this section, this section applies to public utility property that becomes deregulated public utility property after December 21, 2005.

(2) Property that becomes public utility property of the transferee. This section does not apply to property that becomes deregulated public utility property with respect to a taxpayer on account of a transfer on or before March 20, 2008, if after the transfer the property is public utility property of the transferee.

(3) Application of regulation project (REG-104385-01). A reduction in the taxpayer’s excess deferred income tax reserve will be treated as ratable if it is consistent with the proposed rules in regulation project (REG-104385-01) (68 FR 10190) March 4, 2003, and occurs during the period beginning on March 5, 2003, and ending on the earlier of—

(i) The last date on which the utility’s rates are determined under the rate order in effect on December 21, 2005; or

(ii) December 21, 2007.

Linda E. Stiff,
Acting Deputy Commissioner for
Services and Enforcement.

Approved March 6, 2008.

Eric Solomon,
Assistant Secretary of
the Treasury (Tax Policy).

Section 199(a)(1) allows a deduction equal to 9 percent (3 percent in the case of taxable years beginning in 2005 or 2006, and 6 percent in the case of taxable years beginning in 2007, 2008, or 2009) of the lesser of (A) the qualified production activities income (QPAI) of the taxpayer for the taxable year, or (B) taxable income (determined without regard to section 199) for the taxable year (or, in the case of an individual, adjusted gross income).

Section 199(c)(1) defines QPAI for any taxable year as an amount equal to the excess (if any) of (A) the taxpayer’s domestic production gross receipts (DPGR) for such taxable year, over (B) the sum of (i) the cost of goods sold (CGS) that are allocable to such receipts; and (ii) other expenses, losses, or deductions (other than the deduction under section 199) that are properly allocable to such receipts.

Section 199(c)(4)(A)(i) provides that the term DPGR means the taxpayer’s gross receipts that are derived from any lease, rental, license, sale, exchange, or other disposition of (I) qualifying production property (QPP) that was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States; (II) any qualified film produced by the taxpayer; or (III) electricity, natural gas, or potable water produced by the taxpayer in the United States.

Section 199(c)(6) defines a qualified film to mean any property described in section 168(f)(3) if not less than 50 percent of the total compensation relating to production of the property is compensation for services performed in the United States by actors, production personnel, directors, and producers. The term does not include property with respect to which records are required to be maintained under 18 U.S.C. 2257 (generally, films, videotapes, or other matter that depict actual sexually explicit conduct and are produced in whole or in part with materials that have been mailed or shipped in interstate or foreign commerce, or are shipped or transported or are intended for shipment or transportation in interstate or foreign commerce).

Section 199(d)(4)(A) provides that all members of an expanded affiliated group (EAG) are treated as a single corporation for purposes of section 199. Under section 199(d)(4)(B), an EAG is an affiliated group as defined in section 1504(a), determined by substituting “more than 50 percent” for “at least 80 percent” each place it appears and without regard to section 1504(b)(2) and (4).

Under section 199(c)(4)(A)(i)(II), a taxpayer’s gross receipts qualify as DPGR if the receipts are derived from any lease, rental, license, sale, exchange, or other disposition of any qualified film (as defined in section 199(c)(6)) produced by the taxpayer. A film must be both a “qualified film” under section 199(c)(6) and “produced by the taxpayer” under section 199(c)(4)(A)(i)(II) in order for the gross receipts to qualify as DPGR. However, as discussed in the preamble to the proposed regulations published on June 7, 2007 (72 FR 31478), the “by the taxpayer” compensation fraction in §1.199-3(k)(5) in T.D. 9263 (71 FR 31268) may have resulted in a film that was produced entirely within the United States as not qualifying under section 199(c)(6) if less than 50 percent of the total compensation relating to production was paid “by the taxpayer.”

This Treasury decision revises the “by the taxpayer” compensation fraction in §1.199-3(k)(5) in T.D. 9263 (71 FR 31268) for determining the not-less-than-50-percent-of-the-total-compensation requirement under §1.199-3(k)(1). Under the revised fraction in §1.199-3(k)(5), the numerator of the revised fraction is the compensation for services performed in the United States and the denominator is the total compensation for services regardless of where the production activities are performed. The revised fraction essentially compares (in the numerator) the sum of the compensation for services paid by the taxpayer for services performed in the United States and the compensation for services paid by others for services performed in the United States to (in the denominator) the sum of the total compensation for services paid by the taxpayer for services and the total compensation for services paid by others for services regardless of location.

Under §1.199-3(k)(6), a film that is a qualified film under §1.199-3(k)(1) will be treated as “produced by the taxpayer” for purposes of section 199(c)(4)(A)(i)(II) if the production activity performed by the taxpayer is substantial in nature within the meaning of §1.199-3(g)(2). Thus, a qualified film will be treated as produced by the taxpayer if the production of the qualified film by the taxpayer is substantial in nature taking into account all of the facts and circumstances, including the relative value added by, and relative cost of, the taxpayer’s production activity, the nature of the qualified film, and the nature of the production activity that the taxpayer performs.

The revised fraction in §1.199-3(k)(5) follows the statutory language in section 199(c)(6) by referencing all compensation for services related to the production as opposed to the more limited “by the taxpayer” compensation fraction in T.D. 9263 (71 FR 31268). Because taxpayers may have difficulty obtaining information related to the compensation paid by others, this Treasury decision provides a safe harbor in §1.199-3(k)(7) that treats a film as a qualified film if not less than 50 percent of the total compensation for services paid by the taxpayer is compensation for services performed in the United States. The safe harbor further provides that a qualified film will be treated as produced by the taxpayer if the taxpayer satisfies the safe harbor in §1.199-3(g)(3) with respect to the qualified film, which requires that the direct labor and overhead costs incurred by the taxpayer to produce the qualified film within the United States account for 20 percent or more of the total costs of the film. Thus, a taxpayer will be treated as having produced a qualified film if, in connection with the qualified film, the direct labor and overhead of the taxpayer to produce the qualified film within the United States account for 20 percent or more of the taxpayer’s CGS of the qualified film, or in a transaction without CGS (for example, a lease, rental, or license) account for 20 percent or more of the taxpayer’s “unadjusted depreciable basis” (as defined in §1.199-3(g)(3)(ii)) in the qualified film.

As discussed in the preamble to the proposed regulations published on June 7, 2007 (72 FR 31478), §1.199-7(e), Example 10, in T.D. 9263 (71 FR 31268) misapplies §1.1502-13 of the consolidated return regulations. Accordingly, §1.199-7(e), Example 10, has been revised to correctly apply the consolidated return regulations. In addition, as also discussed in the preamble to the proposed regulations published on June 7, 2007 (72 FR 31478), the section 199 closing of the books method under §1.199-7(f)(1)(ii) in T.D. 9263 (71 FR 31268) could have created a larger section 199 deduction than is warranted. Accordingly, this Treasury decision removes the section 199 closing of the books method and revises the Example in §1.199-7(g)(3) to apply the pro rata allocation method.

* * * * *

* * * * *

(k) * * *

(6) Produced by the taxpayer.

(7) Qualified film produced by the taxpayer — safe harbor.

(i) Safe harbor.

(ii) Determination of 50 percent.

(8) Production pursuant to a contract.

(9) Exception.

(10) Examples.

* * * * *

* * * * *

(i) * * *

(8) Qualified film produced by the taxpayer.

(9) Expanded affiliated groups.

* * * * *

Par. 3. Section 1.199-3 is amended by:

1. Revising paragraphs (k)(1), (k)(4), and (k)(5).

2. Redesignating paragraph (k)(6) as (k)(9).

3. Redesignating paragraph (k)(7) as (k)(10).

4. Adding new paragaphs (k)(6), (k)(7), and (k)(8).

5. Revising Example 6 of newly redesignated paragraph (k)(10).

The revisions and additions read as follows:

* * * * *

(k) Definition of qualified film—(1) In general. The term qualified film means any motion picture film or video tape under section 168(f)(3), or live or delayed television programming (film), if not less than 50 percent of the total compensation relating to the production of such film is compensation for services performed in the United States by actors, production personnel, directors, and producers. For purposes of this paragraph (k), the term actors includes players, newscasters, or any other persons who are compensated for their performance or appearance in a film. For purposes of this paragraph (k), the term production personnel includes writers, choreographers and composers who are compensated for providing services during the production of a film, as well as casting agents, camera operators, set designers, lighting technicians, make-up artists, and other persons who are compensated for providing services that are directly related to the production of the film. Except as provided in paragraph (k)(2) of this section, the definition of a qualified film does not include tangible personal property embodying the qualified film, such as DVDs or videocassettes.

* * * * *

(4) Compensation for services. For purposes of this paragraph (k), the term compensation for services means all payments for services performed by actors, production personnel, directors, and producers relating to the production of the film, including participations and residuals. Payments for services include all elements of compensation as provided for in §1.263A-1(e)(2)(i)(B) and (3)(ii)(D). Compensation for services is not limited to W-2 wages and includes compensation paid to independent contractors. In the case of a taxpayer that uses the income forecast method of section 167(g) and capitalizes participations and residuals into the adjusted basis of the qualified film, the taxpayer must use the same estimate of participations and residuals in determining compensation for services. In the case of a taxpayer that excludes participations and residuals from the adjusted basis of the qualified film under section 167(g)(7)(D)(i), the taxpayer must use the amount expected to be paid as participations and residuals based on the total forecasted income used in determining income forecast depreciation in determining compensation for services.

(5) Determination of 50 percent. The not-less-than-50-percent-of-the-total-compensation requirement under paragraph (k)(1) of this section is calculated using a fraction. The numerator of the fraction is the compensation for services performed in the United States and the denominator is the total compensation for services regardless of where the production activities are performed. A taxpayer may use any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances, including all historic information available, to determine the compensation for services performed in the United States and the total compensation for services regardless of where the production activities are performed. Among the factors to be considered in determining whether a taxpayer’s method of allocating compensation is reasonable is whether the taxpayer uses that method consistently from one taxable year to another.

(6) Produced by the taxpayer. A qualified film will be treated as produced by the taxpayer for purposes of section 199(c)(4)(A)(i)(II) if the production activity performed by the taxpayer is substantial in nature within the meaning of paragraph (g)(2) of this section. The special rules of paragraph (g)(4) of this section regarding a contract with an unrelated person and aggregation apply in determining whether the taxpayer’s production activity is substantial in nature. Paragraphs (g)(2) and (4) of this section are applied by substituting the term qualified film for QPP and disregarding the requirement that the production activity must be within the United States. The production activity of the taxpayer must consist of more than the minor or immaterial combination or assembly of two or more components of a film. For purposes of paragraph (g)(2) of this section, the relative value added by affixing trademarks or trade names as defined in §1.197-2(b)(10)(i) will be treated as zero.

(7) Qualified film produced by the taxpayer — safe harbor. A film will be treated as a qualified film under paragraph (k)(1) of this section and produced by the taxpayer under paragraph (k)(6) of this section (qualified film produced by the taxpayer) if the taxpayer meets the requirements of paragraphs (k)(7)(i) and (ii) of this section. A taxpayer that chooses to use this safe harbor must apply all the provisions of this paragraph (k)(7).

(i) Safe harbor. A film will be treated as a qualified film produced by the taxpayer if not less than 50 percent of the total compensation for services paid by the taxpayer is compensation for services performed in the United States and the taxpayer satisfies the safe harbor in paragraph (g)(3) of this section. The special rules of paragraph (g)(4) of this section regarding a contract with an unrelated person and aggregation apply in determining whether the taxpayer satisfies paragraph (g)(3) of this section. Paragraphs (g)(3) and (4) of this section are applied by substituting the term qualified film for QPP but not disregarding the requirement that the direct labor and overhead of the taxpayer to produce the qualified film must be within the United States. Paragraph (g)(3)(ii)(A) of this section includes any election under section 181.

(ii) Determination of 50 percent. The not-less-than-50-percent-of-the-total-compensation requirement under paragraph (k)(7)(i) of this section is calculated using a fraction. The numerator of the fraction is the compensation for services paid by the taxpayer for services performed in the United States and the denominator is the total compensation for services paid by the taxpayer regardless of where the production activities are performed. For purposes of this paragraph (k)(7)(ii), the term paid by the taxpayer includes amounts that are treated as paid by the taxpayer under paragraph (g)(4) of this section. A taxpayer may use any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances, including all historic information available, to determine the compensation for services paid by the taxpayer for services performed in the United States and the total compensation for services paid by the taxpayer regardless of where the production activities are performed. Among the factors to be considered in determining whether a taxpayer’s method of allocating compensation is reasonable is whether the taxpayer uses that method consistently from one taxable year to another.

(8) Production pursuant to a contract. With the exception of the rules applicable to an expanded affiliated group (EAG) under §1.199-7 and EAG partnerships under §1.199-3(i)(8), only one taxpayer may claim the deduction under §1.199-1(a) with respect to any activity related to the production of a qualified film performed in connection with the same qualified film. If one taxpayer performs a production activity pursuant to a contract with another party, then only the taxpayer that has the benefits and burdens of ownership of the qualified film under Federal income tax principles during the period in which the production activity occurs is treated as engaging in the production activity.

* * * * *

(10) * * *

Example 6. X creates a television program in the United States that includes scenes from films licensed by X from unrelated persons Y and Z. Assume that Y and Z produced the films licensed by X. The not-less-than-50-percent-of-the-total-compensation requirement under paragraph (k)(1) of this section is determined by reference to all compensation for services paid in the production of the television program, including the films licensed by X from Y and Z, and is calculated using a fraction as described in paragraph (k)(5) of this section. The numerator of the fraction is the compensation for services performed in the United States and the denominator is the total compensation for services regardless of where the production activities are performed. However, for purposes of calculating the denominator, in determining the total compensation paid by Y and Z, X need only include the total compensation paid by Y and Z to actors, production personnel, directors, and producers for the production of the scenes used by X in creating its television program.

* * * * *

Par. 4. Section 1.199-7 is amended by:

1. Revising Example 10 of paragraph (e).

2. Revising paragraphs (f)(1) and (g)(3).

The revisions read as follows:

* * * * *

(e) * * *

Example 10. (i) Facts. Corporation P owns all of the stock of Corporations S and B. P, S, and B file a consolidated Federal income tax return on a calendar year basis. P, S, and B each uses the section 861 method for allocating and apportioning their deductions. In 2010, S MPGE QPP in the United States at a cost of $1,000. On November 30, 2010, S sells the QPP to B for $2,500. On February 28, 2011, P sells 60% of the stock of B to X, an unrelated person. On June 30, 2011, B sells the QPP to U, another unrelated person, for $3,000.

(ii) Consolidated group’s 2010 QPAI. Because S and B are members of a consolidated group in 2010, pursuant to §1.199-7(d)(1) and §1.1502-13, neither S’s $1,500 of gain on the sale of QPP to B nor S’s $2,500 gross receipts from the sale are taken into account in 2010. Accordingly, neither S nor B has QPAI in 2010.

(iii) Consolidated group’s 2011 QPAI. B becomes a nonmember of the consolidated group at the end of the day on February 28, 2011, the date on which P sells 60% of the B stock to X. Under §1.199-7(d)(1) and §1.1502-13(d), S takes the intercompany transaction into account immediately before B becomes a nonmember of the consolidated group. Pursuant to §1.1502-13(d)(1)(ii)(A)(1), because the QPP is owned by B, a nonmember of the consolidated group immediately after S’s gain is taken into account, B is treated as selling the QPP to a nonmember for $2,500, B’s adjusted basis in the property, immediately before B becomes a nonmember of the consolidated group. Accordingly, immediately before B becomes a nonmember of the consolidated group, S takes into account $1,500 of QPAI (S’s $2,500 DPGR received from B - S’s $1,000 cost of MPGE the QPP).

(iv) B’s 2011 QPAI. Pursuant to §1.1502-13(d)(2)(i)(B), the attributes of B’s corresponding item, that is, its sale of the QPP to U, are determined as if the S division (but not the B division) were transferred by the P, S, and B consolidated group (treated as a single corporation) to an unrelated person. Thus, S’s activities in MPGE the QPP before the intercompany sale of the QPP to B continue to affect the attributes of B’s sale of the QPP. As such, B is treated as having MPGE the QPP. Accordingly, upon its sale of the QPP, B has $500 of QPAI (B’s $3,000 DPGR received from U minus B’s $2,500 cost of MPGE the QPP).

* * * * *

(f) Allocation of income and loss by a corporation that is a member of the expanded affiliated group for only a portion of the year—(1) In general. A corporation that becomes or ceases to be a member of an EAG during its taxable year must allocate its taxable income or loss, QPAI, and W-2 wages between the portion of the taxable year that it is a member of the EAG and the portion of the taxable year that it is not a member of the EAG. This allocation of items is made by using the pro rata allocation method described in this paragraph (f)(1). Under the pro rata allocation method, an equal portion of a corporation’s taxable income or loss, QPAI, and W-2 wages for the taxable year is assigned to each day of the corporation’s taxable year. Those items assigned to those days that the corporation was a member of the EAG are then aggregated.

* * * * *

(g) * * *

(3) Example. The following example illustrates the application of paragraphs (f) and (g) of this section:

Example. (i) Facts. Corporations X and Y, calendar year corporations, are members of the same EAG for the entire 2010 taxable year. Corporation Z, also a calendar year corporation, is a member of the EAG of which X and Y are members for the first half of 2010 and not a member of any EAG for the second half of 2010. During the 2010 taxable year, neither X, Y, nor Z joins in the filing of a consolidated Federal income tax return. Assume that X, Y, and Z each has W-2 wages in excess of the section 199(b) wage limitation for all relevant periods. In 2010, X has taxable income of $2,000 and QPAI of $600, Y has a taxable loss of $400 and QPAI of ($200), and Z has taxable income of $1,400 and QPAI of $2,400.

(ii) Analysis. Pursuant to the pro rata allocation method, $700 of Z’s 2010 taxable income and $1,200 of Z’s 2010 QPAI are allocated to the first half of the 2010 taxable year (the period in which Z is a member of the EAG) and $700 of Z’s 2010 taxable income and $1,200 of Z’s 2010 QPAI are allocated to the second half of the 2010 taxable year (the period in which Z is not a member of any EAG). Accordingly, in 2010, the EAG has taxable income of $2,300 (X’s $2,000 + Y’s ($400) + Z’s $700) and QPAI of $1,600 (X’s $600 + Y’s ($200) + Z’s $1,200). The EAG’s section 199 deduction for 2010 is therefore $144 (9% of the lesser of the EAG’s $2,300 of taxable income or $1,600 of QPAI). Pursuant to §1.199-7(c)(1), this $144 deduction is allocated to X, Y, and Z in proportion to their respective QPAI. Accordingly, X is allocated $48 of the EAG’s section 199 deduction, Y is allocated $0 of the EAG’s section 199 deduction, and Z is allocated $96 of the EAG’s section 199 deduction. For the second half of 2010, Z has taxable income of $700 and QPAI of $1,200. Therefore, for the second half of 2010, Z has a section 199 deduction of $63 (9% of the lesser of its $700 taxable income or $1,200 QPAI for the second half of 2010). Accordingly, X’s 2010 section 199 deduction is $48, Y’s 2010 section 199 deduction is $0, and Z’s 2010 section 199 deduction is $159, the sum of the $96 section 199 deduction of the EAG allocated to Z for the first half of 2010 and Z’s $63 section 199 deduction for the second half of 2010.

* * * * *

Par. 5. Section 1.199-8 is amended by:

1. Adding two sentences at the end of paragraph (a).

2. Adding new paragraphs (i)(8) and (i)(9).

The revisions and additions read as follows:

(a) In general. * * * For purposes of §§1.199-1 through 1.199-9, use of terms such as payment, paid, incurred, or paid or incurred is not intended to provide any specific rule based upon the use of one term versus another. In general, the use of the term payment, paid, incurred, or paid or incurred is intended to convey the appropriate standard under the taxpayer’s method of accounting.

* * * * *

(i) * * *

(8) Qualified film produced by the taxpayer. Section 1.199-3(k) is applicable to taxable years beginning on or after March 7, 2008. A taxpayer may apply §1.199-3(k) to taxable years beginning after December 31, 2004, and before March 7, 2008. However, for taxable years beginning before June 1, 2006, a taxpayer may rely on §1.199-3(k) only if the taxpayer does not apply Notice 2005-14, 2005-1 C.B. 498 (see §601.601(d)(2)(ii)(b) of this chapter), or REG-105847-05, 2005-2 C.B. 987 (see §601.601(d)(2)(ii)(b) of this chapter), to the taxable year.

(9) Expanded affiliated groups. Section 1.199-7(e), Example 10, (f)(1), and (g)(3) are applicable to taxable years beginning on or after March 7, 2008. A taxpayer may apply §1.199-7(e), Example 10, to taxable years beginning after December 31, 2004, and before March 7, 2008.

Linda E. Stiff,
Deputy Commissioner for
Services and Enforcement.

Approved March 3, 2008.

Eric Solomon,
Assistant Secretary of
the Treasury (Tax Policy).

Under section 951(a)(1)(A)(i), a United States shareholder of a CFC includes in gross income its pro rata share of the CFC’s subpart F income for the CFC’s taxable year which ends with or within the taxable year of the shareholder. Section 952(a)(2) defines the term “subpart F income” to mean, in part, “foreign base company income.” Section 954(a)(2) defines “foreign base company income” to include foreign base company sales income (FBCSI) for the taxable year. Section 954(d)(1) defines FBCSI to mean income derived by a 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 of these cases) that the property both 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 Treasury regulations further define FBCSI and the applicable exceptions from FBCSI. These exceptions from FBCSI are contained in §1.954-3(a)(2), which addresses personal property manufactured, produced, constructed, grown, or extracted within the CFC’s country of organization (the same country manufacture exception), §1.954-3(a)(3), which addresses personal property sold for use, consumption or disposition within the CFC’s country of organization, and §1.954-3(a)(4) which addresses personal property manufactured, produced or constructed by the CFC (the manufacturing exception).

Section 1.954-3(a)(4)(i) provides that FBCSI does not include income of a CFC derived in connection with the sale of personal property manufactured, produced, or constructed by such corporation in whole or in part from personal property which it has purchased. It then states generally that a foreign corporation is considered to have manufactured, produced, or constructed personal property which it sells if the property sold is in effect not the property which it purchased. Specifically, §1.954-3(a)(4)(i) states that personal property sold will be considered as not being the property purchased if the provisions of §1.954-3(a)(4)(ii) or (iii) are satisfied.

Section 1.954-3(a)(4)(ii) and (iii) set forth two separate tests to determine whether a CFC is considered to manufacture, produce, or construct personal property that it sells. First, §1.954-3(a)(4)(ii) sets forth a “substantial transformation” test, pursuant to which if personal property is substantially transformed prior to sale, the property sold will be treated as having been manufactured, produced, or constructed by the selling corporation. Examples of substantial transformation provided in the regulations include the conversion of wood pulp to paper, steel rods to screws and bolts, and tuna fish to canned tuna. Second, §1.954-3(a)(4)(iii) sets forth a general “substantive test” and a safe harbor that apply when purchased property is used by the CFC as a component part of personal property that is sold by the CFC. Under the substantive test, the sale of personal property will be treated as the sale of a product manufactured by the CFC rather than the sale of component parts if the operations conducted by the CFC in connection with the property are substantial in nature and generally considered to constitute the manufacture, production, or construction of the property. The assembly of automobiles from component parts is provided as an example of an activity considered to be substantial in nature and generally considered to constitute the manufacture of a product. Under the safe harbor, without limiting the application of the substantive test, the operations of a selling corporation in connection with the use of purchased property as a component part of the personal property that 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. Section 1.954-3(a)(4)(iii) makes clear that, in no event, however, will packaging, prepackaging, labeling, or minor assembly operations constitute the manufacture, production, or construction of property for purposes of section 954(d)(1). For purposes of this preamble, satisfaction of the requirements of §1.954-3(a)(4)(ii) or (iii) will be referred to as satisfaction of the “physical manufacturing test.”

In addition to the general FBCSI rules of section 954(d)(1), section 954(d)(2) provides a special rule for purposes of determining FBCSI if a CFC carries on activities through a branch or similar establishment outside its country of organization and the carrying on of such activities has substantially the same effect as if such branch or similar establishment were a wholly owned subsidiary corporation (the branch rule). Under the branch rule, to the extent prescribed by regulations, the income attributable to the carrying on of such activities is treated as income derived by a wholly owned subsidiary of the CFC and constitutes FBCSI of the CFC. See section 954(d)(2). Section 1.954-3(b)(1)(i) (addressing sales or purchase branches) and (ii) (addressing manufacturing branches) provide rules on the application of the branch rule. The purpose of the branch rule is to prevent a CFC from using a foreign branch to avoid the application of the FBCSI rules. Absent the branch rule, a CFC could engage in purchasing or manufacturing activities with respect to personal property in a high-tax jurisdiction and selling activities with respect to the property in a low-tax jurisdiction without incurring FBCSI. In such a case, the sales income would not be FBCSI to the CFC because the same person would be purchasing or manufacturing the personal property and selling the personal property. The branch rule therefore treats a sales, purchase, or manufacturing branch located outside of the country of organization of the CFC as a separate corporation so as to create a related party transaction between the branch and the remainder of the CFC for purposes of determining FBCSI.

With respect to manufacturing branches, §1.954-3(b)(1)(ii)(a) provides that if a CFC carries on manufacturing, producing, constructing, growing, or extracting activities by or through a branch or similar establishment located outside of its country of organization and the use of that branch or similar establishment for such activities with respect to personal property purchased or sold by or through the remainder of the CFC has substantially the same tax effect as if that branch or similar establishment were a wholly owned subsidiary corporation of such CFC, that branch or similar establishment and the remainder of the CFC will be treated as separate corporations for purposes of determining FBCSI of such CFC. Section 1.954-3(b)(1)(ii)(b) provides that the use of a manufacturing branch or similar establishment will be considered to have substantially the same tax effect as if it were a wholly owned subsidiary corporation of the CFC if the tax imposed on the income derived by the remainder of the CFC satisfies the test set forth in §1.954-3(b)(1)(ii)(b) (the manufacturing branch tax rate disparity test). There is also a separate tax rate disparity test which applies to sales or purchase branches under §1.954-3(b)(1)(i)(b) (the sales branch tax rate disparity test).

For purposes of the manufacturing branch tax rate disparity test, the income considered to be derived by the remainder of the CFC is determined first by applying the rules of §1.954-3(b)(2)(i) which treat the CFC and the manufacturing branch as separate corporations, and then by determining the income of the CFC that would be FBCSI under section 954(d)(1) and §1.954-3(a)(1) if the CFC and the branch were separate corporations (but without applying the exceptions contained in §1.954-3(a)(2), (3), and (4)).

Specifically, §1.954-3(b)(2)(i)(a) treats the remainder of the CFC and the manufacturing branch as separate corporations. In addition, §1.954-3(b)(2)(i)(b) and (c) deem purchases or sales to be made “on behalf of” a related person to take into account that the remainder of the CFC and the branch are treated as separate corporations. Section 1.954-3(b)(2)(i)(b) addresses sales and purchase branches by treating selling or purchasing activities conducted through a branch or similar establishment with respect to personal property as performed on behalf of the CFC if the CFC manufactures, produces, constructs, grows, extracts, purchases, or sells that same property. Section 1.954-3(b)(2)(i)(c) provides a corollary rule addressing manufacturing branches, pursuant to which the purchase or sale of personal property by the remainder of the CFC is treated as performed on behalf of a branch that manufactures, produces, constructs, grows, or extracts that property. The general rule of §1.954-3(a)(1) is then applied to determine the income that would be FBCSI if the branch and the remainder of the CFC were separate corporations subject to the “on behalf of” related party transactions described above.

Section 1.954-3(b)(1)(ii)(b) provides that the manufacturing branch tax rate disparity test is satisfied if the income that would be FBCSI after applying these special rules is taxed in the year when earned at an effective rate of tax that is less than 90 percent of, and at least 5 percentage points less than, the hypothetical effective rate of tax. The hypothetical effective rate of tax is the effective rate of tax which would apply to such income under the laws of the country in which the manufacturing branch is located, if, under the laws of such country, the entire income of the CFC were considered derived by such CFC from sources within such country from doing business through a permanent establishment therein, received in such country, and allocable to such permanent establishment, and the CFC were created or organized under the laws of, and managed and controlled in, such country.

If the manufacturing branch tax rate disparity test is satisfied, §1.954-3(b)(1)(ii)(a) then treats the branch and the remainder of the CFC as separate corporations and the special rules of §1.954-3(b)(2)(ii) are applied for purposes of determining FBCSI. Section 1.954-3(b)(2)(ii)(a) through (c) provide separate CFC and related party rules that mirror §1.954-3(b)(2)(i)(a) through (c). Section 1.954-3(b)(2)(ii)(d) through (f) provide special rules to prevent double counting of FBCSI and to align treatment of branches with the treatment of separate CFCs. In particular, §1.954-3(b)(2)(ii)(e) provides that income derived by a branch or similar establishment, or by the remainder of the CFC, will not be FBCSI if the income would not be so considered if it were derived by a separate CFC under like circumstances.

In Rev. Rul. 75-7, 1975-1 C.B. 244, revoked by Rev. Rul. 97-48, 1997-2 C.B. 89, the IRS considered a case in which a CFC purchased raw material from related persons outside of its country of organization, contracted with an unrelated manufacturer located outside of its country of organization to process the raw material into a finished product, and then sold the finished product to unrelated persons outside of its country of organization. Under the terms of the arrangement, the contract manufacturer was paid a conversion fee. The raw material, work in process, and finished product remained the property of the CFC at all times. The CFC alone had complete control over the time and quantity of production as well as complete quality control over the conversion process. The IRS ruled, under these facts, that the performance of the operations by the contract manufacturer whereby the raw material was processed into a finished good was considered to be a performance by the CFC, and the CFC would therefore be treated as having substantially transformed personal property. The ruling further concluded that, because the CFC conducted the manufacturing activity outside of its country of organization, it was considered to do so through a branch or similar establishment. Because the manufacturing branch tax rate disparity test was not satisfied, however, the activities of the “branch” were not treated as the activities of a separate CFC and the CFC was therefore entitled to the manufacturing exception from FBCSI. See §601.601(d)(2)(ii)(b).

In Ashland Oil, Inc. v. Commissioner, 95 TC 348 (1990), the Tax Court held that an unrelated manufacturing corporation in a contract manufacturing arrangement with a CFC cannot be treated as a branch or similar establishment of the CFC. In Vetco, Inc. v. Commissioner, 95 TC 579 (1990), the Tax Court held that a wholly owned subsidiary of a CFC in a contract manufacturing arrangement with the CFC also cannot be treated as a branch or similar establishment of the CFC.

In Rev. Rul. 97-48 the IRS revoked Rev. Rul. 75-7. Rev. Rul. 97-48 states that the IRS will follow Ashland Oil, Inc. v. Commissioner and Vetco, Inc. v. Commissioner, and therefore confirms that the IRS will not treat a separate contract manufacturer as a branch for purposes of section 954(d)(2). In addition, Rev. Rul. 97-48 rules that the activities of a contract manufacturer cannot be attributed to a CFC for purposes of either section 954(d)(1) or section 954(d)(2) to determine whether the income of a CFC is FBCSI. However, the ruling does not address the circumstances under which the activities of the CFC itself may qualify as manufacturing when a contract manufacturing or similar arrangement is in place. See §601.601(d)(2)(ii)(b).

Final regulations addressing FBCSI were first published in 1964 (T.D. 6734, 1964-1 C.B. 237 [29 FR 6392]). Since then, global economic expansion and globalization have led to significant changes in manufacturing. Many multinational groups have extensive manufacturing networks that straddle geographic borders. These cross-border manufacturing networks are created primarily to leverage expertise and cost efficiencies. In addition, the use of contract manufacturing arrangements has become a common way of manufacturing products because of the flexibility and efficiencies it affords. Accordingly, updated rules in this area are important to the continued competitiveness of U.S. businesses operating abroad.

Section 954(d)(1) includes, as FBCSI, income derived in connection with the purchase of personal property from a related person and “its” sale to any person, and income derived in connection with the purchase of personal property from any person and “its” sale to a related person. Some taxpayers argue that use of the word “its” implies that the property sold must be the same property that is purchased for the sales income to be FBCSI. Accordingly, these taxpayers assert that where the personal property purchased by the CFC is manufactured such that the property purchased is not the same as the property sold by the CFC, the property sold by the CFC is not the property purchased and therefore the sale of such property does not generate FBCSI, even if the CFC itself performs little or no part of the manufacture of that property. They further argue that the manufacturing exception under §1.954-3(a)(4)(i) provides a safe harbor but does not define the universe of cases in which personal property sold by a CFC is considered to be different from the property purchased by the CFC for purposes of determining FBCSI. In addition, they argue that §1.954-3(a)(4)(i) supports their view because it states, in part, that “[a] foreign corporation will be considered, for purposes of this subparagraph, to have manufactured, produced, or constructed personal property which it sells if the property sold is in effect not the property which it purchased.”

The Treasury Department and the IRS believe that the position taken by these taxpayers is contrary to existing law, and results from an incorrect reading of section 954(d)(1) and §1.954-3(a)(4)(i). Section 954(d)(1) requires only a purchase of personal property and the sale of that personal property by the CFC with no indication as to form. Moreover, section 954(d)(1)(A) limits FBCSI to income derived in connection with the purchase (or sale) of personal property that is manufactured, produced, grown, or extracted outside of the CFC’s country of organization, thereby indicating that section 954(d)(1) is concerned with the segregation of purchasing or selling and manufacturing into different jurisdictions, not merely with whether the property was manufactured.

Section 1.954-3(a)(4) provides the only set of rules under which a change in form of personal property is considered relevant for purposes of determining FBCSI. The first sentence of Treas. Reg. §1.954-3(a)(4) sets forth the general rule that “foreign base company sales income does not include income of a CFC derived in connection with the sale of personal property manufactured, produced, or constructed by such corporation in whole or in part from personal property which it has purchased.” The third sentence of that paragraph explains that “the property sold will be considered, for purposes of this subparagraph, as not being the property which is purchased if the provisions of subdivision (ii) or (iii) of this subparagraph are satisfied.” The plain language of the regulation, as well as the examples, clarify that in order to satisfy §1.954-3(a)(4)(ii) or (iii) the relevant manufacturing activities must be performed by the CFC itself. See, for example, Electronic Arts, Inc. v. Commissioner, 118 TC 226, 265 (2002) (stating that “petitioner’s focus on certain language in section 1.954-3(a)(4), Income Tax Regs., overlooks the regulation’s requirement that various actions have been done ‘by’ the corporation being evaluated”). See also, Medchem v. Commissioner, 116 TC 308 (2001).

Further, this regulation was issued shortly after the statute became effective, and is consistent with the legislative history, which contemplates that property sold will be considered different from the property purchased only when the CFC itself manufactures that property. See S. Rep. No. 1881, 87^th Cong., 2d Sess. (1962), 1962-3 C.B. 841, 949 (stating that “[i]n a case in which a controlled foreign corporation purchases parts or materials which it then transforms or incorporates into a final product, income from the sale of the final product would not be foreign base company sales income if the corporation substantially transforms the parts or materials, so that, in effect, the final product is not the property purchased.”)

The proposed regulations clarify that for purposes of determining FBCSI personal property sold by a CFC will be considered to be the property purchased by the CFC regardless of whether it 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, except as specifically provided by the same country manufacture exception contained in §1.954-3(a)(2) and the manufacturing exception contained in §1.954-3(a)(4). Therefore, the only time that the manufacture of a product will affect whether income is FBCSI is when the manufacture of the product is performed by the CFC or performed in the country of organization of the CFC. With respect to the manufacturing exception contained in §1.954-3(a)(4), the proposed regulations clarify that a CFC qualifies for the manufacturing exception only if the CFC, acting through its employees, manufactured the relevant product within the meaning of §1.954-3(a)(4)(i). The proposed regulations also further provide rules to determine whether the activities of a branch or similar establishment outside the country in which the CFC is incorporated have substantially the same tax effect as if the branch or similar establishment were a wholly owned subsidiary corporation, and thus whether under section 954(d)(2) the income attributable to the branch or similar establishment constitutes FBCSI of the CFC.

The Treasury Department and the IRS recognize, however, that due to business considerations in the global marketplace, personal property may be manufactured pursuant to a contract manufacturing arrangement under which the CFC engages in activities related to the manufacture of the property (for example, oversight, direction and control over the contract manufacturer) but does not satisfy the physical manufacturing test. In certain of these cases, the Treasury Department and the IRS believe that the CFC should qualify for the manufacturing exception to FBCSI. Accordingly, the proposed regulations modify §1.954-3(a)(4) to provide that a CFC that provides a “substantial contribution” with respect to the manufacture, production, or construction of personal property, but that could not satisfy the physical manufacturing test, may have manufactured such property for purposes of the manufacturing exception. Specifically, proposed §1.954-3(a)(4)(i) provides that, in addition to proposed §1.954-3(a)(4)(ii) and (iii), a taxpayer may qualify for the manufacturing exception by satisfying the “substantial contribution test” in proposed §1.954-3(a)(4)(iv). Pursuant to proposed §1.954-3(a)(4)(iv)(a), a CFC will satisfy the substantial contribution test with respect to personal property only if the facts and circumstances evidence that the controlled foreign corporation makes a substantial contribution through the activities of its employees to the manufacture of that property.

Factors to be considered in determining whether a CFC makes a substantial contribution to the manufacture of personal property include but are not limited to: (1) oversight and direction of the activities or process (including management of the risk of loss) pursuant to which the property is manufactured under the principles of §1.954-3(a)(4)(ii) or (iii); (2) performance of activities that are considered in, but insufficient to satisfy the tests provided in §1.954-3(a)(4)(ii) and (iii); (3) control of the raw materials, work-in-process and finished goods; (4) management of the manufacturing profits; (5) material selection; (6) vendor selection; (7) control of logistics; (8) quality control; and (9) 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.

In light of the addition of the new test contained in proposed §1.954-3(a)(4)(iv), the interaction between several existing regulation sections and the new test is clarified. First, the existing manufacturing exceptions under §1.954-3(a)(4)(ii) and (iii) are modified to clarify that the applicability of the tests under §1.954-3(a)(4)(ii) and (iii) are restricted to cases in which physical transformation or physical assembly or conversion of component parts is conducted by the selling corporation.

Second, the definition of manufacturing for purposes of the same country manufacture exception contained in §1.954-3(a)(2) is modified to exclude manufacturing as defined under the substantial contribution test, and to ensure that the modifications to the existing manufacturing exceptions under §1.954-3(a)(4)(ii) and (iii) do not narrow the same country manufacture exception. The Treasury Department and the IRS did not intend these regulations to change the scope of the same country manufacture exception. Section 1.954-3(a)(2) excludes manufacturing as defined under the substantial contribution test because a rule that expanded the definition of manufacturing to include §1.954-3(a)(4)(iv) activities for purposes of the same country manufacture exception could prove difficult to administer. Such a rule could require an assessment of activities other than physical manufacturing conducted by an unrelated person. Modifying §1.954-3(a)(2) ensures that the modifications to the existing manufacturing exceptions under §1.954-3(a)(4)(ii) and (iii) do not narrow the same country manufacture exception by clarifying that property manufactured in the country of organization of the selling corporation will qualify for the same country manufacture exception regardless of whose employees engage in manufacturing activities that satisfy the principles of §1.954-3(a)(4)(ii) or (iii).

Third, the proposed regulations modify §1.954-3(a)(6), which addresses the application of the manufacturing exception to a CFC’s distributive share of partnership income where the partnership manufactures and sells personal property. The reference to “the separate activities or property of the controlled foreign corporation or any other person,” in §1.954-3(a)(6) was intended to clarify that the activities of another person could not be attributed to the partnership for purposes of applying the manufacturing exception. Because these proposed regulations clarify that no attribution is allowed for purposes of applying the manufacturing exception that language is now unnecessary and is therefore removed. Section 1.954-3(a)(6) is also modified consistent with the modifications to §1.954-3(a)(4) providing that a CFC may only qualify for the manufacturing exception through the activities of its employees.

Proposed §1.954-3(b)(2)(ii)(c)(2) creates a rebuttable presumption with respect to the application of the substantial contribution test where a CFC claims to satisfy the substantial contribution test with respect to the activities of a branch of that CFC that satisfies §1.954-3(a)(4)(ii) or (iii). Under this rebuttable presumption, if a branch of a CFC satisfies the physical manufacturing test with respect to personal property sold by the remainder of the CFC, the remainder of the CFC will be presumed not to make a substantial contribution to the manufacture of that personal property unless the CFC can rebut that presumption to the satisfaction of the Commissioner.

The Treasury Department and the IRS believe that these rules are necessary as a backstop to the branch rule. In the absence of the rebuttable presumption, a rule permitting a CFC to qualify for the manufacturing exception based upon its contribution to the manufacturing activities of a branch would prove difficult to administer. Such a rule could encourage a CFC to elect classification of its subsidiaries that engage in manufacturing activities as disregarded entities, obfuscating the division of manufacturing labor and income between the CFC and its branches. Of course, the presumption may be rebutted and any adverse consequences alleviated by incorporating the branch that satisfies the physical manufacturing test.

Although §1.954-3(b)(1)(i)(c) provides a rule addressing the use of multiple sales or purchase branches, §1.954-3(b)(1)(ii) does not provide a corollary rule for the use of multiple manufacturing branches. The Treasury Department and the IRS believe that the lack of a specific rule addressing the use of more than one manufacturing branch does not currently limit the general manufacturing branch rule of §1.954-3(b)(1)(ii)(a) from applying to each manufacturing branch of a CFC in a case where a CFC performs manufacturing activities through more than one branch or similar establishment. Rather, such an application is consistent with the rules regarding multiple sales or purchase branches. Nonetheless, for clarity, the proposed regulations set forth rules addressing the use of multiple manufacturing branches.

The proposed regulations set forth two rules addressing the application of the manufacturing branch tax rate disparity test to multiple manufacturing branches.

Proposed §1.954-3(b)(1)(ii)(c)(2) addresses situations in which multiple branches each perform manufacturing activities with respect to separate items of personal property that are then sold by the CFC. Consistent with the rule for multiple sales branches, the proposed regulations require the separate application of the manufacturing branch tax rate disparity test to each branch that is manufacturing a separate item of personal property.

Proposed §1.954-3(b)(1)(ii)(c)(3) addresses situations in which 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 that is then sold by the CFC. 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, the manufacturing branch tax rate disparity test is applied by giving satisfaction of the physical manufacturing test precedence over other contributions to manufacturing. Therefore, if only one branch, or only the remainder of the CFC, satisfies the physical manufacturing test of §1.954-3(a)(4)(ii) or (iii), then the location of that branch or the remainder of the CFC will be the location of manufacturing of the personal property for purposes of applying the manufacturing branch tax rate disparity test. If more than one branch, or one or more branches and the remainder of the CFC, each satisfy 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 will be the location of manufacturing of the personal property for purposes of applying the manufacturing branch tax rate disparity test.

If none of the branches nor the remainder of the CFC satisfies the physical manufacturing test, but the CFC as a whole satisfies the substantial contribution test contained in proposed §1.954-3(a)(4)(iv), then the location of manufacturing of the personal property will be the location of the branch or the remainder of the CFC that provides the predominant amount of the CFC’s substantial contribution to manufacturing. Whether any branch or the remainder of the CFC provides a predominant amount of the CFC’s contribution to manufacturing is determined by applying the facts and circumstances test provided in §1.954-3(a)(4)(iv) to weigh the contribution to manufacturing of each branch or the remainder of the CFC. If a predominant amount of the CFC’s contribution to manufacturing is not provided by any one location, the location of manufacturing of the personal property for purposes of applying the manufacturing branch tax rate disparity test will be that place (either the remainder of the CFC or one of its branches) where manufacturing activity is performed and which would impose the highest effective rate of tax when applying either §1.954-3(b)(1)(i)(b) or (ii)(b).

Because the proposed regulations address cases in which two or more branches, or one or more branches and the remainder of the CFC, perform manufacturing activities related to the manufacture of the same item of property, §1.954-3(b)(2)(ii)(a) is modified to clarify the application of the branch rule where manufacturing activities are performed in more than one location. In such cases, proposed §1.954-3(b)(2)(ii)(a) provides that, for purposes of treating the location of sales or purchase income as a separate corporation for purposes of determining whether FBCSI is incurred, that separate corporation will exclude any branch or the remainder of the CFC that would be treated as a separate corporation, if the hypothetical 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.

The Treasury Department and the IRS also propose to amend certain other aspects of §1.954-3(b) as follows:

While §1.954-3(b)(1)(ii)(a) defines a manufacturing branch as a branch or similar establishment through which a CFC carries on manufacturing activities, it does not explicitly require that §1.954-3(a)(4)(i) be satisfied by the CFC as a whole in order for the manufacturing branch rule to apply. The Treasury Department and the IRS believe that a manufacturing branch only exists with respect to personal property sold by a CFC if the CFC (including any branch of that CFC) has manufactured that property. Accordingly, proposed §1.954-3(b)(1)(ii)(a) clarifies this point by providing that the manufacturing branch rule applies only where a CFC (including any branch of the CFC) satisfies the manufacturing requirement under proposed §1.954-3(a)(4).

Section 1.954-3(b)(2)(ii)(e) provides that income derived by a branch or similar establishment, or by the remainder of the CFC, will not be FBCSI if the income would not be so considered if it were derived by a separate CFC under like circumstances. For example, if a branch of a CFC purchases personal property from an unrelated person and sells the property to an unrelated person without any involvement by the remainder of the CFC, the branch rule will not apply to create a related party transaction between the branch and the remainder of the CFC. Therefore the purchase and sale of that personal property by the branch will not generate FBCSI.

The proposed regulations provide that the substantial contribution test generally applies to a CFC that sells personal property where another person (for example, a second CFC) satisfies the physical manufacturing test with respect to that property. However, a negative presumption applies where a CFC claims to satisfy the substantial contribution test with respect to income from the sale of personal property where the physical manufacturing test is satisfied by a branch of that CFC. The effect of these rules is that, where a CFC seeks to rely on the substantial contribution test with respect to the income from the sale of personal property manufactured (within the meaning of §1.954-3(a)(4)(ii) or (iii)) by one or more of its branches, but cannot rebut the negative presumption to the satisfaction of the Commissioner, a branch or the remainder of a CFC may have FBCSI where a separate CFC would not. Therefore, to integrate the rules regarding the substantial contribution test and its application under the branch rule, proposed §1.954-3(b)(2)(ii)(e) excepts from its general rule cases in which a branch satisfies the physical manufacturing test with respect to personal property and the remainder of the controlled foreign corporation fails to rebut the presumption that it does not satisfy the substantial contribution test with respect to the activities of that manufacturing branch.

In addition, consistent with §1.954-3(b)(2)(ii)(f), §1.954-3(b)(2)(ii)(e) is modified to clarify that it applies only for purposes of paragraph (b) of §1.954-3 (that is, the branch rule). This clarifies that in no event will the branch rule cause income not to be FBCSI if that income would otherwise be FBCSI under section 954(d)(1). For example, assume a CFC incorporated in Country Y purchases personal property from a related party and has that property manufactured by a contract manufacturer in Country Z. If the CFC does not perform any other activity with respect to the manufacture of the property, and if the CFC sells the manufactured property through a branch located in Country Z for use, consumption, or disposition outside of Country Y, the income from the sale of that property is FBCSI under section 954(d)(1). If the branch located in Country Z were a separate CFC the income would not be FBCSI because it would be selling personal property manufactured in its country of organization, Country Z. However, because the income would be FBCSI to the CFC under section 954(d)(1), proposed §1.954-3(b)(2)(ii)(e) does not apply to create a different result.

Commentators have noted that §1.954-3(b)(2)(i)(b) and (ii)(b) can be read to cause a branch that purchases from unrelated persons and sells to unrelated persons to have FBCSI even where the remainder of the CFC has no connection with the personal property that is sold. Although §1.954-3(b)(2)(ii)(e) should prevent such a result, commentators note that a contrary reading is possible because the sales branch rules of §1.954-3(b)(2)(i)(b) and (ii)(b) apply, in part, with respect to personal property manufactured, produced, constructed, grown, or extracted by, or personal property purchased or sold by the “controlled foreign corporation” (as opposed to by the “remainder” of the controlled foreign corporation). For example, in a case in which a branch both manufactures and sells personal property, the branch could be considered to sell on behalf of the remainder of the CFC because the branch’s manufacturing activities would be considered to be manufacturing activities of the CFC, thereby triggering the application of §1.954-3(b)(2)(ii)(b). Further, commentators note that §1.954-3(b)(4), Example 3 appears to support this reading because in that example a branch of a corporation purchases from a related person and sells to an unrelated person, and the branch is treated as selling that property on behalf of the remainder of the CFC, even though the remainder of the corporation does not manufacture, purchase, or sell the personal property.

Section 1.954-3(b)(2)(i)(b) and (ii)(b) are intended to apply only to purchasing or selling by a branch with respect to personal property manufactured, purchased, or sold by “the remainder of” the CFC (including any branch treated as the remainder of the CFC). For example, the branch rule could apply in a case where personal property is manufactured by the CFC in the country of organization of the CFC and then sold by a branch of the CFC located outside of the country of organization of the CFC. However, the branch rule does not apply where, for example, a branch of the CFC purchases personal property from an unrelated party and sells it to an unrelated party without any involvement by the remainder of the CFC. Accordingly, the proposed regulations amend §1.954-3(b)(2)(i)(b) and (ii)(b) by adding the words “remainder of” before each place where the words “controlled foreign corporation” appear in those paragraphs and by adding the words “(or by any branch treated as the remainder of the CFC)” after each place where the words “controlled foreign corporation” appear in those paragraphs. Consistent with this change, the proposed regulations revise the rationale for the result in §1.954-3(b)(4), Example 3 as described below.

In §1.954-3(b)(4), Example 3, a branch of a second-tier CFC purchases finished goods from the first-tier CFC and sells 90 percent of the product for use, consumption, or disposition outside of the country in which the branch is located and the country of organization of the second-tier CFC. The remainder of the second-tier CFC does not engage in any manufacturing or selling activities. The sales branch tax rate disparity test is met in comparison to the effective tax rate of the second-tier CFC (the first-tier CFC and second-tier CFC are organized in the same country). The example concludes that since the sales branch tax disparity test is met, the branch is treated as a separate CFC and is treated as selling personal property on behalf of the second-tier CFC and therefore the 90 percent of sales made for use, consumption, or disposition outside of the branch’s country result in FBCSI.

The rationale of the example is incorrect because the branch is not selling on behalf of the second-tier CFC because the remainder of the second-tier CFC (not including the branch) does not manufacture, purchase, or sell the personal property. Therefore, §1.954-3(b)(2)(i)(b) and (ii)(b) do not apply. However, the result is correct because the branch, treated as a separate corporation, is purchasing from a related person, the first-tier CFC, organized outside of the branch’s country and selling to persons outside the branch’s country and the branch is located in a jurisdiction that satisfies the sales branch tax rate disparity test with respect to the income from the sale of the personal property. Accordingly, the proposed regulations revise §1.954-3(b)(4), Example 3 to provide the correct rationale for the result. In addition, the result in §1.954-3(b)(4), Example 3 is further revised to add two alternative factual scenarios (purchase from an unrelated party, and manufacture within the meaning of proposed §1.954-3(a)(4)(iv) by the selling branch) to illustrate the point that, in general, a branch will not have FBCSI if a separate CFC would not have FBCSI under like circumstances.

(a) * * *

(1) In general—(i) General rules. * * * 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. * * *

* * * * *

Example 1. * * * Corporation A purchases from M Corporation, a related person, articles manufactured in the United States and sells the articles to P, not a related person, for delivery and use in foreign country Y. * * *

Example 2. Corporation A in Example 1 also purchases from P, not a related person, articles manufactured in country Y and sells the articles to foreign corporation B, a related person, for use in foreign country Z. * * *

* * * * *

(2) * * * The principles set forth in paragraphs (a)(4)(i), (a)(4)(ii), and (a)(4)(iii) of this section apply under this paragraph (a)(2) in determining what constitutes manufacture, production, or construction of personal property, excluding, in the case of manufacture, production, or construction by a person other than the controlled foreign corporation, 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 that person’s employees. * * *

* * * * *

(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 in whole or in part from personal property which it has purchased. A controlled foreign corporation will have manufactured, produced, or constructed personal property which the corporation sells only if such corporation satisfies the provisions of paragraphs (a)(4)(ii), (a)(4)(iii), or (a)(4)(iv) of this section through the activities of its employees with respect to such property. 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) * * * 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. * * *

(iii) * * * 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. * * *

(iv) Substantial contribution to manufacturing of personal property—(a)—In general. This paragraph (a)(4)(iv) applies only if a controlled foreign corporation does not satisfy paragraph (a)(4)(ii) or (a)(4)(iii) of this section, but the personal property purchased by a controlled foreign corporation would be considered to be manufactured, produced, or constructed prior to sale (under the principles of paragraphs (a)(4)(ii) or (iii) of this section) by the controlled foreign corporation if the manufacturing, producing, and constructing activities undertaken with respect to that property prior to sale were undertaken by the controlled foreign corporation through the activities of its employees. If this paragraph (a)(4)(iv) applies, the personal property sold by the controlled foreign corporation is manufactured, produced, or constructed by such controlled foreign corporation only if the facts and circumstances evidence 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. 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 will involve, but will not necessarily be limited to, consideration of the activities set forth in paragraph (a)(4)(iv)(b) of this section. The weight given to any activity (whether or not set forth) will vary with the facts and circumstances of the particular business. The presence or absence of any activity, or of a particular number of activities, is not determinative. Further, the fact that other persons make contributions to the manufacture, production, or construction of personal property prior to sale does not necessarily prevent the controlled foreign corporation from making a substantial contribution to the manufacture, construction, or production of that property through the activities of its employees.

(b) Activities. Activities of a controlled foreign corporation’s employees to be considered in determining whether a controlled foreign corporation makes a substantial contribution through the activities of its employees to the manufacture, construction, or production of personal property include but are not limited to—

(1) Oversight and direction of the activities or process (including management of the risk of loss) pursuant to which the property is manufactured, produced, or constructed under the principles of paragraphs (a)(4)(ii) or (iii) of this section;

(2) Performance of 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) Control of the raw materials, work-in-process and finished goods;

(4) Management of the manufacturing profits;

(5) Material selection;

(6) Vendor selection;

(7) Control of logistics;

(8) Quality control; and

(9) 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.

(c) 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 then manufactured (under the principles of paragraph (a)(4)(iii) of this section) into Product X by CM, an unrelated corporation that performs the physical conversion outside of FS’s country of organization, pursuant to a contract manufacturing arrangement. Product X is then sold by FS for use outside of FS’s country of organization. At all times, FS retains control of the raw material, work-in-process, and finished goods, as well as the intangibles used in the conversion process. FS retains the right to oversee and direct the physical conversion of Product X by CM but does not regularly exercise, through its employees, its powers of oversight or direction.

(ii) Result. FS does not satisfy paragraph (a)(4)(ii) or (a)(4)(iii) of this section because FS does not, through the activities of its employees, substantially transform, convert or assemble personal property into Product X. However, Product X was manufactured (by CM), and 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 ownership of materials and intellectual property and contractual rights to exercise powers of direction and control (without the exercise of those powers) are not sufficient to satisfy this paragraph (a)(4)(iv). Therefore, FS is not considered to have manufactured Product X under paragraph (a)(4)(i) of this section.

Example 2. Substantial contribution to manufacturing, unrelated manufacturer. (i) Facts. Assume the same facts as in Example 1, except for the following. FS, through its employees, is engaged in product design and quality control. Employees of FS regularly exercise the right to oversee and direct the activities of CM in the manufacture of Product X.

(ii) Result. FS does not satisfy paragraph (a)(4)(ii) or (a)(4)(iii) of this section with respect to Product X because FS does not, through the activities of its employees, substantially transform, convert or assemble personal property into Product X. However, Product X was manufactured (by CM), and therefore this paragraph (a)(4)(iv) applies. 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. The analysis and conclusion in this Example 2 would be the same if CM were a corporation that was related to FS.

Example 3. Employees of another person. (i) Facts. FS, a controlled foreign corporation organized in Country M, purchases raw materials from a related person. The raw materials are then manufactured (under the principles of paragraph (a)(4)(iii) of this section) into Product X by CM, an unrelated contract manufacturer located in Country C. CM uses employees of another corporation to operate its manufacturing plant and convert the raw materials into Product X. Apart from the physical conversion of the raw materials into Product X, employees of FS perform all of the other activities with respect to the manufacture of Product X (for example, oversight and direction of the manufacturing process, control of raw materials, control of logistics, vendor selection, quality control). FS sells Product X for use, consumption or disposition outside Country M.

(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)(iii) of this section with respect to Product X. Therefore, this paragraph (a)(4)(iv) applies. 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. If CM’s manufacturing plant were located in Country M, the test in paragraph (a)(2) of this section could be satisfied even if CM did not manufacture Product X through the activities of its employees.

Example 4. Automated manufacturing. (i) Facts. FS, a controlled foreign corporation, purchases raw materials from a related person. The raw materials are then manufactured (under the principles of paragraph (a)(4)(ii) of this section) into Product X by CM, an unrelated corporation located outside of FS’s country of organization, pursuant to a contract manufacturing arrangement. Product X is then sold by FS to related and unrelated persons for use outside of FS’s country of organization. Under the contract manufacturing arrangement, CM is responsible for the physical transformation of the raw materials into Product X. At all times, FS retains ownership of the raw material, work-in-process, and finished goods. FS retains the right to oversee and direct the physical conversion of Product X by CM but does not regularly exercise, through its employees, its powers of oversight or 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 to apply any necessary patches or fixes. The software and network systems were developed by employees of DP, the U.S. corporate parent of FS, pursuant to a cost sharing agreement between DP and FS. DP employees regularly supervise the computer technicians, evaluate the results of the automated manufacturing business, and make ongoing operational decisions, including with regard to acceptable performance of the manufacturing process, stoppages of that process, and product and process redesign and updates to meet the needs of the business and its customers. DP employees develop and provide to FS all of the upgrades to the software and network systems. DP also has employees who control the other aspects of the manufacturing process such as product design, vendor and material selection, management and retention of the manufacturing profits, and the selection of CM.

(ii) Result. FS does not satisfy paragraph (a)(4)(ii) or (a)(4)(iii) of this section with respect to Product X because FS does not, through the activities of its employees, substantially transform, convert or assemble personal property into Product X. If the manufacturing activities undertaken with respect to Product X between the time the raw materials were purchased and the time Product X was sold were undertaken by FS through the activities of its employees, FS would have satisfied the manufacturing exception contained in paragraph (a)(4)(iii) 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 ownership of materials and intellectual property together with contractual rights to exercise powers of direction and control and a small number of technical employees are not sufficient to satisfy this paragraph (a)(4)(iv). FS’s primary contribution to the manufacture of Product X is the provision of the software and network systems to CM. Substantial operational responsibilities and decision making are exercised by DP employees who direct the activities of the FS employees. Therefore, FS is not considered to have manufactured Product X.

* * * * *

(6) * * * (i) * * * 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 §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) of this section, only if the manufacturing exception of paragraph (a)(4) 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 the activities of the employees of, and property owned by, the partnership.

* * * * *

(b) * * *

(1) * * *

(ii) * * *

(a) * * *The provisions of this paragraph (b)(1)(ii)(a) will not apply unless 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 paragraph (a)(4)(i) of this section.

* * * * *

(c) Use of more than one branch—(1) Use of one or more sales or purchase branches in addition to a manufacturing branch. * * *

(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 paragraphs (b)(2)(ii)(b) and (c) of this section will be applied separately to each such branch or similar establishment (by treating such branch or similar establishment as if it were the only branch or similar establishment of the controlled foreign corporation and as if any 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. The application of this paragraph (b)(1)(ii)(c)(2) is illustrated by the following example:

Example. Multiple branches that satisfy paragraph (a)(4)(ii) or (a)(4)(iii) of this section. (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 paragraph (a)(4)(ii) or (iii) of this section. 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 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), paragraph (b)(1)(ii)(b) of this section is separately applied 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 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 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.

(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, construct, grow, or extract the same item of personal property—(a)—In general. This paragraph (b)(1)(ii)(c)(3) applies to determine the location of manufacturing, producing, constructing, growing or extracting of personal property for purposes of applying paragraphs (b)(1)(i)(b) or (ii)(b) of this section where more than one branch of a controlled foreign corporation, or one or more branches of a controlled foreign corporation and the remainder of the controlled foreign corporation, each engage in manufacturing, producing, constructing, growing or extracting activities with respect to the same item of personal property which is then sold by the controlled foreign corporation.

(b) Physical manufacture, production, or construction in one or more locations. If only one branch or only the remainder of a controlled foreign corporation satisfies either paragraph (a)(4)(ii) or (a)(4)(iii) of this section with respect to an item of personal property, then that branch or the remainder of the controlled foreign corporation will be the location of manufacturing, producing, or constructing of that property for purposes of applying paragraph (b)(1)(i)(b) or (ii)(b) of this section to the income from the sale of that property. See §1.954-3(b)(1)(ii)(c)(3)(f) Example 1. If more than one branch, or one or more branches and the remainder of the controlled foreign corporation, each independently satisfy either paragraph (a)(4)(ii) or (a)(4)(iii) of this section with respect to an item of property, then the location of manufacturing, producing, or constructing of that property for purposes of applying paragraph (b)(1)(i)(b) or (ii)(b) of this section will be that branch or the remainder of the controlled foreign corporation that satisfies paragraph (a)(4)(ii) or (a)(4)(iii) of this section and that is located or organized in the jurisdiction that would, after applying paragraph (b)(1)(ii)(b) of this section to such branch or paragraph (b)(1)(i)(b) of this section 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 paragraph (that is, either paragraph (b)(1)(ii)(b) or (b)(1)(i)(b) of this section), if, under the laws of such country, the entire income of the controlled foreign corporation were considered derived by such corporation from sources within such country from doing business through a permanent establishment therein, received in such country, and allocable to such permanent establishment, and the corporation were created or organized under the laws of, and managed and controlled in, such country. See §1.954-3(b)(1)(ii)(c)(3)(f) Example 2.

(c) Predominant contribution. If none of the branches nor the remainder of a controlled foreign corporation satisfy paragraph (a)(4)(ii) or (a)(4)(iii) of this section 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 paragraph (a)(4)(iv) of this section, then for purposes of applying paragraph (b)(1)(i)(b) or (ii)(b) or this section, the branch or the remainder of the controlled foreign corporation that makes the predominant amount of the controlled foreign corporation’s substantial contribution with respect to the manufacture, production, or construction of that property will be the location of manufacturing, producing, or constructing with respect to that property. See §1.954-3(b)(1)(ii)(c)(3)(f) Example 3. Whether any branch or the remainder of the controlled foreign corporation provides a predominant amount of the controlled foreign corporation’s substantial contribution is determined by weighing each branch’s or the remainder of the controlled foreign corporation’s relative contribution to the manufacture of the item of property as determined by applying the facts and circumstances test provided in paragraph (a)(4)(iv) of this section. If multiple branches are located in a single jurisdiction, then the activities of those branches will be aggregated for purposes of determining the branch or the remainder of the controlled foreign corporation that makes the predominant amount of the controlled foreign corporation’s substantial contribution with respect to the manufacture, production, or construction of an item of property. For purposes of this paragraph (b)(1)(ii)(c)(3)(c), a branch or the remainder of the controlled foreign corporation makes a predominant amount of the controlled foreign corporation’s substantial contribution with respect to the manufacture, production, or construction of an item of personal property only if it makes a significantly greater contribution to the manufacture, production, or construction of that property than any other branch or the remainder of the controlled foreign corporation.

(d) Location of activity. The location of any activity with respect to the manufacture, production, or construction of an item of personal property is where the controlled foreign corporation makes a contribution through its employees to such activity. For example, the location of any activities concerning intangible property is not determined based on the formal assignment of intangible property, but on where employees of the controlled foreign corporation develop, protect, and direct the use of the intangible.

(e) Where no branch or the remainder of the controlled foreign corporation provides a predominant contribution. If neither a branch nor the remainder of a controlled foreign corporation independently satisfies paragraph (a)(4)(ii) or (iii) of this section and neither a branch nor the remainder of the controlled foreign corporation provides a predominant amount of the controlled foreign corporation’s contribution to the manufacture of an item of personal property, but the controlled foreign corporation as a whole makes a substantial contribution to the manufacture of that property within the meaning of paragraph (a)(4)(iv) of this section, then for purposes of applying paragraph (b)(1)(i)(b) or (ii)(b) of this section, the location of manufacturing of that property will be that branch or remainder of the controlled foreign corporation that provides a contribution to the manufacture of the property and that is located or organized in the jurisdiction that would, after applying paragraph (b)(1)(ii)(b) of this section to such branch or (b)(1)(i)(b) of this section to such remainder of the controlled foreign corporation, impose the highest effective rate of tax on the income allocated to such branch or such remainder of the controlled foreign corporation under that paragraph, if, under the laws of such country, the entire income of the controlled foreign corporation were considered derived by such corporation from sources within such country from doing business through a permanent establishment therein, received in such country, and allocable to such permanent establishment, and the corporation were created or organized under the laws of, and managed and controlled in, such country. See §1.954-3(b)(1)(ii)(c)(3)(f) Example 4.

(f) Examples. The following examples illustrate the application of this paragraph (b)(1)(ii)(c)(3):

Example 1. Multiple branches that contribute to the manufacture of a single product, only one branch that satisfies paragraph (a)(4)(ii) or (a)(4)(iii) of this section. (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 its employees, designs Product X. Branch B, through the activities of its employees, provides quality control and oversight. Branch C, through the activities of its employees, manufactures Product X (within the meaning of paragraph (a)(4)(iii) of this section) using the designs of Branch A and under the oversight of the quality control personnel of Branch B. The activities of Branch A and Branch B do not satisfy either paragraph (a)(4)(ii) or (a)(4)(iii) of this section. 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 risk of loss from the manufacture of Product X and the manufacturing profits from the sales of Product X. Further, employees of FS located in Country M control logistics, select vendors and raw materials, and oversee the coordination between the branches. Employees of FS located in Country M sell Product X to unrelated persons for use, consumption or disposition 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. Because only the activities of Branch C satisfy paragraph (a)(4)(ii) or (a)(4)(iii) of this section, paragraph (b)(1)(ii)(b) of this section is applied by considering only the effective rate of tax that would apply in Country C. The effective rates of tax in Country A and Country B are not considered, because Branch A and Branch B do not satisfy either paragraph (a)(4)(ii) or (a)(4)(iii) of this section. 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%), the use of Branch C has substantially the same tax effect as if Branch C were a wholly owned subsidiary corporation of FS. Therefore sales of Product X by the remainder of FS are treated as sales on behalf of Branch C. Pursuant to paragraph (b)(2)(ii)(c)(2) of this section, FS will only qualify for the manufacturing exception under paragraph (a)(4)(iv) of this section if FS successfully rebuts, to the satisfaction of the Commissioner, the presumption that FS does not provide a substantial contribution to the manufacture of Product X. For this purpose, the activities of FS include the activities of Branch A or Branch B if either of those branches would not be treated as a separate corporation under paragraph (b)(1)(ii)(b) of this section, if that paragraph were applied to each of Branch A and Branch B.

Example 2. Multiple branches satisfy paragraph (a)(4)(ii) or (a)(4)(iii) of this section 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 manufactures (within the meaning of paragraph (a)(4)(ii) of this section) a part of Product X. Branch C then combines that part with other parts to complete Product X. The activities of Branch C are sufficient to qualify as manufacturing under paragraph (a)(4)(iii) of this section with respect to Product X. Country A imposes an effective rate of tax of 12% on sales income.

(ii) Result. Because the activities of Branch A and Branch C satisfy the requirements of paragraph (a)(4)(ii) and (iii) of this section respectively, paragraph (b)(1)(ii)(b) of this section 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 paragraph (b)(1)(ii)(b) of this section were applied separately to Branch A and Branch C. The effective rate of tax in Country B is not considered because Branch B does not satisfy either paragraph (a)(4)(ii) or (a)(4)(iii) of this section. 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%), neither Branch A nor Branch C is treated as a separate corporation and sales of Product X by the remainder of the controlled foreign corporation are not treated as made on behalf of any branch.

Example 3. Predominant contribution by employees located in the country of organization of the controlled foreign corporation, traveling employees, paragraph (a)(4)(iii) of this section satisfied by an unrelated contract manufacturer. (i) Facts. FS, a controlled foreign corporation organized in Country M, purchases raw materials from a related person. The raw materials are then manufactured (under the principles of paragraph (a)(4)(iii) of this section) into Product X by CM, an unrelated corporation located in Country C that performs the physical conversion pursuant to a contract manufacturing arrangement. Employees of FS located in Country M sell Product X to unrelated persons for use, consumption or disposition outside of Country M. Employees of FS located in Country M engage in design, testing, quality control and oversight with respect to the manufacture of Product X. Employees of FS located in Country M also direct the use of intellectual property used in the manufacture of Product X from Country M. At all times, employees of FS located in Country M control the raw material, work-in-process and finished goods. Employees of FS located in Country M also control logistics, select vendors, and manage the risk of loss from the manufacture of Product X and the manufacturing profits from Product X. Quality control and oversight of the manufacturing process is conducted 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. Design work with respect to Product X conducted by Branch A is supplemental to the bulk of the design work, which is done by employees of FS located in Country M. FS as a whole (including Branch A) provides a substantial contribution to the manufacture of Product X within the meaning of paragraph (a)(4)(iv) of this section.

(ii) Result. FS qualifies for the exception to foreign base company sales income contained in paragraph (a)(4) of this section with respect to income from the sale of Product X because FS satisfies the test contained in paragraph (a)(4)(iv) of this section by providing a substantial contribution through the activities of its employees to the manufacture of Product X. The fact that employees of FS travel to the location of CM to perform some of the activities considered in determining whether a controlled foreign corporation makes a substantial contribution through the activities of its employees to the manufacturing of an item of personal property does not prevent activities of such employees while located in Country M from being considered in determining the applicability of paragraph (a)(4)(iv) of this section to FS. In addition, paragraph (b) of this section does not apply to treat a branch of FS as having substantially the same tax effect as if the branch were a wholly owned subsidiary corporation, because FS, as opposed to Branch A, provides the predominant contribution with respect to Product X.

Example 4. Multiple branches perform manufacturing activities, no branch makes a predominant contribution, paragraph (a)(4)(iii) of this section is satisfied by an unrelated contract manufacturer. (i) Facts. FS, a controlled foreign corporation organized in Country M, purchases raw materials from a related person. The raw materials are then manufactured (under the principles of paragraph (a)(4)(iii) of this section) into Product X by CM, an unrelated corporation located in Country C that performs the physical conversion pursuant to a contract manufacturing arrangement. Employees of FS located in Country M sell Product X to unrelated persons for use, consumption or disposition outside of Country M. FS has two branches, Branch A and Branch B, located in Country A and Country B respectively. FS (including Branch A and Branch B) makes a substantial contribution within the meaning of paragraph (a)(4)(iv) of this section with respect to the manufacture of Product X. Branch A, through the activities of its employees, designs Product X. Branch B, through the activities of its employees, provides quality control and oversight of the manufacturing process. At all times, FS controls the raw materials, work-in-process and the finished Product X through employees located in Country M. FS also manages the risk of loss related to the manufacture of Product X and the manufacturing profits from the sales of Product X through employees located in Country M. Further, employees of FS located in Country M control logistics, select vendors, and oversee the coordination between the branches. 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%.

(ii) Result. Based on the facts, neither the remainder of FS (through activities of its employees in Country M), nor Branch A, nor Branch B, provide a predominant amount of the controlled foreign corporation’s substantial contribution to the manufacture of Product X. FS, Branch A, and Branch B each provide a contribution through the activities of their employees to the manufacture of Product X. Accordingly, paragraph (b)(1)(ii)(b) of this section is applied by comparing the effective rate of tax imposed on the income from the sales of Product X against the effective rate of tax that would apply to the sales income in Branch B, which is located in the jurisdiction that would impose the highest effective rate of tax on the sales income (24%). 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%) the remainder of FS is treated as selling on behalf of Branch B. Further, for purposes of determining whether the remainder of FS qualifies for any exception from foreign base company sales income, applying paragraph (b)(2)(ii)(a) of this section, the remainder of FS includes any branch of FS that would not, after the application of paragraph (b)(1)(ii)(b) of this section to such branch, be treated as a separate corporation. In this case, 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 A (20%). Therefore, for purposes of determining foreign base company sales income, the remainder of FS does not include the activities of Branch A. The remainder of FS must therefore independently qualify for the manufacturing exception contained in paragraph (a)(4) of this section or income from the sale of Product X will be foreign base company sales income.

Example 5. Multiple branches contribute to the manufacture of a single product, one branch sells the product, the remainder of the controlled foreign corporation does not participate. (i) Facts. FS is a controlled foreign corporation organized in Country M, a country that imposes a 0% effective rate of tax on sales income. FS operates two branches, Branch A and Branch B, located respectively in Country A, a country that imposes a 30% effective rate of tax on income, and Country B, a country that imposes a 0% effective rate of tax on income. Branch A and Branch B each perform different activities with respect to the manufacture of Product X. Branch A, through the activities of a large number of its employees working at a state of the art facility, expends significant time and resources to design a sophisticated product, Product X. Branch B, through the activities of its employees, purchases raw materials from a related person and contracts with CM, an unrelated corporation located in Country C, to manufacture Product X. The raw materials are then manufactured (under the principles of paragraph (a)(4)(iii) of this section) into Product X by CM. Branch A, through the activities of its employees, directs the use of intellectual property it developed, including product designs, to provide quality control and oversight to CM with respect to the manufacture of Product X. Branch B controls the raw materials, work in process, and the finished Product X. Branch B manages the risk of loss with respect to Product X throughout the manufacturing process. Branch B also controls logistics and selects vendors in connection with Product X. Branch B then sells Product X to unrelated persons for use, consumption or disposition outside of Country M. FS (including Branch A and Branch B) provides a substantial contribution within the meaning of paragraph (a)(4)(iv) of this section with respect to the manufacture of Product X. FS does not provide a contribution to the manufacture of Product X through employees located in Country M.

(ii) Result. Based on the facts, neither Branch A nor Branch B provides the predominant amount of FS’s contribution to the manufacture of Product X. Further, Branch A and Branch B each provide a contribution through the activities of its employees to the manufacture of Product X. Accordingly, pursuant to paragraph (b)(2)(ii)(c)(3)(e), Branch A is treated as the location of manufacturing for purposes of applying paragraph (b)(1)(ii)(b) of this section. Therefore, the effective rate of tax imposed on the income from the sales of Product X is compared against the effective rate of tax that would apply to that income if it were earned in Country A, which would impose the highest effective rate of tax on the sales income (30%). Because the effective rate of tax in Country B with respect to the sales income (0%) 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 (30%), Branch B, treated as the remainder of FS pursuant to paragraph (b)(1)(ii)(c) of this section, is treated as selling on behalf of Branch A. Further, for purposes of determining whether the remainder of FS qualifies for any exception from foreign base company sales income, Branch B, treated as the remainder of FS, includes any branch or remainder of FS that would not, after the application of paragraph (b)(1)(ii)(b) of this section to such branch or (b)(1)(i)(b) of this section to such remainder of FS, be treated as a separate corporation. In this case, the effective rate of tax (0%) 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 (30%), but not country M (0%). Therefore, for purposes of determining foreign base company sales income, Branch B, treated as the remainder of FS, does not include the activities of Branch A, but does include the activities of the remainder of FS located in Country M. However, since the remainder of FS in Country M does not perform any activities related to the manufacture of Product X, the inclusion of the remainder of FS does not qualify Branch B for any exception from foreign base company sales income. Branch B, treated as the remainder of FS, must therefore independently qualify for the manufacturing exception from foreign base company sales income contained in paragraph (a)(4) of this section or the income from the sale of Product X will be foreign base company sales income.

Example 6. Multiple branches contribute to the manufacture of a single product, the selling branch is located in the higher tax jurisdiction, the remainder of the controlled foreign corporation does not participate. (i) Facts. Assume the same facts as in Example 5 except that Branch B rather than Branch A is located in the jurisdiction that would impose the higher effective rate of tax on income from the sales of Product X.

(ii) Result. Based on the facts, neither Branch A nor Branch B provides the predominant amount of FS’s contribution to the manufacture of Product X. Since Branch B is located in the jurisdiction that would impose the higher effective rate of tax on income from the sale of Product X, Branch B is considered to be the location of manufacturing of Product X for purposes of applying paragraph (b) of this section. Because all of the income from the sale of Product X is already taxed in Country B, the use of Branch B is not treated as having substantially the same tax effect as if Branch B were a wholly owned subsidiary corporation of FS, and therefore Branch B and the remainder of FS are not treated as separate corporations under paragraph (b)(1)(ii)(a) of this section for purposes of determining foreign base company sales income.

(2) * * *

(i) * * *

(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, constructed, grown, or extracted 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 as performed on behalf of the remainder of the controlled foreign corporation.

(ii) * * *

(a) Treatment as separate corporations. * * * For purposes of applying the rules of this paragraph (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 paragraph (b)(2)(ii)(c) of this section, will exclude any other branch or similar establishment or remainder of the controlled foreign corporation that would be treated as a separate corporation (apart from the branch or similar establishment of a controlled foreign corporation that is treated as a separate purchasing or selling corporation under paragraph (b)(2)(ii)(b) of this section or the remainder of the controlled foreign corporation that is treated as a separate purchasing or selling corporation under paragraph (b)(2)(ii)(c) of this section) 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 §1.954-3(b)(1)(i)(b) or (ii)(b) of this section against the effective rate of tax that would apply to such income if it were earned in the jurisdiction of 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, constructed, grown, or extracted 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) Treatment of the use of a manufacturing branch by a controlled foreign corporation—(1) Activities treated as performed on behalf of branch. * * *

(2) Presumption where a controlled foreign corporation claims to satisfy the substantial contribution test and its own branch satisfies the physical manufacturing test. If a branch or similar establishment is considered to manufacture, produce, or construct an item of personal property under paragraph (a)(4)(ii) or (a)(4)(iii) of this section, the remainder of the controlled foreign corporation (or any branch treated as the remainder of the controlled foreign corporation) will be presumed not to manufacture, produce, or construct that same item of personal property under paragraph (a)(4)(iv) of this section (even if it would have otherwise satisfied paragraph (a)(4)(iv) of this section with respect to such property). However, if a controlled foreign corporation demonstrates, to the satisfaction of the Commissioner, that the remainder of the controlled foreign corporation (or any branch treated as the remainder of the controlled foreign corporation) makes a substantial contribution to the manufacture of that item of personal property within the meaning of paragraph (a)(4)(iv) of this section, then the remainder of the controlled foreign corporation (or any branch treated as the remainder of the controlled foreign corporation), if treated as a separate corporation apart from its manufacturing branch under paragraph (b)(2)(ii)(a) of this section, will be considered to manufacture, produce, or construct that item of personal property under paragraph (a)(4)(iv) of this section. The application of this paragraph (b)(2)(ii)(c)(2) may be illustrated by the following examples:

Example 1. Manufacturing branch, paragraph (b)(1)(ii)(b) satisfied. (i) Facts. FS, a controlled foreign corporation organized in Country M, a country that imposes a 0% effective rate of tax on sales income, purchases raw materials from a related person. FS has one branch, Branch A, organized in Country A, a country that imposes a 30% effective rate of tax on sales income. The raw materials are manufactured (within the meaning of paragraph (a)(4)(iii) of this section) into Product X by Branch A. FS sells Product X for use, consumption, or disposition outside of Country M. Absent the application of paragraph (b)(2)(ii)(c)(2) of this section, the remainder of FS would also be considered a manufacturer of Product X under paragraph (a)(4)(iv) of this section. FS proves to the satisfaction of the Commissioner that the remainder of FS makes a substantial contribution to the manufacture of Product X.

(ii) Result. Since the effective rate of tax (0%) imposed on the sales income 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 jurisdiction of Branch A (30%), the remainder of FS is treated as a separate corporation selling on behalf of Branch A.The remainder of FS (not including Branch A) does not satisfy paragraph (a)(4)(ii) or (a)(4)(iii) of this section with respect to Product X. If the manufacturing activities undertaken with respect to Product X between the time the raw materials were purchased and the time Product X was sold were undertaken by the remainder of FS (not including Branch A) through the activities of its employees, the remainder of FS would have satisfied the manufacturing exception contained in paragraph (a)(4)(iii) of this section with respect to Product X. Therefore, paragraph (a)(4)(iv) of this section applies. Because FS has successfully rebutted the presumption of paragraph (b)(2)(ii)(c)(2) of this section by proving to the satisfaction of the Commissioner that the remainder of FS makes a substantial contribution to the manufacture (within the meaning of paragraph (a)(4)(iv) of this section) of Product X, it qualifies for the exception in paragraph (a)(4)(iv) of this section with respect to Product X. Therefore income from the sale of Product X, when treated as sold by the remainder of FS on behalf of Branch A, is not determined to be foreign base company sales income.

Example 2. Manufacturing branch, paragraph (b)(1)(ii)(b) is not satisfied. (i) Facts. Assume the same facts as in Example 1, except that Branch A is located in Country B, a country that imposes a 3% rate of tax on sales income.

(ii) Result. Paragraph (b)(1)(ii)(b) of this section is not satisfied, because the effective rate of tax imposed on the sales income in Country M (0%) 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 jurisdiction of Branch A (3%). Therefore, Branch A is not treated as a separate corporation for purposes of determining foreign base company sales income. FS qualifies for the manufacturing exception in paragraph (a)(4) of this section because FS (including Branch A) satisfies paragraph (a)(4)(iii) of this section with respect to income from the sales of Product X.

* * * * *

(e) Comparison with ordinary treatment. With the exception of cases in which a controlled foreign corporation seeks to rely on paragraph (a)(4)(iv) of this section and is unsuccessful in rebutting the presumption created by paragraph (b)(2)(ii)(c)(2) of this section, income derived by a branch or similar establishment, or by the remainder of the controlled foreign corporation, will not be determined to be foreign base company sales income under paragraph (b) of this section if the income would not be so considered if it were derived by a separate controlled foreign corporation under like circumstances.

* * * * *

(4) * * *

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 then 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 paragraph (a)(4)(iv) of this section in conjunction with the manufacture of the articles (within the meaning of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) by an unrelated contract manufacturer, then 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 paragraph (a)(4)(i) of this section.

* * * * *

(d) Effective/applicability date. The second sentence of paragraph (a)(1)(i), the second sentence of paragraph (a)(1)(iii) Example 1, the first sentence of paragraph (a)(1)(iii) Example 2, the third sentence of paragraph (a)(2), paragraph (a)(4)(i), the first sentence of paragraph (a)(4)(ii), the first sentence of paragraph (a)(4)(iii), paragraph (a)(4)(iv), paragraph (a)(6)(i), the last sentence of paragraph (b)(1)(ii)(a), paragraph (b)(1)(ii)(c)(2), paragraph (b)(1)(ii)(c)(3), paragraph (b)(2)(i)(b), the last sentence of paragraph (b)(2)(ii)(a), paragraph (b)(2)(ii)(b), paragraph (b)(2)(ii)(c)(2), paragraph (b)(2)(ii)(e), and paragraph (b)(4) Example 3 shall apply to taxable years of controlled foreign corporations beginning on or after the date these rules are published as final regulations in the Federal Register, and for taxable years of United States shareholders in which or with which such taxable years of the controlled foreign corporations end.

Linda E. Stiff,
Deputy Commissioner for
Services and Enforcement.

These regulations provide guidance with respect to certain of the provisions of section 432. Specifically, these regulations provide guidance regarding the determination of when a plan is in endangered status or critical status and the associated notices. These regulations do not provide guidance with respect to all issues relating to a multiemployer plan that is in endangered or critical status. For example, no guidance is provided on the parameters for the adoption of a funding improvement plan or rehabilitation plan. Guidance with respect to additional issues will be included in a second set of regulations that are expected to be issued this year.

Section 1.432(a)-1 provides general rules relating to section 432, including definitions of certain terms used for purposes of section 432 and the special rules that apply to participants in multiemployer plans who are not participating pursuant to a collective bargaining agreement.

The regulations provide that effective on the date that a notice of critical status for the initial critical year is sent to the plan participants, the plan must not pay any benefit in excess of the monthly amount paid under a single life annuity (plus any social security supplement) and is not permitted to purchase an irrevocable commitment from an insurer to pay benefits. The restriction does not apply to the small-dollar cash-outs allowed under section 411(a)(11) nor to the make-up payments under a retroactive annuity starting date.

The regulations provide that if the notice described in section 432(b)(3)(D) has been sent and the restrictions provided under section 432(f)(2) have been applied, and it is later determined that the restrictions should not have been applied, then the plan must correct any benefit payments that were restricted in error. The regulations provide two examples of situations requiring this correction, each of which involves an actuary certifying that the plan is reasonably expected to be in critical status for the first plan year beginning after 2007, followed by an early notification of critical status that is made to employees under the rules of section 212(e)(2) of PPA ’06. In one example of a plan taking actions that require correction, the plan restricts benefits before the first plan year beginning after 2007 (the effective date of section 432). In the second such example, the plan is not in critical status for the first plan year beginning after 2007 (even though the enrolled actuary for the plan had certified that it is reasonably expected that the plan will be in critical status with respect to that year).

The regulations incorporate a number of definitions listed in section 432(i) along with other definitions that are located in sections 432(c) and (e). The regulations do not include the broad provision under section 432(i)(8) to use the unit credit funding method for purposes of the plan’s “normal cost, actuarial accrued liability, and improvements in a plan’s funded percentage.” Instead, consistent with the intended scope of section 432(i)(8), the regulations require the use of this funding method solely for purposes of determining a plan’s funded percentage and the section 432(b)(2)(C)(i) comparison of contributions with the sum of the plan’s normal cost and interest on the amount of unfunded liability. Thus, the determination of whether a plan is projected to have an accumulated funding deficiency in the determination of a plan’s status under section 432 is based on the plan’s actual funding method, rather than the unit credit funding method. The regulations substitute the term “initial endangered year” for the statutory term “initial determination year.”

In addition, the regulations provide guidance for plans that change their status in subsequent years. For example, a plan that is in critical status may emerge from that status and later reenter critical status. In such a circumstance, the year of reentry into critical status is treated as the initial critical year. Similarly, a plan that is in endangered status may have a status change and at a later date reenter endangered status. In such a circumstance, the year of reentry into endangered status is treated as the initial endangered year.

The regulations provide rules for the determination of whether a plan is in endangered status or critical status within the meaning of section 432(b)(1) and (2). These rules reflect the different ways a plan can be in endangered status under section 432(b)(1)(A) or (B) and in critical status under section 432(b)(2)(A), (B), (C), or (D). The regulations also provide that a plan is in critical status for a plan year if it was in critical status in the immediately preceding year and the plan does not meet the emergence from critical status rule of section 432(e)(4)(B). Thus, a plan that was in critical status for the prior year will remain in critical status if the enrolled actuary for the plan certifies that the plan is projected to have an accumulated funding deficiency for the plan year or any of the 9 succeeding plan years, without regard to the use of the shortfall funding method, but taking into account any extensions of the amortization periods under section 431(d).

The regulations provide limited guidance on the actuarial projections that are used for purposes of the certification of status by the enrolled actuary for the plan. The projections must generally be based on reasonable actuarial assumptions and methods that, as under section 431(c)(3), offer the actuary’s best estimate of anticipated experience under the plan. The actuarial projection of future contributions and assets must assume either that the terms of the one or more collective bargaining agreements pursuant to which the plan is maintained for the current plan year continue in effect for succeeding plan years, or that the dollar amount of employer contributions for the most recent plan year will continue indefinitely. If the actuarial projections assume the continued maintenance of the collective bargaining agreements, the plan sponsor must provide a projection of activity in the industry, including future covered employment, to the plan actuary, and the actuary is permitted to rely on those projections. In making these projections, the plan sponsor must act reasonably and in good faith. The alternative assumption that the dollar amount of contributions remains unchanged into the future is only available if the enrolled actuary for the plan determines there have been no significant demographic changes that would make such assumption unreasonable. In addition, the regulations provide that the alternative assumption is not available for purposes of determining whether the plan is in critical status under the tests in section 432(b)(2)(A) and (D).

The projected present value of liabilities as of the beginning of such year is determined based on the most recent information reported on the most recent of either the actuarial statement required under section 103(d) of ERISA that has been filed with respect to the most recent year, or the actuarial valuation for the preceding plan year.

The regulations provide that, for purposes of section 432, if the plan received an extension of any amortization period under section 412(e), the extension is treated the same as an extension under section 431(d). Thus, such an extension is taken into account in determining endangered status under section 432(b)(1)(B) and emergence from critical status under section 432(e)(4)(B). In contrast, such an extension is not taken into account in determining whether a plan has or will have an accumulated funding deficiency for purposes of determining critical status under section 432(b)(2)(B) and (C).

The regulations describe the content of the annual certification required under section 432(b)(3) that must be sent to the plan sponsor and the IRS. The annual certification must be provided regardless of whether the plan is in endangered or critical status. If the plan is certified to be in endangered or critical status, then the certification must identify the plan, the plan sponsor, and the enrolled actuary who signs the certification; provide contact information for the plan sponsor and actuary; state whether or not the plan is in endangered or critical status for the plan year; and, if the certification is for a year other than the initial endangered year or the initial critical year, whether the plan is making the scheduled progress described in the plan’s funding improvement plan or rehabilitation plan. The regulations also provide an IRS address to which the certification is to be mailed.

The regulations also provide that the content of the annual certification and the IRS address to which it is mailed may be added to or modified in guidance of general applicability to be published in the Internal Revenue Bulletin. Such additional information may include, for instance, which endangered status or critical status standard(s) applies to the plan; supporting information for the classification; a description of the actuarial assumptions used in making the certification; and a projection of the plan’s funded percentage for future years. The guidance may also require additional supporting information for certifications made prior to the issuance of the guidance.

The regulations provide guidance on the notice required under section 432(b)(3)(D).^[2] In particular the regulations require that, in the case of a plan that is in critical status and which provides for benefits that would be restricted under section 432(f)(2), the notice for the initial critical year must tell participants about the restriction. A plan sponsor that sends the model notice provided by the Secretary of Labor pursuant to section 432(b)(3)(D)(iii) satisfies this requirement.

If a section 432(b)(3)(D) notice for such a plan was sent prior to the deadline in that section and the notice did not contain the disclosure regarding the immediate restriction on benefits under section 432(f)(2), then the regulations provide that the notice does not satisfy the requirements for notice under section 432(b)(3)(D). Accordingly, the restrictions under section 432(f)(2) do not apply as a result of the issuance of such a notice and the plan will not be treated as having issued the notice for purposes of the section 432(e)(8)(A)(ii) restriction on reducing adjustable benefits for participants whose benefit commencement dates are prior to the issuance of that notice. However, if additional notice that includes all of the information required under the regulations is provided prior to the required date for notice for the initial critical year under section 432(b)(3)(D) (that is, 30 days after the certification for the plan year), then the notice requirements of section 432(b)(3)(D) are satisfied as of the date of the later notice. In such a case, if the earlier notice contained the information described in section 432(b)(3)(D)(ii), then the date of that earlier notice will apply for purposes of the section 432(e)(8)(A)(ii) restriction.

The regulations reflect the rules of section 212(e)(2) of PPA under which a plan sponsor is permitted to send an early notice to plan participants. This early notice, which applies solely to the first plan year beginning after 2007, is only available if the plan actuary certifies to the plan sponsor that the plan is reasonably expected to be in critical status for that initial plan year. This preliminary certification that the plan is reasonably expected to be in critical status is different from the annual certification that the plan actuary must make; accordingly, the plan actuary must still certify whether the plan is in critical or endangered status (or in neither critical nor endangered status) for that plan year by the normal 90-day deadline for the certification.

As of the date of the issuance of these proposed regulations, bills have been introduced in the House of Representatives and the Senate that would exclude from the section 432(f)(2) limitation on accelerated benefits a distribution with an annuity starting date that is before the date that the notice under section 432(b)(3)(D) is provided.^[3] Section 1.432(a)-1(a)(3)(iii)(C) has been reserved in order to accommodate any enacted changes.

(a) In general—(1) Overview. This section provides rules relating to multiemployer plans (within the meaning of section 414(f)) that are in endangered status or critical status under section 432. Section 432 and this section only apply to multiemployer plans that are in effect on July 16, 2006. Paragraph (b) of this section sets forth definitions of terms that apply for purposes of section 432. Paragraph (c) of this section sets forth special rules for plans described in section 404(c) and for the treatment of nonbargained participation.

(2) Plans in endangered status—(i) Plan sponsor must adopt funding improvement plan. If a plan is in endangered status, the plan sponsor must adopt and implement a funding improvement plan that satisfies the requirements of section 432(c).

(ii) Restrictions applicable to plans in endangered status. If a plan is in endangered status, the plan and plan sponsor must satisfy the requirements of section 432(d)(1) during the funding plan adoption period specified in section 432(c)(8).

(iii) Restrictions applicable after the adoption of funding improvement plan. In the case of a plan that is in endangered status after adoption of the funding improvement plan, the plan and the plan sponsor must satisfy the requirements of section 432(d)(2) until the end of the funding improvement period.

(3) Plans in critical status—(i) Plan sponsor must adopt rehabilitation plan. If a plan is in critical status, the plan sponsor must adopt and implement a rehabilitation plan that satisfies the requirements of section 432(e).

(ii) Restrictions applicable to plans in critical status. If a plan is in critical status, the plan and the plan sponsor must satisfy the requirements of section 432(f)(4) during the rehabilitation plan adoption period as defined in section 432(e)(5). The plan must also apply the restrictions on single sum and other accelerated benefits set forth in paragraph (a)(3)(iii) of this section.

(iii) Restrictions on single sums and other accelerated benefits—(A) In general. A plan in critical status is required to provide that, effective on the date the notice of certification of the plan’s critical status for the initial critical year under §1.432(b)-1(e) is sent, no payment in excess of the monthly amount payable under a single life annuity (plus any social security supplements described in the last sentence of section 411(a)(9)), and no payment for the purchase of an irrevocable commitment from an insurer to pay benefits, may be made except as provided in section 432(f)(2). A plan amendment that provides for these restrictions does not violate section 411(d)(6).

(B) Exceptions. Pursuant to section 432(f)(2)(B), the restrictions under this paragraph (a)(3)(iii) do not apply to a benefit which under section 411(a)(11) may be immediately distributed without the consent of the participant or to any makeup payment in the case of a retroactive annuity starting date or any similar payment of benefits owed with respect to a prior period.

(C) [Reserved.]

(D) Correction of erroneous restrictions. If the notice described in §1.432(b)-1(e) has been sent and the restrictions provided under this paragraph (a)(3)(iii) have been applied, and it is later determined that the restrictions should not have been applied, then the plan must correct any benefit payments that were restricted in error. Thus, for example, if pursuant to section 212(e)(2) of the Pension Protection Act of 2006, Public Law 109-280, 120 Stat. 780 the enrolled actuary for the plan certified that it was reasonably expected that the plan would be in critical status with respect to the first plan year beginning after 2007, and the notice described in §1.432(b)-1(e)(3)(i) was sent, but the plan is not later certified to be in critical status for that plan year, then the plan must correct any benefit payments that were restricted after the notice was sent. Similarly, if the enrolled actuary for the plan certified that it was reasonably expected that the plan would be in critical status with respect to the first plan year beginning after 2007, and the notice described in §1.432(b)-1(e)(3)(i) was sent before the first day of that plan year, the restriction on benefits under section 432(f)(2) first applies beginning on the first day of the first plan year beginning after 2007. If the plan restricts benefits before that date, then the plan must correct any improperly restricted benefits.

(iv) Restrictions applicable after the adoption of rehabilitation plan. In the case of a plan that is in critical status after the adoption of the rehabilitation plan, the plan and the plan sponsor must satisfy the requirements of section 432(f)(1) until the end of the rehabilitation period.

(b) Definitions. The following definitions apply for purposes of section 432 and the regulations:

(1) Accumulated funding deficiency. The term accumulated funding deficiency has the same meaning as the term accumulated funding deficiency under section 431(a).

(2) Active participant. The term active participant means a participant who is in covered service under the plan.

(3) Bargaining party. Except as provided in paragraph (c)(1) of this section, the term bargaining party means an employer who has an obligation to contribute under the plan and an employee organization which, for purposes of collective bargaining, represents plan participants employed by an employer which has an obligation to contribute under the plan.

(4) Benefit commencement date. The term benefit commencement date means the annuity starting date (or in the case of a retroactive annuity starting date, the date on which benefit payments begin).

(5) Critical status. A multiemployer plan is in critical status if the plan meets one of the tests set forth in §1.432(b)-1(c).

(6) Endangered status. A plan is in endangered status if the plan meets one of the tests set forth in §1.432(b)-1(b).

(7) Funded percentage. The term funded percentage means a fraction (expressed as a percentage) the numerator of which is the actuarial value of the plan’s assets as determined under section 431(c)(2) and the denominator of which is the accrued liability of the plan, determined using the actuarial assumptions described in section 431(c)(3) and the unit credit funding method.

(8) Funding improvement period for endangered or seriously endangered plans. The term funding improvement period means the period that begins on the first day of the first plan year beginning after the earlier of the second anniversary of the date of the adoption of the funding improvement plan, or the expiration of the collective bargaining agreements that are in effect on the due date for the actuarial certification of endangered status for the initial endangered year and which cover, as of such due date, at least 75 percent of the active participants in the plan. The funding improvement period ends on the last day of the 10^th year (15 years for seriously endangered plans, except as provided in section 432(c)(5)) after it begins or, if earlier, the date of the change in status described in section 432(c)(4)(C).

(9) Funding plan adoption period. The term funding plan adoption period means the period that begins on the date of the actuarial certification for the initial endangered year and ends on the day before the first day of the funding improvement period.

(10) Inactive participant. The term inactive participant means —

(i) A participant who is not an active participant,

(ii) A beneficiary under the plan, or

(iii) An alternate payee under the plan.

(11) Initial critical year. The term initial critical year means the first year for which the enrolled actuary for the plan has certified that the plan is or will be in critical status. If a plan is in critical status in one year, emerges from critical status in a subsequent year and then returns to critical status, the year of reentry into critical status is treated as the initial critical year with respect to subsequent years.

(12) Initial endangered year. The term initial endangered year means the first year for which the enrolled actuary for the plan has certified that the plan is in endangered status. If a plan is in endangered status in one year, changes from endangered status in a subsequent year and then returns to endangered status, the year of reentry into endangered status is treated as the initial endangered year with respect to subsequent years.

(13) Nonbargained participant. The term nonbargained participant means a participant in the plan whose participation is other than pursuant to a collective bargaining agreement within the meaning of section 7701(a)(46). A participant will not be treated as a nonbargained participant merely because the participant is no longer covered by the collective bargaining agreement solely as a result of retirement or severance from employment.

(14) Obligation to contribute. The term obligation to contribute means an obligation to contribute arising under one or more collective bargaining (or related) agreements or as a result of a duty under applicable labor-management relations law.

(15) Plan sponsor. Except as provided in paragraph (c)(1) of this section, the term plan sponsor means the association, committee, joint board of trustees, or other similar group of representatives of the parties who establish or maintain the plan.

(16) Rehabilitation period. The term rehabilitation period means the period that begins on the first day of the first plan year beginning after the earlier of the second anniversary of the date of the adoption of the rehabilitation plan, or the expiration of the collective bargaining agreements that are in effect on the due date for the actuarial certification of critical status for the initial critical year and which cover, as of such due date, at least 75 percent of the active participants in the plan. The rehabilitation period ends on the last day of the 10^th year after it begins or, if earlier, the plan year preceding the plan year in which the plan has emerged from critical status as described in section 432(e)(4)(B).

(17) Rehabilitation plan adoption period. The term rehabilitation plan adoption period means the period that begins on the date of the actuarial certification for the initial critical year and ends on the day before the first day of the rehabilitation period.

(18) Seriously endangered status. A plan is in seriously endangered status if the plan is in endangered status and is described in both §1.432(b)-1(b)(2) and (3).

(c) Special rules—(1) Plan described in section 404(c). In the case of a plan described in section 404(c), or a continuation of such a plan, the association of employers that is the employer settlor of the plan is treated as a bargaining party and is treated as the plan sponsor for purposes of section 432.

(2) Plans covering both bargained and nonbargained participants. In the case of an employer that contributes to a plan with respect to both employees who are covered by one or more collective bargaining agreements and employees who are nonbargained participants, if the plan is in endangered status or critical status, benefits of and contributions for the nonbargained participants (including surcharges on those contributions) are determined as if those nonbargained participants were covered under the employer’s collective bargaining agreement in effect when the plan entered endangered or critical status that is the first to expire.

(3) Plans covering nonbargained participants only. In the case of an employer that contributes to a multiemployer plan only with respect to employees who are not covered by a collective bargaining agreement, section 432 and the regulations thereunder are applied as if the employer were the bargaining party, and its participation agreement with the plan were a collective bargaining agreement with a term ending on the first day of the plan year beginning after the employer is provided the schedules described in sections 432(c) and (e).

(d) Effective/applicability date. These regulations apply to plan years ending after March 18, 2008, but only with respect to plan years that begin on or after January 1, 2008.

Par. 3. Section 1.432(b)-1 is added to read as follows:

(a) In general. This section provides rules relating to multiemployer plans (within the meaning of section 414(f)) that are in endangered status or critical status under section 432. Section 432 and this section only apply to multiemployer plans that are in effect on July 16, 2006. Paragraph (b) of this section sets forth the factors for determining whether a plan is in endangered status. Paragraph (c) of this section sets forth the factors for determining whether a plan is in critical status. Paragraph (d) sets forth the requirements for the annual certification by the plan’s enrolled actuary. Paragraph (e) of this section describes the notice to employees that is required for plans that are in endangered or critical status.

(b) Determination of endangered status—(1) In general. A plan is in endangered status for a plan year if, as determined by the enrolled actuary for the plan, the plan is not in critical status for the plan year and if, as of the beginning of the plan year, the plan is described either in paragraph (b)(2) of this section or paragraph (b)(3) of this section. The enrolled actuary’s determination of whether a plan is in endangered status is made under the rules of paragraph (d)(5) of this section.

(2) Endangered status based on funding percentage. A plan is described in this paragraph (b)(2) for a plan year if the plan’s funded percentage for such plan year is less than 80 percent.

(3) Endangered status based on projection of funding deficiency. A plan is described in this paragraph (b)(3) for a plan year if the plan has an accumulated funding deficiency for such plan year (or is projected to have such an accumulated funding deficiency for any of the 6 succeeding plan years), taking into account any extension of amortization periods under section 431(d).

(c) Critical Status—(1) In general. A multiemployer plan is in critical status for a plan year if, as determined by the enrolled actuary for the plan, the plan is described in one or more of paragraphs (c)(2) through (c)(6) of this section as of the beginning of the plan year. The enrolled actuary’s determination of critical status must be made in accordance with the rules of paragraph (d)(5) of this section. Notwithstanding paragraph (d)(5)(iii) of this section, for purposes of applying the critical status tests described in paragraphs (c)(2) and (c)(5) of this section, the actuary must assume that the terms of all collective bargaining agreements pursuant to which the plan is maintained for the current plan year continue in effect for succeeding plan years.

(2) Critical status based on 6-year projection of benefit payments. A plan is described in this paragraph (c)(2) if the funded percentage of the plan is less than 65 percent, and the present value of all nonforfeitable benefits projected to be payable under the plan during the current plan year and each of the 6 succeeding plan years (plus administrative expenses for such plan years) is greater than the sum of—

(i) The fair market value of plan assets, plus

(ii) The present value of the reasonably anticipated employer contributions for the current plan year and the 6 succeeding plan years.

(3) Critical status based on short term funding deficiency. A plan is described in this paragraph (c)(3) if—

(i) The plan has an accumulated funding deficiency for the current plan year, not taking into account any extension of amortization periods under section 431(d), or

(ii) The plan is projected to have an accumulated funding deficiency for any of the 3 succeeding plan years (4 succeeding plan years if the funded percentage of the plan is 65 percent or less), not taking into account any extension of amortization periods under section 431(d).

(4) Critical status based on contributions less than normal cost plus interest. A plan is described in this paragraph (c)(4) if—

(i) The present value of the reasonably anticipated employer and employee contributions for the current plan year is less than the sum of—

(A) The plan’s normal cost (determined under the unit credit funding method), and

(B) Interest (determined at the rate used for determining costs under the plan) on the excess if any of—

(1) The accrued liability of the plan (determined using the actuarial assumptions described in section 431(c)(3) and the unit credit funding method) over

(2) The actuarial value of assets determined under section 431(c)(2),

(ii) The present value, as of the beginning of the current plan year, of nonforfeitable benefits of inactive participants is greater than the present value of nonforfeitable benefits of active participants, and

(iii) The plan has an accumulated funding deficiency for the current plan year (or is projected to have such a deficiency for any of the 4 succeeding plan years), not taking into account any extension of amortization periods under section 431(d).

(5) Critical status based on 4-year projection of benefit payments. A plan is described in this paragraph (c)(5) if the present value of all benefits projected to be payable under the plan during the current plan year or any of the 4 succeeding plan years (plus administrative expenses for such plan years) is greater than the sum of—

(i) The fair market value of plan assets, plus

(ii) The present value of the reasonably anticipated employer contributions for the current plan year and each of the 4 succeeding plan years.

(6) Critical status based on failure to meet emergence criteria. A plan is described in this paragraph (c)(6) if—

(i) The plan was in critical status for the immediately preceding plan year, and

(ii) The enrolled actuary for the plan has certified that the plan is projected to have an accumulated funding deficiency for the plan year or any of the 9 succeeding plan years, without regard to the use of the shortfall funding method but taking into account any extensions of the amortization periods under section 431(d).

(d) Annual certification by the plan’s enrolled actuary—(1) In general. Not later than the 90th day of each plan year of a multiemployer plan, the enrolled actuary for the plan must certify to the Secretary of the Treasury and to the plan sponsor—

(i) Whether or not the plan is in endangered status for such plan year;

(ii) Whether or not the plan is or will be in critical status for such plan year, and

(iii) In the case of a plan which is in a funding improvement or rehabilitation period, whether or not the plan is making the scheduled progress in meeting the requirements of its funding improvement or rehabilitation plan.

(2) Transmittal of certification—(i) Transmittal to the plan sponsor. The certification of plan status described in paragraph (d)(1) must be submitted to the plan sponsor at the address stated by the plan sponsor on their Annual Report (Form 5500) or such other address as the plan sponsor may designate in writing for receipt of this certification.

(ii) Transmittal to the Secretary of the Treasury. Except as provided in guidance of general applicability to be published in the Internal Revenue Bulletin, the annual certification of plan status described in paragraph (d)(1) must be transmitted to the Secretary of the Treasury by mailing the certification to:

Internal Revenue Service
Employee Plans Compliance Unit
Group 7602 (SE:TEGE:EP)
Room 1700 — 17th Floor
230 S. Dearborn Street
Chicago, IL 60604

(3) Content of annual certification—(i) In general. The annual certification must contain the information described in this paragraph (d)(3). The Secretary may add to or otherwise modify the requirements in this paragraph (d)(3) in guidance of general applicability to be published in the Internal Revenue Bulletin.

(ii) Plan identification. The annual certification must include the name of the plan; the plan number; the name, address, and telephone number of the plan sponsor; and the plan year for which the certification is being made.

(iii) Enrolled actuary identification. The annual certification must include the name, address and telephone number of the enrolled actuary signing the certification; the actuary’s enrollment identification number; the actuary’s signature, and the date of the signature.

(iv) Information on plan status. The annual certification must state whether the plan is in endangered status (which includes seriously endangered status); critical status, or neither endangered nor critical status.

(v) Information on scheduled progress. If the annual certification is made with respect to a plan year that is within the plan’s funding improvement period or rehabilitation period arising from a prior certification of endangered or critical status, the actuary must also certify whether or not the plan is making scheduled progress in meeting the requirements of its funding improvement or rehabilitation plan.

(4) Penalty for failure to secure timely actuarial certification. A failure of a plan’s actuary to certify the plan’s status under this paragraph (d) by the date specified in paragraph (d)(1) of this section is treated as a failure or refusal by the plan administrator to file the annual report required to be filed with the Secretary of Labor under section 101(b)(4) of the Employee Retirement Income Security Act of 1974.

(5) Actuarial projections of assets and liabilities—(i) In general. In making the determinations and projections under section 432(b) and this section, the enrolled actuary for the plan must make projections required for the current and succeeding plan years of the current value of the assets of the plan and the present value of all liabilities to participants and beneficiaries under the plan for the current plan year as of the beginning of such year. These projections must be based on reasonable actuarial estimates, assumptions, and methods in accordance with section 431(c)(3) and that offer the actuary’s best estimate of anticipated experience under the plan. Notwithstanding the previous sentence, the actuary is permitted to rely on the plan sponsor’s projection of activity in the industry provided under paragraph (d)(5)(iii) of this section. The projected present value of liabilities as of the beginning of such year must be determined based on the most recent information reported on the most recent of either—

(A) The actuarial statement required under section 103(d) of the Employee Retirement Income Security Act of 1974 that has been filed with respect to the most recent year, or

(B) The actuarial valuation for the preceding plan year.

(ii) Determinations of future contributions. Any actuarial projection of plan assets shall assume either—

(A) Reasonably anticipated employer contributions for the current and succeeding plan years, assuming that the terms of the one or more collective bargaining agreements pursuant to which the plan is maintained for the current plan year continue in effect for succeeding plan years, or

(B) That employer contributions for the most recent plan year will continue indefinitely, but only if the enrolled actuary for the plan determines there have been no significant demographic changes that would make such assumption unreasonable.

(iii) Projected industry activity. The plan sponsor shall provide any necessary projection of activity in the industry, including future covered employment, to the plan actuary. For this purpose, the plan sponsor must act reasonably and in good faith.

(6) Treatment of amortization extensions under section 412(e). For purposes of section 432, if the plan received an extension of any amortization period under section 412(e), the extension is treated the same as an extension under section 431(d). Thus, such an extension is not taken into account in determining whether a plan has or will have an accumulated funding deficiency under paragraph (c)(3) and (c)(4) of this section, but it is taken into account in determining whether a plan has or will have an accumulated funding deficiency under paragraph (b)(3) of this section.

(e) Notice of endangered or critical status—(1) In general. In any case in which the enrolled actuary for the plan certifies that a multiemployer plan is or will be in endangered or critical status for a plan year, the plan sponsor must, not later than 30 days after the date of the certification, provide notification of the endangered or critical status to the participants and beneficiaries, the bargaining parties, the Pension Benefit Guaranty Corporation, and the Secretary of Labor.

(2) Plans in critical status. If it is certified that a multiemployer plan is or will be in critical status for a plan year, the plan sponsor must include in the notice an explanation of the possibility that adjustable benefits (as defined in section 432(e)(8)) may be reduced, and such reductions may apply to participants and beneficiaries whose benefit commencement date is on or after the date such notice is provided for the first plan year in which the plan is in critical status. If the plan provides benefits that are restricted under section 432(f)(2), the notice must also include an explanation that the plan cannot pay single sums and similar benefits described in section 432(f)(2) that are greater than the monthly amount due under a single life annuity. A plan sponsor that sends the model notice issued by the Secretary of Labor pursuant to section 432(b)(3)(D)(iii) satisfies this requirement.

(3) Transition rules—(i) Early notice permitted. If, after August 17, 2006, the enrolled actuary for the plan certifies that a plan is reasonably expected to be in critical status with respect to the first plan year beginning after 2007, then the notice described in this paragraph (e) may be provided before the date the actuary certifies the plan is in critical status for that plan year. The ability to provide early notice does not extend the otherwise applicable deadline for providing the notice under paragraph (e)(1) of this section.

(ii) Reformation of prior notice. If notice has been provided prior to the date required under paragraph (e)(1) of this section, but the notice did not include all of the information described in paragraph (e)(2) of this section, then that notice will not satisfy the requirements for notice under section 432(b)(3)(D). Accordingly, the restrictions under section 432(f)(2) will not apply as a result of the issuance of such a notice. However, if prior to the date notice is required to be provided under paragraph (e)(1) of this section additional notice is provided that includes all of the information required under paragraph (e)(2) of this section, then the notice requirements of section 432(b)(3)(D) are satisfied as of the date of that additional notice and the restrictions of section 432(f)(2) will apply beginning on that date. In such a case, the date of the earlier notice will still apply for purposes of section 432(e)(8)(A)(ii) provided that the earlier notice included all of the information required under section 432(b)(3)(D)(ii).

(f) Effective/applicability date. These regulations apply to plan years ending after March 18, 2008, but only with respect to plan years that begin on or after January 1, 2008.

Linda E. Stiff,
Deputy Commissioner for
Services and Enforcement.