Processing limit still applies to agricultural commodities

Plain-English summary

A controlled foreign corporation bought an agricultural raw material, had a related foreign corporation manufacture a finished product, and sold the product to a related U.S. corporation. The taxpayer argued that 2009 regulations had eliminated a rule excluding a product from the agricultural-commodities exception when manufacturing or processing accounts for at least half its fair market value. Chief Counsel rejected that reading. The regulatory change clarified when a CFC itself must manufacture property; it did not alter the separate agricultural-commodities exception. Because at least half the product's value came from processing and the selling CFC did not qualify for the manufacturing exception, its sales income was foreign base company sales income.

Ruling snapshot

• Question: Did the 2009 regulations eliminate the 50-percent manufactured-or-processed limitation in the agricultural-commodities exception?
• Outcome: No; the limitation remained effective, and the related-party sales generated foreign base company sales income
• Key authorities: IRC § 954(d); Treas. Reg. § 1.954-3(a)(1)

Full text (IRS public release)

Office of Chief Counsel
Internal Revenue Service
Memorandum

Number: 201532033
Release Date: 8/7/2015

CC:INTL:B02
POSTU-128339-14

UILC: 954.03-00

date: April 30, 2015

to: Elizabeth Rice
Senior Analyst, Offshore Compliance
(Small Business/Self-Employed)

from: Jeffery Mitchell
Chief, Branch 2
(International)

subject: Application of Agricultural Commodities Exception

This Chief Counsel Advice responds to your request for assistance dated April 1, 2015.
This advice should not be used or cited as precedent.

LEGEND

Raw Material =
Finished Product =
USC =
CFC Y =
CFC Z =
Country A =
Country B =

ISSUE

POSTU-128339-14 2

Whether the third sentence of Treas. Reg. § 1.954-3(a)(1)(i), added by T.D. 9438,
eliminated the 50 percent manufactured or processed limitation on the definition of
agricultural commodities for purposes of the agricultural commodities exception in
Treas. Reg. § 1.954-3(a)(1)(ii).

CONCLUSION

The third sentence of Treas. Reg. § 1.954-3(a)(1)(i), added by T.D. 9438, did not
eliminate the 50 percent manufactured or processed limitation on the agricultural
commodities exception.

FACTS

CFC Y, incorporated in Country B, takes title to Raw Material that is purchased from
farmers in Country A and delivered to CFC Z’s manufacturing facility. CFC Z,
incorporated in Country A, produces Finished Product from Raw Material pursuant to a
contract with CFC Y. CFC Y sells Finished Product to USC, a domestic corporation.
CFC Y, CFC Z, and USC are related parties within the meaning of section 954(d)(3).
CFC Y does not qualify for the CFC manufacturing exception in Treas. Reg. § 1.954-
3(a)(4) because it does not manufacture the Finished Product (which is produced by
CFC Z in Country A), nor does it make a substantial contribution to CFC Z’s
manufacturing.

Taxpayer, the United States shareholder (within the meaning of section 951(b)) of CFC
Y, argues that CFC Y’s income from sales of Finished Product to USC does not meet
the definition of foreign base company sales income (FBCSI) because Raw Material is
an agricultural commodity and the third sentence of Treas. Reg. § 1.954-3(a)(1)(i),
added by T.D. 9438, eliminated the 50 percent manufactured or processed limitation on
the definition of agricultural commodities.

LAW AND ANALYSIS

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. Consistent with the legislative history to section
954(d), the regulations thereunder provide manufacturing exceptions. The IRS and the
Treasury Department have always interpreted the statute to require the relevant CFC
itself to manufacture the product it sells to avoid FBCSI (the “CFC manufacturing
exception”), unless the manufacturing is performed within the CFC’s country of
organization (the “same-country manufacturing exception”). In T.D. 9438, the IRS and
the Treasury Department revised the regulations under section 954(d) to clarify that

POSTU-128339-14 3

interpretation of the statute.¹ Certain sentences were eliminated, revised, and added to
the regulations to underscore that -- apart from physical manufacturing or a substantial
contribution to such manufacturing, in both cases performed by employees of the CFC
itself -- changes to the form of personal property are irrelevant for purposes of the CFC
manufacturing exception.² Thus, the third sentence was added to Treas. Reg. § 1.954-
3(a)(1)(i) to clarify that, in accordance with the plain language and intent of section
954(d), when the same-country manufacturing exception does not apply, the relevant
CFC must perform the manufacturing to avoid FBCSI treatment.

Importantly, the 2009 Regulations did not revise the agricultural commodities exception
in Treas. Reg. § 1.954-3(a)(1)(ii). Agricultural commodities that are not grown in
commercially marketable quantities in the United States and that otherwise qualify for
the exception are excluded from the term “personal property” as used in section
954(d).³ Therefore, sales of products that qualify for the exception do not generate
FBCSI.

In addition to listing certain agricultural commodities that are grown in the United States
in commercially marketable quantities (and thus are not eligible for the exception) and
certain agricultural commodities that are not to be considered grown in the United

¹ See T.D. 9438 (Dec. 29, 2008) (the “2009 Regulations”).
² The 2009 Regulations added the following sentence (the third sentence) to Treas. Reg. § 1.954-
3(a)(1)(i):

For purposes of the preceding sentence [relating to the definition of FBCSI], 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.

Prior to revision by the 2009 Regulations, Treas. Reg. § 1.954-3(a)(4)(i) read as follows:

(4) Property manufactured or produced 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 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. In the case of the manufacture, production, or
construction of personal property, 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. 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
subparagraph (5) of this paragraph. (Emphasis added.)

³ Treas. Reg. § 1.954-3(a)(1)(ii)(a).

POSTU-128339-14 4

States in commercially marketable quantities (and thus are potentially eligible for the
exception), the regulations set forth a manufacturing test: “the term ‘agricultural
commodities’ shall not include … any commodity at least 50 percent of the fair market
value of which is attributable to manufacturing or processing, determined in a manner
consistent with the regulations under section 993(c)” (the “50 percent manufactured or
processed limitation”).⁴

Therefore, under the 50 percent manufactured or processed limitation, if at least 50
percent of the fair market value of the agricultural product is attributable to
manufacturing or processing by anyone, the agricultural commodities exception is not
available to the selling CFC because the regulations define the term “agricultural
commodities” to exclude such product. In other words, the processed commodity no
longer constitutes an “agricultural commodity” for purposes of the exception.

The 2009 Regulations did not eliminate the 50 percent manufactured or processed
limitation on the agricultural commodities exception. As described above, the third
sentence was added to Treas. Reg. § 1.954-3(a)(1)(i) to clarify that the relevant CFC
itself must perform the manufacturing for purposes of the CFC manufacturing exception.
In stark contrast, the 50 percent manufactured or processed limitation (like the same-
country manufacturing exception) has never depended on the identity of the
manufacturer. The agricultural commodities exception, unchanged by the clarifying
revisions in the 2009 Regulations with respect to the CFC manufacturing exception,
remains a narrow exception for certain foreign-grown agricultural commodities that have
not been processed to the point that 50 percent or more of the fair market value of the
property sold is attributable to manufacturing or processing.

Taxpayer maintains that the sentence added to Treas. Reg. § 1.954-3(a)(1)(i) effectively
overrides or erases the express language and outcome of the 50 percent manufactured
or processed limitation. However, the IRS and the Treasury Department did not strike
the 50 percent manufactured or processed limitation upon the issuance of the 2009
Regulations – the limitation remains in the regulations. As noted above, the 2009
Regulations added a sentence to Treas. Reg. § 1.954-3(a)(1)(i) and eliminated and
revised certain other sentences in Treas. Reg. § 1.954-3(a)(4) pertaining to the CFC
manufacturing exception – but did not revise the agricultural commodities exception in
Treas. Reg. § 1.954-3(a)(1)(ii). Thus, the plain language of the 50 percent
manufactured or processed limitation must be applied in accordance with the express
terms of the regulation. Even if it were necessary to consider Treas. Reg. § 1.954-
3(a)(1)(i) when construing the 50 percent manufactured or processed limitation, then,
under the canons of regulatory interpretation, it would be necessary to adopt an
interpretation that reconciles and gives meaning to both provisions – not to assert, as
Taxpayer does, that the former provision effectively overrides or erases the latter
provision. The two provisions are reconciled, as indicated above, by interpreting the
former provision as providing the scope of application of the CFC manufacturing

⁴ Id.

POSTU-128339-14 5

exception, and the latter provision as providing the scope of application of the
agricultural commodities exception. Therefore, these two distinct provisions address
different issues and the sentence added to Treas. Reg. § 1.954-3(a)(1)(i) in the 2009
Regulations does not override the 50 percent manufactured or processed limitation.

In sum, Taxpayer’s argument is incorrect. The 2009 Regulations did not eliminate the
50 percent manufactured or processed limitation to the agricultural commodities
exception. At least 50 percent of the fair market value of the property sold by CFC Y,
whether the property is considered to be Raw Material or Finished Product, is
attributable to manufacturing or processing. Therefore, the property is not included in
the term “agricultural commodities” for purposes of section 954(d).⁵ CFC Y’s income
from sales to USC does not qualify for the CFC manufacturing exception or the
agricultural commodities exception and therefore constitutes FBCSI.

Please call (202) 317-6934 if you have any further questions.

⁵ See Exam’s prior submissions; Treas. Reg. § 1.954-3(a)(1)(ii)(a); Treas. Reg. §§ 1.993-3(g)(4)(iii) and
(iv), and 1.993-3(c)(2)(iv).