The application and analysis of the new proposed contract manufacturing regulations.

• Author: Hadjilogiou, Steven

Not surprisingly, most taxpayers prefer to pay as little tax as possible. In the context of the international sales of goods, prior to the creation of the Transfer Pricing and Subpart F rules, a taxpayer could create a subsidiary corporation in a foreign low-tax jurisdiction and then sell goods to that foreign subsidiary at a price equal to or slightly above cost, triggering a small amount of U.S. taxable gain. The foreign subsidiary could then sell those goods in foreign jurisdictions at a marked-up price, triggering only the low-tax jurisdiction's tax rate on the gain. One of the reasons Congress imposed the foreign base company sales income (FBCSI) rules of Subpart F was to currently tax U.S. taxpayers on the gain realized by the foreign subsidiary on sales income generated in such low-tax jurisdictions.1 Congress was concerned with income of a selling subsidiary that had been separated from manufacturing activities of a related corporation merely to obtain a lower rate of tax for the sales income. However, Congress only intended the FBCSI rules to apply where the foreign subsidiary did not add any appreciable value to the product, such as manufacturing, major assembling, or construction activity. Therefore, the FBCSI rules contain an exemption for manufacturing activities conducted by the foreign subsidiary.

Since the current regulations were promulgated in 1964, manufacturing has increasingly been outsourced to third-party manufacturers in so-called contract manufacturing arrangements. Under a typical contract manufacturing arrangement, a party contracts with the contract manufacturer to convert raw materials into finished goods or to assemble component parts into a finished product, in accordance with the party's specifications. Title to the property changes hands depending on the type of arrangement entered between the parties. In turnkey arrangements, the contract manufacturer retains title to the raw materials or component parts during the manufacturing process and title is transferred to the party at the time the finished product is delivered.

In consignment manufacturing arrangements, the party retains title to the raw materials during the entire manufacturing process. The question of whether a controlled foreign corporation (CFC) may enter into a contract manufacturing arrangement while still meeting the manufacturing exception to the FBCSI rules has been a matter of contention between taxpayers and the IRS for over three decades. The current regulations do not address the issue of contract manufacturing arrangements. However, on February 27, 2008, the Treasury finally issued new regulations to address the contract manufacturing debate (the proposed regulations). This article provides an overview of the current regulations, the historical background regarding the application of contract manufacturing to the current regulations, the application of the recently issued proposed regulations, and a discussion of a potential unintended consequence of the proposed regulations.

Current Law

A U.S. shareholder of a controlled foreign corporation is required to include his or her pro rata share of Subpart F income in his or her gross income for the taxable year. (2) IRC [section]951(b) Subpart F income is made up of foreign base company income derived by the CFC. (3) Finally, foreign base company income is made up of FBCSI. (4) FBCSI is income derived by the CFC where the CFC purchases property from or on behalf of a related person, sells property to a related person, or purchases property on behalf of a related person. Furthermore, the property must be manufactured, produced, grown, or extracted outside the country of the CFC's incorporation and the property is sold outside the CFC's country of incorporation. (5) Thus, property manufactured, produced, constructed, grown, or extracted within the CFC's home country is not FBCSI regardless of who actually manufactures the product (the same country manufacturing exception). (6) Furthermore, property sold for use, consumption, or disposition within the country in which the CFC is created is also not FBCSI (the same country sales exception). (7) Finally, FBCSI does not include income of a CFC derived in connection with the sale of personal property manufactured, produced or constructed by such corporation from personal property that it has purchased (the manufacturing exception).

Under the manufacturing exception, a foreign corporation will be considered to have manufactured, produced, or constructed personal property if the activities meet the requirements of either one of the physical manufacturing tests--the "substantial transformation" test or the "substantive" test. The substantial transformation test is met when purchased personal property is substantially transformed prior to sale. (9) The regulations do not define substantial transformation, but give the following examples: the conversion of wood pulp to paper, the transformation of steel rods to screws and...