Contract manufacturing: a different perspective.

AuthorTello, Carol P.

Contract manufacturing continues to be an important issue for both taxpayers and the government. Although the Internal Revenue Service articulated its position on the issue in Rev. Rul. 97-48, (1) it has not formalized that position in regulations. (2) The lack of regulatory guidance is striking in view of the importance of the issue and particularly in light of the IRS's intent to litigate the issue on the basis of Rev. Rul. 97-48. (3) Although taxpayers have developed structures to avoid the direct confrontation with the issue, the uncertainty surrounding the law coupled with the likelihood that the IRS will litigate the issue provides an uneasy situation for tax directors.

This article examines the history of the current IRS position as manifested in Rev. Rul. 75-7 (4) and Rev. Rul. 97-48. It contends that the use of a toller by a controlled foreign corporation (CFC) to qualify for the "manufacturing" exception does not violate the fundamental policy concerns underlying the Subpart F provisions. In addition, the article suggests that the IRS understands, but does not accept, the tax consequences of the general manufacturing exception to the foreign base company sales provisions. Specifically, the general manufacturing exception in the Subpart F regulations means that certain income from sales made by CFCs that otherwise would have been characterized as Subpart F income can escape the tax net, but in an effort to nullify this result, the IRS has applied the branch rule to separate entity tollers. Finally, the article concludes that a functional analysis approach to the contract manufacturing issue should be adopted in lieu of the current "attribution" or "agency" approaches argued by taxpayers and formerly accepted by the IRS in Rev. Rul. 75-7.


For purposes of the subsequent discussion, a "contract manufacturer" must be distinguished from a "toller." (5) A toller is a manufacturing services provider that typically does not own either the raw materials or finished goods. Because a toller has no ownership interest in the raw materials or the finished goods, no sale is created either upon the toller taking physical custody of the raw materials or in returning the finished goods to the services recipient that typically owns the raw materials and the finished goods. (An example of a toller, which the IRS describes as a "consignment manufacturing affiliate, can be found in FSA 20020005.) In contrast, a contract manufacturer owns the raw materials and when the raw materials have been transformed into finished goods, the contract manufacturer sells those finished goods to the person who commissioned the manufacture of the finished goods. (FSA 20020005 refers to such a party as a "manufacturing affiliate.") The distinction between a toller and a contract manufacturer is significant for purposes of the foreign base company sales provisions because of the lack of a sale either to, or from, the toller.

A brief summary of the relevant Subpart F rules under section 954(d) is helpful to place the issue in context and identify the stakes involved. Under the foreign base company sales rules in Subpart F, any related party purchase or sale in the chain of distribution of a product potentially may create Subpart F foreign base company sales income (FBCSI). (6) Exceptions are provided that, if applicable, may permit the avoidance of Subpart F income even when such a related party is in the chain of distribution. First, income derived from purchases from unrelated parties followed by sales to unrelated parties escapes FBCSI characterization. (7) Further, the statute provides a same country or local manufacturing exception (8) that exempts the sales income that the CFC derives from sales of the finished goods from FBCSI as long as that toller or contract manufacturer is located in the country of incorporation of the CFC. Finally, a same country or local use, consumption, or disposition exception is provided, (9) pursuant to which the sales income from the sale of goods by a CFC for use, consumption, or disposition in its country of incorporation escapes FBCSI characterization, regardless of where the goods were produced or whether they were purchased from (or sold to) a related party.

If the above three explicit exceptions were the only exceptions from FBCSI characterization, the contract manufacturing issue would not be so contentious. The regulations, however, provide a general manufacturing exception. (10) Although many practitioners believe that a general manufacturing exception is implicit in the section 954(d)(1) statutory language, (11) the exception apparently is derived from the legislative history of the Subpart F foreign base company sales provisions. (12) That legislative history contains language providing an explicit basis for the general manufacturing exception. (13)

Under the general manufacturing regulatory exception, a CFC that "manufactures" the products that it sells is protected from FBCSI characterization of the income from the sales of those manufactured products. This is the case even if the sales are made to related parties or to customers outside of the CFC's country of incorporation and even if the manufacturing takes place outside the CFC's country of incorporation. Thus, the general manufacturing exception potently expands the type of sales that a CFC may make without the taint of FBCSI characterization. In other words, under the general manufacturing exception, a CFC may manufacture anywhere and may sell anywhere.

To circumscribe the ability of manufacturing CFCs to shift sales income into lower tax jurisdictions through the use of a branch, Congress engrafted a branch rule to prevent this shift of sales income. (14) (The use of a branch avoids a related party purchase or sale transaction and, thus, the potential application of section 954(d)(1).) The branch rule, (15) which applies to a CFC that has either a sales branch or a manufacturing branch, operates to treat a branch as if it were a separately incorporated CFC in the country in which it operates. Hence, the income either of the sales branch or, the sales income of the CFC where the CFC has a manufacturing branch (other than income derived from local...

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