Subpart F and the new contract manufacturing regs.

• Author: Arber, Stephen

Subpart F of the Code generally requires U.S. persons who own at least 10% of the total combined voting power of the voting stock of certain controlled foreign corporations (U.S. shareholders) to include in current income profits derived from certain related-party transactions (including income derived from the sale of property). One important exception involves the sale of property where the seller manufactured the property sold (the manufacturing exception).

On December 29, 2008, final regulations (T.D. 9438) were issued on the application of the manufacturing exception to certain contract manufacturing arrangements-arrangements where a CFC does not itself perform the manufacturing but instead contracts with a third party to perform the manufacturing. These regulations, which are effective for tax years of controlled foreign corporations (CFCs) beginning after June 30, 2009, and for tax years of U.S. shareholders in which or with which such tax year of the CFC ends, provide certain areas of uncertainty in tax planning. This uncertainty will require taxpayers to reconsider whether subpart F applies to their foreign structures and may allow room for planning by taxpayers to manage these issues.

Under the new regulations, only the activities of the CFC's own employees are considered when determining whether the CFC meets the manufacturing exception (i.e., the actual manufacturing processes of the contract manufacturer are not taken into account). One of the more important changes in the final regulations involves the liberalization of the "substantial contribution" test, which provides for the application of the manufacturing exception to subpart F income for CFCs whose business operations substantially contributed to the manufacturing process, even where the activities of the CFC's own employees did not reach the level of manufacturing. In such cases, the final regulations provide a noninclusive list of seven activities (considered "indicia of manufacturing") that, when performed by the CFC's own employees, are each weighted and aggregated to determine whether the CFC's activities meet the manufacturing exception. These seven activities include:

* Oversight and direction of the manufacturing activities;

* Activities considered in, but insufficient to satisfy, the substantial transformation or component parts test;

* Material selection, vendor selection, or control of raw materials, work in process, or finished goods;

* Management of...