Virtual manufacturing and the proposed contract manufacturing regulations.

• Author: Granwell, Alan W.

Introduction

On February 27, 2008, the Internal Revenue Service issued the long-awaited proposed regulations dealing with whether contract manufacturing arrangements entered into by a controlled foreign corporation (CFC) will constitute manufacturing for subpart F purposes. The proposed regulations also clarify the application of the subpart F branch rules, particularly with respect to the application of the manufacturing branch rule and multiple manufacturing branches, and request comments on a series of related issues. The proposed regulations are prospective in nature and will apply to taxable years of CFCs beginning on or after the date they are published as final regulations in the Federal Register, and for taxable years of U.S. shareholders in which or with which such taxable years of the CFCs end. Significantly, taxpayers may choose to apply the proposed regulations in their entirety to all open tax years as if they were final regulations.

In general, the proposed regulations provide that a CFC can be treated as manufacturing a product when the physical manufacturing test of subpart F is not satisfied by the CFC but where the CFC is involved in the manufacturing process. Under the proposed regulations, a CFC can be treated as manufacturing a product by making "substantial contributions" to the manufacturing of personal property through a contract manufacturer arrangement (hereinafter, the "substantial contributions" test), but only if such contributions are made by its employees. This test, if satisfied, generally treats the CFC as the manufacturer for all purposes of the foreign base company sales income provisions and, if the foreign base company sales income branch rules are not implicated, will enable the CFC to obtain deferral under subpart F. In contrast, if a CFC's branch (or disregarded entity treated as a branch) were to satisfy the substantial contributions test, the subpart F manufacturing branch rule may produce undesirable results, particularly where the branch is located in a high-tax country and the remainder of the CFC is located in a low-taxed country and thereby generates subpart F income.

With respect to physical manufacturing, the proposed regulations make clear that (1) property sold generally will be considered to be the property purchased even if sold in a modified form, thereby rejecting the "its" defense; and (2) in order for the CFC (or its branch) to qualify for the foreign base company manufacturing exception, either by satisfying the physical manufacturing tests or the substantial contributions test, the CFC must manufacture the property purchased through the activities of its employees, thereby rejecting the "attribution" defense.

Thus, the proposed regulations may provide an alternative basis for support for those taxpayers who have been relying on attribution under the current rules. Careful review is necessary as stated above in cases where the CFC has multiple jurisdictional locations.

Background

1. Globalization

   Globalization has led to significant changes in supply chain business models. Multinational corporations have restructured their overseas business models from those that were conducted under a vertically integrated business model (i.e., in which full-fledged manufacturing, distribution activities, and associated services were conducted through separate locally incorporated entities) to those that are conducted under a centralized supply chain business model that has substance and qualified employees and assumes overall responsibility for managing and conducting the business segment, including R&D, manufacturing, distribution, and associated services.

   In this centralized supply chain business model, the entrepreneur company obtains the residual returns while contracting with limited risk manufacturers (i.e., contract manufacturers) and distributors / commissionnaires to perform the routine manufacturing and distribution functions. The business reasons for this shift to a centralized supply chain business model are to increase growth, enhance margins, leverage resources, lower costs, and manage costs. The proposed regulations recognize this shift in the reality of business models.

2. Contract Manufacturing

   An important component of the centralized supply chain business model is the use of contract manufacturing arrangements to enhance the flexibility and efficiencies. In a typical contract manufacturing relationship, the entrepreneur (or principal) provides the contract manufacturer with the product specifications and rights to use intangibles to manufacture the product, etc., while the contractor owns the plant, property, and equipment, and uses its own employees to perform the actual manufacturing activities. The principal may exercise varying degrees of control over the manufacturing activities, such as controlling the quantity, quality, and timing of production. Either the principal or the contractor may have title to the raw materials, work-in-process, and finished products.

   Contract manufacturing arrangements can be subdivided into two categories. In a "consignment" or "tolling" arrangement, the principal acquires the raw materials/components and consigns them to the contract manufacturer, who performs the manufacturing or tolling service. In this arrangement, the principal has title to the property (i.e., raw materials, components, and work-in-process) while it is being manufactured. In contrast, in a "turn-key" of a "'buy-sell" arrangement, the contractor holds title to the raw materials, components, and work-in-process and, upon completion of the manufacturing process, transfers title to the finished product to the entrepreneur. Under a turn-key or buy-sell arrangement, the contractor typically incurs the risk of loss while the property is undergoing manufacturing.

   In both scenarios, the principal has the entrepreneurial risk of selling the finished product to customers, and the contractor has the risk of manufacturing the goods to the satisfaction of the principal. Other benefits and burdens may be allocated under both types of arrangements.

3. Legal Precedents

   The area of contract manufacturing has a confusing array of legal precedents. Revenue Ruling 75-7 (1) was the seminal public ruling that attributed the manufacturing activities of a contract manufacturer to the principal for subpart F purposes and branch rule purposes. (2) Two court cases held that a contract manufacturer corporation, whether unrelated or related, could not be treated as a branch or similar establishment of a CFC for branch rules purposes. (3) These cases enabled taxpayers to use the approach of Revenue Ruling 75-7 to attribute the manufacturing activities of the contract manufacturer to the CFC without implicating the subpart F branch rules.

   In response to this planning strategy, the IRS issued Revenue Ruling 97-48, (4) which revoked Revenue Ruling 75-7. In the 1997 ruling stated that (1) the IRS will follow Ashland and Vetco, and will not treat a separately incorporated contract manufacturer as a branch for purposes of the subpart F branch rule, and (2) the activities of a contract manufacturer cannot be attributed to a CFC for purposes of determining whether the CFC is manufacturing property. The ruling did not address the circumstances under which the activities of a CFC may qualify as manufacturing when a contract manufacturing arrangement is in place.

   The IRS decided to update the subpart F manufacturing/branch rules, which have little continuing relevance to the current globalized business models; to rationalize the current rules and to promote certainty and clarity, in view of the FIN 48 obligations; and, as stated in the preamble to the proposed regulations, to promote U.S. competitiveness abroad ("updated rules in this area are important to the continued competitiveness of U.S. businesses abroad").

   Highlights of Proposed Regulations

   The proposed regulations can be read to have three primary objectives:

   * Rejection of the "its" and "attribution" defenses.

   * Inclusion of the substantial contribution test manufacturing exception to address "principal"-based foreign operations under the centralized supply chain business model.

   * Clarification of the branch rule to the revised manufacturing exceptions and miscellaneous clarifications.

1. Subpart F Manufacturing Exceptions

   The proposed regulations clarify that a CFC qualifies for the subpart F manufacturing exceptions from foreign base company sales income (FBCSI) only if the CFC, acting through its employees, either manufactures the product under the physical manufacturing tests or satisfies the "substantial contributions" test under which a CFC can be treated as manufacturing a product even though the CFC does not engage in the physical manufacturing of the product. The proposed regulations reject the so-called its argument to avoid FBCSI on the grounds that the property purchased is not the same as the property sold by the CFC (for example, because the property purchased becomes a component of the property sold). They also reject the attribution approach of Revenue Ruling 75-7, under which a CFC could be treated as manufacturing the property on the basis of the contract manufacturer's activities.

   The proposed regulations do not alter the definition of manufacturing for purposes of the "same country" exception to subpart F. In other words, the substantial contributions test to determine whether a CFC is manufacturing a product does not apply for purposes of the same country exception. The same country manufacturing exception can apply as long as the property is physically manufactured in the CFC's country of incorporation and irrespective of whose employees, either related or unrelated parties, engage in the manufacturing activities in that country.

2. Branch Rule Modifications

   The proposed regulations modify the manufacturing branch rule in several respects. As an initial matter, a branch of a CFC can satisfy...