New Contract Manufacturing Regulations for CFCs

New contract manufacturing regulations related to Controlled Foreign Corporations (CFC) make clear that the "manufacturing exception" can apply to a CFC that does not perform physical manufacturing, but nonetheless makes a "substantial contribution" to the contract manufacturing process.

Generally, a controlled foreign corporation (CFC) is a foreign corporation where more than 50 percent of its vote or value is owned by U.S. shareholders, (meaning U.S. persons including a corporation, LLC, partnership or individual) who own directly, indirectly, or constructively 10 percent or more of the vote or value of the CFC. [See IRC § 958 for ownership attribution rules.]

[1] Introduction to the Taxation of Income of CFCs

Pursuant to IRC Section 951(a)(1)(A)(i),  the U.S. shareholders of a CFC are taxed on a current basis on their respective shares of the CFC's Subpart F income, whether or not the CFC makes a distribution to its U.S. shareholders, and whether or not the CFC repatriates its profits to the U.S. [IRC § 952(a) and Treas Reg 1.952-1(a).]

Subpart F income is a broad term that includes, along with other items of income, foreign based company sales income ("FBCSI")... [I]ncome of a CFC that neither purchases products from related persons, nor sells its products to related persons, and that does not purchase or sell the products on behalf of related persons should not constitute FBCSI. In addition, income of a CFC that manufactures in the same jurisdiction or country as it is organized the products it sells generally should fall outside the definition of FBCSI. [Treas Reg 1.954-3(a)(4); IRC 954(d)(1)(A).]...

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Pursuant to the new final regulations under Section 954,... manufacturing is also defined to include contract manufacturing, where the CFC makes a "substantial contribution" to the manufacturing of the products sold by the CFC. [Effective for tax years beginning after June 30, 2009 (which most likely includes tax years beginning in January 1, 2010) and thereafter the IRS has issued final regulations addressing the application of FBCSI manufacturing exception, and modifying the branch rulesTD 9438, IRB 2009-5, December 29, 2008, as corrected March 20, 2009, provides final and temporary regulations that provide guidance relating to foreign base company sales income; and TD 9563, IRB 2012-9, guidance regarding foreign base company sales income, February 6, 2012.] The regulations list the activities... that are considered in determining if the CFC makes a substantial contribution to the manufacturing process. [The statute defines FBCSI, stating that (i) the purchase of property by the CFC from any person and "its" sale to a related person, or (ii) the purchase of property by the CFC from a related person and "its" sale to any person. Many taxpayers looked at the "its" language and incorrectly and erroneously concluded that provided the CFC purchased or sold an item of property different from the property that it purchased, the CFC did not realize FBCSI, irrespective of what party completed the transformation of product (commonly referred to as the " 'its' argument"). The preamble to the Final Regulations clearly rejects this argument as "contrary to existing law" and as representing an "incorrect reading" of the statute. Under the law the property sold will be considered the same as the property purchased, even if the property is sold in a different form...]

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[2] The New and Improved "Substantial Contribution" Test

Income derived from the sale of the property does not constitute FBCSI, and is therefore excluded from Subpart F income for tax purposes when the property is (i) manufactured within the CFC's jurisdiction or country of organization, or (ii) sold by the CFC for use, consumption, or disposition within the CFC's jurisdiction or country of organization.

[a] Substantial Transformation Test

A CFC is considered to have manufactured the personal property that it sells if the property sold is, in effect, transformed and therefore not the personal property originally purchased. This "substantial transformation" test is met when property is substantially transformed prior to sale, treating the property sold as new property manufactured by the selling corporation...

... [A] CFC qualifies for the manufacturing exception from FBCSI only if the CFC, acting through its own employees, manufactures the products that are sold to related parties and that give rise to income for the CFC. [See Treas Reg § 3121(d)-1(c).] Manufacturing occurs only if one of three tests is met: the two existing tests for physical manufacturing (i.e., the substantial transformation test and component parts test) and the new "substantial contribution" test.

[b] Substantial Contribution Test

... [U]nder the new regulations, a CFC can now qualify for the manufacturing exception to FBCSI by satisfying a new "substantial contribution" test even where the taxpayer cannot satisfy the "substantial transformation" and "substantive" tests. To qualify under this new test, the CFC must make a substantial contribution to the manufacture of its product through the activities of its employees...

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This test will be applied on a product by product basis. The weight given to any activity will vary with the facts and circumstances of the particular business, and the presence or absence of any activity, or of a particular number of activities, is not dispositive.

[c] Taxpayer Favored Change

... The new final regulations take the position that the "substantial contribution" test is qualitative, not quantitative...

[d] Business Records

... [T]he CFC's business records... should be retained... [Treas Reg § 1.954-3 describes the record keeping requirements of the U.S. shareholder.]

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Information referenced herein is provided for educational purposes only. For legal advice applicable to the facts of your particular situation, you should obtain the services of a qualified attorney licensed to practice law in your state.

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LEXIS users can access the complete commentary HERE. Additional fees may apply. (Approx. 7 pages)

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RELATED LINKS: For further discussion on the new regulations related to CFCs, including the branch rules generally and the tax rate disparity text, see:

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