Subpart F: “Indicia of Manufacturing”

By Lowell D. Yoder, Esq.McDermott Will & Emery LLP, Chicago, IL

A controlled foreign corporation (CFC) that hires a contract manufacturer to physically manufacture the property it sells is considered as also manufacturing such property for purposes of Subpart F if it substantially contributes to the physical manufacture of the property. The activities that are taken into account for purposes of determining whether a CFC satisfies the substantial contribution definition of manufacturing are referred to as “indicia of manufacturing.”1 A CFC that substantially contributes to the physical manufacture of the property it sells qualifies for the manufacturing exception, but if manufacturing indicia are performed in a branch, the manufacturing branch rule can apply -- resulting in Subpart F income, whether or not the CFC relies on the manufacturing exception.2

The regulations do not provide a general definition of “indicia of manufacturing.” While the regulations list types of activities that are considered as manufacturing indicia, the descriptions generally include a required connection to physical manufacturing, and the list is not exclusive. Fundamentally, as discussed below, the touchstone for determining whether a particular activity is a manufacturing indicium is whether, under the particular facts and circumstances, the activity directly relates to the physical manufacture of the product sold by the CFC.

By way of background, sales income derived by a CFC is generally not Subpart F foreign base company sales income (FBCSI) unless there is a related-party transaction (e.g., the CFC purchases the products from a related person, or sells the products to a related person).3 Even if the CFC has a related party transaction, an exception to the definition of FBCSI is provided for income from the sale of products that the CFC manufactures.4

Where the CFC engages in manufacturing activities in a branch with respect to the property it sells, the manufacturing branch rule can apply. This rule treats the manufacturing branch and the remainder of the CFC as separate CFCs, and the remainder is considered as selling the products on behalf of a related person. Thus, the manufacturing branch rule can result in FBCSI to a CFC that does not purchase property from or sell property to related persons and also can limit the application of the manufacturing exception -- generally causing the exception to apply only to the income attributed to the manufacturing branch itself, as opposed to income attributable to sales or purchase activities derived by another branch or the remainder.5

Under regulations promulgated in 1964, manufacturing is defined as the physical transformation, conversion, or assembly of purchased property (“physical manufacturing”). Property sold by a CFC is considered as physically manufactured if the property is substantially transformed (e.g., steel rods into screws), or the production operations are substantial in nature and generally considered to constitute manufacturing (e.g., assembly of automobiles). A safe harbor provides that property will be considered as physically manufactured if conversion costs (direct labor and factory burden) account for 20% or more of the total costs of goods sold.6

Regulations issued in 2008 introduced the concept of substantial contribution to the definition of manufacturing. Now a CFC may be considered to have manufactured the personal property that it sells if the property is physically manufactured by someone (e.g., a contract manufacturer) and “the facts and circumstances evince that the controlled foreign corporation makes a substantial contribution through the activities of its employees7 to the [physical] manufacture, production, or construction of the personal property sold.”8

The regulations further provide that “[t]he determination of whether a controlled foreign corporation makes a substantial contribution through the activities of its employees to the [physical] manufacture, production, or construction of the personal property sold involves, but will not necessarily be limited to, consideration of the following activities”:

• Oversight and direction of the activities or process pursuant to which the property is physically manufactured;

• Physical manufacturing activities that are insufficient in extent to constitute full physical manufacturing in and of themselves;

• Material selection, vendor selection, or control of the raw materials, work-in-process or finished goods;

• Management of physical manufacturing costs or capacities (for example, managing the risk of loss, cost reduction or efficiency initiatives associated with the manufacturing process, demand planning, production scheduling, or hedging raw material costs);

• Control of manufacturing-related logistics;

• Quality control (for example, sample testing or establishment of quality control standards); and

• Developing, or directing the use or development of, product design and design specifications, as well as trade secrets, technology, or other intellectual property for the purpose of manufacturing, producing, or constructing the personal property.

Other activities also may be taken into account, and the performance or lack of performance of any particular activity, or of a particular number of activities, is not determinative.

No minimum performance threshold must be exceeded before an activity can be considered. Thus, all functions performed by a CFC's employees are considered, even if the CFC's employees perform only some of the functions in connection with any one activity (for example, some, but not all, of the vendor selection). The weight given to the performance of “any quantum of any activity” will vary based on the facts and circumstances of the particular business. Thus, the importance of each activity,9 as well as the level of activity that is considered sufficient (e.g., to control quality),10 depends on the particular business. The weight given to any functions performed will be based on the economic significance of those functions to the physical manufacture of the relevant property. In addition, the fact that other persons make contributions (even “substantial” contributions) to the manufacture of the property does not necessarily prevent the CFC from satisfying the substantial contribution test through the activities of its own employees.11

Therefore, in identifying manufacturing indicia, the key question is whether an employee activity “contributes” to the physical manufacture of a product manufactured by a contract manufacturer for the CFC. For example, oversight and direction is taken into account only to the extent it pertains to the activities or process pursuant to which the property is physically manufactured (e.g., oversight of the contract manufacturer's activities of transforming raw materials or assembling components into finished products). On the other hand, oversight and direction of the marketing of the product would not be considered as a manufacturing activity.

The final regulations and the Preamble describe the necessity of a connection between an activity and the physical manufacturing process. For example, the Preamble clarifies that, in determining whether a CFC meets the substantial contribution test, “[t]he weight given to any functions performed by employees of the CFC with respect to any activity will be based on the economic significance of those functions to the manufacture, production, or construction of the relevant personal property.”12

Consistent with this focus, the final regulations narrowed or clarified the scope of various activities relative to the prior proposed regulations, so that only activities relating directly to the physical manufacturing process can constitute indicia of manufacturing. For example, the “control of logistics” factor was changed to “control of manufacturing related logistics” in order to exclude post-manufacturing logistical activities. In addition, protection of intellectual property was eliminated as an indicium of manufacturing in order to exclude legal work relating to the protection of intellectual property.13

The evolution of “management of manufacturing costs or capabilities” as an indicium of manufacturing in particular illustrates the focus on the manufacturing process. This activity replaced “management of the risk of loss” and “management of the manufacturing profits” as labeled in the proposed regulations. The Preamble to the final regulations pointed out that some commentators suggested that these indicia of manufacturing should include management of “enterprise risk” that is not related to sales and marketing, while others thought it might encompass finance activities. In clarifying the kinds of management activities that are treated as indicia of manufacturing, the Preamble indicated that Treasury and the IRS “intend that the substantial contribution test recognize contributions made by a CFC's employees to the manufacturing process through functions which help to ensure that a plant is run in an economically efficient manner….” Further, the Preamble clarified that not all corporate management decisions are taken into account in the substantial contribution test, “because many such decisions are not directly related to the manufacture of the personal propertywith respect to which the substantial contribution analysis is being performed.”14 For this reason, “general management of enterprise risk” is not to be considered an indicium of manufacturing.

These technical developments and explanatory comments demonstrate the substantial contribution test's exclusive focus on activities that directly relate to the physical manufacturing of the property sold by the CFC.

Because activities are manufacturing indicia only if they relate to the physical manufacture of the property, a determination is required that the activities of the contract manufacturer satisfy one of the physical definitions of manufacturing (e.g., transformation of raw materials or assembly of components). For example, quality control activities would not contribute to the manufacture of a product, and thus not be an indicium of manufacturing, where the property is not considered physically manufactured by the contract manufacturer.15 Nevertheless, the courts have established a relatively low threshold for satisfying the physical manufacturing definition (e.g., assembly of sunglasses).16

As indicated above, the performance of manufacturing indicia by a CFC will be considered as manufacturing the property sold only if such activities substantially contribute to the physical manufacture of the property sold. No definition of “substantial” is given, and no safe harbor is provided; this is a facts-and-circumstances determination, and depends on the particular industry.17

If the CFC satisfies the substantial contribution definition of manufacturing, and manufacturing activities are performed in a branch of the CFC, then the manufacturing branch rule must be considered.18 A branch location outside of the CFC's country of organization is potentially a manufacturing branch if activities of its employees performed in such location are considered indicia of manufacturing and a tax rate disparity test is met.19 The tax rate disparity test generally is met where the purchasing or selling income is subject to a relatively low tax rate compared with the tax rate in the country where the CFC is considered to be manufacturing the property.20 If the activities of the CFC's employees performed in such branch location are not considered indicia of manufacturing, then the manufacturing branch rule would not apply.

A CFC that relies on the manufacturing exception based on the substantial contribution definition of manufacturing generally performs sufficient manufacturing activities in the location with the sales activities and income and, in addition or alternatively, in a location that does not have a tax rate disparity with the sales location. Under such circumstances, whether a particular activity performed in another branch location with a tax rate disparity is an indicium of manufacturing generally should be inconsequential, because the income from the sale of the products should qualify for the manufacturing exception regardless of whether the manufacturing branch rule applies.21

On the other hand, if the CFC is not relying on the manufacturing exception -- e.g., it purchases the products from and sells the products to unrelated persons -- then identifying a particular activity as a manufacturing indicium can be important. If an activity performed in a foreign branch is not an indicium of manufacturing, then the manufacturing branch rule would not apply. On the other hand, if the activity is a manufacturing indicium, then the manufacturing branch rule would have to be analyzed and, if it applied, could result in the products being treated as sold on behalf of a related person. Accordingly, whether an activity performed in a branch is a manufacturing indicium can make the difference between sales from the products being FBCSI or not, and this is of particular concern if such activity provides an important contribution to the physical manufacture of the product.22

Where a CFC does not have a related-party transaction and also is considered as manufacturing the property it sells, the determination of whether an activity is an indicium of manufacturing would not be necessary if all manufacturing activities occur in the same location as the purchase and sales activities.23 In addition, an analysis of manufacturing activities would be unnecessary where the activities are performed in a branch located in a low-tax-rate jurisdiction such that the tax rate disparity test is not met with respect to the sales location.24

In sum, a CFC that hires a contract manufacturer to physically manufacture property on its behalf will need to perform an analysis of its (the CFC's) manufacturing indicia, i.e., the activities of its employees that contribute to the manufacture of the property. This is necessary to determine the application of the manufacturing exception and the application of the manufacturing branch rule, whether or not the manufacturing exception is relied on. Fundamentally, an activity is a manufacturing indicium if, under the particular facts and circumstances, the activity directly relates to the physical manufacture of the personal property sold by the CFC.

This commentary also will appear in the October 2009 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Yoder, 928 T.M., CFCs -- Foreign Base Company Income (Other than FPHCI), and in Tax Practice Series, see ¶7130, U.S. Persons' Foreign Activites.

1 T.D. 9438, 73 Fed. Reg. 79334, 79335 (12/29/08).

2See Yoder, “Final and Temporary Subpart F Contract Manufacturing Regulations,” 35 Int'l Tax J. 3 (2009).

3 §954(d)(1); Regs. §1.954-3(a)(1).

4 Regs. §1.954-3(a)(4).

5 §954(d)(2); Regs. §1.954-3(b). The government rejected comments requesting that the regulations apply the manufacturing branch rule only when the CFC relies on the manufacturing exception. 73 Fed. Reg. at 79342-43.

6 Regs. §1.954-3(a)(4)(i), (ii), (iii).

7 The general definition of employee for Federal income tax purposes applies, and such term may include seconded workers and employees of related entities. Regs. §§1.954-3(a)(4)(i) and 31.3121(d)-1(c); Rev. Rul. 87-41, 1987-1 C.B. 296.

8 Regs. §1.954-3(a)(4)(iv).

9See Regs. §1.954-3(a)(4)(iv)(d), Ex. 8 (“Because use of intellectual property plays little or no role in the manufacture of Product X, it is not important to the substantial contribution analysis….”); Ex. 10(“The activities most relevant to the substantial contribution analysis under these facts are material selection, product design and management of the manufacturing costs and capacities.”).

10See Regs. §1.954-3(a)(4)(iv)(d), Ex. 11 (“In the X industry, quarterly visits to a manufacturing facility by qualified persons are sufficient to control the quality of manufacturing.”).

11 Regs. §1.954-3(a)(4)(iv)(c); 73 Fed. Reg. at 79,336.

12Id. (emphasis added).

13 73 Fed. Reg. at 79336-37.

14 73 Fed. Reg. at 79337 (emphases added).

15 Physical manufacturing activities of the CFC and activities of a subcontractor of the contract manufacturer may also be taken into account in determining whether the property sold is physically manufactured. See Regs. §1.954-3(a)(4)(iv)(a), (b)(2), and (d), Ex. 4.

16Bausch & Lomb, Inc. v. Comr., 71 T.C.M. 2031 (1996). See also Dave Fischbein Manufacturing Co. v. Comr.,59 T.C. 338 (1972); Yoder, “Subpart F: LMSB Provides Guidance Concerning the Definition of Manufacturing,” 35 Tax Mgmt. Int'l J. 360 (7/14/06). For a detailed analysis of the definition of physical manufacturing, see Yoder, 928 T.M., CFCs -- Foreign Base Company Income (Other than FPHCI), at VII.

17Cf. Regs. §1.954-3(a)(4)(iii) (the assembly operations of a CFC constitute physical manufacturing under a facts-and-circumstances analysis if the activities are substantial in nature and generally considered to be manufacturing).

18 The location of any manufacturing activity is the location where the employees of the CFC perform such activity. Regs. §1.954-3T(b)(1)(ii)(c)(3)(iv).

19 Manufacturing activities of traveling employees performed outside of the CFC's country of organization and outside of any country in which the CFC has a branch should not require an analysis of the manufacturing branch rule. Regs. §1.954-3T(b)(1)(ii)(c)(3)(v), Ex. 6; 73 Fed. Reg. at 79341-42.

20 Regs. §1.954-3(b).

21See Regs. §1.954-3T(b)(4), Ex. 9.

22 As described above, the manufacturing branch rule potentially applies only if the product sold by the CFC is physically manufactured by the contract manufacturer and the CFC satisfies the substantial contribution definition of manufacturing. Nevertheless, it seems inappropriate to require a CFC that does not rely on the manufacturing exception to perform a detailed analysis of manufacturing indicia and an analysis of the complex manufacturing branch rule only for purposes of ensuring that the manufacturing branch rule does not apply. This seems particularly onerous because this was not the rule for over 40 years under the prior regulations and the government has indicated that the issue can be avoided by performing the manufacturing indicia in a separate CFC, but that is not necessarily feasible.

23See Yoder, “Same-Country-of-Manufacture Exception to Subpart F Sales Income,” 38 Tax Mgmt. Int'l J. 240 (4/10/09).

24See Yoder, “Limits on the Application of the Subpart F Branch Rules,” 38 Tax Mgmt. Int'l J. 366 (6/12/09).