Contract manufacturing: a different perspective.

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.

Background

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 sales), is characterized as FBCSI if the tax rate imposed on the sales income is lower than the tax rate imposed on the manufacturing income. (16)

The consequences of the general manufacturing exception cannot be overemphasized and explain in large part why the government has tenaciously clung to an interpretation that would require the contorted application of the branch rule. Essentially, the IRS argues that a separate corporation is to be treated as a branch (or as a part of another corporation) so that it can be treated as a separate corporation! (17)

The history underlying this position, which dates back to a 1964 private letter ruling, is quite informative. In PLR 6412105700A, the IRS held that a CFC engaging the services of an iron ore converter would not earn FBCSI on the sale of that converted iron ore even though the iron ore was purchased from related parties and was converted into ferroalloy outside of the country of incorporation of the CFC. The CFC owned the raw materials and finished goods at all times, and also assumed the economic risk with respect to the raw materials and finished goods. The iron ore converter received a fee for its services, which was its only economic interest and compensation in the transaction. PLR 6412105700A did not apply section 954(d)(2)'s branch rule to the CFC and the iron ore services provider.

Inasmuch as the letter ruling was issued merely two years after the Subpart F provisions were enacted, (18) the issue was most likely one of first impression. Because of the importance and general application of the letter ruling's determination, the IRS initiated the process of developing a generally applicable revenue ruling. As a result, in 1966, the Chief Counsel's office issued a General Counsel Memorandum on the topic. (19)

GCM 333357 notes that the laws of agency were applied in the ruling letter to treat the contractor as an agent of the CFC and, therefore, that the iron ore processing activities were considered as having been performed by the CFC. The GCM further states that the iron ore contractor "obviously" is "an instrumentality" of the CFC. The GCM concludes that the determination whether the sales income from the sale of the ferroalloy was FBCSI could be made only after the application of the branch rule. The 1966 GCM reached this conclusion because, it reasoned, the agency principles that were applied to consider the activities of the iron ore converter as the activities of the CFC should also be invoked to apply the branch rule. (20)

Significantly, the GCM's rationale was that "[t]o hold otherwise would be to enlarge out of all proportion the manufacturing exception" applicable to income that would otherwise be FBCSI. The GCM expresses doubt that Congress intended the branch rule to be avoided through the use of an "instrumentality" rather than through a more conventional branch operation. It is important to note that the term "instrumentality" in the 1966 GCM refers to is an independent separate entity with no relationship to the CFC. (21)

The Assistant Commissioner (Technical), who had issued the original letter ruling, responded to GCM 333357 in 1972 by eliminating any reference in the draft revenue ruling to a principal-agent relationship between the CFC and the iron ore converter. Two years later, GCM 35961 was issued, rejecting the deletion of the reference to the principal-agent relationship as a satisfactory response to its application of the branch rule to the facts. The 1974 GCM states that the proposed revenue ruling implies that the general manufacturing exception is broad enough to cover manufacturing activities conducted in another country by an unrelated "corporate agent" of a CFC. That GCM further states that the Chief Counsel was "not bothered" by the fact that in the typical case the branch rule applies to a permanent establishment of the CFC rather than to an unrelated corporation on behalf of that CFC. The rationale for disregarding this very important distinction was that in either case the CFC will incur a separate tax on the manufacturing income either directly or indirectly as a cost of the manufacturing. The result according to the GCM is a separation of the taxation of the CFC's manufacturing and selling activities. A few months later, the IRS issued Rev. Rul. 75-7, which did apply the branch rule to a separate entity.

Discussion

The toller-contract manufacturer distinction is particularly important in the context of the application of the branch rule to a toller, whether related or unrelated to a CFC, because of the way the branch rule applies section 954(d)(1). The branch rule does not create a sale; instead, it treats either the sales branch or the selling CFC as selling on behalf of the other division of the same corporation. For example, if the CFC manufactures in one country and conducts its sales through a sales branch in a low-tax jurisdiction, the sales branch is treated as selling on behalf of the manufacturing CFC. This causes the income realized on the sales made through the sales branch of the CFC to be treated as FBSCI of the CFC. (22) The application of the branch rule to a separate toller entity causes the CFC to be treated as if it is selling the goods produced or manufactured by the toller on behalf of the toller. (23) The toller, however, has no economic interest in the sales income. Its economic interest is limited to its services fee. Thus, had the 1966 and 1974 GCMs fully reasoned the application of the branch rule to an unrelated separate corporation, this first fallacy would have been apparent.

Closer examination of GCM 35961's statement that it is "not bothered" by the application of the branch rule to a separate unrelated corporation reveals that no supporting analysis is provided to support that statement or to explain why the GCM dismisses such a concern. The implications of applying the branch rule to a separate entity can be illustrated by comparing the tax effect of the use of two separate entities to that of two divisions or branches of a single corporation. (See chart below).

Comparing Tax Effects of Using a Single Corporation
With the Use of Two Corporations

Assume: $100.00 gross sales receipts
        $30.00 factory costs (labor, etc.)
        $50.00 cost of materials

Single Corporation with Sales Branch
Use section 863(b) standard to apportion income

Manufacturing Branch               Sales Branch
(High Tax Jurisdiction)       (Low Tax Jurisdiction)
Gross Receipts   $100.00                 $10.00
Factory costs     (30.00)                 0.00
Cost of Materials (50.00)                  0.00
                 $ 80.00
Taxable
Income           $10.00                  $10.00

Assume 40% rate                    Assume 5% rate
Tax = $4.00                           Tax = $.50

Use of Branch results in $3.50 of tax savings or 44%
Without Branch, CFC has $20 taxable income and $8 tax

Two Corporations--Income and Expenses
Remain in CFC

CFC                              Related
                                 Toller
Gross Receipts $100.00           $ 31.50
                                  (30.00)
                                 (factory costs)
Factory Costs     ($ 31.50)
    ($30.00+ (.05 x $30.00)

Cost of
materials         ($ 50.00)
Taxable            $ 18.50          $1.50
Income

In each situation, assume $100 of gross sales receipts, $30 of factory costs (labor, etc.), and $50 for the cost of materials. In the case of a single corporation with a sales branch, further assume that section 863(b) would apply to apportion income between the home office of the CFC and the sales branch. Assume also that the sales branch is located in a low-tax jurisdiction with a 5-percent tax rate and that the home office where the manufacturing activity occurs is a high-tax jurisdiction that applies a 40-percent rate. Under section 863(b), the sales branch earns half of the taxable income, or $10 in the example. The tax on the home office's $10 of income is $4, whereas the sales branch pays only $0.50 in tax on the same amount of income. Without the use of a branch, the CFC would pay $8 in tax on $20 of taxable income. Thus, the use of the sales branch in the low tax jurisdiction results in a tax savings of $3.50 or a 44-percent savings.

Clearly, the policy objective underlying section 954(d)(2) is met by application of the branch rule in this instance because the $10 of sales branch income would be taxed currently in the United States at approximately 35 percent with a foreign tax credit for foreign taxes paid on the income, if any, thereby virtually eliminating the tax advantage that otherwise would be enjoyed by the U.S. parent corporation through the use of the branch structure.

Now compare the foregoing tax result with the dramatically different result of using two separate corporations, one of which is a toller. Assume that the toller receives a fee based upon a 5-percent mark-up over its costs. Because the factory costs are assumed to be $30, the toller's fee would be $31.50. After subtracting the toller's costs from its gross income of $31.50, the toller is left with $1.50 of taxable income. The CFC, however, still has factory costs of $31.50 and $50.00 of cost of materials. The CFC is left with $18.50 of taxable income rather than $20 because of the 5-percent conversion services fee paid to the toller.

If the toller is subject to a lower tax rate on its income, that lower rate is of no benefit to the CFC, whether or not the toller is related to the CFC. (24) All of the CFC's $18.50 of taxable income will be subject to the tax rate in the CFC's country of incorporation or, if the CFC uses a sales branch, section 954(d)(2) would apply to test whether the use of the branch results in FBCSI. (25) This is seemingly how the statute was designed to apply. The application of the branch rule to a separate toller entity, however, in effect nullifies the general manufacturing exception to the extent that a toller is used. But the example confirms that this should not be the result. (26)

The consequence of the general manufacturing exception is exactly as the 1974 GCM identifies: It broadly permits a CFC to sell anywhere and to anyone. But is this really an affront to the policy concerns underlying Subpart F? The government presumably would argue yes--that, if the CFC were located in a low-tax jurisdiction, the $18.50 of income would be lightly, if at all, taxed. The statute, however, generally does not determine whether income is Subpart F income on the basis of the generally applicable tax rates of the jurisdiction in which the CFC is incorporated except with respect to the application of the branch rule. For example, if a CFC manufactures goods in a country that imposes no income tax, the income from the sale of those goods is not FBCSI under the local manufacturing exception provided in section 954(d)(1). (27) Rather, the statute makes Subpart F determinations on the basis of whether the income is passive investment-type income or, in the case of foreign base company sales and services income, whether a portion of the income from the sales or services activity of a single entity has been artificially separated from the core activities involved in the production of that entity's income.

The IRS has legitimate concerns about techniques designed to avoid the application of the taxing statutes. In the contract manufacturing situation, however, a more beneficial and successful approach (28) may be to adopt a functional analysis similar to that employed in the transfer pricing context and to forgo the current "attribution" or "agency" analysis. Such an approach would be more consistent with current business practices in which the owner of valuable intangible property will frequently hire a services provider to manufacture goods using that intangible property.

Of course, whether the courts will fully endorse the IRS position as enunciated in Rev. Rul. 97-48 seems unlikely in view of recent cases. Equally important, not all taxpayers will have sufficient participation in the manufacturing process to successfully argue their case.

The courts in Medchem (P.R.) Inc. v. Commissioner (29) and Electronic Arts Inc. v. Commissioner (30) provide an analysis similar to, if not identical to, that of functional analysis, though the opinion in neither case identifies the analysis as such. Instead, the Tax Court looked to the activities of the CFC to determine whether the CFC had an active role in the manufacturing activities through such activities as oversight and quality control. Cases that have considered toller activities in non-Subpart F contexts, such as Suzy's Zoo v. Commissioner, (31) also have employed this functional analysis approach, though again that court did not use this terminology. Hence, even though the Tax Court has explicitly rejected the use of the non-Subpart F cases as precedent for Subpart F cases, the analysis in those cases may prove helpful in considering contract manufacturing cases. The business context appears to be the same as in the toller context, i.e., an owner of valuable intellectual property oversees the manufacture of goods using that intellectual property.

The IRS also has examined the type and quantity of activities undertaken by a CFC in the latest National Office consideration of the issue. In FSA 2000220005, the IRS seemingly adopted that approach, but did not reach a logical conclusion based upon its examination of the activities of the subject CFC. The FSA provides very detailed descriptions of the various functions of several branches of the CFC. For example, the CFC had four reporting units, and the activities of those units included such activities as the ownership of the non-U.S. marketing rights, sales, licensing, banking, insurance, raw material purchasing, financial reporting, product flow, customs compliance, and product development. Despite the lengthy description of the CFC's activities in relation to its manufacturing oversight, the FSA dismisses those activities in one conclusionary sentence, essentially contrasting the activities of the CFC in Rev. Rul. 75-7 with the taxpayer in the FSA and finding that the FSA taxpayer fell short. This is an odd conclusion in that the FSA provides a far more detailed description of the CFC's activities than does Rev. Rul. 75-7.

Conclusion

In summary, the IRS analysis in the so-called contract manufacturing cases is flawed. A better approach would be to adopt the functional analysis approach based upon current business practices in which the owners of valuable intangible property engage service providers to assist in the delivery of goods to the marketplace. A taxpayer that owns or licenses valuable intangible property, engages a manufacturing services provider to produce goods using that valuable intangible property, is engaged in the overall oversight and quality control of the manufacturing process, and assumes the economic risk for the goods is just as much a manufacturer as a taxpayer that directly employs the workers making or producing the product. The U.S. economy since the early 1960s has undergone a shift from heavy manufacturing activities to services provider activities and from vertically integrated businesses to more horizontal businesses that do not perform every function from beginning to end. This change in the U.S. economy should be matched by new tax rules to measure the income produced by the new type of business activity.

(1) 1997-2 C.B. 89.

(2) The IRS issued proposed regulations on contract manufacturing in March 1998 as part of the proposed Brown Group regulations, but those proposed regulations were withdrawn in July 1999. The subsequent Brown Group regulations did not include any provisions concerning contract manufacturing. Nevertheless, the language "any other person" in Treas. Reg. [section] 1.954-3(a)(6) (limiting the activities to be taken into account for purposes of the manufacturing exception to only those of the partnership) seemingly directly prohibits the use of a toller by a partnership. This language may simply have been overlooked when the contract manufacturing regulations were removed from the 1999 proposed regulations. Neither the IRS nor the Treasury Department has officially commented on the inclusion of this language in the Brown Group final regulations.

(3) See FSA 200220005.

(4) 1975-2 C.B. 244.

(5) The IRS does not make such a distinction in its guidance, though the subject of Rev. Rul. 75-7, the iron ore converter, appears to be a toller and not a contract manufacturer. In this revenue procedure, the iron ore converter received a fee for its highly skilled services, but at no time owned the raw materials or other ingredients necessary to perform the processing operation. A CFC, the owner of the raw materials, bore all risk of loss and controlled the quantity and quality of production. The activities to convert the iron ore occurred outside the country of incorporation of the CFC.

(6) I.R.C. [section] 954(d)(1).

(7) Id.

(8) I.R.C. [section] 954(d)(1)(A).

(9) I.R.C. [section] 954(d)(1)(B).

(10) Treas. Reg. [section] 1.954-3(a)(4)(i).

(11) This argument is based upon the term "the purchase of personal property ... and its sale" in section 954(d)(1).

(12) S. Rep. No. 87-1881, 87th Cong., 2d Sess. 84 (1962).

(13) An argument that the statute does not contain an implicit general manufacturing exception is supported by section 954(d)(2)'s providing only a sales branch rule. Further, the legislative history provides: "Moreover, the fact that a lower rate of tax for such a company is likely to be obtained only through purchases and sales outside of the country in which it is incorporated, accounts for the fact that the provision is made inapplicable to the extent the property is manufactured, produced, grown, or extracted in the country where the corporation is organized or where the property is sold for use, consumption, or disposition in that country." See S. Rep. No. 87-1881, at 84. The branch regulations added a manufacturing branch rule that would not be necessary if the only manufacturing exception was limited to the same country or local exception expressly provided in section 954(d)(1). Additionally, because the local manufacturing exception is subsumed in the general manufacturing exception, the question arises why both exceptions would be provided under those circumstances.

(14) "Also included in foreign base company sales income are operations handled through a branch (rather than a corporate subsidiary) operating outside of the country in which the controlled foreign corporation is incorporated, if the combined effect of the tax treatment accorded the branch, by the country of incorporation of the controlled foreign corporation and the country of operation of the branch is to treat the branch substantially the same as if it were a subsidiary corporation organized in the country in which it carries on its trade or business." S. Rep. No. 87-1881 at 84.

(15) I.R.C. [section] 954(d)(2) and Treas. Reg. [section] 1.954-3(b)(1).

(16) Treas. Reg. [subsection] 1.954-3(b)(1)(i)(b) and -3(b)(1)(ii)(b).

(17) This circular reasoning was noted by the Tax Court in Vetco Inc. v. Commissioner, 95 T.C. 579 (1990). The court furthered noted that such reasoning makes section 954(d)(1) superfluous because section 954(d)(1) already covers separate related corporations.

(18) The Subpart F provisions and the underlying Treasury regulations were effective for taxable years of foreign corporations that began after December 31, 1962.

(19) This GCM was issued on October 24, 1966.

(20) At first blush, the logic for the conclusion seems to be to consistency. The GCM, however, does not identify the basis for its application of agency principles in the context of the branch rule or consider the implications of this application. Certainly, one entity may be an agent for another. In the context of a permanent establishment, the agency relationship may lead to lead to taxation of the principal in the country where the agent performs activities on behalf of the principal. Thus, that analysis treats the agent as a branch of the principal. But for purposes of the branch rule, the consequence of the treatment of an agent as a branch of the principal is to treat the "branch" as a separate entity from the principal, the reverse of the permanent establishment context. In this case, however, a separate entity already exists.

(21) The facts indicate that the iron ore converter was only one of a few such converters in the world due to the highly specialized skill required to convert the iron ore into ferroalloy. The facts also indicate that neither party intended that the arrangement would be to participate in a joint venture or other risk or profit sharing arrangement in the manufacture of the ferroalloy.

(22) The income attributable to the manufacturing activity is not characterized as FBCSI and remains eligible for deferral. See Treas. Reg. [subsection] 1.954-3(b)(2)(ii)(e) and -3(b)(4) (Example 2).

(23) The toller would necessarily be treated as a manufacturing branch of the CFC that would conduct the sales.

(24) The Tax Court makes this point in Ashland Oil Inc. v. Commissioner, 95 T.C. 348 (1990) ("Drew Ameroid (the CFC) had no claim to Tensia's (the toller) manufacturing income and thus had no corresponding distributable amount that it was retaining in lieu of distributing dividends to Drew Chemical in the United States.").

(25) If the CFC subsequently uses a sales branch, section 954(d)(2) will apply to any portion of the $18.50 that is diverted to that sales branch. The branch rule of section 954(d)(2) applies only when section 954(d)(1) does not apply to create FBSCI, which would be the case in this example if the activity of the toller qualifies the CFC for the manufacturing exception.

(26) The result of the application of the branch rule to the toller situation seemingly causes all of the CFC's $18.50 of taxable income to be characterized as FBSCI, whereas only $10 of FBSCI is created with the use of a branch of a single corporation. Surely, the IRS would have no basis to treat the toller's income as Subpart F income of the CFC.

(27) See Treas. Reg. [section] 1.954-3(a)(2) & Example (1) and TAM 8509004. The tax rate applicable is not referenced because it is irrelevant to the determination of FBSCI.

(28) The IRS lost in the Tax Court on the issue of the application of the branch rule to a separate entity and more recently has focused on the denial of the attribution of the activities of a services provider to the services recipient as demonstrated in Rev. Rul. 97-48. It is not clear that the courts will accept the current IRS position as enunciated in Rev. Rul. 97-48.

(29) 295 F. 3d 118 (1st Cir. 2002), aff'g 116 T.C. 308 (2001).

(30) 118 T.C. No. 13 (2002).

(31) 273 F. 3d 875 (9th Cir. 2001), aff'g 114 T.C. 1 (2000). Among the activities of Suzy's Zoo cited by the Tax Court were the specification of the card, the color of ink, the grade of paper, the ownership of the intangible trademark and the copyrights to the cartoons used in the various products, and the quality control.

CAROL P. TELLO is counsel with the Washington office of Sutherland Asbill & Brennan LLP. She formerly worked in IRS's Office of Associate Chief Counsel (International) and was a Special Assistant to the Assistant Commissioner (International). Her practice focuses primarily on international tax matters. Before joining Sutherland, Ms. Tello was a special tax counsel for a Washington D.C. law firm where she focused on international tax planning for both business entities and individuals.