International Tax Strategy for Importers with Contract Manufacturing

International tax planning for the Contract Manufacture

International tax planning for the Contract Manufacturing

A new contracting manufacturing international tax law is allowing small business to reduce taxes.  If you import products into the U.S., you want to look at this new law.

Briefly, you form and control a foreign corporation where you contract your manufacturing.  The corporation manufactures products for you.  It sells these products, at a profit, to your U.S. business or directly to your customers.

The tax law does not tax you on the profit made by this corporation.

The tax provides that the shareholder of a  foreign corporation is not taxable on the income from the sale of personal property (including inventory) manufactured by a corporation formed in the same country as the manufacturing.[1]  In other words, tax on this profit from manufacturing is not taxed.[2]

The sale of the property takes place outside the U.S. This means title to the property occurs anywhere other than the U.S. Usually, the sale takes place when the property leaves the factory of the contract manufacturer.

You or an employee must only do one or more of these activities either via the internet or in person:
(1) Oversee and direct the activities or process which the property is manufactured, produced, or constructed or
(2) Select the materials or the vendor or
(3) Control the raw materials or the work-in-process or the finished goods or
(4) Manage the manufacturing costs or capacities or
(5) Control of manufacturing logistics or
(6) Control the quality such as overseeing the sample testing or establishing the quality control standards or
(7) Develop and direct the use or development of the product, design, and specification.

This is a fantastic tax law.  Importers are reaping significant tax savings. Importer tax plans rely upon a solid IRS regulation for contract manufacturers.

I know that you are busy and   I wish I could place all the tax breaks on a few paragraphs.   However, to have a blog post for as many different types of businesses, this post is a few pages.

If you want to schedule a time to talk, then email me Brian Dooley, CPA, MBT [email protected],

Here is how contract manufacturing tax avoidance works  You do not pay income tax on your controlled foreign corporation income that is not classified as “subpart F income.”  Subpart F is the location in the tax code that talks about the taxable income.  You want your controlled foreign corporation to earn income that is not Subpart F income.

Subpart F income does not include income from the sale of personal property manufactured, produced, or constructed by a foreign corporation.[1]

For example, Ford Motor manufacture in England.  These cars are sold in the U.K. and Europe through independent dealers.  None of the income is Subpart F income.  The income is not taxed by the United States.

Avoiding U.S.  taxes for Big Business like Ford is easy.  They can afford to build a factory.

Now, small businesses have the same opportunity for tax planning.  Contract manufacturing allows the small business to manufacture its products.

This tax break was never passed by Congress.  It was by order of President Bush and continued by President Obama.  President Bush ordered the IRS (which is part of the Executive Branch) to write the regulations to give a small business that contract manufacture the same tax savings enjoyed by Big Business.

A controlled foreign corporation’s contract manufacturing will qualify as manufactured, produced, or constructed by the corporation if the corporation contributes to the manufacturing of the property.  This contribution must by accomplished via the activity of one or more employees.[2]

One thing.  Manufactured, produced, or constructed is more than merely changing the property’s form when it was purchased.  For example, you purchase hair brushes for resale.  You modify the handle to a new type.  This is merely changing the form.

To save taxes with contract manufacturing, an employee (either full time or part time) must do one or more of these:

(1) Oversee and direct the activities or process which the property is manufactured, produced, or constructed or
(2)  Selection of the materials or vendor or
(3) Control of the raw materials or the work-in-process or the finished goods or
(4) Management of manufacturing costs or capacities[3]  or
(5) Control of manufacturing related logistics or
(6) Quality control such as overseeing the sample testing or establishment of the quality control standards or
(7) Developing and directing the use or development of the product, design and specification.[4]

Just what is “substantial contribution”?    You will find passing the substantial contribution test is easy.  And you will learn that the IRS states, “no threshold level of activity is required.”  The IRS also provides that in determining whether the activities of the CFC constitute a substantial contribution, there is no minimum performance threshold before an activity can be considered.

The IRS provides that the weight accorded to the performance of any quantum of any activity will vary with the facts and circumstances of the particular business.  Yep, this is vague. However, I have the best IRS examples below.

First, here is an example from the IRS of what not to do.  So, if you want to save taxes, don’t do this.    FS, a controlled foreign corporation, purchases raw materials from a related person.  The raw materials are manufactured into Product X.  FS hired CM as a contract manufacturer.

CM physically performs the substantial transformation, assembly, and conversion.
FS retained the right to control the raw materials, work-in-process, and finished goods, and the right to oversee and direct the activities or process pursuant to which Product X is manufactured.

However, FS’s employees do not exercise its powers to control the raw materials, work-in-process, or finished goods.  Also, FS’s employees do not exercise its powers of oversight and direction.

Likewise, FS’s employees do not develop or direct the use or development of the intellectual property for manufacturing Product X.

Here is the bad news: If the manufacturing activities are undertaken on Product X before sale had been undertaken by FS through the activities of its employees, FS would have satisfied the manufacturing law.

But, FS does not satisfy the tests because it does not make a substantial contribution through the activities of its employees to the manufacturing of Product X.

Merely having contractual rights to control materials, contractual rights to oversee and direct the manufacturing activities or process under which the property is manufactured, and ownership of intellectual property are not enough.

Now here is an example of what to do to save taxes.

Same facts as above except FS’s employee engage in product design and quality control and controls manufacturing related logistics.  The Employees oversee and direct the activities of CM in the manufacture of Product X.

This does not mean that the employees are there full time.  But, they show up at the correct time to do the work.  Also, please keeps a log or diary detailing the employee’s activities.

There are other ways to get your tax savings.

One is the procurement of raw materials by the contract manufacturer.   Consider this IRS example:    FS, a controlled foreign corporation, enters into an agreement with CM to manufacture Product X.

CM physically does all of the work and substantial transformation, assembly, or conversion required to manufacture Product X.  Product X is sold by FS to a related person for use outside of FS’s country of organization.

However, FS employee selects the materials that will be used to manufacture Product X. FS does not own the materials or work-in-process during the manufacturing process.  FS employee oversees and directs the manufacturing process and provides quality control.

FS manages the manufacturing costs and capacities on Product X by managing the risk of loss and engaging in demand planning and production scheduling.  This activity can be done in the United States.

The IRS concluded that the above satisfies the contract manufacturing tax law.

The IRS has an example regarding the physical conversion by employees of a person other than the contract manufacturer.   FS, a controlled foreign corporation organized in Country M, purchases raw materials from a related person.

The raw materials are manufactured into Product X by CM (an unrelated contract manufacturing).   CM does physically perform the substantial transformation, assembly, or conversion required to manufacture Product X.

Product X is sold by FS.   CM contracts with another corporation for its employees to operate CM’s manufacturing plant.

Apart from the physical performance of the substantial transformation, assembly, or conversion of the raw materials into Product X, employees of FS oversee and direct all of the other manufacturing activities required in connection with the manufacture of Product X.  These activities can be oversight and direction of the manufacturing process; vendor selection; control of raw materials, work-in-process, and finished goods; control of manufacturing related logistics; and quality control.

The IRS concluded that FS qualifies for the contract manufacturing tax savings.

This next example is about robots saving you taxes by overseeing the manufacturing.

FS, a controlled foreign corporation, purchases raw materials from a related person.  The raw materials are manufactured into Product X by CM (an unrelated contract manufacturing).  CM physically performs the substantial transformation, assembly, or conversion of the Product X.

Product X is sold by FS to related and unrelated persons.  At all times, FS retains ownership of the raw materials, work-in-process, and finished goods.

FS retains the right to oversee and direct the activities or process pursuant to which Product X is manufactured by CM but does not exercise its rights (through its employees).

FS is the owner of sophisticated software and network systems that remotely and automatically (without human involvement) takes orders, route them to CM, order raw materials, and perform quality control.

FS has a small number of computer technicians who monitor the software and network systems to ensure that they are running smoothly and apply any necessary patches or fixes.  The software and network systems were developed by employees of DP, the U.S. corporate parent of FS.

DP’s employees supervise the computer technicians, evaluate the results of the automated manufacturing business. They make ongoing operational decisions, including decisions related to the acceptable performance of the manufacturing process, stoppages of that process,  They make decisions related to product and manufacturing process design.

DP’s employees develop and provide to FS all of the upgrades to the software and network systems.  DP also has employees who direct and control other aspects of the manufacturing process; They include vendor and material selection, management of the manufacturing costs and capacities and the selection of the contract manufacturer.

The need for DP’s employees to direct the activities of the FS employees and otherwise contribute to the manufacturing process evinces that substantial operational responsibilities and decision making are required to be exercised by parties other than CM to manufacture Product X.

The IRS conclude that if the manufacturing activities undertaken on Product X had been undertaken by FS through the activities of its employees, FS would have satisfied the tax law.

The IRS concluded that FS did not meet the test because it does not make a substantial contribution through the activities of its employees to the manufacture of Product X.

The title to the next IRS example is “Automated manufacturing supervised by FS.”

The IRS assumed the same facts except for FS through its employees, engages in the activities undertaken by DP’s employees in the preceding example.

DP’s employees also contribute to product and manufacturing process design and provide support and oversight to FS in connection with functions performed by FS through its employees.

The IRS concluded that FS qualified for the tax savings.  So, yes, you can remotely control your robot or computer and get the tax benefits.

The IRS goes to the next level of technology with an example entitled “Automated manufacturing supervised by FS with purchased intellectual property.”

Assume the same facts before except for the following.  The software and network systems and the upgrades to those systems were purchased by FS rather than developed by employees of FS.

The IRS concluded that the lack of performance of software and network system development activities is not determinative in passing the tests.    Therefore, FS satisfies the test because it made a substantial contribution through the activities of its employees to the manufacture of Product X.

Here is the IRS example about significant contributions by more than one CFC.

FS1 and FS2 are two unrelated controlled foreign corporations.  They jointly contract with CM to manufacture Product X.  CM physically performs the substantial transformation, assembly, or conversion required to manufacture Product X.
Neither FS1 or FS2 owns the materials or work-in-process during the manufacturing process.

FS1, through its employees, designs Product X. FS1 directs the use of the product design and design specifications, and other intellectual property, for manufacturing Product X. Employees of FS1 also select the materials that will be used to manufacture Product X and the vendors that provide those materials.

FS2, through its employees, designs the process for manufacturing Product X. FS2, through its employees, manages the manufacturing costs and capacities on Product X.

FS1 and FS2 each provide quality control, oversight, and direction of CM’s manufacturing activities on different aspects of the manufacture of Product X.

The fact that other persons make a substantial contribution to the manufacture of personal property does not preclude a controlled foreign corporation from making a substantial contribution to the manufacture of personal property through the activities of its employees.

In the analysis of whether FS1 or FS2 make a substantial contribution to the manufacture of Product X, each company takes into account its individual activities, including those of providing quality control and oversight and direction of the manufacture of Product X.

Also, “no threshold level of activity is required,” including on providing quality control or oversight and direction of the activities or process before FS1 and FS2 can take into account their respective activities.  The IRS concluded that both FS1 and FS2 satisfy the test.

This next IRS example is titled “Direction and oversight of manufacturing and quality control through periodic visits.”

In this example, FS is a controlled foreign corporation.  It purchases raw materials from a related person.  The raw materials are manufactured into Product X by CM, a contract manufacturer and unrelated corporation to FS.

FS controls the raw material, work-in-process, and finished goods.  It manages the manufacturing costs and capacities.  It provides oversight and direction of the manufacture of Product X.

Employees of FS visit CM’s manufacturing facility for one week each quarter and perform quality control tests on a random sample of the units of Product X produced during the week.

In the X industry, quarterly visits to a manufacturing facility by qualified persons are sufficient to control the quality of manufacturing.   The IRS concluded that FS satisfied the tests.  

If you want to be an expert or to have your CPA be an expert, then here is our easy two hour to read book on international tax strategies. 

 

Footnotes

[1] Treas. Reg. Sec. 1.954-3(a)(4)(i) provides, in relevant part, that Subpart F does not include income of a CFC derived in connection with the sale of personal property manufactured, produced, or constructed by such corporation.

The deferral continues until the CFC either distributes money or invests in an asset that has a U.S. situs (such as stock of a domestic corporation, loan to a U.S. shareholder or any U.S. person, U.S. real estate, or guarantees a loan to a U.S. person, etc.)  – see section 956.

[2]  Section 31.3121(d)-1(c) defines an employee.

[3] Examples include the managing the risk of loss, cost reduction or efficiency initiatives associated with the manufacturing process, demand planning, production scheduling, or hedging raw material costs)

[4]  This may include the use of practical know-how, trade secrets, technology, or other intellectual property for manufacturing, producing, or constructing the personal property.

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