Subpart F and the New Contract Manufacturing Regs.

By Stephen Arber, CPA, J.D., LL.M., New York, NY, and Don Jones, CPA, San Jose, CA

Editor: Lorin D. Luchs, CPA, J.D., LL.M.

Subpart F of the Code generally requires U.S. persons who own at least 10% of the total combined voting power of the voting stock of certain controlled foreign corporations (U.S. shareholders) to include in current income profits derived from certain related-party transactions (including income derived from the sale of property). One important exception involves the sale of property where the seller manufactured the property sold (the manufacturing exception).

On December 29, 2008, final regulations (T.D. 9438) were issued on the application of the manufacturing exception to certain contract manufacturing arrangements—arrangements where a CFC does not itself perform the manufacturing but instead contracts with a third party to perform the manufacturing. These regulations, which are effective for tax years of controlled foreign corporations (CFCs) beginning after June 30, 2009, and for tax years of U.S. shareholders in which or with which such tax year of the CFC ends, provide certain areas of uncertainty in tax planning. This uncertainty will require taxpayers to reconsider whether subpart F applies to their foreign structures and may allow room for planning by taxpayers to manage these issues.

Under the new regulations, only the activities of the CFC’s own employees are considered when determining whether the CFC meets the manufacturing exception (i.e., the actual manufacturing processes of the contract manufacturer are not taken into account). One of the more important changes in the final regulations involves the liberalization of the “substantial contribution” test, which provides for the application of the manufacturing exception to subpart F income for CFCs whose business operations substantially contributed to the manufacturing process, even where the activities of the CFC’s own employees did not reach the level of manufacturing. In such cases, the final regulations provide a noninclusive list of seven activities (considered “indicia of manufacturing”) that, when performed by the CFC’s own employees, are each weighted and aggregated to determine whether the CFC’s activities meet the manufacturing exception. These seven activities include:

  • Oversight and direction of the manufacturing activities;
  • Activities considered in, but insufficient to satisfy, the substantial transformation or component parts test;
  • Material selection, vendor selection, or control of raw materials, work in process, or finished goods;
  • Management of manufacturing costs or capacities (including managing risk of loss, manufacturing cost reduction or efficiency initiatives, demand planning, or production scheduling);
  • Control of manufacturing logistics;
  • Quality control; and
  • Development or direction of the use or development of product design, and design specifications, trade secrets, technology, or other intellectual property related to manufacturing, producing, or constructing the personal property (Regs. Sec. 1.954-3(a)(4)(iv)(b)).

According to the preamble to the regulations, the weight given to the performance of any of the above activities varies based on the facts and circumstances, and the performance (or lack of performance) of any individual activity will not necessarily be accorded more weight than any other activity.

When applying the new regulations in practice, tax advisers should document to what extent the activities of the CFC’s own employees are listed activities. It is important to note that the final regulations do not include a safe harbor because Treasury felt no safe harbor could be fairly applied across all industries potentially subject to the new rules.

In contrast, the assembly of component parts by the CFC does contain a safe harbor under which the CFC’s activities would be considered manufacturing, as long as the CFC’s conversion costs (i.e., direct labor and factory burden) are at least 20% of the cost of goods sold (Regs. Sec. 1.954-3(a)(4)(iii)). Without such safe harbor for substantial assistance activities, advisers cannot be certain that a particular CFC’s activities are protected from subpart F income under a mere computational analysis.

As a result, in practice it may be wise to take a two-prong approach in documenting the exposure from this issue. First, taxpayers should quantify the activities of the CFC’s employees that meet one or more of the listed activities, using a method similar to that for component parts.

Example: Assume that Q, a CFC, uses an unrelated contract manufacturer for its manufacturing activities. Employee A performs duties that, among other nonmanufacturing activities, include quality control over the contract manufacturing process. Half of A’s time is spent on these manufacturing support activities. Assume that A is paid $100,000 per year and that Q’s cost of goods sold for the year is $200,000. Finally, assume that none of Q’s other employees perform any of the seven listed activities.

Although the cost of A’s activities would appear to be sufficient under the component part test ($100,000 × 50% of time spent on manufacturing support ÷ $200,000 = 25%), without the 20% safe harbor under the final regulations Q will not necessarily meet the substantial assistance manufacturing exception. However, this ratio should be considered as support for Q’s position and should be computed and documented for the files.

In addition to the computational approach, Q should also weight and document how important A’s quality control activities are to the overall manufacturing process (including the activities performed by the contract manufacturer itself).

In the example, although the quality control activities A performs constitute only 25% of the total cost of goods sold, if there is sufficient support that A’s activities are clearly substantial to the overall manufacturing process, then Q should qualify for the manufacturing exception even though it uses a contract manufacturer to perform the majority of its manufacturing process. The procedure for weighting and quantification should include interviews and analysis by management with regard to how important these support activities are to the overall manufacturing process.

Further, because the overall manufacturing process used by Q, as well as the individual activities performed by Q’s employees, may develop and change over time, it is important to update the analysis on a regular basis to ensure that a change in job functions does not unwittingly result in the loss of the exception in the future. Equally important is to ensure that the functions Q is relying on to meet the manufacturing exception are actually being performed as identified, rather than merely being provided for in an employee’s job description.

CFCs should also consider the above when planning for subpart F income, which could include moving listed activities to employees of certain CFCs in order to meet the manufacturing exception, as needed (assuming this is practical from both a business and a tax perspective). The area becomes more complicated when considering the manufacturing and sales branch rules, which, under certain circumstances, work to treat certain branches of a CFC as separate CFCs for subpart F determination purposes. These rules are very complex and are outside the scope of this item.

As a result of the above uncertainty and the lack of a safe harbor under the new regulations, all U.S. shareholders of CFCs should examine their manufacturing arrangements in light of the final regulations and plan for the July 1, 2009, effective date. These final regulations should also be considered when documenting and quantifying income tax exposures under FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, and FASB Statement No. 109, Accounting for Income Taxes, in addition to the U.S. shareholder’s potential subpart F inclusion exposure.


Lorin Luchs is a partner in National Tax Services of BDO Seidman, LLP in Bethesda, MD.

Unless otherwise noted, contributors are members of or associated with BDO Seidman, LLP.

For additional information about these items, contact Mr. Luchs at (301) 634-0250 or

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