Who Is a Manufacturer Under the Proposed Contract Manufacturing Regs.?

By Irene Pik-Wah Hui, CPA, Washington, DC

Editor: Annette B. Smith

In February 2008, the IRS issued proposed regulations (REG-124590-07) intended to clarify the manufacturing exception in the context of foreign base company sales income (FBCSI) under Sec. 954(d)(1). Among other things, the proposed regulations address the application of the manufacturing exception where a controlled foreign corporation (CFC) does not satisfy the physical manufacturing test but the CFC (or its branch) is involved in the manufacturing process. Until the regulations are finalized, taxpayers may follow the existing final regulations or elect to apply the proposed rules.

“Substantial Contribution” Standard

The IRS recognized that due to business considerations in the global marketplace, property may be produced under a contract manufacturing arrangement under which a CFC engages in manufacturing-related activities but does not itself manufacture the property. Thus, the proposed regulations introduce a new test of a CFC’s nonphysical “substantial contribution” to manufacturing. Under this new approach, a CFC principal may be deemed the manufacturer of a product—and thus qualify for the manufacturing exception—if its employees conduct activities that constitute a substantial contribution to the manufacturing process, even if the principal itself does not physically manufacture the product. Whether a CFC principal has satisfied the substantial contribution test is based on facts and circumstances.

The regulations offer a nonexclusive list of factors to consider in determining whether a CFC principal makes a substantial contribution:

  • Oversight and direction of the activities or process (including management of the risk of loss). The regulations emphasize the CFC principal’s substantive activities, rather than mere contractual rights.
  • Performance of manufacturing activities that are considered in, but would not satisfy, the “physical manufacturing” tests of Regs. Sec. 1.954-3(a)(4). The IRS reiterated its intent to consider nonphysical manufacturing activities as well as those that are physical but do not qualify as “substantial transformation” under the existing subpart F regulations, such as minor assembly.
  • Control of raw materials, work in process, finished goods, material selection, vendor selection, and logistics. The proposed regulations would not explicitly require ownership of inventory by the CFC principal to be considered to have control. Rather, the regulations focus on the substantive control activities in the supply chain during the manufacturing process.
  • Management of manufacturing profits. Such profits may relate to the impact on the overall profitability contributed by manufacturing.
  • Quality control. Relevant activities may include exercising oversight and control rights over the quality of the products manufactured and providing guidelines and remediation decisions when a quality control threshold is breached.
  • Direction of development, protection, and intellectual property used in manufacturing the product. This standard focuses on manufacturing-related intellectual property.

The regulations specifically use the word “employee” to ensure that only the activities performed by the employees of the CFC principal would be considered in determining whether a substantial contribution has been made to the manufacturing process by the CFC principal. The proposed regulations also would not distinguish between buy-sell and toll (consignment) contract manufacturing arrangements, although the examples appear to center on a toll arrangement.

Dismissing the “Its” Argument

In the preamble and, implicitly, in the language of the proposed regulations themselves, the IRS dismissed the “its” argument, under which taxpayers take the position that no FBCSI would result when a CFC sells different property than the property it buys. Taxpayers have argued that because Sec. 954(d)(1) refers to the purchase of personal property from a related person and “its” sale to any person, the provision applies only when the same property is sold. The regulations also implicitly reject the approach of “attributing” the contract manufacturer’s activities to the CFC principal.


Although the proposed regulations were intended to reduce controversy and provide clarification on certain contract manufacturing arrangement issues, taxpayers have expressed many concerns about the proposed rules. The proposed facts-and-circumstances test for substantial contribution could result in both flexibility and uncertainty. For example, the weight given to any activity (whether or not listed above) varies with the circumstances of a particular business. The presence or absence of any of the above activities, or of a particular number of activities, is not determinative.

In addition, the regulations provide examples to illustrate both the substantial contribution standard and other issues. Some of the other examples may have unintended implications for the substantial contribution standard. Questions have been raised about the interaction of these examples and how the IRS might use them during an examination. IRS officials have urged taxpayers to focus on the rules themselves rather than on the examples. Therefore, it is unclear to what extent taxpayers may rely on the examples.

Multinational corporations may need to reevaluate existing structures in light of the proposed regulations. Some companies may find it preferable to avoid contract manufacturing arrangements in favor of other structures, while others may find it advantageous to enter into new contract manufacturing arrangements.


Annette B. Smith is with Washington National Tax Services PricewaterhouseCoopers LLP in Washington, DC

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

If you would like additional information about these items, contact Ms. Smith at (202) 414-1048 or annette.smith@us.pwc.com.

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