New tax regulations for contract manufacturing

In December of 2008 the United States Treasury department in conjunction with the IRS released new regulations for contract manufacturing. The new regulations were designed to update the previous contract manufacturing regulations so that the regulations were taking a more modern approach to the issues at hand.

Here is a closer look at the more significant changes to the regulations for contract manufacturing.

Number one: Substantial contribution test
This regulation kept the fundamental approach of the substantial contribution test, under this test a controlled foreign corporation can satisfy the contract manufacturing exception only if their employees have made a significant contribution to the manufacturing of the property. This regulation specifies that all employee activity is to be considered in the aggregate and no one type of activity will be considered more important than another. There will also not be any minimum activity level for the activity to be considered. These regulations will apply to any controlled foreign corporation that purchases or sell personal property from unrelated parties, but this only applies if the contract manufacturing company conducts significant contribution activities through branches.

Number two: Indicia of manufacturing
This regulation was written to clear up the oversight and direction that the manufacturing process was taking. It was written to provide manufacturing companies with clarification that the oversight and direction of the manufacturing process was not a prerequisite for satisfying the substantial contribution test. This regulation was also designed to recognize the importance of the manufacturing process not being a prerequisite and that the importance of it will vary depending on the facts and circumstances involved. The new regulation also indicates that a controlled foreign corporation can provide a large contribution to an automated manufacturing process if it is done through their employees. The regulation also clarifies that the buy-sell contract manufacturing arrangements that are made within the contract manufacturing company can qualify for the substantial contribution test.

Number three: Manufacturing branch rule
This regulation made a lot of changes to the original manufacturing branch section, which would be section 954 (d) (2). The difference between these new regulations and the above new regulations is the ones made to the manufacturing branch rule are considered temporary, where the others ones are permanent. One of the highlights of this regulation is that it provides a uniformly available tax incentive that is supposed to be considered when applying the tax rate disparity test. It also states that when employees are travelling to a branch location of the manufacturing plants they need to treat this travel as if they were conducting activities for the branch. The rule that is supposed to be applied to these situations is going to depend on the level of significant contribution activities in the various branches.

One of the great things about these temporary regulations is that they state that if one or more sales branches have already been tested under the manufacturing branch rule they do not need to be tested under the sales branch rule. This regulation removes the assumptions that were applied when physical manufacturing and significant activities where done in the same controlled foreign corporation. One of the assumptions that these regulations removed was that the non-physical activities fail the substantial contribution test. In order to be tested under the manufacturing branch rule the branch that is being tested must be involved in selling or purchasing activities. This means that if you have a branch that is not involved in the selling or purchasing aspect of manufacturing it cannot be considered a manufacturing branch under these rules and therefore cannot earn any sales income.