The Application and Analysis of the New Proposed Contract Manufacturing Regulations

Most taxpayers want to pay as little tax as possible. In the past, some taxpayers were able to set up a company in a country with low taxes, sell goods to that company at a low price, and then sell the goods in other countries at a higher price, paying only the low tax rate. Congress created rules to tax these types of sales income, but they exempt manufacturing activities. However, many companies now outsource their manufacturing to third-party companies. In these arrangements, the third-party manufacturer makes the goods according to the company’s specifications, and the company may or may not own the materials during the process. In a consignment manufacturing deal, one party keeps ownership of the raw materials throughout the manufacturing process. For over 30 years, there has been a debate between companies and the IRS about whether a foreign company can still get tax exemptions while doing this type of manufacturing. In 2008, the Treasury issued new regulations to settle this debate. This article gives an overview of the current rules, the history of the debate, the new regulations, and a potential unintended result of the new rules. If an American owns a foreign company, they have to include their share of certain types of income in their taxes. This income comes from the foreign company buying or selling things with a related person outside of the country where the company is based. But there are exceptions – if the things are made or sold in the company’s home country, or if they’re sold within the company’s home country, then it doesn’t count as this type of income. There’s also an exception for when the company buys something and then changes it a lot before selling it. If the changes cost a certain amount compared to the total cost, then it’s considered a new product. When a foreign company operates a branch in a high-tax country and sells goods made there in a low-tax country, the branch is treated as a subsidiary of the company. This means the company has to pay taxes on the sales as if it were selling the goods itself, even though it’s technically the branch doing the selling. This rule prevents companies from avoiding taxes by using branches in low-tax countries. If a company in one country has a branch in another country and that branch does manufacturing work, the branch rule applies. This means that if the income from the branch is taxed at a much lower rate than it would be in the country where the branch is located, there could be tax implications.

In 1975, the IRS made a ruling about a company that hired another company in a different country to make a product for them. The IRS said that the company hiring the other company was still responsible for the manufacturing work, and the other company should be treated like a branch of the hiring company. After a ruling by the IRS in 1975, some taxpayers only followed part of it. They hired other companies to make their products, but didn’t treat those companies as part of their own business. The IRS tried to challenge this in court, but lost. In response, they changed the rule and agreed with the court decisions. So, taxpayers started using a new argument to avoid paying certain taxes, saying that the products made by the other companies weren’t technically theirs anymore. The IRS has proposed new rules to bring clarity to the tax issue of contract manufacturing. The changes include getting rid of a certain argument, adding a new test, and giving guidelines for cases with multiple manufacturing branches. These rules are meant to make things clearer and fairer for everyone involved. The new rules say that a foreign company can’t use the “its” argument to avoid taxes. The company has to do its own manufacturing, and its employees have to play a big role in making the products. There’s also a new test to see if the company is doing enough to contribute to manufacturing. If the company has branches, it has to show that it’s involved in making the products, and there are different rules if each branch makes something different or if they all work together to make the same thing. The proposed regulations for determining where a company manufactures items can be complicated, especially if the company has multiple branches. The rules depend on different factors, like where the branch is located and the tax rates in that location. The proposed regulations also have a lower threshold for what activities count as manufacturing, which could affect how foreign branches of a company are classified. For example, a branch that does research and development could be considered a manufacturing branch under the new regulations, even if it doesn’t actually make the products. This could change how the company is taxed. The proposed regulations are meant to provide clarity for U.S. companies that have or are planning to restructure their supply chains. They recognize that manufacturing includes more than just physical production, and they also serve as a warning to companies trying to avoid certain taxes. Some parts of the proposed regulations may have unintended consequences, and a simple solution to this problem is to allow certain companies to opt out of certain tax requirements. Steven Hadjilogiou is a tax attorney at a law firm in Miami. He helps businesses and individuals with international tax planning in many countries. This information is from the Tax Section of The Florida Bar.

Source: https://www.floridabar.org/the-florida-bar-journal/the-application-and-analysis-of-the-new-proposed-contract-manufacturing-regulations/