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April 1, 2013
Economic Analysis: U.S. Contract Manufacturing and Dave Camp's Option C
by Martin A. Sullivan

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By Martin A. Sullivan --

Nearly a decade ago, H. David Rosenbloom of New York University School of Law asked: "Why should U.S. companies be required to situate economic functions abroad to achieve a desirable result?"

Rosenbloom went on to suggest that the practical exemption from U.S. tax for foreign-based companies that perform a "middleman function" should be extended to subsidiaries performing the same function in the United States. That might erode the U.S. corporate tax base, but, Rosenbloom countered, it would eliminate distortions, promote U.S. employment, and have no detrimental effects on the competitiveness of U.S. multinationals. (Prior coverage: "Why Not Des Moines? A Fresh Entry in the Subpart F Debate," Tax Notes, Jan. 12, 2004, p. 274.)

On March 15 at a Washington conference sponsored by the Tax Policy Center and the International Tax Policy Forum, titled "Tax Policy and U.S. Manufacturing in a Global Economy," the conversation focused on whether manufacturing should get preferential tax treatment. Those in favor said manufacturing is mobile and research-intensive and that there is a strong economic case that mobile capital and research should be tax favored. Opponents said mobile capital and research should be subsidized directly if necessary, not manufacturing generally, and that in any case, the political and administrative difficulties of defining winners and losers greatly dilute any potential benefits.

In the midst of this mostly broad discussion, tax attorney Paul W. Oosterhuis of Skadden, Arps, Slate, Meagher & Flom LLP provided a detailed introduction on the international tax structures used by U.S. multinationals to manufacture and sell abroad. He showed how U.S. multinationals transfer the non-U.S. rights to U.S.-developed intangibles to affiliates in low-tax countries. And he showed how U.S. multinationals shift risk (and therefore profit) to these affiliates from manufacturing and distribution affiliates where most foreign real activities take place. Oosterhuis also explained how the check-the-box regulations and their legislated counterpart -- the look-through rules of section 954(c)(6), now scheduled to expire at the end of 2013 -- as well as the manufacturing exception to the foreign base company sales rules can be used to avoid U.S. tax under subpart F.

All this background paved the way for Oosterhuis's main point -- that for practical business reasons, it is much more difficult for a U.S. contract manufacturer than a foreign contract manufacturer to satisfy the tax rules that make foreign tax planning structures tax efficient. Specifically, it is more difficult for a related-party U.S. contract manufacturer to qualify for the manufacturing exception to the foreign base company sales rules of section 954(d). Thus, the playing field is tilted against U.S. multinationals manufacturing in the United States.

That finding is surprising because subpart F rules, of which foreign base company sales rules are a part, are usually thought of as tilting the playing field in favor of U.S. over foreign operations by preventing foreign operations from shifting profits to low-tax jurisdictions. But it would not be the first instance in which U.S. tax rules, which ostensibly seek to raise taxes on foreign investment, actually encourage foreign investment. Section 482 transfer pricing rules are a significant example. It is routine for the IRS to argue that a paucity of real business activity performed by a foreign affiliate does not justify that affiliate's high rate of profit. In response, multinationals over time have transferred functions from domestic to foreign locations in order to conform to the IRS's concept of what constitutes legitimate foreign profit. So, success in preventing artificial profit shifting can lead to real profit shifting.

Maybe we should just let multinationals park profits in tax havens without any foreign activity. Sounds absurd, doesn't it? But as long as the U.S. statutory corporate rate remains the world's highest, multinationals will have an incentive to invest abroad. Giving mobile U.S. investment the same tax benefits it has abroad is a lower-cost, targeted response to the problem.

Along those lines, Oosterhuis suggested -- as Rosenbloom did -- that the United States level the playing field for domestic and foreign operations if those domestic and foreign operations perform the same functions. For Rosenbloom, the target beneficiary was a domestic company buying products and selling products, with a related party on one side or the other. For Oosterhuis, the target beneficiary is a contract manufacturing affiliate in the United States that manufactures products for sale outside the United States on behalf of a foreign principal in a low-tax country.

Rosenbloom's proposal, more provocative than politically viable, never went anywhere. However, Oosterhuis's idea could play an important role in international tax reform. In particular, it could guide modifications to one set of the anti-base-erosion provisions proposed by House Ways and Means Committee Chair Dave Camp, R-Mich., in his discussion draft on tax reform. Under option C, which is by far the most discussed of the three anti-base-erosion options in Camp's first discussion draft, intangible profits from U.S. manufactured goods sold into foreign markets would receive a reduced tax rate. But a preferential tax rate that applies to exported products could be seen as an export subsidy that violates international trade law. Camp might want to consider replacing that preferential rate with a change in foreign base company sales rules that would facilitate U.S. contract manufacturers' inclusion in typical tax planning structures.

Contract Manufacturing

In his talk at Brookings, Oosterhuis presented three different structures that U.S. multinationals use to allow them to book profits in low-tax jurisdictions. At the center of all three of these structures is an affiliate, called a principal or entrepreneur, that holds the foreign rights to the U.S. multinational's intangible property and that is responsible for manufacturing and distributing products outside the United States. However, the principal is rarely physically involved in either of those processes. Related-party manufacturers and distributors are where most of those activities take place. A principal will typically locate in a low-tax jurisdiction like Ireland, Luxembourg, Switzerland, Hong Kong, or Singapore. Or it might be located in a country like the Netherlands, with a relatively high tax rate but where tax authorities will grant advance rulings allowing most profits to be shifted through royalty payment to a holding company in a tax haven.

Of the three structures discussed, the one given the most attention -- because it is the most commonly used -- is the contract manufacturing model, in which the principal's sales income (from sales to its related distributor) avoids subpart F because it qualifies for the manufacturing exception to the foreign base company sales rules. In the example from his presentation, Oosterhuis located the principal in Ireland, the manufacturer in Germany, and the distributor in Italy, and above all three is a holding company in Luxembourg. That is nearly identical to the structure used for the foreign operations of the real company given the fictitious name of Foxtrot by the Joint Committee on Taxation in its 2010 study of offshore profit shifting. The figure illustrates the JCT version, with the principal in the Netherlands, the manufacturer in Hong Kong, the distributors in unidentified locations, and a holding company in Bermuda. (See "Present Law and Background Related to Possible Income Shifting and Transfer Pricing," July 20, 2010. This structure is also described in the appendix to a recent OECD study, "Addressing Base Erosion and Profit Shifting" (Feb. 12, 2013)).

In what is now common practice, the holding company in Bermuda acquires the foreign rights to U.S.-developed intangibles through a cost-sharing arrangement with its U.S. parent. The arrangement has two parts. In the first part, Bermuda buys the foreign rights to existing intangibles. This buy-in payment is paid over a 10-year period. The second part has Bermuda paying a share of ongoing U.S. research spending equal to the foreign share of worldwide sales for the foreign right to newly developed intangibles. In general, inadequate buy-in payments are one of the biggest reasons why foreign profits of U.S. multinationals are often disproportionately large compared with foreign sales, assets, employees, and other indicators of business activity.

To support foreign sales for which it is responsible, the principal in the Netherlands compensates Bermuda for intellectual property rights by paying royalties. In the old days, cross-border royalties would normally be foreign personal holding company income subject to U.S. tax. That can be avoided in the current circumstances because the Netherlands principal is a disregarded entity that has checked the box, so it is considered for U.S. purposes to be in Bermuda. (Or it could qualify for exception to the foreign personal holding company rules under the look-through rules of section 954(c)(6).)

Let's now focus on the foreign and U.S. advantages of a structure in which the principal employing a contract manufacturer qualifies for the manufacturing exception. To get profits out of jurisdictions where manufacturing and distribution actually take place and into the Netherlands, the multinational adopts a transfer pricing strategy so that only the smallest rate of profit is assigned to the contract manufacturer and the limited risk distributor. By contractual arrangement, the principal agrees to make small guaranteed payments to manufacturers and distributors equal to fixed markup over their costs. All the residual flows to the principal. Risk entitles you to profit, and in normal times the principal gets a large share of the manufacturing and distribution profits that in the past would have been routinely attributed to the manufacturing and distribution subsidiaries.

Besides avoiding U.S. tax from a subpart F inclusion on royalties, the other bullet that must be dodged is subpart F inclusion on Netherlands sales to limited-risk related-party distributors. If requirements are not met, these sales could generate foreign base company sales income and be subject to full U.S. tax. The drafters of the original subpart F rules in 1962 did not want U.S. multinationals running products through tax havens because they knew transfer pricing rules would be unable to prevent them from parking profits there. But they did provide an exception for when an intermediary in the low-tax jurisdiction added real value and therefore presumably had real business purpose.

Typical Contract Manufacturing Structure

We need not rehash here the tortured history of the U.S. manufacturing exception. What is important for our purposes is to know that the regulations were significantly revised in 2008. The highlight of the new regulations is that a principal can qualify for the manufacturing exception if it makes a "substantial contribution" to the manufacturing operations. In terms of the figure, the Netherlands principal must substantially contribute to the manufacturing done by Hong Kong, or income from sales to low-risk distributors will be subject to U.S. tax.

Qualification for the manufacturing exception is still a facts and circumstances determination, but the 2008 regulations clarify what is required. Mere contractual language asserting oversight of manufacturing by the principal does not suffice. That is bad news for the more aggressive taxpayers. But the good news is that the principal is not required to actually engage in any physical manufacturing activities. Under the new rules, to qualify for the manufacturing exception, employees of the principal must engage in management activities to support the contract manufacturer, such as oversight of the production process, material and vendor selection, quality control, and logistics control.

While meeting these requirements, it is important that the principal not overdo it. Otherwise, the tax authorities in the country of the contract manufacturer -- Hong Kong, in the figure -- may deem the principal to be conducting business in that country and tax it accordingly. So employees of the Netherlands principal have to keep their distance.

Now, it is not impossible for a U.S. multinational to use a U.S. contract manufacturer in place of a foreign contract manufacturer. The law does not prohibit U.S. contract manufacturers, and the requirements are the same for both U.S. and foreign contract manufacturers. But Oosterhuis, who has extensive practice experience, points out that as a practical matter, it is much more difficult for a U.S. contract manufacturer to meet the requirements. The natural management of a potential U.S. contract manufacturer of a U.S. multinational would be the U.S. employees of that multinational. In our example, most of them would be required to move to Hong Kong, manage remotely, and not spend significant time back in the United States.

In addition to the awkwardness of these circumstances, there is a risk that the transfer pricing strategy -- on which the tax advantages of the entire structure depend -- could unravel. With most headquarters and research functions performed in the United States, and with all physical manufacturing in the United States, it is more difficult for the IRS to accept the idea that the lion's share of profit from foreign operations should reside in a principal located in a low-tax country with relatively few employees.

So, Oosterhuis concluded, the evolution of U.S. tax rules and practices in recent years has created an unintended but significant bias against U.S. multinationals using domestic manufacturers. To remedy the imbalance, base company sales rules would need to somehow be modified so it would not be so difficult for principals using U.S. contract manufacturers to qualify for the manufacturing exception. Moreover, transfer pricing rules may need to be modified to clarify that profitability levels attributed to U.S. contract manufacturers cannot be allowed to drift above those routinely given to foreign contract manufacturers.

Camp's Option C

In his far-reaching discussion draft on international tax reform, Camp has proposed that the United States move to a territorial system. He has also argued that international tax reform should be revenue neutral. Everybody understands that to offset the costs of a territorial system, Camp will need to toughen up the subpart F rules. Along these lines, he has offered three options. The one getting the most attention is option C. (Prior coverage: "Reform of Intangibles Income Taxation Debated," Tax Notes, Feb. 18, 2013, p. 809.)

Option C would be a radical departure from current law. It would significantly reduce the incentive to move intangible income to tax havens by eliminating deferral on intangible income earned in low-tax jurisdictions. Under option C, if low-tax intangible income was generated from foreign sales, the U.S. tax rate would be 15 percent. If low-tax intangible income was generated from sales into the United States, the U.S. tax rate would be 25 percent. (It is Camp's goal to reduce the top corporate rate to 25 percent, but he has not yet provided any hints about what steps he would take to offset that annual revenue loss of approximately $100 billion.) So in effect, Camp is eliminating deferral on intangible profits from U.S. sales and imposing a minimum tax on intangible profits for foreign sales. In February 2012 President Obama floated the idea of a minimum tax on all foreign earnings, but he did not specify a rate.

Option C is not all bad news for U.S. business. Under it, all intangible income earned in the United States from sales into foreign markets would also be taxed at 15 percent. This preferential rate for income related to intangible assets would have many similarities to a U.K. patent box. But there is one big difference, and that difference could be a deal-breaker. The Camp proposal would limit its benefits for domestic business to intangible income used for foreign sales. That limitation changes the nature of the benefit from a general business incentive to an export incentive. That is a potential violation of international trade agreements, and given the failure of past efforts (domestic international sales corporations, foreign international sales corporations, and the extraterritorial income regime) to pass muster with our trading partners, there is good reason to believe this provision would eventually also have to be repealed. (Prior coverage: "Camp Plan Would Likely Violate WTO Rules, Buckley Says," Tax Notes, Dec. 12, 2011, p. 1327.)

Ultimately, Oosterhuis suggested that removing the current bias against domestic contract manufacturing in subpart F might be worth considering as a fallback. His idea would only involve changing U.S. subpart F rules, and it would only remove a bias in current law against U.S. manufacturing for export rather than providing a targeted incentive for U.S. manufacturing. So it would be far less likely to violate WTO rules.

Under the expanded subpart F rules of option C, the Netherlands principal in the figure would pay an immediate 15 percent tax on intangible income related to the sale of products into foreign markets and a 25 percent tax on intangible income related to the sale of products into the U.S. market. Only non-intangible income, most of which is likely to arise from the assumption of risks of the Hong Kong contract manufacturer and of the limited-risk distributor, would be eligible for exemption under the new territorial system. Therefore, the value of the manufacturing exception is less significant than under current law. But it is still valuable.

Relaxing the substantial contribution requirements would make it easier for principals to qualify for the manufacturing exception (regardless of whether domestic or foreign contract manufacturers are employed). But the relative benefit would be to U.S. contract manufacturers, who would no longer face the requirements that are more difficult for them to meet than their foreign counterparts. There would be a level playing field for domestic and foreign contract manufacturing for multinationals selling products into foreign markets.

It is hard to argue with that limited objective. And given that everybody in Washington seems to want to help promote manufacturing -- particularly the White House -- the administration might not reject the idea out of hand. The main objection would be that a benefit is provided only to multinationals that do domestic manufacturing. In the absence of other relief, purely domestic manufacturers would pay the top rate, and on top of that they could lose other tax benefits when the tax base is broadened as part of overall reform.

But from the perspective of Camp's limited objective of getting tax reform up for a vote in his committee this year, the idea of extending some of the tax benefits that would remain for manufacturing after his expansion of subpart F to domestic manufacturing could have considerable appeal.

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