OREGON STATE BAR ASSOCIATION
INTERNATIONAL LAW SECTION
FROM THE INSIDE AND OUT: FEDERAL AND FOREIGN TAX CONSIDERATIONS IN CROSS-BORDER TRANSACTIONS
A CASE STUDY
“CLEAN TECH GOES GLOBAL”
PANELISTS
Gabe B. Gartner Ellen McMillan Director of Corporate Tax Planning International Tax Manager Microsoft Corporation Tektronix, Inc. Redmond, WA Beaverton, OR
John Shepherd Mark McGinley Manager of International and Federal Tax International Tax Partner Louisiana-Pacific Corporation Moss Adams LLP Portland, OR Eugene, OR
Jon Brian Davis Asa Altmark Managing Director International Tax Senior Manager Chainbridge Research International Grant Thornton LLP Washington, DC Portland, OR
MODERATOR
Todd M. Beutler Tax Partner Lane Powell PC Portland, Oregon
A CONTINUING LEGAL EDUCATION PROGRAM
University of Oregon White Stag Block Building • Portland, OR • November 9, 2009
OSB – INTERNATIONAL LAW SECTION
CASE STUDY: CLEAN TECH GOES GLOBAL
Background
A retired University of Oregon professor of molecular physics was tinkering around her garage laboratory in Eugene when she stumbled upon a photo- induced chlorophyll substrate-reduction process that generated tremendous energy and would soon set the renewable energy world ablaze. Realizing the vast environmental and commercial implications of her discovery, Mary approached a biomechanical engineer colleague at Oregon State University and together they raised sufficient funds from investors in their circle of friends and family, along with funds from a generous, local angel investor, to establish a company, Solnetik, to develop commercial applications for this new solar energy technology.
After experimenting with various applications, Solnetik’s research and development team achieved a major breakthrough. Using experimental nanotechnology, they discovered that it was possible to arrange within an extremely thin polymer sheet an intricate series of nanochannels through which the energy-generating chlorophyll substrate could be kinetically-propelled for both an indefinite period of time and in such a manner as to maximize its photovoltaic output. This obviously opened up a number of possibilities for commercializing small- and large-scale, unobtrusive, high-output, flexible solar arrays, which Solnetik was keen to develop.
After further research and development, Solnetik developed several prototypes and displayed its flexible polymer array prototypes at the annual renewable energies convention being held in Portland. Solnetik’s new technology and functioning prototypes took the convention by storm and Solnetik received the coveted “Golden Photon Award” for its ground-breaking contribution to the renewable power industry. Solnetik’s arrays even became the focus of the convention’s keynote speech delivered by a former Vice President of the United States. Afterwards, Solnetik’s flexible polymer arrays were subsequently featured in a cover article in the next issue of The Journal of Renewable Technologies.
Over the next couple of years, Solnetik experienced breakaway growth and quickly joined the top ranks of renewable energy companies. With steady growth anticipated in the U.S. market and significant sales domestically and internationally, Solnetik has determined the time is right to look to key foreign markets for additional sales growth as well as sourcing, manufacturing and research.
Page 1 OSB – INTERNATIONAL LAW SECTION
PANEL ONE – DOING BUISNESS IN CHINA
I. EXPLORING THE CHINESE MARKET
A. Overview
Solnetik’s management needed to understand China before entering the market.
• Notes / Issues:
B. U.S. Sales Representative in China
One of Solnetik’s first major initiatives outside the U.S. was to send sales representatives to China to introduce its technology and products to the Chinese market. Solnetik saw an opportunity to position itself as the market leader in harnessing renewable energy to fuel the continued growth of the Chinese economy. Solnetik’s goal was to be well-positioned in the market for when China abandoned its dependence on coal and foreign oil and adopted more eco-friendly practices focusing on renewable energy. To start, Solnetik sent employees from Oregon over to Shanghai and other Chinese cities.
• Notes / Issues:
Page 2 OSB – INTERNATIONAL LAW SECTION
C. Hiring Chinese Representatives
Solnetik quickly discovered that local employees and contacts were a key ingredient to success in the Chinese market. Accordingly, it called home its U.S. sales representatives and instead hired a Chinese citizen to help develop those contacts and expand sales in the market.
• Notes / Issues:
D. Committing to Presence in China
With its continued success in the Chinese market, Solnetik established a regional sales office in Shanghai to bolster its growing market share there and in neighboring countries, as well as to identify potential sourcing and manufacturing opportunities. Employees from the U.S. were sent to the Shanghai office, and additional Chinese employees were hired to staff the office.
• Notes / Issues:
Page 3 OSB – INTERNATIONAL LAW SECTION
D. Committing to Presence in China (cont.)
The Shanghai office showcased Solnetik’s technology and products for prospective customers. The office was built out as a state of the art showroom for Solnetik’s flexible polymer arrays, and upon entry guests were greeted by walls of moving images demonstrating the company’s products in various applications (e.g., on buses, railcars, office buildings, aircraft).
• Notes / Issues:
In addition to more standardized items, Solnetik focused its sales efforts on custom fabrication projects involving various applications of its solar technology and products. For these projects, Solnetik’s Shanghai account representatives would visit with customers as part of a standardized inspection, bid and bid- review process. After visiting a customer’s site to gather information, the Shanghai account representatives and office manager would develop a preliminary bid for the customer. If satisfied with the terms of the preliminary bid, the customer would sign the sales documents and return them to the Shanghai office. Solnetik’s documents all state that an accepted bid does not become a binding agreement until the home office approves the bid and signs the documents. In practice, however, the responsible officer in Portland could not oversee each sale in China, and bids routinely receive approval without review.
• Notes / Issues:
Page 4 OSB – INTERNATIONAL LAW SECTION
E. Delivering Services in China
Not long after entering the market, Solnetik’s local customers began to demand that it provide various services in China (e.g., general consulting, maintenance). To ensure high levels of customer satisfaction, Solnetik’s management determined that the best course of action would be to send personnel from the U.S. home office to China, and to simultaneously hire local employees or agents, to meet the demand for services.
• Notes / Issues:
II. STRATEGIC EXPANSION IN CHINA
A. Incorporating a Branch
Solnetik’s Shanghai operations allowed the company to quickly achieve good market penetration in China. As a result, Solnetik’s management decided that pursuing self-distribution within China made sense. One of the first options to consider was whether Solnetik could or should incorporate its existing branch.
• Notes / Issues:
Page 5 OSB – INTERNATIONAL LAW SECTION
B. Acquiring a Chinese Company
To jump-start its expansion into the Chinese market, Solnetik identified a local company for acquisition. The Chinese company was in the business of manufacturing custom gateways and batteries used in certain Solnetik products. Solnetik’s management believed that the acquisition of this company would facilitate Solnetik’s adoption of a more vertical source and supply chain, which would further add to its bottom line.
• Notes / Issues:
C. Reconsidering Go-it-Alone Distribution
Solnetik’s Shanghai operations allowed the company to quickly achieve good market penetration in China. Nonetheless, Solnetik – like most companies new to the China market – found that the distribution channels within the country were difficult to access and organic logistics development was next to impossible. Accordingly, the company determined that it could more-efficiently enhance its total market penetration by partnering with a local sales/distribution company.
• Notes / Issues:
Page 6 OSB – INTERNATIONAL LAW SECTION
D. Joint Development of Additional IP
While the solar array operations firmly established in China, Solnetik’s management turned to the question of future developments. As it happened, the company’s scientists had again stumbled on some “promising findings” in the laboratory – this time in the geothermal energy space. Solnetik’s management met with its advisors, and came away with the understanding that the Chinese government was keen to develop geothermal energy technology locally. Further, the company’s advisors offered to introduce Solnetik’s management to representatives from a reputable Chinese chemical engineering firm considered to be a most-trusted development partner. After meeting with the Chinese engineering firm’s representatives, Solnetik decided to jointly develop its “promising findings” with the Chinese engineering firm.
• Notes / Issues:
Page 7 OSB – INTERNATIONAL LAW SECTION
III. OTHER STRATEGIC CONSIDERATIONS
A. Further Structuring
Several of Solnetik’s advisors had suggested to management that efficiencies might be gained if the company were to hold its Chinese operations through a separate non-U.S. holding company. Management was intrigued.
• Notes / Issues:
B. Contract Manufacturing
Although its Chinese operations were functioning well, Solnetik’s management had heard tax advisors praise a strategy known as “contract manufacturing”, yet simultaneously warn of its pitfalls. They had absolutely no idea what this was, but they were concerned.
• Notes / Issues:
Page 8 OSB – INTERNATIONAL LAW SECTION
PANEL TWO – DOING BUSINESS IN CANADA
Just as Solnetik was exploring opportunities in China, there was also a drive to secure the Canadian market. Capturing revenue from the sale of products and services in Canada was a natural goal for Solnetik, a company headquartered and operating in the Pacific Northwest. Further, given that the Canadian government was under continuous pressure to increase its commitment to renewable technologies, Solnetik wanted to be well-positioned to secure opportunities in Canada.
I. COMMITTING TO THE CANADIAN MARKET
A. Overview
Despite its proximity and significance as a key U.S. trading partner, Solnetik’s management wanted to better understand the Canadian market before jumping in head first.
• Notes / Issues:
B. U.S. Sales Representatives in Canada
Since receiving the “Golden Photon Award,” Solnetik had been inundated with inquiries (and even some small purchase orders) from various motorcoach and aerospace manufacturers in Canada. To address the significant volume of sales inquiries arriving from Canada, the company assigned to certain of its U.S. sales representatives responsibility for specific Canadian provinces and territories. These sales representatives typically spent 25% of their time in Canada, largely
Page 9 OSB – INTERNATIONAL LAW SECTION
presenting materials to prospective customers at customer offices and, when relevant, negotiating a sales contract. All Canadian sales of this sort were subject to headquarters approval, and because the Canadian sales manager in Portland believed Canada to be Solnetik’s central non-U.S. market, particular care was paid to each such contract. The terms of the Canadian sales contracts were routinely modified by the home office before final execution.
• Notes / Issues:
C. Truly Committing to a Presence in Canada
Before long, Canadian sales began to represent a significant component of overall sales, and Solnetik management determined that it would be wise to truly commit its resources to Canada. Accordingly, Solnetik’s management leased commercial office space in Toronto, with the intention of operating the space as a local sales office/showroom. Employees from the U.S. were sent to the Toronto office, and additional Canadian employees were hired to staff the office and handle sales accounts. Within one month, however, Solnetik’s management realized that the large potential volume of Canadian sales mandated that the Toronto office be run as a regional office, if any operational efficiency was to be achieved. Accordingly, the company hired Barry – a Canadian citizen who had previously served as one of the senior executives in Transport Canada – to serve as the Toronto general manager. Barry possessed full operational authority and accountability in respect of Canada.
• Notes / Issues:
Page 10 OSB – INTERNATIONAL LAW SECTION
D. Incorporating a Branch
Sales closed through the Toronto office quickly climbed to 40% of Solnetik’s overall receipts. While this was fantastic news in terms of revenue, the tax department began to explore whether it made more sense from an efficiency perspective to implement an alternative Canadian sales/distribution structure. One of the first options to consider was again whether Solnetik could or should incorporate the existing Toronto office.
• Notes / Issues:
E. What about Hybrids?
Despite all of the progress in Canada, Solnetik’s management remained concerned about developing a proper structure in China. Various members of management recalled that in their early meetings on Canada, several advisors had mentioned that there were certain tax issues with using “hybrids” in connection with Canada. They’ve turned to their tax advisors for counsel.
• Notes / Issues:
Page 11 OSB – INTERNATIONAL LAW SECTION
F. Is the Price Right?
One of the other concerns facing Solnetik’s management was whether it had properly priced its products. In this respect, certain members of management recalled that their advisors had stressed the need in Canada to use appropriate “pricing” models. They actually had no idea what that meant.
• Notes / Issues:
II. STRATEGIC EXPANSIONS IN CANADA
A. Delivering Services in Canada
Based on its experience in Canada, Solnetik determined that there was a separate and significant market in Canada for green energy advisory services. Accordingly, Solnetik met with a U.S.-based engineering group, and it was decided that the two parties would establish a U.S.-based joint venture – SRE Advisors LLC – that would provide green engineering consulting services worldwide. Canada was identified as the first non-U.S. market appropriate for development.
• Notes / Issues:
Page 12 PANEL ONE DOING BUSINESS IN CHINA China Overview China “doing business” considerations • Highly regulated environment • Strict import /export rules • Strict documentation requirements for paying non-residents • Foreign exchange controls – Generally domestic contracts must be in RMB – Generally foreign contracts cannot be in RMB • Activities limited to business license • Incentives • IP protection? Common forms of doing business in China • Representative Offices (cannot be profit making activities) • Equity Joint Venture -profits allocated based on equity contribution. • Cooperative Joint Venture – profits allocated based on contract • Wholly Foreign Owned Enterprise (WFOE) China Tax Overview
•Enterprise Income Tax on income of resident entities. •Income tax on non residents with respect to business income earned within China •Withholding taxes on investment income from Chinese sources •Turnover taxes – (78% of Chinese tax revenue) –Value Added Tax –Consumption Tax –Business Tax Enterprise Income Tax
• Effective January 2008, but phased in • Equalized tax treatment of foreign owned and Chinese owned Chinese companies • Standard tax rate of 25%. • Companies located in special economic zones will have tax rates phased in over 5 years. • Previously granted tax holidays will be respected • 15% tax rate still available for certain high tech companies which own their core technology Business Tax
• Ranges from average of 3-5%, but can go as high as 20% • Is imposed on residents and non- residents • Imposed on – Provision of certain services in China – Provision of services to an entity in China (even if the services are performed outside of China). – Transfers of intangible assets in China – Sales of immovable property in China • If the taxpayer subject to the business tax does not have a PE in China, then the Chinese buyer must withhold and pay the tax. • US creditability of the business tax? Business Tax Example
• Business Tax assessed on Royalty payments from Chinese manufacturer to US entity (in addition to withholding taxes). • Business tax assessed on services charged from US entity to Chinese subsidiary. Recent Chinese Tax Changes
• Stringent transfer pricing documentation requirements- effective for 2008 tax years • Tax circular for on treaty benefits for dividends- anti treaty shopping measures • Revised turnover tax rules (Jan 2009) • Revised corporate reorganization rules • Tax audits of cross border secondment arrangements • High Tech tax regime • Super deduction for qualifying R& D expenses Exploring the Chinese Market
Solnetik sends Oregon-based employees to Shanghai and other Chinese cities
Solnetik IP
US
US Funds
CHINA Product
US-Payroll Sales Chinese Sales Reps Solicitation Customers Exploring the Chinese Market
Solnetik realizes that local salespersons are critical to success in China
Solnetik IP
US
US Funds
CHINA Product
Chinese Sales Chinese Sales Rep Solicitation Customers Exploring the Chinese Market
Solnetik formalizes its presence with a Representative Office (RO) in Shanghai
Solnetik IP
US
US Funds
CHINA Product
Shanghai Sales Chinese RO Solicitation Customers
US-Payroll Chinese Chinese Sales Reps Office Mgr Sales Reps Exploring the Chinese Market
Solnetik realizes that it needs to provide services to its local customers
Solnetik IP
US
US
CHINA Service Funds Providers
Product Services
Shanghai Sales Chinese RO Solicitation Customers
US-Payroll Chinese Chinese Sales Reps Office Mgr Sales Reps Strategic Expansion into China
Solnetik feels that its China sales justify the establishment of a wholly-owned Chinese sales/distribution company
Solnetik IP
US
US
CHINA •Customer list • Distribution assets • Contracts • Employees / sales reps • Shanghai office 100% Equity • Advertising • Other assets Shanghai • Capital RO
US-Payroll Chinese Chinese Sales/Distb. Sales Reps Office Mgr Sales Reps WFOE China
SEE NEXT SLIDE Strategic Expansion into China
Solnetik’s local sales/distribution WFOE (resulting structure)
Solnetik IP
US US
CHINA
100% Product Sales
Sales/Distb. Chinese WFOE China Product Retail Customers
•Customer list • Distribution assets • Contracts • Sales reps • Shanghai office •Other employees • Capital • Advertising Strategic Expansion into China
Solnetik also believes that manufacturing in China will add to its bottom line, and thus acquires an existing Chinese manufacturer; immediately following the acquisition, Solnetik contributes to its newly-acquired manufacturing WFOE the rights to use/exploit its new solar technology in China
Solnetik IP
US
1 US
CHINA Cash Shares
Chinese SHs 100% 100%
2 Manufacturing Co. China Sales/Distb. SEE NEXT WFOE SLIDE China Strategic Expansion into China
Solnetik’s China manufacturing and sales/distribution operations (resulting structure)
Solnetik IP
US
US
CHINA
100%
China Manufacturing Sales/Distb. Chinese IP WFOE Product Sales WFOE Product Retail Customers China China
• Manufacturing ops • Sales ops Strategic Expansion into China
Upon further reflection, Solnetik determines that distribution in China would be more efficient with the assistance of a local expert, and thus it instead establishes a sales/distribution joint venture with a Chinese distributor
Solnetik IP
US
US
CHINA
Chinese Distb. 80% Equity Network •Customer list Distributor • Contracts China • Shanghai office Shanghai • Sales reps 20% Equity RO • Other assets • Distribution network (access) • Capital •Employees • Advertising • Capital
US-Payroll Chinese Chinese Sales/Distb. Sales Reps Office Mgr Sales Reps JV China SEE NEXT SLIDE Strategic Expansion into China
Solnetik’s local sales/distribution JV (resulting structure); Solnetik continues to believe that a wholly-owned manufacturing WFOE approach is best
Solnetik IP
US US
CHINA Chinese Distb. Distributor Network 80% China Product Sales 20%
Sales/Distb. Chinese JV China Product Retail Customers
•Customer list • Distribution network (access) • Contracts • Sales reps • Shanghai office •Other employees • Capital • Advertising Strategic Expansion into China
Solnetik’s China manufacturing and sales/distribution operations (resulting structure)
Solnetik IP
US
US
CHINA
Chinese Distributor China
80% 20%
China Manufacturing Sales/Distb. Chinese IP WFOE Product Sales JV Product Retail Customers China China
• Manufacturing ops • Sales ops Strategic Expansion into China
Based on its experience with the Chinese market, Solnetik begins to believe that developing future IP could be done in China with a venture partner
IP Solnetik
US
US
CHINA Chinese X% Equity • Capital Research China
Y% Equity • Laboratories • Engineers • Government relations
R&D JV
China SEE NEXT SLIDE Strategic Expansion into China
Solnetik’s new new IP development venture (resulting structure)
IP Solnetik
US
US
CHINA Chinese X% Research China
Y%
R&D JV
China
• Laboratories • Government relations • Engineers • Capital Strategic Expansion into China
Solnetik would like to keep the revenue from rights unrelated to the US market outside the US tax net, if possible
IP Solnetik
US
US
CHINA US Rights Chinese X% Research COST SHARING China AGREEMENT Y%
ROW R&D JV Rights China
• Laboratories • Government relations • Engineers • Capital Other Strategic Considerations
Solnetik’s management believes that tax-efficiencies may be achieved by establishing a holding company structure
Solnetik IP
US Shares US
SINGAPORE / HONG KONG Shares Regional Holdco Singapore / HK
CHINA
X% 80%
Manufacturing Sales/Distb. ROW IP R&D JV China rights IP WFOE JV China China China SEE NEXT SLIDE • Manufacturing ops • Sales ops Other Strategic Considerations
Solnetik’s post-restructuring Asia operations (resulting structure)
Solnetik IP
US US
SINGAPORE / HONG KONG Regional Holdco Other Retail Singapore / HK
CHINA
Product X% Sales 80%
Manufacturing Product Sales/Distb. China ROW IP R&D JV China rights IP WFOE Sales JV Retail China China China
• Manufacturing ops • Sales ops Overview of Relevant CFC Rules
Controlled Foreign Corporation – – A foreign corporation – more than 50 percent of its vote or value is owned by U.S. shareholders defined as U.S. persons who own, directly, indirectly or constructively (by attribution) ten percent or more of the CFC’s voting power.
Subpart F rules apply only to U.S. shareholders who directly or indirectly own ten percent or more of the CFC’s voting power In general, U.S. shareholders of a CFC are taxed currently on their pro rata share of the CFC’s “Subpart F” income for the year, regardless of whether the CFC makes any distributions to its U.S. shareholders.
Subpart F income includes, among other items, most “passive” income, but also certain “active” business income such as “foreign base company sales income” (“FBSCI”). FBSCI
FBSCI is defined as income derived by a CFC from or in connection with four basic types of transactions: (1) the purchase of personal property from a related party and its sale to any person; (2) the purchase of personal property from any person and its sale to a related party; (3) the purchase of personal property from any person on behalf of a related party (i.e., acting as a purchasing agent for the related party); or (4) the sale of personal property to any person on behalf of a related party (i.e., acting as a sales agent for the related party). Common FBCSI Transaction
Related Party Sales FBCSI has to be both (i) manufactured (or produced, grown or extracted) outside the CFC’s country of incorporation, and (ii) sold for use, consumption or disposition outside that foreign country. Under a special “manufacturing exception” to the FBCSI rules, a CFC does not have FBCSI if it • is considered to manufacture the property that it sells, or • if the goods sold are manufactured in the CFC’s country of incorporation, regardless of who manufactures the property. Manufacturing Exception (Former Position) - Attribution of Contract Manufacturing Under new regulations, a CFC can now qualify for the manufacturing exception if the CFC’s employees make a “substantial contribution” to the manufacture of the goods sold by the CFC.
Substantial Contribution is a facts and circumstances test. Consideration will be given to (but not limited by) the following activities:
• (1) oversight and direction of the production activities or process; • (2) activities of the type considered in, but insufficient to satisfy, the physical manufacturing test; • (3) material selection, vendor selection, or control of the raw materials, work-in- process, and finished goods; • (4) management of the manufacturing costs or capacities (for example, managing the risk of loss, cost reduction or efficiency initiatives associated with the manufacturing process, demand planning, production scheduling, or hedging raw material costs); • (5) control of manufacturing related logistics; • (6) quality control (for example, sample testing or establishment of quality control standards); and • (7) developing, or directing the use or development of, product design and design specifications, as well as trade secrets, technology, or other intellectual property for the purpose of manufacturing, producing, or constructing the personal property. PANEL TWO DOING BUSINESS IN CANADA Canada Overview
• Things to know about Canada (compared to US)
Canada U.S.
• Income Tax Rates: 2010 ~30% 38-40% 2012 ~27% 38-40%
• Canada still has a capital gain tax regime • A new U.S.-Canada Treaty was entered into in late 2008 • Reduced withholding tax on cross-border interest to 0% • Left in place the 5% withholding tax on dividends • Made it more difficult to use hybrid entities to gain tax advantage • Modified permanent establishment (PE) provision • Transfer pricing is important to CRA and to the IRS • Section 367 – IP transfer •Hybrids • Possible Obama legislation Canada Overview
• Doing business in a foreign jurisdiction
• Just selling product to Canadian customers OR • Product / inventory in • Really doing business in Canada • Sales Office in • Regional Office in • Distribution Facility and/or Manufacturing Facility in
• Crossing the threshold is a major commitment that more than doubles the effort and costs in a lot of areas within a company Committing to the Canadian Market
Solnetik sends Oregon-based employees throughout Canada; the sales representatives will meet with a potential customer at a customer’s office
Solnetik IP
US
US Funds
CANADA Product
US-Payroll Sales Canadian Sales Reps Solicitation Customers Committing to the Canadian Market
Solnetik formalizes its presence by establishing a regional office in Canada
Solnetik IP
US
US
CANADA Product
Funds
Toronto Sales Canadian Office Solicitation Customers
US-Payroll Toronto Canadian Sales Reps General Mgr Sales Reps Committing to the Canadian Market
Solnetik determines that it may achieve efficiencies by incorporating its Toronto sales operations in Canada
Solnetik IP
US
US
CANADA •Customer list • Contracts • Toronto office 100% • Distribution assets Equity • Employees • Sales reps Toronto • Advertising Office • Capital
US-Payroll Toronto Canadian Sales/Distb. Sales Reps Office Mgr Sales Reps CanCo Canada
SEE NEXT SLIDE Committing to the Canadian Market
Solnetik’s regional sales/distributions operations (resulting structure)
Solnetik IP
US US
CANADA
Product Sales 100%
Sales/Distb. Canadian CanCo Canada Product Retail Customers
•Customer list • Distribution assets • Contracts • Sales reps • Toronto office • Employees • Capital • Advertising Hybrid Entities
• Hybrid Entities – Article IV(7) – Where ULC’s are used as part of a financing structure, options are available to maintain tax efficient features of the financing structure but can be more complex.
– A review should be undertaken of any structure with hybrid entities to determine whether changes are required before the January 1, 2010 effective date.
– Paragraph 7 of Article IV does not target hybrid instruments. Hybrid Entities Denial of Benefits – Article IV(7)(b) Currently: For U.S. tax purposes, ULC losses (if any) flow up to U.S. ULC subject to Canadian tax on Canadian operations. 5% withholding tax on dividends from ULC. Payment from Canadian resident to a U.S. resident
January 1, 2010: 25% withholding on dividends, interest and royalties from ULC (not eligible for treaty benefit).
Article IV(7)(b) Income is received from an entity that is fiscally transparent. Hybrid Entities
• Option1: Convert ULC to an LLC • Option 2: Convert ULC to a Canadian Branch Strategic Expansion into Canada
Solnetik’s management decides to establish a US joint venture with a US engineering firm. The joint venture will deliver advanced green energy advisory services worldwide, including to Canadian clientele.
US Solnetik IP Engineering
US Firm US
50% 50%
100% SRE ADVISORS
LLC US
US
CANADA
CanCo or Canada Canadian Consultants Toronto Office Consulting Services Clientele NEW CONTRACT MANUFACTURING REGULATIONS PRESENT PLANNING OPPORTUNITIES1
Todd M. Beutler Lane Powell PC
The Internal Revenue Service (the “Service”) has issued final regulations providing much needed, and generally taxpayer favorable, guidance on the tax treatment of contract manufacturing arrangements entered into by controlled foreign corporations (“CFCs”). Under the final regulations, a U.S. parent company can obtain tax deferral on a CFC’s income from sales of goods where the CFC, through the activities of its employees, is considered to manufacture such goods in the CFC’s country of incorporation even though the goods are physically manufactured in another country by a related or unrelated contract manufacturer. Specifically, the test is whether the CFC’s employees make a “substantial contribution” to the overall manufacturing process.
With the regulations being effective January 1, 2010, for CFC’s with calendar tax years, taxpayers with CFC’s should be critically evaluating their existing operations not only to ensure compliance with these regulations but to take advantage of the opportunities presented by these regulations for structuring their foreign manufacturing operations. There may be opportunities for U.S. tax deferral, enhanced cash flow and other benefits from structuring their foreign manufacturing operations consistent with these regulations. Retroactive tax benefits also may be available.2
Overview of Relevant CFC Rules
A foreign corporation is a CFC if more than 50 percent of its vote or value is owned by U.S. shareholders, defined as U.S. persons who own, directly, indirectly or constructively (by attribution) ten percent or more of the CFC’s voting power. Only U.S. shareholders who directly or indirectly own ten percent or more of the CFC’s voting power are subject to the Subpart F income inclusion rules.
In general, U.S. shareholders of a CFC are taxed currently on their pro rata share of the CFC’s “Subpart F” income for the year, regardless of whether the CFC makes any distributions to its U.S. shareholders. Subpart F income includes, among other items, “foreign base company sales income” (“FBSCI”).
FBSCI is defined as income derived by a CFC from or in connection with four basic types of transactions:
(1) the purchase of personal property from a related party and its sale to any person; (2) the purchase of personal property from any person and its sale to a related party; (3) the purchase of personal property from any person on behalf of a related party (i.e., acting as a purchasing agent for the related party); or (4) the sale of personal property to any person on behalf of a related party (i.e., acting as a sales agent for the related party).
1 The Service has also issued temporary and proposed regulations addressing branch manufacturing rules, which may lead to results that are less favorable to taxpayers than the rules in effect under the currently effective regulations. These regulations are beyond the scope of this contract manufacturing overview.
2 Given that taxpayers can elect to apply the regulations immediately and retroactively to all open taxable years, businesses should review their FIN 48 positions for open years to determine whether financial statement reserves should be released.
However, there can only be FBCSI if the property is both (i) manufactured (or produced, grown or extracted) outside the CFC’s country of incorporation, and (ii) sold for use, consumption or disposition outside that foreign country.
In other words, FBCSI is income derived by the CFC in connection with the purchase or sale of property manufactured and sold for use outside of the CFC’s country of incorporation where a related party is involved on the purchase or sale side of the transaction.
Common Foreign Base Company Sales Income Transaction
Related Party Sales
USCo Resale of same Parent goods by CFC to related party USA
CountrySale of Xgoods
CFC
Country Y Third party manufacturer sells Manufacturer goods to CFC of Goods
Manufacturing Exception and Contract Manufacturing Under the Final Regulations
Under a special “manufacturing exception” to the FBCSI rules, a CFC does not have FBCSI if it is considered to manufacture the property that it sells, or if the goods sold are manufactured in the CFC’s country of incorporation, regardless of who manufactures the property.
For years, taxpayers and the Service have clashed over whether a CFC could avoid FBCSI under the manufacturing exception based on attributing the manufacturing activities of a contract manufacturer to the CFC. The Service opposed the position adopted by many taxpayers that a CFC should be treated as having manufactured goods in its country of incorporation where the goods were actually manufactured by the CFC’s contract manufacturer in another country.
2
Copyright © 2009 Todd M. Beutler Manufacturing Exception - Attribution of Contract Manufacturing
USCo Parent
USA
Country X
Taxpayer adopts position CFC that CFC is manufacturer ― without any activity by employees of CFC
Country Y Finished goods Contract Raw Materials Manufacturer
The final regulations resolve this issue by adopting the Service’s position that the activities of a contract manufacturer cannot be attributed to a CFC for purposes of qualifying for the manufacturing exception. In closing one door, however, the Service opened another by adding a new “substantial contribution” test in the regulations, which applies in contract manufacturing situations. Under the final regulations, a CFC can now qualify for the manufacturing exception if the CFC’s employees make a “substantial contribution” to the manufacture of the goods sold by the CFC.
Manufacturing Exception - Attribution Based on Substantial Contribution of CFC Employees
USCo Parent
USA
Country X
CFC’s employees make a substantial contribution to CFC CFC’s the manufacturing of the finished goods sold by CFC employees’ Country Y activities Finished goods Contract Raw Materials Manufacturer
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Copyright © 2009 Todd M. Beutler Only the activities of the CFC’s employees are considered in determining whether the CFC satisfies the substantial contribution test. In general, the activities of regular employees are counted as well as the activities of part-time or seasonal workers. The activities of seconded workers, workers on the payroll of a related employment company and even contractors, may be considered if the CFC exercises sufficient control over their activities.
Previously, taxpayers and the Service often focused on whether a CFC was required to have possession of, hold legal title to or bear the economic risk of loss with respect to, the raw materials, work-in-process or finished goods in a contract manufacturing arrangement. Under the new regulations, contractual rights, legal title, tax ownership or assumption of risk of loss are not considered in determining whether the CFC has substantially contributed to the manufacture of a product. Only the activities of the CFC’s employees are considered and, as a result, no minimum level of contractual control or ownership is required. In particular, the regulations provide that there can be substantial contribution in a buy-sell or turnkey arrangement, as well as in a consignment manufacturing arrangement.
The final regulations make it clear that a “facts and circumstances” analysis is required and that there is no safe harbor or objective standard for determining when a CFC’s activities will rise to the level of “substantial.” Instead, the regulations set forth a non-exclusive list of seven broadly-grouped activities, referred to as “indicia of manufacturing,” to be considered in determining whether a CFC’s activities rise to the level of substantial contribution.
Indicia of Manufacturing
A CFC does not need to perform all or any particular number of the indicia of manufacturing in order to establish a substantial contribution. The performance or lack of performance of any particular activity, whether or not among the indicia of manufacturing, is not determinative. Further, the CFC’s employees do not need to meet a minimum threshold of performance with respect to a particular activity before such activity can be taken into account. All employee activity will be considered in the aggregate.
In considering whether a CFC makes a substantial contribution, the weight accorded the performance of various activities/indicia will depend on the economic significance or value of those activities relative to the manufacture of the product, considering the particular business and industry. No particular indicia or other activity is mandatory or accorded more weight than other indicia. In other words, the regulations reject any “super factor” approach.
The fact that other related or unrelated persons make a substantial contribution to the manufacture of a product does not, in and of itself, preclude a CFC from also making a substantial contribution to the manufacture of the same product. More than one party can substantially contribute to the manufacture of a product. Thus, multiple CFCs owned by different U.S. shareholders can each substantially contribute to the physical manufacture of the same product.
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Copyright © 2009 Todd M. Beutler The Regulations list seven indicia of manufacturing:
1. Oversight and direction of the activities and process pursuant to which the property is physically manufactured. Although the regulations acknowledge this may be an important factor, the regulations do not deviate from the “no super factor” approach and make it quite clear that there is no requirement for a CFC to perform oversight and direction activities with any minimum regularity.
2. Material selection, vendor selection, or control of the raw materials, work-in-process or finished goods. Contractual control or ownership of raw materials, work-in-process or finished goods is not required.
3. Management of manufacturing costs or capacities. This indicia encompasses managing the risk of loss, cost reduction or efficiency initiatives associated with the manufacturing process (such as optimizing plant capacity and reducing waste), demand planning, production scheduling and hedging raw material costs, but not activities such as corporate finance decision making and general management of enterprise risk.
4. Control of manufacturing related logistics. The relevant logistical activity is limited in scope to that directly relating to the manufacturing process, thus including activities such as arranging delivery of raw materials to the contract manufacturer, but excluding post-manufacturing logistical activities such as arranging the shipment of finished goods to customers.
5. Quality control. This indicia encompasses sample testing or establishment of quality control standards.
6. Developing, or directing the use or development of, product design and design specifications, as well as trade secrets, technology or other intellectual property for the purpose of physically manufacturing the property. Only activities with respect to intangible property used in the manufacturing process are taken into account. Developing, or directing the use or development of, marketing intangibles is not taken into account. Protection of intangible property also is not taken into account.
7. Activities that are considered in, but that are insufficient to qualify as physical manufacturing.
The regulations provide no guidance concerning the manner in which a taxpayer should document the activities of its CFC. The regulations merely state that the required documentation will likely vary by industry and providing such standards would inappropriately limit flexibility in the application of the substantial contribution test. This leaves taxpayers to their own devices; however, maintaining detailed, contemporaneous documentation should go a long way towards establishing compliance with the new rules.
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Copyright © 2009 Todd M. Beutler Examples from the Regulations
The final regulations include several examples that identify the types of activities that, if performed by a CFC’s employees, could qualify the CFC for the manufacturing exception. These examples of substantial contribution to the manufacturing activity carried out by the CFC’s contract manufacturer (“CM”) include the following types of activities:
• CFC’s employees design the product and select the materials that CM will use to manufacture the product. • CFC’s employees manage the manufacturing costs and capacities. • CFC’s employees provide oversight and direction of the manufacture of the product. • CFC’s employees visit CM’s manufacturing facility for one week each quarter and perform quality control tests on a random sample of the units of the products. • CFC’s employees manage the overall risk of loss and engage in demand planning and production scheduling. • CFC owns the supply chain software, which is utilized by CFC’s employees. • CFC’s employees supervise the computer technicians, evaluate the results of the automated manufacturing business, and make ongoing operational decisions related to acceptable performance of the manufacturing process, stoppages of that process and decisions related to product and manufacturing process design. • CFC’s employees develop and provide all upgrades to the software and network systems. • CFC’s employees direct and control other aspects of the manufacturing process such as vendor and material selection, management of manufacturing costs and capacities and the selection of CM. • U.S. parent corporation contributes to product manufacturing process design and provides support and oversight to CFC in connection with functions performed by CFC’s employees.
Conclusion
The regulations embrace a highly factual approach to determining whether a CFC, through its employees, has substantially contributed to the manufacture of the product it sells. Without a bright-line or other objective test, businesses must carefully evaluate their existing operations and adopt the necessary changes to ensure compliance with the new rules. At the same time, businesses should consider restructuring existing operations to take advantage of the tax planning opportunities presented by these regulations. Businesses may achieve U.S. tax deferral, enhanced cash flow and other benefits from structuring their foreign manufacturing operations consistent with these regulations. Retroactive tax benefits also may be available.
IRS Circular 230 Disclosure
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any matters addressed herein.
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Copyright © 2009 Todd M. Beutler