United States: Alignment Of Sourcing And Tax Principles In Contract Manufacturing

Keywords: contract manufacturing, non-US subsidiaries, outsourcing arrangements

Contract manufacturing offers a variety of benefits to non-US subsidiaries of US-based multinational companies that want to outsource the manufacture of their products to be sold in the United States. It includes the provision of manufacturing and supply services, such as sourcing, manufacturing, packaging and labeling of products, by an offshore manufacturer for the benefit of a multinational company's non-US affiliate. The non-US affiliate then transfers title to the products to the multinational parent company, or one of its US affiliates, prior to the time the products enter the US. Profits from the sale of the products are recognized by the offshore affiliate. Such profits generally are not subject to US tax until the non-US affiliate dividends the funds up to the US parent (or another US affiliate).

Fundamental sourcing principles apply to contract manufacturing services in virtually the same manner in which they apply to other outsourcing arrangements. Contract manufacturing agreements should include:

  • Provisions ensuring the timeliness and quality of product research and development; 
  • Strong quality assurance and internal controls covering, among other things, raw material sourcing, the manufacturing processes and the products themselves; 
  • Performance standards, including service levels and development milestones, coupled with remedies for failure to meet the same; and
  • Appropriate intellectual property protections related to both the products and tooling.

Further, the agreement should have (i) cost control provisions, (ii) efficient and effective inventory, forecasting and ordering processes, (iii) timely delivery requirements, (iv) appropriate termination rights and (v) post-termination transition obligations to ensure the uninterrupted availability of products. Product quality should be enforced through, among other things, reporting obligations, inspection and audit rights, remedies for defective products and failure of the contract manufacturer to meet its obligations and an active program of exercising and enforcing these rights.

Similarly, from a tax perspective, the offshore affiliate must make a "substantial contribution" to the sourcing, manufacturing, packaging and labeling of the products. Many of the key factors examined to support the substantial contribution test align well with sourcing principles:

  • Quality standards/controls. It is essential that the offshore affiliate retain and exercise rights of inspection and control over the manufacturing process and the products themselves. This includes (i) requiring that the contract manufacturer employ adequate equipment, production methods and manufacturing quality control procedures to ensure that the products meet the specifications and that the products are manufactured in compliance with good manufacturing practices, (ii) rights of the offshore affiliate to inspect and test the manufacturer's performance and facilities in order to ensure compliance by the manufacturer with its obligations under the agreement, (iii) tight product specifications and controls over changes thereto and (iv) the right of the offshore affiliate to make recommendations to improve the manufacturing processes and to exercise remedies should the contract manufacturer decline to adopt such recommendations.

    The tax principles related to quality standards and controls align nicely with key sourcing principles concerning quality assurance, internal controls and performance standards discussed above.
  • Cost savings. Another important factor to support the "substantial contribution" test is the right of the offshore affiliate to maintain cost controls. This is usually accomplished through requiring the manufacturer to provide detailed data related to the costs of raw materials and packaging materials and other manufacturing costs on a regular basis, accompanied by rights of the offshore affiliate to audit the books and records of the manufacturer.

    The above tax principle aligns well with the key sourcing principles around cost control and cost savings. A "cost plus" structure is common in contract manufacturing, which means there will be some fluctuations in prices due to the changes in the costs of raw materials, together with a fixed charge or fixed pricing methodology for the manufacturer's services. From a sourcing perspective, the offshore affiliate will want to maintain controls over costs to support the goal of cost reduction.
  • Raw materials sourcing/vendor selection. Under most contract manufacturing arrangements, the offshore affiliate will have the right to provide raw materials to the manufacturer or to direct the manufacturer in purchasing raw materials. The offshore affiliate can further establish its substantial contribution to the manufacturing and supply services by bearing the costs and risk of loss associated with the raw materials.

    The ability of the offshore affiliate to maintain controls over raw materials sourcing will enhance the ability to maintain quality over the products, consistent with sourcing principles.

    Nevertheless, there are instances where there is a divergence between tax and sourcing principles: for example, with the issues of risk of loss, indemnities and transfer of title. An offshore affiliate's substantial contribution to the manufacturing process is enhanced through bearing risks and assuming indemnity obligations related to raw materials, manufacturing processes and the products themselves (with the likely exception of risks related to the negligence or breach of contract by the contract manufacturer). Similarly, the tax structure requires that title to the products transfer outside of the US, with title often transferring either at the manufacturer's facilities or just outside the territory of the country in which the manufacturer's facilities are located and the multinational bearing the risk of loss related to the products while in transit. No similar benefit exists under sourcing principles, and the typical sourcing position is to require that the manufacturer bear such risks.

Outsourcing principles and tax requirements need to be coordinated in order to meet contract manufacturing objectives. In many instances, sourcing principles support a company's tax objectives. However, in instances where sourcing principles and tax requirements diverge, the arrangements must be structured carefully from both a sourcing and tax perspective to achieve the desired results.

Originally published 19 December 2012

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This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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