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1 transfer pricing insider onesource transfer pricing Volume 2, issue 3 december 2008 Chinese Contract Manufacturing Structures: Navigating the New Landscape Source: WG&L Journal of International Taxation The changes to the U.S. CFC rules and the new China CIT Law will force companies to examine intercompany pricing with related-party contract manufacturers and consider implementing new contract manufacturing arrangements, including a structure similar to the basic contract manufacturing paradigm discussed in this article Author: Stephen R.A. Bates, Peter Kung, Zachary K. Perryman, and Amy Tao Stephen R.A. Bates, principal, and Zachary K. Perryman, senior manager, are with the International Corporate Services group of KPMG LLP s Washington National Tax practice in San Francisco. Peter Kung is a partner with KPMG China in charge of China tax in Hong Kong and Southern China, and head of KPMG China s Consumer Market line of business in Southern China. Amy Tao is a senior manager with KPMG China s Tax practice in Hong Kong. The authors thank Thomas Zollo, a principal with the International Corporate Services group of KPMG LLP s Washington National Tax practice, for his helpful comments on this article. The views and opinions are the authors and do not necessarily represent those of KPMG LLP or KPMG China. Chinese Contract Manufacturing Structures: Navigating the New Landscape Background PRC Tax Reform New Chinese tax rates. Incentive policies and grandfather rules. Taxation of nonresident companies. Bottom line. U.S. Contract Manufacturing Proposed Rules IRS-taxpayer contract manufacturing dispute. New substantial contribution test. Multiple manufacturing branch rules. Summary. Impact of New CIT Law on China-Based Contract Manufacturing Arrangements Contract processing (consignment) mfg. arrangements. Treatment of an import processing (buy-sell) arrangement. U.S. Treatment of Import and Contract Processing Arrangements Under Contract Mfg. Prop. Regs. Treatment under existing law. Treatment under Proposed Regulations. Adjusting China Contract Mfg. Structures for New Rules Conclusion Rev. Rul Exhibit 1. Exempt, Credit, and Refund Method of Calculating VAT Footnotes About OneSource Transfer Pricing Tax & Accounting

2 U.S.-based taxpayers in recent years have made extensive use of contract manufacturing arrangements with manufacturers located in the Peoples Republic of China (PRC or China ), 1 particularly in the southern regions of the Guangdong Province, such as Shenzhen, Dongguan, and Guangzhou. 2 Evolving multinational business models (e.g., the acquisition of captive manufacturers located in the PRC) and a growing and more affluent PRC consumer market have driven growth in, and complexity with respect to, PRC-based contract manufacturing arrangements. Fundamental changes in both U.S. and Chinese tax laws are creating complications for PRC-based contract manufacturing arrangements. Generally, under new Chinese tax legislation, PRC manufacturers that are foreign investment enterprises (FIEs) 3 will be subject to higher PRC income tax rates. Moreover, foreign-based principals with a physical presence in China must navigate a new definition of a PRC tax resident which now subjects non-prc enterprises with a place of effective management in China to worldwide PRC taxation in addition to existing permanent establishment (PE) rules. Yet, proposed U.S. rules addressing the taxation of contract manufacturing arrangements put greater pressure on these foreign-based principals to take an active part in the manufacturing process to avoid taxation under the U.S. Subpart F regime. Thus, U.S. taxpayers with China-based contract manufacturing arrangements may be forced to deal with both increasing tax costs and risks. U.S. taxpayers using or planning Chinabased contract manufacturing arrangements should reexamine these arrangements and plans within the context of the significant tax law changes. This article provides an overview of contract manufacturing in China, including highlights of the recent PRC tax reform and the U.S. contract manufacturing Proposed Regulations and the impact of the rules on a basic contract manufacturing arrangement involving a controlled foreign corporation (CFC) organized outside China (in a tax-favored jurisdiction) that engages a China-based contract manufacturer to produce finished goods ( basic contract manufacturing paradigm ). Background Contract manufacturing generally entails the production of goods by one company under the brand or label of another company. Use of contract manufacturing arrangements, particularly in China, has grown exponentially over the last 20 years. Today, anyone with a product idea and the requisite means can engage any one of a number of firms offering China-based, turnkey (design, production, and delivery) manufacturing services to turn the product idea into reality. 4 U.S.-based multinational corporations have used a host of different types and variations of contract manufacturing arrangements to leverage cost efficiencies of manufacturing in China and to take advantage of the flexibility that these arrangements have traditionally afforded. 5 The arrangements have been heavily influenced by tax incentives and other relief afforded to taxpayers under China s old tax regime. Contract manufacturing arrangements vary depending on factors such as the allocation of risks and functions between the contract manufacturer and the principal, and ownership of intellectual property, equipment and tooling, and raw materials. Although a wide variety of contract manufacturing arrangements are discussed in this article, the focus is on what is referred to above as the basic contract manufacturing paradigm using a CFC organized outside China to produce finished goods from a contract manufacturer located in mainland China, with the CFC bearing at least some of the manufacturing risk. Within the context of China s new corporate income tax regime and the U.S. contract manufacturing Proposed Regulations, discussed below, this article examines two variations of the basic contract manufacturing paradigm commonly used by U.S.-based corporations: (1) contract processing or consignment arrangements, and (2) import processing or buy-sell arrangements. For each of these arrangements, the significance, from a Chinese tax perspective, of sourcing raw materials and selling finished goods both within and outside China is discussed. PRC Tax Reform The corporate income tax law ( CIT Law ), enacted on March 16, 2007 (effective from January 1, 2008), replaces two former Chinese income tax regimes: (1) the Provisional Rules of Enterprise Income Tax ( EIT Provisional Rules ), which applied to Chinese domestic enterprises, including those that were less than 25% foreign owned; and (2) the Foreign Investment Enterprise and Foreign Enterprise Income Tax Law ( FEIT Law ), which applied to FIEs that were at least 25% foreign owned and foreign enterprises that derive income from sources within China. The CIT Law significantly affects many FIEs engaged in manufacturing activities in China by revoking tax holidays and other tax incentives, subject to certain grandfather rules, thus increasing their income tax burden. 6 In addition, the law and its implementation rules have introduced a 10% withholding tax on dividend distributions. Thus, the CIT Law may significantly increase the total Chinese tax (i.e., tax on operating income and dividend withholding taxes) imposed on the Chinese income of certain FIEs. Consequently, the CIT Law will provide affected FIEs 2

3 and their foreign investors with an incentive to consider revised structures and intercompany arrangements that may reduce their Chinese tax base. New Chinese tax rates. Under the new CIT Law, the standard CIT rate is 25%. There are two specific exceptions: A 20% rate for certain small-scale enterprises with low profitability ( Small-Scale Enterprise ). A 15% rate for Advanced and New Technology Enterprises. Under the former FEIT Law, a reduced 15% FEIT rate applied to FIEs recognized as Advanced and New Technology Enterprises and located in hightech geographic zones. Under the new CIT Law, these incentives have been extended to enterprises recognized as Advanced and New Technology Enterprises outside the high-tech zones. However, the new guidance and criteria for recognizing Advanced and New Technology Enterprises that will be eligible for tax incentives under the new CIT Law are different from, and generally more restrictive than, the old guidance and criteria. Under the new guidance, a qualified Advanced and New Technology Enterprise must own proprietary intellectual property rights for the core technology used for its products or services by means of the following: Its own research and development or acquisition as a gift or through assignment or merger in the past three years. Exclusive license to use the technology for more than five years. Under the old guidance, no such requirement applied. If a FIE cannot qualify as an Advanced and New Technology Enterprise under the new guidance, it will have to pay CIT at a 25% rate, unless it is entitled to other preferential policies or grandfather relief under the CIT Law. Small-Scale Enterprises are enterprises outside of certain government-restricted or prohibited industries that meet the following conditions: For industrial enterprises, the taxable income for the year does not exceed RMB 7 300,000, total employees do not exceed 100, and total assets do not exceed RMB 30 million. For all other enterprises, the taxable income for the year does not exceed RMB 300,000, total employees do not exceed 80, and total assets do not exceed RMB 10 million. Incentive policies and grandfather rules. The new CIT Law contains several tax incentives. However, unlike the former FEIT Law, which provided tax incentives to encourage manufacturing generally, and foreign investment in particular locations, the tax incentives under the new CIT Law are more narrowly tailored to encourage specific activities. For example, the law provides that tax holidays may be granted to income derived from infrastructure, environmental protection, energy saving, and water conservation projects. Subject to the grandfather relief discussed below, the CIT Law repeals the tax holidays available under the FEIT Law. Thus, the CIT Law repeals the 2+3 tax holiday 8 offered to production FIEs with an operation period of at least ten years, as well as the extended tax holidays applicable to Technologically Advanced Enterprises and Export-Oriented Enterprises. 9 The CIT Law also repeals the reduced tax rates for FIEs established in special economic zones (SEZs) 10 and engaged in certain activities, such as production activities, and established in certain other development zones, such as the Pudong New District of Shanghai, Economic and Technological Development Zones, Export Processing Zones, Free Trade Zones, and Coastal Economic Development Zones. FIEs that were approved before the CIT Law was enacted (i.e., March 16, 2007) may be entitled to grandfather relief. As further defined in subsequent tax regulations, FIEs that had completed their business registrations before March 17, 2007, could be eligible for grandfather relief under the transition rules. FIEs that qualified for the reduced 24% state FEIT rate are now subject to the standard 25% CIT rate, unless they qualify for the reduced CIT rates at 15% (applicable to recognized Advanced and New Technology Enterprises) or 20% (applicable to Small-Scale Enterprises). FIEs that qualified for the reduced 15% state FEIT rate by virtue of operating in a SEZ will be subject to a transitional rule that gradually increases CIT rates from 15% to the new 25% rate over a five-year transitional period beginning on January 1, The CIT rates during the transitional period will be 18% in 2008, 20% in 2009, 22% in 2010, 24% in 2011, and 25% in Special transition rules apply to FIEs that previously claimed benefits under the 2+3 holiday regime and other tax holidays granted by the FEIT Law. FIEs that were profitable prior to January 1, 2008, and were still within the 2+3 holiday period as of December 31, 2007, will continue to enjoy the existing 2+3 holiday until it expires. FIEs that would have qualified for the 2+3 tax holiday, but had not been profitable before January 1, 2008, can receive this holiday only until December 31, During the transition period, the 50% reduction 3

4 under the tax holiday will be based on the phase-in rate. For example, if an FIE is in the 50% reduction period in 2008 and the transitional CIT rate applicable to the FIE is 18% in 2008, the FIE would be subject to CIT at 9% in Pursuant to tax regulations issued following the enactment of the CIT Law, there are no future benefits and no transitional relief for Export-Oriented Enterprises or Technologically Advanced Enterprises. 11 Therefore, these enterprises will see a significant increase in applicable CIT rates unless they are entitled to other grandfather relief or qualify for new tax incentives under the CIT Law. The new CIT Law has several targeted tax incentives in addition to the rate changes described above that are designed to encourage technological improvements and development, construction of infrastructure, development of agriculture, environmental protection, energy conservation, production safety, and charitable works, as well as to provide tax relief to enterprises suffering natural disasters. The new tax policy focuses on designated industries and generally does not favor geographic locations within China. Taxation of nonresident companies. A nonresident enterprise is one that is incorporated or organized in accordance with foreign laws and regulations and has its place of effective management outside China. If a foreign enterprise that is incorporated or organized in accordance with foreign laws and regulations has its place of effective management in China, the CIT will now treat that entity as a PRC-resident entity. Such an entity is subject to worldwide PRC taxation, as well as other aspects of the CIT, such as the new Chinese CFC rules. Otherwise, a nonresident enterprise is subject to CIT only on income derived from sources within China. If a nonresident enterprise has an establishment or a place of business in China, it will be subject to tax on the income attributable to that Chinese establishment at the normal 25% CIT rate. The CIT Law provides that establishment or a place of business refers to places of management, business offices, representative offices, factories, farms, exploitation of natural resources, places for the provision of services, places for construction, installation, assembly, and exploration activities, and establishments or places of business where productions or operation activities are conducted. Where a nonresident enterprise engages a business agent to carry out production or business operations in the territory of China, including engaging an entity or individual to habitually conclude contracts, or store or deliver goods on its behalf, this business agent will be deemed an establishment or place of business of the nonresident enterprise in China. The CIT Law has a new chapter entitled Special Tax Adjustments that will be relevant for foreign principals (owning subsidiaries in jurisdictions outside China) found to be Chinese residents under the CIT Law. The Special Tax Adjustments rules reflect the Chinese Government s increasing emphasis on tax administration and collection. The provisions of this new chapter introduce CFC, thin capitalization, and general anti-abuse rules. The CFC rules provide that where a resident enterprise by itself, or together with individual Chinese residents, controls an enterprise that is established in a jurisdiction where the effective income tax burden is less than 50% of the standard CIT rate (i.e., 12.5%, or 50% of 25%) and that enterprise does not distribute its profits or reduces the distribution of its profits not on account of any reasonable operational needs, the portion of the profits attributable to the resident enterprise will be included in that enterprise s taxable revenue. The thin capitalization rules provide that if the loans obtained directly or indirectly from related parties, on which a taxpayer pays interest or interest equivalents, exceed the maximum amount of related-party loans allowed under the stipulated ratio of related-party loans to equity investment, the interest on the excess amount of the loans is not deductible for tax purposes. The ratio is yet to be announced by the tax authority. The new chapter also authorizes the Chinese tax authorities to make adjustments to a taxpayer s taxable revenue or income based on a reasonable transfer pricing method if the taxpayer does not conduct related-party transactions at arm s length and reduces its taxable revenue or income thereby. In addition, a nonresident enterprise that derives dividends, interest, rentals, capital gains, royalties, or other income from Chinese sources that is not attributable to a Chinese establishment will be subject to a 10% withholding tax on these items. The determination of whether a nonresident has established a taxable presence in China, and the withholding tax rates applicable to other income, may be modified by applicable tax treaties. Bottom line. Prior to the tax reform, although the marginal income tax rate under the FEIT Law was 33% on FIEs before any tax incentives, 12 the average effective income tax rate on FIEs was approximately 15% because of various incentive policies. 13 Under the new CIT Law, tax incentives are granted mainly to enterprises engaging in encouraged operations and industries or set up in less-developed regions, rather than to FIEs engaging in manufacturing activities or set up in relatively developed regions. Further, under the reform, the average income tax burden for FIEs performing manufacturing activities or set up in SEZs will almost 4

5 certainly increase, whereas the average income tax burden for service FIEs outside of the SEZs or other enterprises, such as most domestic enterprises (which were not entitled to any tax incentives before the tax reform), will likely decrease. The impact of this increased income tax rate on FIEs may be exacerbated in some instances, as not all taxpayers have been diligent with respect to the profit levels earned by the contract manufacturers. Because these companies operated under a tax holiday or other incentives and Chinese transfer pricing documentation requirements are relatively new (introduced in 2008), taxpayers did not necessarily perform a rigorous analysis with respect to their contract manufacturer s profits or simply did not make adjustments to the pricing even though the overall manufacturing profit level changed (e.g., due to increased labor or commodities costs 14 ). In these situations, the contract manufacturer often earned profits that arguably exceeded or were below an arm s-length return, which can be demonstrated via a transfer pricing analysis and appropriate documentation. If profit levels exceed an arm s-length return, as discussed below, it may be difficult to convince the Chinese tax authorities to accept lower profit levels now that the holidays or other incentives are expiring. However, where the tax authority considers that the profit level of the contract manufacturer is below an arm s-length return, it will make tax adjustments by using reasonable methods. U.S. Contract Manufacturing Proposed Rules A U.S. shareholder of a CFC must include in its current year income its pro rata share of the CFC s Subpart F income for the CFC s tax year. 15 Subpart F income includes foreign base company income. 16 Foreign base company income includes, inter alia, foreign base company sales income (FBCSI). FBCSI consists of income derived by a CFC from a sale of personal property purchased from or sold to a related party if (1) the purchased property was manufactured, produced, grown, or extracted outside the CFC s country of organization, and (2) the property is sold for use, consumption, or disposition outside the CFC s country of organization. Thus, where property is (1) manufactured within the CFC s country of organization, or (2) sold by the CFC for use, consumption, or disposition within the CFC s country of organization, income derived from a sale of the property should not constitute FBCSI. These two exceptions are referred to as the same-country manufacturing and same-country sales exceptions. In addition to these two explicit exceptions, the statute implicitly (and the legislative history explicitly) excepts from FBCSI income derived by a CFC where it is considered the manufacturer of the personal property sold. Section 954(d)(1) requires the purchase of personal property from one person and its sale to another person (see discussion below on the its defense). Accordingly, where a CFC manufactures the personal property that it sells, it should not be considered both purchasing and selling the same item of personal property ( manufacturing exception ). Based on existing law, it is not clear whether an entity claiming the manufacturing exception to the CFC rules for sales income must conduct manufacturing activities directly. The statute does not require, either explicitly or implicitly, that the CFC itself directly perform the manufacturing activities. IRS-taxpayer contract manufacturing dispute. There has been a longstanding dispute between U.S. taxpayers and the Service regarding the U.S. tax treatment of contract manufacturing arrangements under the Subpart F FBCSI rules, 17 resulting from differing interpretations of the statutory language, legislative history, applicable Regulations, and case law. During this dispute over the treatment of contract manufacturing arrangements and whether they generate Subpart F income for CFC principals, taxpayers have said no and the Service has said yes. In an attempt (perhaps precatory) to quell some taxpayer arguments and end the longstanding dispute, on February 27, 2008, Treasury and the Service issued Proposed Regulations relating to FBCSI and contract manufacturing arrangements ( Proposed Regulations ). 18 The Proposed Regulations are intended to modernize FBCSI rules in light of current contract manufacturing practices by U.S. multinationals. They address three main areas: (1) application of the manufacturing exception when the physical manufacturing test of Reg (a)(4)(i) is not satisfied by the CFC but the CFC or its branch is significantly involved in the manufacturing process (by adding a substantial contribution test); (2) application of the branch rule to business structures involving the use of one or more branches engaged in manufacturing, producing, constructing, growing, or extracting activities; and (3) other miscellaneous branch rule issues (including clarification of the definition of a manufacturing branch). The manufacturing exception is in Reg (a)(4)(i). Under the current Regulations, property sold by a CFC will not be the same as the property that it purchased if one of two tests is met. The first test, in Reg (a) (4)(ii) ( substantial transformation test ), provides that if the property purchased by the CFC is substantially transformed prior to sale by the CFC, the property sold will be treated as having been manufactured by the CFC. The Regulations provide several examples of substantial transformation, such as turning wood 5

6 pulp into paper, steel rods into bolts, and fish into canned fish. The second test, in Reg (a)(4)(iii) ( component parts test ), provides that [i]f purchased property is used as a component part of personal property which is sold, the sale of the property will be treated as the sale of a manufactured product, rather than the sale of component parts, if the operations conducted by the selling corporation in connection with the property purchased and sold are substantial in nature and are generally considered manufacturing. The Proposed Regulations reject the its defense to the application of the FBCSI rules, which is premised on a purported plain reading of the statutory language of Section 954(d)(1). The its defense generally provides that where a CFC purchases property and sells property that is not the same as the property it purchased, income derived by the CFC from sales of the property cannot be FBCSI. 19 The Regulations also reject the attribution theory, under which taxpayers have argued that the activities of contract manufacturers should be imputed to the CFC principal for purposes of determining whether the CFC is engaged in manufacturing under Section 954(d)(1) (see sidebar on Rev. Rul ). The Proposed Regulations purportedly clarify existing law, providing that for purposes of determining FBCSI, personal property sold by a CFC will be considered the same property purchased by the CFC, regardless of whether it is sold in the same form in which it was purchased, or as a component part of a manufactured product. Under the Proposed Regulations, the only exceptions to this rule are if (1) one of the same-country exceptions applies, or (2) the manufacturing exception is satisfied. Regarding the manufacturing exception of Reg (a)(4)(i), the Proposed Regulations clarify that a CFC qualifies for the manufacturing exception from FBCSI only if the CFC, acting through its own employees, manufactures the products that are sold to related parties and that give rise to income for the CFC. Manufacturing occurs only if one of three tests is met: the two existing tests for physical manufacturing (substantial transformation test of Reg (a)(4)(ii) and component parts test of Reg (a)(4)(iii)) (see above) and the new substantial contribution test of Prop. Reg (a)(4)(iv) (discussed below). The contract manufacturing Regulations would apply to tax years of CFCs beginning on or after the date that the rules are published as final Regulations in the Federal Register. Until the Regulations are final, taxpayers can apply the Proposed Regulations to all open tax years as if they were final. Based on statements from U.S. government officials, the Proposed Regulations are expected to be final by the end of the 2008 calendar year. 20 New substantial contribution test. The contract manufacturing Proposed Regulations attempt to resolve the longstanding dispute over the treatment of contract manufacturing arrangements by making clear that the manufacturing exception can apply to a CFC that does not perform physical manufacturing but nonetheless makes a substantial contribution to the manufacturing process. In effect, the Service is willing to concede the fundamental issue in dispute whether a CFC that does not conduct physical manufacturing directly can meet the manufacturing exception provided that taxpayers abandon the arguments ( its and attribution) that could allow a CFC without any substantive manufacturing oversight to meet this exception to Subpart F. 21 In many respects, the Proposed Regulations represent a return to the era of revoked Rev. Rul (see sidebar). Under the proposed substantial contribution test, a CFC that provides a substantial contribution with respect to physical manufacturing qualifies for the manufacturing exception. Whether a CFC satisfies the substantial contribution test depends on the specific facts and circumstances of each taxpayer s arrangement. For purposes of determining whether the substantial contribution test is satisfied, the Proposed Regulations set forth nine, non-exhaustive factors to be considered: (1) oversight and direction of the activities or process (including management of the risk of loss) pursuant to which the property is manufactured, produced, or constructed under the principles of... [physical manufacturing tests of Reg (a)(4)(ii) or (iii)]; (2) performance of activities that are considered in but that are insufficient to satisfy the tests provided in... [physical manufacturing tests of Reg (a)(4)(ii) or (iii)]; (3) control of raw materials, work-in-process and finished goods; (4) management of the manufacturing profits; (5) material selection; (6) vendor selection; (7) control of logistics; (8) quality control; and (9) direction of the development, protection, and use of trade secrets, technology, product design and design specifications, and other intellectual property used in manufacturing the product. 22 Multiple manufacturing branch rules. The Proposed Regulations provide rules on the application of the manufacturing branch tax rate disparity test to multiple manufacturing branches. The rules target situations in which (1) multiple branches each perform manufacturing activities regarding separate items of personal property that are sold 6

7 by the CFC (requiring separate application of the manufacturing branch tax rate disparity test to each branch manufacturing a separate item); or (2) multiple branches, or one or more branches and the remainder of the CFC, perform manufacturing activities regarding the same item of personal property that is then sold by the CFC (requiring application of the manufacturing branch tax rate disparity test). Where manufacturing activities with respect to a single item of property are conducted by multiple branches, four priority rules (see below) determine which branch should be treated as the manufacturing branch. The proposed priority rules ensure that sales income earned by the remainder need be tested only against a single manufacturing branch. Once the tested manufacturing branch is identified under the rules, the existing Regulations provide that the remainder must be tested to the extent that it conducts selling activities. If multiple locations conduct selling activities, each sales branch is tested separately as though it were the remainder. 23 While these rules are somewhat burdensome to apply, the goal is to ensure that each CFC has only one manufacturing branch that must be tested for FBCSI. (1) If only one branch satisfies the physical manufacturing test and another branch (or the remainder) satisfies the substantial contribution test, the location of the manufacturing will be the location of the physical manufacturing activities. 24 In this situation, a sales branch or the remainder of the CFC will not be considered to have made a substantial contribution to the manufacture of the property unless it can establish to the IRS s satisfaction that its contribution was substantial ( rebuttable presumption rule ). 25 (2) If multiple branches satisfy the physical manufacturing test, the location with the lowest effective tax rate will be used to test the selling activities of the remainder. 26 The rebuttable presumption rule also applies. (3) If none of the branches (or the remainder of the CFC) satisfies the physical manufacturing test, but the CFC as a whole satisfies the substantial contribution test, the location of the manufacturing will be the location of the branch or the remainder of the CFC that provides the predominant amount of the CFC s contribution to the manufacturing. 27 (4) If none of the branches (or the remainder of the CFC) satisfies the physical manufacturing test and the CFC as a whole satisfies the substantial contribution test but there is no predominant location, the location of manufacturing will be the location of manufacturing activities subject to the highest effective tax rate. 28 A potential trap with regard to the ordering rules described above is that the Regulations deem manufacturing to occur in the location with the highest tax rate where no one location is the predominant manufacturing location. Neither the existing nor Proposed Regulations define branch. 29 This uncertainty could lead to unknown (and potentially problematic) manufacturing branches. Summary. The contract manufacturing proposed rules provide some certainty for taxpayers regarding the treatment of their contract manufacturing arrangements. To limit the potential for taxation under Subpart F, however, centralization of manufacturing oversight and other substantive manufacturing functions is typically required. Impact of New CIT Law on China-Based Contract Manufacturing Arrangements As described previously, the basic contract manufacturing paradigm that is the focus of this article involves a U.S. parent company that owns a CFC organized in a tax-favored jurisdiction (i.e., a jurisdiction with a lower tax rate than China or the United States). The CFC engages a China-based contract manufacturer to produce finished goods that the CFC sells to related parties. For purposes of the FBCSI rules, a person is related to a CFC if the person controls (e.g., owns, directly or indirectly, more than 50% of the vote or value) or is controlled by the CFC, or the person is controlled by the same person that controls the CFC. 30 While it may be possible for U.S. purposes to structure unrelated purchase and sale transactions (e.g., using check-the-box local distributors), this approach is not viable for sales to the United States and nevertheless requires a manufacturing branch analysis under the Proposed Regulations. The contract manufacturer (related or unrelated), at a minimum, provides a manufacturing facility and employees that will perform the physical steps necessary to produce finished goods for the CFC. The amount of involvement in the manufacturing process on the part of the CFC will vary, as discussed below. To facilitate discussion, particularly with respect to many of the China tax issues that contract manufacturing arrangements implicate, the basic paradigm is considered within the context of a contract processing (consignment arrangement) and import processing (buy-sell) arrangement. 7

8 Contract processing (consignment) mfg. arrangements. In a contract processing arrangement, raw materials or component parts are mainly purchased in the name of the CFC (by the CFC) for use by the contract manufacturer in the production of the finished goods. The contract manufacturer will import raw materials into China and may acquire auxiliary materials in-country. The CFC has the legal title to raw materials, work-in-process (WIP), and the finished goods throughout the manufacturing process and at all times bears the risk of loss. Consistent with this approach, many U.S. taxpayers implemented buysell arrangements that were effectively consignment arrangements because the contract manufacturer held no more than bare legal title (equivalent to a security interest) while the CFC principal bore all of the real risk of loss with respect to raw materials, WIP, and finished goods. 31 The finished goods are exported by the contract manufacturer outside China and the CFC sells finished goods to related parties outside the CFC s country of incorporation. Direct China tax issues. Under this arrangement, the China tax consequences will depend on whether the CFC principal has established a taxable presence in China. In general, the CFC principal should not have a taxable presence in China merely by reason of the contract processing arrangement. However, as is likely, if the CFC principal wants to maintain substantial local manufacturing oversight, this oversight could create a taxable presence in China. Effective January 1, 2008, if the place of effective management of the CFC principal is in China, the CFC principal will be regarded as a resident enterprise in China regardless of whether it is established in China. Consequently, China will tax the worldwide income of the resident CFC at 25%. Where the CFC principal is not a resident enterprise in China and has a PE in China due to performing local oversight of the contract processing, in principle, the CFC principal should be subject to CIT on profits attributable to the PE in China. 32 Although at present Chinese tax authorities generally tax processing fees derived by Chinese manufacturers rather than profits attributable to PEs of foreign principals in China, it is possible that, in the future, the authorities will assert that the foreign principals have PEs in China and attempt to tax their profits as well. In some extreme situations, the Chinese tax authorities may even treat the principal as a PRC resident subject to worldwide PRC income tax if the principal s place of effective management is in China. However, at press time, there was no indication from the State Administration of China regarding a change to the current practical treatment, i.e., only the processing fee derived by the contract manufacturer is taxed in China. Under GuoShuiHan [2007] No. 403, a Hong Kong principal is temporarily exempt from CIT even if it has a PE in China due to its involvement in the production, supervision, management, or sales function under a contract processing arrangement. However, to mitigate the risk of the CFC principal being deemed to have a PE in China by performing local oversight of the contract processing in China, the CFC principal may consider engaging a related or unrelated service company, which should be a separate legal entity, to perform the local oversight. Under this arrangement, the PE exposure of the CFC principal in China will be mitigated, as the CFC principal will not, by itself, perform local oversight in China. However, the CIT implications of the service company must be considered. From a China CIT Law perspective, Hong Kong should be a favorable location to establish the service company. According to some tax treaties concluded by China with other countries or tax jurisdictions ( Treaty Countries ), a resident company of the Treaty Country will be deemed to have a PE in China, by virtue of the relevant tax treaty, if it provides services, including consultancy services, directly or through its employees or other personnel employed for the same project or connected project for a period or periods aggregating more than six months in any 12-month period in China ( six-month threshold ). At present, the relevant China tax ruling 33 explaining how to determine whether a foreign company providing services in China has exceeded the six-month threshold is rather complex and different tax authorities may have different interpretations. However, the second protocol to the Arrangement between the Mainland of China and the Hong Kong Special Administrative Region for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income provides that the above six months will be replaced by 183 days and will, therefore, clear up current uncertainties in determining PE status of Hong Kong companies providing services in China. At press time, China had not yet ratified the second protocol. To avoid having all of its profit, which may include a substantial intellectual property (IP) and risk-based component, potentially exposed to China CIT, the CFC principal should be established and have its place of effective management outside China. As a threshold matter, the CFC principal will have a taxable presence in the country of its incorporation, assuming that it maintains an office there, where employees regularly perform procurement services. Pertinent to Hong Kong-based CFC principals, from fiscal year 2008/2009, Hong Kong will normally impose a 16.5% income tax on the portion of the profits arising in or derived from Hong Kong. With respect to Singaporebased CFC principals, in 2008, Singapore will normally 8

9 impose an 18% income tax on the portion of a Singapore corporation s service fees derived or accrued in Singapore. If the CFC principal is based in Hong Kong or Singapore, it may qualify for favorable home-country tax treatment on its profits. For example, Hong Kong law permits a Hong Kong principal that enters into a qualifying contract processing arrangement with a PRC consignment manufacturer to treat 50% of its profits as sourced offshore and, therefore, nontaxable in Hong Kong. This effectively reduces the Hong Kong principal s tax rate to 8.25%. Although a Singapore principal theoretically would be subject to normal Singaporean tax (reduced to 18% in 2008), Singapore offers a broad range of incentives that may cut the actual tax rate to between zero and 15%. Where a CFC principal is established outside China and does not have its place of effective management in China, but derives certain income from sources within China such as dividends, royalties, rental, or interest that is not attributable to a PE in China, the CFC principal should be subject to withholding tax at 10% on the income. Chinese withholding tax rates may be modified by applicable tax treaties, 34 which would cap the Chinese withholding tax rate at 5% on dividends paid by a Chinese resident company to a beneficial owner that is a resident of Singapore or Hong Kong Special Administrative Region (SAR), provided that the beneficial owner is a company holding directly at least 25% of the capital of the Chinese resident enterprise. Tax treaties may also provide favorable withholding tax rates applicable to interest and royalty payments if the relevant conditions are met. Where the Chinese manufacturer and CFC principal are related parties, the contract processing fee should be determined at arm s length that is, what a third party would earn under similar circumstances. As discussed above, where related-party transactions are not carried out at arm s length and the taxpayer understates its taxable revenue or profits thereby, the tax authority is authorized to make relevant adjustments according to reasonable methods, which include comparable uncontrolled price, resale price, cost-plus, transactional net margin (similar to comparable profits method in the United States), profit split, and other methods that conform with the arm s-length principle. Under a contract processing arrangement, the cost-plus method is generally used to determine the reasonable range of the contract processing fee that a CFC principal should pay to a Chinese manufacturer. Indirect tax issues. An enterprise is generally subject to VAT on (1) the amount that it pays for imports into China, plus customs duty and consumption tax on the imports where applicable; (2) its revenue from domestic sales; and (3) its revenue from providing processing, maintenance, and repair services in China. 35 In general, the VAT uses a credit system under which a general taxpayer obtains credits for its qualified input VAT (VAT that the taxpayer paid to its suppliers on purchases) against its output VAT (VAT that the taxpayer collected on its sales to customers). 36 Hence, a general taxpayer is required to pay only the excess of its output VAT over its input VAT. The standard VAT rate applicable to general taxpayers is 17% for most goods. Under a contract processing arrangement, the Chinese manufacturer will be exempt from the customs duty and import VAT on the raw materials imported for processing purposes provided that the finished products will all be exported and the records of the imported materials can be duly reconciled and cleared. A CFC principal should pay a processing fee to the Chinese manufacturer for processing activities. The processing fee would be exempt from VAT subject to the tax authority s approval. Therefore, where all or most of the raw materials for processing purposes are procured outside China and imported into China, a contract processing arrangement should be a taxefficient arrangement. However, in practice, some local authorities in China are becoming reluctant to approve contract processing arrangements. In addition, a contract processing cannot be used where the goods to be processed fall within the Catalogue of Merchandises Prohibited From Processing Trade. Generally the Chinese manufacturer would be allowed to purchase auxiliary materials in China for processing purposes under the contract processing arrangement. The Chinese suppliers of local materials will charge VAT on the sales to the Chinese manufacturer. This input VAT is not recoverable by the Chinese manufacturer and will become costs of the manufacturer. Therefore, the net VAT effects on the Chinese manufacturer under the contract processing arrangement will be different from those under an import processing (buysell) arrangement (as described below). Whether the contract processing arrangement is advantageous from a Chinese tax perspective will depend on the products manufactured by the Chinese manufacturer and the consumption of domestic materials. Since raw materials for production of many products can now be found in China at competitive prices, before deciding whether a contract processing arrangement should be adopted, the CFC principal should consider the relative costs of raw materials to be procured in and outside China for production purposes, the costs for transporting raw materials from outside China to China, and the irrecoverable input VAT on a domestic purchase. Generally, under a contract processing arrangement, all finished products must be exported and no 9

10 domestic sales are allowed without special approval from the appropriate authority. Alternatively, if the CFC principal intends to sell the finished products to Chinese customers, the Chinese manufacturer may export the finished products to certain special customs zones in China, such as the Bonded Logistics Parks, so that the finished products will be regarded as exported. Thereafter, the Chinese customers may import the finished products from the special customs zones as if they were importing from outside China. No special approval for domestic sales under a contract processing arrangement is required under this alternative arrangement. The Chinese customers must pay customs duty, consumption tax (if applicable to the goods imported), and import VAT on the finished products imported. Under these arrangements, the logistics costs in relation to transportation and storage of finished goods should be considered. The contract processing arrangement should be approved by the relevant authority. After the consent is obtained, the Chinese manufacturer should register the contract processing agreement with the customs office and tax authority in charge. The customs office will subsequently issue a customs log book to the Chinese manufacturer. However, as noted, it is becoming more difficult in practice to obtain approval for contract processing arrangements from local authorities in certain regions in China. In sum, contract processing has some attractive aspects for U.S. multinationals provided that the risk borne by the principal is acceptable and commercially viable (particularly for third-party contract manufacturers). These arrangements are consistent with and support the its argument with respect to CFC principals, allow for cost-plus compensation of the contract manufacturer, do not give rise to income tax in China for the principal (at least historically), and do not result in irrecoverable VAT (except for the materials purchased by the contract manufacturer for processing purposes under the contract manufacturing arrangement). On the other hand, these arrangements face significant hurdles based on the restrictions noted above, including restrictions on the types of products, limitations regarding the source of raw materials, and the need for government approval. Accordingly, many taxpayers engaging contract manufacturers have instead used the import processing arrangements described below. Treatment of an import processing (buy-sell) arrangement. Generally, in an import processing arrangement, the CFC sells certain raw materials to, and purchases finished goods from, the contract manufacturer and does not hold legal title to any raw materials or WIP during the process. The contract manufacturer is compensated either on the cost of the materials plus a markup or per unit. 37 In any event, the contract manufacturer s risks are tax limited except in instances of nonperformance, implying that, for U.S. tax purposes, the CFC is the owner of the raw materials and WIP. 38 The CFC purchases (i.e., takes title to) the finished goods at the end of the manufacturing process and sells the finished goods to a related party for use, disposition, or consumption outside of its country of incorporation. Direct tax issues. Under the import processing arrangement, China CIT implications for the CFC principal and the Chinese manufacturer are essentially the same as those described above with respect to contract processing arrangements. If, however, the Chinese manufacturer is related to the CFC principal, the transfer pricing between the two parties would face more scrutiny from the Chinese tax authorities. According to GuoShuiHan [2007] No. 236, a tax ruling issued by the State Administration of Taxation on February 28, 2007, where a FIE undertakes only a production function ( single production function ) and manufactures products according to the overall operational plan and purchase orders of its overseas parent company, and the overseas parent company (or related parties) performs functions such as operational decision-making, product R&D, marketing, and sales, the FIE should not assume any risks or losses resulting from decision errors by the parent company, underuse of its production facilities, or excess inventory. The ruling concluded that, in accordance with international transfer pricing principles, an FIE solely performing a production function should maintain a minimum level of profitability and not incur losses. Under the 2007 ruling, tax officials were required to seriously investigate FIEs performing a single production function. For FIEs that incurred losses or marginal profits, tax officials were authorized to determine the minimum level of profitability of the enterprises based on appropriate comparable uncontrolled prices or comparable companies via proper economic analyses. This 2007 ruling, however, did not address or define marginal profits. Although the 2007 ruling was issued under the former FEIT regime (now superseded by the new CIT Law), tax officials likely will still conduct thorough investigations of FIEs performing a single manufacturing function according to operational decisions or purchase orders of their overseas related parties. Indirect tax issues. As discussed above, the standard VAT rate applicable to general taxpayers is 17% for most goods. For exports, if the VAT refund rate is 17%, the exports are effectively zero rated. In other words, 10

11 there should not be a VAT on export and the exporter may recover the input VAT attributable to export sales, either as a credit against its VAT on domestic sales or as a refund. However, if the exports are subject to a VAT refund rate of less than 17%, effectively there will be a tax charge (i.e., irrecoverable VAT) on the export. A manufacturer that exports its self-manufactured goods should adopt the exempt, credit and refund method in calculating its VAT based on tax notice CaiShui (2002) No. 7. The VAT is calculated based on the steps in Exhibit 1. Effective January 1, 2004, China revised its VAT refund rates several times to create a differential between the input rates and the refund rates. Hence, the recoverable VAT rate on most exported products (other than specified products such as certain machinery and high-tech products) is limited to 5%, 9%, 11%, or 13%. The difference between the standard VAT rate (17% for most goods) and the VAT refund rate represents a net cost of manufacturing in China. In addition to the abolition and reduction of export VAT refunds for some products in September 2006, on June 19, 2007, the Ministry of Finance and State Administration of Taxation jointly issued a new ruling that will (1) abolish the export VAT refund for products in 553 categories, including salt, cement, and fertilizers; and (2) reduce the recoverable VAT rate for 2,268 products, including shoes, clothing, and plastic products, effective July 1, The VAT cost has increased the cost of doing an import processing business in China and a CFC principal should consider this factor when it evaluates its business in the PRC. Similar to a contract processing arrangement, buysell agreements under contract manufacturing arrangements are also subject to review and approval by the relevant authorities. As discussed above, an import processing arrangement for the processing of goods will not be approved where the goods to be processed fall within the Catalogue of Merchandises Prohibited From Processing Trade. After approval is obtained, the Chinese manufacturer must register the agreements with the local customs office and tax authority and set up a customs log book with the customs office. Previously, customs log books were manually handled by contract manufacturers and customs offices, which caused significant inconvenience and administrative burden to contract manufacturers. However, subject to approval from the customs office, qualified contract manufacturers can now set up electronic log books and handle registration, amendment of records, verification, and cancellation, as well as import and export of goods through a computer network with the customs office. When the Chinese manufacturer imports raw materials under the import processing arrangement, they are treated as bonded goods and the Chinese manufacturer need not pay customs duty or import VAT on them, provided that all finished products under the import processing arrangement will be re-exported. The Chinese manufacturer may apply to the customs office for customs verification and clearance of bonded materials imported under the import processing arrangement after the finished goods are exported. FIEs engaged in import processing are allowed to make domestic sales of finished products. There are two basic options for selling finished goods in China. The first is for the Chinese manufacturer to sell the finished goods in China. To do so, the Chinese manufacturer must first obtain approval from the relevant local authority on the domestic sale of the finished products, and then pay the customs office the customs duty and import VAT on bonded materials used for the production of the finished goods sold domestically. The Chinese manufacturer can offset the import VAT on raw materials against output VAT in calculating its VAT payables if it is a general VAT payor. However, the customs duty will become its costs. The second option is for the CFC principal to buy the finished goods from the Chinese manufacturer first and then sell them in China. Under this option, the CFC principal may keep a larger portion of profits outside China in relation to the buy/sell activities than under the first option. The finished goods must be exported under the import processing arrangement out of China or to certain special customs zones in the PRC before they are re-imported into China. Under this option, however, the Chinese manufacturer may incur nonrefundable VAT on the export to the CFC principal. In addition, logistics costs in relation to the transportation and storage of the finished goods may be significantly higher than under the first option. Further, the Chinese customers will have to conduct the importation formalities with the customs office and pay customs duty and import VAT on the import value of the finished goods. In view of the above, the CFC principal should consider the relevant logistics, tax, and other business costs before deciding which option for selling finished goods in China should be adopted. U.S. Treatment of Import and Contract Processing Arrangements Under Contract Mfg. Prop. Regs. Import (buy-sell) and contract (consignment) processing arrangements, though they have distinct legal countenances that affect their treatment under Chinese law, can be tailored so that they are virtually indistinguishable from a U.S. tax standpoint. For purposes of this discussion, each arrangement, in the 11

12 context of the basic contract manufacturing paradigm, is assumed to be economically equivalent and treated similarly under Subpart F. Treatment under existing law. Under existing law, a typical taxpayer using the basic contract manufacturing paradigm is likely to marshal several arguments (premised on statutory, regulatory, administrative, and judicial authority) to defend the arrangement under the FBCSI rules. If the CFC s level of involvement with respect to manufacturing is limited or nonexistent, the taxpayer is forced to make one of two arguments to defend the arrangement under the Subpart F rules. The first is the its argument described above that Subpart F is avoided because the CFC purchases raw materials or component manufacturing inputs and sells finished goods, so that the CFC is not considered to purchase and sell the same item of property. The second argument that a taxpayer with a minimally involved CFC is likely to make is that the contract manufacturer s activities should be attributed to the CFC in determining whether it manufactures under the manufacturing test. The its defense and the attribution argument have yet to be tested through litigation. However, many U.S. tax advisors, at least until promulgation of the Proposed Regulations, have blessed the basic contract manufacturing paradigm under one or both of these arguments. 39 The advantage and appeal of the its and attribution arguments are that, if these arguments are successful, taxpayers can avoid FBCSI under Section 954(d)(1) and at the same time have little risk of running afoul of the manufacturing branch rules of Section 954(d)(2), since the direct efforts of the CFC s employees would not be required to be a part of the manufacturing process under either argument. Where the CFC actively participates in the manufacturing process (e.g., by conducting manufacturing oversight and raw materials procurement), this participation forms the ground for a third defense against the application of the FBCSI rules that supports, and is consistent with, the first two arguments under Section 954(d)(1) regarding the basic contract manufacturing paradigm. 40 In the active participation scenario, the CFC s own activities (i.e., those of its employees or officers) are significant enough in their own right, so that the CFC should qualify as a manufacturer under the existing manufacturing tests (component parts or substantial transformation). Avoiding FBCSI through the efforts of the CFC s own employees, however, raises the risk that the CFC has a manufacturing branch under Section 954(d)(2) if those employees regularly work outside the principal s home office. Treatment under Proposed Regulations. Under the Proposed Regulations, the its and attribution arguments are stripped from the taxpayer s arsenal. According to those rules, a CFC that satisfies the substantial contribution test through the efforts of its own employees can avoid FBCSI by qualifying as a manufacturer under Section 954(d) (1). Thus, for taxpayers using CFCs that are minimally involved (physically or otherwise) in the manufacturing process, avoiding Subpart F income will be significantly more difficult, if not impossible. These taxpayers should consider how to adapt or change their structures to deal with the narrowing confluence of Chinese and U.S. tax laws. Taxpayers that are already satisfying the substantial contribution test should focus on their structures in terms of avoiding taxation under the new China tax regime. Some general observations and suggestions are offered below. Adjusting China Contract Mfg. Structures for New Rules The changes to the U.S. CFC rules and the new CIT Law provide opportunities and obstacles for U.S. taxpayers. The new rules will force companies to evaluate their existing China-based contract manufacturing structures, examine intercompany pricing with related-party contract manufacturers, and consider implementing new contract manufacturing arrangements. U.S. taxpayers already operating under the basic contract manufacturing paradigm (a China-based contract manufacturer and a CFC principal based in a tax-favored jurisdiction) must contend with the narrowing gap in which a CFC principal can avoid Subpart F. These taxpayers should examine their structures with an eye towards ensuring two objectives: That the CFC performs activities sufficient to satisfy the substantial contribution test. That the CFC does not perform activities within China sufficient to give rise to a branch or PE or a Chinese resident enterprise. These objectives may require changes to contractual terms with the contract manufacturer, the economic arrangement between the parties, the location or employment of the personnel performing certain functions, or the corporate structure (e.g., altering branch or corporate status through the U.S. checkthe-box regulations or otherwise). U.S. taxpayers with PRC check-the-box entities should be mindful of rising PRC tax rates and the implications of these rising rates with respect to the presumption under the Proposed Regulations that manufacturing is deemed to occur in the location with the highest tax rate where neither the branches nor the remainder perform the predominant 12

13 amount of manufacturing but the substantial contribution test is otherwise satisfied. 41 Taxpayers in this situation might consider un-checking their subsidiaries, but that might portend other difficulties (e.g., dealing with CFC subsidiaries in a post-section 954(c)(6) look-through era). Though careful planning is required, if these objectives are achieved, they should prevent the CFC from earning income that is currently subject to PRC or U.S. tax. The U.S. Subpart F analysis, however, requires consideration of where the predominant amount of the substantial contribution activities occur. Otherwise, the CFC could be deemed to have a manufacturing branch somewhere within its structure and, therefore, must contend with a branch rule analysis under Section 954(d)(2). As noted above, there is also some uncertainty regarding the definition of a branch under Section 954(d)(2). Consistent with the approach taken elsewhere in the U.S. Regulations, 42 a branch is likely to be present where a PE exists for foreign purposes. The U.S. analysis does not end here because, although the existence of a PE presumably will give rise to Chinese tax liability, that Chinese PE will not automatically result in Subpart F income under the Proposed Regulations. In these circumstances, the Proposed Regulations provide that only the location with the predominant amount of manufacturing oversight and other substantial contribution activities is treated as a manufacturing branch. For some taxpayers, these objectives will require significant changes to their existing structures. For example, taxpayers that are relying on its or attribution arguments with little or no substance will need to explore whether the CFC can perform additional functions through its existing employees or by adding employees (through new hires, transfers/ loans of staff, secondments, or check-the-box elections). To the extent that additional functions are performed in check-the-box or other branches, it will be necessary to consider the Section 954(d)(2) branch rules. The key will generally be to ensure that the majority of relevant manufacturing oversight activities are centralized in a lower cost jurisdiction. Example. A CFC organized in Macau engaged a PRC contract manufacturer but conducted all oversight pursuant to a service contract with a separate CFC with activities in Hong Kong and the PRC. To comply with the new substantial contribution tests, the taxpayer should consider its options. One approach would be to transfer sufficient personnel to Macau to enable Macau to satisfy the substantial contribution test, but this approach has obvious business constraints. Another would be to check-the-box on Hong Kong; however, even if Hong Kong employees conduct sufficient oversight activities, if the sales continue to be made through Macau, the manufacturing branch rule would likely cause Macau s sales income to be FBCSI (because of the rate disparity with Hong Kong). Alternatively, Hong Kong could take over from Macau as the principal in the contract manufacturing arrangement. While this approach is probably safest from U.S. Subpart F and Chinese PE perspectives, a Hong Kong CFC principal is likely to be subject to a higher overall effective tax rate than Macau. Nevertheless, the benefits of obtaining U.S. tax deferral may be substantial. For other taxpayers, only minor changes will be required. In some instances, taxpayers that have only limited oversight activities may want to bolster these activities to obtain a greater level of comfort that they will satisfy the substantial contribution test. In other instances, the existing activities may be more than adequate and it may be possible to decrease the risks borne or functions performed by the CFC, particularly if a taxpayer would like to convert a consignment arrangement (contract processing) to a buy-sell arrangement (import processing). The aspiration to change contractual terms could be driven by a combination of business considerations (e.g., shifting some risks to business partners, PRC indirect tax planning, customs issues); however, these changes will require PRC government approval. A subset of taxpayers operating under the basic contract manufacturing paradigm may face transfer pricing issues that will come to the fore with the increased income tax burden in China. For a variety of reasons (e.g., lack of documentation requirements, changes to the cost base/margins), many contract manufacturers in China received cost-plus or per-unit fees that exceeded arm s-length compensation given their relatively low level of risk. It may be difficult, however, to convince the Chinese tax authorities that a lower profit level for the related contract manufacturer is appropriate, even if supported by a transfer pricing study and other documentation. Indeed, one audit criterion that Chinese tax officials use is whether the profitability of a manufacturing enterprise drops after the expiration of a tax holiday or other incentive. Taxpayers in this position should look to identify substantive changes in the arrangement such as adding new product lines or reducing functions to satisfy the Chinese tax authorities that new pricing is appropriate. Arguing that more risks are borne by the principal, or that the principal has simply been overpaying in the past, may not provide sufficient grounds for adjusting intercompany pricing. U.S. taxpayers that are not already operating within the basic contract manufacturing paradigm, and that operate directly within China through a CFC 13

14 to avoid the increased tax cost of operating directly within China, might consider converting to a structure similar to the basic contract manufacturing paradigm discussed in this article. As noted above, potential desirable locations for the CFC principal include Hong Kong and Singapore, due to the favorable tax rates and economic incentives offered by those jurisdictions. 43 The flexibility and certainty of the contract manufacturing Proposed Regulations will make these locations more attractive for some taxpayers. 44 On the extreme end of the spectrum, some taxpayers might consider terminating their Chinese contract manufacturing arrangements altogether. China is not as attractive as a contract manufacturing destination as it once was, and many global firms, after weighing the costs, risks, and logistics of operating within China, are concluding that other jurisdictions are more attractive. 45 Potential competitors to China for contract manufacturing arrangements include Vietnam, Malaysia, and Indonesia. Conclusion The changing cost structure in China, including significant income tax changes, may make it more difficult to operate a manufacturing operation there. In addition to higher labor costs, the combination of higher tax rates and fewer tax incentives will force companies to consider how they operate in China, including existing and new contract manufacturing arrangements, and whether they are entitled to any tax incentives under the CIT Law, such as the 15% rate for qualified Advanced and New Technology Enterprises. Taxpayers with existing contract manufacturing arrangements involving CFC principals need to evaluate their structures in light of the changes in China, as well as the coming changes in U.S. law. The U.S. Proposed Regulations may necessitate greater involvement on the CFC s part in the manufacturing process, but this greater need for involvement in the manufacturing process must be balanced against Chinese PE and place-of-effective-management risks. In other situations, the greater degree of certainty under Subpart F provided by the Proposed Regulations, coupled with the need to have predictable manufacturing profit levels in China, may lead many taxpayers to consider whether contract manufacturing in China is viable from a business perspective. Rev. Rul Rev. Rul. 75-7, CB 244, concluded that the manufacturing activities of an unrelated contract manufacturer should be treated as performed by the CFC. In the Ruling, a CFC purchased metal ore concentrate from related persons in the United States and Canada and entered into an arm s-length contract with an unrelated foreign corporation (the contract manufacturer), incorporated in a different foreign country than the CFC, to convert the ore concentrate into ferroalloy. The conversion process was assumed to rise to the level of manufacturing. The CFC sold the finished product produced by the contract manufacturer to unrelated parties for use, consumption, or disposition outside its country of incorporation. Under the terms of the contract, the contract manufacturer received a conversion fee for its services. It did not have any risk of loss and did not participate in profits from the sale of the final product by the CFC. The raw materials, workin-process, and finished products remained the sole property of the CFC at all times. The CFC maintained complete control over the production process and sent advisors and inspectors to the contract manufacturer s facility. Rev. Rul was revoked by Rev. Rul , C.B. 89. In Rev. Rul. 75-7, the Service focused on risk of loss and control over the quantity, timing, and quality of production as key factors in determining whether the CFC should be treated as manufacturing a product manufactured on its behalf by a contract manufacturer. Although the Service revoked Rev. Rul after more than 20 years, the Ruling nonetheless is seen as relevant because it sets forth factors for determining which party to a transaction bears the economic risk of loss and thus should be viewed as the owner of the property. The factors represent general common-law ownership principles that are not limited to Rev. Rul and are not affected by its repeal. Indeed, the Service has applied some or all of the Rev. Rul factors in private letter rulings issued subsequent to the publication of Rev. Rul See Ltr. Rul (Sept. 8, 1987) (CFC retained economic risk of loss even though contract manufacturer had title to certain parts, components and materials); Ltr. Rul (June 17, 1987) (contract manufacturer had minimal risk of loss with respect to work-in-process inventory); Ltr. Rul (Dec. 29, 1983) (CFC retained economic risk of loss and title to raw materials, and exercised supervision and control). 14

15 exhibit 1. exempt, credit and refund method of calculating vat: A manufacturer that exports its selfmanufactured good should adopt the exempt, credit, and refund method in calculating its VAT, which is based on the following steps: Exempt: Export is generally not subject to output tax. Credit: The input tax (including import VAT, if any) on raw materials and supplies can be offset against the output tax on domestic sales. However, the enterprise should treat a portion of input tax as irrecoverable (i.e., as cost of sales). VAT payable = output VAT - (input VAT - irrecoverable input VAT) Irrecoverable input VAT = (FOB value of exports - value of bonded raw material imported) x (VAT charge rate - VAT refund rate) Refund: If VAT payable is negative (a credit balance), VAT becomes refundable. Footnotes 1 Throughout this article and solely for purposes of analyzing tax issues, China will be used to refer to mainland China, excluding Hong Kong SAR (Special Administrative Region), Macau SAR, and Taiwan. For U.S. and Chinese tax purposes, all of these jurisdictions are treated as separate countries. See Notice 97-40, CB 287 (exclusion of Hong Kong); Article 132 of the Implementation Rules of the CIT Law (enterprises established in Hong Kong SAR, Macau SAR, and Taiwan will be treated in accordance with the relevant regulations applicable to enterprises established under foreign laws and regulations). 2 See Mihaly, Doing Business in China U.S. and PRC Tax Issues, 17 JOIT 44 (March 2006). 3 For purposes of this article, FIEs are Sino-Foreign Equity Joint Ventures, Sino-Foreign Contractual Joint Ventures, and Wholly Foreign Owned Enterprises (WFOEs). 4 A simple Internet search for China contract manufacturing turns up hundreds of contract manufacturing options for U.S.-based operators. 5 For an expanded discussion of the various contract manufacturing arrangements, and the risks associated with these arrangements under the new China tax legislation, see Zollo, Kvalseth, Zuvich, and Tao Chinese Procurement Under New Enterprise Income Tax Law, 33 Int l Tax J. 39 (September-October 2007). 6 On the other hand, an FIE paying tax at the full rate of 33% under the FEIT regime will receive an 8% income tax rate reduction. 7 Renminbi, also referred to as the Yuan. The exchange rate as of early June 2008 is approximately 6.95 RMB to one U.S. dollar. 8 The 2+3 tax holiday consisted of a two-year tax exemption beginning in the year that an FIE first became profitable, followed by a three-year 50% reduction of the applicable rate. 9 According to Article 75(7) of the detailed rules of the FEIT Law, if the total exportation value of an approved Export-Oriented Enterprise exceeds 70% of its total production in a year, the Export-Oriented Enterprise can receive the 50% reduction in state FEIT after the 2+3 tax holiday, provided that the state FEIT rate after the reduction will not be lower than 10%. 10 The SEZs of China include Shenzhen, Zhuhai, Shantou, Xiamen, and Hainan Province. 11 According to Guofa [2007] No. 39, Guofa [2007] No. 40, and Caishui [2008] No

16 12 Under the former FEIT Law, the standard tax rate was 33% (30% state FEIT and 3% local FEIT). 13 According to the Explanation of PRC Corporate Income Tax Law (Draft) made by the former minister of PRC Ministry of Finance, March 8, In a cost-plus pricing arrangement, the contract manufacturer may benefit from increased costs. 15 Section 951(a)(1)(A)(i). 16 Section 952(a)(2). 17 Sections Prop. Reg , REG , February 27, 2008, 73 Fed. Reg (February 28, 2008). For an extensive discussion of the long-running dispute and an overview of the Proposed Regulations, see Bates and Kirkwood, Contract Manufacturing: Is the War Over?, 50 Tax Notes Int l 61 (March 26, 2008). 19 Section 954(d)(1) defines FBCSI, in part, as (1) the purchase of personal property by a CFC from a related person and its sale to any person, and (2) the purchase of personal property from any person and its sale to a related person (emphasis added). Thus, the definition of FBCSI would appear to require the purchase and resale of the same item of property. 20 Contract Manufacturing Rules to Be Finalized This Calendar Year, Treasury Official Says, 2008 TNT (May 12, 2008). 21 If the Proposed Regulations are finalized in their current form and their validity is subsequently upheld in the litigation that is likely to ensue, taxpayers that have relied solely on the its defense will have to restructure their contract manufacturing arrangements to avoid FBCSI. 22 Prop. Regs (a)(4)(iv)(b)(1)-(9). 23 Reg (b)(1)(ii)(c). 24 Prop. Reg (b)(1)(ii)(c)(3)(b). 25 Prop. Reg (b)(2)(ii)(c)(2). 26 Prop. Reg (b)(1)(ii)(c)(3)(b). 27 Prop. Reg (b)(1)(ii)(c)(3)(c). 28 Prop. Reg (b)(1)(ii)(c)(3)(e). 29 The issue of what constitutes a branch for purposes of Section 954(d)(2) was heavily contested in Ashland Oil, 95 TC 348 (1990). The Tax Court, consulting Black s Law Dictionary, adopted the taxpayer s suggested definition of a branch (a division, office, or other unit of business at a location different from the main office or headquarters), finding it consistent with the legislative history of Section 954(d). 30 Section 954(d)(3). The constructive ownership rules of Section 958 apply for purposes of determining relatedness under Section 954(d)(3). 31 This approach was not necessarily used in all instances, for example, if the taxpayer relied on the attribution argument. 32 GuoShuiHan [2007] No. 403, which explains relevant Articles of the China-Hong Kong double tax arrangement and applies to the same Articles in other Chinese tax treaties for which no previous explanations were made 33 Notice GuoShuiHan [2007] See, e.g., China s double tax arrangements with Singapore and Hong Kong. 35 An enterprise is generally subject to a 5% business tax instead of VAT on revenue from providing services other than processing, maintenance, and repair services in China. 36 Special VAT rules apply to small-scale taxpayers. To qualify for these rules, a taxpayer mainly engaged in a manufacturing or VATable service business must have annual turnover of less than RMB 1 million and a wholesaler or retailer must have annual turnover of less than RMB 1.8 million. 37 In many instances, the per-unit price is intended to ensure cost recovery plus a markup and thus may be effectively equivalent. 38 That a contract manufacturer has legal title to raw materials and WIP to secure performance of the CFC principal should not prevent treating the CFC principal as the tax owner of the raw materials and WIP. See Ltr. Rul ; cf. Ltr. Rul (retaining ownership of raw materials not determinative as to whether a contract manufacturing relationship existed when other factors indicated that the contract manufacturer did not bear risk of loss). 39 See, e.g., Dolan, Dupuy, and Jackman, Contract Manufacturing: The Next Round, 27 Tax Mgmt. Int l J. 59 (February 1998). 40 The combination of the its argument with manufacturing oversight activities is consistent with the Service s approach in Rev. Rul (see sidebar). 41 Prop. Reg (b)(1)(ii)(c)(3)(e). 42 See Reg (a)-7(g)(1). 43 Neither Hong Kong nor Singapore has an income tax treaty with the United States. 44 The basic contract manufacturing paradigm might also be attractive to taxpayers that have a China business trust in place but are concerned about PRC resident status or other issues. 45 Manufacturing in Asia: The Problem With Made in China, The Economist (January 13, 2007). 16

17 KEEP TRANSFER PRICING PENALTIES AT ARM S LENGTH! Important Guidance from WG&L! The United States has targeted transfer pricing as an issue of major importance, for both inbound and outbound investments. Therefore, one of the most crucial business and tax considerations for any multinational corporation is how it prices goods, services, and intangibles. WG&L s U.S. International Transfer Pricing examines the case law and regulations and applies those principles to such topics as: Transfer planning studies Presenting positions in the context of litigation or controversy Obtaining an advance pricing agreement (APA) Responding to a summons or examination It explores transfer pricing at work under the constraints of state taxation, customs laws, and other relevant areas. U.S. International Transfer Pricing includes detailed coverage of: The arm s-length standard Essential premises of transfer pricing law The transfer pricing penalty APAs IRS examination and controversy process Don t get caught in the web of complex regulations, risking huge penalties for noncompliance. Let the expert authors of U.S. International Transfer Pricing help you through the planning processes to make the right decisions. Call or visit ria.thomson.com now to learn more about this critical guidance. About the Authors: Sewell, LLP. Associates, New York, New York. Wynne Sewell LLP. INTP6/ Thomson Tax & Accounting. Checkpoint, RIA, PPC and WG&L are registered trademarks of Thomson Professional & Regulatory Inc. Other names and trademarks are properties of their respective owners. TAX & ACCOUNTING