The 20-Percent Conversion-Cost Test and the IC-DISC

Foreign contract manufacturing can satisfy the 20-percent conversion-cost test, but that cuts both ways for IC-DISC purposes. If the foreign contractor’s work is treated as manufacturing because the seller’s contract price for that work equals at least 20 percent of the seller’s cost of goods sold or inventory amount for the property, the property has undergone further foreign manufacturing. In that case, the property generally will not be treated as having been manufactured in the United States solely because of earlier U.S. work, so it may fail the export-property requirement of section 993(c)(1)(A) unless there is later qualifying U.S. manufacturing after reimportation [4] [1].

Table of Content

1. General rule
2. Effect of foreign contract manufacturing on the 20-percent test
3. Why this matters for export-property qualification
4. When foreign contract manufacturing does not necessarily break qualification
5. Reimportation and later U.S. processing
6. Related regulatory support
7. Practical implications
8. Conclusion

General rule

For IC-DISC purposes, export property must be property manufactured, produced, grown, or extracted in the United States by a person other than a DISC, held primarily for sale, lease, or rental for direct use, consumption, or disposition outside the United States, and meeting the foreign-content limitation [1]. Treas. Reg. § 1.993-3(a) restates that export property must be manufactured, produced, grown, or extracted in the United States by a person other than a DISC [2].

Under the DISC manufacturing rules described in Rev. Rul. 78-228, property is treated as manufactured or produced if one of three tests is met:

1. substantial transformation,
2. substantial operations generally considered manufacturing or production, or
3. the 20-percent conversion-cost test [4].

The 20-percent test is therefore an independent manufacturing test, not merely supporting evidence [4].

Effect of foreign contract manufacturing on the 20-percent test

Rev. Rul. 78-228 is the key authority on contract manufacturing. It explains that property is considered manufactured or produced by a person if it is manufactured or produced by that person or by another person pursuant to a contract with that person [4].

That has two important implications.

1. The seller uses the contract price as its conversion cost

Where the processing is performed by a contractor, the relevant conversion cost for the seller is the contract price paid to the contractor, not the contractor’s internal labor or overhead [4]. So if a U.S. seller sends partially finished goods to a foreign contract manufacturer and pays a processing fee, that fee is the amount tested against the seller’s total cost of goods sold or inventory amount for the property [4].

2. Foreign contract work can itself become “further manufacturing”

If that foreign contract price equals or exceeds 20 percent of the seller’s total cost of goods sold, the foreign work is treated as manufacturing even if it does not substantially transform the property and is not otherwise generally considered manufacturing [4].

That is the central risk. Once the foreign contract work rises to the level of manufacturing, the property has undergone further manufacture outside the United States. Rev. Rul. 78-228 states that property manufactured in the United States that sustains further manufacture or production outside the United States before sale generally will not be considered manufactured or produced in the United States by that person solely by reason of the earlier U.S. work [4].

Why this matters for export-property qualification

Section 993(c)(1)(A) requires U.S. manufacture, production, growth, or extraction [1]. If foreign contract manufacturing satisfies the 20-percent test, the taxpayer may lose the ability to rely on the original U.S. manufacturing to satisfy that requirement [4].

So the practical consequence is:

• foreign contract manufacturing can prove that manufacturing occurred,
• but it may prove that the relevant manufacturing occurred abroad rather than in the United States,
• which can disqualify the property as export property at that stage [4] [1].

When foreign contract manufacturing does not necessarily break qualification

Rev. Rul. 78-228 also draws the opposite line. If the foreign activity is only assembly or other non-manufacturing activity, then the property can still be considered manufactured or produced in the United States by reason of the earlier U.S. work [4].

That means foreign contract manufacturing is problematic only if the foreign work itself satisfies one of the manufacturing tests, including the 20-percent conversion-cost test [4].

Reimportation and later U.S. processing

Rev. Rul. 78-228 also provides the principal recovery path. Even if foreign contract manufacturing interrupts U.S.-manufactured status, the property may still qualify as export property if it is reimported into the United States and then subjected to sufficient U.S. manufacturing before export [4].

In the ruling, the taxpayer’s later U.S. processing exceeded the 20-percent threshold, so the property again satisfied the U.S. manufacturing requirement of section 993(c)(1)(A) [4].

So the sequence matters:

1. initial U.S. manufacturing,
2. foreign contract manufacturing that may interrupt qualification,
3. reimportation,
4. later qualifying U.S. manufacturing that may restore export-property status [4].

Related regulatory support

The FSC temporary regulations, which parallel DISC export-property concepts in relevant respects, reinforce this same principle. They provide that property sustaining further manufacture, production, or processing outside the United States after U.S. manufacture can still qualify only if it is reimported into the United States for further manufacturing, production, or processing before final export sale, and all other export-property requirements are met [5]. While those are FSC regulations, they are consistent with the reasoning in Rev. Rul. 78-228 on the DISC side [5] [4].

Practical implications

The main implications of foreign contract manufacturing for the 20-percent test are these:

• The foreign contractor’s fee is generally the seller’s relevant conversion cost for the test [4].
• If that fee is at least 20 percent of the seller’s cost of goods sold or inventory amount, the foreign work is treated as manufacturing [4].
• Once the foreign work is treated as manufacturing, earlier U.S. manufacturing generally no longer suffices by itself to satisfy section 993(c)(1)(A) [4] [1].
• If the foreign work does not rise to the level of manufacturing, the earlier U.S. manufacturing may still support export-property status [4].
• If the property is reimported and later subjected to qualifying U.S. manufacturing, export-property status may be restored [4].

Conclusion

Foreign contract manufacturing can satisfy the 20-percent conversion-cost test because the seller generally measures conversion cost by the contract price paid to the foreign processor. But if that foreign contract work meets the 20-percent threshold, it is treated as foreign manufacturing, which generally interrupts prior U.S.-manufactured status for purposes of section 993(c)(1)(A). As a result, the property may cease to qualify as IC-DISC export property unless the foreign work is only non-manufacturing assembly or the property is later reimported and subjected to sufficient U.S. manufacturing before export [4] [1] [5].

Cited Sources

1. Sec. 993 Definitions and special rules
2. Sec. 1.993-3  Definition of export property.
3. Sec. 1.936-5  Intangible property income when an election out is made: Product, business presence, and contract manufacturing.
4. Rev. Rul. 78-228
5. TD 8126