Contract manufacturing is becoming more important as some manufacturers angling for section 45X credits for making components for wind, solar and storage projects farm out the physical work to other companies.

An example is where a battery or tracker company hires out the physical work to a for-hire factory to make parts of its batteries or trackers using proprietary designs.

Section 45X is a new tax credit in the Inflation Reduction Act for manufacturing components for wind, solar and storage projects. The tax credits are generally fixed amounts per component. For example, the tax credit for making torque tubes — the horizontal rod on which solar panels sit — is 87¢ a kilogram. It is $35 a kilowatt hour of storage capacity for making battery cells.

The tax credits can be claimed on such components produced and sold through 2032, but they start to phase down in amount after 2029.

Cases where a for-hire factory does the physical work raise questions about who is the "manufacturer" for purposes of claiming tax credits.

Anyone in this position would be wise to do the following. If the goal is to have company A rather than for-hire factory B claim section 45X tax credits, then A should supply the raw materials used to make the product and retain title to the raw materials and finished products during manufacture.

It should hold the patents and other intellectual property rights needed to make the product. Factory B should not make the product for anyone else and not sell any excess product to anyone else. Company A should decide the amount of output to be produced. The more A is engaged in directing product design, controlling manufacturing-related logistics and managing costs, the better.

Ideally B should be paid on a cost-plus-fixed-fee basis so that A bears the costs to manufacture the articles.

The contract between A and B should make clear that the parties will treat A as the "producer" and it, rather than B, will claim any section 45X tax credits.

The same question which of A and B is the manufacturer for purposes of taxes or tax benefits comes up in at least three other contexts.

The federal government collects manufacturer's excise taxes from the manufacturers of various products. The issue is whether the company selling the product or the for-hire factory should pay the excise tax. In contract manufacturing situations, the "manufacturer" is the person who supplies the raw materials and retains title to the raw materials and the finished product during manufacture.

The IRS and the courts have analyzed a series of situations where B manufactures articles under contract to A using B's own materials and labor. A is the manufacturer if it owns the patent required to manufacture, decides on the amount of output to be produced and has exclusive rights to the output so that B is not free to sell to others. However, change one fact — let B produce more product than A requires and sell the excess to third parties — and B is the manufacturer.

The federal government allowed taxpayers engaged in domestic production in the United States through 2017 to deduct 9% of the income from such activity, leading to an effective tax rate on such income of 31.5% compared to the 35% rate that applied at the time to other corporate income. The deduction was an inducement for American companies to do their manufacturing at home.

In contract manufacturing cases, the IRS focused on which of the two parties had the "benefits and burdens of ownership of the [product]" during manufacture to determine which was the producer entitled to the deduction.

IRS regulations gave examples of how the IRS analyzed who had the benefits and burdens. In one example, A designed a machine and hired B to build them. B was the manufacturer under the following facts: A owned the intellectual property and allowed B to use it solely to manufacture machines for A. However, B retained control over how they were manufactured, sold them at a fixed price per machine to A, suffered a loss or earned a profit depending on its cost to manufacture and had legal title until the machines were conveyed to A.

Another context where contract manufacturing comes into play is where US manufacturers create offshore holding companies in an effort to shift profits from offshore manufacturing to tax havens. The United States looks through foreign corporations that are controlled by US shareholders and taxes the US shareholders on any earnings considered "subpart F" income without waiting for the earnings to be repatriated to the United States.

One type of subpart F income is "foreign base company sales income" that the foreign corporation earns by buying goods from a related person and reselling them to a third party, or by buying goods from a third party and reselling them to a related person. This is intended to prevent a US company from shifting income to a tax haven. An example is where a US company forms a subsidiary in the Cayman Islands that it uses to buy goods manufactured by an affiliate in Germany and to resell the goods to customers in France.

The US does not usually look through the foreign corporation if the corporation manufactured the goods.

This raises the question who is the manufacturer where the foreign corporation hires out the physical work to the German affiliate. IRS regulations treat the foreign corporation as the manufacturer only if it makes a "substantial contribution" to manufacture of the product through its own employees.

The regulations have a list of seven activities that are evidence of such a contribution, including oversight and direction of the manufacturing, material selection, vendor selection and control of raw materials, work-in-process or the final goods, developing or directing product design, managing costs, such as through efficiency initiatives and hedging raw materials, and controlling manufacturing-related logistics.