North Carolina Issues Guidance on the Sourcing of Contract Manufacturing Services Fees from Affiliate

By: Jess Johannesen, SALT Senior Manager

At a glance

• The main takeaway: North Carolina required a contract manufacturer to source its service revenue from a related entity in the same way that the related entity sourced its revenue from the sales of manufactured goods. 
• Assess the impact: In some states, the sourcing rules for taxpayers from transactions with related parties may deviate from the rules when those transactions are with unrelated third parties. Businesses may need to engage in more due diligence to comply with these sourcing rules.
• Take the next step: Aprio’s State and Local Tax (SALT) team has experience analyzing state sourcing rules and can help you determine how these rules apply to your operations.

Schedule a free consultation today to learn more!

The full story:

In a recent North Carolina private letter ruling, a Taxpayer asked the North Carolina Department of Revenue (the Department) for guidance regarding the sourcing of contract manufacturing service fees received from a related entity.¹

A closer look at the case

The Taxpayer operates manufacturing facilities in North Carolina and serves as its foreign parent’s primary source for products manufactured and sold in the US. Specifically, the Taxpayer and the foreign parent have a Manufacturing Services Agreement under which the foreign parent pays the Taxpayer a reimbursement of production costs plus a service fee (collectively, the Service Fees) in exchange for the Taxpayer’s contract manufacturing services. 

Under the agreement, the Taxpayer may receive some or all of the raw materials from the foreign parent, or it may be responsible for procuring those from third-party suppliers. It then uses those raw materials to manufacture the product based on the specifications in the agreement. At all times, inventories remain the property of the foreign parent. After the Taxpayer finishes manufacturing the products, the Taxpayer’s obligations under the agreement end. The products are transferred from the Taxpayer’s manufacturing facilities to a temporary warehousing facility where the products await distribution.² The foreign parent distributes and sells the products both in the US and around the world.

The ruling explained

To address the Taxpayer’s question, the Department cites a rule that applies to receipts from other than the sale of tangible personal property. This rule provides that when a taxpayer has receipts from transactions with a related entity customer, information that the related customer has regarding the sourcing of receipts from these transactions shall be imputed to the taxpayer.³

Based on this rule, the Department concludes that the Taxpayer should source its Service Fees based on the ultimate destination of the finished product because the companies are related entities, and the finished product is tangible personal property. Essentially, since the foreign parent is selling the tangible personal property that was manufactured by the Taxpayer, the Taxpayer must source its Service Fees “in the same manner as its related customer – as a sale of tangible personal property.” Similar to other states, North Carolina sources receipts from sales of tangible personal property based on where the property is received by the purchaser.⁴

Finally, the Department states that if the Taxpayer is not provided with the ultimate destination and cannot determine the locations where the products are ultimately delivered, then the Service Fees in such situation should be sourced entirely to North Carolina since that is the location where the Taxpayer performs the contract manufacturing services. This ruling highlights a couple of interesting points: 

• First, when engaging with a related party, it is important to check the state sourcing provisions to determine if there are any special rules regarding related-party receipts. For example, in the absence of North Carolina’s related-party rule noted above, this Taxpayer may have sourced its Service Fees based on the state’s standard market-based sourcing rules applicable to service revenues, which may have produced a different sourcing result.
  
• Second, the Department rules that in the absence of any information from the foreign parent to determine the locations where the products are ultimately delivered, the Service Fees should be sourced to North Carolina since that is where the Taxpayer performs the manufacturing services. This argument appears to depart from the state’s market-based approach for sourcing service revenue, which looks to the location where the service is delivered.

Specifically, the Department has a regulation regarding receipts from in-person services⁵ which states:

“[I]f the service is performed with respect to the customer’s tangible personal property and the tangible personal property is to be shipped or delivered to the customer, whether the service is performed within or outside North Carolina, the service is received in North Carolina if the property is shipped or delivered to the customer in North Carolina.”⁶

The bottom line

The Department’s ruling is unclear as to the rule(s) it relied upon to reach its sourcing conclusion in the situation where there is an absence of information from the foreign parent. 

Aprio’s SALT team has experience analyzing state sourcing rules and assisting businesses with apportionment calculations, which has a major impact on tax liability. We can help you determine how these rules apply to your operations and we will look for opportunities to minimize your multistate income tax liability, particularly in cases where there is a significant transaction (e.g., a sale of the business or a segment thereof). We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

This article was featured in the October 2023 SALT newsletter.

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¹ Corporate Private Letter Ruling No. 2023-02, June 20, 2023.

² The location of the temporary warehousing facility is not specifically identified in the ruling, although the impression is that it is also in North Carolina.

³ NC Admin. Code §5G.0303

⁴ See N.C. Gen. Stat. § 105-130.4(l)(3).

⁵ This is defined as “services that are physically provided in person by the taxpayer, where the customer or the customer’s real or tangible property upon which the services are performed is in the same location as the service provider at the time the services are performed.” N.C. Admin. Code 5G.0801.

⁶ N.C. Admin. Code 5G.0802(3).