2014-Issue 13—Many companies use third parties to manufacture their products or designs. When a company uses a third party to manufacture its products, the question arises: which entity is entitled to the IRC Section 199 Domestic Production Deduction (DPD), a “permanent” tax benefit for financial accounting purposes, related to the manufactured product? The answer depends on whether the contracting firm or the third-party manufacturer retains the “benefits and burdens” of ownership during the production phase of the contract.
The DPD generally allows a taxpayer to receive an additional deduction based on qualified production activity income (QPAI) resulting from domestic production. For all years after 2009, the deduction is the lesser of:
- 9 percent of QPAI;
- 9 percent of taxable income; or
- 50 percent of the Form W-2 wages deducted in arriving at QPAI.
QPAI is defined as an amount equal to the excess (if any) of the taxpayer's domestic production gross receipts (DPGR) for such taxable year over expenses (direct and indirect) that are allocable to such production receipts.
A taxpayer’s DPGR comes from one of three qualifying activities:
- The sale, exchange or rental of qualifying production property (QPP) manufactured, produced, grown or extracted (MPGE) by the taxpayer within the USA, production of qualified film within the USA or qualified production of energy within the USA;
- Construction of real property in the USA by a taxpayer engaged in the active conduct of a construction trade or business; or
- Engineering or architectural services performed in the USA by a taxpayer engaged in the active conduct of an engineering or architectural trade or business.
Gross receipts derived from the performance of services generally do not qualify as DPGR.
QPP is tangible personal property, computer software or sound recordings. Tangible personal property includes any tangible property other than land or buildings (including structural components).
The regulations clarify that the taxpayer that may claim the Section 199 deduction is the entity that retains the "benefits and burdens" of ownership of the QPP during the production process. In a contract manufacturing arrangement, the hiring company often provides a design or formula to a contract manufacturer who, for an agreed-upon price, produces the hiring company’s product. Which entity retains the benefits and burdens of ownership is a factual inquiry that is influenced by all of the surrounding facts and circumstances.
Benefits and Burdens Question
Companies have wrestled with the facts and circumstances surrounding contract manufacturing since the Section 199 deduction was introduced in the early 2000s. However, in a contract manufacturing arrangement, each taxpayer may retain some of the benefits and burdens of ownership with respect to the QPP. Therefore, deciding who may claim the DPD in a contract manufacturing situation is often difficult and contentious.
October 2013 Directive
On October 29, 2013, the IRS issued a directive that makes it easier for a taxpayer to avoid challenges to its claimed Section 199 deduction as long as the taxpayer enters into an agreement with its contract manufacturer to ensure that the deduction is being claimed by only one party. The October 29 directive updates a July 24, 2013 directive, which itself updated and superseded a February 2012 directive. The October 29 directive provides that if both parties to a contract manufacturing arrangement come to an agreement over who retains the benefits and burdens of ownership, the IRS generally won’t challenge the arrangement. The agreement should include the following:
(1) A statement explaining the basis for the taxpayer’s determination that it had the benefits and burdens of ownership in the year or years under examination;
(2) A certification signed by the taxpayer providing that the taxpayer has determined that (A) it has the benefits and burdens of the qualifying property when the qualifying activities were performed; (B) the taxpayer was not required to record a reserve for financial statement purposes under its accounting standard for its determination that it had benefits and burdens over the qualifying property; (C) the contract was not governed by the rules applicable to expanded affiliate groups, qualifying in-kind partnership, expanded affiliated group (EAG) partnerships and government contracts; and (D) the qualifying activities occurred in whole or in significant part within the United States; and
(3) A certification signed by the taxpayer’s counterparty in the contract manufacturing arrangement certifying that the counterparty did not, and will not, claim the Section 199 deduction for any taxable year covered by the contract pursuant to which the same qualifying activities were performed.
However, if a taxpayer is unwilling or unable to provide each of the three statements, the IRS will apply regular audit procedures to determine which entity has the benefits and burden of ownership for purposes of Section 199.
The October 29 directive represents a practical approach by the IRS for resolving Section 199 benefits and burdens controversies. By effectively deferring to the taxpayer’s determination regarding who retains the benefits and burdens, the IRS can quickly identify and address duplicated Section 199 deductions, while avoiding difficult, time-consuming audit procedures. Although the October 29 directive represents a significant improvement, it does not resolve uncertainties concerning arrangements where the hiring firm and the contract manufacturer both believe they are entitled to the Section 199 deduction. In a recent decision, the Tax Court addressed just such a case.
ADVO, Inc., v. Commissioner
In ADVO, Inc. v. Commissioner, 141 T.C. No. 9 (10/24/2013), the Tax Court, in a case of first impression, addressed the Section 199 benefits and burdens requirement in a contract manufacturing arrangement.
ADVO is a direct-mail advertiser. ADVO created, assembled and coordinated distribution of its direct mail products in-house. ADVO contracted with third-party printers for the actual printing of its advertising materials. During the printing process, ADVO owned the paper on which the advertisements were printed, but the printer owned the ink used to print the advertisements.
The crucial question before the Tax Court was whether ADVO “manufactured” the advertising mailing materials or produced only intangible property that third-party printers used to produce tangible personal property. Under the regulations, ADVO must have retained the benefits and burdens of ownership of the property during the production activities to be considered to have “manufactured” the products for Section 199 purposes.
ADVO argued that its gross receipts attributed to its printed direct mail advertising and distribution products qualified as “domestic production gross receipts” because ADVO retained the benefits and burdens throughout the production process. Essentially, ADVO argued that it controlled the entire production and manufacturing process “from cradle to the grave” and, therefore, must have had the benefits and burdens throughout.
The IRS argued that ADVO did not retain the benefits and burdens of any qualifying production property during production because ADVO contracted out the actual printing of the advertising materials. The court agreed with the IRS, holding that ADVO did not retain the benefits and burdens of ownership of its direct advertising materials during their manufacture. Therefore, ADVO was not entitled to a domestic production activities deduction of over $1.5 million.
In reaching its decision, the Tax Court established a nine-factor, non-exclusive standard to determine whether ADVO retained the benefits and burdens of the qualifying property:
(1) Whether legal title passes;
(2) How the parties treat the transaction;
(3) Whether an equity interest was acquired;
(4) Whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments;
(5) Whether the right of possession is vested in the purchaser and which party has control of the property or process;
(6) Which party pays the property taxes;
(7) Which party bears the risk of loss or damage to the property;
(8) Which party receives the profits from the operation and sale of the property; and
(9) Whether ADVO actively and extensively participated in the management and operations of the activity.
After applying the nine factors to ADVO’s facts and circumstances, the Tax Court held that the printing company, not ADVO, had “produced” the property for Section 199 purposes because the printers retained more of the benefits and burdens of ownership of the property during the production process.
Alvarez & Marsal Taxand Says:
As demonstrated by ADVO, a Section 199 benefits and burdens analysis is inherently fact specific and, as a result, can be time-consuming and expensive to resolve. However, with advance planning, a taxpayer can mitigate or avoid this issue. When you enter a contract manufacturing arrangement, you can insulate yourself from potential Section 199 issues by requesting that the counterparty provide at the time of contracting the certifications required by the October 29 directive. In ADVO, the Tax Court implicitly endorsed this strategy. The court opines in a footnote that the directive “can resolve in advance, cases like this one.”
The October 29 directive, however, cannot be used to prevent all Section 199 controversies in the contract manufacturing arena. Where both the hiring firm and the contract manufacturer believe they are entitled to the deduction or where the taxpayer is simply unable to meet the certification requirements of the directive, the IRS and courts will continue to apply the fact-intensive benefits and burdens standard outlined in ADVO.
We recommend that our clients consider this issue as many enter into a new tax year. If our clients are unable to meet the benefits and burdens standard, we encourage them to consider the economic benefit the contract manufacturer will achieve from this contract as they negotiate pricing for future contracts. Alvarez & Marsal has experience representing our clients in tax and related operating expense reduction projects.
Charles Henderson IV
Managing Director, Atlanta
+1 404 720 5226
Andrew Martin, Senior Director, and Kyle Foust, Associate, contributed to this article.
For More Information:
Robert J. Filip
Managing Director, Seattle
+1 206 664 8910
Managing Director, Washington D.C.
+1 202 688 4213
Managing Director, Miami
+1 305 704 6688
Managing Director, Houston
+1 713 221 3932
As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
About Alvarez & Marsal Taxand
Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the U.S., and serves the U.K. from its base in London.
Alvarez & Marsal Taxand is a founder of Taxand, the world's largest independent tax organization, which provides high quality, integrated tax advice worldwide. Taxand professionals, including almost 400 partners and more than 2,000 advisors in 50 countries, grasp both the fine points of tax and the broader strategic implications, helping you mitigate risk, manage your tax burden and drive the performance of your business.