2016-Issue 6 – If you haven’t heard, the latest installment of the Star Wars saga arrived in theaters in mid-December. Incredibly, it’s been almost 40 years since the original Star Wars premiered. In that first episode, Luke Skywalker and a plucky group of rebels band together to destroy the Galactic Empire’s Death Star. In the sequel, The Empire Strikes Back, the Galactic Empire, led by evil Darth Vader, pursues and captures many of the rebels and severely wounds Luke Skywalker.
In a similar vein, a band of rebel courts deeply wounded the Treasury “Empire” and halted its intention to limit the application of the Internal Revenue Code Section 199 domestic production deduction (DPD). In the present episode, Treasury has struck back with proposed regulations in an attempt to defeat the courts and reimpose order upon the DPD galaxy. Now that we’ve grabbed your attention, here’s your chance to get your popcorn and prepare for another thrilling episode.
Section 199, in General
The DPD was designed to protect United States jobs and replace the extraterritorial income exclusion. It covers a broad range of production activities, including the manufacture of tangible personal property; the production of computer software, sound recordings and certain films; the production of electricity, natural gas and water; and construction, engineering and architectural services.
The Section 199 regulations broadly describe manufacturing as “manufacturing, producing, growing, extracting, installing, developing, improving, and creating.” This includes “making qualified property out of scrap, salvage, or junk material as well as from new or raw material by processing, manipulating, refining, or changing the form of an article, or by combining or assembling two or more articles.” Unfortunately, Section 199 does not provide a definition of manufactured, produced, grown or extracted (MPGE).
However, the regulations also provide that if a taxpayer packages, repackages, labels or performs minor assembly of qualified property and the taxpayer engages in no other MPGE activity with respect to that qualified property, then the taxpayer's packaging, repackaging, labeling or minor assembly does not qualify for the deduction. These terms — packaging, repackaging, labeling and minor assembly — are not defined in the regulations, except for an example stating that customizing automobiles by adding roof racks, sunroofs, etc., is minor assembly and not an MPGE activity.
The Dean and Precision Dose Decisions: Transforming a Product’s Demand = Section 199 Manufacturing
As previously discussed in Tax Advisor Weekly 2013-45 (“Don't Look a Gift Horse in the Mouth: the Dean Decision Means Now Is the Time to Reexamine Your Section 199 Methodology”), the taxpayers in United States v. Dean, No. 11-01977 (C.D. Cal. 2013) were the owners of an S corporation, Houdini, Inc., that was in the business of “designing, assembling, and selling” gift baskets and gift towers through retail and wholesale distributers. Houdini purchased all the products used in the gift baskets and towers (i.e., prepackaged candy, chocolate, cheese, wine and crackers) and assembled the final product for sale. Houdini had approximately 300 full-time employees and hired about 4,000 temporary employees during its busy season of August through December. During the holiday season, Houdini finished up to 80,000 gift baskets in one day.
The IRS filed suit on the basis that Houdini and its shareholders were not entitled to a Section 199 deduction because Houdini merely packaged and repackaged items in the gift baskets. Houdini’s shareholders contended that Houdini manufactured or produced gift baskets. The California district court agreed that Houdini’s activities rose to the level of MPGE and qualified for the Section 199 deduction. The court held that Houdini’s activities were not merely packaging, but changed the “form and function” of the individual items into a new product with a different demand (i.e., from a grocery item into a holiday gift).
Because Section 199 does not specifically define MPGE, the court initially turned to Merriam-Webster’s dictionary to determine the “ordinary, contemporary, common meaning” of manufacture and package. These definitions include for manufacturing, “to make a product suitable for use . . . by hand or by machinery . . . according to an organized plan and with division of labor” and for packaging, “to make into a package . . . in such a way as to heighten its appeal.” Relying on these definitions, the court stated that because Houdini makes products suitable for use as gifts using machinery and according to an organized plan with division of labor, that its activities may qualify as manufacturing or production under Section 199. However, the court also noted that Houdini takes items and puts them together in a package to make them more attractive to the public, so alternatively, Houdini’s activities may only involve packaging.
To resolve this question, the court then looked to the regulations and determined that Houdini’s production process “changes the form of an article.” Specifically, the court found that Houdini’s “complex production process” relies on assembly line workers and machines to produce gift baskets and towers that are “distinct in form and purpose from the individual items inside.” The court noted that the “individual items would typically be purchased by consumers as ordinary groceries . . . but after Houdini’s production process, they are transformed into a gift that is usually given during the holiday season.”
The court further distinguished Houdini’s activities from the “minor assembly” example in the prior final regulations involving the customization of an automobile. The court held that Houdini changes the form and function of the individual food items by creating distinct gifts through its production process. According to the court, Houdini “creates a new product with a different demand.” The court also favorably quoted an IRS notice (2005-14, 2005-1 C.B. 498) that states “the IRS and Treasury believe Congress intended for the deduction under section 199 to be available for a wide variety of production activities” and therefore “defines MPGE broadly.”
A similar decision was reached by another court in Precision Dose, Inc. v. United States, No. 3:12-cv-50180 (N.D. Ill. 2015). That court held that a company purchasing drugs in bulk and reselling them in non-reusable containers for single-dose administration qualified for the Section 199 domestic production deduction. The taxpayer in Precision Dose purchased drugs and containers from third parties and processed them to produce a prepackaged unit dose.
The Precision Dose court concluded that for purposes of Section 199, the prepackaged unit doses were qualified production property that was MPGE in the United States by the taxpayer. The court rejected the government’s argument that the taxpayer’s activities were excluded from Section 199 because they constituted packaging, repackaging, labeling or minor assembly. In its opinion, the district court cited and accepted the reasoning of the Dean court. The Precision Dose court found the taxpayer’s production of prepackaged unit doses to be analogous to the production of gift baskets in Dean and viewed its packaging or repackaging activity as ancillary to a complex production process resulting in a distinct final product. The court disagreed with the government that Dean was wrongly decided and determined the taxpayer’s prepackaged unit doses to be unique products, holding that the gross receipts from the sale of the products resulted in domestic product gross receipts for purposes of Section 199.
Proposed Section 199 Regulations
On August 26, 2015, the Treasury Department issued proposed regulations under Section 199 (REG-136459-09) that addressed a number of technical issues. If finalized, these regulations will apply to tax years beginning on or after the date the final regulations are published in the Federal Register. Comments regarding the proposed regulations were due on November 25, and a public hearing was held on December 16.
The proposed regulations address 11 separate areas under Section 199. These include certain issues related to qualified films, oil-related production activities, gross receipts realized from multiple building projects, hedging transactions, the definition of “by the taxpayer,” allocating cost of goods sold under a long-term contract method, agricultural and horticultural cooperatives, and activities occurring in Puerto Rico. In terms of potential impact on taxpayers, the proposed regulations attempt to limit the scope of what activities qualify as “manufacturing” in a direct rebuke to the Dean and Precision Dose decisions.
Regarding what activities may qualify as manufacturing, the proposed regulations state:
Section 1.199-3(e)(2) provides that if a taxpayer packages, repackages, labels, or performs minor assembly of QPP and the taxpayer engages in no other MPGE activities with respect to that QPP, the taxpayer's packaging, repackaging, labeling, or minor assembly does not qualify as MPGE with respect to that QPP. This rule has been the subject of recent litigation. See United States v. Dean, 945 F. Supp. 2d 1110 (C.D. Cal. 2013) (concluding that the taxpayer's activity of preparing gift baskets was a manufacturing activity and not solely packaging or repackaging for purposes of section 199). The Treasury Department and the IRS disagree with the interpretation of section 1.199-3(e)(2) adopted by the court in United States v. Dean, and the proposed regulations add an example (Example 9) that illustrates the appropriate application of this rule in a situation in which the taxpayer is engaged in no other MPGE activities with respect to the QPP other than those described in section 1.199-3(e)(2).
Although not a direct response to the Dean and Precision Dose decisions, the proposed regulations also remove the rule in Section 1.199-3(f)(1) that treats a taxpayer in a contract manufacturing arrangement as engaging in the qualifying activity only if the taxpayer has the benefits and burdens of ownership during the period in which the qualifying activity occurs. In place of the benefits and burdens of ownership rule, the proposed regulations provide a new bright-line rule that states that if a qualifying activity is performed under a contract, then the party that performs the activity is the taxpayer for purposes of Section 199(c)(4)(A)(i).
Alvarez & Marsal Taxand Says:
We feel the proposed Section 199 regulations should be improved prior to being finalized. We recommend that the final regulations adopt the standard applied by the Dean and Precision Dose courts in determining whether a taxpayer’s production activities satisfies Section 1.199-3(e)(1)’s MPGE requirement. That is, if a taxpayer’s production activities change the form and function of an item (and therefore, the potential market or demand for the item), then the taxpayer’s activities satisfy the MPGE requirement. This rule would further Congressional intent that the Section 199 deduction be available to a wide range of taxpayers and that the term MPGE be broadly defined.
We also recommend that the final regulations should either retain the current benefits and burdens standard or allow the parties in a contract manufacturing arrangement to agree who possesses the benefits and burdens of ownership during production and is thus entitled to the Section 199 deduction. The new bright-line rule included in the proposed regulations would not properly address the complexity that exists in most contract manufacturing situations. In most cases, the proposed regulations' performing party rule would not incentivize the party that actually makes the decision to manufacture products in the United States.
Although the Treasury / IRS Empire has struck back at the Dean and Precision Dose courts with the proposed Section 199 regulations, it should keep in mind the Star Wars trilogy’s conclusion, Return of the Jedi. In that epic finale, the Galactic Empire and Darth Vader were eventually defeated because they could not overcome the strong force used by the rebels to destroy a second Death Star. That same strong force of logic was evident in the Dean and Precision Dose decisions. Those courts correctly interpreted Congressional intent and applied Section 199’s MPGE requirement broadly. Just like Darth Vader, Treasury’s proposed changes regarding what qualifies as manufacturing under Section 199 are destined to end up on a funeral pyre, as taxpayers continue to broadly define and apply the MPGE standard as Congress intended.
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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 advisers. 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 advisers before determining if any information contained herein remains applicable to their facts and circumstances.
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