Now that the domestic production activities deduction under Section 199 of the Internal Revenue Code has finally reached its peak statutory rate, the deduction has become the largest permanent tax benefit for many taxpayers. The increasing size of the benefit has brought increased scrutiny from the Internal Revenue Service (IRS). Indeed, the Section 199 deduction has been designated a Tier 1 issue by the IRS. Accordingly, taxpayers claiming a Section 199 deduction should expect close scrutiny from the IRS on both basic issues of eligibility (i.e., whether the taxpayer's activities meet the requirements of Section 199) and more technical issues of computation. Although taxpayers tend to focus more on the accounting and computation sides of Section 199 deduction, it is important not to overlook the basic eligibility issues. In particular, taxpayers who engage contractors to perform manufacturing services in their domestic production process should be prepared for an IRS audit on the benefits and burdens of ownership issue.
In fact, on February 1, 2012, the IRS issued guidance for examiners seeking to determine which taxpayer in a contract manufacturing situation has the benefits and burdens of ownership for purposes of the Section 199 deduction.
Having recently worked with a taxpayer in an IRS examination of this issue under general tax principles and also under the new IRS examination guidelines, our experience and insight on this issue may be helpful to other companies finding themselves in similar situations.
Background ---- Increased IRS Scrutiny on Section 199
Section 199, enacted as part of the American Jobs Creation Act of 2004, allows qualifying taxpayers a special deduction for goods manufactured or produced in the United States. For taxable years beginning in 2010 and subsequent years, the Section 199 deduction is generally equal to 9 percent of the lesser of (i) qualified production activities income (QPAI) or (ii) taxable income computed without such deduction. Moreover, the Section 199 deduction is further capped by 50 percent of the W-2 wages paid by the taxpayer that are allocable to domestic production.
QPAI is generally computed as the gross proceeds derived from, among other things, the sale of qualifying production property (QPP) that was manufactured or produced in whole or in significant part within the United States, less any cost of sales or allocable expenses or deductions. With some limited exceptions (e.g., for qualified Federal government contracts), only one taxpayer may claim a Section 199 deduction for the same qualifying activity performed in connection with the same QPP. Regulations under Section 199 provide that if a taxpayer engages another party to perform a qualifying activity, then only the person who has the benefits and burdens of ownership of the QPP during the period the qualifying activity occurs is treated as engaged in the qualifying activity and may claim a Section 199 deduction with respect to the QPP. (See Treas. Reg. Section 1.199-3(f)(1).)
For a taxpayer who engages an unrelated contractor to perform a significant part of the manufacturing services in its otherwise qualified domestic production process, a major issue that will be subject to close scrutiny by IRS exam teams is whether the QPP can be deemed to be produced "by the taxpayer," i.e., whether the taxpayer has the benefits and burdens of ownership of the QPP during the manufacturing or production process. This is a high-risk audit issue because (a) it is about eligibility, so that taxpayer could lose all of the Section 199 deduction based on the QPP if the taxpayer loses the issue and (b) the analysis of benefits and burdens of ownership is a complex factual determination that can present a significant amount of uncertainty.
Factors for Testing Benefits and Burdens of Ownership
For purposes of Section 199 deduction, the benefits and burdens of ownership question is determined based on general Federal income tax principles. The regulations under Section 199 do not adopt or refer to a specific type of benefits and burdens of ownership inquiry, out of concern, as noted in the preamble to the proposed regulations, that only a general test can cover all different types of contract manufacturing situations.
There is still no published court decision applying the benefits and burdens of ownership test in the context of Section 199. The regulations under Section 199 provide only a few examples of the benefits and burdens of ownership test. These examples suggest the following factors are potentially relevant in the application of the benefits and burdens of ownership test in the context of a manufacturing contract:
- Whether the taxpayer owns the intellectual property attributable to the design;
- Whether the taxpayer may use the design outside the manufacturing process and has the right to exploit the associated intellectual property;
- Whether the taxpayer controls the details of the manufacturing process while the property is being produced;
- Whether the taxpayer bears the risk of loss or damage during the manufacturing process;
- Whether the taxpayer bears the economic risk of gain or loss; and
- Whether the taxpayer has legal title to the property during the manufacturing process.
The first two factors about ownership of intellectual property and design do not seem to carry as much weight in the regulations as they do in case law about benefits and burdens of ownership in other Federal income tax contexts. In addition to the above factors that are specifically noted by the Section 199 regulations, case law on the benefits and burdens of ownership in a variety of Federal income tax contexts has also evaluated other factors such as:
- What is the intent of the parties with regard to tax ownership of the property;
- Who is the party with the right to possession, control use, and enjoyment of the property;
- Who is the party with power to make decisions about disposition of the property;
- How the parties treat the property for other purposes;
- Which party receives profit from operation of the property; and
- Which party pays the costs of ownership, such as property tax.
No single factor is decisive. An evaluation of the factors generally would need to take into account and weigh all the relevant facts and circumstances. Accordingly, an analysis of the benefits and burdens of ownership in a contract manufacturing arrangement can be complex and uncertain, as a taxpayer will generally have some but not all of the factors in its favor.
New Audit Guidance for Benefits and Burdens of Ownership under Section 199
The IRS recently issued new audit guidance for use by IRS examiners to determine whether a taxpayer has the benefits and burdens of ownership in a contract manufacturing arrangement. The audit guidance sets forth a three-step process that focuses on nine factors (three factors per step) for the benefits and burdens determination. The three steps relate to (1) contract terms, (2) production activities and (3) economic risks. Each step requires the examiner to answer three questions. If the answer is "yes" to at least two of the questions, then the step is completed (in favor of the taxpayer). If any two of the three steps are completed, then the taxpayer is deemed to have the benefits and burdens of ownership for purposes of Section 199.
Step 1 ---- Contract Terms
- Did the taxpayer have title to the work in process (WIP)?
- Did the taxpayer have risk of loss over the WIP?
- Was the taxpayer primarily responsible for insuring the WIP?
Step 2 ---- Production Activities
- Did the taxpayer develop the qualifying activity process (determined without regard to who designed the property, provided the specifications for the property, or holds intellectual rights to the property)?
- Did the taxpayer exercise oversight and direction over the employees engaged in the qualifying activity (determined without regard to who designed the property, provided the specifications for the property, or holds intellectual rights to the property)?
- Did the taxpayer conduct more than 50 percent of the quality control tests over the WIP while the qualifying activity was occurring?
Step 3 ---- Economic Risks
- Was the taxpayer primarily liable under the "make-good" provisions of the contract, for example, the warranty, quality of work, spoilage, overconsumption or indemnification provisions?
- Did the taxpayer provide more than 50 percent, based on cost, of the raw materials and components used to produce the property?
- Did the taxpayer have the greater opportunity for profit increase or decrease from production efficiencies and fluctuations in the cost of labor and factory overhead?
If at least two of the three steps are not completed, i.e., each step having at least two "no" answers, then the guidance instructs the examiner to determine the benefits and burdens issue based on all facts and circumstances as in any examination risk assessment. For that broad analysis, the guidance instructs the examiner not to rely solely on the nine questions listed in the guidance but to consider all relevant factors.
The new audit guidance provides a uniform method for IRS examiners to evaluate the benefits and burdens issue. However, the new audit guidance does not provide definitions or explanations to clarify the meaning of some of the questions and how they are to be applied. Hence, there remains a significant amount of ambiguity and uncertainty in any audit process on the benefits and burdens of ownership issue.
Alvarez & Marsal Taxand Says:
The new IRS audit guidance serves as a reminder that the IRS is focused on the Section 199 deduction, particularly in the context of contract manufacturing arrangements. Taxpayers with such arrangements should prepare well in advance for an IRS inquiry on the issue of eligibility (i.e., benefits and burdens) for the Section 199 deduction.
Taxpayers who prepare for an audit on the benefits and burdens issue should begin by developing a solid summary of all relevant facts with the audit guidance in mind. From our experience with an IRS audit of the benefits and burdens issue, the IRS tends to focus on the language in the contracts or public documents and neglect to develop a full understanding of the facts and the operation of the parties. Because the actual relationship between a taxpayer and the contractor in a continuous service arrangement often goes well beyond the standard contracts and is governed also by order forms, price sheets, technical instructions and specifications, quality control procedures, other documents and actual conduct of the parties, it is important for the taxpayer to include company personnel knowledgeable about the production process in gathering the facts. It is quite likely that many important facts showing the extent of the taxpayer's control over details of the production process or the taxpayer's economic risk of loss are not reflected in the contracts or other documents, and need to be gathered from people with direct knowledge of the production process.
In our experience, it is likely to be in the taxpayer's interest to define the production process for the IRS, to demonstrate how many activities performed by the taxpayer are part of the production process and to show these activities as practical necessities or industry norms.
The new IRS audit guidance gives taxpayers a uniform audit check: if the taxpayer meets enough of the factors and steps, then the taxpayer is deemed to have the benefits and burdens of ownership. If not, the examiner is required to go on to examine all relevant facts and circumstances. Accordingly, the three-step process in the audit guidance can be thought of as more restrictive than the general benefits and burdens standard under case law. Because some of the questions in the new audit guidance could be open to different interpretations, a taxpayer should present its case not just in a narrow fashion focusing on the questions in the new audit guidance, but in a broader narrative that reflects other relevant facts and circumstances.
The questions in the new IRS audit guidance can also serve as a frame of reference for planning purposes, to help taxpayers know what factors to focus on to improve their tax position and minimize any audit or litigation risk with respect to the benefits and burdens issue. Nonetheless, taxpayers should not lose sight of other criteria that could be relevant for a determination of benefits and burdens of ownership. For example, although the audit guidance does not focus on the intent of the parties with regard to tax ownership of the property during the production process, in our experience it is still helpful for the contracts and other related documents such as purchase orders to reinforce or clearly express the intent of the parties that the taxpayer be treated as the manufacturer and producer in the relationship under Federal income tax principles, e.g., by using terms and language that better characterize a contract service relationship rather than a buy-and-sell manufacturing arrangement.
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Nicholas Nguyen, Director, contributed to this article.
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