On April 1, the Internal Revenue Service (IRS) released ILM 2013130201 (ILM) in response to an IRS Appeals Division request. It concludes that planning and development activities undertaken by a publisher of books and other printed materials did not constitute a qualifying manufacture, production, growth, or extraction activity for purposes of the Section 199 deduction.2 The issues raised in the ILM are similar to those in two pending U.S. Tax Court cases. The pending results in these cases may have a dramatic effect on taxpayers who enter into contract manufacturing arrangements and claim a Section 199 deduction.
Section 199 Background
Section 199 allows a deduction equal to a percentage of a taxpayer's income attributable to domestic production activities. For taxable years beginning in 2010 and thereafter, the deduction is generally equal to 9 percent of the lesser of either a taxpayer's "qualified production activities income" (QPAI) or taxable income determined without regard to the deduction itself. QPAI for any taxable year is equal to the taxpayer's "domestic production gross receipts" (DPGR), reduced by the sum of the cost of goods sold and below-the-line expenses allocable to DPGR.
For a taxpayer to have DPGR and the ability to claim the Section 199 deduction, it must meet several requirements. One of those requirements is to have the DPGR derived from the sale of qualified production property manufactured "by the taxpayer."3 Treas. Reg. Section 1.199-3(f)(1) further defines what is meant "by the taxpayer" in that only the taxpayer that has the "benefits and burdens" of ownership of the qualified production property during the period in which the production activities occur can claim the benefits of Section 199. This means that only one taxpayer may claim the domestic production activities deduction for the same function performed with respect to the same property. Consequently, with specified exceptions (e.g., for certain government contractors), if one party performs any qualifying Section 199 production activity under a contract with another party, then only the taxpayer that has the benefits and burdens of ownership of the property while the activity occurs is treated as having performed the qualifying Section 199 production activity with respect to that property.4 The parties cannot by contract designate which one is to be treated as having the benefits and burdens of ownership of the relevant property under federal income tax principles.5
Determining which party meets the benefits and burdens requirement is based on all of the facts and circumstances.6 Treas. Reg. Sec. 1.199-3(f)(4) contains two examples illustrating various factors relevant to the benefits-and-burdens determination for nongovernment contracts. The two examples cite various ownership factors contained in the extensive body of case law addressing ownership for federal income tax purposes, including whether the taxpayer owns the intellectual property associated with the qualified property, who controls the production process details, and who bears the risk of loss or damage during production, realizes economic gain or loss upon disposition of the qualified property or possesses legal title to the qualified property during the production process.
The IRS Large Business & International Division issued Directive 4-0112-001 (Directive), which outlines a three-step process containing nine factors to assist with the determination of who has the benefits and burdens of ownership for Section 199.7 The Directive outlines three steps, each of which consists of three yes/no questions addressing specific factors relevant to determining whether a taxpayer meets the benefits and burdens requirement.8 The Directive instructs IRS examiners to apply the step process in a matrix type of application. If the answer is "yes" to at least two of the questions in the step, the step is completed (i.e., the benefits and burdens requirement is deemed satisfied for that step). If any two of the three steps are affirmatively completed, the taxpayer has met the benefits and burdens requirement for purposes of Section 199. Conversely, if at least two of the three steps are not affirmatively completed (i.e., the benefits and burdens requirement is not satisfied for at least two of the three steps), the examiner is then instructed to perform a facts and circumstances analysis to determine whether the taxpayer has met the benefits and burdens requirement. The Directive further instructs that if the facts and circumstances analysis is required, tax examiners "should consider all relevant factors" and not rely solely on the nine factors cited in the Directive.9 A taxpayer may thus still rely on the traditional factors not outlined in the Directive in determining if it has the benefits and burdens of ownership. Its seems that the Directive, however, is still leaving taxpayers that enter into contract manufacturing arrangements with uncertainty as the IRS is applying the laws narrowly when it comes to Section 199.
ILM
The taxpayer-publisher in the ILM performed market research, resource planning, content and layout development, and editing activities that facilitated the creation of an electronic version of a book. The publisher also developed print specifications, including paper type, page size, printing process, ink type, and binding. To mass-produce its books, the publisher provided a contract manufacturer with the electronic version of the book and its print specifications. The contract manufacturer used its own employees, machinery, and plant to print and assemble the books. The contract manufacturer would either ship the books directly to customers or ship them to the publisher for packaging and distribution.
The IRS determined in the ILM that the taxpayer's activities of producing the electronic books do create valuable assets but that those assets are intangibles and therefore do not qualify as QPP. The ILM states that a taxpayer's non-manufacturing activities could be considered part of the manufacturing of qualifying production property if the taxpayer performed other activities that were the manufacturing of QPP. In the ILM, however, the taxpayer contracted with a manufacturer to produce the book. Because a different taxpayer performed the manufacturing activities, the taxpayer's activities were not part of the manufacturing of the QPP according to the ILM. The IRS also concluded that providing print specifications to the manufacturer did not produce QPP.10
The ILM focused on Example 5 of Treas. Reg. Sec. 1.199-3(e)(5) in reaching its conclusion. In that example, the taxpayer performs materials analysis and selections, subcontractor inspections and qualifications, testing of component parts, assistance to customers in their review and approval of the QPP, routine production inspections, product documentation, diagnosis and correction of system failure, and packaging for shipment to customers. The example concludes that these activities are part of the manufacturing of the QPP because the taxpayer performed the manufacturing. If the taxpayer did not manufacture the QPP, then those activities are not part of the QPP. Thus, the IRS believes that the activities would only be part of the manufacturing of QPP if the publisher did the manufacturing itself and had not contracted with a manufacturer for the contract manufacturer to mass-produce the books. The IRS seems to be creating a rule out of the example in the Regulations that does not exist by not analyzing the benefits and burdens in the ILM.
Tax Court Cases
There are a pair of Tax Court cases pending that could be very influential in determining how to apply the Section 199 rules in contract manufacturing situations. The first case, Advo Inc. & Subsidiaries v. Commissioner of the Internal Revenue is currently pending decision in the Tax Court.11 According to the Tax Court petition, Advo sells printed advertising products to its customers and subcontracted the printing of certain printed advertising products to third-party commercial printers under a cost-reimbursement arrangement. During the printing process, Advo owned the paper on which the product was printed and the ink was owned by the third-party printer. Moreover, the contracts between Advo and the printer specified that they were for printing services and not the sale of goods. Advo claimed a Section 199 deduction for the printed products and the IRS denied the deduction because Advo did not establish that the qualified property was manufactured by Advo.
The IRS response in its reply brief urges the Tax Court to deny the deduction because it believes that Advo did not possess the benefits and burdens of ownership during the manufacturing process. In the reply brief, the IRS rejects Advo's "cradle to grave" argument that it should receive the Section 199 deduction for activities in the beginning of the process, when Advo's client place an order, and the end of the process, when it is delivered.12 The IRS argues that these activities are not manufacturing and thus precludes Advo from claiming the Section 199 deduction. The flaw in this argument is that these activities may be non-manufacturing activities in a vacuum. But, the design, selling and delivery are critical factors in the overall ownership of the qualified property that is being manufactured and must be considered when determining which party has the benefits and burdens of ownership. The printer is merely a service provider that has been contracted by Advo. The fact that the printer owns the equipment and the labor force that does the physical labor is not as relevant a factor since it is at the direction of Advo, who was the owner of the property.
The second Tax Court case with this issue, Limited Brands Inc. and Subsidiaries et al. v. Commissioner of Internal Revenue, is pending hearing.13 According to the petition, Limited Brands manufactures and produces personal care products under several brands including Victoria's Secret and Bath and Body Works. A subsidiary of Limited Brands manufactured various products and contracted with numerous vendors and contract manufacturers to produce and assemble these products. Limited Brands controlled and monitored every stage of the production cycle as well as controlled all design and testing of the products. Importantly, Limited Brands owned all the intellectual property created during the development of its products and limited the ability of the vendors and contract manufacturers from selling any of the products to third parties under their contracts. Limited Brands claimed a Section 199 deduction for these activities and the IRS denied the deduction because it believed that Limited Brands could not establish that it manufactured the QPP. While this case is pending hearing, Limited Brands has submitted an amicus brief in the Advo case. In the amicus brief, Limited is properly pointing out that the design and intellectual property ownership are key factors that should weigh on who has the benefits and burdens of ownership.
Pepper Perpective
By denying the taxpayers their respective Section 199 deductions, the IRS is taking a very narrow view of contract manufacturing arrangements and seems to be at odds with the legislative purpose of Section 199. For example, the IRS asserted in its opening brief in the Advo case that Section 199 "is not a deduction for taxpayers, like Advo, who use the manufacturing services of other taxpayers in the court of their business operations" and that Congress "expressed concern with taxpayers attempting to piggyback onto the manufacturing operations of other taxpayers."14 These statements are in contradiction to the Section 199 rules. There is no prohibition in the legislative history, statutes or Treasury Regulations that prohibits the use of contract manufacturers. The taxpayer merely needs to meet the benefits and burdens of ownership during the manufacturing process. It doesn't matter who performs the process to have manufactured the QPP, as it is a facts-and-circumstances test. The design, title and intellectual property ownership of the property must key factors that weigh heavily on determining the benefits and burdens of ownership. The IRS is reading the examples contained in the Treasury Regulations and the LMSB directive as if they are rules that exclude certain facts from making a determination as to who has the benefits and burden of ownership. To make that determination, all relevant factors need to be weighed. Clearly, the design of a product as well as intellectual property ownership must be highly relevant in considering ownership. An IRS win in court would not only be an erroneous application of the Section 199 rules, it may potentially drive jobs offshore, which is contrary to the intent of the legislation in the first place.
Footnotes
1 April 1, 2013. An ILM is an IRS Legal Memorandum.
2 Unless otherwise stated, all references to "Section" are to the Internal Revenue Code of 1986, and all references to "Regulation" or "Treas. Reg." are to the Treasury Regulations promulgated thereunder.
3 Section 199(c)(4)(A)(i)(1).
4 Treas. Reg. Section 1.199-3(d)(1) and Treas. Reg. Section 1.199-3(e)(1).
5 See Preamble to TD9263, 5/24/2006.
6 Treas. Reg. Section 1.199-3(f)(1).
7 LB&I-4-0112-001 (Feb 1, 2012).
8 The three steps and nine questions outlined in the directive are reproduced below:
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 quali
fying 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?
9 The Directive specifies that the guidance is applicable only where the contract parties are not treated as related persons under Section 199(c)(7).
10 Curiously, the IRS National Office did not address in the ILM the benefits and burdens of ownership issue at Appeals request. Also of note, the release date of the ILM was prior to the LMSB directive issued in 2012, which may be why the benefits and burden issue was not addressed.
11 Docket No. 17247-10.
12 Page 41 of the reply brief for respondent.
13 Docket Nos. 17903-10 and 14667-12.
14 Pages 55 and 56 of the opening brief.
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