Ramifications of removing the section 199 benefits-and-burdens test
INSIGHT ARTICLE |
Section 102(a) of the American Jobs Creation Act of 2004, P.L. 108-357, enacted section 199, allowing the domestic production activities deduction. Congress enacted the deduction to “improve the cash flow of domestic manufacturers and make investments in domestic manufacturing facilities more attractive,” believing that doing so would “create and preserve U.S. manufacturing jobs” (H.R. Rep’t No. 108-548, 108th Cong., 2d Sess., at 115 (2004)).
The original version of the deduction was phased in through 2009 and is currently equal to 9 percent of the lesser of the taxpayer’s qualified production activities income (QPAI) or the taxpayer’s taxable income. The amount of the deduction cannot exceed 50 percent of the taxpayer’s Form W-2 wages for the tax year. To determine QPAI, a taxpayer must compute its domestic production gross receipts (DPGR). DPGR are the taxpayer’s gross receipts that are “derived from any lease, rental, license, sale, exchange, or other disposition of qualifying production property [QPP] which was manufactured, produced, grown, or extracted [MPGE] by the taxpayer . . . , any qualified film produced by the taxpayer, or electricity, natural gas, or potable water produced by the taxpayer in the United States” (section 199(c)(4)).
Taxpayers often enter into contractual arrangements with other parties to perform all or a portion of the activities required to produce QPP. This contractual relationship requires an analysis to determine which taxpayer is entitled to take the section 199 deduction. Section 199(d)(10) directs Treasury to prescribe regulations to carry out the purposes of section 199, including rules preventing more than one taxpayer from being allowed a deduction for a single activity. To limit the deduction to one taxpayer, Regs. section 1.199-3(f)(1) requires that “only the taxpayer that has the benefits and burdens of ownership of the QPP” be treated as engaged in the qualifying activity. The determination of which party to the contract has the benefits and burdens of ownership is to be based on all relevant facts and circumstances. This analysis is often referred to as the benefits-and-burdens test.
Although Regs. section 1.199-3(f)(4) includes three examples demonstrating the application of the benefits-and-burdens test, subsequent rulings and case law relied on varying factors, which made determining a taxpayer’s eligibility for the deduction laborious and uncertain. This ambiguity burdened taxpayers that sought certainty as to the rightful recipient of the deduction before engaging in contract manufacturing arrangements and caused time-consuming exams and incongruent results for IRS agents. In response to these issues, the IRS released a series of directives to provide examiners with an appropriate process to follow in determining whether a taxpayer has the benefits and burdens of ownership. It is important to note that IRS directives are not official pronouncements of law and cannot not be relied on as precedent.
In February 2012, the IRS released directive LB&I-4-0112-001 (the first directive), which provided examiners with a three-step process for analyzing a taxpayer’s benefits and burdens. Each step consisted of three questions; to complete a step, two of the three questions had to be answered in the affirmative. If two of the three steps were completed, the taxpayer was deemed to have the benefits and burdens of ownership. If two of the three steps were not completed, the examiner was directed to conduct a facts-and-circumstances test based on all relevant factors.
Step one related to the contract terms and asked if the taxpayer had title to, risk over, and primary responsibility for insuring the work in process. Step two focused on production activities and asked about the development of the activity process, oversight of the employees engaged in the activity, and the portion of quality-control tests the taxpayer conducted. If both these steps were completed, the agent was advised that step three was not necessary. However, if only one step was completed, the agent was to continue to step three. Step three addressed economic risks and asked if the taxpayer was primarily liable for any “make-good” provisions of the contract, provided more than 50 percent (based on cost) of the raw materials and components used to manufacture the property, and had a greater opportunity for profit or a decrease in production inefficiencies.
After reconsidering its approach, the IRS released directive LB&I-4-0713-006 in July 2013 and an update to that directive in October 2013 (LB&I-04-1013-008). These directives superseded the first directive and aimed to ease the “extensive resource expenditures for taxpayers and the Service” that came with attempting to apply the facts-and-circumstances approach to the benefits-and-burdens test (see LB&I-04-1013-008, or the third directive).
The third directive advises examiners who are deciding whether to challenge a taxpayer’s position to request that the taxpayer provide three statements to demonstrate that it is the party with the benefits and burdens of ownership. The first is a statement explaining the taxpayer’s basis for determining it has the benefits and burdens of ownership. The second and third are certification statements, one signed by the taxpayer and one by the counterparty. Templates for the certification statements are attached as appendices to the directive and state that the taxpayer has the benefits and burdens over the QPP and that the counterparty will not claim a deduction for the property.
The Tax Court addressed the benefits-and-burdens test in its ruling in ADVO, Inc., 141 T.C. 298 (2013). In ADVO, the court conducted a facts-and-circumstances analysis based on nine factors, emphasizing that no one factor is determinative. These factors were (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 the company actively and extensively participated in the management and operations of the activity” (141 T.C. at 324–325). These factors are the ones currently relied upon to conduct the benefits-and-burdens test, and, unlike the IRS directives, the ADVO decision can be used and relied upon as legal precedent.
On Aug. 27, 2015, Treasury issued proposed regulations (REG-136459-09) covering many section 199 issues, including the benefits-and-burdens test. The proposed regulations would remove the benefits-and-burdens test entirely and instead provide that, in a contract manufacturing relationship, the party that performs the section 199 activity is the taxpayer eligible for the deduction. The preamble says the purpose for this conclusive and unilateral rule is threefold: (1) to provide administrable rules consistent with the statute, (2) to reduce the burden on both the IRS and taxpayers in evaluating the benefits-and-burdens-of-ownership factors, and (3) to prevent more than one taxpayer from being allowed the deduction, as required under section 199(d)(10).
Currently, taxpayers have an incentive to contract with domestic contract manufacturers to manufacture the products they wish to outsource to third parties. A taxpayer that maintains the benefits and burdens of ownership over the property is the taxpayer eligible for the deduction (see the nine ADVO factors, above). However, under the proposed rule, the contract manufacturer becomes the one eligible for the deduction. This poses two distinct problems:
1. Without an incentive to use the domestic contract manufacturer, the taxpayer might move its manufacturing activities abroad to a location where the activities could be completed for significantly less money. This outcome would be in direct contrast to Congress’s stated intent of increasing domestic manufacturing activities. Treasury has suggested that a taxpayer might be able to utilize the deduction if the contract manufacturer were to pass it through to the taxpayer (see IRS Public Hearing on Proposed Regulations, “Amendments to Domestic Production Activities Deduction Regulations; Allocation of W-2 Wages in a Short Taxable Year and in an Acquisition or Disposition,” Dec. 16, 2015). However, this fails to take into account that, in most situations, the deduction for a contract manufacturer would be far less than the corresponding deduction to the taxpayer under the benefits-and-burdens test, simply because a contract manufacturer’s profit margin is generally going to be less than the taxpayer’s).
2. By deeming the contract manufacturer as the taxpayer eligible to take the deduction, Treasury creates a larger conundrum within the further requirements of the section 199 rules. Specifically, how can a contract manufacturer lease, rent, sell, exchange, or dispose of QPP that is MPGE when the contract manufacturer is merely performing a service, may not have title to the property, and thus may be unable to make a sale or disposition? If the contract manufacturer is unable to meet this requirement, the section 199 deduction would be disallowed to both parties. Not only would congressional intent again be thwarted under these circumstances, but so would achievement of Treasury’s stated purpose of reducing the IRS’s burden in evaluating the factors of the benefits-and-burdens test.
A benefits-and-burdens analysis would become necessary to determine if the contract manufacturer had the proper possession over the production property such that it could sell or dispose of the property. Although the proposed rules would succeed in preventing more than one taxpayer from being allowed a section 199 deduction, had Congress sought a rule disallowing either party to a contract the ability to claim the deduction, it likely would have phrased section 199(d)(10) in that way.
Treasury’s stated purpose of providing administrable rules consistent with section 199 that also reduce the IRS’s burden in evaluating the benefits-and-burdens factors is not realized by the proposed rule. Furthermore, the stated purpose in the preamble to the proposed regulations of reducing the IRS’s burden of evaluating the ownership factors overlooks the third directive (LB&I-04-1013-008), which already shifts most of the burden of establishing ownership onto the taxpayer in the form of certification statements. As discussed above, the proposed rule is not consistent with section 199 and likely would not reduce the IRS’s burden more than the third directive already has, as a benefits-and-burdens analysis would be necessary to qualify for other aspects of the deduction. For these reasons, it is likely that manufacturers would be unduly disadvantaged by the removal of the benefits-and-burdens-of-ownership test from the present regulations.
Excerpted from the April 2016 issue of The Tax Adviser. Copyright © 2016 by the American Institute of Certified Public Accountants, Inc.