Advertising allowances and domestic production activity deductions
TAX ALERT |
The IRS recently released a generic legal advice memorandum (GLAM) addressing the circumstances under which advertising allowances can be included in domestic production gross receipts (DPGR) for purposes of the domestic production activities deduction (DPAD) contained in section 199.
Based on the GLAM, retailers should review any current advertising or marketing agreements they have with vendors to assess the relevant language pertaining to advertising allowances. If a taxpayer wants to include for DPAD purposes any advertising allowances received, it should clearly indicate in the relevant advertising and marketing agreements that the advertising allowances are intended to compensate the retailer for advertising services performed.
Advertising allowances are commonly used in the retail industry to encourage a retailer to promote a specific vendor’s products. The vendor could be a manufacturer, supplier, wholesaler or distributor of a product. Under a typical arrangement, the vendor and retailer will contractually agree as to exactly how the vendor’s products will be promoted by the retailer. For example, an electronics retailer may agree to produce a printed advertising flyer promoting a specific vendor’s electronic products and may agree to distribute the flyers in the retailer’s stores and through the mail and newspapers. Typically, the retailer bears responsibility for all aspects of designing, creating and distributing the advertising materials and bears the upfront costs of producing the materials. In return, the retailer receives an advertising allowance from the vendor. The agreement between the parties could provide that the amount of the allowance will be based on the volume of advertised products that the retailer purchases from the vendor during a specified period. Advertising allowances can be paid directly by the vendor to the retailer or can be issued as a credit against past or future purchases.
For tax purposes, payments made by vendors to retailers as an inducement to purchase a vendor’s products are not treated as separate items of gross income by the retailer, but instead are considered adjustments to the cost of the merchandise purchased. The intent of the parties to the agreement is the key factor in determining whether a payment, credit, rebate or allowance is a purchase price adjustment or something else. If the parties intended the payment to represent an adjustment to the price of the product, then the consideration given is a purchase price adjustment and not a separate item of gross income.
If an allowance is contingent on the performance of services by the purchaser, the allowance is not a trade or other discount, and hence not a purchase price adjustment. Instead, the allowance would be considered a separate item of gross income under section 61.
These distinctions are important for purposes of the DPAD because the calculation depends in part on the classification of items comprising a taxpayer’s DPGR. The Code defines DPGR as the taxpayer’s gross receipts derived from any lease, rental, license, sale, exchange or other disposition of qualifying production property that was manufactured, produced, grown or extracted (MPGE) by the taxpayer in whole or in significant part in the United States. Gross receipts derived from an advertising allowance would not be included in the definition of DPGR because they do not involve a disposition of production property. IRS regulations provide generally that the gross receipts described above do not include advertising income and product-placement income.
An exception to these rules, however, allows advertising-related gross receipts to qualify as DPGR in cases of certain tangible personal property. Reg. section 1.199-3(i)(5)(ii) provides that a taxpayer’s gross receipts derived from the disposition of newspapers, magazines, telephone directories, periodicals and other similar printed publications that are MPGE in whole or significant part within the United States include the advertising income from advertisements placed in those media, but only if the gross receipts, if any, derived from the disposition of the newspapers, magazines, telephone directories or periodicals are (or would be) DPGR.
The IRS provided three fact patterns to illustrate these rules:
Fact pattern 1
Retailer and Vendor enter into an agreement under which Retailer is required to perform advertising services for Vendor. Retailer will receive an allowance for including Vendor’s products in weekly advertising flyers and must comply with Vendor’s advertising policies in order to receive the allowance. The allowance is based on a percentage of Retailer’s purchase costs for the advertised products during a certain period. The amount of the allowance is reasonable compared to the advertising services being performed by Vendor. Under these facts, the purpose and intent of the allowance is to compensate Retailer for performing advertising services for Vendor, and the allowance is treated as a separate item of gross income under section 61.
In the first year, the Vendor pays Retailer a $5 advertising allowance pursuant to their agreement. Prior to this allowance, Retailer’s gross receipts from the sale of the advertised products are $100, its cost for the products sold is $20, and its cost to produce and distribute the advertising materials is $25. As noted above, under these facts, the $5 advertising allowance is treated as a separate item of gross income for federal income tax purposes. Accordingly, Retailer’s taxable income before the application of section 199 is:
|Gross income ($100 gross receipts minus $20 cost of goods sold)||$80|
|Advertising service income
|Expense to produce and distribute advertising||(25)|
|Retailer’s taxable income||$60|
The advertising allowance, as a separate item of gross income, must be categorized for purposes of the DPAD. As noted above, while the income is related to advertising services and would normally not be considered DPGR, there is an exception that allows gross receipts from advertising to qualify as DPGR in cases of certain tangible personal property. The flyers would be “other similar publications” for purposes of the application of Reg. section 1.199-3(i)(5)(ii). As a result, the gross receipts derived from the advertising allowance associated with the design and production of the flyers would be included in DPGR, assuming Retailer met all the other requirements of section 199.
Fact pattern 2
Retailer and Vendor enter into an agreement under which Retailer will provide advertising services for Vendor. Retailer will receive a flat rate allowance for including advertisements of Vendor’s products in Retailer’s weekly advertising flyer and must comply with Vendor’s policies and procedures in order to receive the allowance. The allowance is not calculated based on Retailer’s purchase costs of the advertised products, and Retailer is not required to purchase any of Vendor’s products. The allowance is reasonable in relation to advertising services Vendor performs. As in the previous fact pattern, under these facts, the purpose and intent of the allowance is to compensate Retailer for performing advertising services for Vendor, and the allowance is treated as a separate item of gross income under section 61. The fact that the allowance is at a flat rate and Retailer is not required to purchase any of Vendor’s products does not change the parties’ intention that the purpose of the payment is to compensate Retailer for advertising services.
Assume the Vendor makes the same advertising allowance payment as in Fact Pattern 1 and Retailer’s costs are the same. Retailer’s taxable income would be $60, as it was in Fact Pattern 1.
For DPAD purposes, the same analysis as in Fact Pattern 1 would apply, and the $5 advertising allowance would be included in DPGR, assuming Retailer met all of section 199’s requirements.
Fact pattern 3
Retailer and Vendor enter into an agreement under which Retailer is not required to perform any specific services for the benefit of Vendor, and Vendor does not expect Retailer to perform any specific services. Retailer will receive an allowance based on a percentage of its purchase costs for Vendor’s products. Under the agreement, the intent of the allowance is to reduce Retailer’s cost for the products that it purchases from Vendor.
Under these facts, it is clear that the intention of the parties is to treat the allowance as a purchase price adjustment. The $5 allowance payment is not a separate item of gross income under section 61 and would not be included in DPGR for purposes of section 199.
Accounting method issues
The GLAM may also serve as a reminder to taxpayers either paying or receiving advertising allowances that the timing of when an advertising allowance is taken into account for federal income tax purposes is generally an accounting method issue. The discussion included in the GLAM should clarify the facts and circumstances under which an advertising allowance will be treated as either a purchase price adjustment or an item of advertising expense/income. Taxpayers that incur or earn advertising allowances should work with their tax advisors to determine whether their present treatment is proper.
For taxpayers improperly accounting for advertising allowances, two possible automatic changes of accounting method may be available. Automatic change #46, contained in Appendix Section 19.05 of Rev. Proc. 2011-14, allows accrual-method taxpayers that incur cooperative advertising costs to change to a method that is consistent with Rev. Rul. 98-39. Under Rev. Rul. 98-39, an accrual-method manufacturer’s liability to pay a retailer for cooperative advertising services meets the all-events test of section 461 in the year the services are performed, provided the taxpayer is reasonably able to estimate the liability, even if the retailer does not submit the required claim form until the following year.
Automatic change #53, contained in Appendix Section 21.04 of Rev. Proc. 2011-14, provides that a taxpayer receiving qualifying volume-related trade discounts may change its method of accounting to treat the discounts as a reduction in the cost of merchandise purchased at the time the discount is recognized in accordance with Reg. section 1.471-3(b). A discount satisfying the following criteria is considered a “qualified volume-related trade discount”:
- The taxpayer receives or earns the discount based solely upon the purchase of a particular volume of the merchandise to which the discount relates
- The taxpayer is neither obligated nor expected to perform or provide any services in exchange for the discount
- The discount is not a reimbursement of any expenditure incurred or to be incurred by the taxpayer
Based on this generic advice and the fact patterns presented, it is clear that the intention of the parties is determinative of how an advertising allowance will be treated for DPAD purposes. Since the IRS likely would review any written advertising or marketing agreements between a retailer and its vendors, retail taxpayers should review any existing agreements to ensure that the intention of the parties is clear regarding how advertising allowances are to be treated. If a taxpayer intends to include an advertising allowance for purposes of DPGR, it should establish clearly in its agreements that the allowances are intended to compensate the retailer for advertising services performed.
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