Recent guidance clarifies qualification for section 199 deduction
Addresses packaging, assembly and contract manufacturing activities
TAX ALERT |
Several recent developments have provided important insights into the current circumstances under which a taxpayer may claim the domestic production activities deduction (DPAD) under section 199. While four of these developments have been taxpayer-favorable, qualification determinations are fact-specific, and taxpayers should evaluate the applicability of this guidance to their activities prior to claiming a section 199 deduction. In a recent Chief Counsel Advice, the IRS allowed a taxpayer to claim the DPAD for converting raw pills that it purchased from third parties into blister packs. While the regulations provide that packaging and repackaging activities alone generally do not qualify for the DPAD, the IRS determined that the manufacturing process the taxpayer used was sufficiently complex to qualify.
In a recent federal district court case, a gift basket maker was allowed to claim the DPAD despite the IRS argument that the process of taking separate goods and assembling them into a gift basket constituted nothing more than a packaging activity. The court determined that because the taxpayer utilized a very sophisticated assembly line approach for making the baskets themselves (enabling the company to produce up to 80,000 gift baskets per day), the taxpayer's process went beyond mere packaging and repackaging, thereby qualifying for the DPAD.
In a recent IRS Chief Counsel Memorandum, the taxpayer owned a chain of retail pharmacy stores that included areas where employees performed photo processing. The IRS agreed with the taxpayer that many of these photo processing activities qualified for the DPAD because the photo processing involved taking raw materials (photo paper, ink, chemicals, etc.) and converting them into a different tangible product.
In a recent directive issued to IRS agents, the "benefits and burdens" approach to determining which party in a contract manufacturing arrangement is entitled to claim the DPAD was further simplified. While examiners previously were instructed to evaluate as many as nine factors to determine which party had the benefits and burdens of ownership, this guidance provided that examiners should not challenge a taxpayer claiming the DPAD as long as the taxpayer provided three statements: (1) a statement explaining the basis for determining that it had the benefits and burdens of ownership, (2) a certification statement signed by the taxpayer, and (3) a certification statement signed by the other party to the contract manufacturing arrangement.
A recent Tax Court case illustrates a situation where the benefits and burdens test was not met and the taxpayer was denied the DPAD. Advo v. Commissioner involved a taxpayer engaged in the direct mail business. The taxpayer worked with its customers to design advertising materials that were to be directly mailed to potential customers. Even though Advo was heavily involved in the advertisement design, it did not physically create the materials. Advo contracted an unrelated third party to print and process the advertising materials from raw paper stock based on specifications received from Advo. Even though Advo did not physically create the advertising materials, it claimed that it qualified for the DPAD because it had the benefits and burdens of ownership of the materials.
The Tax Court noted the IRS's nine-factor test above, but, as it was internal IRS guidance, it could not be used as legal precedent. The court instead relied on a previous Tax Court case and requirements in the tax law pertaining to controlled foreign corporations that set forth the following nine factors in determining the benefits and burdens of ownership:
- Whether legal title passes
- How the parties treat the transaction
- Whether an equity interest is acquired
- 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
- Whether the right of possession is vested in the purchaser and which party has control of the property or process
- Which party pays the property taxes
- Which party bears the risk of loss or damage to the property
- Which party receives the profits from the operation and sale of the property
- Whether the taxpayer actively and extensively participated in the management and operations of the activity
The court determined that all nine factors were either against Advo or neutral at best. Accordingly, it determined that Advo did not have the benefits and burdens of ownership of the printed advertising materials and was not entitled to the DPAD.
While it is clear from the favorable developments noted above that the IRS continues to accept a reasonable range of activities as qualifying for the DPAD, taxpayers should be careful not to overreach. The blister pack, gift basket and photo processing activities that qualified for the DPAD all involved relatively complex production processes. Less sophisticated processes may not meet the substantial in nature threshold necessary to qualify for the DPAD. Taxpayers involved in a contract manufacturing arrangement should objectively evaluate their unique facts in light of the multiple factors noted above to determine whether they have sufficient benefits and burdens of ownership to claim the DPAD.