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Sec. 199 issues arising from contract manufacturing arrangements.

Taxpayers often enter into contract manufacturing arrangements with independent third parties to manufacture components or products on behalf of the taxpayers. Under these arrangements, the taxpayer typically approaches the contract manufacturer with a formula or design. The contract manufacturer will quote the parts based on material and labor costs, processes, and tooling. For an agreed-upon price, the contract manufacturer essentially acts as the taxpayer's factory, producing and shipping units of the design on behalf of the taxpayer.

In the context of the domestic production activities deduction (DPAD) provided by Sec. 199, Congress intended that only one taxpayer may claim the deduction for the same function performed regarding the same property. In order to determine whether the taxpayer or the contract manufacturer is entitled to the Sec. 199 deduction for the same manufacturing activity, the Sec. 199 rules require an analysis of which party in a contract manufacturing relationship has the "benefits and burdens of ownership" under judicially developed federal income tax principles.


For tax years beginning after December 31, 2004, manufacturers and producers may be eligible for a deduction relating to income from certain qualifying domestic production activities under Sec. 199. The DPAD is equal to a percentage of the lesser of qualified production activities income or taxable income (as determined without the Sec. 199 deduction). The percentage is phased in from 3% in tax years 2005 and 2006 to 6% in tax years 2007-2009, and 9% in tax years 2010 and beyond.

Under Sec. 199(c)(4), "domestic production gross receipts" refers to the gross receipts derived from, among other things, any lease, rental, license, sale, exchange, or other disposition of:

* Qualifying production property (QPP) that was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States;

* Any qualified film produced by the taxpayer; and

* Electricity, natural gas, or potable water (i.e., utilities) produced by the taxpayer in the United States.

The regulations under Sec. 199 clarify that the deduction is allowed only for manufacture or production by the taxpayer. Regs. Sec. 1.199-3(f) mandates, with certain exceptions, that only one taxpayer may claim the deduction for the qualifying activities discussed above that are performed in connection with the same QPP or the production of a qualified film or utilities. Further, the regulation provides that if one taxpayer performs a qualifying activity under a contract with another party, only the taxpayer that has the "benefit and burdens of ownership" of the property under federal income tax principles while the qualifying activity occurs is treated as engaging in the qualifying activity. The party without the benefits and burdens of ownership, by default, is treated as a mere service provider.

Benefits and Burdens of Ownership

The final Sec. 199 regulations retain the rules previously set out in Notice 2005-14 on how to determine which party has the benefits and burdens of ownership of the property. Notice 200514, which provided interim guidance until the final Sec. 199 regulations were issued in 2006, indicated that the benefits and burdens of ownership standard is based on the principles under Secs. 263A and 936. While those tests are not entirely directed toward qualification under Sec. 199, similar factors can be derived from these provisions to provide some direction on the application of the benefits and burdens of ownership test for purposes of Sec. 199.

Sec. 263A uses the benefits and burdens test to determine which taxpayer owns the produced property; the "producer" is the taxpayer to which the Sec. 263A capitalization requirements apply. Under Sec. 263A, the case most on point is Suzy's Zoo, 273 F.3d 875 (9th Cir. 2001). In that case, the taxpayer appealed a Tax Court decision in which the Tax Court found that the taxpayer exercised such a degree of control over the manufacturing of its products by third-party contractors that the taxpayer should be considered the owner and producer of the products for purposes of Sec. 263A.

The taxpayer created cartoon characters that were imprinted on its greeting cards, stationery, and various other products. Several independent contractors manufactured these products. Throughout the manufacturing process, the independent contractors supplied labor and materials, held title to the materials and printed goods until they shipped the goods to the taxpayer, and bore the risk of loss for the materials and printed goods in the event of destruction prior to shipment or in the event of defective production. However, the independent contractors were not permitted to sell the printed goods to anyone other than the taxpayer and did not have a proprietary interest in the cartoon characters created by the taxpayer.

The Tax Court ruled that the taxpayer was subject to the Sec. 263A capitalization requirements because the taxpayer was the owner of its greeting cards until it sold the cards to its customers. The printer never met the requirements of a tax owner. The Tax Court rejected the taxpayer's contention that risk of loss should determine which party owned and produced the greeting cards, finding that identification of the property owner for purposes of Sec. 263A did not turn on which party to an agreement bears the risk of loss but instead required an examination of all the facts and circumstances.

The Ninth Circuit upheld the decision, finding that the relevant requirement necessary to be considered a producer under Sec. 263A was that the taxpayer be considered the owner of the property produced for tax purposes. The court based its determination of ownership on the degree of control that the taxpayer exercised over the manufacturing process from beginning to end. It found that the taxpayer had significant dominion and control over the details of the manufacturing process because it:

* Controlled the manufacturing process, including the quality and quantity of the items manufactured;

* Owned the images reproduced as part of the manufacturing process; and

* Stood to profit most from its sale of the items manufactured (or, alternatively, was exposed to any loss that might occur from the sale of the items manufactured).

Thus, according to the court, the taxpayer was the owner of the property under Sec. 263A.

Sec. 936

Notice 2005-14 also refers to Sec. 936 regarding the determination of what party has the benefits and burdens of ownership. Sec. 936 employs a benefits and burdens test to ascertain whether the possession corporation performs sufficient manufacturing within the possession to meet the "significant business presence" test. Factors that indicate a contract manufacturing relationship can include performing work on inventory without the passage of title, performing production activities under the direct supervision and control of another party, and not undertaking any significant risk in manufacturing the product.

Although not mentioned directly, the factors used in the pre-December 2008 subpart F rules for determining whether a contract manufacturer's manufacturing activities are attributed to a foreign subsidiary that engages its services can also be considered relevant by reference to Sec. 936. These factors similarly refer to the party that controls the process and bears the economic risk of loss as the manufacturer. In both cases, the taxpayer who stands to gain from a successful product and to lose from a product failure is the taxpayer that should be treated as the manufacturer.

Finally, although there is no direct reference given under any Sec. 199 guidance, a taxpayer can also consider tax ownership tests related to the sale or lease of assets. Whether a sale or lease transaction should be respected for federal income tax purposes depends on whether the benefits and burdens of asset ownership have truly passed to the buyer. The facts and circumstances, including the intentions of the parties, are considered in this determination (Grodt & McKay Realty, Inc., 77 T.C. 1221 (1981)). These include such factors as:

* 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;

* Who carries insurance or pays property taxes on the property;

* Whether legal title to the property passes;

* Who is responsible for replacing the property; and

* Who has the benefit of any remainder interest in the property.


While no firm guidance exists to specifically address the benefits and burdens of ownership standard for Sec. 199 purposes, the regulations instruct taxpayers to determine which party in a contract manufacturing arrangement has the benefits and burdens of property ownership "under federal income tax principles" during the qualifying activity. Notice 2005-14 refers taxpayers to the benefits and burdens tests used in Secs. 263A and 936. In a contract manufacturing arrangement, the factors discussed above can give taxpayers some guidelines to help determine which party will be deemed to manufacture the property and thereby be entitled to claim the Sec. 199 deduction.

From Brandy L. Arbuthnot, CPA, Dallas, TX
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Author:Arbuthnot, Brandy L.
Publication:The Tax Adviser
Date:May 1, 2009
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