Qualified production activities under IRC Section 199: review and analysis of new developments.
IRS Statistics of Income for 2012 reported that the primary corporate beneficiaries of the deduction were manufacturing companies, and thus taxpayers might assume that the DPAD is limited to manufacturing entities that produce a tangible product. But the deduction is actually available for entities engaged in a wide variety of activities. Companies engaged in information services, mining, agriculture, forestry and logging, utilities, engineering, and construction have also claimed significant deduction amounts.
The complex rules of IRC section 199 require costly0 recordkeeping and activity analyses. To determine the DPAD available, companies must carefully analyze production activities, revenues generated from such activities, and expenses allocable to such revenues. CPAs can play an essential role in advising companies on how to calculate the deduction, determine qualified activities, and navigate the rules for claiming the DAPD.
Definitions and Computations
IRC section 199 defines qualified production activities (QPA) income, domestic production gross receipts (DPGR), and W-2 wages. Given the title of this IRC section ("Income Attributable to Domestic Production Activities"), it seems somewhat odd that it does not define domestic production activities; however, the definitions of other key terms found in the IRC and related regulations contribute to an understanding of QPAs. For purposes of this discussion, a QPA is defined as any activity or service that results in the realization of DPGR.
The DPAD is equal to 9% of the lesser of QPA income or taxable income before deduction of the DPAD. QPA income equals DPGR minus the sum of the cost of goods sold allocable to receipts and other expenses (other than the DPAD) that are properly allocable to DPGR. The DPAD is further limited to 50% of the W-2 wages allocable to domestic production activities. Computation of the DPAD is relatively straightforward, but the difficulty lies in the identification of QPAs, DPGR, and properly allocable expenses.
IRC section 199(c)(4) defines DPGR as gross receipts derived from any sale, lease, exchange, or other disposition of 1) qualified production property (QPP) manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States; 2) qualified film produced by the taxpayer; or 3) electricity, natural gas, or potable water produced by the taxpayer in the United States. DPGR also includes gross receipts from construction of real property in the United States and from engineering or architectural services related to the construction of real property in the United States.
Qualified Production Property
IRC section 199(c)(5) defines QPP as 1) tangible personal property, 2) computer software, and 3) sound recordings. The regulations define QPP and illustrate the variety of activities eligible for the DPAD. QPP includes tangible personal property made from either new materials or from scrap, salvage, or junk material. Whether property is QPP is determined on an item-by-item basis (i.e., the determination is not based upon the output of a division or product line). This might prove burdensome for manufacturers producing property that might not qualify for the DPAD.
If a taxpayer's disposition of an item of property does not result in the receipt of DPGR, then a component of an item may be treated as giving rise to DPGR. Example 1 of Treasury Regulations section 1.199-3(d)(4) illustrates this situation. Assume that a taxpayer manufactures shoe soles in the United States and imports shoe upper parts. The taxpayer attaches the soles to the upper parts and sells the finished shoes. Even if the sale of the shoes does not qualify as DPGR because the shoes were not manufactured by the taxpayer in whole or in significant part within the United States, the taxpayer should treat the sole (a component of the shoe) as an item for purposes of determining whether the sale to customers generates DPGR. In such cases, CPAs can assist in determining the relevant components that generate DPGR and identifying the costs properly allocable to the DPGR.
Qualified Production Activities
QPAs include a wide variety of manufacturing, producing, growing, and extracting activities. Generally, the provision of services is not a QPA and such activities are not eligible for the DPAD; however, exceptions exist for the construction and engineering or architectural services discussed below. IRC section 199(c)(4)(B) excludes from the definition of DPGR (and, thus, from QPA) the following activities: 1) the sale of food and beverages prepared at a retail establishment; 2) the transmission or distribution of electricity, natural gas, or potable water; or 3) the sale, lease, exchange, or other disposition of land.
Manufacturing activities. Taxpayers must not only produce property that meets the definition of QPP; they must also demonstrate that the production of QPP resulted from manufacturing, producing, growing, and extracting activities. The regulations provide that packaging, repackaging, labeling, or the minor assembly of property are not manufacturing (therefore, not QPA), unless taxpayers engage in other qualified activities with respect to the same QPP.
Example 6 of Treasury Regulation section 1.199-3(eX5) illustrates the minor assembly rule. Consider a taxpayer that purchases automobiles and customizes them by adding spoilers, custom wheels, and sunroofs, but does not manufacture any of the accessories. The final product, a customized car, is tangible personal property. But the customization activities constitute "minor assembly," which is not a manufacturing, producing, growing, or extracting activity. Taxpayers must identify and document qualified activities; they are not guaranteed the IRC section 199 deduction merely because tangible property is produced as the result of a series of activities.
Manufacturers with both overseas and U.S. operations might qualify for the DPAD if QPP is manufactured in whole or "in significant part" within the United States (i.e., the 50 states and District of Columbia). The regulations provide a safe harbor for the significant part test, which is met if direct labor and overhead costs incurred by the taxpayer in the United States equals or exceeds 20% of the cost of goods sold of the property. The safe harbor rule might allow the taxpayer to treat an item of property (rather than a mere component) as QPP and, thus, increase DPGR. CPAs can assist in determining the most appropriate and beneficial treatment of activities and sales of products manufactured partly in the United States and partly abroad.
Construction, engineering, and architectural services. Generally companies that provide services do not engage in QPA; however, those that primarily provide non-qualifying services may also engage in QPA and qualify for the DPAD. Companies providing services in the areas of transportation and warehousing, entertainment and recreation, and healthcare and education have claimed the DPAD. CPAs can provide a valuable service by understanding all of a company's products and services. They should not assume that a company does not engage in qualified activities merely because it is not a manufacturing entity.
The construction of real property performed in the United States is a qualified activity for the DPAD. Real property includes buildings and structural components (e.g., partitions, wiring, plumbing, central air and heating systems, elevators), permanent land improvements (e.g., parking lots, sidewalks), oil and gas wells, and infrastructure (e.g., roads, power lines, sewers). Construction activities include services performed in connection with a project to erect or substantially renovate real property. Services may include those provided by painters, plumbers, electricians, carpenters and framers, general contractors, and others.
In terms of engineering and architecture, DPGR includes gross receipts derived from engineering and architectural services performed with respect to the construction of real property in the United States. These services include activities such as consultation, investigation, planning, design, supervision, and feasibility studies.
Food preparation. When a fast food restaurant assembles ingredients, cooks pizza, and serves the product to a customer, is the restaurant selling a manufactured product or providing a service? Arguably both occur. IRC section 199(c)(4)(B)(i) provides that DPGR does not include gross receipts derived from the sale of food or beverages which are prepared by the taxpayer at a retail establishment; however, products that are produced at other facilities and sold at the retail establishment do generate DPGR In addition, sales to other wholesalers and retailers generate DPGR
How does a taxpayer identify QPA and DPGR if the taxpayer is engaged in both sales of food and beverages prepared at a retail establishment and sales of products produced at other facilities to wholesale and retail customers? Treasury Regulations section 1.199-3(o)(3) illustrates such a situation and discusses the DPGR implications. Consider a taxpayer that buys and roasts coffee beans, sells the roasted beans to wholesale and retail businesses, and also sells brewed coffee at a retail establishment. Production of the coffee beans is a QPA, and sale of the beans, both at the wholesale and retail level, generates DPGR; however, selling brewed coffee does not generate DPGR Even though sales of the brewed coffee do not generate DPGR the taxpayer may allocate a portion of the receipts from the sale of brewed coffee to DPGR to the extent of the value of the coffee beans used to brew the coffee. CPAs can provide valuable services by understanding of all the company's business activities so that QPA can be properly identified.
Packaging medications in blister packs. In a recent chief counsel advice (CCA 201246030, November 2012), the IRS considered a case in which the taxpayer purchased medications (not manufactured by the taxpayer) in bulk. The taxpayer then packaged them in blister packs for sales to nursing homes and other healthcare facilities. The IRS concluded that the manufacture of the blister packs constituted a QPA; therefore, the blister packs and the pills should be treated as separate components of a product. The taxpayer could allocate gross receipts to the blister packs and the pills. The IRS concluded that gross receipts allocable to the blister packs constituted DPGR; gross receipts allocable to the pills did not.
Photo processing. IRS attorneys recently concluded (LAFA 20133302F, July 2013) that a portion of a taxpayer's photo processing activities were QPAs for purposes of the DP AD. Activities that required the combining of raw materials (e.g., paper, ink, chemicals) to produce a finished product were also QPAs. But the IRS concluded that the transfer of customers' computer files containing images or videos to a CD or DVD did not constitute a QPA and did not result in the manufacture of QPP.
Gift boxes. In U.S. v. Dean [112 AFTR 2d 2013-5592, DC CA (2013)], the district court held that the taxpayer engaged in manufacturing activities and was entitled to claim the DP AD. The taxpayer assembled gift boxes (which included chocolates, candies, and cheeses) that were packaged in decorative materials (wrapping paper, boxes, and baskets). The assembly process was performed at three production facilities. Production of the gift boxes and baskets required machines and assembly labor. The taxpayer employed 300 to 4,000 assembly workers, depending upon the season. The IRS relied on Treasury Regulations section 1.199-3(e)(2) and asserted that these activities consisted of nothing more than "packaging, repackaging, labeling, or minor assembly" and, therefore, held that the taxpayer was not entitled to the DP AD.
The court rejected the IRS's arguments and held that the gift baskets did not result from mere packaging and repackaging but were produced by a complex production process that changed the form and function of the objects from ordinary food items to distinctive gifts. This case illustrates the importance of detailed documentation on the nature and complexity of all production activities. Such documentation will aid in the identification of QPA and the determination of related revenues and expenses.
Electronic book publishers. In a recent chief counsel advice (CCA 201313020, March 2013), the IRS held that the taxpayer, a publisher of electronic versions of books, was not eligible for the DP AD. The publisher provided market research, editing, layout and formatting, print specifications, and related services that resulted in the creation of an electronic book, which was made available to contract printers who printed the books and shipped them to either the taxpayer or directly to the customer. The IRS held that the electronic version of the book did not constitute tangible personal property; therefore, activities related to its production did not quality for the DP AD. The IRS concluded that the printing activities of the contract printer were QPAs, and that such activities resulted in the production of QPP. The IRS noted that the taxpayer's activities would have been considered QPAs had the taxpayer both created the electronic books and printed them.
Direct-mail advertising. In AD VO Inc. v. Comm'r [141 TC 9 (2013)], the Tax Court disallowed the taxpayer's claim for the DP AD for activities related to the printing and distribution of direct-mail advertising materials. ADVO contracted with printers to print the direct-mail advertising materials, which ADVO later mailed to the advertising recipients. The court held that the party meeting the benefits and burdens of ownership (BBO) standard (i.e., ADVO or the contract printer) was entitled to the DP AD. [See Treasury Regulations section 1.199-3(f)(4).] ADVO argued that IRC section 263A, which also uses a BBO standard and allows for more than one taxpayer to be considered the producer of the same property, should be applied under IRC section 199. The Tax Court held that the intent of IRC section 199 was that only one party in a contract manufacturing arrangement could claim the deduction with respect to the same QPA.
The court concluded that ADVO failed to meet the BBO test after considering the following factors:
* Legal title did not pass to ADVO while the printer held the products.
* ADVO did not exercise control over the printing activities and failed to actively participate in the management of the printing, cutting, and folding processes.
* The printer bore the risk of loss while in possession of the printed materials.
* The printer assumed the risk of economic loss related to the contract.
After review of the facts and circumstances, the court held that the contract printer, rather than ADVO, met the BBO standard; thus, it qualified as the party entitled to the DP AD.
The activities of the direct-mail advertiser and the electronic book publisher in the previous example would have qualified if the taxpayer had retained the BBO of the property (advertising materials/tangible books) during the period in which the contract printer printed the materials/books. CPAs can help determine whether the BBO tests have been met and, if not, whether the benefit of the DP AD warrants consideration of changes to the contractual arrangements.
Contract Manufacturing Arrangements
IRC section 199 regulations require the application of the BBO standard in order to determine which party has performed QPAs in a contract manufacturing arrangement. Relevant factors depend upon which party--
* designs the product and owns the intellectual property rights to the product,
* controls the manufacturing process,
* bears the risk of loss or damage to the property during the production process,
* has legal title to the property during the production process, and
* bears the burden (earns the reward) of economic loss (gain) that occurs during the production process.
Decisions are based upon an analysis of all of the facts and circumstances of each case. (See Treasury Regulations section 1.199-3(f)(4), Example 1.]
Two recent IRS Large Business and International (LB&I) directives (LB&I 40112-001, February 2012; LB&I 4-0713006, July 2013) provide guidance to examiners in making determinations regarding the BBO in contract manufacturing arrangements. The 2012 directive describes actions to be taken by IRS examiners in determining which party has the BBO. The 2013 directive describes procedural rules that, if followed by the taxpayer and contract manufacturer, should eliminate a challenge by an examiner of the taxpayer's claim of satisfying the BBO test.
The 2012 directive requires examiners to review contract terms, production activities, and economic risks. In reviewing contract terms, the examiner should determine which taxpayer 1) has title to the work in process (WIP), 2) retains the risk of loss of the WIP, and 3) has primary responsibility for insuring the WIP. The examiner should review production activities to determine which taxpayer 1) develops the qualified activity process, 2) directs employees in the qualified activity, and 3) conducts more than 50% of the quality control tests of the WIP. When assessing economic risks, the examiner must determine which party provides a majority (based on cost) of the raw materials and components required for production, and which party has the greater opportunity (risk) for profits (losses) related to the cost of labor and factory overhead. The test required of the examiner in the BBO determination is rather mechanical in nature and may be supplemented with an analysis based on all of the facts and circumstances. The directive provides a list of factors considered to be determinative by the IRS.
The 2013 directive describes procedural guidance for examiners and taxpayers in determining which party has the BBO in a contract manufacturing arrangement. The parties to the contract manufacturing agreement are referred to as the "taxpayer" or the "counterparty." If the taxpayer provides a BBO certification and the counterparty provides a certification that it will not claim the DPAD, examiners are instructed that they should not challenge the taxpayer's (or the counterparty's) claim of satisfying the BBO test. The BBO certification must explain the basis for claiming the BBO. Taxpayers should understand that the certifications and agreements do not bind the IRS. As in any significant economic transaction, CPAs should help structure the contract manufacturing arrangement in a manner designed to reduce the risk of an IRS challenge. Early planning and compliance with the directive could yield the most desirable tax outcome for the client.
Coordination with Other Taxes
Alternative minimum tax (AMT). Lortunately for both corporate and noncorporate taxpayers, the interaction between the DPAD and the AMT is generally not complex. Noncorporate taxpayers subject to the AMT are allowed to deduct 9% of the lesser of QPA income or taxable income for the year (subject to the W-2 wage limitation). Corporations subject to the AMT are allowed to deduct 9% of the lesser of QPA income or AMT income for the year (subject to the W-2 wage limitation). QPA income is determined without the numerous adjustments required for computing AMT income. Generally, QPA income is less than taxable income; therefore, the limitation based upon AMT income might be moot. The DPAD is preserved even for taxpayers subject to the AMT, and the additional deduction complexities are not significant.
State income tax deduction. States have little incentive to allow the DPAD for state income taxation purposes. Allowance of the DPAD reduces tax collections. Job creation within a state is likely to be trivial unless the qualified activities and wage limitations are applied at the state level. Despite the lack of incentives, CCH Multistate Corporate Tax Guide reports that approximately half of the states allow a deduction similar to or based upon the DPAD; however, New York is one of the 22 states that disallow the deduction. The deduction is often limited to either corporate taxpayers or individual taxpayers. The DPAD is one of many potential adjustments required in the reconciliation of federal taxable income and state taxable income. CPAs can assist with the complexities of the DPAD and the determination of adjustments needed to comply with state income tax laws.
An Essential Role for CPAs
IRC section 199 presents a valuable deduction that reduces the taxpayer's income tax liability and does not require an outflow of cash; however, its complexity creates numerous problems for taxpayers. Voluminous regulations (more than 100 pages) provide definitions, computational guidance, and illustrations needed to understand the DPAD. Without the assistance of CPAs, taxpayers might overlook the deduction or fail to claim the maximum allowable deduction. Taxpayers might also claim an excessive deduction and risk a costly IRS audit. CPAs can assist in planning, analyzing activities, and developing supporting documentation. By planning in advance for the DPAD, taxpayers can gain a significant benefit and reduce the risk of an unfavorable outcome from an IRS audit.
Wayne E. Nix, DBA, CPA, is an assistant professor at Jackson State University, Jackson, Miss. Ray A. Knight, JD, MA, CPA/PFS, is a visiting professor of practice, and Lee G. Knight, PhD, is the Hylton Professor of Accounting, both at Wake Forest University, Winston-Salem, N.C.
|Printer friendly Cite/link Email Feedback|
|Title Annotation:||Taxation: tax incentives; Internal Revenue Code|
|Author:||Nix, Wayne E.; Knight, Ray A.; Knight, Lee G.|
|Publication:||The CPA Journal|
|Date:||Jun 1, 2014|
|Previous Article:||Implications of the Volcker rule: accounting treatment for investments in debt securities.|
|Next Article:||Comparing the foreign earned income exclusion and the foreign tax credit: which leads to greater tax savings?|