Recent Developments Concerning the Domestic Production Activities Deduction (article)
In the past year, there have been several developments concerning the application of the IRC §199 Domestic Production Activities Deduction ("DPAD"). The DPAD provides eligible taxpayers a deduction of up to 9% of their taxable income from qualifying production activities. Many of these recent developments provide guidance on the types of activities that qualify as "manufacturing or production" for purposes of the DPAD. Taxpayers currently not claiming the DPAD should review their position in light of these rulings.
The DPAD enables domestic manufacturers and producers to deduct for the tax year 9% of the lesser of:
1. The taxpayer's qualified production activities income ("QPAI"), or
2. The taxpayer's taxable income (modified adjusted gross income, for individual taxpayers), without regard to the DPAD.
The DPAD cannot exceed 50% of the W-2 wages from domestic production activities of the taxpayer. Under (2) above, taxpayers with an overall net loss receive no DPAD benefit.
Qualifying activities for the DPAD are the:
1. Manufacture, production, growth, extraction, installation, development, improvement, or creation of qualifying production property (tangible personal property) by a taxpayer either in whole or in significant part within the United States ("MPGE");
2. Construction or substantial renovation of real property in the U.S., including residential and commercial buildings and infrastructure such as roads, power lines, water systems, and communications facilities;
3. Engineering and architectural services performed in the U.S. relating to the construction of real property;
4. Farming of agricultural products and food; and
5. Processing of agricultural products and food (but not the sale of food and beverages prepared by the taxpayer at a retail establishment).
Many of the developments in the past year provide guidance for the types of activities that qualify as "manufacturing or production" under the DPAD rules:
Photo processing and related services:
In FAA 20133302F, IRS Chief Counsel's office concluded that a retail pharmacy's photo processing and printing activities through which the taxpayer produced photo-related products, such as photo prints and photo books, qualified for the DPAD. The IRS counsel stated that the taxpayer, using its own equipment, used raw materials (the photo paper, ink and other chemicals) to produce a different tangible product in form and function — finished photos or photo books — that were then sold to its customers. The process of affixing a customer's intangible files (i.e., images) to a CD or DVD that was not manufactured by the taxpayer, however, was not a qualifying activity for the DPAD. In that process, neither the intangible files nor the CD or DVD were changed to a different form. The process of affixing files onto a CD or DVD was deemed to be a service that the taxpayer performed for its customers.
In CCA 201313020, the IRS Chief Counsel's office concluded that the taxpayer's publishing activities for electronic books did not qualify for the DPAD. The IRS noted that the taxpayer's market research, content and layout development, and editing were activities that resulted in the taxpayer creating an electronic version of a book. The taxpayer's electronic version of a book had the same layout and design as the book would have if printed and bound, but the IRS stated that the electronic version of the book is not tangible personal property or computer software so it does not qualify for the DPAD.
This CCA further explained that the IRS position could change and the electronic books could qualify for the DPAD if the taxpayer also produced physical books and did not use a third party contract manufacturer to mass produce the books. In that situation, the activities needed to create the intangible property (the electronic books) would be the same as those that create the tangible personal property (physical books).
In U.S. v. Dean, et al. (112 AFTR 2d 2013-5592), the IRS argued that the taxpayer's process of producing gift baskets merely constituted packaging or repackaging gift items, rather than manufacturing or producing, and therefore did not qualify for the DPAD. The District Court disagreed with the IRS, however, and ruled that the taxpayer's production process changed the form of the property sufficiently to qualify for the DPAD. The taxpayer's process involved selecting various items for gift baskets or towers and assembling them as part of many detailed plans. The process relied on both assembly line workers and machines, resulting in final products distinct in form and purpose from the individual items inside. Although those items in the gift basket would typically be purchased as ordinary groceries, the taxpayer's production process transformed them into gifts that were usually given during holiday season and thus created new product with different demand. The court concluded that transformation was sufficient to qualify the activity for the DPAD.
In CCA 201246030, a pharmaceutical products provider manufactured "blister packs" for repackaging pills for sale to customers. If a taxpayer packages, repackages, labels, or performs minor assembly of qualified production property ("QPP") and the taxpayer engages in no other MPGE activity with respect to that QPP, the taxpayer's packaging, repackaging, labeling, or minor assembly does not qualify as MPGE with respect to that QPP. In general, QPP must be MPGE in whole or in significant part by the taxpayer and in whole or in significant part within the United States to qualify. The IRS Chief Counsel's office concluded that this activity was excepted from the general rule that repackaged goods do not qualify for DPAD. In this instance, the taxpayer's activities exceeded mere repackaging because the taxpayer engaged in other MPGE production activities with respect to the blister packs containing the pills, because it also manufactured the blister packs pursuant to strict FDA regulations. The IRS ruled that this situation qualified for DPAD, assuming the MPGE activities were significant and occurred in the United States.
Direct mail advertising:
In ADVO, Inc. v. Commissioner, 141 T.C. No. 9 (2013), the Tax Court held that a direct mail advertiser did not have the benefits and burdens of ownership of the advertising materials, and therefore, was not entitled to the DPAD. This case hinged on whether the taxpayer or the third-party printers were considered the manufacturers of the advertising mailing packages for purposes of the DPAD. The court stated that the intent of the DPAD was that only one taxpayer may claim the deduction for the product manufactured, and that taxpayer must be the one that has the benefits and burdens of ownership of the product. The court ruled that the third-party printer was the eligible party to claim the DPAD, based on its analysis of nine factors of the benefits and burdens test, including:
1. Legal title;
2. Intention of the parties;
3. Equity interest;
4. Present obligation;
5. Right of possession and control;
6. Property taxes;
7. Risk of loss or damage;
8. Profits from operation and sale; and
9. Active and extensive participation.
CCA 201302017 involved a taxpayer that constructed both mobile and traditional billboards and rented advertising space on those billboards. IRS Chief Counsel concluded that mobile billboards are tangible personal property and may qualify for the DPAD, while traditional billboards are real property and thus do not qualify for the DPAD. The CCA stated that mobile billboards are intended to be moved frequently and thus are not real property. Therefore the construction of the mobile billboard qualified for the DPAD.
Benefits & burdens test and contract manufacturing:
The IRS's Large Business and International (LB&I) division issued an updated directive (LB& I-04-1013-008) to its auditors for determining which party qualifies for the DPAD under a contract manufacturing arrangement. Under the DPAD rules, if one taxpayer performs a qualifying activity pursuant to a contract with another party, then (as in the ADVO, Inc. case discussed above) only the taxpayer that has the benefits and burdens of ownership of the property during the period the qualifying activity occurs is treated as engaged in the qualifying activity and may claim the DPAD with regard to the property. A determination as to which party has the benefits and burdens is based on all facts and circumstances.
This new directive requires IRS auditors to obtain the necessary information (in writing) in order to determine the benefits and burdens of ownership of the property. According to the directive, the taxpayer must provide:
1. A statement that explains the basis for the taxpayer's determination that it had the benefits and burdens of ownership in the year or years under examination;
2. A certification statement (using a form contained in the directive) signed by the taxpayer; and
3. A certification statement (using a form contained in the directive) signed by the counterparty.
The counterparty's principal certification is that it did not claim, and will not claim, the DPAD for any tax year covered by the contract pursuant to which the same qualifying activities were performed. For more information on this directive, see our CBIZ MHM Tax Alert, New LB&I Procedures Simplify Code Sec. 199 Claims Under Audit Involving Contract Manufacturing.
The DPAD is a very valuable tax benefit available to a wide range of taxpayers. As the above rulings illustrate, however, determining whether an activity will qualify for the DPAD is not an easy task. In many cases and situations, taxpayers may not be aware that the DPAD may apply, but based on the positions in these recent developments, it may be worthwhile to investigate whether the DPAD is available. Contact your local CBIZ MHM tax professional to discuss whether your activities may qualify for the DPAD.
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