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LB&I Directive Provides Examiners With Guidance on Benefits and Burdens of Ownership Analysis

FEB. 2, 2012

LB&I-04-0112-001

DATED FEB. 2, 2012
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Citations: LB&I-04-0112-001

Superseded by LB&I-04-0713-006

Impacted IRM 4.51.2

 

Date: February 1, 2012

 

 

MEMORANDUM FOR

 

INDUSTRY DIRECTORS

 

DIRECTOR, FIELD SPECIALISTS

 

DIRECTOR, PRE-FILING AND TECHNICAL GUIDANCE

 

DIRECTOR, INTERNATIONAL BUSINESS COMPLIANCE

 

 

FROM:

 

Heather C. Maloy

 

Commissioner, Large Business & International Division

 

 

SUBJECT:

 

Guidance for Examiners on I.R.C. § 199 Benefits and Burdens

 

of Ownership Analysis in Contract Manufacturing Arrangements

 

 

INTRODUCTION

 

 

This LB&I Directive provides guidance to Large Business & International (LB&I) Examiners in making a determination whether a taxpayer has the benefits and burdens of ownership under a contract manufacturing arrangement for purposes of Treas. Reg. § 1.199-3(f)(1)1

 

BACKGROUND

 

 

Section 199 of the Internal Revenue Code allows certain taxpayers to claim a deduction for a percentage of the lesser of: (1) qualified production activities income resulting from domestic production activities; or (2) taxable income (determined without regard to the section 199 deduction). Section 199 was enacted as part of the American Jobs Creations Act of 2004, Pub. L. 108-357, sec. 102(a), 118 Stat. 1424, and is effective for taxable years beginning after December 31, 2004. The Treasury Department issued interim guidance (Notice 2005-14, 2005-1 C.B. 498), proposed regulations (70 Fed. Reg. 67240 (Nov. 4, 2005)), and final regulations (T.D. 9263, 2006-1 C.B. 1063).

Taxpayers frequently enter into contractual arrangements with unrelated parties2 to perform some or all of the activities required to manufacture, produce, grow, or extract (the "qualifying activity") tangible personal property, computer software, sound recordings, electricity, natural gas, potable water, or qualified films (the "property"). Section 199(d)(10) authorizes the Treasury Department to issue regulations to ensure that only one taxpayer may claim the section 199 deduction for a particular activity. Treas. Reg. § 1.199-3(f)(1) provides that if one taxpayer performs a qualifying activity pursuant to a contract with another party, then only the taxpayer that has the benefits and burdens of ownership of the property during the period the qualifying activity occurs ("Benefits and Burdens") is treated as engaged in the qualifying activity and may claim a deduction under section 199 with regard to the property. A determination as to which party has the Benefits and Burdens is based on all facts and circumstances.

The final regulations include three examples illustrating the application of the benefits and burdens of ownership test. See Treas. Reg. § 1.199-3(f)(4).

 

EXAM GUIDANCE

 

 

This Directive provides a three step process that an examiner should use in determining whether a taxpayer has the Benefits and Burdens. The steps relate to Contract Terms, Production Activities, and Economic Risks. Each step asks three questions. If the answer is "yes" to at least two of the questions, the step is completed. If any two of the three steps are completed, the taxpayer has the Benefits and Burdens.

If at least two of the three steps are not completed, the examiner should determine whether the taxpayer has the Benefits and Burdens based on all facts and circumstances as in any examination risk assessment. In doing so, the examiner should not rely solely on the nine questions listed below but should consider all relevant factors.

Step 1 -- Contract Terms

 

1. Did the taxpayer have title to the work in process ("WIP")?

2. Did the taxpayer have risk of loss over the WIP?

3. Was the taxpayer primarily responsible for insuring the WIP?

 

Step 2 -- Production Activities

 

1. Did the taxpayer develop the qualifying activity process (determined without regard to who designed the property, provided the specifications for the property, or holds intellectual rights to the property)?

2. Did the taxpayer exercise oversight and direction over the employees engaged in the qualifying activity (determined without regard to who designed the property, provided the specifications for the property, or holds intellectual rights to the property)?

3. Did the taxpayer conduct more than 50% of the quality control tests over the WIP while the qualifying activity was occurring?

 

Examiner: Did you answer "yes" to at least two questions in both Step 1 and Step 2? If so, the taxpayer has the Benefits and Burdens and you do not need to go to Step 3.

Examiner: Did you answer "no" to at least two questions in both Step 1 and Step 2? If so, you must determine whether the taxpayer has the Benefits and Burdens based on all the facts and circumstances as described above.

Examiner: Did you answer "yes" to at least two questions in either Step 1 or Step 2 but not both? If so, go to Step 3.

Step 3 -- Economic Risks

 

1. Was the taxpayer primarily liable under the "make-good" provisions of the contract, for example, the warranty, quality of work, spoilage, overconsumption, or indemnification provisions?

2. Did the taxpayer provide more than 50%, based on cost, of the raw materials and components used to produce the property?

3. Did the taxpayer have the greater opportunity for profit increase or decrease from production efficiencies and fluctuations in the cost of labor and factory overhead?

 

Examiner: Did you answer "yes" to at least two questions in Step 3? If so, the taxpayer has the Benefits and Burdens.

Examiner: Did you answer "no" to at least two questions in Step 3? If so, you must determine whether the taxpayer has the Benefits and Burdens based on all the facts and circumstances as described above.

This LB&I Directive is not an official pronouncement of law, and cannot be used, cited, or relied upon as such. It does not apply to any other provision of the Internal Revenue Code, including I.R.C. § 263A.

 

FOOTNOTES

 

 

1 Most LB&I taxpayers that claim the section 199 deduction are subject to Treas. Reg. § 1.199-3(f)(1), which is effective for tax years beginning on or after June 1, 2006. This Directive also applies to LB&I taxpayers subject to Prop. Reg. § 1.199-3(e)(1) and Section 4.04(4) of Notice 2005-14.

2 This Directive only applies to persons that are not treated as related persons under Section 199(c)(7).

 

END OF FOOTNOTES

 

 

Page Last Reviewed or Updated: February 02, 2012
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