Changes to Manufacturing Regs Will Hurt Film Industry, Firm Says

Sidley Austin LLP is pleased to provide these comments on the proposed regulations under section 199¹ published in the Federal Register on August 27, 2015 (the "Proposed Regulations") on behalf of A&E Television Networks, LLC. We appreciate your continuing efforts to bring clarity to the interpretation and administration of this very important provision. Indeed, certain aspects of the Proposed Regulations provide important and much needed guidance on aspects of section 199. We thank you for your diligence in providing timely and helpful clarity.

Unfortunately, other elements of the Proposed Regulations, while well-intentioned, result in proposed rules that are inconsistent with the statute and legislative intent and sacrifice important policy objectives for administrative ends. In particular, the blanket elimination of consideration of the benefits and burdens of ownership in deciding which taxpayer is eligible to claim the deduction and the automatic assignment of the deduction to the contract manufacturer in all cases may result in an inappropriate misallocation or complete elimination of the deduction for many taxpayers.² This undesirable effect is particularly pronounced in the case of key segments of the film industry, an industry specifically identified by Congress in section 199 as needing the benefits of these provisions.³

We believe that the existing regulations properly interpret section 199 and provide appropriate and workable rules that should remain in force. This comment presents background on section 199 and explains how the existing regulations are consistent with the statute and fulfill the purpose for section 199. We then describe the infirmities in the Proposed Regulations and the difficulties they will create for contract manufacturing generally and segments of the film industry in particular. We conclude with a suggestion that further study is appropriate before taking a drastic step that will significantly impinge upon the effectiveness of section 199.

Congress has enacted a variety of provisions to attempt to stimulate domestic production, including various tax credits and accelerated and bonus depreciation. Congress has also provided several mechanisms over the years to make U.S. industry more competitive with foreign producers. Unfortunately, none of the latter was successful, as each was challenged by the European Union or its predecessor. After the World Trade Organization authorized the European Union to impose billions in retaliatory tariffs if the U.S. did not eliminate the tax benefits of its Extraterritorial Income ("ETI") regime, Congress repealed those provisions and replaced them with what is now section 199. The Senate Finance Committee, in reporting on its version of the ETI repeal, stated:

Other statements by the relevant Congressional committees on the proposed legislation that would become section 199 make clear that Congress's intent in enacting the provision was to stimulate domestic production activities. In its report on the JOBS Act, the Senate Finance Committee also stated, "The Committee believes that creating new jobs is an essential element of economic recovery and expansion, and that tax policies designed to foster job creation also must reverse the recent declines in manufacturing sector employment levels." Id. at 11.

Congress recognized that the film industry faced unique difficulties assuring domestic production. Sending U.S. film and television production offshore is referred to as the "runaway production" problem. In 2001, the Department of Commerce, at the request of Congress, issued a report on the runaway production problem. See DoC TV Report at i, 4. It noted that the number of made-for-television and feature film productions by U.S. companies that were produced outside of the United States was increasing. Id. at 1. Foreign countries, particularly English-speaking foreign countries, such as Canada, the United Kingdom, Ireland, and Australia, were aggressively courting U.S. film production. Id. at 1, 46. "These countries have four main traits in common, they are all English-speaking, they all have a skilled workforce, they each offer a variety of incentive programs to the film industry, and they all have rapidly growing film markets." Id. at 46. "Taking advantage of exchange rates, government-backed incentives, lower wage rates and lower costs in general, many foreign countries have been able to attract film productions that in the past would most certainly have stayed in the United States." Id. at 63. By some estimates, the U.S. suffers economic losses of as high as $10.3 billion per year and loses as many as 47,000 jobs a year from the runaway production problem. STEPHEN M. KATZ CTR. FOR ENT. INDUS. DATA & RESEARCH, THE GLOBAL SUCCESS OF PRODUCTION TAX INCENTIVES AND THE MIGRATION OF FEATURE FILM PRODUCTION FROM THE U.S. TO THE WORLD: YEAR 2005 REPORT at 2 (Mark A. Rosenthal ed., 2006); THE MONITOR CO., THE ECONOMIC IMPACT OF U.S. FILM AND TELEVISION RUNAWAY FILM PRODUCTION at 2 (1999). Reducing or eliminating the section 199 deduction will only exacerbate this problem.

Taking considerations like these into account, Congress included film production as a qualifying production activity in section 199 and then amended section 199 to provide special rules for films.⁵ Those actions evidence Congress's expectation that the film industry would be covered by section 199 and its recognition that it needed rules specially tailored to the unique aspects of film production that distinguish it from traditional manufacturing. For example, the Joint Committee on Taxation noted that "Congress believes that domestic film production is important to the United States economy" and that domestic production activities rules under section 199 should "take into consideration how the film industry operates." STAFF OF THE J. COMM. ON TAXATION, GENERAL EXPLANATION OF TAX LEGISLATION ENACTED IN THE 110TH CONGRESS, JCS-1-09 at 447 (2009) (discussing modifications made to section 199 specific to the film industry).

Since the enactment of section 199, the Department of the Treasury ("Treasury") and the Internal Revenue Service ("IRS" or the "Service") have provided detailed and thoughtful regulations and guidance interpreting its provisions and creating a safe harbor to allow qualification for the deduction. A key aspect of those regulations has been the recognition that identifying who the manufacturer is for purposes of allowing the deduction is not always clear from a simple examination of the parties' contracts and that multiple parties may play a sufficient enough role in production to warrant their receiving the benefit of the deduction, consistent with the statute. The regulations have recognized that, oftentimes, the entrepreneurial entity making the choice of where and how to produce, bearing key costs of production, directing the operation, and selling the products whose production section 199 is meant to encourage is different from the entity "turning the screws." The section 199 regulations have long accepted that it is consistent with the language and purpose of section 199 to allow the former entity, the one that bears the risk and has the ability to choose where the production will occur, to obtain the section 199 benefit. Thus, in one form or another, those regulations have allowed the deduction to the entity with the benefits and burdens of ownership of the product throughout the production process.

This determination is consistent with similar decisions made in other areas of the law. For example, this flexible approach has much in common with the rules promulgated pursuant to section 263A with respect to the capitalization of costs for property produced by the taxpayer. See Treas. Reg. § 1.263A-2(a)(1)(ii)(B)(l) ("Property produced for the taxpayer under a contract with another party is treated as property produced by the taxpayer to the extent the taxpayer makes payments or otherwise incurs costs with respect to the property."); see also Treas. Reg. § 1.993-3(c)(2).⁶ Similarly, the regulations under section 954 allow an entity to qualify for the same country exception under the Subpart F rules where it makes a substantial contribution to manufacturing, even if someone else turns the screws. See Treas. Reg. § 1.954-3(a)(4).⁷ Hence, it is consistent with the statute and with established practices to treat the principal in a contract manufacturing arrangement as the party entitled to the section 199 deduction, as Treasury and the IRS have permitted in appropriate circumstances since its enactment over a decade ago.

Since the decision to apply the benefits and burdens test in this context, the IRS has worked to clarify it and ease its administration. Those efforts have recognized the validity of the benefits and burdens test and have aimed at defining its boundaries. In recent guidance, the Service stated that the benefits and burdens test was implemented to ensure specifically that only one party obtained the deduction. See Directive LB&I-04-1013-008 (Oct. 29, 2013). Given that it is not always obvious from a quick examination who has those benefits and burdens in a contract manufacturing situation, the Service allows a taxpayer claiming the deduction to provide (a) a statement explaining the basis of its determination that it has the benefits and burdens, and (b) certifications signed by the taxpayer and the counterparty agreeing on who may claim the deduction. If a taxpayer provides the specified documents, then the Service will not challenge that the taxpayer had the benefits and burdens of ownership. That Directive was only put into place on October 29, 2013, and its effectiveness has not yet been evaluated in practice.

The benefits and burdens test has stood the test of time. It has been applied across a broad array of Internal Revenue Code sections, and its confines are widely understood. See Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981). While there have been disputes under it, there have not been an excessive number of disagreements, and the courts have had little difficulty resolving questions when called upon to do so. Moreover, the Service fared well when a controversy under section 199 regarding which party had the benefits and burdens of ownership required judicial intervention. See ADVO, Inc. v. Commissioner, 141 T.C. 298 (2013). Finally, as noted, the Directive described above is new, and the Service has not yet had an opportunity to see if it is effective at reducing disputes. We believe that the combination of the permitted statement and the certification should resolve any lingering difficulties with administering the well-established test in a fair manner that allows section 199 to provide the needed incentive.

First, as noted above, the benefits and burdens test has been commonly applied across a broad array of code sections for decades. It has not proven too difficult to administer, and a well-developed body of cases and rulings gives it color and definition. See ADVO, Inc., 141 T.C. at 298; Grodt & McKay, 77 T.C. at 1221. Moving away from it for this one section will place the administration of section 199 on a different footing than other parts of the tax law where the parties also must consider whether one qualifies as a manufacturer or decide who owns property.

Second, the "problem" of two parties' claiming the deduction is purely theoretical from an economic perspective. Two people cannot get a deduction for the same revenues under this statute. If a contract manufacturer claims the deduction, its benefit is based on a percentage of its income, which is determined by computing the revenue it receives from its principal, reduced by its costs. Even if the principal also qualifies, the income to which the section 199 percentage is applied for the principal is reduced dollar for dollar by the amount it paid the contract manufacturer. Hence, there can be no double counting. Moreover, a rule like the certification rule in the Directive addresses the perceived problem without denying a risk-bearing entrepreneur the benefit of section 199 that Congress intended it to have.

Finally, this new rule is antithetical to the purposes of section 199 in the case of contract manufacturing. The deduction is a percentage of Qualified Production Activities Income. Contract manufacturers tend to be lower margin entities for which the deduction is of much less value. For example, Professor Jason Dedrick of Syracuse University, who studies contract manufacturing and supply chains, is quoted in The New York Times as saying "[Contract manufacturers are] like Wal-Mart stores, . . . They're low-margin, high-volume. They survive by being efficient .'. . . They compete fiercely on price to earn small profit margins, analysts say. And they seek to benefit from tiny operational changes." David Barboza, Clues in an iPhone Autopsy, THE NEW YORK TIMES, July 6, 2010 at Bl (emphasis added).

As a result, a new rule directing that in all circumstances it is the contract manufacturer that gets the deduction will significantly reduce the net amount of deductions available in a given contract manufacturing arrangement because the contract manufacturer will generate little, if any, income from a qualifying sale, license or other disposition of the property. That, in turn, may make domestic production more expensive, driving principals again to look offshore for their production. Even though the contract manufacturer can in principle pass through some or all of the benefit it receives in the form of a lower price to its principal to allow the latter to share in the benefit of the deduction, the reduced absolute dollar amount of the deduction limits the salutary effect of section 199.

The section 199 deduction works best when it inures to the benefit of the "mobile taxpayer" -- the one that will find it most easy to relocate operations. Domestic contract manufacturers have already invested in property, plant and equipment on shore, and they cannot easily relocate overseas. Hence, the deduction likely has little direct effect on their decisionmaking. As they also typically operate at a lower margin, the deduction does less to make them competitive. Conversely, when the deduction is available to principals deeply involved in the manufacturing process if they work with American contract manufacturers, it can have the desired effect. Since the statute was enacted, Treasury and the IRS have correctly interpreted it to allow such principals to claim the deduction, and the Proposed Regulations take that ability away for questionable administrative reasons.

Segments of the film industry will be particularly hard hit by the Proposed Regulations. Unlike physical manufacturing, which often requires specialized facilities that once built cannot easily be relocated, film production is highly mobile. Indeed, that is why foreign (and state) governments are able to attract film production with incentive packages -- because the business is highly mobile. Production is often described as a "floating factory" as "the same workers with the same skills produce the same products using the same 'machinery' (sets, lights, cameras), but with a production set, the 'factory' moves around, depending on the requirements of each scene in the film." DoC TV REPORT at 12. If Treasury's actions have the effect of significantly reducing or taking away this incentive intended by Congress, the principals that engage independent film production service companies to perform contract manufacturing may look offshore.

Some cable program networks do not self-produce all of their content and hire production service companies to produce much of it. Many of those production service companies are smaller, lower margin operations that will not benefit significantly from the deduction. See Ernst & Young SPOTLIGHT ON PROFITABLE GROWTH VOLUME VII MEDIA & ENTERTAINMENT at 6 (2014) (showing that film and television content producers have lower EBIDTA margins). That, in turn, will make domestic film production more costly and may drive more production offshore, defeating the purpose of the special film provisions in section 199. Thus, even if one concludes that the investment in domestic property, plant and equipment makes it less likely that traditional manufacturing operations will be displaced by these new rules, the same cannot be said for film production. As Congress specifically designed section 199 in its current form "to take into consideration how the film industry operates," JCS-1-09 at 447, the final rule must recognize that difference and protect the domestic film industry.

The proposed rule has other infirmities as well. It creates situations in which there is domestic production and yet no one receives the deduction. Often, the contract manufacturer "turns all the screws" but the principal owns the raw materials, work-in-process, and finished goods (a common toll manufacturing structure). Under the proposed rule, the principal may not claim the deduction, nor may the contract manufacturer, because it never makes a qualifying disposition. The Preamble appears to recognize this gap in the proposed rules, see Preamble at ¶ 7, but the Proposed Regulations do not solve it. Finally, the Proposed Regulations treat two similarly situated segments of the film industry inconsistently, because they appropriately retain the statutory entitlement of vertically integrated producers to the deduction, but deny it to cable program networks whose business models involve their working with independent film production service companies.

Thank you for considering these comments.

² The Proposed Regulations would remove the benefits and burdens test from Treas. Reg. § 1.199-3. They would also alter the calculation of the numerator of the Treas. Reg. § 1.199-3 safe harbor fraction.

³ As used herein, "film" refers to any motion picture film or video tape. See section 199(c)(6) (incorporating the definition of a "film" found in section 168(f)(3)).

⁴See also H.R. Rep. 108-755 at 275 (2004) (Conf. Rep.).

⁵See, e.g., sections 199(b)(2)(D), (c)(4)(A)(i)(II), and (c)(6).

⁶ "[P]roperty which is sold or leased by a person is considered to be manufactured or produced by such person if such property is manufactured or produced . . . by such person or by another person pursuant to a contract with such person." Treas. Reg. § 1.993-3(c)(2)(i).

⁷ We recognize that sections 199 and 954 serve different purposes, but the fact that the substantial contribution regulations allow one who does not turn the screws to be treated as manufacturing a product demonstrates that Treasury's interpretation of section 199 over the past decade has close analogs throughout the tax law.