Menu
Tax Notes logo
HOMETax Notes ResearchFederalOther Documentspublic comments on regulations

Firm Suggests Adding Safe Harbor Rule to Manufacturing Regs

NOV. 24, 2015

Firm Suggests Adding Safe Harbor Rule to Manufacturing Regs

DATED NOV. 24, 2015
DOCUMENT ATTRIBUTES

 

November 24, 2015

 

 

The Honorable John A. Koskinen

 

Commissioner

 

Internal Revenue Service

 

1111 Constitution Avenue, NW

 

Washington, DC 20224

 

 

James Holmes

 

Office of the Associate Chief Counsel

 

Passthroughs and Special Industries

 

Internal Revenue Service

 

1111 Constitution Avenue, NW

 

Washington, DC 20224

 

 

The Honorable William J. Wilkins

 

Chief Counsel

 

Internal Revenue Service

 

1111 Constitution Avenue, NW

 

Washington, DC 20224

 

RE: Proposed Regulations (REG-136459-09): Relating to Guidance under Section 199 on Domestic Production Activities Deduction Issued on September 14, 2015

 

Dear Messrs. Koskinen, Wilkins, and Holmes:

Karlins Ramey & Tompkins, LLC (KRT) submits the comments below in response to the proposed regulations (REG-136459-09) published on September 14, 2015 requesting feedback on how the term minor assembly in § 1.199-3(e)(2) should be defined and the submission of examples illustrating the term. These comments were developed by Dale W. Spradling, PhD, CPA who is a principal in KRT. We commend the Internal Revenue Service (IRS) for attempting to clarify the definition of minor assembly in order to reduce the likelihood of future controversy and litigation.

Section 199(c)(4)(A)(i) -- MPGE QPP

A. Recommendation

KRT recommends the IRS amend the proposed regulations and proposed Example 9 to adopt the safe harbor rule of § 1.954-3(a)(4)(iii) where incurring direct labor and factory burden equal to 20 percent of the taxpayer's cost of goods sold is defined as the floor for determining what is not minor assembly.

B. Analysis

Section 199 of the Internal Revenue Code allows a deduction of a specified percentage of "qualified production activities income" for the taxable year [ § 199(a)(1)(A)]. "Qualified production activities income" equals the taxpayer's "domestic production gross receipts" (DPGR) minus the related cost of goods sold and other expenses, losses, or deductions [ § 199(c)(1)]. DPGR is defined, in relevant part, as the taxpayer's gross receipts derived from "any lease, rental, license, sale, exchange, or other disposition of . . . qualifying production property which was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the United States" [ § 199(c)(4)].

While section 199 does not define "manufactured, produced, grown, or extracted" (MPGE), Treas. Reg. § 1.199-3(e)(1) says it includes "manufacturing, producing, growing, extracting, installing, developing, improving, and creating qualified production property (QPP); making QPP out of scrap, salvage, or junk material as well as from new or raw material by processing, manipulating, refining, or changing the form of an article, or by combining or assembling two or more articles." However, Treas. Reg.§ 1.199-3(e)(2) goes on to say: "If a taxpayer packages, repackages, labels, or performs minor assembly of 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." Consequently, with respect to defining MPGE in the current context, the conflict is between (e)(1) (MPGE QPP) and (e)(2) (Minor Assembly), where MPGE QPP qualifies as DPGR and Minor Assembly does not.

This divergence between MPGE QPP and Minor Assembly was the focus of United States v. Dean, 945 F. Supp. 2d 1110 (G.D. Cal. 2013) (Dean) and Precision Dose, Inc. v. United States, No. 3:12-cv-50180 (N.D. Ill. 2015) (Precision Dose). The facts of Dean were summarized by the IRS in proposed Example 9:

 

Example (9). X is in the business of selling gift baskets containing various products that are packaged together. X purchases the baskets and the products included within the baskets from unrelated third parties. X plans where and how the products should be arranged into the baskets. On an assembly line in a gift basket production facility, X arranges the products into the baskets according to that plan, sometimes relabeling the products before placing them into the baskets.

 

The facts in Precision Dose have a similar contextual analysis:

 

Corporation engaged in development and sales of "unit doses" of medication. Taxpayer's activities included applying its processes to drugs, and syringes and cups in which they came, so as to cause unit doses to come into existence. Although repackaging was part of what taxpayer did, its activities also included other production activities, which ran from searching out drugs suitable for processing to designing lidding and conducting testing and other studies.

 

The IRS argued in Dean, and has taken the same position in these proposed regulations, the taxpayer engaged no other activity besides packaging, repackaging, labeling, or minor assembly with respect to the gift baskets. Therefore, it did not engage in the MPGE QPP. The IRS took a similar position in Precision Dose by claiming the taxpayer was only engaged in repackaging, which is expressly excepted from the definition of MPGE QPP.

Both the Dean and the Precision Dose courts disagreed with the IRS and ruled the activities of the taxpayers in each case resulted in changing "the form of article" within meaning of the § 1.199-3(e)(1), i.e., the MPGR QPP rule. Both the Dean and Precision Dose courts instead adopted a "creation of a new or unique product" theory where, based on the facts of each case, the sum of the taxpayer's activities trumped the Minor Assembly repacking rule of § 1.199-3(e)(2) and gave rise to MPGE QPP as defined in § 1.199-3(e)(1).

Regardless of which side of the fence one comes down on, neither the proposed regulations nor the Dean and Precision Dose cases offer a widely applicable objective test for distinguishing MPGE QPP from Minor Assembly. Furthermore, proposed Example 9 does not offer any definitive guidance because a taxpayer could argue its facts and circumstances differed from the proposed example, which could lead to future controversy and possible litigation.

This inability to draw a black line leads us to recommend a focus on wages paid instead of an analysis of the underlying activities, of which there appears to be an infinite variety of fact patters. More specifically, we recommend the administration of the section 199 deduction will be better served if these proposed regulations adopt the safe harbor language of § 1.954-3(a)(4)(iii) as the measuring stick for MPGE QPP:

 

(iii) * * * the operations of the selling corporation in connection with the use of the purchased property as a component part of the personal property which is sold will be considered to constitute the manufacture of a product if in connection with such property conversion costs (direct labor and factory burden) of such corporation account for 20 percent or more of the total cost of goods sold. In no event, however, will packaging, repackaging, labeling, or minor assembly operations constitute the manufacture, production, or construction of property for purposes of section 954(d)(1). [Emphasis added.]

 

We do not recommend adopting the last sentence of this regulation because doing so would defeat the objective of developing a black-line rule. Said another way, if the congressional goal of section 199 is to incentivize the creation of manufacturing jobs in the United States, using wages paid in any kind of manufacturing context would better align the final section 199 regulations with congressional intent than any subjective facts and circumstances test for defining MPGE.

The application of using the safe harbor language of § 1.954-3(a)(4)(iii) to distinguish between MPGE and Minor Assembly may be illustrated by the following proposed Example 9:

 

Example (9). X is in the business of selling gift baskets containing various products that are packaged together. X purchases the baskets and the products included within the baskets from unrelated third parties. X plans where and how the products should be arranged into the baskets. On an assembly line in a gift basket production facility, X arranges the products into the baskets according to that plan, sometimes relabeling the products before placing them into the baskets. On a per unit basis, X's selling price and costs of each gift baskets are as follows:

 

 Selling price                                                   $25.00

 

 Cost of goods sold:

 

 Total material acquired from unrelated third parties --  $14.75

 

 Conversion costs (direct labor and factory burden) --     $3.25

 

 Total cost of goods sold                                        $18.00

 

 Allocable Indirect Costs                                         $1.00

 

 QPAI                                                             $6.00

 

 DPD                                                              $ -0-

 

 Non-allocable Administrative and selling expenses                $2.00

 

 Taxable income                                                   $4.00

 

Because X's conversion costs are less than 20 percent of total cost of goods sold ($3.25/$18.00 or 18 percent), the operations conducted by X in connection with the property purchased and sold are not MPGE and constitute minor assembly.

 

Here, the worst case scenario for abusive behavior would be for X to pay 50 cents more in wages to get above the proposed 20 percent threshold ($3.75/$18.50). This would allow X to claim a 50 cent section 199 deduction (($25.00-$18.50-$1.00) x 9%) on its tax return, resulting in $3.00 in taxable income. Even then, assuming a 25 percent marginal rate, the nominal 25 cent loss in tax revenue ($1 of tax at $3.25 in wages and no section 199 deduction versus $.75 of tax at $3.75 in wages and a $.50 section 199 deduction) should be offset by 12.5 cents ($.50 x 25%), i.e., the marginal income tax on the additional 50 cents in wages, resulting in a net potential revenue loss of 12.5 cents.

We believe it is possible this potential 12.5 cent revenue loss, which would only happen in the most extreme cases as outlined above, caused by adopting a 20 percent safe harbor rule would be most likely offset by reduced administration costs compared to the expense of enforcing the current (e)(1) versus (e)(2) model. Moreover, it would align the final section 199 regulations with congressional intent for increasing manufacturing wages.

Conclusion

Changing the proposed section 199 regulations definition from a facts and circumstances test to a 20 percent bright-line objective test should help address any problems which currently exist with regard to distinguishing between MPGE and Minor Assembly. We appreciate your consideration of these comments and welcome the opportunity to discuss these issues further. Please feel free to contact me at (281) 364-0245 or dspradling@krtcpas.com.

Respectfully submitted,

 

 

Dale W. Spradling, PhD, CPA

 

Principal, Karlins Ramey &

 

Tompkins, LLC

 

The Woodlands, TX
DOCUMENT ATTRIBUTES
Copy RID