Keep the Ownership Rule in Manufacturing Regs, Magazine Group Says

MPA -- The Association of Magazine Media appreciates the opportunity to comment on the proposed rulemaking under Section 199 of the Internal Revenue Code (IRC) issued in August, 2015 by the Internal Revenue Service and U.S. Department of Treasury (collectively "IRS").

As the national trade association for the consumer magazine industry, MPA represents approximately 175 domestic magazine media companies with more than 900 national publications that span an enormous range of genres across print and digital media. Our industry plays a prominent role in culture, society and the economy by fulfilling readers' desires for timely information and entertainment that appeal to a broad spectrum of personal interests. Our members connect more than 90% of all U.S. adults to the print and digital magazine titles they trust and value most.

Section 199, the Domestic Production Activities Deduction, provides an important tax incentive for U.S. domestic manufacturers and producers -- including magazine publishers -- that supports U.S. jobs as well as the nation's economy. While we understand the IRS's concerns regarding multiple taxpayer claims for a particular activity involved in contract manufacturing, and appreciate the IRS's effort to minimize the use of IRS and taxpayer resources by simplifying administrative processes, it is our strong belief that the proposed approach is flawed. Replacing the long-standing and widely used benefits and burdens of ownership rule with a unilateral assignment of the deduction to the taxpayer performing the qualified activity ("the proposed rule") not only fails to appropriately resolve the double claimant issue, but also undermines the original intent of the law to the detriment of domestic manufacturers and the U.S. economy. Further, the proposed rule is contrary to the requisite statutory requirement that a taxpayer derive its gross receipts from a qualifying disposition. We look forward to working with the IRS in order to establish a solution that better resolves the IRS's stated concerns, while strengthening the tools currently available to effectively ensure the deduction is awarded to the rightful contracting party.

Existing Rule and Proposed Rulemaking

Section 199 was added to the IRC by the American Jobs Creation Act of 2004. Under current law, taxpayers may claim a 9% deduction of the lesser of taxable income derived from the sale of qualified production property grown, manufactured, produced or extracted in the United States, or taxable income. The amount of the deduction shall not exceed 50 percent of the W-2 wages of the taxpayer for the taxable year. The statute grants the IRS authority to issue regulations providing that only one taxpayer is permitted to claim a deduction per manufacturing activity of qualified production property.

The IRS has issued regulations to determine the appropriate beneficiary of the deduction when one taxpayer performs an activity pursuant to a contract with another party to produce qualified production property. In that case, only the taxpayer with the 'benefits and burdens of ownership' of the qualified production property under Federal income tax principles during the period in which the qualifying activity occurs is treated as engaging in the qualified activity. This determination requires an analysis of facts and circumstances relating to contract terms, production activities and economic risk to determine which taxpayer bears the benefits and burdens of ownership of the qualified production property during this period, including: (1) Whether legal title passes between the parties; (2) how the parties treat the transaction; (3) whether an equity interest is acquired; (4) whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments; (5) whether the right of possession is vested in the purchaser and which party has control of the property or process; (6) which party pays the property taxes; (7) which party bears the risk of loss or damage to the property; (8) which party receives the profits from the operation and sale of the property; and (9) whether a taxpayer actively and extensively participated in the management and operations of the activity.¹

On August 27, 2015, the IRS proposed amendments to these regulations that would remove the benefits and burdens of ownership rule and instead provide a rule that only the party performing the qualified activity is treated as engaging in the qualified activity. In most, if not all, contract manufacturing arrangements, the proposed rule would award the Section 199 deduction to the contract manufacturer. The IRS expressed concerns that the benefits and burdens of ownership rule does not clearly identify the eligible party, due to the many factors and analysis required for consideration, and may result in more than one taxpayer claiming the deduction for the same activity. Resolving the discrepancies between the taxpayers requires significant IRS and taxpayer resources.

However, instead of providing a solution that strengthens the clarity and efficiency of this important process, the proposed rule completely ignores the important factors that impact the determination of deduction eligibility. Prescribing a one-size fits all approach to such a complex set of circumstances does little more than blindly pick a winner and loser, to the potential detriment of both parties involved, and undermines the original intent of the law and the U.S. economy. In addition, such an approach is contrary to the requisite statutory requirement that a taxpayer derive its gross receipts from a qualifying disposition. As detailed below, this approach is deeply troubling to U.S. magazine publishers.

Failure to Recognize the Nature of Contract Manufacturing

Contract manufacturing is a common service arrangement engaged in by magazine publishers and the printers they hire to print their publications. Not every magazine publishing contract manufacturing arrangement is the same, but there is a general pattern that applies in most instances. The magazine publisher hires employees to produce the content of its publications, designs the publications, selects and purchases paper and other materials, is actively involved in the printing process by providing detailed printing instructions (including directing where the printing is to be done), performs quality control procedures, and sells the publication to its customers. This is generally set forth in a contractual agreement the publisher initiates with the printer. Based on this arrangement, the printer provides printing services by printing and binding the content produced by the publisher according to layout designed by the publisher onto the paper owned by the publisher and then ships the magazines to newsstand wholesalers and subscribers on publisher sourced carriers and/or at the publisher's direction.

The publisher does not transfer ownership of the magazine, its content or paper to the printer. Without a transfer of ownership, all risks and liabilities of the magazine remain with the publisher. In fact, ownership remains with the publisher throughout the entire production process, from creation to distribution. Ownership is only transferred from the publisher to the end customer.

The benefits and burdens of ownership rule recognizes the complex nature of contract manufacturing, which the proposed rule fails to do. If the IRS's ultimate goal is to ensure the Section 199 deduction is awarded to the appropriate contracting party, then consideration must be paid to the varying circumstances that impact contract manufacturing. Removing the benefits and burdens of ownership rule eliminates a time-tested process the IRS has relied on to ensure proper enforcement of Section 199 since the enactment of Section 199 to determine ownership of property for depreciation and other purposes. In addition, MPA questions how the benefits and burdens of ownership rule has been the proper test that was written and upheld by the IRS since the enactment of Section 199 and yet, without any statutory changes to Section 199(d)(10), the IRS has suddenly determined that the benefits and burdens of ownership rule should now be eliminated and prospectively replaced with another rule. Finally, the proposed rule upsets existing contractual relationships that were influenced by the benefits and burdens of ownership rule.

IRS is undermining the foundation of the Domestic Production Activity Deduction

Section 199 was enacted to enhance the domestic manufacturing sector, stimulate job creation, and grow the nation's economy. On June 16, 2004, the House Ways and Means Committee submitted its report to the House of Representatives in order to provide the policy rationale for specific provisions of the American Jobs Creation Act. Among the details provided, the report specifically addresses the Committee's legislative intent related to Section 199, by stating:

This has proven true for magazine publishers, who according to the Alliance for Audited Media, produce close to 4 billion magazines annually.³ The Section 199 deduction claimed by magazine publishers has helped to offset higher wage costs for utilizing U.S. contract manufacturers and has allowed American magazine businesses to maintain production activities, like printing and fulfillment services, in the United States.

In terms of Congressional intent, it is also worth noting that the Section 199 deduction was intended to be a replacement for the then-repealed Extraterritorial Income export incentives (ETI). Under the ETI, publishers were the qualified party, not printers. Given that publishers were the party that qualified for ETI, it is illogical to think that Congress intended to take a tax benefit away from eligible ETI beneficiaries and provide a deduction for taxpayers, i.e., printers that likely did not qualify for ETI in the first place.

To effectuate the original intent of Congress, MPA strongly encourages the IRS to consider several factors prior to issuing regulations that impact the scope of the Section 199 deduction as it relates to contract manufacturing. Those factors include:

In most, if not all, contractual agreements between magazine publishers and printers, the proposed rule would make a blanket determination that contract printers are always the eligible taxpayer, and publishers are never the eligible taxpayer. Without the ability to claim the Domestic Production Activities Deduction, American publishers may take their contract outsourcing to Canada, Mexico or overseas to lower-cost suppliers. The proposed rule fails to effectively account for the important factors mentioned above and therefore undermines the foundation of the Domestic Production Activities Deduction.

The Proposed Rule Could Lead to Neither Party Qualifying for the Deduction

Under current law, the Domestic Production Activities Deduction allows taxpayers a deduction based on the lesser of taxable income derived from qualified production activities (QPAI) or taxable income. A taxpayer's QPAI is equal to the taxpayer's domestic production gross receipts (DPGR), reduced by (1) the cost of goods sold that is allocable to those receipts; and (2) other deductions, expenses, and losses that are properly allocable to those receipts. DPGR means the gross receipts derived from any lease, rental, license, sale, exchange or other disposition of qualifying production property.

For purposes of Section 199, gross receipts must be derived from the disposition of a property. This was a well-established rule as the original drafters of Section 199 made it very clear that a taxpayer had to have the benefits and burdens of ownership in order to have a qualifying disposition of the property, noting that a taxpayer cannot sell, and therefore have a qualifying disposition, what it does not own. Magazine publishers claim deductions under Section 199 based on the income derived from the sale of the magazine itself, and the sale of advertisements printed in the magazine. The payment the printer receives from the publisher is related to the performance of printing services, which are not DPGR because there is no qualified disposition of property by the printer when the printer does not own the magazine to sell. The fact that the printer is a service provider to the publisher is especially highlighted where the printer is performing its printing services on paper that is owned by the publisher. In such cases, a printer cannot sell the paper that it never owned in the first place.

Because the deduction requires a taxpayer to derive its gross receipts from a qualifying disposition of qualifying property, the proposed rule, by treating the party performing the contract manufacturing activity as the party that performs the MPGE activity irrespective of benefits and burdens or ownership, could eliminate either party's ability to claim the deduction. Printers do not own, and thus cannot sell, the magazines they print. If only the printer is treated as the party performing the MPGE activity, but it has no DPGR, then neither the publisher nor the printer may be able to take the deduction. Eliminating either party's ability to claim the deduction contradicts the language and purpose of the statute.

Conclusion

As demonstrated above, the proposal to replace the benefits and burdens of ownership rule with a unilateral determination of eligibility fails to recognize the nature of contract manufacturing, and the important factors that have determined Section 199 eligibility since 2005. The proposed rule eliminating those considerations from the eligibility determination would completely alter the scope and applicability of the deduction. In actuality, the proposed rule is a major reversal of the existing regulations and stands to impose real consequences on the U.S. manufacturing sector.

The preamble to the proposed rule states "This rule, which applies solely for purposes of Section 199, reflects the conclusion that the party actually producing the property should be treated as engaging in the qualifying activity for purposes of Section 199, and is therefore consistent with the statute's goal of incentivizing domestic manufacturers and producers." This conclusion by the IRS ignores the fact that in many cases it is the contracting party (who develops the product) that determines where the product is to be manufactured. By eliminating the benefits and burdens considerations from the eligibility determination and, in the case of the publishing industry and in most, if not all, other contract manufacturing arrangements, unilaterally awarding the Section 199 deduction to the contract manufacturer, the result will subvert the clear intent of the statute and impose unintended consequences on the U.S. manufacturing sector.

The U.S. consumer magazine industry urges the IRS not to abandon the benefits and burdens of ownership rule and replace it with a unilateral determination of deductibility for contract manufacturers. We strongly believe that there are alternatives that the IRS should consider to provide administrable rules that are consistent with Section 199 and that do not require significant IRS and taxpayer resources, and prevent more than one taxpayer from being allowed the deduction. The IRS should refocus its efforts on strengthening, as opposed to eliminating, the important benefits and burdens of ownership rule. Doing so can provide administrative clarity while ensuring appropriate application of the rule that supports the U.S. manufacturing sector and the original legislative intent.

MPA and our members appreciate the opportunity to comment and would be happy to meet with the IRS to further discuss our concerns and recommendations regarding the proposed rule. We look forward to working with the IRS to strengthen the application of Section 199, the Domestic Production Activities Deduction.

² H.R. REP. No. 108-548.

³ MPA calculations based upon Alliance for Audited Media FH 2015 data.