Firm Offers Alternative for Manufacturing Deduction Eligibility

In response to the proposed changes to the regulations promulgated under Section 199 of the Internal Revenue Code, we provide these comments that are trained on proposed Treasury Regulation §§ 1.199-3(e), (f).

Currently, the final regulations permit a taxpayer who contracts with another party to produce "qualified production property" ("QPP") to claim a Section 199 deduction if the taxpayer has the "benefits and burdens" of owning the QPP during the period of qualifying production. See Treas. Reg. §§ 1.199-3(e)(1), (f)(1). This rule has created substantial controversy between taxpayers and the Internal Revenue Service (the "Service") in determining who has the benefits and burdens of ownership of the QPP during the production process. As the preamble to the proposed regulations accurately states, both the Service and taxpayers have expended substantial resources in attempting to make this determination. Indeed, we have represented several clients on this very issue, and have witnessed first-hand the difficulty both sides have had in resolving this issue.

In an effort to provide a more administrable methodology, the proposed regulations would award the Section 199 deduction in a contract manufacturing context to the taxpayer that actually performs the production activity even if that taxpayer does not have the benefits and burdens of ownership. We believe that the proposed rule conflicts with Section 199,and is inconsistent with Congressional intent.

The Proposed Regulation Conflicts with Section 199

Section 199 grants a deduction equal to 9 percent of the lesser of a taxpayer's "qualified production activities income" ("QPAI") or taxable income. See Sec. 199(a)(1). QPAI is determined based upon a taxpayer's "domestic production gross receipts" ("DPGR"). See Sec. 199(c)(1). DPGR is defined as the gross receipts of the taxpayer derived from, inter alia, any "sale, exchange, or disposition of qualifying production property which was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States." See Sec. 199(c)(4)(A). Accordingly, to be entitled to claim a Section 199 deduction, a taxpayer must generate DPGR.

Taxpayers that only provide services do not have DPGR because they do not otherwise sell, exchange or dispose of QPP. Accordingly, the benefits and burdens of ownership test is integral to determining whether the taxpayer has DPGR from qualifying activity. The proposed regulation, however, would permit a taxpayer that only provides services to claim the Section 199 deduction merely because it performs the production activity. Accordingly, the proposed rule is in direct conflict with Section 199(c)(4)(A).

Moreover, it is clear that Congress knows how to make the Section 199 available to service providers who do not otherwise have DPGR. In 2005, Congress enacted Section 199(c)(4)(C) to provide a statutory exception to allow government contractors who only provide services pursuant to the Federal Acquisition Regulation to treat the gross receipts derived from the government contractors production activities of QPP as gross receipts from the lease, rental, license, sale, or disposition of QPP. Without a similar statutory provision, the Service and Treasury do not have the authority to treat the gross receipts of a contract manufacturer who only provides services as DPGR.

The Proposed Regulation Contravenes Congressional Intent

The proposal to eliminate the contract manufacturing rule in the final regulations under Section 199 contravenes Congressional intent. In fact it is clear from the legislative history that Congress enacted Section 199 to incentivize domestic production to increase jobs in the United States. See Joint Committee on Taxation, General Explanation of Tax Legislation in the 108^th Congress (JCS-5-05), May 2005, p. 170. The proposed rule, however, does not encourage job growth in the United States, and, instead, may promote moving jobs to countries with lower wage costs.

In the context of contract manufacturing, the principal taxpayer decides where the property will be manufactured. Accordingly, giving the Section 199 benefit based only upon who performs the activity will not incentivize the principal taxpayer who controls the decision of who does the contract manufacturing and whether that production is performed by domestic contract manufacturers. Instead, the proposed rule may encourage moving production that is currently taking place in the United States to countries with lower wages. Clearly, a rule that incentivizes principals to move manufacturing jobs outside the United States is not what Congress intended when it enacted Section 199.

An Alternative to the Proposed Regulation

While the current "benefits and burdens" test in the final regulations does achieve Congress's intent to create and keep jobs in the United States, we agree that the rule in practice is difficult to administer. An alternative test that keeps jobs in the United States and realizes the Service's desires to simplify administration and permit only one taxpayer to claim the Section 199 deduction is found in the regulations promulgated under Section 263A.

Treasury Regulation § 1.263A-2(a)(1)(B) provides that a taxpayer who hires a third-party manufacturer under a contract is treated as having produced the property to the extent the taxpayer makes payments or otherwise incurs costs with respect to the property. This rule deems the taxpayer as the producer of the property for Section 263A purposes if the agreement is entered into before production of the property is completed. See Treas. Reg. § 1.263A-2(a)(1)(B)(2)(i). To guard against abuse, the routine production activities of the third-party are not attributed to the taxpayer. See Treas. Reg. § 1.263A-2(a)(1)(B)(2)(ii). The regulations make clear that for the taxpayer to be considered the producer, the property being produced under the contract must be tailor-made to the taxpayer's specific needs.

This rule could be adopted easily for Section 199 purposes. In that context, the rule would permit only one taxpayer to claim the Section 199 benefit, and Congress's intent to incentivize domestic production would be similarly preserved.

Conclusion

The proposed rule of granting the Section 199 deduction only to the taxpayer that actually performs the production activities is in conflict with Section 199 and inconsistent with Congressional intent. Instead, a rule that can achieve the Service's objective of efficient and effective administration already exists in the context of Section 263A.