Farmer Co-op Seeks Clarification to Domestic Manufacturing Regs

NCFC wishes to comment on the proposed change to the rules related to contract manufacturing contained in Prop. Treas. Reg. § 1.199-3(i).

Many farmer cooperatives are marketing cooperatives. They receive, process and market the farm products of their members on a cooperative basis. When they do so without the assistance of contract manufacturers, there is no question that they have manufactured, processed, grown or extracted ("MPGE'd") the products that they market based on the cooperative attribution rule contained in Section 199(d)(3)(D) and on their own processing activities.

The receiving and processing plants of the cooperatives usually are located close to the farms of their members, but at a considerable distance from the principal markets for their finished products (which may be national and international in scope). It is not uncommon for cooperatives to engage in significant processing of their members' products at their plants. They then ship processed products in bulk form to contract manufacturers located nearer to their customers' markets. The contract manufacturers produce and package finished products for the cooperatives which the cooperatives then sell to their customers.

For instance, a cooperative may process its members' fruit into a juice concentrate and ship the concentrate to a contract manufacturer, who then adds water and packages the juice for the cooperative. The cooperative sells the finished product to its customers.

There are many business reasons cooperatives engage contract manufacturers. For instance, they may do so to save transportation costs (why pay to ship water?). Contract manufacturers may have specialized equipment, which a cooperative does not have, that is required to produce the finished product. In other cases (particularly involving international sales), it simply is less expensive to out-source this stage of production than to do it in-house.

Cooperatives generally retain title throughout the process and control the ultimate marketing of the finished products. The contract manufacturers perform their services in accordance with detailed specifications established by the cooperatives. The contract manufacturers do not have rights to the products themselves. The finished products bear cooperative brand names and labeling. The contract manufacturers receive a negotiated price for their services.

The activity performed by a contract manufacturer may be extensive enough to constitute MPGE, if the contract manufacturer were the owner of the qualifying production property at issue. The cooperatives view the contract manufacturing companies as providing them with a service. They do not treat the contract manufacturers' activities as their MPGE in order to meet the MPGE test. They meet that test independently based upon the cooperative attribution rule and their own processing activity. In short, they treat the finished product as a qualifying product for Section 199 purposes.

In the case of products destined for export, often there are legal reasons why the cooperatives cannot retain title throughout the process. It often is necessary to structure the arrangement as, in form, a sale of bulk processed product with a repurchase of the finished product for an amount equal to what was paid for the bulk product plus a negotiated price for the contract manufacturer's services. In substance, such arrangements are the same as those where title is retained throughout. The repurchase is contractually required from the start.

Issue

NCFC is concerned that in cases where the cooperative retains title, the language of the proposed amendment to the regulations might result in the cooperative not being regarded as having MPGE'd the product solely because it engaged a contract manufacturer to provide it with services.

Proposed Treas. Reg. § 1.199-3(i) states:

If the rule is applied to automatically preclude a taxpayer from having MPGE'd a product whenever the services of a contract manufacturer are involved, it is likely neither party would be able to claim the Section 199 deduction with respect to the product. The cooperative would be precluded from claiming the Section 199 deduction under the proposed rule, and the contract manufacturer would be precluded from claiming the Section 199 deduction because it is simply a service provider.

Presumably the rule is intended to provide simply that the MPGE of a contract manufacturer will not be attributed to the taxpayer in such a situation and nothing more.

NCFC believes that the result should be the same where the cooperative finds it necessary to structure a contract manufacturing arrangement as a sale of the bulk processed product with a repurchase of the finished packaged product from a contract manufacturer after the contract manufacturer has provided processing and packing services. Sale/repurchase arrangements are most common with foreign contract manufacturers. In substance, the foreign contract manufacturers are doing no more than provide services to the cooperative.

By eliminating a benefits and burdens analysis, the proposed change potentially creates differences in treatment of contract manufacturing arrangements that are in substance the same. Here what is important for a cooperative is not attribution of the activity of the foreign contract manufacturers' activities to the taxpayer to meet the MPGE requirement, since the MPGE is not domestic. Through the cooperative attribution rule and the cooperative's own activities, the finished product should be treated as having been MPGE'd by the cooperative. What is important is recognition that the arrangement does not result in what is a single product being treated as two products based on the formality that the arrangement is structured as a sale/repurchase. We believe that the proposed regulations should recognize the functional similarity of the two arrangements.

Since 1929, NCFC has been the voice of America's farmer cooperatives. Our members are regional and national farmer cooperatives, which are in turn composed of almost 3,000 local farmer cooperatives across the country. NCFC members also include 22 state and regional councils of cooperatives. NCFC is unique in Washington as the only national organization devoted solely to promoting, protecting and advancing the interests of farmer cooperatives and their owner-members.

Thank you for your time and consideration of our recommendations. If you have any questions or would like additional information, please contact NCFC Staff Marlis Carson at mcarson@ncfc.org.