Tech Group Wants IRS to Keep Ownership Rule in Manufacturing Regs

The Silicon Valley Tax Directors Group ("SVTDG") hereby submits these comments on the above-referenced proposed regulations issued under § 199 of the Internal Revenue Code of 1986, as amended, in REG-136459-09, 80 Fed. Reg. 51978 (August 27, 2015). SVTDG members are listed in the Appendix of this letter.

I respectfully request an opportunity to present oral comments, on behalf of the SVTDG, at the public hearing on December 16, 2015. An outline of the topics I propose to discuss, and the approximate time devoted to each topic, is given on the next page.

1. Recommendation that the current BBO rule not be replaced [8 minutes, total]

The SVTDG represents U.S. high technology companies with a significant presence in Silicon Valley, that are dependent on R&D and worldwide sales to remain competitive. The SVTDG promotes sound, long-term tax policies that allow the U.S. high tech technology industry to continue to be innovative and successful in the global marketplace.

B. Recommendation that the current BBO rule not be replaced

A taxpayer's deduction under § 199 depends on a taxpayer's domestic production gross receipts ("DPGR"), defined to include the taxpayer's gross receipts derived from the sale or disposition of qualifying production property ("QPP") that was manufactured, produced, grown, or extracted ("MPGE") by the taxpayer in whole or in significant part within the U.S.

In a situation involving a U.S. contract manufacturer ("CM") manufacturing products for a taxpayer principal, the current BBO rule in § 1.199-3(f)(1) provides that the party with the benefits and burdens of ownership of QPP under Federal income tax principles (the "BBO") during the period of manufacturing is treated as engaging in the manufacturing. The current BBO rule attributes to the taxpayer principal the CM's manufacturing activities if, as is common, the taxpayer principal has the BBO. The taxpayer principal's gross receipts from the sale of the QPP can thus constitute DPGR if the attributed manufacturing activities are substantial in nature. By contrast, if in this situation the CM has the BBO, the current BBO rule attributes to the CM the manufacturing activities it actually performs, and the CM's gross receipts from disposing of the QPP can constitute DPGR if the activities are substantial in nature. The current BBO rule ensures only one party gets a manufacturing deduction with respect to the sale of the QPP, because only one party can have the BBO during manufacture.

The proposed regulations¹ remove the current BBO rule and impose a new rule whereby the party actually performing an MPGE activity is always treated as performing the activity. In a contract manufacturing situation, consequentially, a taxpayer principal would never be attributed MPGE activities. The taxpayer principal's gross receipts from disposing of QPP manufacture by a CM would never constitute DPGR. The taxpayer principal would never get a § 199 deduction. We recommend the proposed rule be withdrawn and the current BBO rule be allowed to stand.

The Treasury Department and the IRS have failed to consider an important aspect of this issue. The determination of DPGR (in all cases in which there's a sale of QPP) turns on which taxpayer has BBO of the QPP. A sale of property for tax purposes rests on the legal conclusion that the BBO of that property have been transferred. If a CM doesn't have the BBO of the QPP during the time of manufacture, the CM can't sell the QPP and its gross receipts can't constitute DPGR. In this extremely common case neither the CM nor the principal would derive DPGR from the sale of the QPP -- no § 199 deduction could be claimed by either party. Determination of BBO is an essential process.

The proposed regulations give three alleged justifications for replacing the current BBO rule with the proposed rule, but two are false and the third certainly doesn't justify replacing the current BBO rule. First, the proposed rule is no more administrable than the current BBO rule because -- as just explained -- a BBO determination must still be made to determine if a CM's gross receipts constitute DPGR. Second, and for the same reason, the proposed rule won't reduce the burden on taxpayers and the IRS in evaluating BBO factors. In any event this burden, under an LB&I Industry Director Directive, falls initially and primarily on taxpayers. Third, admittedly the proposed rule prevents more than one taxpayer from being allowed a § 199 deduction with respect to any MPGE activity, but so does the current BBO rule, so why not keep the current BBO rule?

Importantly, the proposed rule is contrary to the purposes of § 199. First, in a U.S. contract manufacturing situation, the effect of the proposed rule -- denying the taxpayer principal a deduction -- will likely drive such taxpayers to use lower cost foreign CMs. The proposed rule is thus almost certain to reduce U.S. manufacturing jobs and capabilities. The Treasury Department and the IRS have pointed to no evidence suggesting the proposed rule is likely to preserve, or not materially lower, the amount of U.S. manufacturing jobs. Second, again in a contract manufacturing situation, the proposed rule will result in no § 199 deduction being available to the CM if the principal has BBO of the QPP during the manufacturing period. This follows because the CM needs BBO of the QPP before it can sell or dispose of the QPP and derive DPGR. We believe this will occur in many cases. The resulting evaporation of § 199 deductions in U.S. contract manufacturing situations is contrary to the Congressional intention that money from the repeal of FSC/ETI regimes be used to support U.S. manufacturing.

Although the SVTDG strongly believes the proposed rule denying attribution of MPGE activities to the party having the BBO should not be finalized, if the Treasury Department and the IRS insist on finalizing the proposed rule, the cost-plus exception described in the proposed regulations should be included. The proposed exception would, in some situations, prevent some of the problems described above. The SVTDG recommends a "materiality" threshold should be added to the cost-plus exception to prevent contractual arrangements from being disqualified from the exception by failures to reimburse de minimis costs.

C. Support for proposed and temporary regulations dealing with W-2 wages in the cases of an acquisition

Proposed rules (and their temporary equivalents) modify the § 199(b) W-2 wage limitation for acquisitions and dispositions. W-2 wages are proposed to be allocated between multiple taxpayers based on the period during which employees of the acquired or disposed of trade or business were employed by each taxpayer. In the case of a short taxable year not including a calendar year end, W-2 wages are proposed to be those wages paid to employees in the short taxable year. The SVTDG believes these proposed and temporary rules are sensible and practical applications of the W-2 wage limitation in the context of acquisitions and dispositions.

D. Recommendation that testing per se shouldn't be excluded as an MPGE activity, and that Example 5 of § 1.199-3(e)(5) should be removed

Treasury and the IRS signaled in the preamble to the proposed regulations their belief that testing activities, alone, can't qualify as an MPGE activity. We disagree with this, and recommend testing be taken into consideration in determining a taxpayers MPGE activities. Testing of components and products can be of a fundamentally different character and importance than other activities carved out from MPGE (i.e., packaging, repackaging, labeling, minor assembly, and installation). In the high tech industry, for example, component and product testing can cost as much, take as much time, and add as much or more value, as assembling the product; can involve considerable efforts of many engineers and manufacturing specialists; and can involve development and use of sophisticated, extensive software. The blanket exclusion of testing as an MPGE activity in all cases ignores the role of product testing in the manufacturing process, which is wrong. The facts-and-circumstances "substantial-in-nature" test under § 1.199-3(g)(2) allows the IRS to assess the contribution of testing to the overall manufacturing process on a case-by-case basis.

We also recommend Example 5 of § 1.199-3(e)(5) be removed. It gives no guidance on how to determine if activities performed by a taxpayer are MPGE, instead beginning with the conclusory statement that a party "MPGE QPP within the United States." As described more fully below, Example 5 is confusing, and will undoubtedly lead to disputes and wasted IRS and taxpayer resources.

A taxpayer's deduction under § 199 depends on the taxpayer's DPGR, defined to include the taxpayer's gross receipts derived from "any lease, rental, license, sale, exchange, or other disposition" of "[QPP] which was [MPGE] by the taxpayer in whole or in significant part within the United States."² In a situation in which a taxpayer sells to customers QPP made by a U.S. CM hired by the taxpayer (principal), the taxpayer can't -- absent some mechanism -- get a § 199 deduction because the taxpayer didn't perform the MPGE activities. Without the § 199 deduction, the U.S. taxpayer principal has much less incentive to hire U.S. CMs, and would likely hire a foreign CM (likely at a lower cost to the principal). U.S. CMs don't manufacture of their own accord -- they depend on principals hiring them. The flight of manufacturing from the U.S. is in large part because it's cheaper to make QPP abroad, so giving principals an incentive to hire U.S. CMs helps counter this flight and promotes U.S. manufacturing capabilities.

Paragraph 1.199-3(f)(1) of the current regulations alleviates this harsh outcome. It provides that -- in a U.S. contract manufacturing situation -- the party that has the BBO during the period of manufacture is treated as engaging in the manufacturing (the "current BBO rule"). A taxpayer principal that has the BBO of the QPP during the period of manufacture is thereby attributed the manufacturing activities. The taxpayer's gross receipts from selling the QPP to customers can thus qualify as DPGR because the taxpayer is deemed to have made the QPP it sold to customers. The taxpayer can, if the U.S. manufacturing activities are sufficiently substantial, get a § 199 deduction, so it's incentivized to hire U.S. CMs.

Alternatively if, in a U.S. contract manufacturing situation, the CM has the BBO of QPP during the period of manufacture, the CM is deemed under the current BBO rule to have made the QPP it in fact made. The CM's gross receipts from disposing of the QPP can qualify as DPGR. The BBO of QPP lies only with the principal or the CM (not both), so the current BBO rule ensures only one party gets a § 199 deduction with respect to the QPP.

Significantly, the economics of such contract manufacturing situations are such that the § 199 deduction a principal can get is in many cases much greater than any deduction the CM could get. This follows because operating margins CMs make are typically quite small -- they typically provide industry standard manufacturing services and make more profit by making more products.

B. The proposed rule relating to contract manufacturing arrangements

BBO determination is fundamental for tax purposes. Whether a taxpayer sells property depends on whether the BBO of that property have transferred.⁵ If a CM doesn't have the BBO of the QPP during the time it performs MPGE activity, it's not possible for the CM to sell or dispose of the QPP. Determining whether a CM has DPGR in a contract manufacturing situation therefore still requires a determination of whether a CM has BBO, thus an examination of the BBO factors. The proposed rule therefore won't result in a reduction in the burden of evaluating the BBO factors.

The proposed rule would undercut these purposes at least two ways. First, in contract manufacturing situations in which a § 199 deduction is still available (i.e., in which the CM has the BBO of QPP during the manufacture), the magnitude of the deduction -- and the corresponding incentive for companies to hire U.S. CMs to manufacture in the U.S. -- is likely to be substantially reduced. As noted above, the § 199 deduction for CMs is typically much smaller than the § 199 deduction for principals because CMs typically have lower operating margins. The SVTDG expects many principals would hire foreign CMs, which are generally cheaper than U.S. CMs, even taking into account a deduction allowed to the CM. The proposed rule is therefore contrary to the purpose of investing in U.S. manufacturing facilities and retaining U.S. manufacturing jobs. U.S. CMs will suffer as the companies that hire them lose their § 199 deduction. The Treasury Department and IRS have pointed to no evidence demonstrating the proposed rule is likely to preserve, or at least not materially lower, the amount of U.S. manufacturing jobs.

Second, there'll be significantly fewer situations in the contract manufacturing context in which a § 199 deduction is available at all. In the experience of members of SVDTG, it's common for a principal to have the BBO in contract manufacturing arrangements. In this common situation the principal would be denied a deduction under the proposed rule, and the CM won't have sold or disposed of the property (because it can't transfer BBO it doesn't have), so no party would get a § 199 deduction. The amounts Congress intended to be returned to the manufacturing sector via a § 199 deduction would be blocked by the proposed rule. The SVTDG believes these situations would be fairly common. The IRS has seen a large sample size of contract manufacturing arrangements. The IRS, however, has produced no study or other evidence showing the effect of the proposed rule on aggregate § 199 deductions.

The combined effects of the proposed rule -- severely curtailed availability of any § 199 deduction in contract manufacturing situations, and significantly smaller deductions when available -- is in effect a significant tax increase on the U.S. manufacturing sector and is likely to cost a significant number of U.S. manufacturing jobs. The second, related purpose of § 199 -- to return the projected proceeds from FSC/ETI repeal to the manufacturing sector via a deduction -- will also be thwarted.

The proposed rule undercuts the purposes of § 199 without increasing administrability. The proposed rule with respect to contract manufacturing arrangements therefore should not be finalized and the current BBO rule should be maintained.

Although the SVTDG strongly believes the proposed rule denying attribution of MPGE activities to the party having the BBO should not be finalized, if the Treasury Department and the IRS insist on finalizing the proposed rule, the cost-plus exception should be included. As described below, the proposed exception would, in some situations, prevent some of the problems described above. The SVTDG also believes a "materiality" threshold should be added to the cost-plus exception to prevent contractual arrangements from being disqualified from the exception by failures to reimburse de minimis costs. Therefore the SVTDG requests the exception require the CM be "reimbursed for, or provided with, all substantial [or significant or material ] materials, labor, and overhead costs related to fulfilling the contract." This will help avoid disputes over minor items without changing the substance of the requirement.

Comments on the three requested areas are set forth below.

The regulations should permit the criteria of the proposed cost-plus exception be met in substance. That is, even if a contract with a CM isn't drafted using "cost-plus" language, if the contract provides economically for the reimbursement of the specified costs and an additional payment for the allowance for a profit, it should fall within the proposed cost-plus exception.

C. The temporary rule on W-2 wage limitations in the context of acquisitions and dispositions is welcome and sensible

Subsection 199(b) limits a taxpayer's deduction from its domestic production activities to 50 percent of its W-2 wages paid during the taxable year. If an acquisition or disposition occurs during the taxable year, the proposed rule (and the temporary rule at § 1.199-2T(c)) provides for the allocation of W-2 wages between multiple taxpayers based on the period during which employees of the acquired or disposed of trade or business were employed by the taxpayer. The proposed and temporary rule also treats as W-2 wages those wages paid to employees in a short taxable year that doesn't include the end of a calendar year. There's no good policy reason for denying a § 199 deduction to a company just because it has no calendar-year-end W-2 wages because it's acquired. The proposed and temporary rule is thus a sensible and practicable application of the W-2 wage limitation in the context of acquisitions and dispositions.

D. Current Example 5 of § 1.199-3(e)(5) should be removed from the final regulations; testing per se shouldn't be excluded as an MPGE activity

Paragraph 1.199-3(e)(1) defines MPGE to include "developing, improving, and creating QPP. . . ." Although no all-encompassing definition is given, what constitutes MPGE is subject to carve-outs in §§ 1.199-3(e)(2) and (3) for packaging, repackaging, labeling, minor assembly, and installation of QPP if no other MPGE activity occurs. There are no other exceptions. All activities described in § 1.199-3(e)(1) -- and presumably others, as the list isn't exhaustive -- should be considered when determining if a taxpayer MPGE QPP.

Example 5 of § 1.199-3(e)(5) gives no guidance on how to determine if activities performed by a taxpayer are MPGE. The example begins with the conclusory statement "Z MPGE QPP within the United States. The following activities are performed by Z as part of the MPGE. . . ."¹¹ The phrase "as part of" implies some MPGE activity occurred other than the activities listed, but such other activities aren't described. No guidance is given as to what activity is sufficient on these facts to constitute MPGE.

Example 5 concludes the listed activities are MPGE activities "[b]ecause Z MPGE the QPP. . . ." The activities listed, however, aren't limited to packaging, repackaging, labelling, minor assembly, and installation. Example 5 therefore appears to augment the list of activities (i.e., packaging, repackaging, labeling, minor assembly, and installation) that don't, alone, constitute MPGE. This isn't explicit, however, and it's unclear whether there are other activities that don't, alone, constitute MPGE. Example 5 is confusing as to what activities are MPGE, and will undoubtedly lead to disputes and wasted IRS and taxpayer resources.

The activities listed in Example 5 (i.e., "materials analysis and selection, subcontractor inspections and qualifications, testing of component parts, assisting customers in their review and approval of the QPP, routine production inspections, product documentation, [and] diagnosis and correction of system failure") should constitute MPGE under the definition in § 1.199-3(e)(1). These activities could each play a significant role in "developing, improving, and creating QPP."¹² These activities aren't carved out from what constitutes MPGE activities. These activities should therefore be considered in determining if a taxpayer MPGE QPP even if the taxpayer conducts no other MPGE activity, but Example 5 doesn't say how -- or if -- these activities are considered. Example 5 should be removed.

Treasury and the IRS propose adding to the end of Example 5 the sentence "[i]f Z did not MPGE the QPP, then these activities, such as testing of component parts, performed by Z are not the MPGE of QPP." In trying to justify this addition, the preamble states "[t]he Treasury Department and the IRS disagree that testing activities, alone, qualify as an MPGE activity."¹³ This blanket rejection of testing as an MPGE activity is unprincipled.

Testing of component parts can be of a fundamentally different character and importance than other activities carved out from MPGE (i.e., packaging, repackaging, labeling, minor assembly, and installation). Testing of component parts can be a major part of the design and manufacturing process. Product testing -- particularly in the high tech industry -- can cost as much, and take as much time, as assembling the product. Testing often involves many engineers and manufacturing specialists devoting considerable time and effort. Testing can involve development and use of sophisticated, extensive software. The blanket exclusion of testing as an MPGE activity blindly downplays the role of product testing in the manufacturing process.

Paragraph 1.199-3(g)(1) requires QPP to be MPGE in whole or in significant part by the taxpayer. For this purpose, § 1.199-3(g)(2) applies an all-facts-and-circumstances test to determine if the "MPGE of the QPP by the taxpayer . . . is substantial in nature. . . ." If the taxpayer's aggregate activities aren't sufficiently extensive or important, they may fail the "substantial in nature" test. A blanket rule against specific types of activity is unnecessary and unreasonably harsh. The all-facts-and-circumstances test under § 1.199-3(g)(2) can be applied in an industry-targeted manner. Activities that are minor in one industry might be significant in another.

² § 199(c)(4)(A)(i)(I).

³ Prop. § 1.199-3(f)(1).

⁴ 80 Fed. Reg. at 51982.

⁵See, e.g., Sollberger v. Commissioner, 691 F.3d 1119, 1124 (9th Cir. 2012) ("To determine whether a sale occurs for tax purposes, we continue to apply a flexible, case-by-case analysis of whether the burdens and benefits of ownership have been transferred."); Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237 (1981) ("The key to deciding whether petitioners' transactions with [purported sellers] are sales is to determine whether the benefits and burdens of ownership have passed from [purported sellers] to petitioners.")

⁶ 141 T.C. 298 (2013).

⁷ H.R. REP. NO. 108-548, at 115 (2004).

⁸ 150 CONG. REC. 3,120 (2004) (statement of Sen. Chuck Grassley, sponsor of bill S. 1637).

⁹ 150 CONG. REC. 22,972 (2004) (statement of Sen. Chuck Grassley).

¹⁰See, e.g., Illinois Power Co. v. Commissioner, 87 T.C. 1417, 1436 (1986), acq. in result only 1990-2 C.B. 1 ("A significant factor to be used in determining ownership of property is the extent to which the taxpayer has potential for profit or loss as a result of holding the property."); Grodt & McKay Realty v. Comm'r, 77 T.C. 1221, 1242-43 (1981).

¹¹ § 1.199-3(e)(5) Example 5 (emphasis added).

¹² § 1.199-3(e)(1).

¹³ 80 Fed. Reg. at 51982.