Firm Seeks Withdrawal of Domestic Manufacturing Regs

In response to the proposed regulations published along with T.D. 9731 in the Federal Register on August 27, 2015, we respectfully submit the following responsive comments on behalf of Wine Country Gift Baskets. Wine Country Gift Baskets is the d/b/a name of the Subchapter S corporation owned by Tim and Michelle Dean and John O'Brien, the taxpayers we represented in the U.S. District Court for the Central District of California, Docket No. SACV 11-1977 and 12-472. The decision in these cases was reported under the caption United States v. Dean.¹

The following comments address § 1.199-3(e)(2) and, specifically, the definition of manufactured, produced, grown and extracted ("MPGE") and Example 9 (collectively, the "Proposed Regulations.") We appreciate your consideration of our comments.

The Proposed Regulations contradict Congressional intent and exceed Treasury's rulemaking authority. They should be withdrawn.

Congress enacted the American Jobs Creation Act of 2004 (the "Act") to incentivize growth in labor-intensive domestic industries by providing in Sec. 199 a broadly available tax deduction. As the Act's title explicitly states, its purpose was to create jobs to help stimulate a troubled economy. The Act's historical context explains its breadth: in the service of creating jobs, Sec. 199 was designed to be widely available and export-neutral.

Because there is no ambiguity in the broad group of industries entitled to claim Sec. 199 deductions, Treasury has no authority to deviate from the intent of Congress in its regulations. (Congress did direct Treasury to provide "legislative regulations" on other very specific issues, but not in defining eligible taxpayers.) Treasury and IRS have twice attempted to limit access to Sec. 199 in litigation. Both taxpayers successfully overcame the attempted disqualification on summary judgment in two different district courts. Despite these clear and consistent decisions, and despite hearing clear testimony in one of those cases from the House Ways and Means Chairman who sponsored the Act, Treasury has issued Proposed Regulations which again attempt to limit who is eligible for the Sec. 199 deduction. The Proposed Regulations directly contradict Congressional intent.

The Notice of Proposed Rulemaking ("Notice") makes clear that Treasury disagrees with the district court that decided U.S. v. Dean. We presume Treasury likewise disagrees with the district court that later decided U.S. v. Precision Dose. However, the Notice fails to explain Treasury's policy agenda and does not explain how restricting eligibility for the Sec. 199 deduction can be harmonized with the intent of Congress or the rebukes of the judicial branch based on the plain language of the statute.

Treasury is not authorized to issue legislative regulations on this question, and it may not issue interpretive regulations that contradict Congressional intent. Treasury must therefore abandon its efforts to rewrite Sec. 199 and accede to the will of Congress and acquiesce to the judgments of the courts.

II. Legislative and Interpretive Regulations

The second test -- if one gets there -- requires consistency with congressional intent. Even with the benefit of Chevron deference, ". . . the second step of Chevron . . . asks whether the Department's rule is a "reasonable interpretation" of the enacted text."⁴ In practical terms, this means that a regulation must at least be consistent with the intent of the statute to be a permissible construction.

There is no gap because the meaning of MPGE is well-settled. Congress presumably chose the term MPGE because it had used the term before -- in 1971 it was made part of the definition of "export property" eligible for the Domestic International Sales Corporation ("DISC") tax benefit in Sec. 993(c)(1)(A). Congress presumably was aware of Treasury's DISC regulations which for the past thirty years have interpreted the terms "manufactured" and "produced" in Sec. 993.

Reg. 1.993-3(c)(2) defines "manufactured or produced" for DISC purposes. It states that manufacture or production does not include packaging or assembly unless:

Congress had ample reason in 2004 to expect that by repeating the DISC term "MPGE" in Sec. 199, Treasury would conform the definition of "199-MPGE" to "DISC-MPGE." And, in light of the legislative history of Sec. 199 (discussed below) it would have been inconceivable for Congress to have expected Treasury to invent a more restrictive definition of 199-MPGE.

There is no "gap." As such, the statute's use of the term MPGE fails the threshold test for Chevron deference.

Congress could not have been more explicit in its expression of a job-creation purpose for Sec. 199. But how was Congress to express in the statute which businesses qualified? That's why Congress used the DISC term "MPGE." The DISC regulations contain an overall 20%-of-cost rule that serves to disqualify businesses creating little or no additional employment. Congress rightly expected Treasury to incorporate that 20% rule into the Sec. 199 regulations. Why did Treasury veer off in a different direction?

The Proposed Regulations simply fail the second Chevron test. They remove the DISC-MPGE 20% rule and instead they automatically disqualify any business that engages solely in "packaging, repackaging, labeling or minor assembly" regardless of its value-added or the number of jobs it creates. Treasury does this without explaining how it serves the job-creation purpose of Congress. In fact, the Proposed Regulations would deny the Sec. 199 deduction to many businesses on the basis of a criterion that is not relevant to job creation. As such, the Proposed Regulations are not a "permissible construction" as required by Chevron.

An interpretive regulation is promulgated under the Secretary's general rulemaking power under Sec. 7805(a) for the limited purpose of interpretation. Interpretive regulations must harmonize with the origin and purpose of the statute.⁷ Interpretative regulations have a higher burden than legislative regulations of demonstrating congruence with the purpose of Congress, and no departure from Congressional intent is permissible.⁸

When Congress enacts unambiguous tax laws, Treasury has a duty to promulgate regulations to further develop the law to achieve the intent of Congress. Treasury may not pursue a different or conflicting agenda.

• Applying Sec. 199 when a taxpayer buys or sells a major portion of their business during the year;

• Properly allocating income, deductions, expenses, and losses between domestic production activities and other activities; and

• Applying the benefit to pass-through organizations and determining the allocable share of wages of an S Corporation shareholder.

III. Background and History of Sec. 199

At the time Sec. 199 was enacted, Congress sought to accomplish two goals: (1) repeal the tax benefit for extraterritorial income ("ETI") that had led to the assessment of retaliatory tariffs by the European Union ("E.U.") after the World Trade Organization ("WTO") deemed the subsidy to be noncompliant with international trade agreements, and (2) replace the ETI provisions with new tax provisions that would help employers create jobs in the U.S.

The first of these subsidies, the DISC, enacted in 1971,¹² was clearly designed to provide preferential tax treatment to exports. DISC was replaced in 1984 by the FSC provisions. FSC was similar to DISC in that it provided a tax benefit to exporters selling abroad through a specially qualified subsidiary corporation.¹³ However, the FSC provisions required subsidiary corporations to be incorporated outside the U.S. and to conduct certain management activities or economic processes abroad.¹⁴ The ETI was the third Congressional attempt to level the competitive playing field for U.S. and foreign corporations. Enacted in 2000, the ETI allowed tax benefits for both domestic and foreign corporations and could be applied to income from both foreign operations and exports.

In fact, the E.U. began WTO proceedings to challenge the ETI provisions within a few months of their enactment in 2000. In August 2002, the WTO authorized the E.U. to impose tariffs against $4 billion worth of U.S. exports.

The economy was recovering relatively slowly from the recession in 2001, and lawmakers saw this as an opportunity to encourage U.S. production and manufacturing and to incentivize employers "to reinvest, expand and, most importantly, create new jobs in the United States."²¹

IV. A primary Congressional objective of Sec. 199 was to create jobs in the U.S.

Congress drafted and redrafted Sec. 199 over the course of several legislative sessions, with bipartisan agreement among lawmakers as to the specific objectives of sound tax policy that would encourage domestic job growth and promote U.S. economic competitiveness.²²

Sec. 199 was the product of multiple bills, including the Job Protection Act of 2003 (H.R. 1769) and the companion bill in the Senate, S. 970. These bills contained provisions similar to Sec. 199, but some lawmakers were still concerned about violating international law,²³ while others were concerned that the provision gave an unfair advantage to manufacturing over other industries and could lead to harmful economic distortions. In light of these concerns, the final version of Sec. 199 was intentionally made broader and more inclusive.

Eligibility for the Sec. 199 deduction was not limited to manufacturers. Rather, eligible revenue streams included income derived not only from manufacturing, but also production, growth, and extraction, which collectively are referred to as "MPGE." Moreover, the statute includes explicit "carve ins" of activities that may not ordinarily be considered part of MPGE, such as:

• film production,

• electricity generation,

• natural gas extraction,

• potable water production,

• timber production, and

• architectural and engineering services employed for U.S. construction projects.

The final legislation was the product of a conference negotiation between the House and Senate that debated whether Sec. 199 should: (1) set a maximum tax rate on "qualified production activities income" or (2) establish a nine percent deduction against such income, limited to 50 percent of the wages paid in the taxable year.²⁴ Throughout these final negotiations the parties agreed that "Congress should enact tax laws that enhance the ability of domestic business, and domestic manufacturing firms in particular, to compete in the global marketplace."²⁵ Reports of the House and Senate Committees highlight the bipartisan recognition that the manufacturing industry was vital to the overall economy, especially with regard to creating new jobs for U.S. workers. For example, the House Committee stated that it "believes that a reduced tax burden on domestic manufacturers will improve the cash flow of domestic manufacturers and make investments in domestic manufacturing facilities more attractive. Such investment will create and preserve U.S. manufacturing jobs."²⁶ The Senate Committee echoed this sentiment stating it "believes that it is necessary and appropriate to replace the ETI regime with new provisions that reduce the tax burden on domestic manufacturers, including small businesses engaged in manufacturing."²⁷ The final Conference Report further highlighted and emphasized the importance of a broad tax law that encourages increased manufacturing activities in the U.S.:

After three decades of thwarted attempts to offer export tax benefits to U.S. manufacturers, Sec. 199 was finally enacted to offer broad tax incentives to labor-intensive domestic industries in a way that would not be subject to attack as an unfair export benefit. Throughout the development of Sec. 199 both the House and Senate agreed on the basic framework -- that qualified production activities income can be derived from:

There is, however, absolutely no discussion in the legislative history of Sec. 199 about limiting the scope or definition of MPGE. Rather, lawmakers sought to replace the ETI with a broad tax benefit that was expressly available to manufacturers "and others."³¹To the extent Treasury has a policy agenda to limit the availability of Sec. 199, that objective does not reflect or implement Congress's intent in enacting Sec. 199.

V. The Proposed Regulations limit the definition of MPGE and thereby contradict the express purpose of Sec. 199.

By its own admission, IRS clearly understood that the Sec. 199 deduction should be available for "a wide variety of production activities," stating that the IRS "defines MPGE broadly."³² The IRS Notice states that:

• manufacturing,

• producing,

• growing,

• extracting,

• installing QPP [Qualifying Production Property],

• developing QPP,

• improving QPP,

• creating QPP,

• making QPP out of scrap, salvage or junk material as well as or from new or raw material by:

• • processing,

  • manipulating,

  • refining,

  • changing the form of an article,

  • by combining or assembling two or more articles;

• cultivating soil,

• raising livestock,

• fishing, and

• mining materials.³⁴

Both the IRS Notice and the legislative history clearly indicate that Sec. 199 is meant to be available broadly to a variety of activities. Yet, the Proposed Regulations ignore this clear intent and instead create a new list of disqualified activities, namely packaging, repackaging, labeling and minor assembly. This approach directly contradicts the express purpose of Sec. 199. Sec. 199 does not authorize Treasury to issue legislative regulations on this issue nor to issue interpretive regulations which pursue a policy agenda that narrows the scope and availability of Sec. 199.

VI. The Dean and Precision Dose decisions.

The Government pointed to Regulation 1.199-3(e)(5) contending that Houdini was simply packaging and repackaging its products. However, the court rejected the Government's assertion and found that Houdini's manufacturing process was a complex process undoubtedly within the scope of MPGE. Furthermore, the court looked to IRS Notice 2005-14 and stated that given the deference that is afforded to IRS interpretations and practices, the ruling in favor of the defendants "further supports the Court's interpretation of MPGE, as used in Sec. 199."³⁶

The Dean court found that the final products were gifts that were distinct in both form and purpose from the individual food and gift items inside, that Houdini's production processes "change the form and function of individual items by creating distinct gifts," and that Houdini's "complex production process" was "similar to purchasing various automobile parts from suppliers -- such as the frame, engine, wheels, etc. -- and assembling them to create the car itself, which is undoubtedly manufacturing."³⁷ Not surprisingly, the court found that some of the activities Houdini performed necessarily included packaging and repackaging. But it noted that any packaging activities were only a part of the larger and more complex production process which resulted in a distinct final product. In fact, the Dean court found the facts of the case so clear and persuasive that it disposed of Treasury's arguments on summary judgment.

The government argued that Dean was incorrectly decided and that "the court failed to understand that all Houdini's activities were just part of the repackaging process."³⁹ The Precision Dose court, however, disagreed and stated that Sec. 199 did apply and that the "decision in [the] case depends on a legal interpretation of [the Treasury regulation]."⁴⁰ Despite being offered expert testimony, the court stated that it "did not consider the opinions of [the] proffered experts in interpreting the regulation as the meaning of the language of the regulation is for the court to determine. No expert opinion is necessary . . . to that interpretation,"⁴¹ meaning that court needed no persuasion beyond the plain language of Sec. 199 and the regulations to reject Treasury's position.

Neither district court found Sec. 199 to be ambiguous, nor did either court find Congressional intent to be unclear. Both courts found that by applying the existing Treasury regulations, the IRS was impermissibly attempting to narrow the scope of the Sec. 199 deduction. Both courts found that production activities exactly like those described in the Proposed Regulations were, in fact, manufacturing and both courts declined to apply the existing regulations regarding packaging and repackaging.⁴⁴

Dean and Precision Dose make clear that the Proposed Regulations directly contradict the express purpose of Congress in enacting Sec. 199. The decisions correctly elucidate Congress's intent that Sec. 199 be available where a production process changes the form and function of individual items by creating a distinct product, even if a part of the process involves packaging or repackaging, so long as the packaging is one step in a more complex production process that ultimately results in the production of a distinct final product.

Accordingly, both courts not only found the language in Sec. 199 to be unambiguous, they both disregarded current regulations to the extent the regulations would have disqualified the defendants for the Sec. 199 deduction.

Both the existing regulations regarding packaging and the more restrictive Proposed Regulations have effectively been declared incorrect by these two district courts. This is the constitutional duty of the judicial branch when an executive branch agency asks it to enforce improper regulations. Treasury now has a constitutional duty to withdraw the offensive regulations.

VII. New Example 9 is Treasury's attempt to further narrow the scope of MPGE after two district courts have rejected the underlying regulations.

Treasury now disagrees with two federal district courts as well as Congress. Its Proposed Regulations now attempt to advance some unstated policy that will persuade some other court to overturn the Dean and Precisions Dose decisions. In attempting to do this, Treasury completely disregards the role that packaging and repackaging play in larger and more complex production processes, and instead selectively uses the presence of those two activities as per se disqualifiers for Sec. 199. The district courts that decided Dean and Precision Dose were correct in rejecting these disqualifiers.

The expert witness report he submitted in the Dean case quoted the Senate Finance Committee report accompanying the Act, which stated, "The Committee believes that creating new jobs is an essential element of economic recovery and expansion, and that tax policies designed to foster job creation also must reverse the recent declines in manufacturing sector employment levels."⁴⁶ "[T]he final bill made no restrictions with regard to the definition or scope of manufacturing. In fact, the provision was defined to include not only manufacturing but also additional activities -- namely, income derived from property that was produced, grown, or extracted as well as manufactured."⁴⁷

Example 9 in the Proposed Regulations is based on Treasury's attempt to disqualify MPGE activities that include packaging, repackaging, labeling, or minor assembly. There is no basis for this policy in the statute. These regulations impermissibly stray from Congress's intent:

²Chevron, USA, Inc. v. Natural Resources Defense Council, 467 US 837, 842-843 (1984).

³Id.

⁴Mayo Foundation for Medical Ed. & Research v. U.S., 131 S.Ct. 704, 107 AFTR 2d 2011-341 (2011).

⁵Id. citing Long Island Care at Home, Ltd. v. Coke, 551 U. S. 158, 173-174 (2007).

⁶ Reg. 1.993-3(c)(2)(ii).

⁷National Muffler Dealers Association, Inc., 43 AFTR 2d 79-828, 440 US 472, 59 L Ed 2d 519, 79-1 USTC ¶ 9264, 477 (1979).

⁸Koshland v. Helvering, 298 US 441 (1936). See also Caterpillar Tractor Co. v. US, 589 F2d 1040, 1045 (Ct. Cl. 1978) ("no room for Treasury interpretation" of statute that is unambiguous on its face; sole purpose of interpretative regulations is to "reconcile ambiguities in the statute with reasoned interpretation"); Rowan Cos. v. US, 452 US 247, 253 (1981) (if regulation can be measured against specific provision of Code, "we owe the interpretation less deference than a regulation issued under a specific grant of authority to define a statutory term or prescribe a method of executing a statutory provision").

⁹Wall Street Journal, "Foreign Tax Fight," September 17, 2003.

¹⁰Id.

¹¹ 150 Cong. Rec. H4393-01, 150 Cong. Rec. H4393-01, 2004 WL 1369655.

¹² David L. Brumbaugh, "A History of the Extraterritorial Income (ETI) and Foreign Sales Corporation (FSC) Export Tax-Benefit Controversy," CRS Report RL31660, September 22, 2006.

¹³Id.

¹⁴Id.

¹⁵Id.

¹⁶Id.

¹⁷ James Joseph Shallue, An Analysis of Foreign Sales Corporations and the European Communities' Four Billion-Dollar Retaliation, 131 Denv. J. Int'l L. & Pol'y 179, 181 (2002-2003).

¹⁸ David L. Brumbaugh, "A History of the Extraterritorial Income (ETI) and Foreign Sales Corporation (FSC) Export Tax-Benefit Controversy," CRS Report RL31660, September 22, 2006.

¹⁹ Philip Crane, "Unity Against Sanctions," Financial Times, September 16, 2002.

²⁰ Hearing Before the Committee on Finance, July 8, 2003. .

²¹ 150 Cong. Rec. H4295-01, 150 Cong. Rec. H4295-01, 2004 WL 1365908.

²² Expert Report of William M. Thomas, United States v. Dean, 945 F. Supp. 2d 1110 (C.D. Cal. 2013).

²³Wall Street Journal, "Foreign Tax Fight," September 17, 2003.

²⁴ Conference Report to Accompany H.R. 4520, October 7, 2004.

²⁵ House Committee on Ways and Means, "Report to Accompany H.R. 4520 together with Dissenting and Additional Views," June 16, 2004; Senate Finance Committee, "Report Together with Additional and Minority Views to Accompany S. 1637," November 7, 2003.

²⁶ House Committee on Ways and Means, "Report to Accompany H.R. 4520 together with Dissenting and Additional Views," June 16, 2004.

²⁷ Senate Finance Committee, "Report Together with Additional and Minority Views to Accompany S. 1637," November 7, 2003.

²⁸ Conference Report to Accompany H.R. 4520, October 7, 2004.

²⁹ Expert Report of William M. Thomas, United States v. Dean, 945 F. Supp. 2d 1110 (C.D. Cal. 2013).

³⁰ "Income Attributable to Domestic Production Activities," 26 USC § 199 (emphasis added).

³¹ Expert Report of William M. Thomas, United States v. Dean, 945 F. Supp. 2d 1110 (C.D. Cal. 2013).

³² IRS Notice 2005-14, § 3.04.

³³Id.

³⁴ Treas. Reg. § 1.199-3(e).

³⁵ Expert Report of William M. Thomas, United States v. Dean, 945 F. Supp. 2d 1110 (C.D. Cal. 2013).

³⁶Dean, 945 F. Supp. 2d at 1118.

³⁷Dean, 945 F. Supp. 2d at 1118.

³⁸Precision Dose, Inc. v. United States, Case No. 12 CV 50180 (N.D. Ill. 2015).

³⁹Id. at 11.

⁴⁰Id. at 12.

⁴¹Id.

⁴²Dean, 945 F. Supp. 2d at 1118; Precision Dose, Inc., Case No. 12 CV 50180 at 11.

⁴³Id.

⁴⁴Id.

⁴⁵ P.L. 108-357.

⁴⁶ Senate Finance Committee, "Report Together with Additional and Minority Views to Accompany S. 1637," November 7, 2003.

⁴⁷ Expert Report of William M. Thomas, United States v. Dean, 945 F. Supp. 2d 1110 (C.D. Cal. 2013).

⁴⁸Id.