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CVS Suggests Changes to Domestic Manufacturing Regs

NOV. 24, 2015

CVS Suggests Changes to Domestic Manufacturing Regs

DATED NOV. 24, 2015
DOCUMENT ATTRIBUTES

 

November 24, 2015

 

 

Internal Revenue Service

 

Room 5203

 

P.O. Box 7604

 

Ben Franklin Station

 

Washington, DC 20044

 

CC:PA:LPD:PR (REG-136459-09)

 

RE: REG-136459-09

 

Dear Sir or Madam:

CVS Health Corporation ("CVS Health"), on behalf of its subsidiaries and affiliated entities, appreciates the opportunity to comment on REG-136459-09, Notice of Proposed Rulemaking proposing amendments to various Treasury regulations related to the Domestic Production Activities Deduction (the "Notice") under Section 199 of the Internal Revenue Code of 1986, as amended (the "Code"). CVS Health is a pharmacy innovation company helping people on their path to better health. Through our more than 7,900 retail pharmacies, more than 1,000 walk-in clinics, a leading pharmacy benefits management business with more than 70 million members, a dedicated senior pharmacy care business serving more than one million patients per year and an expanding specialty pharmacy services business, we enable people, businesses and communities to manage health in more effective ways, by lowering the cost of and increasing the access to quality health care. As a preeminent pharmacy benefit manager, we maintain a national network of more than 68,000 retail pharmacies, consisting of approximately 41,000 chain pharmacies (including our CVS retail pharmacies) and 27,000 independent pharmacies in the United States, Puerto Rico, the District of Columbia, Guam and the Virgin Islands. As of December 31, 2014, CVS Health had over 215,000 employees. Although CVS Health conducts the majority of its business activities, including certain production activities, through its large base of U.S. employees, certain of our income-producing production activities are undertaken through third-party contract service providers.

Code Section 199 was enacted by Congress as part of the American Jobs Creation Act of 2004 (the "Jobs Act") with the goal of supporting the domestic manufacturing sector in the face of increasing global competition. By reducing the tax burden on domestic manufacturers, Congress intended to make domestic manufacturing more attractive. CVS Health maintains its own production activities in the United States and engages domestic third-party contract service providers in part because of the incentive provided by the Section 199 deduction. For these reasons we are submitting these comments, specifically with respect to the proposed (a) replacement of the "benefits and burdens of ownership" requirement and (b) changes regarding the provision that denies a Section 199 deduction where the taxpayer merely performs "minor assembly".

Benefits and Burdens of Ownership

Under current law, only one taxpayer is entitled to the Section 199 deduction with respect to any qualified activity. Where a taxpayer contracts with another party to perform all or some of the qualified activity, Treasury regulations section 1.199-3(f)(1) provides that only the party with the benefits and burdens of ownership over the qualifying production property ("QPP") during the period of the qualified activity (the "BBO Requirement") is entitled to the Section 199 deduction with respect to that qualified activity. The determination of whether the BBO Requirement has been met is made based on a facts and circumstances analysis.

Among the changes proposed in the Notice (the "Proposed Regulations") is a proposal to remove the BBO Requirement and, in its place, provide that if a qualified activity is performed under a contract, then the party that performs the activity is the taxpayer for purposes of Section 199(c)(4)(A)(i) (the "Contract Service Provider Rule"). The stated rationale for making this change is "to provide administrable rules that are consistent with Section 199, reduce the burden on taxpayers and the IRS in evaluating factors the BBO Requirement, and prevent more than one taxpayer from being allowed a deduction under Section 199 with respect to any qualifying activity."

Although we certainly appreciate the importance of clear and administrable rules, we are opposed to this new rule for several reasons. First, we believe that Contract Service Provider Rule is in direct conflict with Section 199 and, as such, is invalid. Congress granted explicit authority to the IRS to publish regulations that are "necessary to carry out the purposes of [Section 199], including regulations which prevent more than 1 taxpayer from being allowed a deduction with respect to [the disposition of QPP] (emphasis added)." Section 199 explicitly requires that, for a taxpayer to be eligible for a deduction, the taxpayer must sell or otherwise dispose of the eligible property in a qualified disposition. Under the new proposed Contract Service Provider Rule, however, a third-party contract service provider that merely provides services on behalf of the taxpayer could claim a deduction under Section 199. Because the Contract Service Provider Rule would give the benefit of the Section 199 deduction to a taxpayer that has not made the required disposition of QPP, we believe that the Contract Service Provider Rule is manifestly contrary to the statute and, as such, would not be regarded as a valid regulation under Section 199.

An alternative, but no less troubling, read of the Contract Service Provider Rule could result in neither the contract service provider, nor the principal being able to take advantage of the Section 199 deduction. As previously noted, the Contract Service Provider Rule states that if a qualified activity is performed under a contract, then the party that performs the activity is the "taxpayer" for purposes of Section 199(c)(4)(A)(i). Section 199(c)(4)(A)(i) states that domestic production gross receipts ("DPGR") of the taxpayer include any gross receipts from the disposition of QPP by the "taxpayer". If the Contract Service Provider Rule is adopted, then neither the principal nor the contract service provider would be eligible for the Section 199 deduction because the contract service provider would be regarded as the "taxpayer" and, as it receives service income from its activities, it would have no DPGR. Surely such a result was not the intention of Congress.

Another way in which the Contract Service Provider Rule is clearly contrary to Congressional intent behind the Jobs Act is that it would be likely to drive manufacturing jobs to offshore service providers. In many contract manufacturing arrangements, the party that is contracting for the production of the QPP dictates where the property is to be produced. If the contract service provider is the taxpayer that is entitled under this rule to the Section 199 deduction, principals will have significantly less incentive to utilize a domestic contract service provider to assist in production of the QPP. As a result, domestic contract service providers likely stand to lose a substantial amount of the work that they currently do in the U.S. on behalf of their domestic clients that are presently able to take the Section 199 deduction by application of the BBO Requirement. Such a result clearly would be contrary to the intent of Congress when it enacted Section 199, which was to make domestic manufacturing more attractive and to enhance the ability of domestic firms to compete. For these reasons, therefore, we do not believe that the Contract Service Provider Rule should be adopted.

Our Proposal: A "Pre-production Rule"

A proposed rule that would be administrable, valid under Section 199, and consistent with the Congressional intent behind the Jobs Act could be readily crafted from the existing rules under Treasury regulations section 1.263A-2(a)(1)(ii)(B)(2), which the IRS has been administering for over 20 years. Treasury regulations section 1.263A-2(a)(1)(ii)(B)(2) provides that a taxpayer will be considered to have produced its inventory if it is produced for the taxpayer under a contract entered into before the production of the property is completed and the contract is not a routine purchase order for fungible property.

On this basis, we propose a new "Pre-production Rule," which would provide that the taxpayer in a contract manufacturing arrangement will be treated as performing the Qualifying Activity if the taxpayer enters into the contract with the third-party contract service provider before the production of the property to be delivered under the contract is completed and the contract is not a routine purchase order for fungible property. The Pre-production Rule would be valid under Section 199 because a third-party contract service provider that enters into the contract after production of the property is already completed (or enters into a routine purchase order contract) traditionally is viewed as selling property. It would also be consistent with the Congressional intent behind the Jobs Act because it would incentivize taxpayers to select a domestic third-party contract service provider, as well as incentivize third-party contract service providers to locate, expand and enhance facilities in the U.S. to be selected for such contracts.

Moreover, in terms of administrability, Treasury regulations section 1.199-3(e)(4) requires now that a taxpayer take consistent positions with respect to Sections 199 and 263A. Therefore, failure to adopt the Pre-production Rule in the Section 199 regulations could arguably result in taxpayer confusion and inconsistency.

Finally, it permits only one taxpayer to claim the Section 199 deduction: if the contract is for a routine purchase order or if the property is completed at the time the contract is entered into, the third-party contract service provider may claim the Section 199 deduction; otherwise, the taxpayer may claim the deduction. For all of these reasons, CVS Health proposes the adoption of the Pre-production Rule instead of the Contract Service Provider Rule.

The proposed "Cost-Plus Contract Exception"

The Treasury Department and the IRS have requested comments on whether there should be a limited exception to the proposed Contract Service Provider Rule for certain fully cost-plus or cost-reimbursable contracts. If the Pre-production Rule is not adopted and the Contract Service Provider Rule is adopted, then CVS Health recommends that a broad exception be provided in order to make the Contract Service Provider Rule valid under Section 199 and consistent with Congressional intent behind the Jobs Act. CVS Health does not believe that the proposed exception, which would permit a taxpayer to take the Section 199 deduction only if the contract service provider that it engaged was under a fully cost-plus or cost reimbursable contract (the "Cost-Plus Contract Exception"), is broad enough to meet these goals. The exception must be much broader, to ensure that the principal is eligible to claim the Section 199 deduction in situations where it is not acquiring the property from the contract service provider because the contract service provider is merely providing services to the principal.

Based on our significant experience with a large number of contract manufacturers and contract manufacturing arrangement with third parties, we believe that it is rare (and possibly impossible) to find a third-party commercial agreement with the cost-plus or cost reimbursable terms described in the Notice. A cost-plus or cost-reimbursable contract of the type described in the Notice would invite inefficiency. To prevent that result, certain terms are required to keep contract manufacturers from incurring unnecessary costs. An example of such a term often used in third-party commercial agreements is a requirement that the contract service provider is limited to reimbursement for the cost of materials purchased on the principal's behalf to the extent that it has accurately estimated such costs. Variances against such estimates must be absorbed by the contract service provider. Absent such terms, the contract service provider could purchase materials on the principal's behalf at rates that exceed the market price for the materials and profit from the excessive cost by having its cost-plus mark-up applied to a higher cost base. It might not seek out all volume discounts, for example, or negotiate the most competitive rates. Although we believe that the terms of these kinds of contracts are as close to fully cost-plus that can be found in the commercial market, even these might not qualify for the Cost-Plus Contract Exception as proposed.

While we appreciate the availability of exceptions, which are from time to time essential to ensure that Congressional intent is fulfilled, taxpayers should not be compelled to enter into business arrangements that are uneconomic and not reflective of arm's-length behavior in order to rely on one. CVS Health recommends that the Cost-Plus Contract Exception be modified to provide that the principal in a contract manufacturing agreement will be treated as performing the qualifying activity if the contract has the expected hallmarks of arm's-length contracts, including provisions that create the right incentives for efficiency and cost control. Contracts that include terms whereby the taxpayer provides (or reimburses the third-party contract service provider for) most of the materials, and provides an additional amount reasonably expected to cover supplies, labor, overhead, as well as a potential profit, should not be excluded from the exception because they also include provisions that drive efficiency or shift the risk of cost variances to the contract service provider. This proposed exception is more consistent with market practice. Further, it is consistent with Section 199 because if the taxpayer supplies (or reimburses the third-party contract service provider for) most of the materials, it cannot be said that the third-party contract service provider is selling the property back to the taxpayer. They are, instead, solely providing services. In such cases, if the taxpayer did not pay the invoices rendered by the third-party contract service provider, the third-party contract service provider would not sue for the value of the property (which may have little value), but for the value of its services. In such a case it would be clear that the taxpayer and not the third-party contract service provider would be the party that is selling or otherwise disposing of the property and should be the party to whom the Section 199 deduction is available.

Minor Assembly

Treasury regulations section 1.199-3(e)(2) provides that if a taxpayer packages, repackages, labels or performs minor assembly of QPP and the taxpayer engages in no other manufacturing, producing, growing or extracting ("MPGE") activities with respect to that QPP, the taxpayer's packaging, repackaging, labeling or minor assembly does not qualify as MPGE with respect to that QPP. The regulations do not contain a definition of what constitutes "minor assembly," as opposed to assembly that is sufficient to qualify as MPGE for purposes of the Section 199 deduction. The lack of a definition of "minor assembly" has lead to controversy between the IRS and taxpayers on this issue. For example, in United States v. Dean, 945 F. Supp. 2d 1110 (C.D. Cal. 2013) the Court held for the taxpayer that assembly of various component products into a single gift basket exceeded the threshold of "minor assembly," and, as a result, the taxpayer was entitled to a Section 199 deduction. As noted in the Notice, the IRS disagreed with the holding in Dean. In response the Proposed Regulations seek to include an example (Example 9) using facts similar to those in Dean, but concluding that the activities are not sufficient to permit the taxpayer to take a Section 199 deduction. In addition the Notice requests comments on whether there should be a definition of "minor assembly" and, if so, what that definition should be.

First, with respect to the question of whether the Proposed Regulations should define the term "minor assembly," we believe that the better approach would be to remove the concept of "minor assembly" entirely from the analysis of whether a taxpayer's activities constitute MPGE. The statute itself provides that a taxpayer will not be eligible for a Section 199 deduction unless it manufactured, produced, grew or extracted the QPP in whole or in significant part. The addition of the term "minor assembly" in Notice 2005-14 (2005-1 CB 498 (February 14, 2005) did not clarify the statutory concept of "in significant part;" rather, it complicated the analysis by layering term upon term and test-upon-test. The government's interest in protecting against taxpayer misuse of the Section 199 deduction is already served by the "in-whole-or-in-significant-part" requirement so there is no need for reference to additional defined terms or concepts.

If, however, the IRS chooses to retain the minor assembly concept, we ask that the IRS consider a definition that acknowledges that, if a taxpayer's activity transforms a product into something different than the original components, it cannot be classified merely as "minor assembly." Transformation of constituent parts or ingredients into something with different uses and properties is the essential difference that separates production activities from mere minor assembly. The current examples in Treasury regulations section 1.199-3(e)(5) already reflect this important principle about the nature and outcomes of manufacturing processes. In Example 1, taxpayer C purchases a raw agriculture product and transforms that product into a refined agriculture product. The facts suggest that C did not harvest the raw product itself. Nevertheless, that transformative process is acknowledged in the example as MPGE without thought of questioning whether such activity is more properly regarded as minor assembly or something akin to it. Once the raw materials have been transformed into the finished product, a new, different product has come into existence. In other words, transformation equals production for purposes of Section 199.

By contrast, in Example 6 taxpayer X is conducting minor assembly and not MPGE activities when it purchases automobiles from third parties and customizes them with accessories that it also purchases from third parties. Unlike taxpayer C in Example 1, who transformed raw agriculture product into a refined product, the activities of taxpayer X do not transform the car into something new; rather the end product is substantially the same as the product that taxpayer began with, but with superficial and insignificant additions and adjustments. In order to better highlight this distinction and the apparently critical requirement of a transformation process, we recommend that Example 6 be amended to included an explicit statement that the reason why adding accessories to an automobile is considered minor assembly is because the process does not transform the products that are used into a product that is different than the components.

In addition, we would recommend inclusion of an example in Treasury regulations section 1.199-3(e)(5) to further acknowledge the fact that transformative activities are eligible for the Section 199 deduction. One possible example would be that of a cement contractor that sells poured cement to a building developer. The cement contractor purchases dry cement from a wholesaler, adds water and sand to the cement, mixes the compound and pours it into the location designated in the contract. After the cement contractor has processed the cement, it has been transformed into a new product, different from the constituent materials that comprised the cement compound. Therefore, the cement contractor's activities are MPGE of the QPP. This is just one of several possible examples that could be used to highlight the importance of the concept of transformation in the MPGE analysis.

Once again, we thank you for the opportunity to comment on the Proposed Regulations. Although CVS Health is not requesting to provide oral comments at the public hearing, I would be happy to discuss them with you should you have any questions. My email address is John.Kennedy@CYSHealth.com or I can be reached by phone at 401-770-2378.

Respectfully submitted,

 

 

John P. Kennedy

 

Chief Tax Officer

 

Senior Vice President

 

CVS Health Corporation

 

Cumberland, RI
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