Attorneys Comment on Treatment of Rebuild Contracts Under Manufacturing Deduction Rules

We are writing to you on behalf of our clients in response to Notice 2005-14, 2005-7 I.R.B. 498, requesting comments from interested parties regarding regulations that will be proposed under section 199 of the Internal Revenue Code, relating to the deduction for domestic production activities income.

On March 31, 2005, we submitted comments on behalf of our clients on a broad range of issues under section 199. Set forth below is an additional comment regarding the application of section 199 to contracts to rebuild property that is owned by the customer.

We regret that we were unable to provide our comment on this important subject before the March 31 deadline. We understand that the Treasury is on a tight schedule to meet its goal of promulgating proposed regulations this Summer. Nonetheless, we hope that you will be able to consider our recommendations for dealing with rebuild contracts in drafting the proposed regulations.

Notice § 4.04(4) provides that where one taxpayer performs a qualifying activity with respect to particular property pursuant to a contract with another taxpayer only the taxpayer that has the benefits and burdens of ownership of property during the period the qualifying activity is performed is treated as engaging in the qualifying activity for purposes of claiming the section 199 deduction. Section 3.04(4) of the Notice explains that the purpose of this rule is to ensure that only one taxpayer is eligible for the section 199 deduction with respect to any particular activity.

We recommend that Treasury clarify how these rules apply to contracts to either repair or rebuild an item of preexisting property, where ownership of the property being produced is divided between the customer and the contractor, with the customer owning the preexisting property that is the subject of the repair or rebuild contract, whereas the contractor owns all of the new parts and components that will be incorporated into the repaired or rebuilt item.

We believe that a distinction should be drawn between ordinary repair contracts and rebuild contracts. In the case of ordinary repair contracts, the contractor should be entitled to treat as DPGR the portion of its gross receipts from the repair that are attributable to the value of the parts produced by the contractor that are installed in the customer's property, as well as the value of the labor to remove the old part and the labor to install the replacement part. In contrast, the portion of the gross receipts attributable to the value of purchased parts, including any costs of removal of the old part and installation of the replacement part, should not be treated as DPGR. In addition, the value of any costs of refurbishing the customer's equipment would not qualify as DPGR.

In contrast, in the case of rebuild contracts, the contractor should be eligible to test all of its gross receipts from the rebuild transaction in the aggregate for qualification as DPGR, where the value of the rebuild work is substantial in comparison to the value of the customer's property immediately before the rebuild and where the majority of the contractor's cost of performing the rebuild work or the majority of the value of the rebuild work is attributable to new parts and materials that were produced by the contractor. Such rebuild contracts should be treated differently than contracts involving insubstantial repairs of a customer's property, because of the substantial nature of the work performed in relation to the value of the customer's property, and where the work as a whole meets a threshold for the use of new parts that have been manufactured by the taxpayer performing the work. In such cases, it should not be necessary to separate the work as a whole into each individual task. Instead, the taxpayer performing the work should be treated as having produced and sold a single item of property, namely, the improvement of the relevant property. If each individual part or component that is installed as part of the rebuild activity were tested separately, substantial allocation issues would arise and, without a clarification, no taxpayer may be able to claim a section 199 deduction with respect to activities for which the section 199 deduction clearly should be available.

The only obstacle to F treating all of the new parts and components installed in the customer's property in the rebuild transaction as a single item of property for purposes of testing under section 199 is that, during the rebuild, ownership of the ultimate property being produced -- i.e., the rebuilt railcar -- is divided between F and F's customer. This fact prevents the separate parts from being aggregated into a single item of QPP despite the fact that the separate parts are incorporated into a single item of property.

We recommend that Treasury resolve the issue raised by this division of ownership by providing that, in a rebuild contract (defined as a contract where the value of the rebuild work exceeds 25 percent of the value of the rebuilt property immediately before the rebuild), if either (i) more than 50 percent of the contractor's costs of performing the rebuild are attributable to the cost of parts and components that were produced by the contractor or (ii) more than 50 percent of the fair market value of the rebuild work is attributable to the fair market value of parts and components that were produced by the contractor (a "qualifying rebuild contract"), the contractor should be allowed to treat all of the separate purchased and produced parts and components installed in the rebuilding of a single item of property as a single "item" of property. As a result, where the purchased and produced parts and components qualify in the aggregate as having been produced by the taxpayer within the United States, all of the contractor's gross receipts allocable to the parts and components, as well as the gross receipts attributable to the disassembly and reassembly of the customer's property, would qualify as DPGR. Furthermore, because most of the costs or value in such a rebuild contract are incurred in the acquisition, development, and installation of new parts and components, it is entirely consistent with the statute for Treasury to treat the gross receipts earned from a qualifying rebuild contract as gross receipts derived from the sale of QPP.

We believe that a different approach should be adopted in cases where the work performed by the taxpayer on property owned by another party is so substantial that the work goes beyond the mere repair of a customer's property and includes the substantial rebuilding of the customer's property and where either the majority of the taxpayer's costs or the majority of the value of the rebuild is attributable to new parts and components produced by the taxpayer.

In a rebuild contract, the rebuild work substantially increases the value of the property or extends the property's actual useful life. Generally, this is the type of situation where historically the customer would be required to capitalize the cost of the work, rather than being permitted to deduct the cost as a repair. However, since the approach we are recommending for purposes of section 199 addresses this type of situation from the perspective of the contractor rather than the perspective of the customer, and, in addition, for ease of administration, we recommend that the Treasury adopt an objective test for determining when treatment as a rebuild contract generally is available. Under our proposal, a contract would be considered a rebuild contract where the value of the rebuild work exceeds 25 percent of the value of the property immediately before the rebuild.

Performance under a rebuild contract requires delivery of a rebuilt piece of equipment or machinery and not the delivery of individual parts. It is clear that, if a taxpayer first purchased the customer's railcar, rebuilt the railcar, and then sold the railcar, the railcar would be the item tested for whether it was MPGE'd in whole or in significant part within the United States. A rebuild contract requires integration of the new parts and components into a single end product, which includes the customer's preexisting property, to the same degree as where the manufacturer owns both the pre-existing property and the new parts and components during production. The taxpayer performing the rebuild work is in effect producing and selling a single item of property, namely, the substantial improvement of the customer's property. Thus, in cases where more than 50 percent of a contractor's costs of performing a rebuild contract or more than 50 of the fair market value of a rebuild contract is attributable to the contractor's production of new parts and components, the contractor should be able to treat all of the new parts and components that are incorporated by the contractor into the customer's single item of preexisting property in the rebuild transaction as a single item for purposes of section 199.

The rule in the Notice that states that eligibility for the section 199 deduction is determined by reference to which party has ownership of the property being processed does not contemplate the type of split or divided ownership situation that is present in a rebuild contract. When the level of work is sufficiently substantial, when this substantial work effort involves the use of a substantial amount of new material produced by the taxpayer, and when all of the new material added is owned by the taxpayer performing the work, not only would it be an inappropriate outcome for there to be no section 199 deduction available, but the factual situation is also sufficiently different from a more conventional repair contract that a different treatment under section 199 is warranted. In such a situation, the fact that the taxpayer that is actually performing the work is also the owner of all of the new material that is being added to the preexisting property should be sufficient to offset the single fact that this taxpayer is not the owner of the original property that is being rebuilt. Because the purpose of the ownership test is to determine which taxpayer should be treated as performing the production activities, it makes sense for the test to turn on the ownership of the new parts and components instead of ownership of the preexisting property, particularly where the party that is actually performing the work is the same party that owns all the new material being added to the existing property and either the cost of that produced material exceeds 50 percent of the total cost of the work performed or the fair market value of that produced material exceeds 50 percent of the total fair market value of the work performed.

In all three fact patterns, the manufacturing activity performed is exactly the same. Consequently, we believe the potential for section 199 benefits should also be the same and do not believe the statutory term "by the taxpayer" or the definition of "item" requires a different result.

Thus, we recommend that Treasury resolve the split ownership in rebuild contracts by adopting a rule that would allow all of the parts and components that are installed in the customer's preexisting property to be treated as a single item for purposes of section 199, where either more than 50 percent of the contractor's total cost to perform the rebuild or more than 50 percent of the total fair market value of the rebuild is attributable to the new parts and components produced by the taxpayer that are incorporated into the rebuilt property. We would propose that a rebuild contract be defined as a contract where the value of all the work performed exceeds 25 percent of the value of the property to be rebuilt immediately before the rebuild effort. In such a rebuild contract, most of the disassembly and reassembly costs are attributable to the installation of the new parts and components produced by the taxpayer. By treating all of the work performed as a single item, the approach we recommend would eliminate the need for onerous allocations of these and other installation activities among the various purchased and produced parts that are installed as part of the rebuild transaction.

Recommended Definition of a "Rebuild Contract." Generally, where the contractor performs work on property owned by the customer that is so substantial that the work is properly viewed as a rebuild of the customer's property instead of as a repair, based on the fact that the work substantially increases the value of the property or substantially extends the actual useful life of the property, this is the type of situation where the customer likely would be required to capitalize the cost of the work, rather than being permitted to deduct the cost as a repair. See, e.g., Rev. Rul. 88-57 (describing the rehabilitation of railcars and requiring capitalization by the owner) and Rev. Rul. 2001-4, Situation 3 (describing the upgrade of an airframe and requiring capitalization by the owner).

However, since the approach we are recommending focuses on the perspective of the contractor rather than the perspective of the customer, it does not seem appropriate to the treatment we are recommending for purposes of section 199 for the contractor directly to the treatment by the customer in terms of the customer's actual capitalization versus deduction of the customer's costs. Additional considerations weighing against tying the treatment we recommend for the contractor directly to the treatment by the customer are the fact that the contractor performing the rebuild will not have access to the information regarding whether the customer actually capitalized the cost of the rebuild. Furthermore, in many cases, the contractor will not have access to the facts and circumstances relevant to a determination of whether the customer should have capitalized the cost of the rebuild under existing federal tax law. Finally, even if the contractor did have access to this information, considerable uncertainty has developed regarding when heavy maintenance and overhaul contracts are required to be capitalized under existing law.

Therefore, because the test we propose applies to the contract rather than the customer, and additionally, in view of the administrative burden that would be imposed by requiring the contractor to make the proper determination in each case as to whether the customer either did capitalize or should have capitalized the rebuild, we recommend that, for purposes of section 199, "rebuild contract" should be defined as any contract where the value of the rebuild work performed exceeds 25 percent of the value of the preexisting property immediately before the rebuild.

Recommended Definition of a "Qualifying Rebuild Contract." In light of the fact that the treatment we are recommending focuses on the ownership of the new parts and components and disregards the ownership of the preexisting property, a prerequisite for this treatment should be that the cost or fair market value of the new material is substantial in relation to the fair market value of the entire rebuild project. Furthermore, because we understand that the Treasury believes that only the installation of parts produced by the taxpayer should qualify for section 199 benefits, we would further limit our proposed treatment to rebuild contracts where either the majority of the taxpayer's costs of performing the rebuild work are attributable to the cost of the parts and components that were produced by the taxpayer or the majority of the value of the rebuild work is attributable to the fair market value of the parts or components that were produced by the taxpayer. We recommend that Treasury allow taxpayers to elect to determine the percentage of the rebuild work attributable to new parts or components based on either cost or fair market value data, because taxpayers' access to such data varies and some taxpayers may find one of the two ratios easier to compute.

Therefore, in order to be a "qualifying rebuild contract," either the cost or fair market value of the new parts and materials produced by the taxpayer and used in the rebuild must represent more than 50 percent of the total cost or the total fair market value, respectively, of the rebuild work. Under this test, the predominant nature of the work performed by the contractor would be regarded as the sale of property produced by the taxpayer. Moreover, since eligibility for special treatment would depend on such a high level of produced parts, when that cost is taken together with the cost of installing such parts, the predominant nature of the transaction is that of a sale of produced parts and not a simple repair.

Thus, in example 1, since either (i) the cost of the new parts and materials produced by the taxpayer and used in the rebuild are more than 50 percent of the total cost of the rebuild work or (ii) the fair market value of such parts is more than 50 percent of the total fair market value of the rebuild work, the new parts and components would be treated as a single item for purposes of section 199 because they are being integrated into the customer's single item of preexisting property. As a result, F would be treated as earning gross receipts from the sale of the parts and components in the aggregate and such gross receipts would qualify as DPGR provided that the parts and components, as a unit, qualify as having been produced by F in significant part within the United States. This treatment eliminates the need for difficult allocations of the gross receipts attributable to F's activities under the contract, including the disassembly and reassembly of the railcar.

We appreciate the opportunity to provide this comment on behalf of our clients on this important subject. If you have any questions concerning this comment or would like to discuss any of the points raised herein in more detail, please feel free to call any of the undersigned at (202) 393-7600.

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