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Attorneys Suggest Solutions to Manufacturing Deduction Issues

MAR. 31, 2005

Attorneys Suggest Solutions to Manufacturing Deduction Issues

DATED MAR. 31, 2005
DOCUMENT ATTRIBUTES
  • Authors
    Schneider, Leslie J.
    Smith, Patrick J.
    Rolfes, Danielle E.
  • Institutional Authors
    Ivins, Phillips & Barker
  • Cross-Reference
    For Notice 2005-14, 2005-7 IRB 498, see Doc 2005-1241 [PDF] or

    2005 TNT 13-7 2005 TNT 13-7: Internal Revenue Bulletin.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2005-8315
  • Tax Analysts Electronic Citation
    2005 TNT 77-30

 

March 31, 2005

 

 

Commissioner of Internal Revenue

 

Courier's Desk

 

Internal Revenue Service

 

1111 Constitution Avenue, N.W.

 

Washington, D.C. 20224

 

Attention: CC:PA:LPD:PR (Notice 2005-14)

Re: Comments on Notice 2005-14 Guidance on Deduction for Domestic Production Activities

 

Dear Sir:

We are writing to you on behalf of our law firm's 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.

We represent a wide range of clients in the manufacturing and construction industries whose interests would be vitally affected by the rules that are adopted to interpret section 199. Set forth below are our comments on various sections of Notice 2005-14. In each case, we have endeavored to provide you with a real world example of the issues that are posed by the particular section of the Notice on which we are commenting together with our suggested solution to the issues posed.

Set forth below is a list of our comments in the order in which they appear below:

 

1. Notice § 4.04(4) - MPGE Must be Performed by the Owner of QPP - Application of this Rule to Contracts with the United States Government. This comment requests clarification to confirm that under the benefits and burdens test the contractor is considered the owner of property being produced for the United States Government under both fixed-price and cost-reimbursement type government contracts.

2. Notice § 4.03(1) - Determining Qualified Production Activities Income - Definition of "Item." This comment requests clarification of the definition of item for purposes of determining what is QPP and for purposes of applying the de minimis test for embedded services.

3. Notice § 4.03(3) - Treatment of Advance Payments as DPGR - Application to Revenue from Long-Term Contracts Accounted for Under the Percentage of Completion Method. This comment requests guidance on how to determine the portion of revenue recognized under the percentage of completion method that qualifies as DPGR.

4. Notice § 4.04(7)(b) - Gross Receipts from the Performance of Services are not DPGR - Scope of the Exception for Services that Are Integral to the Production of QPP and of the Exception for Embedded Services. This comment requests clarification of when gross receipts attributable to services that are integral to the production and sale of QPP will be considered DPGR and a change to the definition of an embedded service.

5. Notice § 4.04(4) - Definition of "by the taxpayer" - Application to Installation Activities Following Passage of Title. This comment requests clarification that installation of QPP that occurs shortly after the transfer of ownership of the QPP from the manufacturer to the customer qualifies as MPGE by the manufacturer.

6. Notice § 4.04(7)(b) - Gross Receipts from the Performance of Services are not DPGR - Application to Installation Activities Following Passage of Title. This comment requests clarification that installation of QPP that occurs shortly after the transfer of ownership of the QPP from the manufacturer to the customer qualifies as gross receipts derived from the sale of the QPP.

7. Notice § 4.04(5)(b) & (c) - Whether MPGE is Substantial in Nature - Treatment of Development Costs. This comment requests clarification of the definition of development costs and whether such costs must be included in the cost-of-goods-sold denominator under the safe harbor test.

8. Notice § 4.04(3)(b) - Consistency Between Section 199 and Section 263A. This comment requests clarification of the intended scope and breadth of the consistency requirement.

9. Notice § 4.04(7) - Definition of "Derived From the Lease, Rental, License, Sale, Exchange, or Other Disposition of Qualified Production Property - Tax-Free Exchange." This comment requests guidance regarding when property that is received in a non-taxable exchange is considered QPP produced by the taxpayer.

10. Notice § 4.05(2)(b) - Allocation of Cost of Goods Sold - Specific Identification. This comment requests clarification of the intended scope of the requirement to specifically identify gross receipts when specific identification information is available.

11. Notice § 4.05(2)(a) - Allocating Cost of Goods Sold - LIFO. This comment requests further guidance on how to determine CGS of particular sales when a taxpayer uses the LIFO method, particularly the dollar-value LIFO method.

DETAILED COMMENTS

 

 

1. Notice § 4.04(4) - MPGE Must be Performed by the Owner of QPP - Application of this Rule to Contracts with the United States Government

This section of the Notice provides guidance on how to determine whether MPGE of QPP was performed by the taxpayer claiming the section 199 deduction in circumstances where the taxpayer is performing the MPGE on QPP pursuant to a contract with another party. This section of the Notice provides that where one taxpayer performs a qualifying activity pursuant to a contract with another party, the section 199 deduction is available only to the taxpayer that has the benefits and burdens of ownership with respect to the property at the time the qualifying activity is performed. The Notice explains that the reason for this rule is to assure that the section 199 deduction is available to only one taxpayer with respect to any particular activity.

The foregoing rules in this section of the Notice present an issue with respect to a situation where a taxpayer produces QPP for the United States Government pursuant to a contract between the taxpayer and the United States Government. The issue that is presented in such a case is whether the taxpayer is entitled to a section 199 deduction with respect to the taxpayer's gross receipts under the contract that are attributable to the QPP produced by the taxpayer for the United States Government.

Under the rules that are set forth in the Notice, the resolution of this issue relating to the availability of a section 199 deduction for a taxpayer producing property for the United States Government depends on whether the contractor is considered to have the benefits and burdens of ownership with respect to the property being produced for the United States Government for purposes of the foregoing rule in the Notice. A second aspect of the issue is whether the answer to the foregoing question differs depending on whether the contract with the United States Government is a fixed-price contract or is instead a cost-reimbursement type contract.

We believe, based not only on the long-standing position of the Internal Revenue Service with respect to the treatment of these types of contracts for purposes that are closely related to the standards that have been adopted under section 199, but also based on application of the benefits and burdens standard in the context of the relevant standard form Government contract clauses, that the contractor should be considered to have the benefits and burdens of ownership while producing property for the Government and, accordingly, should be eligible to claim the section 199 deduction for both fixed-price contracts and cost-reimbursement type contracts requiring the contractor to produce tangible personal property for the United States Government.

The foregoing points will be discussed in more detail below.

 

a. Illustrative Examples

 

i. Example (1)
Contractor A enters into a long-term contract with the United States Government to produce 100 units of a new type of tank. The contract is a fixed-price type contract. The price for each tank set forth in the contract is $75 million. The contract provides for monthly progress payments by the Government to the contractor pursuant to FAR § 52.232-16, "Progress Payments." This particular FAR clause applies only to fixed-price contracts and thus does not apply to cost-reimbursement type contracts. See FAR § 32.500(a).

The amounts of these progress payments are determined in accordance with this FAR clause as 80% of costs incurred by Contractor A. See also FAR § 32.501-1(a) ("The customary progress payment rate is 80 percent.") In addition to incorporating FAR § 52.232-16, the contract also incorporates FAR § 52.245-2, "Government Property (Fixed-Price Contracts)." Each of these FAR clauses includes a provision stating that the Government has title to any material while the contractor is processing the material for the Government (FAR § 52.252-16(d) and FAR § 52.245-2(c)).

ii. Example (2)
Contractor B enters into a long-term contract with the United States Government to design a new type of radar unit for use on naval destroyers and to produce 5 such units. The contract is a cost-reimbursement type contract, with an incentive fee. Under a cost-reimbursement type contract, the contractor is entitled to charge the United States Government for its allowable costs. The incentive fee in this contract is determined under a formula based on the amount of Contractor B's allowable actual costs, as compared to the contract's target cost. Target cost is a predetermined amount that is agreed upon between the contractor and the Government as an estimate of what it is likely to cost the contractor to complete the work required by the contract. The target cost amount is changed only in the event the contract is modified to increase (or reduce) the amount of work required under the contract.

Under the formula for determining the fee, the starting point in the determination of the fee is a fixed amount (determined as a fixed percentage of target cost), but this fixed amount is then adjusted upward or downward depending on whether the actual costs incurred by the contractor in performing the contract are below or above the contract's target cost. The result of this adjustment is the actual fee. If the actual costs incurred are below target cost, the fee is increased by 25% of the difference between target cost and actual cost. If the actual costs incurred are above target cost, the fee is reduced by 25% of the difference between target cost and actual cost. Thus, the contractor is rewarded if actual costs are below target cost and penalized if actual costs are above target cost.

The contract provides for regular payments during the performance of the contract based on costs incurred, with payment once every two weeks, pursuant to FAR § 52.216-7, "Allowable Cost and Payment." A portion of the expected total fee is invoiced on the same schedule. The contract incorporates in its terms the FAR clause providing that the United States Government has title to the contractor's work-in-process, FAR § 52.245-5, "Government Property (Cost-Reimbursement, Time-and-Material, or Labor-Hour Contracts)," specifically § 52.245-5(c), "Title."

 

b. Issues

 

In examples (1) and (2), does the presence of the standard FAR title passage clauses that are cited above prevent the contractors in either of the two types of contracts from being considered the manufacturers of QPP for purposes of being eligible to claim a deduction under section 199 with respect to the work? In addition, in the case of example (2), does any other aspect of the cost- reimbursement type of contract prevent Contractor B from being considered the manufacturer of QPP for the United States Government?

 

c. Comment

 

i. In General
As noted above, section 4.04(4) of the Notice provides that in determining whether QPP has been MPGE "by the taxpayer," in a case where "one taxpayer performs a qualifying activity under § 199(c)(4)(A)(i) pursuant to a contract with another party," the rule for purposes of section 199 is that "only the taxpayer that has the benefits and burdens of ownership of the property under federal income tax principles during the period the qualifying activity occurs is treated as engaging in the qualifying activity." In addition, section 3.04(4) of the Notice explains that the reason for this rule is to assure that only one taxpayer is able to claim the section 199 deduction with respect to any particular production activity.

Section 3.04(4) of the Notice states that the standard that a taxpayer is eligible to obtain the benefit of section 199 only if "the taxpayer... has the benefits and burdens of ownership of the property under federal income tax principles during the period the qualifying activity occurs" is "based on the principles under § 936 and § 263A." Section 3.04(4) also provides as follows on this subject:

 

If a contractor does not have the benefits and burdens of owning the property under federal income tax principles during the period the qualifying activity occurs, the contractor is more appropriately viewed as performing a service for the customer.

 

Section 4.04(3)(b), dealing with consistency with section 263A, provides that a "taxpayer that has MPGE QPP for the taxable year should treat itself as a producer under § 263A with respect to the QPP for the taxable year unless the taxpayer is not subject to § 263A under the Code, regulations, or other published guidance."

In light of the foregoing statements in Notice 2005-14 to the effect that a taxpayer must have the benefits and burdens of ownership of QPP while engaging in a qualifying activity with respect to that property in order to be eligible for a section 199 deduction, the issue in the context of a contract to produce tangible personal property for the United States Government is whether the contractor is considered to have the benefits and burdens of ownership of the property that is being produced by the contractor for the United States Government.

Treasury representatives have stated that since most aspects of the provisions in section 199 borrow concepts from other existing provisions in the tax law, it is not the Treasury's aim in drafting the regulations under section 199 to develop new concepts exclusively for purposes of section 199 in any case where there are existing concepts in the tax law that can be either directly applied or readily adapted for purposes of section 199. We entirely agree with this approach because it simplifies not only the drafting of the section 199 rules, but also the application of these rules, as well as achieving desirable consistency between section 199 and related areas of the tax law.

In light of the foregoing approach of basing the rules implementing section 199 on existing tax law rules to the greatest extent possible, we would note that in the area of the ownership of property for federal income tax purposes and the related question of which party is considered to be the manufacturer of property that is produced under a contract with a customer, there already exists a long-standing body of law and a framework of existing practices that have been applied by the Internal Revenue Service dealing with the treatment of the production of property by taxpayers under contracts with the United States Government.

That body of law and framework of existing and long-standing IRS practices, which will be discussed in detail below, clearly supports the position that a contractor that is producing property under a contract with the United States Government is considered for tax purposes to be the owner of the property being produced, and that this property represents inventory for federal income tax purposes in the hands of the contractor, notwithstanding any possible interpretation of the FAR clauses on title passage either for credit, security, or other purposes, as placing the ownership of the property being produced in the United States Government. Moreover, that body of law and framework of existing IRS practices reaches the result that the contractor is considered to be the owner of the property while it is being produced, not only where the contract with the United States Government is a fixed-price contract, but also where the contract is a cost-reimbursement type contract.

In light of the foregoing well-established and long-standing IRS treatment of taxpayers producing property under contracts with the United States Government, we see no reason why this issue should now be revisited or reconsidered in the context of section 199. However, we are confident that even if this issue were reexamined in the context of section 199, the long-standing conclusion that the contractor is the owner of the property that is being produced for the United States Government would be reaffirmed for purposes of section 199 based on an analysis of the relevant standard form Government contract clauses, evaluated in light of the tax law precedents dealing with the benefits and burdens of ownership.

Set forth below is a more detailed discussion of the historical IRS precedents and practices on this issue, followed by a separate analysis of the substantive issue on its own merits in terms of the application of the benefits and burdens standard in the context of both fixed-price contracts and cost-reimbursement type contracts to produce tangible personal property for the United States Government.

ii. Historical Precedents on this Issue

 

a. Pre-1987 Period and Experience under Reg. 1.451-3
The first general subject area that is relevant to the issue of whether the contractor has the benefits and burdens of ownership in a contract to produce tangible personal property for the United States Government is the treatment that has been accorded to such contracts under the long-term contract rules. In this context, in both fixed-price contracts and cost-reimbursement type contracts for the production of tangible personal property for the United States Government, the contractor has been treated as the owner of the property being produced for purposes of the long-term contract rules.

Prior to 1973, the long-term contract regulations were interpreted by the IRS as limiting the availability of the completed contract method of accounting to long-term contracts for the construction of buildings and other improvements to real estate. Under this interpretation, contracts for the production of tangible personal property did not qualify as long-term contracts without regard to whether the customer was the United States Government or a private party and without regard to the specific terms of the particular contract.

Starting in 1970, under pressure from Congress and the staff of the Joint Committee on Taxation, the Treasury made the decision to expand eligibility for the completed contract method to include contracts for the manufacture of tangible personal property under certain conditions. One of the conditions was that the property that was to be produced under this category of long-term contract needed to either be unique (i.e., not the type of property stored in a taxpayer's inventory) or take at least 12 months to produce each unit of property under the contract. Reg. § 1.451-3(b)(1).

In contrast, a contract to provide production services to a customer would not have been eligible for the completed contract method. Thus, a contract to produce property where the property being produced was at all times considered as being owned by the customer for tax purposes would not have been eligible to be treated as a long-term contract for tax purposes. It should be noted that after the enactment of section 460 in 1986 repealing the completed contract method for most types of long-term contracts, this rule requiring the contractor to own the property being produced was later changed in the regulations under section 460 to require the percentage-of- completion method to be used by a taxpayer producing property under a long-term contract even in cases where the producer was not the owner of the property. Reg. § 1.460- 1(b)(2)(i).

As a result of the new availability of the completed contract method for certain manufacturing contracts, members of the defense and aerospace industries applied for and received permission from the IRS National Office to use the completed contract method of accounting for contracts to produce tangible personal property for the United States Government that satisfied the uniqueness or 12-month production period tests for long-term contract classification. These contracts contained FAR clauses that placed title to the property being produced in the United States Government.

Nevertheless, not in one single instance did the IRS National Office reject such applications for change on the grounds that the taxpayers should be regarded for federal income tax purposes as providing production services for the United States Government by virtue of the title passage clauses in the FAR. Moreover, no such applications for change were ever rejected or limited on the grounds that the application covered contracts with the Federal Government that were of a cost-reimbursement type.

The IRS National Office's approval of such method change requests cannot be attributed to oversight because after these applications were approved, taxpayers attempted to expand the range of contracts covered by applying the completed contract method of accounting to contracts with the United States Government that involved research, development, and testing of property that was to be produced by the taxpayer. These taxpayers' application of the completed-contract method to such contracts was quickly challenged by the IRS on the grounds that, in these types of contracts, only services were being provided by the taxpayers to the United States Government, particularly where the contracts did not require the produced property to be delivered to the United States Government at the conclusion of the contract, but instead contemplated that the property would be destroyed in testing. In contrast, at no time did the IRS ever suggest that long-term contracts for the production of hardware for the United States Government would be ineligible for the completed contract method on the grounds that the presence of FAR title passage clauses or cost-reimbursement pricing terms had the effect of converting what were in form manufacturing contracts into service contracts.

At the same time that the foregoing developments were occurring in the case of the completed contract method, parallel issues were being raised in the inventory area. In particular, since the completed contract method was not mandatory at this time in history and since some contracts to produce tangible personal property for the United States Government did not qualify as long-term contracts because the property produced was not considered unique and did not require 12 months to produce, it was necessary for taxpayers to determine what accounting methods should be used for such contracts for tax purposes. For example, it was necessary for taxpayers to determine whether they could value their work-in-process on such contracts that did not qualify as long-term contracts under the LIFO method or take write-downs to market under the lower of cost or market method of inventory valuation.

Thus, the IRS National Office was again faced with the issue of whether taxpayers performing contracts with the United States Government have an inventory of work-in-process notwithstanding the presence of FAR title passage clauses in their contracts or the existence of cost-reimbursement pricing terms. For a brief period of time, uncertainty existed when a letter ruling, PLR 8122001, was issued suggesting that the IRS did not believe that contractors working for the Federal Government owned their work product and had inventories. One tax case was even litigated on this issue, Rockwell International Corp. v. Commissioner, 77 T.C. 780 (1981), aff'd. 694 F.2d 60 (3d Cir. 1982), with the court failing to reach a conclusion on the merits of the issue.

However, after balancing the legal issues of ownership with the ramifications for tax purposes if contractors with the United States Government were treated as service providers, the IRS National Office decided to resolve the issue by treating the contractors as the owners of their work-in-process for tax purposes. Thus, in PLR 8517001 and 8510003, the IRS National Office ruled that contractors producing hardware for the United States Government would be viewed as the owners of their work-in-process for tax purposes and, therefore, could value the deferred costs as inventory under the LIFO or lower of cost or market method.

b. Post-1986 Period and Experience under Section 263A
The next relevant area of IRS practice relating to the treatment of contracts to produce tangible personal property for the United States Government relates to the treatment of such contracts after the repeal of the completed-contract method for most types of long-term contracts starting in 1986. In this context, the IRS National Office was confronted very directly with the question of whether taxpayers performing such contracts should be considered the owner of the property being produced. After giving careful consideration to that question, the National Office concluded that in such contracts, the contractor was in fact properly considered the owner.

When the completed contract method was repealed in stages starting in 1986, taxpayers began to reevaluate whether the types of contracts that they had been accounting for on the completed-contract method based on long-term contract classification should continue to be characterized as long-term contracts under section 460, which would require the use of the PCM method. This reevaluation stemmed from the fact that for financial reporting purposes, GAAP does not differentiate among long-term contracts, hardware contracts, and service contracts with the United States Government. In most cases, all of these categories of contracts are accounted for on the PCM method for book purposes. Many taxpayers, particularly those in the defense and aerospace industries, had followed a consistent method for books and tax and they determined that a number of their contracts with the United States Government involved either the production of non-unique hardware or the performance of services, such as research and testing, that were not subject to section 460 for tax purposes.

As a result, during the period immediately following the beginning of the gradual repeal of the completed contract method in 1986, our firm filed accounting method change requests on behalf of a number of taxpayers in the defense and aerospace industry requesting the IRS National Office's consent to change these taxpayers' methods of accounting for contracts for the production of tangible personal property that were not long-term contracts, including contracts with the United States Government, from the PCM method to the accrual shipment and inventory method of accounting. Similarly, we filed accounting method change requests on behalf of many of these same taxpayers to change their method of accounting for contracts to perform services, including contracts with the United States Government, from the PCM method to an accrual method. Under the accrual method as it applies to service contracts, costs are deducted at the time the costs are incurred, and revenue is reported under a three-part test first formulated in Rev. Rul. 74-607, which provides that revenue is reported at the earliest of: (1) when revenue is received; (2) when revenue is due; or (3) when the required performance occurs. Under this three-part test, as applied to Government contracts, the earliest of these events is generally when an amount is due by reason of being billable. See TAM 9818004.

In at least one of these accounting method change requests that we filed during the period shortly after 1986, the taxpayer specifically requested consent from the IRS National Office to change to an accounting method that would treat contracts with the United States Government for the production of property for the United States Government as contracts for the performance of services, rather than as contracts for the production of inventoriable goods. The taxpayer involved in that request has authorized us to discuss that request for purposes of these comments. This request was made for both fixed-price and cost-reimbursement contracts. In response to this request, the IRS National Office studied the issue intensively, and the processing of this accounting method change request extended over a considerable period of time, involving several submissions by the taxpayer and conferences between the taxpayer and the National Office.

However, after giving extended consideration to this issue, the IRS National Office reaffirmed its prior long-standing position that neither the presence of FAR title passage clauses in contracts with the United States Government, nor the presence of cost-reimbursement pricing terms in contracts with the United States Government, would for tax purposes transform contracts for the production of tangible personal property for the United States Government into contracts for the performance of services. As a result of this decision, the IRS National Office refused to grant consent to the taxpayer's request to change its method of accounting for hardware contracts with the United States Government to a method under which the contracts would have been treated as service contracts, and instead required the taxpayer to change from the taxpayer's prior accounting method of treating these contracts as long-term contracts to an accounting method under which the contracts were treated as contracts for the production of goods by the taxpayer, subject to the inventory rules of section 471 and the uniform capitalization rules of section 263A.

Under the treatment required by the National Office, the taxpayer was thus required to capitalize and defer its costs incurred in performing the contract until the time when the property being produced was delivered to the Government. This treatment produced a considerably less favorable tax result for the taxpayer than would have resulted under the treatment requested by the taxpayer, since, under the service contract treatment requested by the taxpayer, the taxpayer would have been able to deduct its costs at the time the costs were incurred, rather than having to defer these costs until the time the property was delivered. Any difference in the time of revenue recognition would not have offset the benefit to the taxpayer of deducting the costs at an earlier time under the service contract treatment.

Moreover, although the foregoing accounting method change request involved only one taxpayer, if the National Office had reached the opposite conclusion in the case of that taxpayer, there is no doubt that other taxpayers producing property for the United States Government would soon have become aware of the outcome and would have promptly filed similar accounting method change requests. Thus, the IRS decision in the case of this one taxpayer for practical purposes decided the question for the entire industry.

In light of the foregoing decision by the National Office of the Internal Revenue Service, when squarely presented with precisely this issue of whether taxpayers with contracts to produce tangible personal property for the United States Government should be treated as performing services or as instead producing property for tax purposes, it is very difficult to see how a different conclusion could now be reached for purposes of section 199. Presumably, to the extent that consideration is now being given to the possibility of reexamining the issue for purposes of section 199, that consideration is not being prompted by the fact that the earlier conclusion that these were production contracts in the context of section 471 produced a relatively disadvantageous tax result for taxpayers compared to the contrary conclusion, whereas in the context of section 199 the conclusion that these contracts are production contracts produces a more favorable tax result for the taxpayers affected than the contrary conclusion.

Our firm's subsequent IRS audit experience on these accounting method changes is entirely consistent with the IRS National Office's position that characterized hardware contracts with the United States Government as inventory contracts, rather than as service contracts, regardless of whether the contract was a fixed-price contract or a cost-reimbursement type contract. Moreover, in accounting method change requests under section 263A, producers of hardware for the United States Government have been treated as being subject to the UNICAP provisions with respect to each contract. Moreover, this treatment has not varied depending on whether the contract with the United States Government was a fixed-price or cost-reimbursement type contract.

In this regard, the UNICAP regulations specifically state that:

 

[A] taxpayer is not considered to be producing property unless the taxpayer is considered the owner of the property produced under federal income tax principles. The determination as to whether a taxpayer is an owner is based on all the facts and circumstances, including the various benefits and burdens of ownership vested with the taxpayer. A taxpayer may be considered the owner of property produced, even though the taxpayer does not have legal title to the property.

 

Reg. § 1.263A-2(a)(1)(ii)(A). If a producer of property for the United States Government is subject to the UNICAP requirements based on the foregoing provision, the applicability of section 263A to such contracts should be conclusive in determining that the taxpayer is likewise the producer of QPP for purposes of section 199.

Thus, based on the foregoing history, it would very clearly be a complete reversal of a long-standing IRS position if the conclusion were now reached for purposes of section 199 that taxpayers producing tangible personal property under contracts with the United States Government are not considered the owners of the property being produced for federal income tax purposes. In enacting section 199, Congress would certainly have expected that this long-standing and well-established treatment of contracts for the production of tangible personal property for the United States Government would lead to the result that contractors would be able to apply section 199 to such contracts.

It would certainly seem highly inappropriate and unfair, after the Internal Revenue Service for many years has required taxpayers to use an inventory treatment for these contracts that produced a tax result that has been considerably less favorable to taxpayers than would have been the case under service contract treatment, for the Treasury and the Internal Revenue Service to now adopt a changed position on the issue, at a time when the tax law has changed in a way that now provides a benefit to taxpayers from inventory treatment, and for the Treasury and the Internal Revenue Service to now suddenly conclude that this long-established position, which was never subject to reexamination during the time that this position produced a disadvantageous tax result for taxpayers, is now determined to have been incorrect and requiring reversal. Such a change in position certainly would call into question the applicability of neutral tax principles.

Moreover, in contrast to many of the issues that have arisen under section 199, this issue does not involve a decision which simply affects which of two taxpayers will receive the benefit of section 199 in connection with a particular activity. Obviously, in light of the fact that the other party to the contracts at issue is the United States Government, a decision adverse to the contractors would have the result that no taxpayer is entitled to any section 199 deduction with respect to a sector of the United States economy that is obviously quite substantial.

However, if, notwithstanding the foregoing long-standing practices, nevertheless, in the context of section 199, the Treasury believes it is necessary to reexamine the issue of whether a contractor producing tangible personal property under a contract with the United States Government is considered the owner of the property being produced for federal income tax purposes, the following discussion is provided.

iii. Substantive Evaluation of Whether the Contractor in a Contract with the United States Government is the Owner of the Work-in-Process

 

a. General Principles
As noted above, Section 3.04(4) of the Notice states that the standard for determining which party is considered the owner of property being produced under a contract for purposes of determining eligibility under section 199 is based in part on the principles that are applicable under section 263A. Reg. § 1.263A-2(a)(1)(ii)(A), quoted above, states that the determination as to which party is considered the owner of property for federal income tax purposes is based on all the facts and circumstances, taking into account the various benefits and burdens of ownership. This provision in the section 263A regulations also states that a party may be considered the owner of property for federal income tax purposes even though that party does not have legal title to the property.

The foregoing statements in Reg. § 1.263A-2(a)(1)(ii)(A) regarding the standard for determining which party is considered the owner of property for federal income tax purposes represent an accurate statement of the principles that have been developed and applied by the courts and the Internal Revenue Service for determining which party is considered the owner of property for federal income tax purposes in a variety of factual situations. These principles are not in any way limited to the context of a situation where property is being produced under a contract.

The issue of which party is considered to be the owner of property that is being produced under a contract is simply a special application of the more general issue in the tax law of which party is considered the owner of any type of property in circumstances where there are two parties who potentially might be considered the owner. Another common factual context in which the issue of which party is considered the owner of property has arisen is in a situation where a party who clearly is the owner of property enters into a transaction concerning that property with another party, and the issue is whether that transaction is a sale of the property or instead some other type of transaction, such as a loan that is secured by the property. The resolution of the issue of whether such a transaction is a sale or instead some other form of transaction turns on the question of which of the two parties is considered the owner of the property for tax purposes after the transaction.

The court decisions and Internal Revenue Service documents that have addressed the issue of which party is considered the owner of property for tax purposes have formulated and applied various lists of factors to be taken into consideration in deciding this issue. The specific factors listed have varied somewhat since in many cases most of the factors are tailored to fit the particular circumstances in which the issue arises as well as the specific nature of the property involved (which in many cases has been intangible property such as debts owed by third parties).

Nevertheless, certain generalizations can be made that are applicable to all of these lists of factors. The lists of factors tend to be somewhat lengthy, with the number of factors identified generally ranging from six to eleven. The question of which party has legal title to the property is generally one of the factors that is identified as being relevant to the issue of which party is the owner, but the question of which party has legal title is not one of the more important factors.

The most important factors in all of these court cases and Internal Revenue Service documents relate to the nature of the economic or financial outcome that the party will experience with respect to the property at issue. The factors dealing with this consideration are generally described as risk of loss and possibility of profit, but these two terms, are really simply slightly different ways of posing the same question, namely how wide is the range of possible economic or financial outcomes (profit or loss) that the party might experience with respect to the property.

If the range of possible economic or financial outcomes (profit or loss) that the party might experience with respect to the property is relatively narrow, or, in the most extreme case, if the economic or financial outcome (the amount of profit or loss) is fixed, predetermined, and certain, with no possibility of variation, then the party will probably not be considered the owner of the property. In contrast, as the range of possible economic or financial outcomes (profit or loss) that the party might experience with respect to the property becomes broader, then it becomes more likely that the party will be considered the owner of the property.

One case that is cited very often with respect to the issue of which of two parties is the owner of property is Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237 (1981): "The key to deciding whether petitioners' transactions... are sales is to determine whether the benefits and burdens of ownership have passed... to petitioners." The property involved in this case was tangible personal property (cattle), and the court identified eight relevant factors that were derived from earlier court decisions, including legal title, possession, risk of loss, and potential for profit.

As noted previously, a number of the cases and Internal Revenue Service documents where the issue of which party is the owner of property has been presented and addressed have involved property that consisted of debt owed by third parties and where the precise issue presented was whether a transaction involving that property was properly characterized as a sale of the property or instead as a loan with the property merely serving as security for the loan. As in Grodt & McKay, the issue of whether such a transaction where the property involved is third-party debt has been decided by reference to the question of which of the two parties has the benefits and burdens of ownership with respect to the third-party debt after the transaction that is at issue.

It should be noted that one complicating factor in applying these authorities in the present context is raised by the fact that in the present context the issue is not whether the Government is ever the owner of the property at issue, but rather the time when the Government becomes the owner of the property. In the present context involving a contract to produce property for the Government, there is no question that at the time the contract is completed, the Government will be the owner of the property. The issue is whether the Government is considered the owner of the property at some earlier time. In contrast, in most of the authorities dealing with the issue of which of two parties was the owner of property, there has not been a comparable circumstance that at the end of the day, it was known that ownership would have passed to a determinable party, with the only question being the determination of the precise point in time when ownership passed.

Court decisions addressing the issue of which of two parties is considered the owner of property in the context of whether a particular transaction involving third-party debt was a sale or instead a loan secured by the third-party debt have included Town & Country Food Co. v. Commissioner, 51 T.C. 1049 (1969) (holding that a transaction involving third-party debt was a secured loan rather than a sale for purposes of the rules relating to dispositions of installment obligations under section 453, relying on factors including title, possession, and right to receive excess proceeds from any actual sale of the debt); United Surgical Steel Co. v. Commissioner, 54 T.C. 1215 (1970) (same issue and same holding as in Town & Country, with the court relying on factors such as risk and profit); Yancey Brothers Co. v. United States, 319 F. Supp. 441 (D. Ga. 1970) (same issue and holding as in Town & Country and United Surgical Steel, with the court relying on those cases); Coulter Electronics, Inc. v. Commissioner, T.C. Memo. 1990-186, aff'd 943 F.2d 1318 (11th Cir. 1991) (whether a transaction involving third-party leases was a sale or instead a secured loan; court cited Grodt & McKay and the eight factors listed there; cited Illionois Power Co. v. Commissioner, 87 T.C. 1417 (1986) for the principle that the "potential for profit or loss" is a "significant factor" in determining which party is the owner of property); and Watts Copy Systems, Inc. v. Commissioner, T.C. Memo. 1994-124 (same issue and same holding as in Coulter Electronics; cited six factors derived from Grodt & McKay, including risk of loss and entitlement to profit).

Two additional cases dealing with the same issue deserve particular mention. Both American National Bank of Austin v. United States, 421 F.2d 442 (5th Cir. 1970), and Union Planters National Bank of Memphis v. United States, 426 F.2d 115 (6th Cir. 1970), placed particular emphasis on the factor of the potential for profit or loss.

In addition to the foregoing court cases, the Internal Revenue Service has also addressed the ownership issue, in the context of whether a transaction involving third-party debt is a sale or a secured loan, in a number of documents, including a series of General Counsel's Memoranda. G.C.M. 34602 (September 9, 1971); G.C.M. 37848 (February 5, 1979); G.C.M. 37989 (June 22, 1979); G.C.M. 39584 (October 10, 1986). In G.C.M. 37848, G.C.M. 37989, and G.C.M. 39584, the Internal Revenue Service identified eleven factors, derived primarily from the court cases discussed above, as being relevant in the determination of which party is the owner in this type of situation. The last of these G.C.M.'s, G.C.M. 39584, focused primarily on the factors of risk of loss and possibility of gain:

 

This shorthand summary of the principles stated above focusses primarily on the risk of loss and possibility of gain. If both are retained by the seller the substance of the transaction is generally a loan and not a sale.

 

More recent Internal Revenue Service documents have listed eight factors as being relevant in determining the issue of ownership in this type of situation, with the factors derived from the court cases discussed above. TAM 199909002; TAM 199909003; FSA 200130009.

Various court decisions such as Suzy's Zoo v. Commissioner, 273 F.3d 875 (9th Cir. 2001), Paccar, Inc. v. Commissioner, 85 T.C. 754 (1985), acq. 1987-2 C.B. 1, aff'd 849 F.2d 393, (9th Cir. 1988), and Robert Bosch Corporation v. Commissioner, T.C. Memo. 1989-655, and various rulings such as Rev. Rul. 83-59, 1983-1 C.B. 103, and PLR 200328002, have stated that the determination of whether the taxpayer is considered to be the owner of property produced by the taxpayer for federal income tax purposes depends on a number of facts and circumstances, including such considerations as formal legal title to the property, exposure to risk of loss upon physical destruction of the property, opportunity for economic gain or exposure to economic loss upon the sale of the property, control over the details of the manufacturing process while the property is being produced, and control over the disposition of the property, including intellectual property rights to the property.

No single one of these factors is determinative in deciding which party is the owner of property. Moreover, as noted in Reg. § 1.263A-2(a)(1)(ii)(A), the taxpayer may be determined to be the owner of property that is being produced by the taxpayer notwithstanding that the taxpayer does not have legal title to the property.

b. Application to Fixed-Price Contracts
In applying the foregoing principles to fixed price contracts with the United States Government, one factor to consider is legal title to the contractor's work-in-process. However, it is clear that for tax purposes, legal title is only one factor, and not one of the more significant factors.

 

Factor of Title

 

 

In the case of fixed-price contracts with the United States Government, FAR § 52.232-16, "Progress Payments," includes a provision dealing with tide, FAR § 52.232-16(d), "Title." This clause provides in part as follows:

 

(1) Title to the property described in this paragraph (d) shall vest in the Government. Vestiture shall be immediately upon the date of this contract, for property acquired or produced before that date. Otherwise, vestiture shall occur when the property is or should have been allocable or properly chargeable to this contract.

(2) Property, as used in this clause, includes all of the below described items acquired or produced by the Contractor that are or should be allocable or properly chargeable to this contract under sound and generally accepted accounting principles and practices.

(i) Parts, materials, inventories, and work in process.

 

There are similar provisions in FAR § 52.245-2, "Government Property (Fixed-Price Contracts)."

While the foregoing FAR clause nominally vests legal title in a contractor's work-in-process under a fixed-price contract with the United States Government in the United States Government from the inception of the contractor's work, there have been a number of legal precedents in a non-tax setting that have reached conflicting conclusions on whether the title passage clause in the FAR vests actual legal title in the contractor's work-in-process in the United States Government or merely conveys a security interest in such property. Similarly, for tax purposes, the cases appear to be divided, although the most recent case (which is not that recent), Consolidated-Hammer and Dry Plate & Film Co. v. Commissioner, 317 F.2d 829 (7th Cir. 1963), held that the title passage clause was more in the nature of a security device.

In our view, the situation with respect to the nature of the title passage clause in the FAR is sufficiently ambiguous that it does not conclusively demonstrate that either party is the legal owner of the work-in-process. Moreover, since the case law and regulations under section 263A, as well as Notice 2005-14, provide that the question of who is the owner of property for federal income tax purposes does not turn on the question of legal title to the property, but rather is based on which party has the benefits and burdens of ownership, we believe that the issue is properly decided from the perspective of the other factors that affect this determination.

 

Factor of Risk of Loss from Destruction

 

 

With respect to the factor of liability for physical destruction or damage to the work-in-process while it is in the possession of the contractor, the same Progress Payments clause quoted above with respect to title, FAR § 52.232-16, includes a provision addressing this subject:

 

(e) Risk of loss. Before delivery to and acceptance by the Government, the Contractor shall bear the risk of loss for property, the title to which vests in the Government under this clause, except to the extent the Government expressly assumes the risk. The Contractor shall repay the Government an amount equal to the unliquidated progress payments that are based on costs allocable to property that is damaged, lost, stolen, or destroyed.

 

A similar provision is included in FAR § 52.245-2(g). Thus, on the issue of liability for damage or destruction of the work-in- process, it is the contractor and not the United States Government that is responsible.

 

Factor of Economic Gain or Loss

 

 

The factor of possibility of economic gain, and exposure to economic loss, is among the most important of the factors in determining which party has the benefits and burdens of ownership of property for federal income tax purposes. This factor clearly weighs strongly in favor of a determination that the contractor is the owner of the work-in-process in a fixed-price contract with the United States Government. In a fixed-price contract, the price is fixed and the contractor assumes the entire risk that it will be able to produce the property and produce it at a cost sufficient to yield a reasonable profit. If costs escalate or the contractor is unable to produce the property as promised in the contract, the contractor is exposed to economic loss, as the United States Government will not agree to increase the fixed price in the contract because of unforeseen factors that cause an escalation in the costs of performance or waive the need for delivery of the finished product in the event the contractor is unable to produce the property. Likewise, if a contractor is able to produce the property for less than expected at the inception of the contract, the contractor is entitled to retain the benefit of that cost savings.

 

Factor of Control of Production Process

 

 

With respect to control over the details of the production process, this factor again favors ownership of the property by the contractor. In this regard, while the United States Government is by the terms of most contracts entitled to establish the specifications of the property to be produced under a fixed-price contract (as would be true in the case of most commercially-produced custom-made property), it is normally within the contractor's discretion to decide how to produce the property and determine the details of the production process.

 

Factor of Control of Intellectual Property Rights

 

 

With respect to the factor of control over the disposition of the property and ownership of any intellectual property rights in the property being produced, the relevant standard clause is the same for both fixed-price and cost-reimbursement type contracts.

The applicable clause is DFAR § 252.277-7013, "Rights in Technical Data Noncommercial Items."

 

DFAR § 252.277-7013(b), "Rights in Technical Data," provides in part as follows:

The Contractor grants or shall obtain for the Government the following royalty free, world-wide, nonexclusive, irrevocable license rights in technical data other than computer software documentation . . .

(1) Unlimited fights. The Government shall have unlimited rights in technical data that are --

(i) Data pertaining to an item, component, or process which has been or will be developed exclusively with, Government funds;

(ii) Studies, analyses, test data, or similar data produced for this contract, when the study, analysis, test, or similar work was specified as an element of performance;

(iii) Created exclusively with Government funds in the performance of a contract that does not require the development, manufacture, construction, or production of items, components, or processes.

 

The term "unlimited rights" that is used in the foregoing provision is defined as follows in subsection (a)(15) of the foregoing clause:

 

"Unlimited rights" means rights to use, modify, reproduce, perform, display, release, or disclose technical data in whole or in part, in any manner, and for any purpose whatsoever, and to have or authorize others to do so.

 

Subsection (c) of this clause, "Contractor rights in technical data," provides in its entirety as follows:

 

All rights not granted to the Government are retained by the Contractor.

 

Under the foregoing provisions, while the rights of the Government are referred to as "unlimited rights," subsection (b) also makes clear that the Government's rights are "nonexclusive... license rights," and subsection (c) likewise makes clear that "[a]ll rights not granted to the Government are retained by the Contractor." Thus, since the Government's rights are merely "nonexclusive license rights," the rights retained by the contractor are necessarily at least as great as the rights granted to the Government. It seems likely that in comparable contracts between two private parties, the customer would be likely to obtain sole and exclusive rights to any technical data developed by the contractor in the course of performing the contract. Thus this aspect of the standard government contract clauses weighs in favor of the conclusion that the contractor is the owner of the work being performed under the contract while the work is being performed.

In conclusion, we believe that on balance, the various factors that affect the determination of which party is considered to be the owner of property being produced for the United States Government pursuant to a fixed-price contract, support the conclusion that the contractor is the owner of the work-in-process under the contract and the contractor should be deemed to be the producer of the property.

c. Application to Cost-Reimbursement Contracts
With respect to cost-reimbursement type contracts with the United States Government, the same questions concerning the effect of the title passage clause in the FAR exists for cost-reimbursement contracts as for fixed-price contracts with the United States Government. Thus, in both types of contracts, the resolution of the issue of which party holds legal title to the work-in-process is inconclusive and in any event, for tax purposes should depend on the remaining factors discussed below.

 

Factor of Loss from Physical Destruction

 

 

With respect to the factor of liability for physical destruction or damage to the work-in-process while it is in the possession of the contractor, the relevant clause is FAR § 52.245-5, "Government Property (Cost-Reimbursement, Time-and-Material, or Labor-Hour Contracts)." FAR § 52.245-5(g), "Limited risk of loss," provides in part as follows:

 

(1) The Contractor shall not be liable for loss or destruction of, or damage to, the Government property provided under this contract or for expenses incidental to such loss, destruction, or damage, except as provided in subparagraphs (2) and (3) below.

(2) The Contractor shall be responsible for loss or destruction of, or damage to, the Government property provided under this contract (including expenses incidental to such loss, destruction, or damage)

(i) That results from a risk expressly required to be insured under this contract, but only to the extent of the insurance required to be purchased and maintained or to the extent of insurance actually purchased and maintained, whichever is greater;

(ii) That results from a risk that is in fact covered by insurance or for which the Contractor is otherwise reimbursed, but only to the extent of such insurance or reimbursement;

(iii) For which the Contractor is otherwise responsible under the express terms of this contract;

(iv) That results from willful misconduct or lack of good faith on the part of the Contractor's managerial personnel; or

(v) That results from a failure on the part of the Contractor, due to willful misconduct or lack of good faith on the part of the Contractor's managerial personnel, to establish and administer a program or system for the control, use, protection, preservation, maintenance, and repair of Government as required by paragraph (e) of this section.

(3)(i) If the Contractor fails to act as provided by subdivision (g)(2)(v) above, after being notified . . . of the Government's disapproval, withdrawal of approval, or nonacceptance of the system or program, it shall be conclusively presumed that such failure was due to willful misconduct or lack of good faith on the part of the Contractor's managerial personnel.

(ii) In such event, any loss or destruction of, or damage to, the Government's property shall be presumed to have resulted from such failure unless the Contractor can establish by clear and convincing evidence that such loss, destruction, or damage --

(A) Did not result from the Contractor's failure to maintain an approved program or system; or

(B) Occurred while an approved program or system was maintained by the Contractor.

 

This clause is somewhat less clear than the comparable FAR clause with respect to fixed-price contracts as it bears on the question of which party is the owner of the work-in-process for tax purposes. Nevertheless, the contractor bears the responsibility for procuring insurance when that is required by the terms of the contract and, even more significantly, the contractor is required to maintain a satisfactory set of procedures for protecting and caring for the property, and if the contractor fails to do so, the contractor becomes responsible for any damage to or destruction of the property that is attributable to such a failure. In light of this requirement to have in place proper procedures to care for the property, and in light of the consequence of the contractor's failure to maintain such procedures, the fact that the contractor does not nominally bear the entire risk of loss is of considerably reduced practical significance.

 

Factor of Economic Gain or Loss

 

 

With respect to the factor of possibility of economic gain and exposure to economic loss in the case of a cost-reimbursement type contract, one consideration that is relevant is the nature of the contract provisions relating to the determination of the contractor's fee. It is clear that in most cost-reimbursement contracts with the United States Government, there are fluctuating fee levels dependent on the contractor's cost of performance. The example provided in these comments provides a representative illustration of the manner in which a contractor can gain a financial benefit if the contractor is able to perform the required work at a cost that is less than the expected cost; in such a case, the contractor's fee is increased by a percentage of the cost savings.

Similarly, this example illustrates that under this type of fee structure, the contractor suffers a financial detriment if the actual cost to perform the work exceeds the expected cost; in such a case, the contractor's fee is reduced by a percentage of the excess cost. Thus, in this variety of cost-reimbursement type contracts, as in fixed-price contracts, the contractor receives a financial benefit by performing for a lower cost than expected and suffers a financial detriment for performing at a greater cost than expected. In addition, cost-reimbursement type contracts may include bonuses for performance that is more rapid than required by the contract terms or for producing a product that exceeds the contract requirements, and may include penalties for performance that is slower than what is required by the contract.

Thus, the first consideration that needs to be taken into account in terms of the factor of economic gain or loss in the case of a cost-reimbursement type contract with the United States Government is the level of the fee. As discussed above, even in the case of a contract that is performed to completion, there is the possibility of a wide range in the level of the fee that may actually be earned by the contractor based on various considerations such as the nature of the formula for determining the fee and the level of costs actually incurred in performing the contract.

Moreover, if the contract were not performed satisfactorily and the Government exercised its remedy of terminating the contract for default, the applicable FAR provision has the consequence that no portion of the fee might be owing to the contractor and the contractor might be required to return any portion of the fee that had been billed on a provisional basis. FAR § 52.249-6(h)(4)(i).

The second aspect of the factor of economic gain or loss in connection with a cost-reimbursement type contract with the United States Government relates to the degree to which the contractor may be at risk of not recovering its costs. In this regard, it should be noted that a cost-reimbursement contract with the United States Government does not guarantee the contractor that it will always recover its costs and, therefore, have no risk of economic loss. There are several reasons for this result.

The first reason that the contractor may not recover the costs it actually incurs in performing a cost-reimbursement type contract with the United States Government is the possibility of disagreements between the contractor and the Government about whether particular costs are in fact allowable costs that are allocable to the contract. It may well be the case with respect to certain costs that at the time the costs are incurred, the contractor has a good-faith, reasonable belief that the costs represent allowable costs that are properly allocable to a particular contract or contracts, but it may nevertheless be the case that when, much later, the costs claimed by the contractor as being allowable costs allocable to the contract are audited by the Government, the Government may reach the conclusion that particular costs claimed as allowable costs are not in fact allowable. Thus, there is uncertainty as to the degree to which costs claimed as allowable costs by the contractor may subsequently determined not to be allowable by the Government.

In addition, a second aspect of the situation relating to recovery of costs relates to the contractor's potential liability to be charged for costs necessary to correct property delivered by the contractor under the contract where the property is determine not to meet the contract requirements. In this regard, the contractor is subject to the possibility of being charged an amount that would not only result in the loss of any fee, but would also result in the contractor not being able to recover all costs that would otherwise be considered allowable costs.

The relevant FAR provision on this point is not located in the FAR clause dealing with termination for default, as might be expected, but rather in the FAR clause dealing with the Government's right to inspect the products produced under the contract to verify that the products are in compliance with the contract specifications, and providing for the Government's remedies in the event the inspection determines that the products do not in fact conform to the contract specifications.

The relevant clause is FAR § 52.246-3, "Inspection of Supplies -- Cost-Reimbursement." (It should be noted that in the FAR clauses, the term "supplies" is used to refer to any type of tangible property, without regard to the complexity of the product.) This inspection clause would be included in any cost-reimbursement type contract involving the production of tangible personal property of any kind (including aircraft, ships, aircraft carriers, submarines, etc.)

This clause provides in part as follows:

 

(a) Definitions. As used in this clause -. . . .

Supplies includes but is not limited to raw materials, components, intermediate assemblies, end products, lots of supplies, and, when the contract does not include the Warranty of Data clause, data. . . .

(f) At any time during contract performance, but no later than 6 months (or such other time as may be specified in the contract) after acceptance of the supplies to be delivered under the contract, the Government may require the Contractor to replace or correct any supplies that are nonconforming at time of delivery. . . .

(g)(1) If the Contractor fails to proceed with reasonable promptness to perform required replacement or correction, the Government may --

(i) By contract or otherwise, perform the replacement or correction and charge to the Contractor, any increased cost or make an equitable reduction in any fixed fee paid or payable under the contract;

(ii) Require delivery of undelivered supplies at an equitable reduction in any fixed fee paid or payable under the contract; or

(iii) Terminate the contract for default.

(2) Failure to agree on the amount of increased cost to be charged to the Contractor or to the reduction in the fixed fee shall be a dispute.

 

(Emphasis added.)

Thus, a contractor producing property for the United States Government under a cost-reimbursement contract is still obligated to provide property that conforms to the specifications in the contract. If the contractor does not fulfill that obligation, the United States Government is free to hire a third party to remedy the defects in the property or complete the manufacture of the property and, if the Government chooses to pursue this course of action, the Government has the right to charge the original contractor for the increased cost of hiring a new contractor to correct the defects or complete the property. Most importantly, the contractor's exposure under this clause is not limited to the contractor's fee, but the exposure extends to the contractor's entitlement to cost reimbursement under the terms of the contract.

As noted previously, the financial exposure of the contractor in a cost-reimbursement type contract for the production of tangible personal property that derives from the FAR provision discussed above is located in the FAR clause dealing with inspection of products, rather than in the FAR clause dealing with termination for default. The FAR clause dealing with termination for default of a cost- reimbursement type contract provides that in the event of a termination for default, the contractor is entitled to be reimbursed for its allowable costs, and does not provide that the contractor is liable for the increased cost to the Government of hiring another contractor to correct or complete the work.

Nevertheless, the remedy discussed above relating to the contractor's liability for the cost to the Government of hiring another contractor to correct the defects in the product is clearly available to the Government under the inspection clause. Another FAR provision clearly confirms that the remedy available to the Government under the inspection clause is broader than the remedy available under the termination for default provision.

FAR § 49.403, "Termination of cost-reimbursement contracts for default," provides some discussion of the rules relating to termination for default of cost-reimbursement type contracts. FAR § 49.403(c) provides in part as follows:

 

[A] cost-reimbursement contract does not contain any provision for recovery of excess repurchase costs after termination for default (but see paragraph (g) of the clause at 52.246-3 with respect to failure of the contractor to replace or correct defective supplies).

 

(Emphasis added.) The foregoing statement clearly confirms that while the termination for default provision in a cost-reimbursement type contract does not impose liability on the contract for "excess repurchase costs," nevertheless, FAR § 52.246-3(g), discussed above, does impose this liability on a contractor in a cost- reimbursement type contract, and it is entirely within the Government's discretion as to what remedy it chooses to pursue against a contractor in the event the contractor delivers products that the Government determines do not satisfy the requirements of the contract specifications.

Accordingly, a contractor performing a cost-reimbursement contract does have a significant risk of economic loss with respect to the basic property to be delivered. Moreover, contractors also have an economic risk of loss with respect to the recovery of bid and proposal costs, independent research and development costs, investments in fixed assets, and other non-allowable costs that nonetheless must be incurred in order to perform the contract. In this sense, the contractor performing a cost-reimbursement contract is not in that much different a position with respect to ownership of property under a cost-reimbursement contract than a contractor's ownership interest in property produced under a fixed-price contract.

This analysis of the nature of cost-reimbursement contracts, and the effect of this analysis has on their tax treatment is not a recent development. In the long-term contract regulations, Reg. § 1.451-3, which governed the treatment of long-term contracts prior to the enactment of section 460 in 1986, this very same issue was considered. During the extended process that culminated in the issuance of revised long-term contract regulations in 1976, careful consideration was given to the issue of whether cost-reimbursement contracts should be eligible for the completed contract method. Prior to the issuance of these revised long-term contract regulations in 1976, there had been an issue as to whether cost-reimbursement type contracts were eligible for the completed contract method. In I.T. 3459, 1941-1 C.B. 236, the IRS had held that the completed contract method could not be used for cost-reimbursement type contracts. However, in Sam W. Emerson Co. v. Commissioner, 37 T.C. 1063 (1962), the Tax Court rejected the position that the completed contract method could not properly be used for cost-reimbursement type contracts.

The IRS issued three successive sets of proposed regulations dealing with long-term contracts in the early 1970's. The relationship among these three sets of proposed regulations with respect to the eligibility of cost-reimbursement type contracts for the completed-contract method of accounting was explained as follows in the technical memorandum, dated September 18, 1972, that accompanied the third set of proposed regulations:

 

A second significant restriction imposed by the first notice on the use of the completed contract method involved cost-plus contracts. The first notice provided that income from a cost- plus contract could not be reported on the completed contract method. This requirement was intended to reverse any implication created by the Emerson case, 37 T.C. 1063 (1962), that the completed contract method is an acceptable method of accounting for such contracts. It was pointed out in protests that this restriction was too harsh, since, in many types of cost-plus contracts, the contractor in fact bears a substantial risk of loss and such contracts are very similar to lump-sum [i.e., fixed-price] contracts.

Consequently, the second notice provided that income from a cost-plus contract could not be reported on the completed contract method if, without regard to collectibility, the taxpayer is assured of a profit on such contract. If the taxpayer bears a substantial risk of losses under all the facts and circumstances he was not to be considered to be assured of a profit on the contract.

The new proposed regulations eliminate the restrictions on the use of the completed contract method for cost-plus contracts where a profit is assured. Testimony at the public hearing indicated that such contracts were very rare, and in practice some indirect costs were borne by the contractor or there was almost always a risk of loss from certain factors which would not be apparent on the face of the contract. Consequently, it was argued that these rules would be applicable only in rare and unusual circumstances, and agents, using a hindsight test, would apply these rules in cases where they should not be applied.

 

In light of the foregoing, in Rev. Rul. 74-129, 1974-1 C.B. 109, amplified by Rev. Rul. 77-38, 1977-1 C.B. 129, the IRS held that the completed contract method could be used for cost-reimbursement contracts.

The foregoing history of the eligibility of cost-reimbursement contracts for the completed contract method under Reg. § 1.451-3 makes clear that in considering whether the completed contract method should be allowed for such contracts, considerations similar to those that are being applied under section 199 were taken into account.

Initially, the first set of proposed regulations were drafted in a way that would have prohibited the use of the completed contract method for cost-reimbursement type contracts based on a belief that contractors performing this type of contract were not subject to sufficient risks for the use of the completed contract method to be appropriate. Based on comments pointing out that cost-reimbursement type contracts did in most if not all cases contain significant risks for the contractor, the second set of proposed regulations would have made the completed contract method available to cost-reimbursement type contracts on a case-by-case basis, depending on the terms of the particular contract. In response to further comments by taxpayers, the third and last, set of proposed regulations made the completed contract method available to all cost-reimbursement type contracts. The rationale was that the number of instances in which the contractor in a cost-reimbursement type contract did not have significant risk would be quite small, and that in light of that fact, requiring a case-by-case determination was simply a recipe for needless and wasteful controversy. The same rationale should be applicable for purposes of section 199.

 

Factor of Control of Production Process

 

 

With respect to control over the details of the production process, this factor again favors ownership of the property by the contractor. To the same extent as in the case of fixed-price contracts, it is normally within the contractor's discretion to decide how to produce the property and determine the details of the production process in a cost-reimbursement contract with the United States Government.

 

Factor of Control of Intellectual Property Rights

 

 

With respect to the factor of control over the disposition of the property and ownership of any intellectual property rights in the property being produced, as discussed previously, the same standard clause relating to rights in technical data is used in both fixed- price contracts and cost-reimbursement type contracts, and this clause gives the contractor rights that are at least as great as those that are given to the Government. As discussed in the case of fixed-price contracts, this factor weighs in favor of the contractor being considered the owner of the property being produced under the contract.
iv. Considerations Relating to Contracts for Custom Property
It should be noted that on occasion taxpayers have taken the position that in a case where a taxpayer is producing custom-designed property for a customer, the customer rather than the contractor should be considered the owner of the property while it is being produced for the customer, simply by reason of the custom-designed nature of the property. Taxpayers have generally been unsuccessful in maintaining this position.

The conclusion that the contractor is the owner of custom-order or custom-designed property while the property is being produced by the contractor has been endorsed by the Internal Revenue Service as recently as PLR 200328002. In that case, a contractor producing custom-order property using designs owned by the contractor's customers contended that because of the restrictions on the contractor's ability to dispose of the property to any party other than the particular customer that ordered the property, the contractor should not be considered the owner of the property while it was being produced and accordingly should not be required to treat the property as inventory.

The Internal Revenue Service rejected that contention, relying on cases such as Frank G. Wikstrom & Sons, Inc. v. Commissioner, 20 T.C. 359 (1953), and The Fame Tool & Manufacturing Co., Inc. v. Commissioner, 334 F. Supp. 23 (S.D. Ohio 1971). In Wikstrom, the taxpayer had contended that it should not be required to capitalize overhead allocable to property being produced under custom orders for customers, in light of the fact that it would be difficult for the taxpayer to sell such custom- order property to any party other than the customer that ordered the property.

The Tax Court in Wikstrom rejected the taxpayer's arguments, concluding that the fact that property was custom-ordered and accordingly would be difficult to sell to anyone but the specific customer that ordered the property did not prevent the property from being considered the inventory of the taxpayer and therefore subject to all of the cost capitalization rules that are applicable to taxpayers holding inventory. The Tax Court concluded that in such a case, the taxpayer's income would not be clearly reflected, but would instead would be distorted, if the costs of producing the goods were deducted in the year the costs were incurred rather than being deferred under the inventory rules until the year in which the goods were completed and delivered to the customer and the revenue associated with the goods was included in income. The court concluded that failing to defer the costs at issue would result in a "distortion of the ultimate profit upon the disposition of the article." 20 T.C. at 362. As noted earlier, however, there is no comparable requirement to match the timing of revenue recognition with the timing of the related costs for a taxpayer performing services and therefore not subject to the inventory rules with respect to the costs incurred in performing the services.

In Fame Tool, the taxpayer was also engaged in the business of producing custom-order property. The taxpayer contended that, because of the custom-order nature of the property, the taxpayer was engaged in the business of performing services and accordingly should not be subject to the inventory rules requiring the capitalization and deferral of costs pending the reporting of the associated revenue. Relying in part on the earlier Tax Court decision in Wikstrom, the court rejected the taxpayer's argument that it was engaged in the business of performing a service and therefore not subject to the inventory rules requiring the capitalization and deferral of costs until the time of related revenue recognition.

Thus, as PLR 200328002, Wikstrom, and Fame Tool make clear, there have been occasions stretching back many years where taxpayers producing custom-order property have attempted to take the position that the taxpayer was engaged in the business of performing services and was therefore not subject to the requirement in the inventory rules that the costs of performing work must be deferred and matched against the associated revenue. Dating back at least as far as the Wikstrom case in 1953, over 50 years ago, taxpayers have been unsuccessful in these arguments.

As discussed previously in the specific context of the treatment of contracts with the United States Government, it would be highly unfair and inappropriate, after so many years during which taxpayers with such contracts have been required to suffer the disadvantageous tax treatment associated with the inventory rules, if now, when the tax law has been changed in a way that confers a new tax benefit on taxpayers properly treated as producing inventory, taxpayers in this situation were to be told that suddenly it had been determined. that this treatment is no longer deemed to be correct.

v. Conclusion
In conclusion, we submit that based on the long-standing position of the IRS that for federal income tax purposes the contractor under both a fixed-price and a cost-reimbursement contract with the United States Government is the owner of the work- in-process and, therefore, is the producer of that property should be determinative in the case of section 199. We do not believe that the policy implications under section 199 call for a different result than for purposes of section 263A, 446 and 471. Moreover, we do not believe that a fresh review of this long-resolved issue is required. However, if such review is undertaken, we submit that the conclusions previously reached by the IRS are amply supported by the facts and that the contractor should be upheld as the owner of property produced for the United States Government regardless of whether the work is being performed under a fixed-price contract or a cost- reimbursement contract.

2. Notice § 4.03(1) - Determining Qualified Production Activities Income -- Definition of "Item"

This provision indicates that QPAI is determined at the item level, which the Notice describes as a more finite level of detail than a product-line-by-product-line, transaction-by-transaction, or division-by-division level of detail. However, the Notice does not provide further guidance on what is an "item." This concept is relevant in several contexts within section 199.

 

a. Illustrative Example

 

Taxpayer T enters into an agreement with a customer for a lump sum price to produce and deliver to the customer one piece of sophisticated production machinery and various quantities of twenty different types of replacement parts for the machinery. Fifteen of the twenty different types of replacement parts were produced by T and the remaining five types of replacement parts were purchased by T. The finished machinery contains both types of parts.

T provides a standard one-year warranty with the machinery. Also included in the contract with the customer is an agreement by T to provide three years of routine maintenance of the machinery, which could include replacing worn-out parts with the spare parts provided to the customer. This obligation to provide routine maintenance is included in the lump-sum price in the agreement.

 

b. Issues

 

What is the item or items in this example and how is the 5 percent de minimis test measured for purposes of determining whether the gross receipts from embedded services qualify as DPGR?

 

c. Comment

 

The definition of an item under section 199 should be flexible depending on the consequences of the definition and should not create onerous administrative burdens for a taxpayer. For purposes of determining what is QPP, it is understandable that the Treasury would define an "item" as each unit of property delivered to the customer. Thus, in the case of the machinery produced for the customer, the entire piece of machinery should be treated as the item, notwithstanding that the machinery contains both purchased and produced parts. In the case of the separate parts that are sold in that form to the customer, each unit of each type of part should be treated as the "item" of property. Thus, gross receipts from the sale of the production machinery and gross receipts from the sale of parts produced by T should qualify as DPGR, whereas gross receipts from the sale of parts purchased by T should not qualify as DPGR. Section 482 principles should apply in determining the allocation of the lump-sum purchase price to each item of property.

In contrast, for purposes of the 5 percent de minimis test for embedded services, if it becomes necessary to compare the portion of the gross receipts attributable to the maintenance services with the gross receipts treated as DPGR from QPP, a taxpayer should be permitted to aggregate all of the QPP in that sales agreement or transaction and treat such QPP as the "item," for purposes of determining whether the embedded services in that transaction are de minimis. Trying to compare the gross receipts from the embedded services with the gross receipts from particular units of QPP in such circumstances would be arbitrary and impractical. Thus, the definition of an item needs to be flexible. While a narrower definition of an item might be appropriate to distinguish between gross receipts that qualify as DPGR and gross receipts that do not qualify as DPGR, aggregation of gross receipts attributable to all items of QPP provided in a single transaction should be permitted for purposes of the de minimis test.

3. Notice § 4.03(3) - Treatment of Advance Payments as DPGR - Application to Revenue from Long-Term Contracts Accounted for Under the Percentage of Completion Method

This section of the Notice provides guidance on how to determine what portion of advance payments received by a taxpayer that are included in a taxpayer's gross income prior to the time that QPP is provided to the customer or services are performed for the customer constitute DPGR. In general, the Notice provides that a reasonable method must be used to allocate advance payments between DPGR and non-DPGR. Section 4.03(2) of the Notice is referenced for purposes of determining what constitutes a reasonable method of allocation.

The Notice fails to address the similar but separate issue of how contractors reporting their income from a long-term contract under the percentage of completion method in Section 460 would determine the portion of the PCM revenue reported on each long-term contract for each taxable year that must be allocated between DPGR and non-DPGR.

 

a. Illustrative Example

 

Contractor S enters into a long-term contract to design and produce 20 units of a new type of jet aircraft. The aircraft are to be delivered at a rate of one aircraft per month over a 20-month period after design and production is completed. In addition, S is obligated under the terms of the contract to provide 100 different types of replacement parts to the customer, with some of the parts being purchased from third parties and some of the parts being produced by S. S generally purchases the replacement parts at the same time that it purchases comparable parts for use in the production process. Also included in the contract is an agreement to perform three years of routine maintenance on the jet aircraft after they are delivered to the customer. Thus, some of the activities for which non-DPGR are generated are performed during the earlier stages of the contract and other activities for which non-DPGR are generated are performed towards the end of the contract. Assume that either each of the foregoing activities is separately priced in the contract or that a separate price for each activity is determinable using the principles of section 482.

 

b. Issues

 

How would the taxpayer determine the allocation of gross receipts between DPGR and non-DPGR during the course of the contract, if income from the performance of the contract is recognized pursuant to the percentage-of-completion method under section 460?

 

c. Comment

 

The proposed regulations should address this situation. The proposed regulations should provide that during the term of a long- term contract accounted for on the percentage-of-completion method under section 460, the taxpayer could use the same type of facts-and- circumstances, analysis to allocate revenue recognized under the percentage-of-completion method between DPGR and non-DPGR as could be used by a taxpayer which included advance payments in gross income prior to the sale of property or the performance of services. The problems posed by these two situations are similar and they should be resolved using the same approach.

However, a number of our clients have indicated that it would be extremely difficult to obtain from their accounting systems such fact-based information during the course of performing the contract. In those circumstances, a default allocation method should be provided in the proposed regulation that is based on the simple assumption that the ratio of DPGR to non-DPGR in the final contract price determines the allocation between DPGR and non-DPGR throughout the term of the contract. Thus, the default allocation method would presume that the allocation of the contract price between DPGR and non-DPGR would be based on the same ratio during each taxable year throughout the term of the contract.

4. Notice § 4.04(7)(b) - Gross Receipts from the Performance of Services are not DPGR - Scope of the Exception for Services that Are Integral to the Production of QPP and of the Exception for Embedded Services

This section of the Notice provides that DPGR does not include gross receipts from the performance of services. A special rule is provided to the effect that "de minimis" "embedded" services may be treated as DPGR where the services are performed as part of the same contract with the production and sale of QPP, provided no more than 5 percent of the total gross receipts are attributable to the embedded services.

The Notice provides little guidance on the distinction between goods and services, where the services performed are part of the production and sale of QPP. In addition, the Notice provides sparse guidance on the definition of an "embedded" service and the distinction between "embedded" services eligible for the 5 percent de minimis exception and non-qualifying services or the distinction, if any, between embedded services and service-type activities that are integral to the production and sale of QPP.

 

a. Illustrative Example (1)

 

L enters into a contract with a customer to design a new type of equipment for the customer that will satisfy certain performance specifications, procure raw materials and purchase component parts produced by other parties for incorporation in the equipment, produce 10 units of that equipment, ship the equipment to the customer, provide a standard one-year warranty, provide operating and maintenance manuals, provide 100 hours of training to the customer's employees on the use and maintenance of the equipment, provide certain spare parts that L purchased, and provide an extended service agreement to maintain the equipment on the customer's premises for a period of three years. The contract contains a single lump-sum price that encompasses all of the foregoing activities.

 

b. Issues

 

Do all of the gross receipts from the foregoing transaction qualify as DPGR? If not, which categories of gross receipts are not DPGR? Are the categories of gross receipts that are not DPGR, if any, treated as "embedded" services for purposes of the 5 percent de minimis exception?

 

c. Comment

 

i. Design Work. Analyzing the various activities chronologically within the time line for performing the various activities, the first activity in the example on which further guidance is required is the treatment of the design work incident to the production of the equipment. Since the design work performed in connection with the production of the 10 units of equipment is incident to and necessary for the manufacture of QPP, none of the gross receipts from the sale of the QPP that might be viewed as being attributable to the design work should be treated as non-DPGR.

ii. Purchased Parts Incorporated in Original Equipment. Obviously, any portion of the gross receipts from the sale of the QPP that is viewed as being attributable to purchased parts that were incorporated as part of the original equipment produced by the Taxpayer should likewise qualify as DPGR, since the equipment was substantially produced by the taxpayer.

iii. Shipping Expenses. With respect to the transportation of the completed equipment to the customer's premises, since this activity is performed as part of a single agreement to produce and sell QPP and, since this transportation function is performed contemporaneous with the sale of QPP, any gross receipts from the sale of the QPP that might be attributed to the shipment of the product to the customer's premises should qualify as DPGR.

iv. Warranty. The standard warranty appears to come within the warranty exception to embedded services in § 4.04(7)(b) of the Notice and, therefore, any gross receipts attributable to the standard warranty should be ignored and treated as DPGR from the sale of the QPP.

v. Operating and Maintenance Manuals. The operating and maintenance manuals should be considered an indispensable part of the equipment that is produced and sold by the taxpayer. Most products come with instruction manuals. In most cases, there would be no separate charge for an instruction manual. Moreover, a customer would not know how to operate or maintain the equipment without the benefit of the manual. Such operating and maintenance manuals are particularly important with complex and technologically advanced equipment. Accordingly, any gross receipts from the sale of QPP that is attributable to the preparation and furnishing of an operating or maintenance manual should be treated as DPGR from the sale of the QPP.

A. Employee Training. With respect to the training of a customer's employees to use the equipment that is QPP, in the case of sophisticated equipment, it would be normal for a producer of the equipment to train the customer's employees on the use and maintenance of the equipment. Accordingly, any gross receipts attributable to the training of employees on the use and/or maintenance of the equipment should be treated as DPGR from the sale of the QPP.

vii. Spare Parts. The provision of the purchased spare parts to the customer would not be regarded as the production and sale of QPP produced by the taxpayer because the parts that are provided are purchased by the taxpayer and are not further processed by the taxpayer. The issue that is posed with respect to this activity is whether the spare parts could be included in the de minimis exception for embedded services.

Obviously, spare parts are tangible property and not services. However, it would be an administrative burden to require taxpayers to isolate nonqualifying activities within the sale of QPP, where those activities are de minimis in amount, regardless of whether the activities represented the provision of goods or the performance of services. We believe that the Treasury should give consideration to including any type of nonqualifying activity, regardless of whether that activity represents the provision of goods or the performance of services, in the de minimis exception for embedded services. There does not seem to exist a potential for abuse in this type of case because the nonqualifying goods need to be embedded in the transaction and the gross receipts allocable to such goods cannot exceed five percent of the total gross receipts from the transaction.

viii. Extended Service Agreement. As noted in section 7.04(7)(b) of the Notice, since the extended maintenance services are separate and apart from the basic warranty on the equipment, any gross receipts from the sale of the QPP that is deemed attributable to the extended service agreement would be non-DPGR. However, such services should meet the test of "embedded" services and the gross receipts attributable to such services should qualify for the de minimis exception for embedded services.

 

d. Illustrative Example (2)

 

Assume the same facts as in example (1), except that the sales agreement contains a separate price for each activity.

 

e. Issues

 

Example 2 poses the issue of whether the existence of separate prices in a sales agreement for the production and sale of QPP changes the analysis of whether gross receipts attributable to the service activities that are incident to and necessary for the production and sale of QPP should qualify as DPGR? An additional issue posed by the example is whether the existence of a separate price in the sales agreement for the extended warranty prevents the extended warranty from being treated as an embedded service eligible for the de minimis exception, as in example 1.

 

f. Comment

 

i. Eligibility as DPGR
The issues presented here relate to the change in the fact pattern to recognize the possibility that a single sales agreement might contain a break down of the total sales price among the various activities making up the sales price. There might be various reasons for such a breakdown of the aggregate sales price, including the desire to provide targets for the triggering of progress payments under the agreement, or, in the case of contracts with the United States Government, such a breakdown might be required or be customary under the applicable government regulations.

We believe that in the foregoing case, any gross receipts attributable to activities that qualify as DPGR in example 1 because the activities are performed incident to and necessary for the production and sale of QPP should continue to qualify as DPGR notwithstanding the break down of the sales price in the sales contract in example 2. Similarly, we submit that any activities that are treated as embedded services for purposes of the de minimis exception in example 1 should continue to be eligible for the de minimis exception in example 2, notwithstanding the existence of separate pricing in the sales contract.

With respect to the first point, we believe that the paramount consideration in determining whether gross receipts attributable to activities that, if performed separately, might be regarded as services, should nevertheless be eligible for treatment as DPGR, is whether the activities at issue are performed incident to and necessary for the production and sale of QPP. In example 1, clearly the activities of designing the QPP are incident to and necessary for the production and sale of the QPP.

This same type of analysis has been followed in the long-term contract regulations, where in Reg. § 1.460-1(d)(1), it is provided that:

 

[I]f a single long-term contract requires a taxpayer to perform a non-long-term contract activity that is not incident to or necessary for the manufacture, building, installation, or construction of the subject matter of the long-term contract, the gross receipts attributable to that non-long-term contract activity must be separated from the contract and accounted for using a permissible method of accounting other than the long-term contract method.

 

Reg. § 1.460-1(d)(2) goes on to illustrate such non-incidental activities as including the separate provision of design or engineering services unrelated to any manufacture or construction of property. This rule derives from an earlier rule that was developed under the completed contract method in Reg. 1.451-3, to prevent taxpayers from including unrelated services in a long-term contract in order to qualify the service activity for the completed contract method. In that context, the issue of what types of services should be carved out of a long-term contract was addressed in G.C.M. 39803 (Nov. 27, 1989). In this G.C.M., the IRS established the following test:

 

Therefore, whether a particular activity (and attributable items of income and expense) should be carved out from the rest of a qualifying building, installation, construction, or manufacturing contract depends on whether the activity directly benefits or is undertaken by reason of the obligation to build, install, construct, or manufacture the subject matter of the contract.

 

In reaching the foregoing conclusion, G.C.M. 39803 distinguished Rev. Rul. 82-134, 1982-2 C.B. 129, Rev. Rul. 80-18, 1980-1 C.B. 103, and Rev. Rul. 70-67, 1970-1 C.B. 117, where it was held that engineering, construction management, and architectural services performed by a taxpayer who did not also perform fabrication or installation could not be accounted for using a long-term contract method. G.C.M. 39803 makes clear that "services performed with respect to the building, installation, construction, or manufacturing of property by the taxpayer are properly characterized as long-term contract activities, even though, if performed alone, such services may be personal services." We believe that the same standard should apply under section 199. Clearly, under this standard, the activities to design QPP to be produced by the taxpayer would be a paradigm example of a type of activity that is incident to and necessary for production.

Moreover, the mere fact that a contract contains line item prices for activities that clearly form a part of a larger activity of producing and delivering property does not mean that the customer would be satisfied with merely obtaining those separately-priced line items of activity in the contract without also obtaining the QPP being produced by the taxpayer. In addition, we think that it is normally unlikely that the parties would have agreed to the line item prices set forth in the agreement as independent prices for the separate promised line items of activity were it not for the inclusion of the production and sale of the QPP in the sales agreement. As noted above, such separate prices often merely serve the purpose of establishing a payment schedule for interim payments and function as a financing mechanism for the producer of the QPP.

Although the remainder of the service-type activities described in example 1 besides design either take place after the completion of the production of the QPP or, if performed contemporaneously with the production of the QPP, are not part of the actual production process of the QPP, we believe that the analysis described above should apply equally to the gross receipts attributable to any activity which, if not separately priced (as in example 1), would qualify as DPGR.

Such an approach would not alter the conclusion that the gross receipts attributable to the spare parts and the extended maintenance services do not qualify as DPGR, but as noted below, separate pricing might affect their eligibility to be treated as embedded services.

ii. Eligibility as Embedded Services
According to Section 4.04(7)(b) of Notice 2005-14, embedded services are defined as non-qualifying services the price for which is included in the sales price of the QPP. Thus, as presently defined, the services viewed as embedded services in example 1 would cease to be treated as embedded services in Example 2 by virtue of the presence of separate line item prices in the sales agreement in Example 2.

We believe that such a result is unjustified and should be reversed. The reason that this result is unjust is that it would impose a significant hardship on taxpayers engaged primarily in producing and selling QPP, but that might otherwise have a de minimis amount of nonqualifying services. It seems unduly harsh to require such taxpayers to separately account for the revenues and costs of the qualifying and nonqualifying activities in circumstances where the amount of nonqualifying services at issue is not large. In transactions where there is a de minimis amount of nonqualifying services, whether or not the services have a separate price in the sales agreement, taxpayers frequently account for regular tax and financial reporting purposes for all of the revenue and costs in such a transaction in accordance with the predominant nature of the activities in the particular transaction. In our experience, it would be rare to encounter a taxpayer that is performing a production contract in which the costs of production comprise 98 percent of the total costs in the contract, but the taxpayer accounts for only 98 percent of the revenue and costs from the transaction as a sale of inventoriable goods and the remaining 2 percent is accounted for as a service transaction. Moreover, the rules on advance payments both in Reg. § 1.451-5 and Rev. Proc. 2004-34 are designed to allow a single treatment of the progress payments based on the predominant nature of the transaction.

From a policy point of view, we believe that the potential for abuse under our suggested approach is self-limiting because of the 5 percent limitation on de minimis embedded services. Thus, we cannot believe that revenues attributable to large amounts of nonqualifying services would qualify for the deduction as a result of our proposed approach.

5. Notice § 4.04(4) -- Definition of "by the taxpayer" -- Application to Installation Activities Following Passage of Title

This section of the Notice provides that only the taxpayer that has the benefits and burdens of ownership of property during the period a qualifying activity occurs is treated as engaging in the qualifying activity for purposes of determining eligibility for the section 199 deduction. This rule raises an issue in connection with the position adopted by Treasury that installation of QPP can qualify as MPGE only when performed by the taxpayer that originally MPGE'd the QPP being installed. We are concerned that the rule requiring ownership of the property MPGE'd by the taxpayer at the time of the qualifying activity might be applied to prevent installation activities from qualifying as MPGE in cases where the manufacturer performing the installation activity had the benefits and burdens of ownership over property during the time the property was originally produced but transferred ownership to the customer before performing the installation activities.

This comment addresses the qualification of installation activities as MPGE by the manufacturer, when installation is performed by the manufacturer after the manufacturer transfers ownership in the QPP to the customer. However, if Treasury concludes that installation should not qualify as MPGE by the manufacturer in such circumstances, and the QPP being installed nonetheless qualifies as having been MPGE'd by the manufacturer in significant part within the United States, the manufacturer's gross receipts attributable to the installation activities should in any event qualify as domestic production gross receipts based on the fact that the installation is incidental to the disposition of the QPP MPGE'd by the manufacturer. This issue is addressed in comment 6, below.

 

a. Illustrative Example

 

Taxpayer D enters into an agreement with a customer to produce, deliver, and install a turbine for a lump sum price. The contract provides that the benefits and burdens of ownership of the turbine pass to the customer when the turbine arrives at the customer's location, even though D is required to install the turbine following the arrival of the turbine at the customer's location.

 

b. Issues

 

Does installation of the turbine qualify as MPGE by D where title to the turbine passes to the customer before D performs the installation activities?

 

c. Comment

 

If a manufacturer such as D has the benefits and burdens of ownership of property while it is produced, the transfer of title to the customer before the manufacturer installs the property should not bar qualification of the installation activities as MPGE by the manufacturer, in a case where the installation is directly related to the sale of the property.

Section 4.04(3)(a) of the Notice provides that the installation of QPP constitutes MPGE. We understand, however, that Treasury intends to limit the qualification of installation activities as MPGE to cases where the taxpayer produced the property it is installing. In this context, we are concerned that Treasury's imposition of an ownership test for purposes of determining which taxpayer performed qualifying activities could preclude installation activities that are incident to a sale of QPP produced by the taxpayer from qualifying as MPGE whenever title to the property that is to be installed passes from the manufacturer to the customer after production of the QPP but before the manufacturer installs the QPP.

In such a case, the customer, although it is the owner of the QPP during the installation activities, could not possibly be treated as performing an MPGE activity because the customer did not produce the QPP being installed and installation qualifies as MPGE only with respect to the producer of the QPP being installed. As a result, there is no reason in this situation for Treasury to impose its requirement that the property must be owned by the taxpayer at the time the taxpayer performs an otherwise qualifying activity, in light of the fact that this requirement was designed to determine which taxpayer should get the deduction in factual situations where two taxpayers might otherwise arguably be eligible.

The position that title passage before installation should not disqualify installation as MPGE is supported by the fact that various business reasons might cause a manufacturer to transfer the benefits and burdens of ownership in QPP to a customer before completing the installation of the QPP in cases where it is nevertheless clear that the installation is performed by the manufacturer as part of the overall sale transaction. There may be substantial business reasons having nothing to do with federal income tax considerations for transferring ownership of the QPP to the customer before the QPP is installed by the manufacturer. For example, a manufacturer may wish to reduce its exposure to liability for events occurring at the customer's location, to recognize the income from the sale for financial accounting purposes, or there may be state and local tax considerations prompting the decision as to when to transfer ownership of the QPP from the manufacturer to the customer. None of these reasons provide a basis for disqualifying the manufacturer from being treated as the taxpayer that performed the installation activities. There is no policy reason or statutory mandate for treating installation activities less favorably when title passes to the customer after the QPP is manufactured but before it is installed in a case where installation would otherwise qualify as MPGE.

Importantly, this issue affects both taxpayers who produce property for customers under contracts with the customers and taxpayers who sell property they have produced out of their inventory, because in both cases the manufacturer might transfer the benefits and burdens of ownership to the customer prior to installing property at the customer's location. This issue would not arise, however, in contract manufacturing arrangements where the customer owned the QPP at all times while the property was being produced, rather than taking title only after the initial production of the QPP was complete but before installation. In those cases involving contract manufacturing of property where the customer owned the property while it was being produced, the customer would always continue its ownership of the property during installation and thus the installation activities would always constitute MPGE performed by the customer.

Treasury interprets section 199 to impose a requirement that only one taxpayer may claim the deduction under section 199 with respect to any particular activity performed with respect to the property. Notice 2005-14, § 3.04(3). Treasury further provides that the determination as to which of the possible taxpayers is allowed the deduction is based on which taxpayer owned the property while the activity was being performed. Id. Treasury imposed this tax ownership test as the means of determining which taxpayer performed a qualifying activity in situations where two taxpayers are involved. Based on the premise that only one taxpayer should get the deduction for each activity, Treasury's ownership test for determining which taxpayer qualifies makes sense, because only a taxpayer that has had ownership over the QPP can earn qualifying gross receipts from the lease, rental, license, sale, exchange or other disposition of the QPP.

The policy that only one taxpayer should get a section 199 benefit for a particular qualifying activity is not implicated, however, when a manufacturer has the benefits and burdens of ownership over QPP while it is produced, but transfers those benefits and burdens to the customer before installing the QPP. In such a case, regardless of which taxpayer owns the property during the installation activities, the installation activities could never constitute MPGE with respect to the customer because the customer did not produce the property being installed and Treasury has indicated that installation of QPP can qualify as MPGE only where the taxpayer performing the installation also produced the QPP being installed. Thus, the ownership test's only purpose -- to determine which taxpayer is attributed qualifying activities when two taxpayers might otherwise claim the deduction -- is not presented for installation activities. Furthermore, as explained in comment 6, below, a manufacturer's gross receipts attributable to installation activities that occur following title passage should be treated as gross receipts derived from the sale of QPP regardless of whether Treasury agrees with this comment that the installation activities should qualify as MPGE.

Although Treasury states that it requires ownership over the property on which the qualifying activity is performed in order to assure that only one taxpayer will be eligible for the section 199 deduction with respect to any particular activity, it would not be an abuse of discretion for Treasury, in the limited context of installation performed by the manufacturer after title passes from the manufacturer to the customer, to allow the taxpayer that actually performed the activity to claim the deduction. Where the ownership test does not serve its usual tie-breaking function, Treasury should not impose the ownership test to deny treatment of activities actually performed by the taxpayer as MPGE by that taxpayer. Thus, an exception should be made to the Notice's requirement that QPP be owned by the taxpayer claiming the section 199 deduction at the time the activity is performed for installation activities performed by a manufacturer that occur shortly after the manufacturer passes title to a customer for goods it produced.

In example 1, the installation of the turbine should be treated as MPGE performed by D. As a preliminary matter, because D had the benefits and burdens of ownership of the turbine while D manufactured the turbine, D is treated as the producer of the turbine and is therefore eligible to treat the installation of the turbine as an MPGE activity. Although D transferred the benefits and burdens of ownership of the turbine to the customer shortly before installing the turbine, the installation activities should nonetheless qualify as MPGE by D because the installation is a production activity that is directly related to the sale of the turbine by D, and the installation cannot qualify as MPGE with respect to D's customer.

6. Notice § 4.04(7)(b) -- Gross Receipts from the Performance of Services are not DPGR -- Application to Installation Activities Following Passage of Title

This section of the Notice provides that DPGR does not include gross receipts from the performance of services. Our comment 4, above, dealt generally with the application of the Notice's distinction between goods and services, where the services performed are part of the production and sale of QPP. This comment addresses in particular the qualification of gross receipts attributable to installation activities as domestic production gross receipts when the installation is performed by the original manufacturer of the property and occurs after the manufacturer transfers ownership of the QPP to the customer.

Many of the observations made in comment 4, above, are equally applicable to this comment regarding installation activities that follow title passage. In addition, however, Section 3.04(4) of the Notice provides that a contractor that does not satisfy the requirement that the property be owned by the taxpayer at the time of the activity is considered to be deriving gross receipts from the provision of services and the receipts are not considered to be "derived from any lease, rental, license, sale, exchange, or other disposition of" the property. This rule might potentially be applied to installation activities performed by the manufacturer of property after title to the property has passed to the customer.

In comment 5, above, we explained that installation in such circumstances should qualify as MPGE by the manufacturer. However, even if the Treasury does not agree that such installation should qualify as MPGE by the manufacturer, this comment asserts that, nevertheless, if the QPP being installed qualifies as having been MPGE'd by the manufacturer in significant part within the United States, the manufacturer's gross receipts attributable to the installation activities should qualify as domestic production gross receipts.

 

a. Illustrative Example

 

Taxpayer E enters into an agreement with a customer to produce, deliver, and install a turbine for a lump sum price. The contract provides that the benefits and burdens of ownership for the turbine pass to the customer when the turbine arrives at the customer's location, even though E is required to install the turbine following its arrival at the customer's location.

 

b. Issues

 

Even if such installation do not qualify as MPGE by E, do E's gross receipts attributable to the installation activities nevertheless qualify as being derived from the sale of the QPP.

 

c. Comment

 

Even if the installation by E of QPP produced by E following the transfer of ownership from E to the customer does not itself qualify as MPGE by E, nevertheless, the gross receipts attributable to such installation activities should be treated as derived from the sale of the QPP because the installation service is not an ancillary "embedded service," but rather is performed as an integral part of the production and sale of the QPP.

We do not believe that Congress intended for the mere fact that an activity occurs after the transfer of ownership of QPP to preclude gross receipts attributable to that activity from being treated as derived from the sale of the QPP, where the activity is integral to the production and sale of the QPP. Installation clearly is viewed as an activity that is integral to the production and sale of QPP. At least when installation precedes the passage of title, installation is treated as MPGE for purposes of determining whether the manufacturer produced the QPP in significant part within the United States. Even if installation is not treated as MPGE by the taxpayer when the installation activity occurs after the manufacturer transfers ownership to the customer, the timing of title passage should not convert such an integral activity from being viewed as part of the production of the QPP itself into an ancillary service that must be separated out from the sale of the QPP.

Especially with complex and technologically advanced equipment, the manufacturer is often the only person qualified to integrate the equipment into the customer's pre-existing operations. Thus, it is normal for the producer of sophisticated equipment to participate in the installation of the equipment. As in the case of the manuals and training discussed in the immediately comment 5, above, the assistance of the manufacturer in the installation of sophisticated equipment is indispensable to the transfer of beneficial enjoyment of operable equipment to the customer.

Finally, the statute only requires that gross receipts be "derived from" a sale of the QPP. Thus, even if installation activities occurring after title passage are not themselves considered MPGE, the gross receipts attributable to such installation activities are certainly derived from the sale of the QPP when the installation is incident to the sale of the QPP. Although section 4.04(7) of Notice 2005-14 indicates that Treasury will interpret "derived from" narrowly to include only the direct proceeds from the lease, rental, license, sale, exchange, or other disposition of the qualifying production property, Treasury has provided exceptions for business interruption insurance, payments not to produce, certain advertising income, and certain oil and gas partnerships. The case for qualification of installation activities following title passage is at least as sympathetic as the case for these exceptions.

As discussed in comment 5, above, the decision of when to pass title is based on entirely independent considerations and, thus, does not change the nature of the gross receipts attributable to the installation activities as integrally related to the sale of the QPP. Accordingly, any gross receipts attributable to the installation of the equipment should be treated as gross receipts derived from the sale of the equipment, even if Treasury does not agree that installation following passage of title should qualify as MPGE by a manufacturer that had the benefits and burdens of ownership during production.

7. Notice § 4.04(5)(b) & (c) -- Whether MPGE is Substantial in Nature -- Treatment of Development Costs

Section 4.04(5)(b) of the Notice provides that QPP will be treated as produced ("MPGE") in substantial part by the taxpayer if, taking into account all of the facts and circumstances, the relative value added by, and the relative cost of, the MPGE activity performed by the taxpayer in the United States is substantial. For purposes of applying this test, development activities (other than for computer software and sound recordings) are not treated as MPGE, even though gross receipts attributable to such activity will be DPGR, if the QPP resulting from such development activities is otherwise deemed produced by the taxpayer.

In addition, section 4.04(5)(c) of the Notice provides a safe harbor test for determining whether QPP is substantially produced by the taxpayer. This safe harbor test involves a comparison of the conversion cost (i.e., direct labor costs and indirect production costs) incurred by the taxpayer with the total cost of the good sold. If the conversion cost incurred by the taxpayer exceed 20 percent of the total cost of the property, the property is considered produced by the taxpayer. However, the Notice provides that for this purpose, development costs do not count as conversion costs incurred by the taxpayer.

The foregoing provisions in the Notice contain certain ambiguities that need to be clarified.

 

a. Illustrative Example

 

A taxpayer contracts to design and produce a new type of diesel engine for a customer. The contract with the customer stipulates that the taxpayer will purchase the necessary raw materials and parts, incur basic and applied research to design and develop the engine and produce five units of the engine. Also assume that one major subassembly incorporated into the engine is produced by an unrelated party and is purchased by the taxpayer. Thus, the taxpayer may need to apply the safe harbor test to determine whether the engines are substantially produced by the taxpayer.

 

b. Issues

 

In the foregoing example, it is necessary to determine whether the engines were substantially produced by the taxpayer in order to qualify as QPP. If, in the foregoing example, the taxpayer incurs research that qualifies as R&E for purposes of section 174, as well as applied design and engineering costs in producing the engines that do not qualify as R&E for purposes of section 174, the issue is posed as to how each of these categories of activities is treated for purposes of determining whether the taxpayer is treated as satisfying the safe-harbor and accordingly treated as having produced the engines for purposes of section 199.

 

c. Comment

 

We believe that the proposed regulations should be clarified to provide that development and engineering costs need to be divided into two separate categories. With respect to the category of R&E that qualifies for a deduction under section 174, those costs are deductible as a period cost, even though the activities might be viewed as creating an intangible asset. Moreover, the UNICAP regulations exclude section 174 R&E from inclusion in the cost of goods produced by the taxpayer. Reg. § 1.263A-1(e)(3)(iii)(B). Based on this treatment of section 174 costs for regular income tax purposes, we agree with the position in the Notice that development costs of this type should not be treated as production costs directly associated with QPP for purposes of applying the 20 percent safe-harbor to determine qualification under section 199. Moreover, we agree with this conclusion, despite the fact that gross receipts attributable to the development activity qualifies for section 199, provided the property otherwise qualifies as produced in significant part by the taxpayer. In addition, since such 174 costs would also be excluded from inventoriable costs according to the UNICAP regulations, such costs would ipso facto be excluded from both the numerator and the denominator of the safe harbor test for determining whether QPP was substantially produced by a taxpayer.

In contrast, we believe that engineering and development costs that occur after the stage that a test model is produced, or costs that otherwise do not qualify as section 174 R&E, constitute a production activity to the same extent as the physical activity of fabricating the engines. This conclusion is borne out by the treatment in the UNICAP regulations of such non-section 174 development costs as inventoriable costs of the products produced as a result of such development activities. Reg. § 1.263A-1(e)(3)(ii)(P). In light of this treatment, we submit that such engineering and other non-section 174 development costs are truly part of the manufacturing activity of the taxpayer and not the costs of creating some other intangible asset. As a result, the proposed regulations should clarify this distinction between section 174 R&E and inventoriable development and engineering costs and provide that the non-section 174 as MPGE by the taxpayer that incurs the costs.

In the event that the proposed regulations do not adopt the foregoing distinction in treatment between section 174 R&E and non-section 174 engineering and development costs and instead exclude both categories of activities from MPGE, the safe harbor test in section 4.04(5)(c) of the Notice needs to be clarified with respect to the treatment of the non-section 174 engineering and development costs. As noted above, such costs are included in inventoriable costs under the UNICAP regulations and, therefore, such costs would be included in the cost of goods sold, which under the Notice becomes the denominator of the safe harbor test referred to above. If it is ultimately determined in the proposed regulations that both types of developments costs, section 174 R&E and non- section 174 development and engineering costs, are ineligible for treatment as MPGE in applying the safe-harbor test, then both types of costs should be excluded from the denominator, as well as the numerator, of the safe harbor test. Otherwise, non-section 174 costs, which in our opinion are more deserving of treatment as MPGE, would be treated less favorably than section 174 R&E costs.

8. Notice § 4.04(3)(b) -- Consistency Between Section 199 and Section 263A

This section of the Notice provides that a taxpayer that is treated as engaging in the production of QPP for a taxable year should also treat itself as a producer of property for purposes of section 263A. The Notice further provides that if a taxpayer has treated a particular activity as the production of QPP, but has not treated the activity as being subject to section 263A for regular tax purposes, the taxpayer must file an accounting method change request to comply with section 263A for regular tax purposes. There is uncertainty as to the intended scope and breadth of this requirement for consistency in treatment as between section 199 and section 263A.

 

a. Illustrative Example

 

A taxpayer is engaged in the trade or business of providing routine maintenance of customers' equipment. The terms of the taxpayer's engagement are that a customer pays a flat fee for maintenance for a one-, two-, or three-year period of service. The maintenance mainly consists of lubricating the various parts of the customer's equipment, as well as periodically replacing certain filters and other minor parts of the equipment that wear out. The filters and other minor parts are purchased by the taxpayer for use in its servicing business. In contrast, the lubricants used by the taxpayer represent a unique blend of components that are produced by the taxpayer. The taxpayer treats the filters, minor repair parts, and lubricants as supplies and accounts for them under Reg. § 1.162-3. The taxpayer characterizes its business as a service business for regular tax purposes and recognizes revenues from such business under the three-part test in Rev. Rul. 74-607, 1974-2 C.B. 149. Expenses are deducted as incurred and the minor repair parts, filters and lubricants are deducted as consumed, pursuant to Reg. § 1.162-3.

 

b. Issues

 

Assuming the taxpayer is permitted to treat the portion of the gross receipts from the maintenance contracts that are attributable to the sale of lubricants produced by the taxpayer as DPGR, how does the conformity rule in section 4.04(3)(b) of the Notice apply with respect to the Taxpayer's treatment of the lubricants that it produces and uses in connection with the maintenance contracts? Does the taxpayer also need to change its method of accounting for regular tax purposes for the revenue derived from the sale of the lubricants?

 

c. Comment

 

For regular tax purposes, we believe that the foregoing transaction would be accounted for as the performance of services utilizing materials and supplies within the meaning of Reg. § 1.162-3. We think that it is unlikely that the lubricants would be regarded as inventory within the meaning of section 471, despite the fact that a portion of the lubricants are physically transferred to a customer each time that maintenance is performed by the taxpayer. It is clear that the use of the lubricants is not driving the income recognition transaction and that the presence of lubricants in the maintenance services is not a material income producing factor.

However, since the lubricants were produced by the taxpayer and ownership of the lubricants is transferred to a customer when its equipment is lubricated by the taxpayer, the portion of the gross receipts from the maintenance transaction that would be deemed allocable to the lubricants would qualify as DPGR for purposes of section 199. Section 199 does not appear to be limited to the sale of QPP that is inventory in the hands of the taxpayer. Thus, we believe that the sole impact of the conformity rule in section 4.04(3)(b) of the Notice should be that the taxpayer in this example must apply section 263A to determine the cost of the lubricants. If a taxpayer is not accounting for the lubricants pursuant to section 263A, the taxpayer must file a method change request to apply section 263A to determine the cost of the lubricants. In other words, we believe that the conformity rule should not be applied in a manner that would require the taxpayer to treat the lubricants used in its maintenance business as inventory, rather than as supplies. Thus, the Notice should be clarified to provide that the conformity rule in section 4.04(3)(b) of the Notice is not intended to require the taxpayer in this example to change its method of accounting so as to treat the lubricants as inventory under section 471.

Likewise, the Notice should be clarified to provide that the conformity rule is not intended to require the taxpayer to change its method of accounting for the income from the maintenance transaction from a method that treats the transaction as a service to a method that treats the transaction as partly the performance of a service and partly a sale of goods. The notion that section 199 fragments a transaction that is in part a sale of goods and in part the performance of services into those two components, should not override long-standing principles in sections 446 and 471 as to whether a particular transaction is characterized as a sale of goods or the performance of services based on the overall character of the transaction.

9. Notice § 4.04(7) -- Definition of "Derived From the Lease, Rental, License, Sale, Exchange, or Other Disposition of Qualified Production Property -- Tax Free Exchange"

The foregoing provision outlines the proposed rules in situations where two parties engage in a taxable exchange of property that was either produced or purchased by one of the parties. However, the provision does not provide guidance on how to how to characterize property that was received in a non-taxable exchange in similar circumstances.

 

a. Illustrative Example

 

Assume that X purchased section 1231 property for use in its trade or business and Y produced section 1231 property for use in its trade or business. Subsequently, X and Y enter into a non-taxable section 1031 exchange of their respective section 1231 properties. In a future taxable year, X and Y independently sell their section 1231 properties to separate third parties.

 

b. Issue

 

Do the gross receipts from either X's or Y's sale to a third party of the section 1231 property received in the section 1031 exchange qualify as DPGR?

 

c. Comment

 

The Notice indicates that in order to qualify as DPGR, there must be a recognition transaction resulting from the sale or exchange of QPP. Accordingly, no DPGR results from the section 1031 exchange of QPP according to section 4.04(2) of the Notice.

Notice § 4.04(7)(a) illustrates the situation where there is a taxable exchange of QPP. In that case, both parties to the taxable exchange would realize DPGR upon the exchange of their QPP. Notice § 4.04(7)(a) also provides that the subsequent resale of the exchanged property by either party would not result in the realization of DPGR because the property that is resold in that case was not produced by the taxpayer. This is the correct result in a taxable exchange of property because the tax attributes of the exchanged property would not carry over to the property received in the exchange if the exchange is treated as a taxable transaction. Section 4.12(2) provides that where a taxpayer exchanges property for replacement property in a section 1031 exchange, then whether the gross receipts from the disposition of the replacement property qualifies as DPGR is determined based solely on the activities performed by the taxpayer. The implication of this provision is that in order for the gross receipts from the subsequent sale of the exchanged property to qualify as DPGR, the taxpayer must engage in MPGE of the exchanged property after the section 1031 exchange.

In contrast, if the exchange qualifies as a non-taxable transaction, we believe that Notice § 4.04(7) should be clarified to provide that the character of the gross receipts resulting from the sale of the property that was received by the taxpayer in exchange for QPP should qualify as DPGR because the attributes of the property disposed of in the tax-free exchange should carry over to the property received in the tax-free exchange. Such a result would be consistent with the treatment of holding periods, computation of basis, and the carry over of recapture attributes in a tax-free exchange of property.

Thus, in the illustrative example, Y's gross receipts from the resale of the exchanged property would qualify as DPGR if the property given up by Y in the exchange was QPP produced by Y. In contrast, X's gross receipts from the resale of the exchanged property would not qualify as DPGR because the property given up by X in the tax-free exchange was not QPP produced by X.

10. Notice § 4,05(2)(b) -- Allocation of Cost of Goods Sold -- Specific Identification

Section 4,05(2)(b) of the Notice provides rules to allocate cost of goods sold between qualifying and non-qualifying DPGR. This section of the Notice further provides that if a taxpayer uses a particular method to allocate gross receipts between DPGR and non-DPGR, the taxpayer may not use a different method to allocate cost of goods sold between DPGR and non-DPGR.

The foregoing provision in the Notice is ambiguous in one respect that needs clarification.

 

a. Illustrative Example

 

A taxpayer purchases from unrelated third parties all of its crude oil supply needs for use in the refining of gasoline and other refined products. While the overwhelming majority of its crude oil is acquired for use in its refining operations, the taxpayer will occasionally sell crude oil that it purchased because of a temporary imbalance between its supply and its storage capacity. When the taxpayer sells purchased crude oil to a third party, the taxpayer is able to specifically identify the gross receipts attributable to such sales, which sales would generate non-DPGR.

However, for costing purposes, the taxpayer uses a standard cost system, with all crude oil purchases valued at their standard cost, adjusted for variances as an additional section 263A cost under the taxpayer's UNICAP allocation method. In addition, the taxpayer values its inventories on the dollar-value LIFO method and includes all of its crude oil and basic refined products in a single natural business unit pool.

 

b. Issues

 

In the foregoing example, it is necessary to determine on a specific-identification basis the cost of goods sold that is allocable to the sales of purchased crude oil, in order to differentiate that cost of goods sold from the cost of goods sold allocable to sales of refined products that qualify as DPGR.

 

c. Comment

 

The Notice indicates that if a taxpayer uses a particular method to allocate gross receipts between DPGR and non-DPGR, the taxpayer must use the same method to allocate cost of goods sold between DPGR and non-DPGR. It is not clear whether the foregoing provision was intended to apply in circumstances where the taxpayer is able to specifically identify the portion of gross receipts that is DPGR and non-DPGR. If the specific identification of gross receipts is considered to be an "allocation" method under the Notice, then the taxpayer in the example would be required to use the specific identification method to determine the cost of the crude oil that was sold. In our opinion, that approach would not be feasible in the example or in any other case where fungible goods are involved.

In the example, the taxpayer would be permitted under the UNICAP regulations to determine the cost of its crude oil purchases using a standard cost method. Reg. § 1.263A-1(f)(3)(ii)(A). Moreover, since the crude oil was purchased by the taxpayer for use in its refining process, the IRS has ruled that such crude oil may be included in the same natural business unit pool with crude actually used in the refining process, as well as the refined products produced by the taxpayer, despite the fact that there may be occasional sales of the purchased crude oil. PLRs 8807036, 8842061.

In view of the foregoing, it would be impossible for the taxpayer to isolate by physical identification the actual cost of the crude oil that was sold in the transaction that generated non-DPGR. In such circumstances, we see no policy reason why the taxpayer could not use its normal UNICAP cost accounting method and its dollar-value LIFO method to determine the allocated cost of the crude oil that was sold. We think this point should be clarified in the forthcoming proposed regulations. In other words, we think the proposed regulations should make it clear that the use of a specific identification method to determine the portion of gross receipts that is DPGR and non-DPGR should not mean that a specific identification approach is also required to determine the cost of goods sold associated with the DPGR and non-DPGR.

11. Notice § 4.05(2)(a) -- Allocating Cost of Goods Sold -- LIFO

This section of the Notice provides that cost of goods sold must be allocated between DPGR and non-DPGR taking into account the principles of sections 263A, 471 and 472. Since section 472 is a method for determining the value of ending inventory and not CGS, further guidance is required to explain how CGS of particular sales is to be determined when a taxpayer uses the LIFO method, particularly the dollar-value LIFO method.

 

a. Illustrative Example

 

A taxpayer purchases from unrelated third parties all of its crude oil supply needs for use in the refining of gasoline and other refined products. While the overwhelming majority of its crude oil is acquired for use in its refining operations, the taxpayer will occasionally sell crude oil that it purchased because of a temporary imbalance between its supply and its storage capacity. When the taxpayer sells purchased crude oil to a third party, the taxpayer is able to specifically identify the gross receipts attributable to such sales, which sales would generate non-DPGR.

However, for costing purposes, the taxpayer uses a standard cost system, with all crude oil purchases valued at their standard cost, adjusted for variances as an additional section 263A cost under the taxpayer's UNICAP allocation method. In addition, the taxpayer values its inventories on the dollar-value LIFO method and includes all of its crude oil and basic refined products in a single natural business unit pool.

 

b. Issues

 

In the foregoing example, it is necessary to determine the cost of goods sold allocable to the purchased crude oil which was sold by the taxpayer and differentiate these costs from the cost of the crude oil that was consumed in the refining process. If the taxpayer uses the dollar-value LIFO method, the portion of the cost of goods sold from the taxpayer's single natural business unit pool that is attributable to the crude oil which is sold is not readily ascertainable.

 

c. Comment

 

In the foregoing circumstances, since it is not possible to identify the portion of the cost of goods sold from a single LIFO pool that is attributable to the sale of any particular item, we suggest that a simplified approach be permitted in the proposed regulations. The simplified approach that we advocate would depend upon whether the pool from which the crude oil was sold experienced an increment (or no change) or a decrement for the year of sale.

If the LIFO pool from which the crude oil was sold experienced an increment (or no change) for the year in which the sale took place, the cost of the crude oil sold would be based on the current-year cost of the type or types of crude oil sold, using the taxpayer's method of determining current-year cost for LIFO purposes. If instead the LIFO pool from which the crude oil was sold experienced a decrement for the year in which the sale took place, the cost of the crude oil sold would be based on the current year cost (as determined in the preceding paragraph), reduced by the overall ratio of the LIFO cost of goods sold to FIFO cost of goods sold for the LIFO pool that experienced the decrement. This is similar to the approach adopted in Reg. § 1.1502-13.

We appreciate the opportunity to provide comments on behalf of our clients on this important subject. If you have any questions concerning these comments 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.

Sincerely yours,

 

 

Leslie J. Schneider

 

Patrick J. Smith

 

Danielle E. Rolfes

 

Distribution:

cc:

 

The Honorable Eric Solomon

 

Acting Assistant Secretary (Tax Policy)

 

 

The Honorable Donald Korb

 

Chief Counsel of the Internal Revenue Service

 

 

Helen M. Hubbard

 

Tax Legislative Counsel

 

 

Nicholas DeNovio

 

Deputy Chief Counsel - Technical

 

 

George Manousos

 

Tax Specialist, Office of the Tax Legislative Counsel

 

 

John L. Harrington

 

Associate International Tax Counsel

 

 

Robert M. Brown

 

Associate Chief Counsel (Income Tax & Accounting)

 

 

Heather C. Maloy

 

Associate Chief Counsel (Passthroughs & Special Industries)
DOCUMENT ATTRIBUTES
  • Authors
    Schneider, Leslie J.
    Smith, Patrick J.
    Rolfes, Danielle E.
  • Institutional Authors
    Ivins, Phillips & Barker
  • Cross-Reference
    For Notice 2005-14, 2005-7 IRB 498, see Doc 2005-1241 [PDF] or

    2005 TNT 13-7 2005 TNT 13-7: Internal Revenue Bulletin.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2005-8315
  • Tax Analysts Electronic Citation
    2005 TNT 77-30
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