Sec. 199 Deduction and Contract Manufacturing Arrangements: Who Gets the Deduction?

From the IRS

The IRS issued new guidance to examiners in its Large Business & International (LB&I) Division regarding how to determine which taxpayer is entitled to claim the Sec. 199 domestic production activities deduction in a contract manufacturing arrangement (LB&I-04-0713-006). The new directive replaces earlier guidance (LB&I-4-0112-001) issued last year, which had used a nine-question test to determine whether a taxpayer conducting production activities under a contract manufacturing arrangement with an unrelated third party meets the benefits-and-burdens-of-ownership requirement outlined in Sec. 199. The new guidance allows the parties to the arrangement to certify which has the benefits and burdens of ownership.

Sec. 199 allows taxpayers to deduct a specified percentage of the lesser of (1) qualified production activities income resulting from specified domestic production activities; or (2) taxable income determined without regard to the Sec. 199 deduction. For 2010 and later tax years the specified percentage is generally 9% (Sec. 199(a)(1)).

When taxpayers enter into a contractual arrangement with an unrelated party to perform some or all of the production activities potentially qualifying for the deduction, it can be unclear which party is entitled to the deduction. (The rules governing the tax treatment of these arrangements under Sec. 199 stipulate that only one taxpayer may claim the Sec. 199 deduction for a particular activity.)

Under Regs. Sec. 1.199-3(f)(1), only the taxpayer that has the benefits and burdens of owning the property during the period the qualifying activity occurs is entitled to claim a Sec. 199 deduction for that property. However, determining which party has the “benefits and burdens” of ownership can be complex.

To simplify the determination, the IRS in 2012 issued a directive telling its examiners to use a three-step process, with each step containing three “yes” or “no” questions. The steps looked at contract terms, production activities, and economic risks.

The new directive simplifies the examiner’s job even further, by replacing the nine-question test with three forms for taxpayers to fill out:

1. A statement that explains the basis for the taxpayer’s determination that it had the benefits and burdens of ownership in the year or years under examination;
2. A certification statement (using a form included in the directive) signed by the taxpayer; and
3. A certification statement (using another form included in the directive) signed by the counterparty.

In general, taxpayers will be required to supply the benefits-and-burdens and certification statements within 30 days of the date that an information document request is issued regarding the Sec. 199 deduction. However, special rules apply to taxpayers that are under examination on the date the directive is issued.