Fuel blending and the Sec. 199 deduction

By Daniel Ehr, CPA; Chad Derenne, CPA; and Jim Malczewski, CPA, Appleton, Wis.

Editor: Mark Heroux, J.D.

Is the blending of motor vehicle fuel at the terminal a qualified production activity for which the Sec. 199 domestic production activities deduction (DPAD) applies? Available guidance does not specifically address this activity. The following are some considerations in determining whether fuel blending may be treated as a domestic production activity for purposes of the deduction.

The DPAD allows a business with domestic production activities to take a deduction equal to 9% of the qualified production activities income (QPAI) of the taxpayer for the tax year, subject to a number of limitations. However, determining whether a business activity is a domestic production activity is complicated, subjective, open to IRS challenge, and dependent on a number of factors.

The Sec. 199 regulations require that qualifying production property (QPP) be manufactured, produced, grown, or extracted (MPGE) in whole or in significant part by the taxpayer (Regs. Sec. 1.199-3(g)(1)). QPP can be treated as MPGE in significant part by the taxpayer if its manufacture, production, growth, or extraction by the taxpayer is substantial in nature (Regs. Sec. 1.199-3(g)(2)). The facts and circumstances considered when testing whether an activity is substantial in nature include:

  • The relative value added by the activity;
  • The relative cost of the activity; and
  • The nature of the QPP and the MPGE activity.

To simplify this test, the regulations provide a safe harbor, which states that a taxpayer will be treated as having MPGE QPP in whole or in significant part if, in connection with the QPP, the direct labor and overhead of the taxpayer to manufacture, produce, grow, or extract the QPP accounts for 20% or more of the taxpayer's cost of goods sold of the QPP (Regs. Sec. 1.199-3(g)(3)). The regulations also note that if a taxpayer simply packages, repackages, labels, or performs minor assembly of QPP and engages in no other MPGE activity with respect to that QPP, the taxpayer's packaging, repackaging, labeling, or minor assembly does not qualify as MPGE with respect to that QPP (Regs. Sec. 1.199-3(e)(2)).

Various factors associated with blending fuel at the terminal must be reviewed to apply the substantial-in-nature test. Blending at the terminal of ethanol, butane, intake valve detergents, and other proprietary additives into raw fuels (e.g., reformulated blendstock for oxygenate blending, or RBOB, and conventional blendstock for oxygenate blending, or CBOB) is required to meet the proper octane, Reid vapor pressure (RVP), and customer brand specifications. While high-octane blends have higher market values and perform differently in combustion engines, the RVP specs are established by the Environmental Protection Agency and vary based on seasonal weather. The RVP is a measure of the vapor pressure of the gasoline blend. If the RVP is too high, the liquid boils (ending up in the atmosphere as a pollutant), and it can result in "vapor lock," where combustion fails to occur. If the RVP is too low, cars will fail to start (especially in cold weather). The base fuel mixtures produced by refineries are delivered to fuel terminals at approximately 84 octane, which is not high enough to reliably power an engine and cannot be legally sold to end users.

Highly trained petroleum terminal operators use sophisticated monitoring, controlling, injecting, and blending equipment to produce a usable finished fuel within exacting regulatory tolerances. Blending various components into the raw fuels results in the components' interacting with each other and contributing to the specifications of the finished fuel. Fully operational petroleum terminals can have millions of dollars invested in highly sophisticated equipment.

Note that the scope of this discussion is limited to sophisticated blending in the terminal. This discussion specifically excludes the industry practice known as "splash blending," in which small amounts of an ingredient are added to a tanker truck and mixed or "splashed" as the truck moves down the road.

Relative value added by the activity

As mentioned above, a base raw material used to produce finished gasoline is RBOB, which in its raw state is generally not suitable for use as automobile fuel, due to substandard octane and RVP and other key characteristics. Therefore, terminal blending would seem to add significant value to the RBOB, converting it to a fuel suitable for use in automobiles. This value added is further evidenced by the fact that the industry monitors the value differential between RBOB and finished gasoline via the "spot-to-rack" cents-per-gallon price spread, as can be found in Oil Price Information Service, or OPIS, daily reports.

Relative cost of the activity

Presumably, it is appropriate for the cost of equipment used to carry out the blending activity to be considered in the relative cost of the activity. Terminal owners invest millions of dollars to install monitoring, controlling, injecting, and blending equipment. That is without even considering baseline storage tanks, pipelines, valves, flanges, etc. Additional costs relate to employment of highly trained personnel who are required to monitor and control the blending process. In such cases, it would seem the relative cost of the activity is quite significant.

The nature of the QPP and the MPGE activity

Unfortunately, the examples in Regs. Sec. 1.199-3(g)(5) shed little light on what is meant by "nature of" in this facts-and-circumstances test. However, Example (6) provides an illustration of what does not qualify. In that example, the taxpayer was a retailer of cigars and pipe tobacco who purchased his merchandise from an unrelated person. The example explains that while the cigars and pipe tobacco sit on the shelf (in a temperature- and humidity-controlled room), they age and become more valuable. Nonetheless, the IRS found that revenue from the sale of the cigars and pipe tobacco was not domestic production gross receipts because the "aging of the cigars and pipe tobacco while being displayed and offered for sale by X does not qualify as an MPGE activity that is substantial in nature." Obviously, the nature of the terminal blending activity is far more sophisticated and complex than the aging of tobacco on retail display, and likely meets this "nature of" test.

So, it would seem that the terminal blending activity described here would meet the Regs. Sec. 1.199-3(g)(2) substantial-in-nature requirement and thus qualify for the DPAD. However, it is also necessary to review the nonqualifying "minor assembly" rules under Regs. Sec. 1.199-3(e)(2). The regulations do not clearly define "minor assembly," and the examples provided in the regulations do not fit the fact pattern of a taxpayer that manufactures QPP by a mechanical blending process.

In the preamble to the proposed DPAD regulations issued Aug. 27, 2015 (REG-136459-09), Treasury discussed potential definitions of minor assembly:

[M]inor assembly could focus on whether a taxpayer's activity is only a single process that does not transform an article into a materially different QPP. Such process may include, but would not be limited to, blending or mixing two materials together, painting an article, cutting, chopping, crushing (non-agricultural products), or other similar activities. An example of blending or mixing two materials is using a paint mixing machine to combine paint with a pigment to match a customer's color selection when a taxpayer did not MPGE the paint or the pigment.

However, the comparison of the fuel-blending processes at the terminal to paint mixing is wholly inaccurate. The mixing of paint is for cosmetic purposes only—the unmixed paint will still cover the wall, protect the painted surface, etc.—even if the color is not mixed to an exact specification. The raw paint is usable before and after the mixing. By comparison, the blending of RBOB, ethanol, butane, etc., creates a product with qualities that none of the materials has standing alone.

The preamble to REG-136459-09 also suggests that if the end user could reasonably engage in the same activity, that activity may be considered minor assembly. As an example, assume QPP made up of component parts purchased by the taxpayer is sold by a taxpayer to end users in either assembled or disassembled form. To the extent an end user can reasonably assemble the QPP sold in disassembled form, the taxpayer's assembly activity would be considered minor assembly. It would be unreasonable to believe that an end user could engage in the extensive, complex fuel-blending process.

The DPAD may provide significant benefit for taxpayers who qualify for the deduction. So, is the blending of fuel at the terminal a domestic production activity for which the Sec. 199 deduction would apply? Given the complexity of the regulations and the limited guidance provided, taxpayers must assess their specific facts to determine whether they have satisfied all the requirements.

Terminal operators often receive unusable raw materials that require modification to exact regulatory tolerance before sale to an end user. Terminal operators have invested substantial amounts in highly complex, specialized capital equipment. The personnel working at the terminals require a high degree of training. These facts indicate an activity that is "substantial in nature" and requires much more than minor assembly. Terminal operators interested in claiming the Sec. 199 deduction should consult with their tax adviser to determine whether they qualify for it.


Mark Heroux is a principal with the National Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.

For additional information about these items, contact Mr. Heroux at 312-729-8005 or mark.heroux@bakertilly.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.

Tax Insider Articles


Business meal deductions after the TCJA

This article discusses the history of the deduction of business meal expenses and the new rules under the TCJA and the regulations and provides a framework for documenting and substantiating the deduction.


Quirks spurred by COVID-19 tax relief

This article discusses some procedural and administrative quirks that have emerged with the new tax legislative, regulatory, and procedural guidance related to COVID-19.