IRS’s Large Business and International (LB&I) division has, for a second time, revised its previously issued directive to auditors on determining which party qualifies for the Code Sec. 199 domestic production activities deduction where one party contracts out manufacturing to another party. Click here for LB&I-04-1013-008, “Updated Guidance for Examiners on Code Sec. 199 Benefits and Burdens of Ownership Analysis in Contract Manufacturing Arrangements” (Oct. 29, 2013).
Background. Code Sec. 199 allows a deduction, the domestic production activities deduction (DPAD), for income derived from any lease, rental, license, sale, exchange, or other disposition of qualifying production property manufactured, produced, grown, or extracted by the taxpayer in whole or significant part within the U.S.; any qualified film produced by the taxpayer; or electricity, natural gas, or potable water produced by the taxpayer in the U.S.
Taxpayers frequently enter into contractual arrangements with unrelated parties to perform some or all of the activities required to manufacture, produce, grow, or extract (the “qualifying activity”) tangible personal property, electricity, natural gas, potable water, qualified films, etc. (the “property”). Code Sec. 199(d)(10) authorizes IRS to issue regs to ensure that only one taxpayer may claim the Code Sec. 199 deduction for a particular activity.
Reg. § 1.199-3(f)(1) provides that if one taxpayer performs a qualifying activity pursuant to a contract with another party, then only the taxpayer that has the benefits and burdens of ownership of the property during the period the qualifying activity occurs is treated as engaged in the qualifying activity and may claim a DPAD with regard to the property. A determination as to which party has the benefits and burdens is based on all facts and circumstances.
In 2012, LB&I issued LB&I-4-0112-001, which contained a series of questions that LB&I auditors were to ask, and a series of steps they were to take based on the answers to those questions, when determining whether a party to contract manufacturing has the benefits and burdens of ownership.
On July 24, 2013, IRS issued a new directive, LB&I-4-0713-006, which superseded LB&I-4-0112-001. It was directed at LB&I auditors who decide whether or not to challenge a taxpayer’s position that it has the benefits and burdens of ownership under a contract manufacturing arrangement with a Counterparty (the other party to a contract manufacturing arrangement with the taxpayer).
It provided that the auditor should request that the taxpayer provide: (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 contained in the directive) signed by the taxpayer; and (3) a certification statement (using a form contained in the directive) signed by the Counterparty.
It said that if the taxpayer provides the benefits and burdens statement and certification statements, the auditor should not challenge that the taxpayer has the benefits and burdens of ownership over each qualifying property upon which a qualifying activity is performed under the contract manufacturing arrangement.
The directive also provided that:
a. One of things that the taxpayer had to certify to in its certification statement was that it was not required to record a reserve for financial statement purposes for its determination that it had benefits and burdens over the qualifying property; and
b. In general, the taxpayer should provide the benefits and burdens statement and certification statements to the auditor within thirty days of the date that an information document request is issued to the taxpayer about the DPAD. If, however, the benefits and burdens determination was under examination on July 24, 2013, the taxpayer had to provide the benefits and burdens statements and the signed certification statements to the auditor by Sept. 22, 2013.
Changes in the new directive. The new directive is identical to LB&I-4-0713-006, except:
It drops the requirement at (a), above, that the taxpayer make a certification about financial statement reserves; and
With respect to (b) above, it provides that if the taxpayer believes more time is needed, an extension of time can be requested. Any extension must be approved by IRS’s Territory Manager.