By Michael H. Salama
The Walt Disney Company, Burbank, CA
Recent grumblings in the type of forums where controversy experiences are often shared reflect what many government officials and practitioners anticipated regarding §199. Applying a facts and circumstances, benefits and burdens, standard to contract manufacturing relationships in some cases can be challenging merely because it requires a review of fact patterns that may differ from case to case. We are aware of a number of cases, where field teams, having identified a benefits and burdens fact pattern, simply disallow the entire §199 deduction claimed. I suppose the approach there is akin to what it was like to run an IT purchasing department in the 1980s: "no one ever gets fired for buying IBM." In the tax context here, there do not appear to be material repercussions for defaulting to disallowance rather than making a reasoned judgment.
In early October 2010 various industry service providers and key stake holders in the LB&I function took a very positive step in the right direction by meeting to discuss practical ways to address this type of substantive issue and provide more certainty. There is no doubt this takes significant courage and no matter the results the effort to tackle this issue ought to be commended. This commentary provides some key considerations on this topic.
II. Defining the Matter Contours
At the heart of a §199 contract manufacturing matter is determining who is entitled to claim the deduction under the common law standard, while at the same time making sure only one taxpayer claims that benefit. The taxpayer with the benefits and burdens of ownership during the time the qualified activity transpires is regarded as engaging in the qualified activity.1 Section 199(d)(10) accords the Secretary authority to issue regulations which "prevent more than 1 taxpayer from being allowed a deduction … with respect to any activity" that is a MPGE activity.2 Due to the highly factual nature of this consideration the IRS has stated in its annual no-rule list that it will not grant letter rulings or determination letters regarding ownership for §199 purposes.3 Taxpayers may not contract for the §199 benefit4 and must apply a facts and circumstances analysis.5
III. What B&B Standard Should One Apply?
The regulations contain examples illustrating the application of the B&B standard.6 In practice examiners in the field have looked to those examples but generally only look to four factors: (1) risk of loss or damage to property during the MPGE activities; (2) economic upside and down-side; (3) legal title; and (4) who controls the MPGE process. The courts have applied a benefits and burdens standard in various contexts to determine who constitutes the owner of property for tax purposes. Commonly considered factors include: (1) how the parties regard the transaction; (2) whether equity was acquired in the property; (3) contract provisions that might obligate the seller to execute and deliver a deed and the buyer to make payments; (4) who holds the right of possession; (5) who has the obligation for paying tax on the property and who pays the tax on the property; (6) who bears the risk of loss; (7) who has the upside; and (8) whether legal title to the property passes.7
These factors are commonly applied in sale-leaseback transactions and the courts do not, a priori, assign relative weight to the factors. However, depending on the commercial context, some factors may be more salient and some less so. As noted in Salama and Tilman, 599 T.M., Film Production: Basis Recovery and Federal Incentives, this concept is illustrated in Torres wherein the Tax Court notes: "because net leases are common in commercial settings, it is less relevant that petitioner was not responsible for the payment of property taxes… ."8
Those faced with an evaluation of a B&B fact pattern should consider the nature and character of the transaction and the general common law requirements the courts and the IRS have applied. However, it is important to neither blindly apply a set of criteria that have emerged from very different contexts, e.g., sale-lease back transactions with back-end purchase options, or seek a degree of a priori quantitative weighting in applying the generally accepted factors. There is a temptation in seeing a list of factors to try to assign relative weight to them, whether pro-rata or otherwise, and then formulaically computing a result. The courts have time and time again resisted such a method in B&B determination contexts and we should as well in the §199 context. The temptation brings to mind a classic movie scene from Robin Williams' in Dead Poets Society:Understanding Poetry, by Dr. J. Evans Pritchard, Ph.D.: To fully understand poetry, we must first be fluent with its meter, rhyme and figures of speech, then ask two questions: One, how artfully has the objective of the poem been rendered and two, How important is that objective? Question 1 rates the poem's perfection; question 2 rates its importance. And once these questions have been answered, determining the poem's greatness becomes a relatively simple matter. If the poem's score for perfection is plotted on the horizontal of a graph and its importance is plotted on the vertical, then calculating the total area of the poem yields the measure of its greatness. A sonnet by Byron might score high on the vertical but only average on the horizontal. A Shakespearean sonnet, on the other hand, would score high both horizontally and vertically, yielding a massive total area, thereby revealing the poem to be truly great. As you proceed through the poetry in this book, practice this rating method. As your ability to evaluate poems in this matter grows, so will your enjoyment and understanding of poetry.
As with Pritchard's rating of poems, a tool to weigh B&B factors without regard to the specific fact patterns should be ripped from our texts and our minds. That does not mean, however, there is no utility in deriving a common list of factors and trying to determine which ones the courts have looked at with greatest frequency in various commercial contexts as a starting point for analysis.
For more information, in BNA's Tax Management Portfolios, see Benko, 510 T.M., Section 199: Deduction Relating to Income Attributable to Domestic Production Activities, and Salama and Tilman, 599 T.M.,, Film Production: Basis Recovery and Federal Incentives and in Tax Practice Series, see ¶2220, Deduction for Domestic Production Activities.
2 Activities that include manufacturing, producing, growing, extracting, installing, developing, and improving, and creating QPP (qualified production property). §199(c)(4)(A)(i)(I),(II). QPP constitutes tangible personal property, computer software or sound recordings as defined by §168(f)(4). The preamble to the October 2005 Proposed Regulations rejects the suggestion that §263A be broadly applied to make the benefits and burdens determination since such might allow for two taxpayers to qualify as the producers of the same item. See, e.g., Suzy's Zoo v. Comr., 114 T.C. 1 (2000), aff'd, 273 F.3d 875 (9th Cir. 2001).
3 Rev. Proc. 2011-3, 2011-1 I.R.B. 111 §3.01(25). Specifically, the provision excludes from determination: "Section 199.—Income Attributable to Domestic Production Activities.—The determination under § 1.199-3(f)(1) as to who is the taxpayer that has the benefits and burdens of ownership under Federal income tax principles of any qualifying production property (as defined in § 1.199-3(j)(1)), qualified film (as defined in § 1.199-3(k)), or utilities (as defined in § 1.199-3(l)) during the period in which a qualifying activity under § 199 occurs."
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