Made in the USA: Does What You Do Qualify for a Tax Deduction?
Uncle Sam rewards companies that engage in MPGE (manufactured, produced, grown, or extracted) activities in the U.S. And the kinds of goods, services, and activities that qualify under this MPGE category are broader than you might think at first.
Created through the American Jobs Creation Act of 2004, the Domestic Production Activities Deduction (“DPAD”) is a permanent deduction under IRC §199(a). It’s equal to 9% of either the taxpayer’s qualified production activities income (“QPAI”) for the taxable year or the taxpayer’s taxable income for the taxable year, whichever is less. Besides being limited to the lesser of QPAI or taxable income, you have to have employees in order to qualify for DPAD, since the whole point of the this deduction is to encourage production and employment in the U.S. The DPAD cannot exceed 50% of the taxpayer’s W-2 wages allocable to domestic production gross receipts (“DPGR”).
DPGR can be derived from the following qualifying production activities, as long as they are conducted by the taxpayer in whole or in significant part within the U.S.:
- Manufacture, production, growth, or extraction by the taxpayer of tangible personal property (this encompasses all tangible personal property [except land and building], computer software, and sound recordings, which is collectively referred to as Qualified Production Property [“QPP”])
- Production of qualified films
- Production of electricity, natural gas, or potable water
- Construction of real property
- Services of architecture and engineering relating to the construction of real property
MPGE activities are broadly defined in the tax code. The list includes manufacturing, producing, growing, extracting, installing, developing, improving, and creating QPP. It also includes making QPP out of scrap, salvage, or junk material, as well as from new or raw material by processing, manipulating, refining, or changing the form of an article, or by combining or assembling two or more articles.
DPGR does not include gross receipts derived from:
- Sale of food or beverages prepared by the taxpayer at a retail establishment
- Transmission or distribution of electricity, natural gas, or potable water
- Lease, rental, license, sale exchange, or other disposition of land
- Property that is leased, licensed, or rented to a related party
While focused on domestic manufacturing activities, the reach of the DPAD goes far beyond manufacturing. This deduction could provide significant tax savings for your company.
Application to Contract Manufacturers – Current Law and Guidance
Current regulations say that if a taxpayer engages in a qualifying MPGE activity on behalf of another business (referred to as a Contractual Manufacturing Arrangement, or “CMA”), only one of them can claim this deduction. To claim it, one of the entities has to prove that they have the benefits and burdens of ownership of the qualifying good or service, or QPP.
However, proving that you have the benefits and burdens of ownership can be harder than it seems, because the guidance the IRS has given leaves a lot of gray area. There are two examples included in this area of the tax law that specifically address how to determine who has the benefits and burdens of QPP. But since these examples don’t provide a list of the specific factors that should be used in the analysis, they often create more questions than answers.
The IRS has also issued a series of three directives to its auditors over the years for examining a taxpayer’s DPAD. Under the latest directive, an IRS agent may request the following documents from the taxpayer in order to determine who can claim the benefits and burdens of ownership of the QPP:
- Statement explaining why the taxpayer has the benefits and burdens of ownership;
- Certification signed by the taxpayer; and
- Certification signed by the counterparty to the CMA.
While this directive provides a safe harbor for determining who has the benefits and burdens of ownership, it only helps if the counterparty to the CMA is cooperative.
If the parties can’t agree, case law provides some insight into how to determine who has the stronger claim to the deduction. In ADVO v. Commissioner (2013), the Tax Court laid out the following nine factors businesses should weigh when analyzing whether they have the benefits and burdens of ownership and are therefore entitled to the DPAD:
- Whether legal title passes
- How the parties treat the transaction
- Whether an equity interest is acquired
- Whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments
- Whether the right of possession is vested in the purchaser and which party has control of the property or process
- Which party pays the property taxes
- Which party bears the risk of loss or damage to the property
- Which party receives the profits from the operation and sale of the property
- Whether a party actively and extensively participates in the management and operations of the activity (IRC §936 test)
Despite the IRS directive and applicable case law, taxpayers still struggle when trying to determine which party to a CMA can lay claim to the DPAD based on the facts and circumstances of each arrangement. To alleviate this uncertainty, the IRS issued Proposed Regulations in August 2015.
The Proposed Regulations concerning CMAs state that the taxpayer or business that performs the qualifying activity under a contract is entitled to take the DPAD. These Proposed Regulations do away with the benefits and burdens test and are intended to:
- Reduce the burden on taxpayers and the IRS in evaluating factors related to the benefits and burdens of ownership; and
- Prevent two different entities from claiming the same deduction.
The simplified Proposed Regulations will likely satisfy their intended objectives. However, their inflexibility will frustrate many principals in contract manufacturing arrangements. Many of the comments filed in response to the Proposed Regulations indicate a desire to allow the parties to a CMA to agree between themselves which party will claim the DPAD.
In response to the comments, the IRS has indicated that a rule allowing the parties to a CMA to decide who will get to take the DPAD is unlikely and not even on the table for discussion. If finalized as they currently stand, the Proposed Regulations will likely eliminate the complexity and uncertainties taxpayers encounter when dealing with the benefits and burdens test. However, they will make it much more difficult for the principal in a CMA to claim the benefits of the deduction
Still have questions about whether or not the goods or services you’re producing could qualify for an extra tax deduction under DPAD? Contact Cherry Bekaert’s Credits/Accounting Methods team to start the conversation. Or reach out to a local member of our client service team so they can guide you through this analysis.