It’s often unclear which activities will create a basis upon which a retailer can take a deduction under section 199 (the DPAD deduction or DPAD). The following discusses a few recent items published by the IRS and the courts illustrating two possible areas of opportunity.
In United States of America vs. Timothy J. Dean et al., 2013 TNT 150-16, the U.S. District Court for the Central District of California recently held that Houdini, Inc. (the company), a gift basket company, was entitled to the refund it received from the IRS. The refund was based on a section 199 DPAD for the company’s gift basket assembly business. Neither Houdini, an S Corporation, nor its shareholders claimed DPAD on their originally filed returns for 2005 and 2006. Subsequently, the shareholders filed amended returns to claim DPAD, and the IRS paid the refund shortly thereafter. After paying the refund, the IRS challenged the validity of the deduction and subsequently filed a civil suit to recover the refund.
The issue in the case centered on whether the act of assembling the gift baskets was a production activity eligible for DPAD. The IRS argued that the actions of purchasing small individually wrapped grocery items, arranging them in purchased gift baskets, shrink-wrapping and topping them with a bow were merely packaging activities that did not qualify as manufacturing, producing, growing or extracting in the United States and thus did not qualify for DPAD. On the other hand, Houdini argued that its production process changed the form of the article, and the court agreed. The production process, as the court detailed, included carefully selecting the individual items such as cookies, chocolates, cheese, crackers, wine, packaging materials, baskets or boxes, which were assembled according to detailed plans. The assembly process relied on assembly line workers and machines. In the court’s view, the final product, a gift basket, was distinct in form and purpose from the individual items inside. The individual items would typically be purchased by consumers as ordinary groceries, but after the production process they were transformed into a gift typically given during the holiday season.
This case was a District Court of California decision, and the IRS is unlikely to agree with its position. However, it does illustrate a fact pattern that might resemble what some retailers are doing in their stores or off-site.
Cooperative advertising allowances
In generic legal advice (AM 2014-001), the IRS considered the circumstances under which cooperative advertising allowances that retailers receive from product vendors for advertising their products in fliers may be treated as domestic production gross receipts for purposes of section 199.
Under the agreements (described in the IRS guidance), retailers receive allowances from vendors for providing specific advertising services. The IRS advised that the proper tax treatment of the allowances, for purposes of section 199, depends on the facts and circumstances of each case, including the language of the agreements between vendors and retailers.
If the purpose and intent of the allowance is to compensate the retailer for advertising services, the allowance is a separate item of gross income for purposes of section 61. The “advertising revenue” (i.e., the advertising allowance) may be treated as domestic production gross receipts under section 199 if the printed fliers (including the advertising) fit within the advertising exception in Treas. Reg. Section 1.199-3(i)(5)(ii). For the retailer to take advantage of the advertising exception, the taxpayer must be viewed as having manufactured –— in whole or significant part within the United States –— the printed fliers in which the advertising is included. If the retailer is not the party physically printing the materials (which would usually be the case), the retailer would be the “manufacturer” only if it has “benefits and burdens of ownership” over the printed materials “during the production process.” Whether a taxpayer has benefits and burdens depends on the specific facts.
The IRS recently released a safe-harbor revenue procedure relating to benefits and burdens. It allows for taxpayers to certify that they have benefits and burdens of ownership. The certification requirement in the safe harbor revenue procedure requires a certification not only from the taxpayer, but also the counterparty. A recent tax court case discussed benefits and burdens in the context of a printer. The Tax Court ruled in ADVO, Inc. v. Commissioner, 141 T.C. No. 9 (2013) that the DPAD deduction under Section 199 was not available to a taxpayer who did not have the benefits and burdens of ownership over the direct advertising materials during the printing process. It is unclear how the ADVO case will affect a taxpayer’s ability to apply the safe harbor revenue procedure in a printing situation.
While a retailer would have to analyze its particular situation, the cooperative advertising allowance fact pattern represents an interesting potential opportunity. Furthermore, the safe harbor and other rules related to benefits and burdens may also provide opportunities for retailers to claim DPAD deductions where they are doing private label manufacturing through third-party contract manufacturers.
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