Despite its name, the Section 199 deduction — also referred to as the domestic manufacturing deduction — isn’t necessarily limited to traditional manufacturing activities within the United States.
The IRS has issued guidance addressing situations where this valuable tax break can — and can’t — be used. A recent Chief Counsel Advice (CCA) answers the question of whether a retailer could take the deduction for marketing materials that ostensibly are made in the United States and generate revenue for products that are manufactured abroad (CCA 201626024).
Background Information
During the past decade, the Sec. 199 deduction was gradually increased from 3% of “qualified production activities income” (QPAI) to 9% for 2010 and thereafter. That means that if your firm is in the 34% federal tax bracket for 2016, a 9% deduction effectively will amount to a tax cut of more than 3%.
Detailed calculations are required to arrive at your company’s QPAI. Basically, you take your domestic production gross receipts and subtract:
- The cost of goods sold allocated to such gross receipts,
- Direct expenses allocated to such receipts,
- A ratable portion of other indirect expenses (such as certain overhead items)
For this purpose, DPGR includes gross receipts derived from the sale, exchange, lease, rental, licensing or other disposition of qualified production property. Significantly, the property also must be “manufactured, produced, grown or extracted” (MPGE) in whole or in significant part within the United States. In other words, this is a home-grown tax break.
Other limits may also come into play. For instance, if your firm’s taxable income is lower than its QPAI before the Sec. 199 deduction is calculated, the deduction is claimed as a percentage of taxable income. Furthermore, the annual deduction is limited to 50% of the W-2 wages paid by your company.
Overall, the IRS guidance for the deduction is favorable to taxpayers, often extending the tax break for DPGR in borderline situations. For example, gross receipts derived from a qualified disposition of Sec. 199 property generally don’t include advertising income and product placement income. However, they do if that income is included in gross receipts from the lease, rental, license, sale, exchange or other disposition of newspapers, magazines, telephone directories, periodicals or similar printed publications that are manufactured or produced in whole or significantly within the United States when the ads were placed in those media.
Important note: This special exception applies only if the gross receipts, if any, derived from the qualified disposition of the printed materials are or would be treated as DPGR.
The IRS provides the following example: Assume that a taxpayer produces and manufactures a newspaper in the United States. Gross receipts from the newspaper include receipts from newsstand sales, subscriptions and advertising placed in the paper. Gross receipts from the ads are then treated as “derived from” newspaper sales and qualify as DPGR.
Facts of the Recent Case
The taxpayer in the Chief Counsel Advice is a specialty retailer of clothing, intimates, accessories and non-clothing gift items distributed under various brand names. Its products are available to U.S. and international customers through the retailer’s website and telephone call centers for its catalogs.
Although manufacturing and producing its physical products happens outside the country, the retailer claimed to be the manufacturer of its catalogs, mailers and other similar printed publications. The materials are distributed for free to existing customers and no advertising space is sold. The advertising in the print materials is only for the retailer’s brands.
The price the retailer charges for its branded clothing includes a component to cover the cost of producing the printed materials, including a profit markup. The retailer claimed that it was entitled to a Sec. 199 deduction for the print materials because advertising is a key component of the clothing and accessories it sells.
It argued that the print media is responsible for generating the majority of the company’s sales. As a result, the retailer claims it qualifies for the Sec. 199 deduction because advertising was a component of the clothing and accessories sold.
IRS Advice
The IRS didn’t buy the argument. It published a CCA, concluding that the taxpayer can’t characterize any gross receipts derived from the sale of its products as DPGR from advertising income.
The retailer’s products are manufactured outside the United States. Accordingly, gross receipts from their sale aren’t DPGR.
The CCA points out that the exception in the regulations for tangible personal property is limited to certain printed publications and applies only to advertising income from ads placed in those media. The Sec. 199 deduction isn’t available just because the taxpayer derives gross receipts from the sale of a tangible product it advertises. In this case, the taxpayer wasn’t paid by a third party for advertisements in its printed media. The ads were solely for the retailer’s own brands.
The fact that advertising taxpayer’s products increases sales has no bearing on the result. Thus, the IRS rang up a no sale on the retailer’s deduction claim.
Key Takeaway
Although this ruling didn’t go the taxpayer’s way, don’t make any broad assumptions concerning eligibility for the Sec. 199 deduction. Notably, an activity that falls outside mainstream manufacturing may still qualify as MPGE in the United States under an exception. Review your company’s situation with a tax adviser who can provide the necessary guidance.
Section 199 Covers a Broad Range of Activities
The Section 199 deduction specifically allows a tax break for many activities that fall outside traditional manufacturing, including:
- Construction of real property,
- Services provided by architects and engineers,
- Production of electricity, natural gas or water,
- Production of computer software,
- Production of qualified film and videotape, and
- Processing agricultural products.
