Sec. 199 issues arising from contract manufacturing arrangements.

• Author: Arbuthnot, Brandy L.

Taxpayers often enter into contract manufacturing arrangements with independent third parties to manufacture components or products on behalf of the taxpayers. Under these arrangements, the taxpayer typically approaches the contract manufacturer with a formula or design. The contract manufacturer will quote the parts based on material and labor costs, processes, and tooling. For an agreed-upon price, the contract manufacturer essentially acts as the taxpayer's factory, producing and shipping units of the design on behalf of the taxpayer.

In the context of the domestic production activities deduction (DPAD) provided by Sec. 199, Congress intended that only one taxpayer may claim the deduction for the same function performed regarding the same property. In order to determine whether the taxpayer or the contract manufacturer is entitled to the Sec. 199 deduction for the same manufacturing activity, the Sec. 199 rules require an analysis of which party in a contract manufacturing relationship has the "benefits and burdens of ownership" under judicially developed federal income tax principles.

Background

For tax years beginning after December 31, 2004, manufacturers and producers may be eligible for a deduction relating to income from certain qualifying domestic production activities under Sec. 199. The DPAD is equal to a percentage of the lesser of qualified production activities income or taxable income (as determined without the Sec. 199 deduction). The percentage is phased in from 3% in tax years 2005 and 2006 to 6% in tax years 2007-2009, and 9% in tax years 2010 and beyond.

Under Sec. 199(c)(4), "domestic production gross receipts" refers to the gross receipts derived from, among other things, any lease, rental, license, sale, exchange, or other disposition of:

* Qualifying production property (QPP) that was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States;

* Any qualified film produced by the taxpayer; and

* Electricity, natural gas, or potable water (i.e., utilities) produced by the taxpayer in the United States.

The regulations under Sec. 199 clarify that the deduction is allowed only for manufacture or production by the taxpayer. Regs. Sec. 1.199-3(f) mandates, with certain exceptions, that only one taxpayer may claim the deduction for the qualifying activities discussed above that are performed in connection with the same QPP or the production of a qualified film or...