IRS changes approach to domestic activities deduction

The IRS has changed its approach to how it will allow the Section 199 domestic production activities deduction in the case of contract manufacturing.

Instead of trying to determine which company – the contractor or the counterparty is entitled to the domestic production activities deduction (DPAD), the IRS will essentially let companies decide among themselves which company will claim it.

The policy change was made when the IRS’s Large Business and International Division (LB&I) revised its previously issued directive to auditors on determining which party qualifies for the deduction when one party contracts out manufacturing to another party.

This directive cannot be used, cited or relied on as an official pronouncement of law. And nothing in the directive should be construed as affecting the operation of any other provision of the tax code. Because LB&I issued the directive, its applicability to other taxpayers – small businesses or the self-employed – is not clear.

However, this directive does provide some guidance about what to expect from the IRS if they are audited. Regulations issued under Section 199 provide that, if one party performs a qualifying activity pursuant to a contract with another party, then only the taxpayer that has the benefits and burdens of ownership of the property during the period the qualifying activity occurs is treated as engaged in the qualifying activity and may claim a domestic production activities deduction. A determination as to which party has the benefits and burdens is based on all facts and circumstances.

In 2012, the LB&I issued a directive that contained a series of questions that auditors were to ask, and a series of steps they were to take based on the answers to those questions, when determining whether a party to contract manufacturing has the benefits and burdens of ownership.

The directive instructs IRS auditors to request certain information in writing from taxpayers claiming the deduction, including:

  • A statement explaining the basis for the taxpayer’s determination that it had the benefits and burdens of ownership
  • A certification statement signed by the taxpayer
  • A certification statement signed by the other party

In addition to the requirement that the contract to which the certification statement applies was not governed by the rules applicable to expanded affiliated groups, etc., and that the qualifying activities occurred in whole or in significant part within the United States, the taxpayer must certify that:

  • The taxpayer has determined that it had benefits and burdens over the qualifying property when the qualifying activities were performed and filed its federal income tax return(s) consistent with that determination.
  • The taxpayer was not required to record a reserve for financial statement purposes for its determination that it had benefits and burdens over the qualifying property. A reserve would be set up for the taxpayer’s estimated tax liability if the IRS contested the deduction.

The other party must certify that it did not claim, and will not claim, the DPAD for any tax year covered by the contract pursuant to which the same qualifying activities were performed.

If the taxpayer provides the benefits and burdens statement and certification statements, the auditor is instructed not to challenge eligibility for the deduction. If the taxpayer does not provide both of the certification statements, the auditor is instructed to apply the existing criteria under directive LB&I-04-0112-001 to determine which party qualifies for the deduction.

Contract manufacturers who want to claim the deduction should write the certification statements into their contracts.