Sports Team's Share of Broadcasting Receipts Didn't Qualify for Sec. 199 Deduction. Chief Counsel Advice

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1 Sports Team's Share of Broadcasting Receipts Didn't Qualify for Sec. 199 Deduction Chief Counsel Advice In Chief Counsel Advice (CCA), IRS concluded that a sports team's share of gross receipts from a contract with a broadcasting network didn't qualify under Code Sec. 199(c)(4)(A)(i)(II) as domestic production gross receipts (DPGR) from the disposition of a qualified film produced by the sports team. Under Code Sec. 199(a), the domestic production activities deduction (DPAD) is, subject to a limitation not relevant here, 9% of the lesser of the taxpayer's qualified production activities income (QPAI) or taxable income determined without regard to the Code Sec. 199 deduction. QPAI is domestic production gross receipts (DPGR) less cost of goods sold allocable to DPGR, less other expenses, losses, or deductions properly allocable to DPGR. ( Code Sec. 199(c)(1) ) DPGR includes the gross receipts of the taxpayer which are derived from any lease, rental, license, sale, exchange, or other disposition of qualified production property (QPP), including tangible personal property and computer software, which was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the U.S. ( Code Sec. 199(c)(4)(A)(i)(I) ) DPGR also include the gross receipts of a taxpayer that are derived from any lease, rental, license, sale, exchange, or other disposition of any qualified film produced by the taxpayer. ( Code Sec. 199(c)(4)(A)(i)(II) ; Reg (j) ) IRS has clarified that the "by the taxpayer" requirement means that, for all qualifying Code Sec. 199 production activities, only one taxpayer may claim the DPAD for the same function performed with respect to the same property. That taxpayer is the one with the benefits and burdens of ownership (under federal 1

2 income tax principles) of the property during the period the activity occurs. Thus, in general, if one party performs any qualifying Code Sec. 199 production activity under a contract with another party, then only the taxpayer that has the benefits and burdens of ownership of the relevant property under federal income tax principles during the period the activity occurs is treated as having performed the qualifying production activity with respect to that property. ( Reg (f)(1) ) A similar rule applies for any activity related to the production of a qualified film. ( Reg (k)(8) ) The regs provide examples of this rule: Illustration 1: X, which designs machines that it uses in its trade or business, contracts with Y for Y to manufacture those machines under a fixed-price contract. The contract specifies that the machines will be manufactured using X's design, which is based on intellectual property that X owns, and which it will provide to Y with the restriction that Y may only use it during the manufacturing process and has no right to exploit the intellectual property further. Under the contract, Y controls the details of the manufacturing process while the machines are being produced; Y bears the risk of loss or damage during manufacturing of the machines; and Y has the economic loss or gain upon the sale of the machines based on the difference between Y's costs and the fixed price. Y has legal title during the manufacturing process, and legal title to the machines isn't transferred to X until final manufacturing of the machines has been completed. IRS concluded that based on all of the facts and circumstances, Y has the benefits and burdens of ownership of the machines under federal income tax principles during the manufacturing period, and, as a result, is treated as the manufacturer of the machines. ( Reg (f)(4), Ex. 1) Illustration 2: T designs and engineers machines that it sells to customers. T contracts with M, an unrelated taxpayer, for the manufacture of the 2

3 machines. The contract between T and M is a cost-reimbursable type contract. Assume that T has the benefits and burdens of ownership of the machines under federal income tax principles during the manufacturing period, except that legal title to the machines isn't transferred to T until the machines are completed. Based on all of the facts and circumstances, T has the burdens and benefits of ownership of the machines during the manufacturing period and so is treated as the manufacturer of the machines for purposes of the DPAD rules. ( Reg (f)(4), Ex. 2) In Advo, Inc. & Subsidiaries, (2013) 141 TC 298, the Tax Court, finding that a company didn't have the benefits and burdens of ownership while the advertising material at issue was printed, held that the advertising company that contracted out the actual printing of its direct mail advertisements wasn't entitled to a Code Sec. 199 deduction. The Court applied nine non-exclusive factors to determine the benefit and burdens of ownership under Code Sec Taxpayer is one of the teams in the League, which acts as agent on behalf of all teams. Taxpayer and the other teams each own rights to broadcast their games. The League serves as agent in negotiating the contracts with all of the networks on behalf of all teams. In the years at issue, the League licensed certain television broadcasting to multiple networks, and the networks generated revenues from the purchased television broadcasting rights directly from selling advertising aired during live distribution of game broadcasts and indirectly from fees from the retransmitters. The CCA is based on the television agreement between Network and the League (Contract). In the years at issue under the Contract, Network paid Amounts to the League. Taxpayer received a percentage share of these Amounts (minus any allocable fees to the League as agent). The Contract grants to Network the right to 3

4 produce a specific package of League game broadcasts (Game Package), and deliver the broadcasts live within a defined territory as provided in the Contract. Under the Contract, Network is required to produce a specified number of game broadcasts per week; the Contract also sets minimum production requirements. For example, Network is required to use a certain number of cameras and broadcast games in stereo and digital format, and use certain video compression standards and encryption (among other things). Network is generally responsible for all domestic production costs for game broadcasts. Network has the exclusive rights for the live broadcasts of the games as transferred in the Contract. All remaining residual rights are assigned to or are retained by the League. The recording of a game is copyrightable property, not the game itself or the right to broadcast the game live. The rights to the live Game Broadcast are the most valuable aspect of any television programming comprised of a Game Broadcast. Most of the revenue from distribution of Game Broadcasts is derived in the form of advertising revenue from commercials aired during the live broadcast, and about 97% of TV sports programming is viewed live. CCA's conclusion. The CCA determined that Network was considered the producer of the Game Broadcasts for purposes of Code Sec Since Taxpayer was not the producer of the Game Broadcasts, none of Taxpayer's gross receipts from the Contract in the years at issue qualified as DPGR. IRS concluded that the most reasonable characterization of the arrangement was that Network was paying for the rights to broadcast, and agreeing to produce, the Game Broadcasts at no charge as part of that agreement. Network then got the opportunity to profit from the sales of advertising with respect to the live Game Broadcast aired on its Network, and Taxpayer retained the remaining rights to the Game Broadcast in order to be able to profit from the Game Broadcast in alternative ways if possible. 4

5 Based on the examples in Reg (f)(4) and analyzing the factors described in the Advo case, IRS determined that it was Network that had the benefits and burdens of ownership of the Game Broadcasts at issue under applicable Federal income tax principles during the period in which the production activity occurred. (1) Whether legal title passed. While both parties had ownership interests in the Game-the League retained copyrights in the recorded Game Broadcasts; Network received the live broadcast rights-network held the most valuable rights during the time of production. Also, because of the simultaneous (or close to) nature of the filming and broadcasting, Network's ownership was during the period that the qualifying activity (production of the Game Broadcast) occurred. This factor either favored Network or was neutral. (2) How the parties treated the transaction. Looking at what the parties actually intended to happen, but with less concern with the label that the parties attached to the transaction, the question was whether Taxpayer intended the Contract with Network to be for "film production services," or for Network to produce a film for it. The facts indicated that the parties intended for Network to produce the Game Broadcast and use its rights with respect to the Game Broadcast to recoup the payment it made to the League (on behalf of the teams) from advertisers. This factor favored Network. (3) and (4) Whether there was an equity interest created and present obligations.advo indicated that these were factors relevant in determining whether a transaction was a bona fide sale or not, but IRS did not believe these factors were necessary in this analysis. These factors were neutral. (5) Whether the right of possession was vested in the purchaser and which party had control of the property or process. Since the property at issue here was intangible, possession of the property was less clear than in Advo. IRS viewed 5

6 which party controlled the process of the Game Broadcast's creation as the more important part of this factor. Facts supported the conclusion that Network was in control of the Game Broadcasts both from a creative side and personnel side, deciding how to film the game, and how to incorporate that film into the refined and complex Game Broadcast (for example, deciding when to zoom, when to show a replay in slow or real-time motion, which players to focus on, and when to pan to the live audience; and providing graphics, sound effects music, and commentary). This factor favored Network. (6) Which party paid the property taxes. Facts with respect to the implications of property taxes were not developed, and IRS did not believe this factor was significant in determining who was the producer of the Game Broadcasts. This factor was neutral. (7) Which party bore the risk of loss or damage to property during the production. Network had more economic downside if an individual Game Broadcast was not produced. Network was responsible for all production costs for Game Broadcasts in the U.S., and not broadcasting a game could have serious revenue consequences since it had no protections from its contracts with advertisers in the Game Broadcasts under the Contract. This factor favored Network. (8) Which party received the profits from the operation and sale of the property. In analyzing this factor, IRS focused on whether Network was paid for its labor by Taxpayer, or whether Network had the chance to profit under the Contract by finding efficiencies in its labor operations. Here, Taxpayer did not pay for Network's production services (in fact, Network paid Taxpayer large amounts so that Network could perform the production activities and broadcast the game). Network had the opportunity to profit from the sale of the Game Broadcast if it was able to more efficiently produce the game through payment from advertisers, rather than from Taxpayer. While this was different from a typical 6

7 contract manufacturing arrangement, IRS found it more persuasive than even a fixed-price contract in determining who could receive the profit from the operations under the Contract. This factor weighed in favor of Network. (9) Whether the taxpayer participated actively and extensively in the management and operations of the production activity. Taxpayer appeared in the games that were the subject of the Game Broadcasts. Taxpayer's participation in the Game Broadcast was essentially equaled by Taxpayer's opponent's participation. This factor was neutral. IRS's analysis also addressed several other issues when applying Code Sec. 199 to the facts, that would limit Taxpayer's gross receipts even if Taxpayer were found to be the producer. 7