26th Annual Health Sciences Tax Conference

Transcription

1 26th Annual Health Sciences Tax Conference Cash tax savings: recent developments and opportunities for life sciences companies December 7, 2016

2 Disclaimer EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. This presentation is 2016 Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, transmitted or otherwise distributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Any reproduction, transmission or distribution of this form or any of the material herein is prohibited and is in violation of US and international law. Ernst & Young LLP expressly disclaims any liability in connection with use of this presentation or its contents by any third party. Views expressed in this presentation are those of the speakers and do not necessarily represent the views of Ernst & Young LLP. This presentation is provided solely for the purpose of enhancing knowledge on tax matters. It does not provide tax advice to any taxpayer because it does not take into account any specific taxpayer s facts and circumstances. These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice. Page 2

3 Presenters Jack Donovan Ernst & Young LLP Washington, DC Dan Penrith Ernst & Young LLP Washington, DC Alexa Claybon Ernst & Young LLP Denver, CO Page 3

4 Agenda Research credit, including Orphan Drug Credit Section 199 Treatment of Abbreviated New Drug Application (ANDA) Fines and penalties Proposed negative Section 263A regulations Post net operating loss (NOL) planning Other cash tax planning opportunities Appendices Page 4

5 Research credit, including Orphan Drug Credit Page 5

6 Research credit overview Section 41 is an incentive provision for certain domestic research and development (R&D) activities. Legislative changes: Credit has been made permanent Certain small taxpayers credit allowed against Alternative Minimum Tax (AMT) Certain start-up taxpayers credit can offset payroll tax liability Qualified research expenses Qualified research Wages Supplies Contract research expenses (65%) Expenses under Section 174 Technological in nature New or improved business components Process of experimentation Exclusions Research outside US Internal use software, except as provided by regulation Funded research After commercial production Marketing Page 6

7 Research credit controversy Section 174 Final regulations published July 21, 2014 Exam s application of the more generous rules Internal use software (IUS) Final regulations published October 4, 2016 Breadth of dual function software Exam s application of the high threshold of innovation standard Supplies used in research Union Carbide case disallowed unsegregated supplies used in process research Prototype costs as supply costs Funded research Fairchild Indus., Inc. v. US; Geosyntec Consultants, Inc. v. US; Dynetics, Inc. v. US Page 7

8 Research credit proposed and final regulations and outlook Internal use software Group credit allocation History Final regulations for IUS IUS = general and administrative Non-IUS = not general and administrative Dual function software Proposed and temporary group credit allocation Requires taxpayers to allocate group credit on basis of qualified research expenses (QREs) of each controlled group member High threshold of innovation test significant economic risk Effective for tax years beginning on or after April 3, 2015 Taxpayers can apply proposed or final regulations to tax years ended on or after January 20, 2015 Amended return Alternative Simplified Credit (ASC) election Guidance outlook Final group credit allocation regulations Final intragroup gross receipts regulations Proposed supplies regulations Page 8

9 Orphan Drug Credit Section 45C Provides incentive for pharmaceutical companies to develop treatments for rare diseases they might otherwise abandon because the small population that would be benefitted is insufficient to justify the research and development costs of creating the drug Credit is equal to 50% of qualified clinical testing expenses Compared to the average savings of roughly 6.5% of eligible expenses generated by the federal R&D tax credit, this incentive is huge! Page 9

10 Orphan Drug Credit To qualify for the credit, the taxpayer must have either: Documentation that the number of people affected by the disease or condition for which the drug is to be developed is fewer than 200,000 persons Or Documentation that demonstrates there is no reasonable expectation that the sales of the drug will be sufficient to offset the costs of developing the drug for the US market and the costs of making the drug available in the United States If an election is made for the Orphan Drug Credit under Section 45C, those expenses cannot be taken into account for purposes of determining the research credit allowable under Section 41. Page 10

11 Section 199 Page 11

12 Section 199 overview Section 199 is an incentive provision relating to certain domestic manufacturing and production activities. The deduction is 9% of the lesser of qualified production activities income (QPAI) or taxable income. QPAI = from less Qualifying activity $ Applicable property Cost of goods sold (COGS) and expense Lease, license, sale Construction, architecture, engineering Qualifying production property (QPP), qualified films, utilities Real property Page 12

13 Section 199 controversy issues Contract manufacturing Only one taxpayer can qualify for the same activity performed on the same property. The benefits and burdens test determines the party considered to have manufactured the property. What is manufactured, produced, grown or extracted (MPGE)? To qualify for the Section 199 deduction for QPP, the taxpayer must manufacture the property in whole or significant part in the United States. Are the taxpayer s activities substantial in nature? Are the taxpayer s activities packaging, repackaging, labeling or minor assembly? Page 13

14 Section 199 controversy issues Online software The regulations disallow domestic production gross receipts (DPGR) from services. The regulations provide an exception to this exclusion for the use of online software if the taxpayer meets one of two exceptions: Self-comparable The taxpayer derives, on a regular and ongoing basis, gross receipts from software through download or disk sales that has only minor or immaterial differences from the online software. Third-party comparable Another person derives, on a regular and ongoing basis, gross receipts from substantially identical software through download or disk sales. Page 14

15 Section 199 controversy issues General Legal Advice Memorandum Taxpayer did not have income attributable to DPGR from customers downloading its computer software application (app) free of charge Third party Third-party app App Taxpayer Customers (individual account holders) Customers (taxpayer s competitor banks) Customers (multiple account holders) Third-party app Page 15

16 Proposed Section 199 regulations and outlook Significant issues addressed by proposed regulations (Aug. 2015) Temporary provisions W-2 wages (statutory change) Construction rules Item rule MPGE Oil-related QPAI (statutory change) Guidance outlook Section 199 final regulations Section 199 online software proposed regulations Litigation outlook Benefits and burdens cases docketed No online software cases Examination activity Section 460 and COGS Qualified film (statutory change) Contract manufacturing Page 16

17 Statutory changes to Section 199 Protecting Americans From Tax Hikes (PATH) Act, 2015 Oil and gas transportation costs Limits transportation expenses to 25% of otherwise allocable amount Results in higher oil-related QPAI Unintended consequence Pending technical correction Potential statutory changes Revision of Section 199(d)(10) relating to contract manufacturing Page 17

18 Cases, guidance and examination Chief Counsel Advice (CCA) and CCA Contract film production by sports league team Based on Advo (publisher/printer) Precision Dose, Inc. v. United States (Dist. Ct. Ill., 2015) Taxpayer s activities constituted MPGE rather than packaging, repackaging, labeling or minor assembly Based on Dean (gift baskets) See also CCA (blister packs) Technical Advice Memorandum (TAM) Taxpayer derives DPGR under Section 199 from licensing computer software to contracting parties and not from the provision of services to the end user Seen as a two-step arrangement: (1) software license to contracting party and (2) contracting party s provision of services to end user TAM Characterization of property as real property under Section 199 Page 18

19 Cases, guidance and examination Docketed cases relating to contract manufacturing: Bare Escentuals, Inc. v. Comm r (Tax Court) Hibu Group (USA), Inc. (f/k/a Yellow Book Inc.) v. Commissioner (Tax Court) AT&T Advertising, L.P., TP Advertising & Publishing, LLC v. United States (Court of Federal Claims) Resolved cases related to contract manufacturing: Limited Brands, Inc. v. Comm r (Tax Court) Taxpayer retained 56% of claimed deduction Examination activity: IPG (Issue Practice Group) Increasing interest in software claims Section 199 campaign Page 19

20 Implementation issues Proving benefits and burdens of ownership for contract manufacturing MPGE Reconsider business activities The evolving computation Page 20

21 Implementation issues Software as the item Third-party comparable Software vs. service Valuation of non-qualifying services Use of economist to value industry-standard markup on embedded services Data gathering (synergies with R&D credit) Page 21

22 Guidance outlook Timing of finalization of proposed regulations Online software regulations Guidance project on Priority Guidance Plan Comments received Outlook for Internal Revenue Service (IRS) administrative guidance Page 22

23 Treatment of Abbreviated New Drug Application (ANDA) Page 23

24 ANDA System for review and approval of generic drug products Applications are submitted to the U.S. Food and Drug Administration s (FDA) Center for Drug Evaluation and Research for approval. After approval, the applicant may manufacture and market the product as a safe, effective, low-cost alternative to brand-name innovator drugs. Application drugs are termed abbreviated because they require abbreviated preclinical and clinical trial data to establish safety and effectiveness. Testing only requires proof of bioequivalency to show the generic counterpart performs in the same manner as the innovator drug. Page 24

25 ANDA tax implications IRS Generic Legal Advice Memorandum (GLAM) W A generic company filing an ANDA with a paragraph IV patent certification must capitalize legal fees incurred to defend against a patent infringement lawsuit as a cost that facilitates obtaining the ANDA under Section 263(a). This is likely inconsistent with a generic company s historic treatment of paragraph IV patent litigation costs. However, a brand company incurring legal fees to try to establish infringement of the company s patent does not have to capitalize those expenses as a cost to perfect title to the company s patent under Section 263(a). This is in line with IRS historical treatment. Page 25

26 Fines and penalties Page 26

27 Statutory overview Section 162(a) Taxpayers may deduct all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.... Page 27

28 Statutory overview Section 162(f) No deduction shall be allowed... [f]or any fine or similar penalty paid to a government for the violation of any law. A fine or similar penalty is a payment: (i) Paid pursuant to conviction or a plea of guilty or nolo contendere for a crime (felony or misdemeanor) in a criminal proceeding (ii) Paid as a civil penalty imposed by federal, state or local law (iii) Paid in settlement of the taxpayer s actual or potential liability for a fine or penalty (civil or criminal) (iv) Forfeited as collateral posted in connection with a proceeding that could result in imposition of such a fine or penalty However, Compensatory damages... paid to a government do not constitute a fine or penalty. (Treas. Reg. Section (b)(2)) Page 28

29 Examples of relevant laws Examples of relevant laws include, but are not limited to, the following: False Claims Act (FCA) Foreign Corrupt Practices Act Federal Deposit Insurance Act Environmental and hazardous waste laws Similarly, payments to various agencies and departments may require a Section 162(f) analysis, for example: Federal departments, agencies and commissions (e.g., Department of Housing and Urban Development; Department of Labor) State public utilities and/or environmental agencies and commissions State departments of labor Page 29

30 What constitutes a fine or penalty? There are many nuances to what constitutes a fine or penalty for purposes of Section 162(f). Under Treas. Reg. Section (b)(2), the amount of a fine or penalty does not include compensatory damages paid to a government. In summary, a punitive settlement payment to the government is not deductible, but a compensatory settlement payment is deductible for federal tax purposes. Page 30

31 Determining deductibility The regulations do not provide clear guidance on how exactly to determine when a settlement payment is punitive and when it is compensatory. We must look to case law and IRS guidance to determine how to characterize settlement payments to the government. Courts generally do not hold the wording in the statute as determinative, but they do look to the purpose of the fine or penalty imposed. Page 31

32 Determining deductibility Civil penalties are considered to be nondeductible similar penalties when the civil penalty is imposed to enforce the law in question or as a punishment for violation of the law. If the civil penalty is imposed to encourage prompt compliance with the law, or as compensation for damages arising from its violation, the penalty is not similar to a fine for purposes of Section 162(f). See Southern Pacific Transportation Co. v. Comm r., 75 T.C. 497, (1980). The critical factor in determining whether a civil penalty is a similar penalty is the statutory purpose that the payment serves (and not the conduct that gives rise to the penalty). Page 32

33 Determining deductibility Talley (Ninth Circuit 1997) The taxpayer and Department of Justice negotiated an agreement to compromise all claims for $2.5m. The parties agreed that the overstated amount of the 10 false claims was $1,885, which was treated as the required amount of restitution. The parties agreed that the total amount of single damages (amount of total false claims over six years) was $1.56m. After agreeing on the above items, the parties exchanged written offers and counter offers to resolve all claims that referred to double damages. The settlement agreement was ultimately silent on the allocation of the settlement. The taxpayer deducted the settlement amount on its federal income tax return under Section 162. The IRS denied the entire deduction under Section 162(f) and the taxpayer petitioned the Tax Court to redetermine the resulting deficiency. Page 33

34 Determining deductibility Talley I: Tax Court granted summary judgment in favor of taxpayer Court reviewed origin of the claims and negotiating history of settlement Case law on the FCA presumed that multiple damages were essentially compensatory Government did not indicate during negotiations that it was seeking punitive damages and agreed to amounts less than double the actual damages Page 34

35 Determining deductibility Talley II: Ninth Circuit reversed and remanded Court emphasized dual remedial/punitive aspect of the double damage provision of the FCA Settlement agreement was ambiguous about the treatment of the $940k in excess of the single damages, so the purpose for including the double damage amount was an issue of fact requiring trial Deductions are a matter of grace and taxpayer bears the consequences of any ambiguity Page 35

36 Determining deductibility Fresenius Medical Care Holdings, Inc. v. US (1st Cir. 2014) The First Circuit refused to follow Talley and applied a different standard: The First Circuit believed the government, in relying on Talley, oversimplified the deductibility question into the presence, or lack thereof, of a tax characterization agreement. Although there was no tax characterization agreement, the First Circuit instead looked to the economic realities of the situation in determining whether the payment was compensatory or punitive. The First Circuit affirmed the trial court s determination that a fact finder must determine to what extent... payments are, in fact, compensatory. Even in the context of settlement, the parties joint intent is not the exclusive means of so doing. It was necessary to consider both the language of the settlement agreements and non-contractual evidence regarding the purpose and application of the payments. Page 36

37 Determining deductibility Fresenius (cont.) The circuit conflict, then, is how determinative the language of the settlement agreement is in evaluating the nature of a settlement payment to conclude whether it is deductible under Section 162. Such an exclusive focus would give the government control of unprecedented ferocity; it could always defeat deductibility by the simple expedient of refusing to agree no matter how arbitrarily to the tax characterization of a payment. Page 37

38 Proposed negative Section 263A regulations Page 38

39 Why care about the new regulations? Tax savings Modified Simplified Production Method (MSPM ) will provide a benefit for the majority of taxpayers (likely >95%) Significant amount of raw materials and most Section 263A costs in the production phase will receive the most benefit Mandatory change for taxpayers that currently have negative Section 263A costs and use the Simplified Production Method (SPM) Taxpayers that have significant negative Section 263A costs (e.g., Section 174) could experience an increase in tax under the new MSPM Even if calculation is 100% correct right now, change required Opportunity to simplify calculations Taxpayers currently using a burden rate method can adopt MSPM and achieve similar results without the complex, time-consuming calculations Page 39

40 Why care about the new regulations? Mitigate potential exposure associated with current method of removing negatives from Section 471 costs IRS often challenged treatment on exam in 2007 and prior years April 2007 IRS issued Notice providing that, pending issuance of additional guidance, it would not challenge the treatment Now that guidance has been issued, these will be open to exam Mitigate potential exposure associated with current method of capitalizing Section 471 costs New definition of Section 471 costs would require a change for taxpayers (mainly retailers) that back out overhead costs capitalized for book (e.g., warehousing costs) and treat as additional Section 263A cost using SPM/Simplified Retail Method Page 40

41 Post-NOL planning opportunities Page 41

42 Post-NOL planning opportunities Overview While generating NOLs, companies may allocate resources away from tax function, decreasing focus on tax planning and operations Companies transitioning from NOL generation state to NOL utilization state face changing priorities and new risks and challenges These companies should consider cash tax planning, which will be valuable regardless of their point in the transition process. Valuable Year in which NOL is fully utilized Good Year before the NOL is fully utilized Better Two years before the NOL is fully utilized Best Two years before valuation allowance release/begin using NOLs Page 42

43 Post-NOL planning opportunities Changing priorities Employing cash tax planning to manage utilization of NOLs Reverse cash tax planning to generate taxable income to use expiring NOLs Traditional cash tax planning to absorb unfavorable adjustments Identify permanent items previously unavailable due to posture limitations Aiding the tax department Develop processes necessary for internal tax department to operate efficiently in NOL utilization state Page 43

44 Post-NOL planning opportunities Risks and challenges Accounting for income taxes is one of the U.S. Securities and Exchange Commission s (SEC) top areas of focus in its reviews of public company financial statement filings. Accuracy of income tax accounts and related disclosures in financial statements is one of the top areas of financial statement material weakness and risk for companies. Companies generating NOLs may be required to establish a valuation allowance (VA) against the related deferred tax assets and will look to release the VA and recognize a benefit in the financial statements. Page 44

45 Other cash tax planning opportunities Page 45

46 Top changes Top five automatic methods changes 1. Change to proper or more favorable capitalization or depreciation method 2. Defer recognition of advance payments 3. Accelerate deductions of prepaid expenses 4. Inventory valuation and methods 5. Accelerate deduction of tax liabilities Top five non-automatic methods changes 1. Defer income recognition until right to receive income is fixed 2. Claim recurring item exception to deduct expenses prior to payment 3. Change from simplified uniform capitalization (UNICAP) method to facts and circumstances method 4. Analyze embedded costs capitalized to inventory 5. Deduct payments for services received within 3½ months from date of payment Page 46

47 Other cash tax planning opportunities Severance liabilities Section 172(f) specified liability losses Defer income from unredeemed gift cards Retail and restaurant remodel-refresh industry issue resolution Charitable contributions of food inventory Exchange of rights and agreements is a like-kind exchange under Section 1031 Safe harbor for ratable service contracts Page 47

48 Appendix A Research credit Page 48

49 Research credit Overview Section 41 is an incentive provision relating to certain domestic research and development activities. The credit provides a permanent tax benefit (federal and states), increases cash flow and enhances shareholder value. The credit is equal to 20% (or 14% for the alternative simplified credit) of the excess of: The qualified research expenses for the current year over a base amount Page 49

50 Research credit Overview Qualified research expenses include: Wages Supplies Contract research expenses (65%) Requirements for qualified research: Expenditures may be treated as expenses under Section 174 Undertaken for the purpose of discovering information that is technological in nature Development of a new or improved business component Substantially all of the activities constitute a process of experimentation Page 50

51 Research credit Overview Important exclusions from qualified research: Research conducted outside of the US Internal use software, except as provided by regulation Research funded by another party Activities occurring after commercial production Marketing research Page 51

52 Research credit Legislative changes Credit has been made permanent For certain small taxpayers, credit is allowed against AMT For certain start-up taxpayers, credit can offset payroll tax liability $5 million dollar gross receipts test Five-year test period $250,000 offset limitation Page 52

53 Research credit controversy Section 174 Final Section 174 regulations were published July 21, 2014 Prototype definition Depreciable property rule clarification Meeting the Section 174 standard for uncertainty is the first step in meeting credit qualified research eligibility Exam s application of the more generous rules: Integration costs Use of inventory items as test beds Prototype costs as supply costs Page 53

54 Research credit controversy Internal use software How to determine the breadth of dual function software Exam s application of the high threshold of innovation standard: Exclusion of design uncertainty in significant economic risk test Interest in documentation showing expectation of cost recovery Page 54

55 Research credit controversy Supplies used in research Union Carbide case disallowed unsegregated supplies used in process research Supplies used to test new or improved processes were indistinguishable from supplies used in production runs Prototype supply costs Page 55

56 Research credit controversy Funded research Most notable judicial authority is Fairchild Indus., Inc. v. US, 71 F.3d 868 (Fed. Cir. 1995) Federal Circuit found research was not funded when payment was contingent on performance (i.e., where the researcher bears the risk of failure) Geosyntec Consultants, Inc. v. US, 776 F.3d 1330 (11th Cir. 2015) Payment was not contingent upon performance and, therefore, Geosyntec did not bear financial risk of failure Dynetics, Inc. v US, 121 Fed. Cl. 492 (2015) Court reviewed contract terms and found that Dynetics had no risk that it would not be paid for unsuccessful research Page 56

57 Section 41 proposed regulations Internal use software Congress excluded from the definition of qualified research software that is developed primarily for the taxpayer s internal use (i.e., IUS) Legislative history identified two types of software that Congress intended to be disadvantaged: Software used to provide certain services Accounting, consulting, banking, etc. Software used to support general and administrative functions Payroll, bookkeeping, personnel management, etc. Result of the lack of specificity in the statute is substantial controversy and repeated attempts to write regulations Page 57

58 Section 41 proposed regulations Internal use software Proposed regulations for IUS (2015) Proposed regulations distinguish IUS from non-ius IUS defined as general and administrative functions, including: Financial management, HR management and support services Non-IUS defined as: Software sold, leased, licensed or otherwise marketed to third parties Software that enables a taxpayer to interact with third parties or that allows third parties to initiate functions or review data on the taxpayer s system Dual function software safe harbor Intended use by third parties of at least 10% results in inclusion of 25% of development costs Page 58

59 Section 41 proposed regulations Internal use software High threshold of innovation test: More closely follows tests described in the legislative history Improvements = reduction in cost, improvement in speed or other metric Significant economic risk = combination of technical uncertainty and uncertainty regarding economic recovery Limits risk to technical uncertainty involving the capability or method, not uncertainty of appropriate design Not commercially available test is unchanged Taxpayers can apply proposed regulations to tax years ended on or after January 20, For prior years, taxpayers can use IUS rules from either of two previous regulation sets. Page 59

60 Section 41 final regulations Alternative Simplified Credit election Final regulations for ASC elections (2015) Final regulations allow a taxpayer to elect the ASC method on an amended tax return, provided the taxpayer did not previously elect the traditional method for that tax year Issued in response to taxpayer and Congressional requests Applies to elections with respect to taxable years ending on or after February 27, 2015 For tax years ending before February 27, 2015, the previously issued temporary regulations allowing amended return claims for open years apply Rule change represents a significant shift from the previous regulation disallowing amended return elections of the ASC Page 60

61 Section 41 proposed and temporary regulations Group credit allocation Proposed and temporary regulations for group credit allocations (2015) Requires taxpayers to allocate the group credit on the basis of the QRE of each controlled group member Previously, group credit was allocated based on whether members QREs contributed to the group credit Issued in response to statutory change Stand-alone credit calculation no longer relevant Effective for tax years beginning on or after April 3, 2015, but taxpayers may apply the temporary regulations for tax years beginning after December 31, Page 61

62 Research credit guidance outlook Finalization of proposed internal use software regulations Finalization of group credit allocation regulations Finalization of gross receipts for intercompany transactions regulations Publication of guidance on supplies Page 62

63 State research credits Most states offer incentives for investments in research and/or development activities by companies, including sales tax exemptions and/or tax credits. State research credits are generally apportioned or computed based on the amount of activity within the state. California The research credit is 15% of QREs in excess of the base amount (minimum of 50% of current year QREs). Arizona The research credit is permanent, and for tax years beginning in 2010, the credit is partially refundable (if elected). Texas The research credit is 5% of QREs in excess of the base amount or the sales/use benefit (credit starts in 2013). Massachusetts, New Jersey and North Carolina are other key states that should be considered. Page 63

64 International research credits and incentives Many US companies with foreign operations have utilized more lucrative incentives for R&D activities offered by other countries. The effective rate for the research credit in the US is approximately 6.5% (without consideration of AMT limitations and/or the ASC method). Incentives for research and development investments that are offered by other countries are significantly greater than the research credit. In 2008, the US ranked 17th overall for research generosity and would have to increase the ASC from 14% to nearly 50% to move to #1 (Spain). Canada s incentives for R&D investments are more than double the amounts offered by the US. Page 64

65 Appendix B Section 199 Page 65

66 Section 199 Overview Section 199 is an incentive provision relating to certain domestic manufacturing and production activities. The deduction provides a permanent tax benefit (federal and states), increases cash flow and enhances shareholder value. The deduction is equal to 9% (or 6% for certain oil and gas) of the lesser of: QPAI Taxable income (determined without regard to Section 199) Section 199 limits the deduction to 50% of DPGR-related W-2 wages. Page 66

67 Section 199 Overview What qualifies? DPGR Gross receipts derived from Qualifying activity Lease, rental, license, sale, exchange or other disposition Construction performed in the United States Engineering or architectural services performed in the United States Applicable property QPP manufactured, produced, grown or extracted by the taxpayer in whole or significant part in the US Qualified film Electricity, natural gas or potable water produced in the US Tangible personal property Computer software Sound recordings Page 67

68 Section 199 Corporations Calculate deduction at expanded affiliated group (EAG) level and allocate to members based on QPAI EAG generally defined under Section 1504 Ownership percentage lowered to >50% for Section 199 purposes Includes possessions corporations Attribution of activities for EAG Pass-through entities Characterize income and expenses at entity level Calculate deduction at owner level Attribution of activities in limited circumstances Page 68

69 Section 199 controversy Contract manufacturing Only one taxpayer can qualify with respect to the same activity performed on the same property For contract manufacturing arrangements, benefits and burdens of ownership test determines which party is considered to have manufactured the property Benefits and burdens test was established by Grodt & McKay Realty, Inc. Addressed whether a cattle sale was a bona fide sale or a sham transaction Page 69

70 Section 199 controversy Benefits and burdens factors Which party has legal title The intention of the parties Which party has an equity interest Whether there is a present obligation to deliver a deed Who has the right of possession and control Who pays property taxes after the transaction Who has risk of loss or damage Who has profit from the sale of the property Whether the taxpayer actively and extensively participated in the management and operations of production Page 70

71 Section 199 controversy Advo, Inc. v. Commissioner (Tax Court, 2013) Question: In a contract manufacturing arrangement, which party would be considered to have produced the product? Only judicial decision applying the Grodt & McKay factors to Section 199 Taxpayer contracted with a printer to print ads it delivered in mailers Taxpayer was substantially involved in the development of the content and graphics of the ads Court found that the taxpayer did not have any of the benefits and burdens of ownership during the manufacturing (i.e., printing) process Page 71

72 Section 199 controversy CCA Question: In a contract manufacturing arrangement, which party would be considered to have produced the product? Office of Chief Counsel s application of the Grodt & McKay factors to Section 199 (closely follows Advo) Involved a professional sports team claiming that its share of gross receipts from a league contract with a television network for the broadcast of games qualify as DPGR from disposition of a qualified film IRS Counsel applied the benefits and burdens test to determine if the team is considered to be the producer of the broadcast IRS Counsel ruled that the team did not have any of the benefits and burdens during the production process In a subsequent determination (CCA ), the IRS determined that the taxpayer did not enter into a contract manufacturing arrangement with the television network Page 72

73 Section 199 controversy Large Business and International (LB&I) Directive LB&I Directive I Permits a taxpayer using a contract manufacturer to claim the deduction if: It provides a statement explaining its basis for its determination that it had the benefits and burdens Provides a certification under penalties of perjury that it has the benefits and burdens The contract manufacturer provides a certification under penalties of perjury that it has not, and will not, claim the Section 199 deduction for the same qualifying activities Page 73

74 Section 199 Controversy MPGE In whole or significant part test To qualify for the Section 199 deduction for qualified production property, the taxpayer must manufacture the property in whole or significant part. The regulations provide that a taxpayer has manufactured the product in significant part if the taxpayer s activities are substantial in nature. A taxpayer can prove (based on facts and circumstances) that its activities are substantial in nature, or it can satisfy a safe harbor test. The taxpayer meets the significant part safe harbor test if the direct labor and overhead incurred by the taxpayer to produce the property equals 20% or more of the cost of goods sold of the property. Page 74

75 Section 199 controversy MPGE If the safe harbor test is not met, use a facts and circumstances analysis that looks at: Relative value added and cost incurred The nature of the property and production activity MPGE exclusions: Packaging, repacking, labeling and minor assembly Costs not part of safe harbor: Design and development activities (there is an exception for software and sound recordings) Page 75

76 Section 199 controversy MPGE case United States v. Dean (Dist. Ct. Cal., 2013) Question: Did the taxpayer s activities rise to the level of MPGE, or was it nonqualified packaging or repackaging? Taxpayer purchased various items and then assembled the items as gift baskets Taxpayer s activities were not solely packaging and repackaging, but changed the form and function of the items with a different demand as a result Transformed the individual raw materials into a gift Court cited examples in the regulations that demonstrated where the form and function were not changed and held that in this example there was a sufficient change Page 76

77 Section 199 controversy MPGE case Precision Dose, Inc. v. United States (Dist. Ct. Ill., 2015) Question: Did the taxpayer s activities rise to the level of MPGE, or was it nonqualified packaging or repackaging? Similar to the Dean case Taxpayer sold unit doses of medications Court held that the taxpayer was entitled to claim the deduction Court further found that the taxpayer performed a complex production process that results in a distinct final product Court based much of its reasoning on Dean Page 77

78 Section 199 controversy Other MPGE considerations LB&I Directive Identifies activities that the IRS believes do not meet the definition of MPGE when performed in a retail setting Cutting blank keys to a customer s specification Mixing base paint and a paint coloring agent Applying garnishments to cake that is not baked where sold Applying gas to agricultural products to slow or expedite fruit ripening Storing agricultural products in a controlled environment to extend shelf life What if the same activities were not performed in a retail setting? Page 78

79 Proposed Section 199 regulations Scope and applicability Issued August 2015 in proposed and temporary format, covering: Contract manufacturing Cost of goods sold W-2 wages for acquisitions, dispositions and short tax years What activities are qualifying activities Definition of the word item Oil-related qualified production activities income Qualified films Treatment of activities in Puerto Rico Hedging transactions Agricultural and horticultural cooperative payments Page 79

80 Proposed Section 199 regulations Temporary provisions W-2 wages Updates regulations for statutory amendment in Tax Increase Prevention Act of 2014, which eliminated situations where, due to a short tax year not ending at December 31, a taxpayer s W-2 limitation results in no Section 199 deduction Revises Section (c) for acquisitions and dispositions, but leaves intact the allocation of W-2 wages between more than one employer Adds new definitions to clarify the meaning of acquisition or disposition and trade or business Page 80

81 Proposed Section 199 regulations Construction rules Conforms definition of substantial renovation to tangible property regulations (TPR ) Explicitly references unit of property (UOP) determination in TPR Current definition is pre-tpr capitalization test and does not explicitly reference UOP New rule on qualified construction activities Taxpayer must engage in construction activities that include more than the approval or authorization of payments or invoices for that taxpayer s activities to be considered as activities typically performed by a general contractor Page 81

82 Proposed Section 199 regulations Item rule Whether gross receipts from an activity are DPGR is determined on an item-by-item basis Current regulations do not define which items are for construction and engineering services, but allow taxpayers to make a reasonable determination Proposed regulations add an example to Section (d)(4) to clarify that only the disposition of the property, which is the subject of qualifying activities, constitutes the item for purposes of determining whether gross receipts from an activity are DPGR Proposed regulations also add an example to Section (d)(4) that demonstrates that the item determination made after the gross receipts related to embedded services is removed Page 82

83 Proposed Section 199 regulations Oil-related QPAI Definitions for oil-related QPAI, oil and primary products of oil Provide a special rule for oil-related DPGR that excludes gross receipts derived from transportation and distribution of oil, gas or any primary product thereof from oil-related DPGR Consistent with the government s general treatment of gross receipts derived from transportation and distribution activities Allocating and apportioning costs when determining oilrelated QPAI Requires taxpayers to use the same cost allocation method to allocate and apportion costs to oil-related DPGR as the taxpayer uses to allocate and apportion costs to regular DPGR Page 83

84 Proposed Section 199 regulations Section 460, COGS Taxpayers using long-term contract accounting methods Proposed regulations provide rules for allocable contract costs under the percentage-of-completion method (PCM) or the completed-contract method (CCM) for long-term contracts Require taxpayers to treat allocable contract costs under the PCM and the CCM as COGS for purposes of determining COGS allocable between DPGR and non-dpgr COGS and inventory Require that COGS be allocated between DPGR and non-dpgr inventory, without regard to taxpayer ability to associate a COGS cost to an activity performed in a prior tax year Page 84

85 Proposed Section 199 regulations Qualified film Definition of qualified film to include copyrights, trademarks or other intangibles with respect to such film: Promotional films Disposition of the promoted item is not from the disposition of a qualified film. Tangible property affixed with a film intangible is not a qualified film. Attribution of activities for partners or shareholders and partnerships or S Corps: Attribution applies regardless of when a film was produced as long as the partner or shareholder owns (directly or indirectly) at least 20% of the capital interests or stock in the pass-through entity. Page 85

86 Proposed Section 199 regulations Qualified film Film production safe harbor Proposed regulations clarify how to satisfy labor and overhead calculation for expensed costs of live or delayed TV programs All costs paid or incurred in the production includable in the unadjusted depreciable basis of program, including licensing fees paid to a thirdparty (but licensing fees are not includable in direct labor and overhead) W-2 wages Proposed regulations modify the definition of W-2 wages to include compensation for services performed in the US by actors, production personnel, directors and producers Page 86

87 Proposed Section 199 regulations Contract manufacturing Contract manufacturing Replaces benefits and burdens of ownership test in favor of a bright-line identification of the party performing the qualified activity Result could be that no taxpayer received deduction Comment request regarding cost-plus contract exception What constitutes MPGE? Example 5 of Section (e)(5) modified to clarify that certain activities will not be treated as MPGE activities if they are not performed as part of other activities that constitute MPGE of QPP New example directly rejects the result in the Dean case with respect to the level of activity that constitutes MPGE Page 87

88 Proposed Section 199 regulations Other Minor assembly Preamble seeks comments on definition of minor assembly Proposed definitional criteria: Whether the activity is a single process that does not transform an article into a materially different QPP Whether an end user could reasonably engage in the same assembly activity of the taxpayer Page 88

89 Section 199 guidance outlook Finalization of proposed Section 199 regulations Publication of proposed Section 199 regulations addressing online computer software Publication of guidance addressing oil-related transportation cost limitation (2015 statutory amendment) Legislative solutions for contract manufacturing Page 89

90 Section 263A basics Page 90

91 Section 263A basics For inventory, application of Section 263A generally results in higher ending inventory, lower tax cost of goods sold and higher taxable income. For self-constructed assets, application of Section 263A generally results in a higher basis for self-constructed assets and: In the year(s) of production, lower business deductions and higher taxable income In subsequent years, increased depreciation deductions, which may result in lower taxable income Page 91

92 Treasury regulations Topic UNICAP Rules for producers Applicable regulation Treas. Reg A-1 Treas. Reg A-2 Rules for resellers Treas. Reg A-3 Rules for farmers Treas. Reg A-4 Certain method change Treas. Reg A-7 rules Interest capitalization Treas. Reg A-8 through -15 Page 92

93 What costs are required to be capitalized under Section 263A? Direct costs Direct material costs Direct labor costs Acquisition costs of property acquired for resale (resellers) Certain indirect costs Costs other than direct costs that directly benefit or are incurred by reason of the performance of production or resale activities Interest expense only applicable to certain types of property Page 93

94 What costs are not required to be capitalized under Section 263A? Treas. Reg A-1(e)(3)(iii) provides for certain indirect costs that are not required to be capitalized under Section 263A: Selling and distribution costs (e.g., marketing, advertising, pick and pack costs) Section 174 costs (e.g., research and experimental expenditures) Section 179 costs (e.g., expenses for certain depreciable assets that a taxpayer has elected to deduct under Section 179) Section 165 losses Cost recovery allowances on temporarily idle equipment and facilities (e.g., equipment operated only during certain shifts, facility shut down for retooling) Page 94

95 Applying Section 263A Inventory and self-constructed assets Step 1: Identify costs capitalized to inventory or self-constructed assets for financial reporting purposes (referred to as Section 471 costs) Step 2: Identify additional Section 263A costs and mixed service costs Step 3: Allocate mixed service costs between capitalizable and excludible activities Total additional Section 263A costs Step 4: Allocate additional Section 263A costs (including capitalizable mixed service costs) between ending inventory and cost of goods sold or to self-constructed assets produced during the year for reporting purposes (referred to as Section 471 costs ) Page 95

96 Methods to allocate additional Section 263A costs between ending inventory and COGS SPM MSPM With or without historic absorption ratio (HAR) With or without HAR Specific identification Predetermined burden rates Standard cost Other reasonable allocation methods (e.g., burden rates based on actual activity and/or costs) Page 96

97 Simplified production method (SPM) If elected, use for all production and resale activities Eligible property Inventory property Non-inventory property held for sale Self-constructed assets that are similar to inventory Substantially identical to inventory Produced in the same manner as inventory Self-constructed tangible personal property produced on a routine and repetitive basis Mass produced Recovery period less than or equal to three years or materials and supplies that will be consumed within three years Page 97

98 Questions? Page 98

99 EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US Ernst & Young LLP. All Rights Reserved This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice.