Contract Manufacturing and the Domestic Production Activities Deduction

Oct. 31, 2013

Businesses can claim a domestic production activities deduction (DPAD) against their taxable income of up to 9 percent (6 percent for oil-related income) for many domestic manufacturing, construction, engineering, and architectural activities. Companies involved in a contract manufacturing arrangement also can qualify for the DPAD but need to carefully analyze which, if any, of the parties involved can claim the DPAD.

A recent Tax Court case, ADVO, Inc. and Subsidiaries v. Commissioner of Internal Revenue, highlights the complexity of claiming DPAD in a contract manufacturing arrangement. ADVO is a direct mailer that worked with customers to ship advertising mailers that were printed under contract printing arrangements with third parties.

ADVO argued it was entitled to the DPAD because it exercised sufficient control over the printing process to have the benefits and burdens of ownership of the printed material. In its decision against ADVO, the court analyzed the following nine factors to identify whether the company maintained the benefits and burdens of ownership of the printed material during production:

  1. Who holds legal title during production?
  2. How did the parties involved treat the transaction?
  3. Was an equity interest in the third-party manufacturer acquired?
  4. Does the contract create a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments?
  5. Who has control of the property and process?
  6. Who pays property taxes?
  7. Who bears risk of loss or damage to the property?
  8. Who receives profits from sale of the property?
  9. Who actively and extensively managed the production activity?

The court found that four of the factors had no impact on ADVO, while the remaining five factors pointed against the company.

The court’s analysis demonstrates that there is a great deal of subjectivity and complexity involved in identifying which party to a contract manufacturing arrangement can claim the DPAD. The analysis is further complicated because typically only one party in a contract manufacturing arrangement can claim the DPAD. Taxpayers that are parties in contract manufacturing agreements should carefully review their arrangement to mitigate the risk of their claims being denied and to make sure they are claiming the correct amount of DPAD.

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