In 2004, after the World Trade Organization determined that then-current US export subsidies were prohibited under treaty, the US congress enacted section 199 of the internal revenue code as part of the American Jobs Creation Act. Known as the domestic production activities deduction, section 199 gives domestic manufacturers a federal income tax deduction equal to a certain percentage of income.
Generally, under section 199, manufacturing means property manufactured, produced, grown, or extracted wholly or in significant part within the US. However, this definition can be quite broad, and does contain exceptions. For example, while the deduction generally can’t be based on advertising income, there is an exception for advertising revenue derived from producing and distributing printed fliers (see treasury regulation 1.199-(3)(i)(5)(ii).)
In Chief Counsel Advice 201626024, the taxpayer was a specialty retailer of private-branded clothing and other items that were marketed under certain brand names. The taxpayer’s products were manufactured outside the US, and the taxpayer made the products available to customers in US and international retail stores through a website as well as telephone call centers for catalog sales.
To drive traffic to its stores and websites, encourage repeat sales, and foster customer loyalty, the taxpayer developed and produced catalogs, mailers, and other similar printed products in the US through its marketing and production teams. The printed products included only advertising for the taxpayer’s own brands, and the taxpayer distributed the printed products free of charge to existing customers. The taxpayer did not sell any printed products, or advertising in the printed products, to third parties.
The price the taxpayer charged for its branded clothing included a component to cover the cost of producing the printed products. The taxpayer said the printed products were responsible for driving a portion of sales, and claimed to be able to identify 92-95% of incremental sales associated with the catalogs, mailers, and other printed media.
The taxpayer believed that it was the manufacturer of the printed media and that it had the benefits and burdens of ownership during the entire manufacturing process, including the printing process, which was typically provided by third party contractors.
The taxpayer said it could claim a section 199 deduction for the printed products under the exception because advertising was a component of the clothing and accessories it sold. Therefore, the taxpayer believed the sales price of the goods sold in stores and online qualified as advertising revenues generated from the disposition of the manufactured printed media.
Here is the relevant section of treasury regulation 1.199-(3)(i)(5)(ii).
(5) Advertising income
(i) In general. Except as provided in paragraph (i)(5)(ii) of this section, gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of qualified production property, a qualified film, or utilities do not include advertising income and product-placement income.
(A) Tangible personal property. A taxpayer’s gross receipts that are derived from the lease, rental, license, sale, exchange, or other disposition of newspapers, magazines, telephone directories, periodicals, and other similar printed publications that are manufactured, produced, grown, or extracted in whole or in significant part within the United States include advertising income from advertisements placed in those media, but only if the gross receipts, if any, derived from the lease, rental, license, sale, exchange, or other disposition of the newspapers, magazines, telephone directories, or periodicals are (or would be) domestic production gross receipts.
(iii) Examples. The following examples illustrate the application of this paragraph (i)(5):
Example 1. X manufactures, produces, grows, or extracts, and sells, newspapers within the United States. X’s gross receipts from the newspapers include gross receipts derived from the sale of newspapers to customers and payments from advertisers to publish display advertising or classified advertisements in X’s newspapers. X’s gross receipts described above are domestic production gross receipts derived from the sale of X’s newspapers.
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It is inappropriate for the taxpayer to characterize any gross receipts derived from the sale of its products as domestic production gross receipts from advertising income under section 1.199- 3(i)(5)(ii)(A) (or any other section 199 rule).
The taxpayer’s products are manufactured, produced, grown, or extracted outside of the US and therefore, gross receipts from the sale are non-domestic production gross receipts. The rules relating to deriving domestic production gross receipts from advertising income are not applicable in this situation.
Section 1.199-3(i)(5)(i) provides the general rule that gross receipts from the disposition of qualifying production property do not include advertising income. The exception in section 1.199-3(i)(5)(ii)(A) for tangible personal property (a type of qualifying production property) is limited to certain printed publications and only applies to advertising income from advertisements placed in those media. For example, the exception allows a newspaper producer (that meets all section 199 requirements with respect to the newspaper) to treat gross receipts derived from people/businesses placing advertisements in the newspaper as derived from the disposition of the newspaper and domestic production gross receipts (see example 1 of section 1.199-3(i)(5)(iii)).
Thus, the exception in section 1.199-3(i)(5)(ii)(A) only applies when a taxpayer that has manufactured, produced, grown, or extracted a printed publication (and meets all other section 199 requirements) derives gross receipts from someone advertising in such printed publication—and not when a taxpayer derives gross receipts from the sale of a product it advertises.
In this case, no one is paying the taxpayer to have an advertisement placed into the taxpayer’s printed media.
The taxpayer argues part of the gross receipts from the sale of its products should be treated as advertising income under section 1.199-3(i)(5)(ii)(A) because the taxpayer’s advertising increases its sales. The fact that advertising your products increases your sales is of no consequence when applying section 1.199-3(i)(5)(ii)(A). For this rule to be relevant, the taxpayer’s customers have to pay to advertise in the taxpayer’s print media. That is not happening when they buy a product.
The taxpayer’s argument is a misapplication of the rules in section 1.199-3(i)(5). The taxpayer’s products are manufactured, produced, grown, or extracted outside of the US, and the gross receipts from their sale are non-domestic production gross receipts.