Editor: Mary Van Leuven, J.D., LL.M.
Expenses & Deductions
According to the IRS, retailers may be eligible to claim a Sec. 199 deduction for advertising revenue derived from producing and distributing printed fliers in cooperation with vendors. This item reviews recent IRS guidance and considers what it might mean for taxpayers that are engaged in cooperative advertising arrangements.
The IRS has affirmed a retailer's potential ability to claim the domestic production deduction of Sec. 199 for its production of advertising fliers. In a generic legal advice memorandum released on Jan. 10, 2014, the IRS examined the application of Sec. 199 to advertising fliers in the context of cooperative advertising amounts that retailers received from their vendors (AM 2014-001 (the GLAM)).
A cooperative advertising agreement is a common means for a vendor to encourage a retailer to feature the vendor's products prominently in the retailer's advertisements. As the GLAM discusses, the terms of these agreements vary, but they generally set forth details regarding the advertising media to be used, the products to be featured, the placement of the products in the flier, the use of the vendor's name and logo, and other commercial terms. The manner in which the retailer is compensated for advertising the vendor's products likewise varies-it can take the form of a direct payment, an offset against the cost of products the vendor sold to the retailer, or other arrangements.
In the GLAM, the IRS discusses whether a retailer may treat cooperative advertising payments received from vendors in connection with the retailer's printed fliers as qualifying revenue for purposes of Sec. 199.
Sec. 199 generally provides a deduction computed as a stated percentage of the taxpayer's net income derived from certain qualifying activities (subject to various limitations). More precisely, the Sec. 199 deduction is computed by first identifying the taxpayer's gross receipts from qualifying activities-its domestic production gross receipts (DPGR). After subtracting from DPGR various allocable costs to derive its qualified production activities income (QPAI), the taxpayer then multiplies the lesser of this amount or its taxable income for the year by 9% to determine its Sec. 199 deduction (again, subject to other limitations). The issue addressed in the GLAM is whether the retailer may include cooperative advertising payments in its DPGR for Sec. 199 purposes.The GLAM concludes that cooperative advertising payments qualify as DPGR (assuming all other requirements of Sec. 199 are satisfied) regardless of whether the amount of the payment is computed by reference to the amount of goods purchased from the vendor-but only if the parties intend the payments to compensate the retailer for providing advertising services to the vendor. This is a factual question, but the GLAM suggests that the relevant factors include the language used in the agreement and whether the amounts paid to the retailer are reasonable in relation to the retailer's obligations under the agreement. On the other hand, when the vendor's payments are computed based only on the volume of goods the retailer purchased from the vendor, with no obligation to advertise the vendor's products, the payments are actually a purchase price adjustment rather than compensation for the retailer's performance of services.
This distinction is critical for Sec. 199 purposes for two reasons: First, Sec. 199 applies only when the taxpayer engages in a qualifying activity that gives rise to qualifying receipts. For this purpose, gross receipts can include a credit issued against future purchases or a reduction in any amount owed to the vendor, in addition to an actual cash receipt. Without gross receipts tied to a qualifying activity, there is no revenue stream that can be included in DPGR. Rebates or vendor allowances treated as purchase price adjustments reducing cost of goods sold, for example, are beyond the scope of Sec. 199. Thus, the GLAM correctly concludes that Sec. 199 applies when the cooperative advertising program generates qualifying receipts.
Second, the GLAM underscores the need for these receipts to relate to a qualifying activity—manufacturing, production, growing, or extraction (MPGE). The definitions of qualifying activities for purposes of Sec. 199 are complex, with many special rules and exceptions. As a general rule, advertising is treated as a nonqualifying service, making gross revenue from providing advertising services normally ineligible for the Sec. 199 deduction. Importantly, however, Sec. 199 does apply to advertising revenue earned in connection with the taxpayer's production of newspapers, magazines, telephone directories, periodicals, and other similar printed publications. This "advertising exception" applies even when the taxpayer does not charge for the media in which the advertising appears. As a result, the GLAM correctly concludes that gross receipts "derived from" the retailer's printed fliers—including cooperative advertising payments compensating the retailer for advertising services associated with the fliers—qualify for the Sec. 199 deduction.
The GLAM also underscores the need for retailers to consider the other requirements of Sec. 199 as applied to the printed fliers, including ensuring that the retailer itself has "produced" the flier in the United States. Retailers generally have little trouble satisfying this requirement when they operate an in-house printing facility, as many national retailers do. Smaller retailers that subcontract the printing of their fliers and other printed advertisements, however, will be required to show that they had the "benefits and burdens" of ownership of the printed materials during the production process. This is also a largely factual analysis. The IRS has issued an Industry Director Directive, LB&I-04-0713-006 updated by LB&I-04-1013-008, to help companies establish which party has the benefits and burdens of ownership in a contract-manufacturing arrangement.
The Tax Court addressed the benefits-and-burdens issue in 2013 in the context of printed advertising materials. In ADVO, Inc., 141 T.C. No. 9 (2013), the court held that the printing company, rather than the advertising company, had the benefits and burdens of ownership during the printing of the taxpayer's advertising mailers, and so the taxpayer was not entitled to the Sec. 199 deduction. The court recognized, however, that the issue is always highly factual and even recommended that other taxpayers attempt to comply with the LB&I directive to avoid controversy.
Retailers who subcontract the production of their advertising fliers to third parties should carefully review the LB&I directive and the ADVO decision. Unless the retailer can demonstrate that it has the benefits and burdens of ownership under its arrangements with its printing contractor, the related advertising revenue—including any cooperative advertising payments—will not qualify for Sec. 199.
Finally, it is important to note that the GLAM endorses potential application of Sec. 199 only to cooperative advertising payments received in connection with printed fliers, concluding that printed fliers are sufficiently similar to newspapers, magazines, and other periodicals to qualify for the advertising exception. The government has refused to treat online media consistent with printed media for this purpose, however. As a result, cooperative advertising payments received in connection with online advertising services are beyond the scope of the GLAM and are unlikely to be accepted as being eligible for the Sec. 199 deduction.
The GLAM is an important reminder that many retailers are eligible to claim a Sec. 199 deduction for advertising revenue derived from producing and distributing printed fliers. The GLAM underscores the need to consider all advertising revenue sources for this purpose, including cooperative advertising revenue received from vendors.
Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or email@example.com.
Unless otherwise noted, contributors are members of or associated with KPMG LLP. The information contained in this item is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This item represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP.