IRS Clarifies When Promotional Allowances Count as Domestic Production Gross Receipts. (Parker Tax Publishing February 2014)

Whether or not promotional trade allowances received by a retailer are considered purchase price adjustments or separate sources of income is important for retailers calculating the domestic production activities deduction. If treated as separate items of income, the promotional allowances can increase the retailer's domestic production activities deduction because they are considered domestic production gross receipts (DPGR). In AM-2014-001, the Chief Counsel's Office explains how to determine whether the promotional allowances constitute DPGR and gives examples of when such allowances are considered a separate item of income and thus eligible to increase the retailers domestic production activities deduction.

Background

Under the facts in AM-2014-001, vendors and retailers enter into co-operative advertising arrangements (CAAs). The arrangements require retailers to produce printed advertisements of the vendors' products and to distribute the printed advertisement flyers in the retailers' stores and through mail and in newspapers. Retailers usually circulate flyers free of charge to retail customers.

The flyers increase foot traffic to the retailers' stores and may increase customer interest and demand for the advertised products offered at the retailers' internet websites. Vendors may be the manufacturer, supplier, wholesaler, or distributor of the product who directly or indirectly sells the product to retailers at the wholesale level. In general, the retailers include the vendors' products in the retailers' flyers under written or oral agreements negotiated annually or on an ad hoc basis with the vendor.

Although the terms of the CAAs between retailers and vendors may differ, the CAAs often require retailers to provide specific advertising services and may specify:

- the advertising media;

-the products that will be featured;

-the placement of the product in the flyer;

-the conditions for advertising specific products;

-the use of the vendor's name and logo;

-the size, length, and frequency of advertisement; and

-the substantiation and payment processes.

Retailers are responsible for all aspects of the production and distribution of the flyers and normally bear the entire up-front cost of the flyers. Under the terms of the CAAs with the vendors, the retailers receive allowances from the vendors for providing specific advertising services. Under the terms of some CAAs, the flyers must meet the vendors' specifications as a condition of retailers receiving allowances. Often CAAs provide that allowances are calculated based on the volume of the advertised products that the retailers purchase from vendors during a specified period.

Typically vendors pay the retailers directly, or the vendors may reduce the amount owed by the retailers for prior purchases, or the vendors may issue a credit to the retailers for future purchases. The vendors may pay allowances periodically (e.g., as a vendor's products are featured in the flyer) or at fixed intervals. Vendors may require retailers to submit invoices, reimbursement substantiation claims, or proofs of performance of the advertising services required under the agreements before paying the allowances.

Domestic Production Activities Deduction

Under Code Sec. 199, taxpayers can deduct an amount equal to 9 percent (for tax years beginning after 2009) of the lesser of (1) the taxpayer's qualified production activities income (QPAI) for the tax year, or (2) taxable income.

QPAI is the excess (if any) of (1) the taxpayer's DPGR for the tax year, over (2) the sum of the cost of goods sold that are allocable to DPGR and other expenses, losses, or deductions that are properly allocable to DPGR.

DPGR is a taxpayer's gross receipts that are derived from any lease, rental, license, sale, exchange, or other disposition of qualifying production property (which includes tangible personal property) that was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the United States.

In calculating the domestic production activities deduction, taxpayers are required to determine gross receipts and cost of goods sold using the same accounting method used for federal income tax purposes.

Generally, gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of qualifying production property, a qualified film, or utilities do not include advertising income and product-placement income. While gross receipts from advertising are generally non-DPGR because the receipts are derived from providing a service, there is an exception allowing advertising-related gross receipts to qualify as DPGR in cases of certain tangible personal property.

Specifically, Reg. Sec. 1.199-3(i)(5)(ii) provides that a taxpayer's gross receipts that are derived from the disposition of newspapers, magazines, telephone directories, periodicals, and other similar printed publications that are MPGE in whole or in significant part within the United States include the advertising income from advertisements placed in those media, but only if the gross receipts, if any, derived from the disposition of the newspapers, magazines, telephone directories, or periodicals are (or would be) DPGR.

Purchase Price Adjustments Versus Separate Items of Income

As a general principle, taxpayers in the retail industry compute gross income from sales during a year by subtracting the cost of the goods sold (CGS) from gross sales receipts. Generally, when payments are made by vendors to retailers as an inducement to purchase merchandise, the payments are not separate items of gross income but instead are an adjustment to the cost or price of the merchandise purchased (purchase price adjustment).

In Affiliated Foods, Inc., v. Comm'r, 128 T.C. 62 (2007), the Tax Court held that a purchase price adjustment or a price rebate that a taxpayer receives for goods that it has purchased for resale is not, itself, an item of gross income but, instead, is treated as a reduction in the cost of the goods sold. A purchase price adjustment may still indirectly affect the amount of a retailer's gross income if it results in a reduction in CGS.

The test for whether a payment, credit, allowance, or rebate is a purchase price adjustment is what the parties intend and for what purpose the payment, credit, allowance, or rebate was paid. If the purpose was to adjust the price of the item between the parties, then the consideration given, regardless of the time or manner of the adjustment, is a purchase price adjustment and is not a separate item of gross income.

The seminal case addressing purchase price adjustments is Pittsburgh Milk v. Comm'r, 26 T.C. 707 (1956). In that case, the Tax Court concluded that allowances that a milk producer paid to buyers lowered the sales price of the milk for income tax purposes. The court held that only the net price was includable in the seller's gross income, even though the discounts were illegal. Thus, when a payment is made from a seller to a purchaser, and the purpose and the intent of the payment is to reach an agreed upon net selling price, the payment is an adjustment to the sales price. However, the Tax Court also said that, if an allowance is contingent upon the performance of services by the purchaser, the allowance is not a trade or other discount. Accordingly, any payment, reduction in any amount owed to a vendor by a retailer for prior purchases, or credit issued by a vendor to a retailer for future purchases that represents compensation for services performed, or to be performed, would be a separate item of gross income and not a trade or other discount that reduces the cost of merchandise purchases.

The IRS has issued guidance concluding that payments received that constitute adjustments to the purchase price are not includible in gross sales. For example, in Rev. Rul. 84-41, the IRS ruled that a manufacturer's rebate received by an automobile dealer is a trade discount and should be treated as a reduction in the cost of the automobile purchased, and not as an item of gross income.

Example: ABC is a retailer and sells electronic products at its stores. Vendor XYZ enters into an agreement with ABC under which ABC is required to perform advertising services for XYZ. Specifically, ABC will receive an allowance for including specifically described advertisements of XYZ's products (the advertised products) in ABC's weekly flyer. ABC must comply with XYZ's advertising policies and procedures in order to receive the allowance. The amount of the allowance is calculated based on a percentage of ABC's purchase costs of the advertised products during a stated period. The allowance is a reasonable amount in relation to the advertising services ABC performs. Under these facts and circumstances, even though the amount of the allowance is calculated by reference to the cost of advertised products purchased by ABC, the purpose and intent of the allowance is to compensate ABC for providing advertising services for XYZ, and, therefore, the allowance is treated as a separate item of gross income for the performance of advertising services. In 2014, XYZ pays a $5 allowance to ABC under the agreement. Before receiving the allowance, ABC's gross receipts from the sale of the advertised products is $100, its cost for the products sold is $20, and its total cost to produce and distribute the flyer is $25.

Under these facts, for federal income tax purposes, the $5 allowance is treated as a separate item of gross income for the performance of advertising services. ABC's gross income from the placement of XYZ's products in ABC's flyers is $5. ABC's gross income from the sale of the advertised products is $80 ($100 gross receipts - $20 CGS). ABC's taxable income, before calculating the Code Sec. 199 deduction, is $60 ($80 gross income from sales of the advertised products + $5 advertising service income - $25 deductible expense). Because the allowance is a separate item of gross income, it must be so characterized for purposes of calculating the Code Sec. 199 deduction. For purposes of Code Sec. 199, the $5 allowance is advertising income from ABC's performance of advertising services. Gross receipts from advertising are generally non-DPGR because the receipts are derived from providing a service. However, the exception to this rule that allows gross receipts derived from advertising to qualify as DPGR in cases of certain tangible personal property applies. Under these facts, ABC's gross receipts derived from placing XYZ's advertisements in the flyers qualify as DPGR if ABC meets all other applicable requirements of Code Sec. 199. Therefore, assuming ABC meets all other applicable requirements, the $5 allowance is included in DPGR. (Staff Contributor Parker Tax Publishing)

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