Retail sales are not advertising income from domestic print media

Plain-English summary

A specialty retailer sold products manufactured outside the United States and distributed catalogs and similar print media that advertised only its own brands. The retailer gave the publications to customers for free and received no payments from third parties to place advertisements in them. It argued that part of its product-sale receipts qualified for the former domestic production deduction because its domestically produced print media drove those sales. Chief Counsel advised that the advertising-income rule covers receipts from others paying to advertise in a qualifying printed publication, not receipts from selling products advertised by the taxpayer. The product-sale receipts therefore were non-DPGR.

Ruling snapshot

• Question: Can sales receipts from foreign-manufactured products qualify as DPGR advertising income because the retailer's domestic print media promoted those sales?
• Outcome: Advice given, the receipts are non-DPGR
• Key authorities: IRC § 199; Treas. Reg. § 1.199-3(i)(5)

Full text (IRS public release)

ID:       CCA-02191123-16
UILC:     199.03-00, 199.03-05

Number: 201626024
Release Date: 6/24/2016
From: ---------------------
Sent: Friday, February 19, 2016 11:23 AM
To: --------------------
Cc: -----------------------------------------
Subject: 199 case advice


Legend:

Taxpayer =                 ------------------------
                             -----------------------

Firm =                      --------------------

Brand Names =             -----------------------------------------------------------------------------------------


Hi --------,

You sent me an email requesting my views on a § 199 case related to Taxpayer that
was made in a presentation by Firm and provided me with facts and Taxpayer’s position
(summarized below).

Issue: Whether Taxpayer can claim a portion of gross receipts derived from the sale of
its products, which are manufactured, produced, grown, or extracted (MPGE) outside of
the United States, are domestic production gross receipts (DPGR) from advertising
income under § 1.199-3(i)(5)(ii)(A).

Conclusion: Taxpayer’s gross receipts derived from the sale of its products are non-
DPGR. None of the gross receipts derived from the sale of its products are advertising
income under 1.199-3(i)(5)(ii)(A).

Facts: Taxpayer is a specialty retailer of private branded, casual-to-dressy clothing,
intimates, accessories, and non-clothing gift items (collectively “products”) under certain
Brand Names. Taxpayer makes its products available to customers in US and
international retail stores, through its website and via telephone through call centers for
its catalogs. The MPGE of the physical products is outside of the United States.


Taxpayer claims to be the manufacturer of its catalogs, mailers and other similar printed
publications (hereinafter “print media”) in the US based on the benefits and burdens of
ownership during the manufacturing of the printed media by third party contractors.

Taxpayer did not sell any print media to third parties. Taxpayer distributed the print
media free of charge to existing customers. Neither did Taxpayer sell advertising to
third parties for inclusion in the print media it distributed. The print media included only
advertising for Taxpayer’s own brands. Thus, there is no advertising revenue
associated with the print media.

Taxpayer’s position: Taxpayer expects to claim a § 199 deduction for its print media
based on the argument that advertising is a component of the clothing and accessories
it sells. Taxpayer argues that:

       Through its marketing and production teams, [Taxpayer] develops and produces
       these printed media (e.g. catalogs, mailers and other similar printed publications)
       for each of [Taxpayer’s] [Brand Names]. [Taxpayer] produces these items in
       order to drive traffic to its stores and websites, encourage repeat sales, and
       foster customer loyalty.

       [Taxpayer’s] price point for its products sold through [Taxpayer’s] network is
       established to drive a profit on the various underlying components, including the
       goods being sold and the related print media, which is designed to cover
       storefront overhead costs, COGS, media production costs, SG&A, etc. …
       [Taxpayer] believes that it is the manufacturer of its printed media and that it has
       the benefits and burdens of ownership during the entire manufacturing process,
       including the printing process, typically provided by third party
       contractors. Therefore, [Taxpayer] believes that its advertising revenues
       generated from the disposition of its manufactured printed media which is
       included in the sales price of its goods sold in its stores and online is qualified
       under § 1.199-3(i)(5).

Per the Taxpayer, the price of Taxpayer’s retail goods includes a component for the
printed media produced, including a profit mark-up. Taxpayer claims that its printed
media campaign is responsible for driving a portion of its sales. Taxpayer claims it is
able to identify 92-95% of its incremental sales associated with its catalogs, mailers,
and other printed media.

The Taxpayer asserts that “The regulations provide that the taxpayer must apply federal
income tax principles to determine whether a transaction is, in substance, a lease,
rental, license, sale, exchange or other disposition, the gross receipts of which may
constitute DPGR….”

       Based on the functional analysis interviews with [Taxpayer’s] personnel, it was
       determined that [Taxpayer’s] major qualified revenue stream relates to its print
       media. [Taxpayer] uses a sophisticated marketing and data analysis software to


       track its customers’ buying habits and impacts of its various mailings (catalogs,
       mailers or other printed media) called ------. Currently, [Taxpayer] is able to track
       92-95% of all sales through the use of ------. ------ is a leader in -----------------------
       software and serves and allows its customers to transform raw data into
       information that businesses can use to improve customer relationships. ------ is
       used by a large number of retailers for this purpose. Based on -------------------,
       [Taxpayer] is able to specifically identify incremental sales associated with their
       printed media (catalogs, mailers and other printed media). The ------ system is
       also tied into their ERP system and they can track the actual COGS associated
       with these sales and the actual cost of the printed media that is driving the sales
       (i.e. their system can produce gross margin from the various printed media
       campaigns)… [Firm] determined [Taxpayer’s] domestic production gross receipts
       by obtaining the incremental sales for the following [Taxpayer] brands: --------------
       --------------------------. Because -------------------- only recently implemented a
       rewards program, the brand does not use the ------ software. For this reason,
       [Firm] was unable to obtain ----------------------- incremental sales. However, as
       --------------------------- sales are almost wholly driven by catalog sales, [Firm]
       obtained and use ----------------------- Net Sales.


Analysis: It is inappropriate for Taxpayer to characterize any gross receipts derived
from the sale of its products as DPGR from advertising income under § 1.199-
3(i)(5)(ii)(A) (or any other § 199 rule). Taxpayer’s products are MPGE outside of the
United States, and therefore, gross receipts from the sale are non-DPGR.

The rules relating to deriving DPGR 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 (QPP) do not include advertising
income. The exception in § 1.199-3(i)(5)(ii)(A) for tangible personal property (a type of
QPP) 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 § 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 DPGR (See Example
1 of § 1.199-3(i)(5)(iii)). Thus, the exception in § 1.199-3(i)(5)(ii)(A) only applies when a
taxpayer that has MPGE a printed publication (and meets all other § 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 Taxpayer to have an advertisement placed into Taxpayer’s
printed media.

Taxpayer argues part of the gross receipts from the sale of its products should be
treated as advertising income under § 1.199-3(i)(5)(ii)(A) because Taxpayer’s
advertising increases its sales. The fact that advertising your products increases your
sales is of no consequence when applying § 1.199-3(i)(5)(ii)(A). For this rule to be


relevant, Taxpayer’s customers have to pay to advertise in Taxpayer’s print
media. That is not happening when they buy a product. Taxpayer’s argument is a
misapplication of the rules in § 1.199-3(i)(5). Taxpayer’s products are MPGE outside of
the United States, and the gross receipts from their sale are non-DPGR.


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