The U.S. District Court for the Northern District of Illinois recently made its decision in Precision Dose, Inc. v. United States of America, and the ruling could create the potential for significant tax deductions for manufacturers.
Precision Dose purchases medicine in bulk and resells it in nonreusable containers intended for single-dose administration. The court held this activity qualified for the Internal Revenue Code (IRC) Section 199 tax deduction for domestic production.
The government contended the company doesn’t qualify for the Sec. 199 deduction because it only engages in repackaging, which is expressly excluded from the definition of “manufactured, produced, grown, or extracted” (MPGE) in §1.199-2(e)(2). The company claimed its activities don’t fall within the repackaging exception because it’s engaged in MPGE with respect to the prepackaged doses and, therefore, entitled to the §199 domestic manufacturing deduction.
The company conducts market research to determine which drugs are suitable and marketable for unit doses. It develops containers and works with third-party vendors to make single dosage cups and syringes using its own proprietary design. It also performs several processes to ensure the medicine maintains specified quality during the production process.
The court relied on United States v. Dean in its decision; the government argued the Dean case was wrongly decided, but the court disagreed. Dean purchases separate items to create gift baskets and gift towers. The individual items are ordinary grocery items to a consumer, but Dean performs a complex production process that transforms these individual items into a distinct gift product. The court held that Dean and Precision Dose have analogous activities.
The court concluded Precision Dose’s production processes qualify as MPGE. The company produces a unique product by engaging in a complex production process that transforms the form and function of materials used in the production process. The final product—the unit dose—is distinct in form and purpose from the individual items inside. The court allowed the company to take the §199 deduction, resulting in a refund for tax years 2007 and 2008.
The definition of MPGE is left very broad. In a memorandum, the IRS Office of Chief Counsel concluded exclusion from the Section 199 deduction for repackaging and labelling activities didn’t apply to a taxpayer that repackages and labels pills it didn’t manufacture, because the taxpayer engaged in other eligible MPGE activities in its production process to create the packaging. The Dean and Precision Dose rulings are consistent with this broad definition.
The IRS disagrees with these rulings and recently added Example 9 to the proposed §199 regulations (§1.199-3(e)(5)). The agency contends packaging, repackaging, labeling or minor assembly with respect to a production process don’t qualify as MPGE. However, these recent rulings suggest courts may continue to rule against the IRS on this topic and that certain packaging activities may qualify as eligible MPGE activities when a production process combines two or more articles and changes the form and function of an item to create a distinct product.
For more information on how these decisions could affect your organization, contact your BKD advisor.