In a newly released Chief Counsel Advice, the Internal Revenue Service (IRS) Office of Chief Counsel treated a collaboration arrangement relating to the development and commercialization of a product as a deemed partnership for U.S. federal tax purposes. The IRS Office of Chief Counsel also concluded that if the deemed partnership is treated as producing the product in the United States, the partner may claim the Section 199 domestic production activities deduction with respect to the gross receipts derived by the deemed partnership from the sale of the product based on its allocable share of the partnership items. A Chief Counsel Advice is not precedential with regard to taxpayers other than the subject of the Chief Counsel Advice, but it does give an indication of IRS thinking.
On June 7, 2013, the Internal Revenue Service Office of Chief Counsel (OCC) issued Chief Counsel Advice 201323015, treating an existing collaboration arrangement between two U.S. companies relating to the development and commercialization of a product as a partnership for U.S. federal tax purposes, notwithstanding the fact that the parties had never filed a partnership tax return or otherwise indicated an intent to form a tax partnership. Having concluded that the collaboration arrangement gave rise to a tax partnership, the OCC then concluded that, assuming that the partnership manufactures the product in whole or in substantial part within the United States, one of the partners was eligible to claim the domestic production activities deduction under Section 199 of the Internal Revenue Code of 1986, as amended (the Code), calculated based on its allocable share of the deemed partnership items.
Two U.S. companies (A and B) entered into a written collaboration agreement (the Agreement). The parties charged all costs incurred for development or marketing of the product against the operating profits of the collaboration.
Under the Agreement, the parties agreed to collaborate in the development and commercialization of the product. The Agreement provides for committees that were in charge of the management and finances of the collaboration, as well as the development and commercialization of the product. Each committee comprised representatives appointed in equal numbers by A and B. The parties charged all development costs incurred for development or marketing against the operating profits of the collaboration. Profits and losses from the collaboration are shared by A and B.
A and B separately maintain records that are relevant to costs, expenses, sales and payments. Periodically, A submits its records to B for B to calculate the collaboration’s profits and losses, and B pays A for its allocable share of profits and losses. A initially treated amounts received from B as royalty payments, but subsequently claimed that the amounts received from B qualified as production activity income.
A and B did not file a Form 1065, U.S. Return of Partnership Income, for the collaboration arrangement for any taxable year, nor did A and B file a written election under Section 761(a) to elect out of subchapter K of the Code. The Agreement is silent with respect to the parties’ intended treatment for tax purposes. However, certain side agreements included a provision expressing the parties’ intent not to treat their arrangement as a partnership, agency, employer-employee or joint venture.
The OCC Analysis
The collaboration arrangement is a partnership for U.S. federal tax purposes.
The OCC concluded that the collaboration arrangement between A and B gave rise to a partnership for U.S. federal income tax purposes. In reaching its conclusion, the OCC first reasoned that the arrangement was eligible to be classified as a partnership because (1) it was not a corporation; (2) it had two members; and (3) the two members did not join together merely to share expenses, but instead to make a profit from selling the product. The OCC acknowledged that the parties had not filed Forms 1065 for the collaboration in any of the preceding years and that the side agreements indicated their intent that the collaboration not be treated as a partnership. Nonetheless, the OCC concluded otherwise. In its analysis, the OCC focused on the principles articulated by the Supreme Court of the United States in Commissioner v. Culbertson, 337 U.S. 733 (1949), and by the U.S. Tax Court in Luna v. Commissioner, 42 T.C. 1067 (1964).
The focus under the Culbertson doctrine is whether the parties in good faith and acting with a business purpose intend to join together in the present conduct of a business. The Luna court constructed an eight factor framework for this analysis. Applying this analytical framework to the collaboration, the OCC concluded that the majority of the eight factors supported characterization of the arrangement as a partnership:
First, the parties entered into a written agreement and have consistently complied with its terms.
Second, both parties contributed cash and services to the venture.
Third, the parties shared in the profits and losses of their operation.
Fourth, both parties maintained records of their respective revenues and expenses, and B calculated the collaboration’s profits and losses based on the aggregate amounts.
Fifth, the parties exercised mutual control and assumed mutual responsibilities for the enterprise.
The OCC noted that the parties’ failure to file a partnership return was a factor weighing against the treatment of the collaboration as a partnership. The OCC also recognized that two of the factors considered in Luna—the parties’ control over income and capital and the right of each to make withdrawals, and whether business was conducted in the joint names of the parties—were neutral. Considering the factors together and applying the doctrine articulated by the Culbertson court, the OCC reasoned that the relationship between A and B clearly evinced an intent to join together in the present conduct of an enterprise through the sharing of net profits and losses from the manufacture, development and marketing of the product. Accordingly, the OCC concluded that the collaboration is a partnership for federal tax purposes.
The OCC also concluded that the deemed partnership was not eligible to elect out of application of the partnership rules. The election out rules have limited application and the collaboration arrangement did not meet the requirements.
The partner may claim Section 199 deduction with respect to its allocable share of partnership items.
Characterization of the collaboration as a partnership has collateral consequences to the partners with respect to the deduction for domestic production activities under Section 199. Although A had been treating the amounts paid to it by B as royalty payments, it now claimed that those amounts should be included in its calculation of qualified production activities income (QPAI) for purposes of determining its Section 199 deduction.
The Section 199 deduction for qualified production activities of a partnership is determined at the partner rather than the partnership level. Each partner is allocated its share of partnership items (including items of income, gain, loss, deduction), cost of goods sold allocated to such items and gross receipts that are included in such items of income. Each partner then aggregates its share of these items with those items it incurs outside the partnership so that it may allocate and apportion deductions to its domestic production gross receipts and compute its QPAI.
In the Chief Counsel Advice, the OCC did not reference the rule under Treas. Reg. § 1.199-5(g), providing that the qualified production activities conducted by a partner generally are not attributable to the partnership. The Chief Counsel Advice also did not state what the deemed partnership was deemed to own or what activity the deemed partnership was deemed to undertake. Instead, the OCC assumed without discussion that the deemed partnership produced the product in whole or in significant part within the United States. Based on this assumption, the OCC concluded that A must determine its allocable share of partnership items to calculate its Section 199 deduction.