                                           ADVO, INC.         &    SUBSIDIARIES, PETITIONER v. COMMISSIONER
                                                           OF     INTERNAL REVENUE, RESPONDENT
                                                     Docket No. 17247–10.                     Filed October 24, 2013.

                                                 R disallowed a deduction P claimed under I.R.C. sec. 199 of
                                               $1,515,992 for the 2006 tax year and $151,047 for the short
                                               2007 tax year. R determined that P was not considered to
                                               have manufactured, produced, grown, or extracted qualifying

                                     298




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                                     (298)                 ADVO, INC. & SUBS. v. COMMISSIONER                                     299


                                              production property under I.R.C. sec. 199 with respect to P’s
                                              direct advertising mailings. Held: P did not have the benefits
                                              and burdens of ownership of the direct advertising materials
                                              and is not entitled to the I.R.C. sec. 199 deduction.

                                       Michael P. Walutes, Craig A. Raabe, John R. Shaugnessy,
                                     Jr., Gary D. Yeats, and Scott E. Sebastian, for petitioner. *
                                       Donald K. Rogers, Charles E. Buxbaum, and William T.
                                     Derick, for respondent.
                                        WHERRY, Judge: This case is before the Court on a petition
                                     for redetermination of deficiencies in income tax respondent
                                     determined for petitioner’s 2006 tax year and short 2007 tax
                                     year.
                                        The only issue for decision in this Opinion in this
                                     bifurcated case is whether petitioner is entitled to a section
                                     199 1 deduction for manufactured, produced, grown, or
                                     extracted qualifying production property with respect to peti-
                                     tioner’s direct advertising mailings. 2

                                                                         FINDINGS OF FACT

                                       The parties’ stipulation of facts, with accompanying
                                     exhibits, and the stipulations of settled issues are incor-
                                     porated herein by this reference. At the time petitioner filed
                                     the petition, its principal place of business was in Con-
                                     necticut.
                                       Petitioner, ADVO, Inc. (ADVO), was the common parent of
                                     the consolidated group ADVO, Inc., & Subsidiaries for the
                                     tax years ending September 24, 2005, and September 30,
                                     2006, and for the short taxable year ending March 2, 2007.
                                     On March 3, 2007, ADVO was acquired by Valassis Commu-
                                     nications, Inc., and continues to exist as its wholly owned
                                     subsidiary.

                                        * Brief amici curiae was filed by Mario J. Verdolini and Ethan R. Gold-
                                     man, as attorneys for Limited Brands, Inc., and Judith A. Mather, as at-
                                     torney for Meredith Corp.
                                        1 Unless otherwise indicated, all section references are to the Internal

                                     Revenue Code of 1986 (Code), as amended and in effect for the taxable
                                     years at issue, and all Rule references are to the Tax Court Rule of Prac-
                                     tice and Procedure.
                                        2 There remains a second issue for resolution, in a separate trial, wheth-

                                     er ADVO is entitled to a credit pursuant to sec. 41 for increasing research
                                     activities in connection with the development of internal use software.




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                                     300                 141 UNITED STATES TAX COURT REPORTS                                    (298)


                                       During 2005, 2006, and 2007, ADVO distributed direct
                                     mail advertising in the United States. Direct mail advertisers
                                     such as ADVO distribute advertising material through the
                                     U.S. Postal Service (USPS) to residential recipients, who are
                                     the targeted potential customers for the products and serv-
                                     ices sold by ADVO’s clients, the advertisers. The advertising
                                     material can be either ‘‘solo direct mail’’ or ‘‘cooperative
                                     direct mail’’. For solo direct mail, the printed advertising
                                     material of a single advertiser is delivered in a stand-alone
                                     envelope or as a postcard to a residential recipient. For
                                     cooperative direct mail, also known as a shared mail pack-
                                     age, the printed advertising material for several different
                                     advertisers is consolidated into a single delivery mechanism
                                     (such as an envelope or sleeve) and delivered as a single unit
                                     to residential recipients. This allows ADVO’s clients to share
                                     the advertisements’ costs of mailing and postage to reach the
                                     target consumers’ mailboxes.
                                       ADVO’s clients are typically businesses whose products
                                     and services are used by the general population or specific
                                     subgroups thereof. These businesses include supermarkets,
                                     quick-serve restaurants, drug stores, discount and depart-
                                     ment stores, home furnishing stores, and other retailers.
                                     Print advertising companies, such as newspapers, regional
                                     and local mailers, direct marketing firms, so-called shoppers
                                     and pennysavers, in the same type of business as ADVO,
                                     compete primarily on the ability to effectively target the
                                     delivery of the client’s advertisement to the consumer house-
                                     holds with the highest propensity to purchase the product
                                     being advertised on a cost-effective basis. The companies also
                                     compete on the extent to which they provide coverage, the
                                     reliability of delivery, and most importantly the ability to
                                     provide a satisfactory return on the advertiser’s investment.
                                       Either ADVO’s clients supply the advertising material for
                                     ADVO to distribute (client-supplied material) or ADVO sup-
                                     plies the materials for distribution (ADVO-supplied mate-
                                     rial). When ADVO supplied the advertising material, ADVO
                                     contracted with third-party commercial printers to print it.
                                     The section 199 deductions at issue were attributable to
                                     direct mail advertising involving only the ADVO-supplied
                                     material.
                                       ADVO’s shared mail packages were distributed weekly,
                                     and each included a ‘‘wrap’’ and various ‘‘inserts’’. A detached




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                                     (298)                 ADVO, INC. & SUBS. v. COMMISSIONER                                     301


                                     address label (DAL), also known as a missing child card, was
                                     also associated with each shared mail package. The DAL was
                                     a card with the address of the consumer recipient and a
                                     missing child’s information printed on one side and an
                                     advertisement printed on the other side. During the years at
                                     issue the wrap was a branded turnkey product known as
                                     ‘‘Shopwise’’. The Shopwise wrap was printed on both sides of
                                     a single sheet of paper and folded in half, and then multiple
                                     inserts were loosely inserted into the wrap to form the
                                     shared mail package, all in accordance with specifications
                                     defined by ADVO. An insert was a printed advertising piece
                                     for a single advertiser.
                                        ADVO marketed the Shopwise wrap to potential customers
                                     by selling ‘‘page positions’’ on the wrap, including Billboard,
                                     Inside Page, and Outside Page, as well as multipage options;
                                     each wrap could accommodate advertising for one or more
                                     customers. ADVO sold the Shopwise wrap across hundreds of
                                     wrap zones nationally, and each wrap zone could have a dif-
                                     ferent Shopwise wrap with different advertisers. There were
                                     approximately 580 wrap zones, and each one was composed
                                     of a cluster of ZIP Codes.
                                        ADVO developed and marketed a portfolio of ADVO-sup-
                                     plied inserts, each of which was differentiated by a set of
                                     defined product specifications, which included paper dimen-
                                     sions, paper weight, and bleed availability. An ADVO client
                                     could choose to advertise on both sides of a single page insert
                                     or on an insert consisting of multiple pages. ADVO sold
                                     ADVO-supplied inserts for distribution via both ZIP Codes
                                     and ‘‘ADVO Targeting Zones’’ (ATZ). An ATZ is a cluster of
                                     consumers, located on specific mail delivery routes, averaging
                                     approximately 3,500 households and is smaller than a wrap
                                     zone to allow for finer targeting of marketing materials to
                                     potential consumers. ATZs were proprietary configurations of
                                     households developed by ADVO which took into account
                                     demographic and psychographic information and could target
                                     the potential buying habits of the target consumers. 3 ADVO
                                     had about 133 million mailing addresses in its system.
                                        ADVO classified its ADVO-supplied material as either
                                     ‘‘turnkey’’ or ‘‘custom’’. A turnkey product was a print
                                       3 Psychographics is the study of personality, values, attitudes, interests,

                                     and lifestyles.




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                                     302                 141 UNITED STATES TAX COURT REPORTS                                    (298)


                                     product that was included in ADVO’s portfolio of products
                                     that met specifications defined by ADVO. A lump sum which
                                     included the advertising services, printing, and distribution
                                     was billed to the client for turnkey products. 4 The pricing for
                                     turnkey products was one rate for the entire process: cre-
                                     ating the advertisement, producing the advertisement, deliv-
                                     ering the advertisement, and targeting the desired end con-
                                     sumers. ADVO handled everything from the design of the
                                     advertisement through distribution of the turnkey product,
                                     and specifications were designed to facilitate cost-efficient
                                     assembly and distribution of the shared mail packages. The
                                     DAL, Shopwise wrap, and ADVO-supplied inserts were turn-
                                     key products.
                                       A custom print product was an insert that was not part of
                                     ADVO’s portfolio of turnkey products because of the client’s
                                     specifications for the insert. ADVO billed two separate
                                     charges for custom inserts: one for the printing and one for
                                     the advertising and distribution.
                                       We discuss infra the general process for ADVO’s products.
                                     Much of the trial was dedicated to the minutest details of the
                                     process, and we by no means list every single step. Our
                                     intention is not to discount those important and necessary
                                     steps not mentioned but to give merely a general idea of how
                                     the cooperative mailings were produced.
                                     The Sales Process
                                       During the years at issue ADVO employed around 600
                                     sales executives. The sales force was responsible for selling
                                     advertising space in the shared mail package. ADVO distrib-
                                     uted 60 to 80 million packages every week of the year.
                                     The Design Process
                                        In varying degrees, ADVO’s graphic print department
                                     assisted ADVO’s clients with the design of the advertisement
                                     graphics. The graphic design requirements with respect to
                                     ADVO-supplied materials generally fell into three categories:
                                     ‘‘rough art’’, ‘‘reprint with changes’’, and ‘‘client-supplied art’’.
                                     Rough art made up 45% to 50% of the graphic art work
                                       4 With respect to turnkey products, ADVO’s calculation of ‘‘domestic pro-

                                     duction gross receipts’’ for the purposes of sec. 199 included all receipts de-
                                     rived from ADVO’s lump-sum charge.




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                                     (298)                 ADVO, INC. & SUBS. v. COMMISSIONER                                     303


                                     designed by ADVO and it was anything from a sketch on the
                                     back of a napkin to an advertisement created from a client’s
                                     general concept for a product or service the client wanted to
                                     advertise. Reprint with changes made up 30% to 35% of the
                                     graphic art work designed by ADVO and involved cir-
                                     cumstances where a previously developed graphic design was
                                     reused after ADVO made changes, such as to the coupon
                                     expiration dates or as required for a different holiday pro-
                                     motion. In these two situations, ADVO retained ownership of
                                     all intellectual property associated with the artwork and
                                     advertisement. 5 Client-supplied art made up the final 15% to
                                     20% of the graphic work. When ADVO’s clients supplied the
                                     art, the client retained the ownership of intellectual property
                                     related to that art. Client-supplied art still required ADVO’s
                                     artwork department to analyze and normalize the files in
                                     order to make sure that they were printable. ADVO produced
                                     between 106,000 and 107,000 graphic designs per year.
                                        ADVO employed 40 to 45 graphic print coordinators whose
                                     role was to coordinate among ADVO’s sales organization,
                                     ADVO’s graphics personnel working on a design, and the
                                     third-party printers. The graphic print coordinators under-
                                     stood the graphic art applications used to create graphic
                                     designs, the development of four-color photography as sup-
                                     ported by the CMYK 6 printing, and the printing process
                                     itself, to ensure the best printable product according to the
                                     functional capabilities of the specific printing press. ADVO
                                     employed 50 to 60 desktop artists during the years at issue.
                                     The desktop artists were responsible for actually creating the
                                     advertisements using the graphic design applications on
                                     Macintosh computers. The desktop artists would also ‘‘pre-
                                     flight’’ all of the graphic designs before they were sent to the
                                           5A
                                            sample example of one of ADVO’s invoices to one of its clients states:
                                     ‘‘We retain the copyright to all artwork and other materials that we create
                                     for you.’’ Further, ADVO states on brief that ‘‘[t]he Petitioner’s third-party
                                     printers do not transfer title to the printing plates’’ and that ‘‘Petitioner’s
                                     interest in the graphic design and related PDF–X1a file does not pass to
                                     the Petitioner’s clients’’.
                                        6 The printer usually uses four printing plates, one for each of the three

                                     subtractive primary colors (cyan, magenta, and yellow) and black. For this
                                     reason the process is sometimes referred to as the four-color printing proc-
                                     ess or CMYK printing. We take judicial notice that black is represented
                                     by ‘‘K’’ for key, because often black is the key printing plate, which is used
                                     to position the other colors.




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                                     304                 141 UNITED STATES TAX COURT REPORTS                                    (298)


                                     third-party printer. ADVO’s purpose for the preflight process
                                     was to ensure that the image the desktop artist saw on the
                                     computer screen would accurately print. ADVO also
                                     employed 20 to 25 quality control artists who proofread the
                                     ads and reviewed the graphic design files to make sure that
                                     they met the printing specifications for the job.
                                        After the desktop artist created an advertisement art file
                                     and it was reviewed by the quality control artist, a low-reso-
                                     lution PDF would be uploaded to the ADVO online graphics
                                     gallery for the client to view and approve the
                                     advertisements. 7 ADVO maintained a file of all the informa-
                                     tion for a client’s advertising job in a ‘‘job jacket’’, which
                                     included the order and the art work. After the client
                                     approved the advertisement, it was released to the printer in
                                     an Adobe PDF X1A format. The printing process colors were
                                     already separated in the PDF sent to the printer.
                                     The Paper Supply
                                        As discussed infra the printing machines used a contin-
                                     uous stream of paper which was pulled through the press
                                     from large rolls. ADVO’s paper supply arrangement between
                                     its paper broker and its third-party printers was known in
                                     the paper and printing industries as a ‘‘directed buy’’ agree-
                                     ment. Pursuant to this agreement a broker, A.T. Clayton for
                                     the years at issue, sold paper ADVO prespecified to ADVO’s
                                     third-party printers for use in fulfilling the printers’ con-
                                     tracts with ADVO. The third-party printers ordered and pur-
                                     chased the paper directly from the broker, and the paper was
                                     shipped directly to the printers. ADVO’s advertisements
                                     made it one of the top 20 print paper users in the United
                                     States, consuming approximately 90,000 tons of paper, pur-
                                     chased pursuant to ADVO’s directed buy agreements, each
                                     year. The printers understood that, absent special specific
                                     authorization from ADVO, they were not allowed to use that
                                     paper for any of their clients but ADVO.
                                        ADVO never took physical possession of the raw paper
                                     stock and did not pay for any paper until the print contract
                                     was completed and it received an invoice from the printer.
                                       7 PDF is an acronym for portable document format. It is a computer file

                                     upon which graphics and other data or information can be stored and
                                     transferred.




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                                     (298)                  ADVO, INC. & SUBS. v. COMMISSIONER                                     305


                                     ADVO did not guarantee payment to the broker in the event
                                     a printer defaulted on the purchase contract.
                                     The Printing Process
                                       ADVO spent approximately $125 million per year on its
                                     turnkey printing needs, $50 million of that for paper and $75
                                     million of it for printing services. ADVO contracted with
                                     third-party printers to print the advertising material. For the
                                     years at issue, ADVO entered into printing agreements with
                                     various printers including: Quebecor World (USA), Inc.;
                                     Trend Offset Printing; Handbill Printers; ESP; Shared Mail
                                     Acquisitions, LLC (KAR); Windward Print Star, Inc., d.b.a.
                                     AdplexRhodes (Adplex); Inserts East; and American Color
                                     Graphics, Inc. The contracts each contained similar ‘‘Risk of
                                     Loss’’ sections, an example of which provides that
                                           Title to and risk of loss, damage to, and delay of the manufactured Prod-
                                           ucts shall pass to ADVO upon delivery to ADVO’s branch facility, F.O.B.
                                           ADVO’s dock. All mechanicals, paper, film, plates, etc., not supplied by
                                           ADVO or its clients but used to perform the services hereunder shall
                                           remain the exclusive property of * * * [printer] unless otherwise agreed
                                           in writing.

                                       The third-party printers were required to maintain insur-
                                     ance with respect to all of ADVO’s work in progress and all
                                     materials. Insurance limits did not limit the printer’s liability
                                     to ADVO, and ADVO was not responsible for the deductible.
                                     All of the policies were to extend coverage to ADVO as loss
                                     payee.
                                       The third-party printers that ADVO contracted with to
                                     print the advertising material it created for its clients used
                                     a process known as Web offset lithography. During this
                                     process a continuous stream of paper is pulled through the
                                     press from rolls of paper which can weigh more than one ton
                                     each. The process is known as offset printing because the
                                     printing plates do not actually touch the paper; instead, the
                                     plates transfer ink to rubber blankets (rollers) that, in turn,
                                     transfer the image to the paper.
                                       Upon receipt of the electronic file, the printer preflighted
                                     the file, typically using computer software. After the preflight
                                     process, the printer determined whether the client’s graphic
                                     design could be ‘‘ganged’’ together or combined with the cli-
                                     ent’s other graphic designs. Ganging involves the arrange-




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                                     306                 141 UNITED STATES TAX COURT REPORTS                                    (298)


                                     ment of the advertisements of multiple advertisers for place-
                                     ment on the set of printer plates used with respect to a
                                     single press run. When ganging is feasible, the printer then
                                     typically uses the electronic file in the computer for creation
                                     of the press run printing plates. ADVO prohibited its third-
                                     party printers from ganging jobs for the printer’s other cli-
                                     ents on the same press run used for ADVO’s products.
                                       After the printer verifies that the imposition has been done
                                     correctly, the printer makes the printing plates. The plates
                                     are typically made using a computer-to-plate exposure unit
                                     which uses an infrared laser to expose or impart the image
                                     onto the plate. Once the plates are exposed, the printer then
                                     runs the plate through an automatic processor for develop-
                                     ment and a water-attracting finisher and preservative is
                                     applied. The printer generally makes four printing plates,
                                     one for each of the three primary colors, cyan, magenta, and
                                     yellow, and one for black. Additional ink colors, if any, are
                                     commonly referred to as ‘‘spat colors’’ and may necessitate
                                     another printing plate and/or a fifth inkwell. The printer per-
                                     forms these tasks with little or no direct operational control
                                     from ADVO.
                                       The printer inspects the plates for and corrects any defects.
                                     When no defects are found or none remain, the printer uses
                                     a machine to bend each plate to conform to the plate cylinder
                                     on which it will be clamped. The bending machine uses
                                     anvils to bend the plates into the shape required to fit on the
                                     plate cylinder. The press operator then mounts each plate on
                                     a cylinder in a separate printing unit or tower for each of the
                                     colors and loads the paper onto the press.
                                       The press operator starts the press and makes adjustments
                                     to bring the press up to the proper color. During this process,
                                     the press operator compares print samples with a proof and
                                     adjusts the color using ink keys which control the thickness
                                     of the ink applied to each portion of the plate. The color
                                     information contained in ADVO’s PDF files, received by the
                                     printer, provide instructions to the press that automatically
                                     set the ink keys near where they are needed to bring the
                                     press run initially up to color. Again the printer executes
                                     these manufacturing and/or production steps with little
                                     active direct involvement by ADVO. ADVO creates hundreds
                                     of graphic designs every day and millions of mailers every
                                     week. ADVO’s Pittsburgh facility alone processed between 35




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                                     (298)                 ADVO, INC. & SUBS. v. COMMISSIONER                                     307


                                     and 50 million wraps, inserts, and DALS every week. Each
                                     wrap comprises numerous pages. Given this taxing weekly
                                     production cycle, the number of items involved and the
                                     geographic scope of its activities, ADVO’s close day-to-day
                                     supervision of the massive printing operation is not achieved
                                     or practically feasible.
                                        ADVO required its third-party printers to achieve a
                                     ‘‘pleasing color’’ standard with respect to its turnkey orders,
                                     and it required its clients to accept the standard for their
                                     order. The pleasing color standard required that pictures
                                     look pleasing to the eye, i.e. that food looked appetizing with-
                                     out a green cast and flesh tones look natural, not too red or
                                     yellow, and smooth. If a client was unwilling to accept the
                                     pleasing color standard, it could purchase a custom print
                                     product with a higher ‘‘exacting color’’ standard. The pleasing
                                     color standard facilitated the ganging of ADVO’s products by
                                     minimizing in-line color conflicts.
                                        During the print run, the printer must also check the reg-
                                     istration of the plates. Registration is the alignment of the
                                     printing plates as they apply their respective colors to the
                                     portion of the image being printed; if the plates are not prop-
                                     erly lined up, the image will not be in focus and the color
                                     may be incorrect. Once the press operator was confident that
                                     the color and registration were correct, then the press speed
                                     was increased and the run was completed. Periodically
                                     during the run, the printer would examine samples of the
                                     printed product for quality review. After the press run,
                                     depending on the finishing requirements for the job, the
                                     printer cut and/or folded the individual print product into
                                     shippable packages and then shipped the product to ADVO
                                     designated location(s).
                                     The Package Assembly
                                       ADVO had 17 shared mail processing facilities around the
                                     country where the shared mail packages were assembled.
                                     The facilities ranged in size, depending on the size of the
                                     market served by the facility. A middle-size facility, such as
                                     the one in Pittsburgh, Pennsylvania, comprised about
                                     138,000 square feet and employed around 150 associates and
                                     80 temporary associates, the number of which would fluc-
                                     tuate according to the season and workload. During the years




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                                     at issue ADVO’s processing facilities used large pieces of
                                     Muller Martini manufactured equipment known as Muller
                                     227s and Alphaliners. These were used to group the wraps
                                     and inserts into shared mailed packages. These machines,
                                     with a cost for new Alphaliners exceeding $1,150,000, have
                                     a series of hoppers in which wraps or inserts are placed; then
                                     the machine collates the wraps and inserts into a shared
                                     mail package. Each machine requires a number of people
                                     with each person maintaining inserts for three or four hop-
                                     pers. Optimally the Muller 227 could process about 7,000
                                     packages per hour and the Alphaliner could process about
                                     15,000 packages per hour.
                                       ADVO spent $25 million a year transporting materials to
                                     the USPS. ADVO spent approximately $500 million in post-
                                     age per year during the years at issue. Because ADVO
                                     wanted to achieve the largest possible discount from the
                                     USPS, it limited the amount of handling required by the
                                     USPS in delivering ADVO’s packages. To that end, ADVO
                                     prepared the DALs in the delivery route walk sequence of
                                     each postal carrier, which enabled that postal carrier to
                                     deliver ADVO’s shared mail packages in the sequence of the
                                     residences as they appeared on the carrier’s route. The postal
                                     carrier would have a stack of ADVO’s shared mail packages
                                     and an ordered stack of the DAL cards; at each address he
                                     would pull the DAL card and associate it with a shared mail
                                     package for delivery.
                                     Expert Report—C. Clint Bolte
                                       ADVO engaged C. Clint Bolte to describe the customary
                                     working relationship between print buyers and printers, the
                                     six steps that are generally performed for commercial
                                     printing, and his analyses of the ‘‘benefits and burdens’’ of
                                     ADVO’s printing process. 8 Mr. Bolte has a bachelor of indus-
                                           8 At
                                            trial respondent objected to this report as well as the rebuttal report
                                     also written by Mr. Bolte discussed infra. Respondent argues that the re-
                                     ports do not assist the trier of fact and constitute legal arguments. As
                                     such, they constitute arguments that require the Court to address its gate-
                                     keeper function and determine the proper weight to be accorded to the con-
                                     clusions of the Bolte reports. See generally Barabin v. Asten-Johnson, Inc.,
                                     700 F.3d 428, 431 (9th Cir. 2012); Esgar Corp. v. Commissioner, T.C.
                                     Memo. 2012–35, slip op. at 30–32 (citing Daubert v. Merrell Dow Pharms.,
                                     Inc., 509 U.S. 579, 591, 597 (1993), Fed. R. Evid. 702 and 703, and Kumho




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                                     (298)                  ADVO, INC. & SUBS. v. COMMISSIONER                                     309


                                     trial engineering degree from the Georgia Institute of Tech-
                                     nology and a master of business administration degree from
                                     the Colgate Darden Graduate School of Business Administra-
                                     tion at the University of Virginia. He has been a print
                                     consultant to the printing industry since 1984, working with
                                     commercial printing organizations regarding technology, best
                                     practices of the business, trade customs, and manufacturing
                                     management audits, as well as serving as an expert witness
                                     for commercial printing matters.
                                        Mr. Bolte concluded that
                                           ADVO exercised a comprehensive and unique level of control over the
                                           entire production of their printed direct mail products. As a result of
                                           their comprehensive policies and processes, ADVO exercised an
                                           uncommon level of control even over that portion of the process during
                                           which a third party printer fulfilled its assigned role of printing the
                                           direct mail piece in accordance with ADVO’s detailed specifications.

                                     Expert Report—Raymond J. Prince
                                       Respondent engaged Raymond J. Prince to opine on the
                                     printing practices involved in the production of direct mail
                                     advertising during the years at issue and used by the
                                     printers ADVO contracted with. Mr. Prince has an associate
                                     of applied science degree and a bachelor of science degree in
                                     printing management from the Rochester Institute of Tech-
                                     nology and a master of science degree in printing manage-
                                     ment from South Dakota State University. He has worked in
                                     the printing industry for the past 53 years serving clients in
                                     the public and private sectors.
                                       Mr. Prince’s report gives a statistical overview of the
                                     printing industry, provides a brief summary of the direct
                                     Tire Co. v. Carmichael, 526 U.S. 137, 148, 152 (1949)), appeal filed (10th
                                     Cir. Sept. 6, 2012).
                                         Mr. Bolte’s testimony explained that the report represented his own
                                     ‘‘findings, my opinions concerning the elements, facts of this case relative
                                     to the printing industry norm and relative to ADVO’s production process
                                     from graphic design all the way through.’’ We find his testimony credible
                                     and overrule respondent’s objection.
                                       The Court evaluates expert opinions in the light of each expert’s dem-
                                     onstrated qualifications and all other evidence in the record. See Parker v.
                                     Commissioner, 86 T.C. 547, 561 (1986). We are not bound by an expert’s
                                     opinions and may accept or reject an expert opinion in full or in part in
                                     the exercise of sound judgment. See Helvering v. Nat’l Grocery Co., 304
                                     U.S. 282, 295 (1938); Parker v. Commissioner, 86 T.C. at 561–562.




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                                     310                  141 UNITED STATES TAX COURT REPORTS                                    (298)


                                     mail advertising business, and describes the four phases of
                                     the direct mail advertising business. The report then focuses
                                     on printers, generally including their production, financial,
                                     and operational responsibilities. The report ends with a
                                     listing of ways printers can increase profitability.
                                     Rebuttal Report—C. Clint Bolte
                                       ADVO also engaged Mr. Bolte to write a rebuttal report to
                                     Mr. Prince’s report. Mr. Bolte criticized Mr. Prince’s report
                                     because it failed to recognize ADVO’s niche in the direct
                                     mailer market and ignored the unique traits of ADVO’s busi-
                                     ness model. He emphasized the job-specific and individual-
                                     ized, as compared to the generic, work done by ADVO and
                                     the broader scope of service and production supervision and
                                     control of all aspects of the work. He explained that
                                           [t]he cradle-to-grave nature of ADVO’s highly standardized shared mail
                                           product as compared to the generic ‘‘direct mail circular,’’ as referenced
                                           but not even described by Mr. Prince, was a vitally important point that
                                           is missing in his report. Mr. Prince’s report is of little value to the
                                           Court’s analysis because it ignores the industry reality that a direct
                                           mailer (like ADVO) who supplies the printed product as part of a direct
                                           mail contract MUST successfully deliver the printed product to the mail-
                                           box of the intended recipient or the direct mailer has not supplied the
                                           printed product purchased by its client. * * *

                                     According to Mr. Bolte’s rebuttal report, ADVO’s comprehen-
                                     sive policies and processes allowed it to exercise an
                                     uncommon level of control even over the process during
                                     which a third-party printer fulfilled its assigned role of
                                     printing the direct mail piece in accordance with ADVO’s
                                     detailed specifications.
                                     Rebuttal Report—Raymond J. Prince
                                       Respondent’s expert, Mr. Prince, also prepared a rebuttal
                                     report. He focused on ADVO’s factual claims regarding the
                                     uniqueness of their product and integrated delivery and tar-
                                     geted marketing service. He contrasted ADVO’s product to
                                     that of other print producers and found, in his opinion, few,
                                     if any, truly unique qualities. He concluded that ADVO
                                     interacted with its printers in a manner not dissimilar to
                                     those of many print customers and consumers. In short, Mr.
                                     Prince concluded that the printing was done by the printers
                                     who produced the tangible personal property product, using




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                                     (298)                 ADVO, INC. & SUBS. v. COMMISSIONER                                     311


                                     ADVO or ADVO customer supplied pre-press intangibles, and
                                     not by ADVO.
                                     Brief Amici Curiae of Limited Brands, Inc., and Meredith
                                     Corp.
                                        On October 9, 2012, the Court granted Limited Brands,
                                     Inc., and Meredith Corp.’s motion for leave to file a brief as
                                     amici curiae and filed the brief. In the brief, the amici curiae
                                     express support for the examples set forth in section 1.199–
                                     3(f)(4), Income Tax Regs., discuss the application of the sec-
                                     tion 263A benefits and burdens test, argue for the applica-
                                     tion of Suzy’s Zoo v. Commissioner, 114 T.C. 1 (2000), aff ’d,
                                     273 F.3d 875 (9th Cir. 2001), in this case, and dispute
                                     respondent’s application of the factors set forth in Grodt &
                                     McKay Realty, Inc., v. Commissioner, 77 T.C. 1221 (1981).
                                     Respondent submitted a reply brief to the brief of the amici
                                     curiae, and ADVO submitted a reply brief to respondent’s
                                     reply.
                                                                                 OPINION

                                     I. Introduction to Section 199
                                        Section 199, enacted as part of the American Jobs Creation
                                     Act of 2004 (AJCA), Pub. L. No. 108–357, sec. 102(a), 118
                                     Stat. at 1424, is in effect for tax years beginning after
                                     December 31, 2004. Section 199, commonly referred to as the
                                     ‘‘Domestic Production Deduction’’, allows a taxpayer to
                                     deduct, subject to a limitation based on ‘‘wages paid’’, a speci-
                                     fied percentage of the lesser of either (1) its ‘‘qualified
                                     production activities income’’ or (2) taxable income. Sec.
                                     199(a) and (b). Section 199 was intended to stimulate job cre-
                                     ation in the United States and strengthen the economy. See
                                     Gibson & Assocs., Inc. v. Commissioner, 136 T.C. 195, 223
                                     (2011) (‘‘The name of the AJCA and the statute’s wage
                                     limitation on the amount of the deduction under section
                                     199(a) indicate that Congress intended that section 199
                                     create jobs in the United States and otherwise strengthen
                                     the U.S. economy.’’). The 2005 Blue Book from the Joint
                                     Committee on Taxation explained that ‘‘The Congress was of
                                     the view that a reduced tax burden on domestic manufactur-
                                     ers will improve the cash flow of domestic manufacturers and
                                     make investments in domestic manufacturing facilities more




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                                     312                  141 UNITED STATES TAX COURT REPORTS                                    (298)


                                     attractive. Such investment will assist in the creation and
                                     preservation of U.S. manufacturing jobs.’’ Staff of J. Comm.
                                     on Taxation, General Explanation of Tax Legislation Enacted
                                     in the 108th Congress 170 (J. Comm. Print 2005).
                                        For the years at issue, section 199(a) allows a taxpayer to
                                     deduct an amount equal to 3% of the taxpayer’s qualified
                                     production activities income for the year. 9 The amount of the
                                     deduction cannot exceed 3% of the taxpayer’s taxable income
                                     for the year and is also limited to 50% of the ‘‘W–2 wages of
                                     the taxpayer for the taxable year.’’ Sec. 199(a) and (b). For
                                     the purposes of this section, ‘‘qualified production activities
                                     income’’ means the excess, if any, of the taxpayer’s domestic
                                     production gross receipts (DPGR) over the cost of goods sold
                                     and other expenses properly allocable to such gross receipts.
                                     Sec. 199(c)(1). We discuss the concept of DPGR in more detail
                                     infra.
                                        ADVO contends that its gross receipts attributable to its
                                     printed direct mail advertising and distribution products
                                     qualify as ‘‘domestic production gross receipts’’. Respondent
                                     counters that because ADVO contracted its actual printing
                                     out to third-party printers it did not manufacture any quali-
                                     fying production property. In order for the gross receipts
                                     ADVO received from the sale of its advertising mail packages
                                     to qualify as DPGR, the mail package must be determined to
                                     be qualified production property, manufactured in the United
                                     States by ADVO. Therefore the critical issue in this case is
                                     whether ADVO manufactured the advertising mailing pack-
                                     ages or produced only intangible property used by printers to
                                     produce tangible personal property in the form of the adver-
                                     tising mail packages. 10 The broad issue confronted here is
                                           9 Both
                                               of the years at issue began before the phase-in increased the
                                     amount of the deduction. See sec. 199(a)(2).
                                       10 As an initial matter the Court notes that at a minimum the original

                                     ADVO electronic file for each print job constitutes qualifying production
                                     property as defined in sec. 199(c)(5)(A) or (B) as either computer software
                                     or tangible personal property manufactured and/or produced by ADVO.
                                     Courts have frequently reached conflicting results in their classification of
                                     electronic files, software, etc., as tangible or intangible for sales and use
                                     tax and investment credit purposes. Compare Chittenden Trust Co. v.
                                     King, 465 A.2d 1100 (Vt. 1983), with Bank of Vt. v. United States, 61
                                     A.F.T.R.2d (RIA) 87–788, 88–1 USTC (CCH) para. 9169 (D. Vt. 1988),
                                     Ronnen v. Commissioner, 90 T.C. 74 (1988), and Northwest Corp. Subs. v.
                                     Commissioner, 108 T.C. 358 (1997).




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                                     (298)                 ADVO, INC. & SUBS. v. COMMISSIONER                                     313


                                     how section 199 applies to U.S. corporations that manufac-
                                     ture products through agreements with contract manufac-
                                     tures. That subject is an issue of first impression in this
                                     Court. 11
                                       Respondent is in a real sense a stakeholder in this dispute.
                                     The printed advertising materials were manufactured and
                                     produced by someone in the United States, and that someone
                                     is entitled to the section 199 deduction to the extent they
                                     otherwise meet the requirements of that section. Here the
                                     question is whether ADVO or the contract printer is the
                                     appropriate recipient, as only one of them may claim the
                                     credit as to each item sold. Sec. 199(d)(9); 12 sec. 1.199–
                                        The problem is that ADVO, unlike some printers or publishers, pursuant
                                     to ADVO’s customer and/or printer contracts never sold, leased, rented, li-
                                     censed, exchanged, or otherwise disposed of the prepress electronic file.
                                     ADVO instead elected to retain ownership thereof and used the file as a
                                     tool for the manufacturing and producing of the mailing packages adver-
                                     tising materials. Therefore, the electronic files themselves do not constitute
                                     or generate ‘‘domestic production gross receipts’’ for purpose of determining
                                     a sec. 199(a) deduction.
                                        We also note that the deduction is limited by sec. 199(b) to 50% of the
                                     ‘‘W–2 wages of the taxpayer for the taxable year’’. There is no evidence in
                                     the record that ADVO’s approximately 600 sales executives were employ-
                                     ees whose wages were reported on Forms W–2, Wage and Tax Statement,
                                     or perhaps commission-based sales persons whose compensation was re-
                                     ported on Forms 1099–MISC, Miscellaneous Income. The 40 to 45 graphic
                                     print coordinators, the 50 to 60 desktop artists, the numerous associates
                                     and temporary associates at each of the 17 mail processing facilities, and
                                     the 20 to 25 quality control artists may well have been Form W–2 employ-
                                     ees. Because we do not find infra that they or ADVO actually produced
                                     any QPP, this has no effect on our holding. However, had this case come
                                     out the other way and had it been disputed, ADVO would have borne the
                                     burden of proving that its employees were Form W–2 employees. See sec.
                                     199(b)(2).
                                        11 A somewhat similar problem involving Houdini, Inc., a producer of gift

                                     baskets consisting of food and alcoholic products produced by third parties
                                     and gift baskets and cardboard or Styrofoam void fillers also manufactured
                                     by third parties according to Houdini’s specifications, was recently ad-
                                     dressed in United States v. Dean, 945 F. Supp. 2d 1110 (C.D. Cal. 2013).
                                     We note that opinions of a U.S. District Court do not constitute binding
                                     precedent in this Court. Even so, we see no need to distinguish Dean given
                                     the factually specific nature of the benefits and burdens test discussed
                                     infra.
                                        12 Sec. 199(d) was amended by the Tax Relief and Health Care Act of

                                     2006, Pub. L. No. 109–432, div. A, sec. 401(a), 120 Stat. at 2953, effective
                                                                                                      Continued




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                                     314                 141 UNITED STATES TAX COURT REPORTS                                    (298)


                                     3(f)(1), Income Tax Regs. 13 If ADVO is entitled to the deduc-
                                     tion, a second question arises, namely the amount of
                                     domestic production gross receipts attributable to and
                                     derived from the lease, rental, license, sale, exchange, or
                                     other disposition of qualifying production property as opposed
                                     to income derived for providing services. 14 Of course if
                                     ADVO is entitled to the deduction it may well be a larger
                                     deduction than if the printer is the entitled party.
                                     II. DPGR
                                        Section 199 allows the taxpayer a deduction computed by
                                     multiplying an applicable percentage (3% here) by the lesser
                                     of the taxpayer’s qualified production activities income
                                     (QPAI) resulting from domestic production activities or the
                                     taxpayer’s taxable income. Sec. 199(a). QPAI is computed by
                                     determining the taxpayer’s DPGR and then reducing the
                                     DPGR by the cost of goods sold and other expenses, deduc-
                                     tions, and losses (computed without regard to the section 199

                                     for tax years beginning after December 31, 2005, id. sec 401(b). This
                                     amendment inserted a new sec. 199(d)(8) and redesignated what had pre-
                                     viously been sec. 199(d)(8) as sec. 199(d)(9). Id. sec. 401(a).
                                       13 The sec. 199 regulations apply for taxable years beginning on or after

                                     June 1, 2006. Sec. 1.199–8(i)(1), Income Tax Regs. For taxable years begin-
                                     ning on or before May 17, 2006, taxpayers may apply secs. 1.199–1
                                     through 1.199–8, Income Tax Regs., provided they apply all provisions. Id.
                                     For taxables years beginning in between June 1, 2006, and May 17, 2006,
                                     taxpayers may apply secs. 1.199–1 through 1.199–9, Income Tax Regs. Id.
                                     But a taxpayer whose taxable year began before June 1, 2006, may choose
                                     to rely on Notice 2005–14, 2005–1 C.B. 498, or the proposed regulations.
                                     Id.
                                       14 ADVO claimed a deduction based on the DPGR derived from its direct

                                     mail advertising business. Those receipts included inter alia: payment for
                                     the production of the electronic computer file transmitted to the contract
                                     printer; review and monitoring of the printing, cutting, and folding process;
                                     operation of the shared mail processing facilities including the Muller 227s
                                     and Alphaliners to group the wrap and inserts into shared mail packages;
                                     and the selection of mail recipients using ADVO’s proprietary demographic
                                     wrap zone and ATZ information. Because some elements of this turnkey
                                     product such as sorting, packaging, and mailing may constitute a service
                                     rather than manufacturing or production, an allocation of receipts might
                                     be necessary. However, as we have concluded ADVO did not have DPGR
                                     and is not entitled to a sec. 199 deduction, we need not address this issue
                                     here. See generally H.R. Conf. Rept. No. 108–755, at 259 n.27 (2004), 2004
                                     U.S.C.C.A.N. 1341, 1351.




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                                     (298)                  ADVO, INC. & SUBS. v. COMMISSIONER                                     315


                                     deduction) that are properly allocable to DPGR. Sec.
                                     199(c)(1).
                                       Section 199(c)(4)(A) defines ‘‘domestic production gross
                                     receipts’’ which are subject to certain enumerated exceptions
                                     in section 199(c)(4)(B) as
                                           the gross receipts of the taxpayer which are derived from—
                                               (i) any lease, rental, license, sale, exchange, or disposition of—
                                                  (I) qualifying production property [QPP] which was manufactured,
                                               produced, grown, or extracted [MPGE] by the taxpayer in whole or
                                               in significant part within the United States,
                                                  (II) any qualified film produced by the taxpayer, or
                                                  (III) electricity, natural gas, or potable water produced by the tax-
                                               payer in the United States,
                                               (ii) in the case of a taxpayer engaged in the active conduct of a
                                             construction trade or business, construction of real property performed
                                             in the United States by the taxpayer in the ordinary course of such
                                             trade or business, or
                                               (iii) in the case of a taxpayer engaged in the active conduct of an
                                             engineering or architectural services trade or business, engineering or
                                             architectural services performed in the United States by the taxpayer
                                             in the ordinary course of such trade or business with respect to the
                                             construction of real property in the United States.

                                     DPGR includes gross receipts from QPP that was manufac-
                                     tured, produced, grown, or extracted (MPGE) in the United
                                     States. Sec. 199(c)(4)(A)(i); Longino v. Commissioner, T.C.
                                     Memo. 2013–80, at *63-*64.
                                       In order to determine DPGR the taxpayer may use ‘‘any
                                     reasonable method that is satisfactory to the Secretary based
                                     on all of the facts and circumstances, [to determine] whether
                                     gross receipts qualify as DPGR on an item-by-item basis (and
                                     not, for example, on a division-by-division, product line-by-
                                     product line, or transaction-by-transaction basis).’’ Sec.
                                     1.199–3(d)(1), Income Tax Regs. The regulations also state
                                     that ‘‘[t]he term item means the property offered by the tax-
                                     payer in the normal course of the taxpayer’s business for
                                     lease, rental, license, sale, exchange, or other disposition’’.
                                     Sec. 1.199–3(d)(1)(i), Income Tax Regs. ADVO’s broadly
                                     defined industry is direct mail advertising. ADVO specializes
                                     in coordinating the entire process from the initial design of
                                     the artwork to delivering the printed material to the targeted
                                     consumers. The primary product produced in this industry is
                                     the printed advertisements.




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                                     316                 141 UNITED STATES TAX COURT REPORTS                                    (298)


                                        Section 199(c)(5) defines QPP as tangible personal property,
                                     any computer software, and any property described in section
                                     168(f)(4) (‘‘sound recordings’’). Tangible personal property is
                                     any tangible property other than land, real property, com-
                                     puter software, sound recordings, qualified films, and elec-
                                     tricity, natural gas, or potable water. Sec. 1.199–3(j)(2),
                                     Income Tax Regs.
                                     III. Manufactured
                                       Congress did not define ‘‘manufacture’’ in the Code. How-
                                     ever, it did direct the Secretary to ‘‘prescribe such regulations
                                     as are necessary to carry out the purposes of this section’’.
                                     Sec. 199(d)(9). On December 21, 2005, Congress, as an aspect
                                     of the Gulf Opportunity Zone Act of 2005, Pub. L. No. 109–
                                     135, sec. 403(a)(13), 119 Stat. at 2619, directed the Secretary
                                     to ‘‘includ[e] regulations which prevent more than 1 taxpayer
                                     from being allowed a deduction under this section with
                                     respect to any activity described in subsection (c)(4)(A)(i)’’.
                                       The Secretary in response promulgated section 1.199–
                                     3(e)(1), Income Tax Regs., which defines ‘‘manufactured, pro-
                                     duced, grown, or extracted’’ (MPGE) to include ‘‘manufac-
                                     turing, producing, growing, extracting, installing, developing,
                                     improving, and creating QPP; making QPP out of scrap, sal-
                                     vage, or junk material as well as from new or raw material
                                     by processing, manipulating, refining, or changing the form
                                     of an article, or by combining or assembling two or more arti-
                                     cles’’. The regulation further states that when the taxpayer
                                     contracts with an unrelated third party for the manufac-
                                     turing of its products the taxpayer must have the ‘‘benefits
                                     and burdens of ownership of the QPP under Federal income
                                     tax principles during the period the MPGE activity occurs’’.
                                     Sec. 1.199–3(e)(1), Income Tax Regs. Neither party chal-
                                     lenges the validity of the regulations nor that the benefits
                                     and burdens standard should be applied in this case, and we
                                     note that ‘‘the Commissioner’s regulatory efforts are gen-
                                     erally entitled to the same Chevron standard as those of any
                                     other agency.’’ Carpenter Family Invests., LLC v. Commis-
                                     sioner, 136 T.C. 373, 377 (2011) (citing Mayo Found. for Med.
                                     Educ. & Research v. United States, 562 U.S. ll, 131 S. Ct.
                                     704 (2011)).




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                                     (298)                  ADVO, INC. & SUBS. v. COMMISSIONER                                     317


                                       The initial interim guidance to taxpayers on section 199
                                     released by the Treasury on January 19, 2005, explains that
                                     the benefits and burdens of ownership standard under Fed-
                                     eral income tax principles ‘‘is based on the principles under
                                     § 936 and § 263A’’. Notice 2005–14, sec. 3.04(4), 2005–1 C.B.
                                     498, 505. The final section 199 regulations do not specifically
                                     adopt the Code sections mentioned in the interim guidance
                                     for the benefits and burdens test, nor do they abandon the
                                     standard discussed in the interim guidance. See sec. 1.199–
                                     3(f)(1), Income Tax Regs. The only mention of the definition
                                     of ‘‘taxpayer’’ in the prologue to the final regulations explains
                                     that
                                              [o]ne commentator suggested a simplifying convention to determine
                                           which party to a contract manufacturing arrangement has the benefits
                                           and burdens of ownership under Federal income tax principles. The com-
                                           mentator requested that the final regulations permit unrelated parties
                                           to a contract manufacturing arrangement to designate, through a writ-
                                           ten and signed agreement between the parties, which of them shall be
                                           treated for purposes of section 199 as engaging in MPGE activities con-
                                           ducted pursuant to the arrangement. The final regulations do not adopt
                                           the commentator’s suggestion. The IRS and Treasury Department con-
                                           tinue to believe that the benefits and burdens of ownership must be
                                           determined based on all of the facts and circumstances and a designa-
                                           tion of benefits and burdens would not be appropriate. [T.D. 9263, 2006–
                                           1 C.B. 1063, 1068.]

                                     But cf. infra note 17. This discussion is enlightening because
                                     it highlights the importance of the fact-specific benefits and
                                     burdens test for each individual situation. 15 Also, this
                                        15 The Court recognizes that sec. 199 is not the only Code section that,

                                     with respect to property, contains the phrase ‘‘manufactured, produced,
                                     grown, or extracted’’. Sec. 954(d), which defines the term ‘‘foreign base
                                     company sales income’’ for the purposes of subpt. F inclusions, also con-
                                     tains the phrase, as do, for example, secs. 904(d)(2)(G), 971(e), and
                                     993(c)(1)(A) and (d)(1)(C). The Treasury Department has previously issued
                                     regulations concerning sec. 954, including guidance on the manufacturing,
                                     producing, growing, or extracting language. Sec. 1.954–3(a)(4), Income Tax
                                     Regs. And we have had cause to interpret these and other relevant regula-
                                     tions and statutes over the years. See, e.g., Garnac Grain Co. v. Commis-
                                     sioner, 95 T.C. 7, 21 (1990) (sec. 993(d) and noting sec. 1.993–3(c)(2)(i), In-
                                     come Tax Regs., which addressed contract manufacturing), supplemented
                                     by T.C. Memo. 1991–363; Webb Export Corp. v. Commissioner, 91 T.C. 131,
                                     138 (1988) (sec. 993(c)); Dave Fischbein Mfg. Co. v. Commissioner, 59 T.C.
                                     338, 354 (1972) (sec. 954(d)); Bausch & Lomb Inc. v. Commissioner, T.C.
                                                                                                       Continued




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                                     318                 141 UNITED STATES TAX COURT REPORTS                                    (298)


                                     discussion explicitly states that the IRS and the Treasury
                                     Department ‘‘continue to believe’’ in the benefits and burdens
                                     standard, implying that the original connection of the test to
                                     section 936 and 263A is still relevant.
                                       The predecessor to section 936 was enacted to ease the
                                     burden of double taxation American companies faced when
                                     operating in U.S. possessions and to encourage American
                                     business to invest in the U.S. possessions. See Medchem
                                     (P.R.), Inc. v. Commissioner, 116 T.C. 308, 333 (2001), aff ’d,
                                     295 F.3d 118 (1st Cir. 2002). Section 936 allows a credit
                                     against Federal income taxes. It requires that the American
                                     company be in an ‘‘active conduct of a trade or business
                                     within a possession’’ in order to avail itself of the tax credit.
                                     Sec. 936(a)(1)(A)(i). While the test for an active conduct of a
                                     trade or business, including situations underlying a manufac-
                                     turing contract, is different from the benefits and burdens
                                     test, it has similar relevant factors: ‘‘[A] taxpayer actively
                                     conducts a trade or business in a U.S. possession only if it
                                     participates regularly, continually, extensively, and actively
                                     in the management and operation of its profit-motivated

                                     Memo. 1996–57 (sec. 954(d)). On the contract manufacturing issue, those
                                     regulations reach a different result from that reached with respect to the
                                     sec. 199 regulations although the statutory language is the same or simi-
                                     lar.
                                        In explanation of this apparent contradiction, when Treasury issued the
                                     sec. 199 regulations, the preamble specifically stated: ‘‘[C]ase law and
                                     other precedent under section 954 are not relevant for purposes of the sub-
                                     stantial-in-nature requirement under section 199. Nor are they relevant
                                     for purposes of determining whether an activity is an MPGE activity under
                                     section 199.’’ T.D. 9263, 2006–1 C.B. 1063, 1069. By adopting these regula-
                                     tions, Treasury clearly intended a different interpretation of these terms.
                                        Further, in sec. 199, Congress specifically tasked the Secretary with pro-
                                     mulgating regulations, which before Mayo Found. for Med. Educ. & Re-
                                     search v. United States, 562 U.S.ll, 131 S. Ct. 704 (2011), would have
                                     been classified by tax specialists as legislative regulations, that ‘‘prevent
                                     more than 1 taxpayer from being allowed a deduction under * * * [sec.
                                     199]’’. Sec. 199(d)(9). This same concern does not seem to be present in sec.
                                     954, nor did Congress give the Secretary a similar instruction. In addition,
                                     Congress specifically intended to exclude from sec. 954 ‘‘cases where any
                                     significant amount of manufacturing, major assembling, or construction ac-
                                     tivity is carried on with respect to the product by the selling corporation.’’
                                     S. Rept. No. 87–1881, at 84 (1962), 1962–3 C.B. 703, 790. Again, no similar
                                     concern appears to have existed with respect to sec. 199.




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                                     (298)                 ADVO, INC. & SUBS. v. COMMISSIONER                                     319


                                     activity in that possession.’’ Medchem (P.R.), Inc. v. Commis-
                                     sioner, 116 T.C. at 336–337.
                                       Section 263A requires the capitalization of expenses in
                                     relation to the production of tangible property. In general, a
                                     taxpayer is not considered to be producing the tangible prop-
                                     erty unless it is an owner of the property. Sec. 1.263A–
                                     2(a)(1)(ii), Income Tax Regs. The section 263A regulations
                                     define the owner ‘‘based on all of the facts and cir-
                                     cumstances, including the various benefits and burdens of
                                     ownership vested with the taxpayer’’. A taxpayer may be
                                     considered an owner of property produced, even though the
                                     taxpayer does not have legal title to the property. Sec.
                                     1.263A–2(a)(1)(ii)(A) and (B)(1), Income Tax Regs. As the
                                     Court of Appeals for the Ninth Circuit noted: ‘‘In addition,
                                     § 263A(g)(2) provides that ‘[t]he taxpayer shall be treated as
                                     producing any property produced for the taxpayer under a
                                     contract with the taxpayer’ ’’. Suzy’s Zoo v. Commissioner,
                                     273 F.3d at 878. But this is not necessarily so under section
                                     199.
                                       Note the similarity of the section 263A regulation dis-
                                     cussed above to section 1.199–3(f)(1), Income Tax Regs., in
                                     which the section 199 test asks whether the taxpayer ‘‘has
                                     the benefits and burdens of ownership.’’ However, as the
                                     amici curiae point out, the section 263A owner test is
                                     arguably broader that the section 199 benefits and burdens
                                     test because the section 263A test asks whether the taxpayer
                                     is an owner of the property, while the section 199 test
                                     requires a finding that the taxpayer is the owner of the prop-
                                     erty and has ‘‘the benefits and burdens of ownership * * *
                                     during the period of the MPGE activity’’. Secs. 1.263A–
                                     2(a)(1)(ii)(A), 1.199–3(e)(1), (f)(1), Income Tax Regs. Although
                                     this may seem like a distinction without a difference for rea-
                                     sons discussed infra, it stands to reason that there may be
                                     more than one owner of section 263A property (and more
                                     than one taxpayer may have the benefits and burdens of
                                     ownership), while only one taxpayer may have the benefits
                                     and burdens of ownership under section 199. 16
                                       16 As    discussed above, the policy motivating the enactment of sec. 199
                                     was to     encourage domestic manufacturing and create jobs in the United
                                     States.    Sec. 263A was enacted as part of the Tax Reform Act of 1986, Pub.
                                     L. No.     99–514, sec. 803(a), 100 Stat. at 2350, to address what was per-
                                                                                                      Continued




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                                     320                  141 UNITED STATES TAX COURT REPORTS                                    (298)


                                           A. Benefits and Burdens
                                        The intent of section 199 was to encourage domestic manu-
                                     facturing, and it was intended that only one taxpayer may
                                     claim the deduction for the product manufactured. In the
                                     event, as is the case here, where one taxpayer pursuant to
                                     a contract performs a qualifying production activity with
                                     another taxpayer, ‘‘then only the taxpayer that has the bene-
                                     fits and burdens of ownership of the QPP * * * under Fed-
                                     eral income tax principles during the period in which the
                                     qualifying activity occurs is treated as engaging in the quali-
                                     fying activity.’’ 17 Sec. 1.199–3(f)(1), Income Tax Regs.
                                     ceived as two significant problems concerning the expense/capital expendi-
                                     ture boundary:
                                           First, the existing rules may allow costs that are in reality costs of pro-
                                           ducing, acquiring, or carrying property to be deducted currently, rather
                                           than capitalized into the basis of the property and recovered when the
                                           property is sold or as it is used by the taxpayer. This produces a
                                           mismatching of expenses and the related income and an unwarranted
                                           deferral of taxes. Second, different capitalization rules may apply under
                                           present law depending on the nature of the property and its intended
                                           use. These differences may create distortions in the allocation of eco-
                                           nomic resources and the manner in which certain economic activity is or-
                                           ganized. * * * [I]n order to more accurately reflect income and make the
                                           income tax system more neutral, a single, comprehensive set of rules
                                           should govern the capitalization of costs of producing, acquiring, and
                                           holding property * * *. [S. Rept. No. 99–313, at 140 (1986), 1986–3 C.B.
                                           (Vol. 3) 1, 140.]

                                     See also Robinson Knife Mfg. Co. v. Commissioner, 600 F.3d 121, 126–127
                                     (2d Cir. 2010), rev’g T.C. Memo. 2009–9. Therefore, Congress necessarily
                                     intended sec. 263A to have a broad sweep in order to capture the costs of
                                     producing, acquiring, and carrying of property, and courts, including this
                                     one, have interpreted this section broadly. See Suzy’s Zoo v. Commissioner,
                                     273 F.3d 871, 879 (9th Cir. 2001), aff ’g 114 T.C. 1 (2000); Reichel v. Com-
                                     missioner, 112 T.C. 14, 18 (1999) (real estate taxes had to be capitalized
                                     under sec. 263A as indirect costs of ‘‘producing’’ property even though
                                     property was not developed); Von-Lusk v. Commissioner, 104 T.C. 207, 215
                                     (1995) (costs of meeting with government officials, obtaining building per-
                                     mits, and drafting architectural plans were development costs amounting
                                     to ‘‘production’’ under sec. 263A); Carpenter v. Commissioner, T.C. Memo.
                                     1994–289 (construction costs incurred by building contractor for an unsold
                                     home had to be capitalized under sec. 263A because the home was ‘‘pro-
                                     duced’’ by the contractor).
                                       17 The Commissioner now recognizes that in contract manufacturing re-

                                     lationships, each party, as in this case, will often have some of the benefits
                                     and burdens of ownership. Consequently the Commissioner, the taxpayer,




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                                     (298)                  ADVO, INC. & SUBS. v. COMMISSIONER                                     321


                                       ADVO directs the Court’s attention to Suzy’s Zoo v.
                                     Commissioner, 114 T.C. 1, a case whose facts seem, at first
                                     glance, to be very close to the case at hand. In that case this
                                     Court held that a corporation, which developed cartoon char-
                                     acters for its line of paper products and then contracted with
                                     independent printing companies, was the ‘‘owner’’ of the
                                     paper products through production and until they were sold
                                     for the purposes of section 263A. Id. at 8. The printers in
                                     Suzy’s Zoo would receive original drawings, photograph the
                                     drawings, create proofs, and then use their own ink and
                                     paper to print the products. Id. at 3.
                                       Respondent argues that Suzy’s Zoo, involving a section
                                     263A dispute, is not determinative of the section 199 issue
                                     here. On November 4, 2005, the Treasury Department issued
                                     proposed rules that included a preamble stating:
                                             While sections 199, 263A, and 936 all have benefits and burdens
                                           standards, the standard under section 199 is not the same as those
                                           under sections 263A and 936. * * * The determination of whether a tax-
                                           payer is considered the owner is based on all of the facts and cir-
                                           cumstances, including the various benefits and burdens of ownership
                                           vested with the taxpayer. Because the standard under the section 263A
                                           regulation is broad, it has been interpreted to allow two taxpayers to be
                                           considered the producer of the same property. Compare, for example
                                           Suzy’s Zoo v. Comm’r, 114 T.C. 1 (2000), aff ’d 273 F.3d 875 (9th Cir.
                                           2001) and Golden Gate Litho v. Comm’r, T.C. Memo (1998–184). [Notice
                                           of Proposed Rulemaking and Notice of Public Hearing, 70 Fed. Reg.
                                           67220, 67228 (Nov. 4, 2005).]

                                     and ultimately the courts may expend significant resources to determine
                                     which party may claim the deduction. I.R.S. LB&I Directive, LB&I–04–
                                     0713–006 (July 24, 2013). In recognition of the cost of such determinations,
                                     the Acting Commissioner of the IRS’ Large Business and International Di-
                                     vision has instructed his examiners not to challenge a taxpayer’s claim to
                                     have the benefits and burdens for a sec. 199 deduction if that taxpayer
                                     provides a certification executed by both parties designating the party who
                                     is to receive the sec. 199 deduction. An acceptable form of certification is
                                     included as an exhibit to the guidance. That form included a counterpart:
                                     written certification that it did not claim the deduction for any taxable
                                     year governed by the contract. Id. While expressly stating that the guid-
                                     ance provided ‘‘is not an official pronouncement of law, and cannot be used,
                                     cited, or relied on as such’’, id., the Commissioner’s policy, as long as it
                                     remains in effect, can resolve in advance cases like this one. It also high-
                                     lights the factually intensive nature of the inquiry of determining to whom
                                     the benefits and burdens of ownership belong when both parties to a con-
                                     tract manufacturing relationship may potentially claim the sec. 199 deduc-
                                     tion.




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                                     322                 141 UNITED STATES TAX COURT REPORTS                                    (298)


                                        We are aware that the Court has previously been
                                     unpersuaded by a preamble to regulations. See Allen v.
                                     Commissioner, 118 T.C. 1, 17 n.12 (2002) ( ‘‘In addition to the
                                     obvious fact that these documents also are not items of legis-
                                     lative history, these documents are afforded little weight in
                                     this Court.’’ (citing Dobin v. Commissioner, 73 T.C. 1121,
                                     1127 n.9 (1980) (‘‘Suffice it to say that we never have under-
                                     stood the preamble to proposed regulations to be preceden-
                                     tial.’’))). We are not bound by the preamble, but because it is
                                     an agency’s interpretation of its statute, we apply the
                                     standard enunciated by the Supreme Court in Skidmore v.
                                     Swift & Co., 323 U.S. 134, 140 (1944). 18 Therefore,
                                     respondent is entitled to at least the lowest level of deference
                                     in interpreting his own regulations and their statutes. See
                                     United States v. Mead Corp., 533 U.S. 218, 221 (2001).
                                        We noted supra that section 263A is an inclusive section
                                     and more than one taxpayer can be the owner of the prop-
                                     erty. Section 199 is a section that allows a deduction. Deduc-
                                     tions and credits are a matter of legislative grace, and tax-
                                     payers must prove entitlement to the deductions and credits
                                     claimed. Rule 142(a); INDOPCO, Inc. v. Commissioner, 503
                                     U.S. 79, 84 (1992); LaPoint v. Commissioner, 94 T.C. 733,
                                        18 In United States v. Mead Corp., 533 U.S. 218, 221 (2001), the Supreme

                                     Court recognized that there are various types of agency pronouncements
                                     that may be entitled to different levels of deference and that the lowest
                                     level of deference, Skidmore deference, has continuing vitality. See id. at
                                     234 (‘‘Chevron did nothing to eliminate Skidmore’s holding that an agen-
                                     cy’s interpretation may merit some deference whatever its form, given the
                                     ‘specialized experience and broader investigations and information’ avail-
                                     able to the agency’’ (quoting Skidmore v. Swift & Co., 323 U.S. 134, 139
                                     (1944))); see also Taproot Admin. Servs., Inc. v. Commissioner, 133 T.C.
                                     202, 208 n.15 (2009), aff ’d, 679 F.3d 1109 (9th Cir. 2012). The Supreme
                                     Court has established a two-prong test for determining whether to afford
                                     an agency pronouncement Chevron deference. Mead Corp., 533 U.S. at
                                     226–227 (‘‘We hold that administrative implementation of a particular
                                     statutory provision qualifies for Chevron deference when it appears that
                                     Congress delegated authority to the agency generally to make rules car-
                                     rying the force of law, and that the agency interpretation claiming def-
                                     erence was promulgated in the exercise of that authority.’’); see also
                                     Marmolejo-Campos v. Holder, 558 F.3d 903, 908 (9th Cir. 2009); PSB Hold-
                                     ings, Inc. v. Commissioner, 129 T.C. 131, 142 (2007) (Commissioner’s inter-
                                     pretation of a statute in a revenue ruling is entitled to some deference, i.e.,
                                     ‘‘consideration by this Court’’); William J. Wilkins, ‘‘Implications of Home
                                     Concrete’’, 31 ABA Sec. of Tax’n News Q. 25 (Summer 2012).




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                                     (298)                  ADVO, INC. & SUBS. v. COMMISSIONER                                     323


                                     736–737 (1990). Under section 199 the alleged manufacturer
                                     must establish that it is the only taxpayer who may be deter-
                                     mined to be the owner of the property with the benefits and
                                     burdens of ownership. Consequently we find that, although
                                     the factors used to determine ownership under section 263A
                                     are helpful in determining ownership under section 199, we
                                     are not bound in applying section 199 by the holding in
                                     Suzy’s Zoo. 19 We agree with respondent that Congress did
                                     not intend for section 199 to be broadly inclusive in deter-
                                     mining the owner of property. 20
                                       19 In Suzy’s Zoo v. Commissioner, 114 T.C. at 9–10, we noted that unlike

                                     the test in sec. 199 the test in sec. 263A does not focus specifically on who
                                     bore the benefits and burdens of ownership when the item was manufac-
                                     tured and/or produced. Instead the Court stated:
                                              Petitioner focuses on the fact that the printers bear the risk of loss
                                           during the printing process. We do not find this fact dispositive as to
                                           who owns (and thus produces) the paper products. The identification of
                                           the owner of property for purposes of the UNICAP rules does not nec-
                                           essarily rest on who bears the risk of loss when the product is fabricated
                                           or assembled, or, for that matter, on who actually turns the screws or
                                           hammers the nails into the product. The owner of property must be iden-
                                           tified from the facts and circumstances of the case, see sec. 1.263A–
                                           2(a)(1)(ii), Income Tax Regs., and who bears the risk of loss is merely
                                           one factor to consider. * * *
                                        For whatever reason Treasury created two distinctly different tests for
                                     sec. 263A purposes and sec. 199 purposes. While this is complicating and
                                     not totally consistent with legislative history and Treasury’s interim guid-
                                     ance, which as previously noted, provides that sec. 199 ‘‘is based on the
                                     principals of §936 and §263A’’, we do not conclude it is invalid. As alluded
                                     to supra, neither party challenges the regulations and in the light of Mayo
                                     Found., 562 U.S. ll, 131 S. Ct. 704, we agree.
                                        20 The amici curiae note at 23 of their brief that the Court found as a

                                     factual matter in Suzy’s Zoo v. Commissioner, 114 T.C. at 8, that the tax-
                                     payer was the ‘‘only ‘owner’ ’’ of the greeting cards under sec. 263A. Al-
                                     though the sec. 263A test and the sec. 199 test are very similar, each test
                                     is very fact specific and the result in one case is not necessarily dispositive
                                     in another similar but factually different case. The amici contend that ‘‘the
                                     party that engages the printer and the printer can [both] be ‘producers’ ’’
                                     but that this does not mean there can be two owners. The Court of Appeals
                                     for the Ninth Circuit, in affirming Suzy’s Zoo, explained: ‘‘Although the
                                     printers use their own supply of paper in producing the greeting cards and
                                     [during the printing, manufacture, and production] bear the risk of loss
                                     until shipment [of the printed product], Suzy’s Zoo is the owner of the
                                     cards from the beginning stage of production due to the degree of control
                                     it exercises over the manufacturing process. Therefore, Suzy’s Zoo is a ‘pro-
                                                                                                       Continued




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                                     324                 141 UNITED STATES TAX COURT REPORTS                                    (298)


                                           B. Benefits and Burdens Test for Section 199
                                        The examples in the section 199 regulations shed some
                                     light on the factors that the IRS and Treasury find relevant
                                     in determining which taxpayer had the benefits and burdens
                                     of ownership during manufacture and/or production. Of par-
                                     ticular interest to this case is Example (1) of section 1.199–
                                     3(f)(4), Income Tax Regs. In this example X designs machines
                                     and contracts with Y, an unrelated person, to manufacture
                                     the machines. X owns the intellectual property attributable
                                     to the design, and Y is allowed to use that property only to
                                     manufacture X’s machines. Y has no right to independently
                                     exploit the intellectual property. Y controls the details of the
                                     manufacturing process, bears the risk of loss or damage
                                     during manufacturing, has legal title to the machines during
                                     manufacturing, and enjoys the economic gain or bears the
                                     loss from the sale of the machines measured by the dif-
                                     ference between Y’s costs and the fixed contract price. On
                                     these facts, Example (1) explains that Y had the benefits and
                                     burdens of ownership during production.
                                        Caselaw has also developed factors for the benefits and
                                     burdens of ownership test with respect to other sections of
                                     the Code. The parties each cite and discuss the factors of
                                     Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. at
                                     1221, and we find these factors plus the section 936 test are
                                     useful in determining whether ADVO had the benefits and
                                     burdens of the printed advertisements while they were being
                                     printed.
                                        The factors we use to determine the benefits and burdens
                                     of ownership under section 199 for the purposes of this case
                                     are: (1) whether legal title passes; (2) how the parties treat
                                     the transaction; (3) whether an equity interest was acquired;
                                     (4) whether the contract creates a present obligation on the
                                     seller to execute and deliver a deed and a present obligation
                                     on the purchaser to make payments; (5) whether the right of
                                     possession is vested in the purchaser and which party has
                                     control of the property or process; (6) which party pays the
                                     property taxes; (7) which party bears the risk of loss or dam-

                                     ducer’ under § 263A.’’ Suzy’s Zoo v. Commissioner, 273 F.3d at 880 (em-
                                     phasis added). In this case we have concluded as a factual matter that the
                                     degree of manufacturing control was not equivalent to that in Suzy’s Zoo
                                     and that ADVO was not the only owner.




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                                     (298)                 ADVO, INC. & SUBS. v. COMMISSIONER                                     325


                                     age to the property; (8) which party receives the profits from
                                     the operation and sale of the property; and (9) whether
                                     ADVO actively and extensively participated in the manage-
                                     ment and operations of the activity. Id.; see also sec. 936;
                                     Hutchinson v. Commissioner, 116 T.C. 172 (2001). 21
                                       As discussed supra, both the prologue to the proposed
                                     regulations and the prologue to the final regulations explain
                                     that the benefits and burdens during manufacture and/or
                                     production standard is based on all of the facts and cir-
                                     cumstances of each particular case. We agree and also note
                                     that no one factor is determinative.

                                           C. Application of the Benefits and Burdens Test
                                           1. Legal Title
                                        According to Commissioner v. Segall, 114 F.2d 706, 709
                                     (6th Cir. 1940), rev’g and remanding 38 B.T.A. 43 (1938),
                                     ‘‘Passage of title is perhaps the most conclusive cir-
                                     cumstance’’ in determining the owner of the property for Fed-
                                        21 These are not the only factors that may be considered in the benefits

                                     and burdens test, which is fact intensive. For examples of other factors
                                     that the IRS has indicated may be relevant in determining which party
                                     had the benefits and burdens of ownership, see the ‘‘Guidance for Exam-
                                     iners on I.R.C. § 199 Benefits and Burdens of Ownership Analysis in Con-
                                     tract Manufacturing Arrangements’’ released on February 1, 2012, by the
                                     Large Business and International Division. I.R.S. LB&I Directive, LB&I–
                                     4-0112–001 (Feb. 1, 2012). Many of the factors focused on by the guidance
                                     are addressed in this Opinion. We mention these factors not to suggest
                                     that this guidance is persuasive or controlling, but rather to illustrate how
                                     the factors we use are not exclusive. In this particular case, they are suffi-
                                     cient for us to determine the benefits and burdens of ownership.
                                        The guidance focuses on three areas. It first looks to the terms of the
                                     contract: (1) did the taxpayer have title to the work in process; (2) did the
                                     taxpayer have risk of loss over the work in process; and (3) was the tax-
                                     payer primarily responsible for insuring the work in process? Then it looks
                                     to the production activities: (1) did the taxpayer develop the qualifying ac-
                                     tivity process; (2) did the taxpayer exercise oversight and direction over
                                     the employees engaged in the qualifying activity; (3) did the taxpayer con-
                                     duct more than 50% of the quality control tests while the qualifying activ-
                                     ity was occurring? And finally, the guidance looks to the economic risks:
                                     (1) was the taxpayer primarily liable under the ‘‘make-good’’ provisions of
                                     the contract; (2) did the taxpayer provide more than 50%, based on cost,
                                     of the raw materials and components used to produce the property; (3) did
                                     the taxpayer have the greater opportunity for profit increase or decrease
                                     from production efficiencies and fluctuations in the cost of labor and fac-
                                     tory overhead?




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                                     326                 141 UNITED STATES TAX COURT REPORTS                                    (298)


                                     eral taxation purposes. See also Harmston v. Commissioner,
                                     61 T.C. 216, 228 (1973) (‘‘passage of title * * * in deciding
                                     when ‘ownership’ has passed * * * is certainly an important
                                     consideration’’), aff ’d, 528 F.2d 55 (9th Cir. 1976). We also
                                     note that Example (1) discusses and concludes that Y, the
                                     party which had the benefits and burdens, had legal title to
                                     the property while it was in production. Sec. 1.199–3(f)(4),
                                     Income Tax Regs. While we recognize that title to the intan-
                                     gible property (i.e. the actual design of the art as transmitted
                                     on the PDF file) never transferred to the printers or to
                                     ADVO’s clients, ADVO’s printing agreements with its con-
                                     tract printers clearly state that ‘‘Title to and risk of loss’’ of
                                     the product (i.e. the printed material) does not transfer to
                                     ADVO until the products have left the printers’ facilities.
                                     This factor weighs in favor of respondent.
                                           2. Intention of the Parties
                                       We are less concerned with the label that the parties give
                                     the transaction; we look to what the parties actually
                                     intended to happen. Oesterreich v. Commissioner, 226 F.2d
                                     798, 801–802 (9th Cir. 1955).
                                       ADVO asserts that the parties’ intention is demonstrated
                                     by the section of the printing agreement entitled ‘‘Governing
                                     Law’’, which in relevant part states: ‘‘The parties hereto
                                     agree that, although this Agreement is for printing services
                                     and not ‘‘goods’’, the Uniform Commercial Code * * * shall
                                     be applicable’’. ADVO believes that this term establishes that
                                     the parties believed that they were contracting with the
                                     third-party printers for services, not for the manufacturing of
                                     a product. Respondent contends that the contracts explicitly
                                     state that ‘‘ADVO will pay * * * [printer] for its manufac-
                                     turing services’’ which shows that the parties intended that
                                     the printers were the manufacturers.
                                       At trial Thomas McCloskey, the chief executive officer and
                                     one of the principal owners of Doodad, one of ADVO’s con-
                                     tract printers, testified that Doodad claimed a deduction
                                     under section 199 for the income attributable to producing
                                     ADVO’s advertising material. Implicitly, this printer obvi-
                                     ously intended that it qualify as the manufacturer of the
                                     advertising material for purposes of claiming the section 199
                                     deduction.




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                                     (298)                 ADVO, INC. & SUBS. v. COMMISSIONER                                     327


                                       The parties contemplated and agreed that the third-party
                                     printers would print the specific advertising material that
                                     ADVO required and then send the printed material to
                                     ADVO. It was always their intent that the printers produce
                                     the actual tangible paper materials using the ADVO intan-
                                     gible pre-press materials. Therefore we find this factor
                                     weighs in favor of respondent.
                                           3 & 4. Equity Interest and Present Obligation
                                       While these factors were relevant in Grodt & McKay in
                                     determining whether the transactions were bona fide sales
                                     and they may prove relevant in future section 199 benefits
                                     and burdens tests, they are not significantly relevant to
                                     determining whether ADVO had the benefits and burdens of
                                     ownership while the advertising material were printed by the
                                     third-party printers. Thus, this factor is neutral.
                                           5. Right of Possession and Control
                                        In determining whether ADVO had the benefits and bur-
                                     dens of ownership of the advertising material during the
                                     printing process, ‘‘[t]ransfer of possession is also significant.’’
                                     Commissioner v. Segall, 114 F.2d at 709. The third-party
                                     printers necessarily had the right of possession during the
                                     printing process. It was the printers who produced the hard
                                     copies of the advertising material, and ADVO did not have
                                     the right of possession until the printed material was deliv-
                                     ered to it.
                                        However, because we are tailoring the factors from Grodt
                                     into the context of section 199, the analysis cannot merely
                                     end with the party that has the right of possession. The par-
                                     ties spent an extensive amount of time discussing each step
                                     of the printing process, with each trying to prove whether
                                     ADVO or the third-party printers were in control of the
                                     process. See sec. 1.199–3(f)(4), Example (1), Income Tax Regs.
                                        ADVO contends that it was ultimately in control of the
                                     printing process. ADVO asserts that its PDF documents
                                     essentially set the color keys for the printer; that their paper
                                     contracts determined which paper the printers were allowed
                                     to use; and that the printing agreements specify exactly
                                     which machines the printers where allowed to use, that the
                                     printers could not gang other parties’ work with theirs, and
                                     at which locations they were allowed to print ADVO’s mate-




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                                     rials. 22 On the other hand, the third-party printers owned or
                                     leased and operated the machinery, sometimes purchasing it
                                     at the behest of ADVO, but it was always the printers’ prop-
                                     erty. The third-party printers and their employees set up the
                                     machines, loaded the paper, fine-tuned the color keys, ran
                                     the printing process, supervised the quality, and then deliv-
                                     ered the advertising materials to ADVO.
                                        Respondent contends in the interim guidance that a tax-
                                     payer who is contracting the printing services out to a third
                                     party must have the benefits and burdens of ownership to
                                     qualify for the section 199 deduction and that this test
                                     ‘‘applies even if the customer exercises direct supervision and
                                     control over the activities of the contractor’’. Notice 2005–14,
                                     sec. 3.04(4). We do not find that, in practice, ADVO exercised
                                     day-to-day control over the activities of the printer. This
                                     factor weighs in favor of respondent.
                                           6. Property Taxes
                                        There is no evidence in the record that ADVO or anyone
                                     else paid property taxes on any of the pre-press PDF files or
                                     the printed property during the manufacturing process. We
                                     find that this factor is neutral.
                                           7. Risk of Loss or Damage
                                       Along with the benefits of ownership must go the burdens.
                                     Harmston v. Commissioner, 61 T.C. at 230. In the instant
                                     case, this factor requires us to determine which party bore
                                     the risk of loss or damage to the advertising material during
                                       22 On March 29, 2013, the Office of Chief Counsel released a memo-

                                     randum in which it addressed a fact pattern similar to the one at issue
                                     in this case. See C.C.A. 201313020 (Mar. 29, 2013). In the memo the tax-
                                     payer published books using third-party printers. Although such a memo-
                                     randum reflects only the opinion of one of the parties and is in no way con-
                                     trolling on this Court, we find the agency’s interpretation of its own regu-
                                     lations enlightening. Specifically the memo states:
                                            Our Office believes that print specification activities are non-MPGE
                                            activities. While providing the print specifications to the contract man-
                                            ufacturer gives the contract manufacturer a detailed description of
                                            how the Taxpayer desires the mass-produced books to look (e.g., size,
                                            color, print type, etc.), the print specifications do not produce QPP.

                                     Although the memo did not address the benefits and burdens test, we have
                                     concluded independently for the reasons discussed above that print speci-
                                     fications do not produce QPP.




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                                     (298)                 ADVO, INC. & SUBS. v. COMMISSIONER                                     329


                                     its production while it was at or in the possession of the
                                     third-party printers. See sec. 1.199–3(f)(4), Income Tax Regs.
                                     (Example (1) discusses risk of loss or damage during the
                                     manufacturing process as an important factor in the benefits
                                     and burdens test).
                                        As noted supra, the risk of loss or damage did not transfer
                                     to ADVO until the advertising materials had either left the
                                     printers’ facilities or been delivered to ADVO. ADVO also did
                                     not assume any risk with respect to the directed buy paper
                                     supply agreements. Although ADVO required its printers to
                                     purchase the paper from a specific source, ADVO did not
                                     guarantee payments to the broker in the event the printers
                                     defaulted on the payments nor did ADVO reimburse the
                                     printer for the paper costs until the printed product had been
                                     completed and shipped per ADVO’s specifications. The third-
                                     party printers were also required to maintain insurance with
                                     respect to all of ADVO’s work in progress and all materials.
                                     Given the insurance and the fact that the risk of loss did not
                                     transfer to ADVO until after completion of the manufac-
                                     turing process, ADVO did not have the burden of the risk of
                                     loss or damage with respect to the advertising materials.
                                        The regulations also suggest that the type of contract plays
                                     a role in determining risk of loss and is one of the facts and
                                     circumstances in determining who has the benefits and bur-
                                     dens. Id. The examples imply a difference between fixed cost
                                     contracts and reimbursable cost type contracts. Sec. 1.199–
                                     3(f)(4), Examples (1) and (2), Income Tax Regs. Thus, the fact
                                     that the manufacturing taxpayer may bear a greater risk of
                                     loss in a fixed cost contract as opposed to a reimbursable con-
                                     tract is significant. One version of ADVO’s contracts bore ele-
                                     ments of a reimbursable contract, such as agreements to
                                     allow price adjustments for increases in freight rates and ink
                                     prices and increases tied to the Consumer Price Index. The
                                     other contracts kept costs firm but included terms implying
                                     that if sufficiently documented, some price changes, for
                                     example to reflect new printing developments in the graphic
                                     arts, might be allowed or even required.
                                        Furthermore, we realize that in the event damage or loss
                                     of the advertising material resulted in the material’s not get-
                                     ting timely delivered to the end consumers, ADVO bore the
                                     economic risk vis-a-vis its clients. ADVO’s contracts with cli-
                                     ents often required quick turnaround periods. If the printer




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                                     330                  141 UNITED STATES TAX COURT REPORTS                                    (298)


                                     does not print an acceptable product in that short amount of
                                     time, ADVO certainly suffers economic harm. This harm is
                                     both quantifiable, in terms of its contract price with its cli-
                                     ents, and more ethereal, in terms of reputation damage. In
                                     the light of these considerations, we find this factor to be
                                     neutral.
                                           8. Profits From Operation and Sale
                                       Similar to the example in section 1.199–3(f)(4), Income Tax
                                     Regs., the third-party printing companies enjoyed the eco-
                                     nomic gain or bore the loss from the sale of the advertising
                                     material according to the difference between the printing
                                     companies’ costs and, as to some of the contracts, the fixed
                                     contract price. Therefore we find that this factor weighs in
                                     favor of respondent.
                                           9. Active and Extensive Participation
                                        The test under section 936 asks whether ADVO actively
                                     and extensively participated in the management and oper-
                                     ations of the activity. Medchem (P.R.), Inc. v. Commissioner,
                                     116 T.C. at 336–337. As discussed under ‘‘Right of Possession
                                     and Control’’, see supra p. 327, ADVO argues that it actively
                                     and extensively participated in the management and oper-
                                     ation of the printing of the advertising material. However,
                                     we find that it did not extensively participate in the oper-
                                     ation of the printing presses or in the cutting or folding proc-
                                     esses, and thus this factor weighs in favor of respondent.
                                     ADVO did extensively participate in the mailing and dissemi-
                                     nation of the advertising materials (i.e., the solo or coopera-
                                     tive mail packages), but that function is a service, not QPP.
                                     Sec. 1.199–3(e)(1) and (2), Income Tax Regs.
                                           10. Conclusion
                                       After careful review of all of the aforementioned factors in
                                     the light of the specific facts and circumstances of this case,
                                     we find that ADVO did not have the benefits and burdens of
                                     ownership while the advertising material was printed. 23
                                           23 On
                                             brief petitioner also argued that its gross receipts with respect to
                                     graphic design, processing, and distribution activities were also DPGR. Be-
                                     cause we did not find that petitioner had the benefits and burdens of own-
                                     ership during the manufacturing activity, we need not address these
                                     issues.




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                                     (298)                 ADVO, INC. & SUBS. v. COMMISSIONER                                     331


                                     Therefore, ADVO did not have ‘‘the benefits and burdens of
                                     ownership of the QPP under Federal income tax principles
                                     during the period of MPGE activity’’. Sec. 1.199–3(e)(1),
                                     Income Tax Regs. The gross receipts from the printing
                                     activity, therefore, are not DPGR. See id. As a result, ADVO
                                     is not entitled to the claimed section 199 deduction for its
                                     2006 taxable year and its 2007 short taxable year.
                                       The Court has considered all of petitioner’s contentions,
                                     arguments, requests, and statements. To the extent not dis-
                                     cussed herein, the Court concludes that they are meritless,
                                     moot, or irrelevant.
                                       To reflect the foregoing,
                                                                                An appropriate order will be issued.

                                                                               f




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