Creating Single Doses of Medicine Held to Be Manufacturing, Taxpayer Qualified for §199 Deduction

In the case of Precision Dose v. United States, 116 AFTR 2d ¶ 2015-5272, the United States District Court for the Northern District of Illinois, Western Division looked into whether a company qualified for the domestic production deduction under IRC §199.

In this case the company performed the following actions in producing single doses of medication:

Plaintiff sells “unit doses” of medications. A unit dose is a drug in a non-reusable container intended for administration as a single dose to a patient. The specific unit doses plaintiff sells are different liquid, oral drugs sealed in various size cups and syringes. Plaintiff buys, in bulk, certain drugs it deems marketable in unit doses and suitable for sale in unit doses.

Plaintiff's LR56.1 statement of facts thoroughly describes the process plaintiff undertakes in producing unit doses. The process runs the gamut from deciding what drugs to consider for possible unit doses; testing to determine their suitability and marketability; preparing specifications and documentation for the materials to be used and standard operating procedures for all processes and equipment to be used; developing cups and syringes (and the molds from which they will be made); working with the vendors that will make the containers; buying cups and syringes; contracting with laboratories to conduct stability studies to insure the drug remains within specifications when put into a unit dose and to establish expiration dates; running validation batches; setting up and conducting fill operations; conducting in process testing; conducting post-fill processing; performing release testing to determine if the unit doses are ready for release to customers; and batch record reviews to confirm no anomalies occurred during production.

The IRS argued that this represented simply “packaging, repackaging, labeling and minor assembly,” activities excluded from the definition of “manufactured, produced, grown or extracted” (MPGE) under Reg. §1.199-3(e)(2).  In that case, the taxpayer would not qualify for a §199 deduction.

The taxpayer argued that they did more than that, claiming to be comparable to the situation in the case of United States v. Dean, 945 F. Supp. 2d 1110 [112 AFTR 2d 2013-5592] (C.D. Cal. 2013) where a taxpayer who put together gift baskets was found to have engaged in activities beyond merely “repackaging” goods, and thus qualified for a §199 deduction.

The Court found this view compelling, noting that:

Here, plaintiff's activities in producing unit doses are analogous to those in Dean. “Package” is defined as “to present (as a product) in such a way as to heighten its appeal to the public” and “to enclose in a package or covering.” (Last visited Sept. 2, 2015). Dean, 945 F. Supp.2d at 1117. “Repackage” is defined as “to package again or anew: to put into a more efficient or attractive form.”, (Last visited Sept. 2, 2015); Dean, 945 F. Supp.2d at 1117. While it is certainly true, that packaging or repackaging is a part of what plaintiff does in producing the unit doses, plaintiff's activities include other production activities which render the (e)(2) exception inapplicable.

The facts show plaintiff looks for drugs it believes it can successfully process into and sell as unit doses. Drug manufacturers do not seek bids from companies to repackage their drugs into small packages. Plaintiff engages in market research to determine which drugs to buy to turn into unit doses. Plaintiff works with potential customers to identify needs for new unit dose products. Plaintiff acquires sample drugs and tests them for suitability to be processed into unit doses. Plaintiff prepares specifications and works with vendors to develop cups and syringes that are suitable to use for unit doses for each drug that it buys. Sometimes existing cups or syringes are used and sometimes new ones are created through the joint efforts of plaintiff's personnel and vendor personnel. Plaintiff conducts mixing studies to determine the best mixing procedures to use to obtain the proper suspension of the active ingredient in each unit dose and whether the drug can be mixed in such a way that the proper suspension can be obtained at all. It tests plastics to determine compatibility with specific drugs for use in the cups or syringes. The cups, lidding, trays and product inserts are produced by vendors using plaintiff's proprietary design. For cups for which plaintiff owns the designs vendors use molds owned by plaintiff to produce the cups, for trays, which are designed by plaintiff, vendors use molds owned by plaintiff. For lidding which is designed by plaintiff, the vendors use cutting dies owned by plaintiff.

This brief recitation of portions of plaintiff's activities in producing the unit doses show, that like in Dean, plaintiff engages in a “complex production process that results in a distinct final product.” Dean, 945 F. Supp.2d at 1118 n.10.

The IRS argues that this isn’t relevant since it holds the that California District Court came to an improper conclusion in the Dean case.  The trial court disagreed with the IRS’s view, and held for the taxpayer.

Unfortunately this is not necessarily the end of the story.  As part of proposed regulations issued just over a month before this decision (REG-133459-09, 8/27/15) the IRS added an example to proposed regulations to specifically provide that repackaging included what had taken place in Dean, with the preamble noting that the new example was meant to clarify the regulation and reiterating that the IRS believed Dean was erroneously decided anyway.

As a practical matter, advisers should expect that agents will continue to assert this position taken in this case and Dean.  As well, if the regulations go final without modification, taxpayers taking the positions advanced in this case would likely be forced to show that the IRS’s interpretation in the regulations was erroneous—not an easy task for the taxpayer to accomplish.