Last week the IRS released an internal memorandum addressing which of the parties to a contract manufacturing arrangement for biodiesel is treated as the “producer” of the biodiesel for certain federal tax purposes.
In the memorandum, the IRS concluded that the owner of raw materials was the “producer” for federal tax purposes, even though it purchased the raw materials from a processor and even though the processor physically processed the biodiesel. The facts described in the IRS Memo are simple—“Owner and Processor have entered into an agreement for the production of biodiesel. Under the agreement, Owner pays Processor to process raw materials into biodiesel. Owner has bought these raw materials from Processor. Owner retains title to the raw materials while they are in Processor’s possession, and Owner holds title to the finished biodiesel that Processor creates.”
The IRS cites Section 48.0-2(a)(4)(i) of the Manufacturers and Retailers Excise Tax Regulations, which provides that if “a person manufactures or produces a taxable article for another person who furnishes materials under an agreement whereby the person who furnished the materials retains title thereto and to the finished article, the person for whom the taxable article is manufactured or produced, and not the person who actually manufactures or produces it, will be considered the manufacturer.”
The IRS memorandum does not address which party is considered the producer in an arrangement in which the owner of raw materials transfers title to the raw materials to the processor, and the processor then produces the biodiesel and transfers title to the finished biodiesel to the owner of the raw materials. Beyond the references to “title,” the IRS memorandum also does not address what other indicia of ownership (e.g., risk of loss) are required for a person to be considered the owner of the raw materials for this purpose.
A producer of biodiesel is required to be registered in accordance with IRC § 4101, both to qualify for certain fuel tax credits and to avoid the potential application of civil and criminal penalties. Accordingly, it is important that contract manufacturing arrangements for the production of biodiesel be carefully reviewed to determine whether the parties’ expectations about who will be treated as the producer are consistent with the IRS view. The new guidance provides some clarity in this area but leaves many questions unanswered.