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Rev. Rul. 78-34 1978-1 C.B. 355

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Revenue Ruling 78-34

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Headnote

Liability for manufacturers tax; pistols. A company that sells sporting pistols of its own design incorporating parts and a method of construction on which it holds the patents, and which are fabricated by another company in specified annual quantities at a fixed price per pistol using its special tools, is the manufacturer of the pistols for purposes of section 4181 of the Code, even though the fabrication agreement names the fabricator as the “manufacturer liable for the manufacturers tax” and requires the fabricator to bear risks associated with ownership and fabrication.

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ISSUE

The Internal Revenue Service has been requested to determine, under the circumstances described below, who is the manufacturer of pistols for purposes of the manufacturers excise tax imposed by section 4181 of the Internal Revenue Code of 1954.

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FACTS

X company designed a sporting pistol of a type subject to the tax imposed by section 4181 of the Code. While the pistol is not patented as such, X owns several patents on single parts of the pistol and method of construction. X entered into an agreement with Y company under which Y fabricates specified annual quantities of the pistol that are purchased by X at a fixed price per pistol. X paid for special tooling and gauges, but Y invested in or appropriated to the agreement the bulk of the tools and equipment necessary for the fabrication of the pistols. The tools paid for by X remain in Y’s possession during the life of the agreement and Y is responsible for maintenance, repair, and insurance for such tooling. The tooling can be removed by X upon payment of a specific removal charge. Upon termination of the agreement, X can remove the tools without such charge being imposed. Under the agreement, Y is required to buy its own raw materials, bears the risk of loss if the price of labor or raw materials increases (unless X agrees to a price adjustment), must carry a continuous inventory of major components, raw materials, and in-process parts equivalent to a specified period of production, and bears the burden of loss if the pistols are defective. In addition, Y exercises complete control and has full responsibility for the entire production process, including test firing, inspecting, cleaning, and packaging the pistols, with no further requirement of fabrication. X furnishes boxes, shipping cartons, and instruction books. The agreement also provides that Y is the manufacturer liable for the manufacturers excise tax. However, X will pay Y an amount equal to such tax upon receipt of a separate bill from Y. If, due to unforeseen circumstances, it becomes necessary for X to discontinue the agreement, X is required to (1) take delivery of and pay for all finished pistols at the contract price; (2) take delivery of and pay for all finished parts, subassemblies, work-in-process, and raw materials at Y’s cost; and (3) take delivery of and pay for at the unamortized book value all capital equipment purchased for the fabrication of pistols that Y could not use.

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LAW AND ANALYSIS

Section 4181 of the Code imposes a tax upon the sale by the manufacturer, producer, or importer of pistols and revolvers. Section 316.4(a) of Regulations 46, made applicable to the 1954 Code by Treasury Decision 6091, 1954-2 C.B. 47, defines the term “manufacturer” to include a person who produces a taxable article from scrap, salvage or junk material, as well as from new or raw material, (1) by processing, manipulating, or changing the form of an article, or (2) by combining or assembling two or more articles. Section 316.4(b) provides that, under certain circumstances, as where a person manufactures or produces a taxable article for a person who furnishes materials and retains title thereto, 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. Rev. Rul. 60-42, 1960-1 C.B. 474, holds, in part, that among the factors to be considered in determining whether a fabricator or its vendee is liable for the manufacturers excise tax are (1) the ownership of the raw materials used in producing the articles and (2) who has the right to control the production and sale of the article. Generally where a company not only owns the patents under which a taxable article is fabricated by another company, but also exercises control as to the amounts to be so fabricated and has exclusive rights to the output so that the fabricator is not free to sell elsewhere, the company owning the patents is the manufacturer for purposes of the manufacturers excise tax. See Polaroid Corporation v. United States, 235 F. 2d 276 (1st Cir. 1956), cert. denied, 352 U.S. 953 (1956). Although Y and others could otherwise fabricate a pistol similar in outward appearance to the pistol in this case, such persons could not produce a pistol that incorporates any of X’s patents without X’s permission. X has all rights and interests to fabricate, or contract to have fabricated, a pistol incorporating its patents and, in having the pistols fabricated in this case, furnishes special tooling and other specified articles. X has control of the amount produced and the distribution of the pistols. The purchase of raw materials by Y is a requirement under the agreement that is a convenience for X. In addition, if X discontinues the agreement, X must assume responsibility for any raw materials and fabricated parts left on hand and reimburse Y for such materials and parts.

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HOLDING

Accordingly, although Y is considered the “manufacturer liable for the manufacturers excise tax” by the contracting parties, and Y purchases the raw materials and bears risks associated with ownership and fabrication, must carry inventories, conducts the production process, is responsible for X’s special tooling, and bears the risks of increased labor and material costs, X is the manufacturer of the pistols for purposes of the manufacturers excise tax imposed by section 4181 of the Code. Therefore, X is liable for the tax imposed by that section on its sales of such articles.