Apparel Contract Manufacturing Costs

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					                          Statement for the Record Submitted by the
                       American Apparel & Footwear Association to the
                                Committee on Ways and Means
                              Request for Written Comments on
                    H.R. 3376, the "Tax Technical Corrections Act of 2005"

On behalf of the American Apparel & Footwear Association (AAFA), I am pleased to submit
comments to the Committee on Ways and Means regarding some of the undefined issues
contained in the American Jobs Creation Act of 2004, P.L. 108-357. AAFA is the national trade
association representing over 400 companies in apparel, footwear and other sewn products
companies, and their suppliers. AAFA members include American companies that produce
clothing, footwear, textile inputs, and related equipment in the United States and around the
world. Many of our domestic manufacturing members specialize in supplying sewn products to
the military. Our motto, “We Dress the World”, accurately portrays the market our members
represent, on the commercial side and the military.

AAFA previously submitted comments to the Department of Treasury regarding the promotion
of two key points for consideration in Treasury’s interpretation of P.L. 108-357. Unfortunately,
the Treasury did not agree with AAFA’s position on these issues; therefore, it is up to the
Committee to effect any change in the Treasury’s current interpretation.

Our main area of focus was having domestic contract manufacturing arrangements considered as
separate qualifying production activities for the purposes of the manufacturing tax deduction. As
design/development is an integral part of the manufacturing process for apparel and footwear
production, it is our position that companies investing in this domestic production should also
benefit from the manufacturing tax deduction proportional to the amount of production
completed domestically.

H.R. 3376 does not currently address either of the issues important to AAFA. On behalf of our
members I urge the committee to consider providing Treasury with additional direction in these
areas so that small businesses that engage primarily in subcontracting and multinational
companies that perform their design and development domestically can also benefit from these
changes in the tax code. Under the current interpretation of the Department of Treasury, contract
manufacturing is not eligible for the deduction as only the taxpayer owning the tangible property
during the manufacturing process is considered the manufacturer.
Contract Manufacturing

Both domestic and multinational companies routinely contract portions of the manufacturing
process to other companies. Recognizing domestic contract manufacturing arrangements as part
of the manufacturing process is paramount for apparel and footwear companies and especially
for the smaller companies as subcontract jobs can make up a significant part of their business.
Many AAFA domestic manufacturers regularly accept subcontracts from larger companies and
also subcontract portions of the highly competitive government contracts.

Government contracts for apparel and footwear, as with other industries, typically span several
years. The difficulties of accurately predicting long-term work flow, the rise and fall of demand
and cost of supplier components among other factors, can contribute to an overload on occasion.
Rather than forfeit a contract, any company will attempt to subcontract a portion of the original
contract. In addition, in most manufacturing processes and businesses, in order to remain
competitive, develop niche markets and specialized expertise. This fosters an atmosphere ripe
for subcontracting specific portions of a program. There may be one or only a few companies
that have the capabilities to perform certain functions in the apparel and footwear manufacturing
process and thus contributing to the additional demand for subcontracting particular portions.

Under current U.S. Code 26 Section 263A, production or the term produce “includes construct,
build, install, manufacture, develop, or improve.” Also under this section, “the taxpayer shall be
treated as producing any property produced for the taxpayer under a contract with the taxpayer;
except that only costs paid or incurred by the taxpayer (whether under such contract or
otherwise) shall be taken into account in applying” direct and indirect costs to the taxpayer.
AAFA supports the inclusion of this language in the interpretation of P.L. 108-357, which would
allow the producer or taxpayer, including subcontractors, of the apparel and footwear
manufacturing process to benefit from the manufacturing tax deduction.

Under P.L. 108-357, the deduction is based on the lesser of the qualified production activities
(QPA) income of the taxpayer or taxable income. The qualified production activities income is
equal to the excess of the domestic production gross receipts over the sum of (1) the cost of
goods sold allocable to such receipts, (2) other deductions, expenses, or losses directly allocable
to such receipts and (3) a ratable portion of other deductions, expenses, and losses not directly
allocable to such receipts or another class of income. Domestic production gross receipts, as it
applies to AAFA members, consists of the receipts for any lease, rental, license, sale, exchange,
or other disposition of qualifying production property which was manufactured, produced,
grown, or extracted by the taxpayer in whole or in significant part within the United States.
Qualifying production property as it applies to AAFA members is the tangible personal property
- apparel and footwear.

The deduction is based on profit - the cost for producing the item from a subcontract basis is
included in the original taxpayer’s overall costs. Therefore, the deduction for the original
taxpayer is not for the same profit received by the subcontractor to make a portion of the product.
This allows for both the subcontractor and original taxpayer to take advantage of the deduction.
AAFA supports separately computed deductions for the original taxpayer and the contractor.

Design and Development

An essential part of the process for manufacturers of apparel and footwear and for most
manufacturing is design and development. The process of producing a design and parlaying that
design into a sample product is the beginning of the manufacturing process. In most instances,
without the design and development, there would be no production. Many U.S. apparel and
footwear companies complete all of the design and development in the U.S. and under the
current interpretation of Treasury, packaging, design, and development are not included in the
consideration for the application of the “significant part” test for the purposes of determining
tangible personal property.

As the face of apparel and footwear manufacturing continues to evolve due to the removal of
quotas worldwide on January 1, 2005, the current practice of completing the design and
development in the U.S. may change. Companies are consolidating their sourcing in fewer
countries and with the advent of manufacturing cities, which include every component in the
manufacturing process in one location - from the supply of yarn, fabric, thread, buttons, zippers,
cutting and sewing, what is there to keep this part of the process in the U.S. Due to this type of
sweeping transformation in the way apparel and footwear companies do business, an incentive to
keep the design and development in the U.S could not come at a better time. The manufacturing
deduction would serve as incentive for companies to continue to make a substantive investment
in the people and process that make up this important phase of the manufacturing process. The
ability to take advantage of a QPA deduction for this part of the manufacturing process will
contribute significantly toward keeping this element of the process in the U.S. Therefore, as an
integral part of the apparel and footwear manufacturing process, AAFA strongly urges the
Committee to consider providing Treasury with more specific direction that would allow
companies performing their design and development in the U.S. to benefit from the deduction in
P.L. 108-357.

AAFA appreciates the opportunity to comment on the Committee on Ways and Means regarding
H.R. 3376. If you have any questions about AAFA’s position on any of the above comments,
please feel free to contact Felicia Cheek at 703.797.9039.


Kevin Burke
President and CEO


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