Rethinking Sec. 199 Based on New Developments

The American Jobs Creation Act, enacted in October 2004, exchanged an export-tax-benefit regime in favor of a rate reduction for income attributable to qualified production activities. The new rules, codified as Sec. 199, provide tax benefits to companies primarily engaged in the manufacturing of personal property or construction of real property within the U.S.; these benefits became effective for tax years beginning after Oct. 22, 2004. The tax-rate benefit of this deduction could have been as much as 1% (3% of taxable income as a deduction) for calendar years 2005 and 2006; beginning in 2010, the maximum benefit may be 3% (9% of taxable income as a deduction).

Background

These new tax benefits have brought complexity with them. Questions quickly arose as to the definition of production income, who qualifies for the deduction and how to calculate it. Notice 2005-14 was issued in January 2005 to address some of these concerns; see Prop. Regs. Secs. 1.199-1 through 8; REG-105847-05 (10/20/05); and Rose, et al., Tax Clinic, “Treasury and IRS Guidance Sheds Light on Sec. 199 Deduction,” TTA, May 2006, p. 274. A taxpayer could rely on either the notice or the proposed regulations to determine taxable income under Sec. 199, and to the extent they are inconsistent, pick and choose between the two.

Guidance: The notice and follow-up proposed regulations contain exhaustive definitions and rules as to qualification of income streams and application to different types of taxpayers.

• Manufacturing industry:

1. The deduction is based primarily on the calculation of domestic production gross receipts (DPGR), which for producers is income from the disposition of qualified production property (QPP). Expenses allocated or apportioned to DPGR result in qualified production activities income (QPAI). A deduction is allowed for 6% in 2007–2009 (9% thereafter) of the lesser of QPAI or taxable income. The resulting deduction is further limited to 50% of the entity’s Form W-2 wages.

2. If less than 5% of gross receipts did not qualify as DPGR, all gross receipts could be considered DPGR under a de minimis rule. This treatment would minimize the complexity of an expense allocation calculation, because the taxpayer would be limited to taxable income in performing the calculation.

3. QPP is tangible personal property (including software) manufactured, produced, grown or extracted in the U.S. Dispositions of certain qualified films or electricity, natural gas or potable water produced in the U.S. also may generate DPGR.

4. The activities of the U.S. taxpayer must be substantial in nature. A safe harbor is provided, based on contribution to indirect labor and factory burden, to qualify as a ratio to total cost of goods sold.

5. Identification of DPGR must be performed on an item-by-item basis, not by product line.

6. Computation of QPAI, including expense apportionment, must also be performed on an item-by-item basis.

7. Revenue is not DPGR if attributable to certain embedded services (i.e., delivery).

8. There should be no attribution of activity (such as manufacturing) between related parties, unless they are members of an “expanded affiliated group.”

9. In determining QPAI, certain simplified expense calculation methods were allowed for smaller companies (generally, those with less than $25 million in gross receipts); use of the default-expense method under Sec. 861 (traditionally concerning foreign-source income determinations) was recommended; for a discussion, see Rollinson, et al., “Allocation and Apportionment of Expenses for Sec. 199 Purposes,” TTA, June 2006, p. 336.

• Construction industry:

1. DPGR includes sales income from real property constructed by the taxpayer, or construction services performed by a taxpayer in the erection or substantial renovation of real property.

2. DPGR does not include revenue attributable to materials or supplies resold as part of a project.

3. DPGR does not include income attributable to a sale of land as part of a real property project.

4. DPGR does not include grading, excavating, clearing or administrative services incidental to a project.

5. In determining the 5% de minimis test for including all income items from DPGR, land is included, which often far exceeds the 5% threshold. (For more details, see Fujita, Tax Clinic, “Determining Qualifying Construction-Related Gross Receipts under Sec. 199,” TTA, October 2005, p. 594.)

These rules did little to simplify the understanding or administrative costs in complying. Consequently, many taxpayers adopted shortcut methods, or took no benefit at all.

New Rules

Companies may now need to rethink their previous positions. Final and temporary regulations were issued in May 2006, providing more simplification and tax benefits. Also that month, Congress passed the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), complicating the Form W-2 wage limit applicable to the calculation by limiting the determination to only “production” wages. Finally, late in 2006, the Financial Accounting Standards Board issued Financial Interpretation No. (FIN) 48, an interpretation of Financial Accounting Standard No. 109, Accounting for Uncertain Tax Positions.

The final regulations (TD 9263) were issued on May 24, 2006, and are mandatory for taxpayer years beginning after May 31, 2006; see Giacoletti, Tax Clinic, “Highlights of the Sec. 199 Final Regs.,” TTA, August 2006, p. 454. However, a taxpayer may choose to adopt the final regulations all the way back to Sec. 199’s initial effective date. Taxpayers choosing to use the regulations must adopt them in full; consequently, to the extent they are more beneficial or simpler to apply, a taxpayer should consider amending prior tax returns filed with no benefit or filed pursuant to the notice or proposed regulations.

Manufacturing: For manufacturing companies, the changes in the final regulations primarily focused on simplifying the calculation required, including:

1. Item-by-item identification is required only when identifying DPGR; once identified, all DPGR items are accumulated for calculation purposes.

2. The “substantial in nature” safe harbor was changed in terms of overhead, rather than factory burden, to provide consistency with the uniform capitalization rules.

3. Reverse de minimis rules were included to assist in the identification of non-DPGR items.

4. The threshold for using the simplified method of expense allocation was increased, from companies with $25 million of gross receipts to those with less than $100 million of gross receipts.

Construction: The largest changes came in the construction industry rules, and were primarily in the taxpayer’s favor:

1. Land is not included in de minimis calculation, making it easier for non-DPGR items to be treated as DPGR for the calculation.

2. Administrative services incidental to projects are included as construction services for DPGR purposes.

3. Revenue attributable to a resale of materials is included as DPGR, to the extent consumed in a project.

4. Revenue from grading, demolition, clearing and excavating in connection with a project is included as construction services for DPGR purposes.

5. General contractor oversight services are clearly included as construction services for DPGR purposes.

6. Structural components of real property definitely include walls, partitions, doors, wiring, plumbing, etc.

Ramifications

These changes may significantly increase a taxpayer’s ability to qualify for the deduction; for others, they may decrease the cost of complying, by qualifying more activity and simplifying the computation of QPAI. Other changes occurring at the same time as the final regulations may also benefit the taxpayer, including temporary regulations assisting software developers in qualifying additional streams of income and Rev. Proc. 2006-22, which provides guidance on calculating the W-2 wage limit for years prior to the TIPRA. Both may have retroactive applicability for taxpayers.

A fresh look at the calculation is further heightened by the recent issuance of FIN 48, which requires a company to evaluate the merits of its tax positions in an objective, systematic way. This is a two-step process involving recognition and measurement. To recognize any benefit, a taxpayer must demonstrate that it is more likely than not to sustain a tax benefit based on the technical merits, in which case a calculation of the likely benefit must be determined. The difference between the result of this two-step process and the benefit taken on a tax return is the amount of the uncertain tax position, which must be booked as a liability. On a permanent item such as Sec. 199, the liability will affect the effective-rate computation, which may also include interest and penalties. Consequently, many companies will be required to perform a more detailed calculation to (1) demonstrate qualification on the technical merits and (2) determine the amount of the uncertainty and measurement of the tax benefit allowed. 

Conclusion

In sum, taxpayers must reevaluate their Sec. 199 positions in light of 2006 developments. The benefits of this evaluation may include (1) potential extra benefit in prior years under the final regulations; (2) development of the calculation method required under the final regulations for future years; and (3) increased compliance, reporting and calculation of tax accounting under FIN 48.

From Chris Arndt, J.D., Minneapolis, MN