Sec. 199 Prop. Regs. Clarify Treatment of Intercompany Transactions

Significant controversy has arisen as to the application of Sec. 199 to intercompany transactions. Taxpayers that want to take advantage of the Sec. 199 qualified production activities deduction (QPAD) and that license intangible assets from one affiliate to another for use in producing qualified production property (QPP) must do so with affiliates in the same consolidated group in order to include the royalty income in qualified production activities income (QPAI) and, thus, maximize the QPAD.

Background

To encourage domestic production, American Jobs Creation Act of 2004 Section 102(a) established the QPAD in Sec. 199. Generally, for 2005 and 2006, Sec. 199(a)(1) allows a 3% deduction (rising to 6% in 2007–2009, and 9% in 2010 and beyond) of the lesser of (1) QPAI or (2) taxable income for the tax year. Sec. 199(b)(1) limits the deduction to 50% of W-2 wages paid by the taxpayer.

Definitions: Sec. 199(c)(1) defines QPAI as the excess of domestic production gross receipts (DPGR) over the sum of (1) the cost of goods sold (COGS) allocable to such receipts; (2) other deductions, expenses or losses directly allocable to such receipts; and (3) a ratable portion of deductions, expenses or losses not directly allocable to such receipts or another class of income.

Sec. 199(c)(4)(A) defines DPGR to include, among other things, a taxpayer’s gross receipts derived from the lease, rental, license, sale, exchange or other disposition of QPP that the taxpayer manufactured, produced, grew or extracted, in whole or in significant part, within the U.S. Sec. 199(c)(5) defines QPP as (1) tangible personal property, (2) computer software and (3) property described in Sec. 168(f)(4) (certain sound recordings). QPP does not include intangibles such as patents or trademarks. Sec. 199(c)(7)(A) excludes from DPGR gross receipts derived from property leased, licensed or rented by a taxpayer to a related person.

Sec. 199(d)(4)(A) provides that an expanded affiliated group (EAG) is treated as a single corporation for Sec. 199 purposes. Sec. 199(d)(4)(B) defines an EAG as an affiliated group as determined in Sec. 1504(a), determined by substituting “more than 50 percent” for “at least 80 percent,” without regard to Sec. 1504(b)(2) and (4). Sec. 199 provides no guidance on the QPAD calculations for consolidated groups. However, recently issued proposed regulations (REG-105847-05, 11/4/05) provide some guidance on this issue.

Prop. Regs.

Both the preamble and Prop. Regs. Sec. 1.199-7(d) address intercompany transactions. The proposed regulations clarify that the Regs. Sec. 1.1502-13(c) matching rule applies in determining timing and attributes for each member’s separate-entity QPAI. In other words, intercompany transactions are redetermined to the extent necessary to produce the same effect on consolidated taxable income as if the members were divisions of a single corporation. The examples below illustrate the different results achieved from the same transaction, depending on whether EAG members file separately or as a consolidated group.

Example 1—affiliates belong to different consolidated groups: In 2006, Intangible Holding Co. (I) and Manufacturer Co. (M) belong to the same EAG, but not to the same consolidated group. I develops a patent and licenses it to M for $1,500. M uses the patent to produce QPP within the U.S. and, in doing so, incurs $800 for labor and $600 for materials. M sells the QPP to unrelated persons for $7,500. The EAG’s QPAD would be $138, calculated as shown in Exhibit 1 below.

Although I had $1,500 gross receipts from the royalty income it received from M, these gross receipts generally do not qualify as DPGR; as was mentioned, DPGR do not include gross receipts derived from property leased, licensed or rented to a related person. Further, Sec. 199(c)(5) excludes from DPGR gross receipts derived from the license of intangibles other than computer software or sound recordings. Accordingly, the royalty payments I received from M do not qualify as DPGR, which would increase the EAG’s QPAD. However, if I and M belonged to the same consolidated group, the result would differ.

Example 2—affiliates belong to same consolidated group: The facts are the same as in Example 1 except that I and M belong to the same consolidated group. The preamble and Prop. Regs. Sec. 1.199-7(d)(1) provide that Sec. 1.1502-13 applies to redetermine the attributes of intercompany items “to the extent necessary to produce the same effect” as if the two were divisions of a single corporation. Thus, the royalty income I takes into account must be redetermined to be DPGR to match the characterization of the deduction taken into account by M. Regs. Sec. 1.1502-13 operates to produce the result shown in Exhibit 2 below.

Regs. Sec. 1.1502-13 applies to items of income, gain, deduction and loss of consolidated group members from intercompany transactions. Regs. Sec. 1.1502-13(b)(1) defines intercompany transactions as transactions between corporations that are members of the same consolidated group immediately after the transaction. In this example, the intercompany transaction is the licensing of the patent between I and M.

Regs. Sec. 1.1502-13(b)(2) defines intercompany items as the selling member’s income, gain, deduction or loss from an intercompany transaction. The intercompany item is I’s $1,500 royalty income from licensing the patent to M. Regs. Sec. 1.1502-13(b)(3) defines a corresponding item as the buying member’s income, gain, deduction and loss from an intercompany transaction; here the corresponding item is M’s $1,500 royalty deduction.

Regs. Sec. 1.1502-13(b)(6) defines “attributes” as an item’s characteristics, other than amount, location and timing, that determine the item’s effect on taxable income and tax liability. Here the attribute of M’s royalty deduction is its characteristic of being directly allocable to DPGR it derived from QPAI conducted within the U.S. 

Regs. Sec. 1.1502-13(c)(1) provides that separate-company attributes of intercompany items and corresponding items are redetermined to the extent necessary to produce the same effect on consolidated taxable income as if the buyer and seller were divisions of the same corporation, and the intercompany transaction were a transaction between those two divisions. In this example, to produce that effect, the attribute to be redetermined is the character of the royalty income taken into account by I.

Regs. Sec. 1.1502-13(c)(4)(i) provides that, to the extent that the buyer’s corresponding item offsets the seller’s intercompany item in amount, the attributes of the buyer’s corresponding item control the attributes of the seller’s offsetting intercompany item. In this example, the amounts offset; thus, M’s corresponding item attributes control the redetermination of I’s intercompany item attributes. I’s royalty income is redetermined to be DPGR to match M’s corresponding item. The result produces the same effect on consolidated taxable income as if I and M were divisions of a single corporation. Accordingly, the $1,500 royalty payment from M to I, which otherwise would not qualify as DPGR, is recharacterized as DPGR.

Prop. Regs. Sec. 1.199-7(d)(5) provides that the QPAD for a consolidated group is allocated to the group members in proportion to each’s QPAI, regardless of whether the member has separate taxable income or loss or W-2 wages for the tax year. In addition, for purposes of making this allocation, any redetermination of a corporation’s receipts from an intercompany transaction as DPGR or non-DPGR (or as nonreceipts), and any redetermination of a corporation’s COGS or other deductions from an intercompany transaction as either allocable to or not allocable to DPGR under Regs. Sec. 1.1502-13(c)(1)(i) or (c)(4), are not taken into account. Exhibit 2 illustrates the consequences of recharacterizing I’s intercompany royalty income as DPGR. For purposes of allocating the $183 QPAD to the EAG, I is deemed to have zero DPGR and zero allocable expenses to such receipts. As a result, the entire $183 EAG QPAD is allocated to M.

From Gary Hecimovich, CPA, and Joseph Vetting, CPA, J.D., LL.M., Washington, DC