State action on the domestic production activities deduction.

• Author: Schaefer, Frank

On Oct. 22, 2004, President Bush signed into law the American Jobs Creation Act of 2004 (AJCA), which provides taxpayers with the rare opportunity to lower their effective tax rates through a statutory mechanism. The legislation's centerpiece is the domestic production activities deduction (DPAD). It is estimated that this deduction, contained in Internal Revenue Code (IRC) Sec. 199, will represent a $76 billion Federal tax break for U.S. companies over the next 10 years.

The Federal tax benefits of this new legislation have been well examined over the past year. (1) However, as the deduction is available for tax years beginning after 2004, practitioners are just starting to pay attention to its state tax implications.

What actions have state legislators taken thus far (or not) in regard to the DPAD? How might the DPAD rules interact with some of the intricacies of multistate corporate taxation? This column addresses these questions but finds that, in many cases, there are no answers.

DPAD Basics

The DPAD deduction is intended to encourage domestic investment, by giving taxpayers that perform certain production activities in the U.S. (qualified production activities) an incentive to continue and increase such activities. Under Sec. 199(c)(5), the following activities are qualified production activities:

* The manufacture, production, growth or extraction in whole or significant part in the U.S. of tangible personal property (e.g., clothing, goods and food), software development or music recordings;

* Film production (with exclusions provided in the statute), provided at least 50% of the total compensation relating to the production of the film is compensation for specified production services performed in the U.S.;

* Production of electricity, natural gas or water in the U.S.;

* Construction or substantial renovation of real property in the U.S., including residential and commercial buildings and infrastructure, such as roads, power lines, water systems and communications facilities; or

* Engineering and architectural services performed in the U.S. and relating to the construction of real property.

The deduction is premised on domestic production gross receipts (DPGR), as defined in IRC Sec. 199(c)(4). Under IRC Sec. 199(c)(1), DPGR are reduced by the associated cost of goods sold, other allocable deductions and certain other deductions, to arrive at qualified production activites income (QPAI).

The DPAD is determined by multiplying the applicable percentage by the lesser of QPAI or taxable income; see IRC Sec. 199(a)(1). The deduction is limited to 50% of the taxpayer's W-2 wages. (2) Under IRC Sec. 199(a)(2), the deduction is 3% for tax years 2005 and 2006; 6% for tax years 2007, 2008 and 2009; and 9% for tax years 2010 or later.

IRC Sec. 199(d)(2) provides that the DPAD is calculated based on an expanded affiliated group basis (3); under IRC Sec. 199(d)(4), the deduction is allocated among group members based on each's proportionate QPAI.

State Conformity

As with the bonus depredation provisions in the Job Creation and Worker Assistance Act of 2002, (4) the states have to decide...