Allocation and apportionment of expenses for Sec. 199 purposes: for many taxpayers, calculation of the Sec. 199 deduction will require an enormous amount of work. This article focuses on one aspect of the deduction, the allocation and apportionment of expenses under the Sec. 861 regulations and the proposed Sec. 199 regulations.

• Author: Rollinson, Marjorie A.

EXECUTIVE SUMMARY

* Sec. 861 REGULATIONS are integral to the Sec. 199 deduction when the Sec. 861 method of allocating deductions is used.

* Regs. Sec. 1.861-8 provides specific allocation rules for some expenses, such as interest and R&E, and a two-step process for other expenses not specifically provide for.

* Taxpayers that will use the Sec. 861 rules in a Sec. 199 context may want to reconsider prior elections under Sec. 861.

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Many calendar-year taxpayers have yet to file their first U.S. income tax return that includes the Sec. 199 deduction introduced by the American Jobs Creation Act of 2004 (AJCA). Even so, taxpayers have certainly needed to calculate the likely deduction, for both estimated tax and financial reporting purposes. What is clear to anyone who may benefit from the deduction is that the calculation requires an enormous amount of work. Almost every aspect of the section requires careful analysis: What constitutes "manufacturing"? What is "substantially within the U.S."? What is "by the taxpayer?" This article will focus on only one of the multiple complex pieces of the Sec. 199 puzzle: the allocation and apportionment of expenses. For taxpayers who have claimed a foreign tax credit (FTC), these rules are not new (but still mysterious). For those who may benefit from Sec. 199, but have never claimed an FTC or otherwise needed to use Sec. 861, the roles must seem baffling.

Background

Sec 199 provides a deduction equal to 3% (increasing to 6% for 2007, 2008 and 2009 and then to 9% for 2010 and there after) of the lesser of qualified production activities income (QPAI) or taxable income. The domestic manufacturing deduction (DMD) is limited to 50% of W-2 wages.

To determine QPAI, a taxpayer must reduce its domestic production gross receipts (DPGR) (1) by:

1. Cost of goods sold (COGS) directly allocable to DPGR.

2. Deductions directly allocable to DPGR.

3. A ratable portion of deductions not directly allocable to DPGR or to another class of income.

   To determine the deductions directly allocable to DPGR and the portion of deductions not directly allocable to DPGR or to another class of income, Prop. Regs. Sec. 1.199-4(c) provides that taxpayers generally must follow the rules in the Sec. 861 regulations. In addition to the methods and principles of allocation and apportionment under Sec. 861, the proposed Sec. 199 regulations provide two alternative methods for the apportionment of deductions other than COGS: (2)

1. The simplified deduction method, which may be used by taxpayers with $25 million or less average annual gross receipts or total assets at the end of the year of $10 million or less; and 2. The small business simplified overall method, which may be used by taxpayers eligible to use the cash method, those that have $5 million or less average annual gross receipts and $5 million or less total costs for the current year, or certain other taxpayers engaged in the farming business.

   If a taxpayer qualifies for one or both of the alternative methods, it may choose the method of allocation and apportionment on an annual basis, (3) provided the taxpayer continues to qualify for the method chosen.

   Why Section 861?

   The Sec. 861 regulations provided the drafters of the Sec. 199 guidance a ready set of rules for the allocation and apportionment of deductions. Although the principal application of the Sec. 861 regulations has been the determination of foreign-source taxable income for purposes of the FTC limitation, they also apply to many other Code sections ("operative sections"). (4) Thus, these rules were easily adopted for Sec. 199 purposes.

   Regs. Sec. 1.861-8(f)(1) already contains an extensive list of the operative sections which require the determination of taxable income from specific sources or activities. Under the proposed Sec. 199 regulations, Sec. 199 would be treated as an operative section if the taxpayer uses the Sec. 861 method for purposes of allocating deductions to DPGR. (5)

   General Rules

   Regs. Sec. 1.861-8 prescribes the general rules for allocating and apportioning deductions primarily for the purpose of computing taxable income from sources within and without the U.S., and was initially adopted in 1977. Subsequently, Treasury has enacted various changes to the Sec. 861 regulations to provide additional guidance on expense allocation and apportionment. Such regulations are now integral to the determination of a taxpayer's DMD when the Sec. 861 method of allocating costs is used. Some of these post-1977 changes include the adoption of specific mandatory allocation and apportionment rules for the following deductions:

   * Interest.

   * Research and experimental (R&E) expenses.

   * Stewardship expenses.

   * Supportive expenses.

   * State and local income taxes.

   * Net operating losses (NOLs).

   * Losses on the disposition of property.

   * Legal and accounting fees.

   * Charitable contributions.

   * Dividends received deduction (DRD).

   The Sec. 861 regulations provide detailed rules for the allocation and apportionment of each of these deductions, and in some cases the computations can be very complex. For deductions other than those listed above, the Sec. 861 regulations establish an overall two-step approach--(1) allocation to a class of gross income and (2) apportionment within the class of gross income--to determine the deduction amount that must be attributed to certain statutorily defined types of gross income for purposes of computing taxable income. Regs. Sec. 1.861-8 provides a general set of criteria for determining the class of gross income to which a deduction is allocated, and the apportionment method used to divide the deduction between the "statutory" and residual groupings of gross income within the class of gross income. (6) Such apportionment includes apportionment between U.S.- and foreign-source income for FTC limitation purposes, and between gross income attributable to DPGR, and gross income attributable to non-DPGR for purposes of the Sec. 199 DMD, among others.

   Affiliated Groups

   Deductions of a domestic corporation are generally not allocated and apportioned on a consolidated group basis. However, Sec. 864(e) and the Sec. 861 regulations provide exceptions to this general rule for certain expenses. Specifically, interest and expenses not directly allocable and apportioned to any specific income-producing activity (such as certain expenses relating to supportive functions, R&E expenses, stewardship expenses and legal and accounting expenses) must generally be allocated and apportioned as if all members of an affiliated group were a single corporation. (7) For this purpose, affiliated group has the same meaning as for consolidated return purposes under Sec. 1504 (without regard to Sec. 1504(b)(4)). However, Temp. Regs. Sec. 1.861-11T(d)(6) deems certain unaffiliated corporations (including certain foreign corporations) to be part of the affiliated group for interest expense allocation purposes.

   In addition, for purposes of computing the DMD, Sec. 199(d)(4)(A) provides that all members of an expanded affiliated group (EAG) are treated as a single corporation. For these purposes, all corporations in a consolidated group are treated as a single member. (8) An EAG is an affiliated group as defined in Sec. 1504(a), determined by substituting "more than 50%" for "at least 80%," and...