Final Section 199 regulations clarify application of domestic production incentive.

• Author: Vance, Scott

Section 199 of the Internal Revenue Code was enacted as part of the American Jobs Creation Act of 2004 to provide a permanent benefit available to taxpayers in a wide variety of industries. (1) Recently issued final, temporary, and proposed regulations, together with a revenue procedure, significantly clarify the scope and application of this provision. (2) This guidance is particularly welcome because many businesses continue to deal with the tax and financial reporting implications of section 199. This article reviews key technical and practical implications of the new administrative provisions, focusing in particular on areas in which the final guidance clarified or changed positions that had been taken earlier.

Overview

For years beginning after December 31, 2004, section 199 provides a deduction equal to a percentage of the lesser of"qualified production activities income" (QPAI) or taxable income. (3) The deduction, however, may not exceed 50 percent of a taxpayer's W-2 wages. (4) QPAI, in turn, equals the excess of "domestic production gross receipts" (DPGR) over the sum of allocable cost of goods sold and other allocable deductions, expenses, and losses. (5) Domestic production gross receipts are generally defined as the gross receipts of the taxpayer which are derived from:

(i) any lease, rental, license, sale, exchange, or other disposition of

(I) qualifying production property which was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the United States,

(II) any qualified film produced by the taxpayer, or

(III) electricity, natural gas, or potable water produced by the taxpayer in the United States,

(ii) in the case of a taxpayer engaged in the active conduct of a construction trade or business, construction of real property performed in the United States by the taxpayer in the ordinary course of such trade or business, or

(iii) in the case of a taxpayer engaged in the active conduct of an engineering or architectural services trade or business, engineering or architectural services performed in the United States by the taxpayer in the ordinary course of such trade or business with respect to the construction of real property in the United States. (6)

There are several statutory exceptions and clarifications to the foregoing definition, which the regulations and revenue procedure explain.

DPGR Determination

Following the issuance of Notice 2005-14 and the proposed regulations, concerns were raised that the initial requirement that QPAI be determined on an item-by-item basis could lead to potentially onerous computations. The government has addressed these concerns by effectively creating a two-part analysis.

First, the presence of DPGR is determined on an item-by-item basis. Eligibility is determined at the item level rather than the division, product line, or transaction level, (7) which is intended to remove potential distortions arising from inappropriate aggregation of eligible and ineligible activities. The term "item" has been clarified to mean, as an initial matter, the property offered by the taxpayer to its customers in the ordinary course of business, without regard to whether the taxpayer sells on a retail or wholesale basis. (8) Under this definition, the taxpayer does not need to determine the unit of property sold to ultimate consumers. The so-called shrinkback rule remains, so that if the unit of property sold to customers does not meet the requirements of section 199, an item is defined as any component of the product that does meet these requirements. (9) Thus, what initially appears as a single product can be disaggregated into multiple items under the shrinkback rule.

The second part of the analysis relates to the computation of QPAI, with the government employing what has informally been characterized as a "bucket" approach. (10) Thus, after items are determined, eligible and ineligible receipts are sorted into DPGR and non-DPGR "buckets" for purposes of COGS and deduction allocation, a process analogous to required calculations under section 263A. For example, assume that W, which manufactures sunroofs, stereos, and tires in the United States, purchases automobiles from unrelated persons and installs these manufactured components in the automobiles, which it then sells in the normal course of business. If the gross receipts derived from the sale of the automobiles do not qualify as DPGR but the gross receipts derived from the sale of each of the three components do qualify, the first part of the analysis dictates that the taxpayer has three items giving rise to DPGR: sunroofs, stereos, and tires. (11) The second part of the analysis then assigns gross receipts from the sale of sunroofs, stereos, and tires to the DPGR "bucket" for purposes of COGS and deduction allocation.

The regulations provide for the sorting of receipts between DPGR and non-DPGR on the basis of specific identification or some other reasonable allocation, though changes in the final regulations are aimed at reducing the burden of such identification...