Interplay between the Sec. 199 manufacturing deduction and the Sec. 965 repatriation provision.

• Author: Fitzpatrick, Cathy

The American Jobs Creation Act of 2004 was signed into law on Oct. 22, 2004. It repealed the extraterritorial income tax regime, but gave corporations various new tax incentives. Among these incentives is Sec. 199, which allows taxpayers, including corporations, a deduction related to certain production (and related) activities undertaken in the U.S., and Sec. 965, which creates a temporary incentive that allows them to repatriate accumulated foreign earnings via a dividends-received deduction for certain controlled foreign corporation (CFC) dividends. Since its enactment, Sec. 199 has raised a number of questions about how to properly order the Sec. 199 deduction in relation to other statutory provisions, including Sec. 965.

Sec. 199

Under this section, a qualifying taxpayer can take a deduction equal to a percentage of the lesser of its taxable income or qualified production activities income (QPAI). The maximum percentage is phased in over five years (stairS with 3% in 2005 and 2006, and reaching a maximum of 9% in 2010 and thereafter). QPM is the excess, if any, of the taxpayer's domestic production gross receipts (DPGR) over the sum of (1) the cost of goods sold allocable to such receipts and (2) other expenses, losses or deductions (other than the deduction provided by Sec. 199 itself) properly allocable to such receipts.

DPGR is defined as gross receipts derived from (1) any lease, rental, license, sale, exchange or other disposition of qualified production property (tangible personal property, computer software or sound recordings) manufactured, produced, grown or extracted by the taxpayer in whole or in significant part within the U.S., qualified films, or electricity, natural gas or potable water produced by the taxpayer in the U.S; (2) construction performed in the U.S.; and (3) engineering or architectural services performed in the U.S. for construction projects performed in the U.S. The deduction cannot exceed 50% of the W-2 wages paid by the taxpayer during the tax year.

Notice 2005-14 offered interim guidance on the calculation of the deduction (including definitions of certain terms), the determination of DPGR, methods of allocating deductions and the application of Sec. 199 to passthrough entities and affiliated groups. Section 6.01(1) of the notice specifically requested comments on how to order Sec. 199's rules in the context of other Code provisions. Sec. 199's rules were further clarified on Nov. 4, 2005, when the IRS...