Treasury and IRS guidance sheds light on Sec. 199 deduction.

• Author: Rose, Kevin

Acting on the belief that it is "important to provide tax cuts to U.S. domestic manufacturers," and in its latest effort to make U.S companies competitive both domestically and abroad, Congress adopted a new deduction for domestic production activities via new Sec. 199. The statutory relief provided under Sec. 199 was enacted in response to a World Trade Organization (WTO) ruling that the extraterritorial income (ETI) exclusion was a forbidden export subsidy. Congress responded to the WTO by repealing the ETI exclusion and effectively replacing it with a new Sec. 199 deduction. Subject to certain limits, the deduction is based on a percentage of the lesser of:

* Qualified production activities income (QPAI); or

* Taxable income, notwithstanding the Sec. 199 deduction.

QPAI is determined as the excess of:

1. The taxpayer's domestic production gross receipts (DPGR) per Sec. 199 (c)(4),

2. Less the sum of:

(a) Cost of goods sold (COGS) allocable to such receipts;

(b) Other expenses and losses directly allocable to such receipts; and

(c) A ratable portion of other deductions, expenses and losses not directly allocable to those receipts or to another residual class of income.

The deduction is effective for tax years beginning in 2005, and will be phased in; see the exhibit on p. 275.

Determining Costs

On Oct. 20, 2005, the IRS released Prop. Kegs. Secs. 1.199-1 to -8, which expand on the initial guidance offered in Notice 2005-14 by clarifying and providing additional instruction on a number of critical issues, including the rules for allocating and apportioning income and expenses in computing the base amount available for the Sec. 199 deduction.

Under the proposed regulations, taxpayers must account for qualifying receipts and expenses recognized in different tax years (e.g., as in accounting for advanced payments) under their regular accounting method. Thus, when determining a Sec. 199 deduction, costs must be determined by the accounting method used for Federal income tax purposes.

Allocating COGS

Taxpayers generally must specifically identify COGS directly allocable to DPGR and a ratable portion of other deductions not directly traceable to DPGR or another income class (Prop. Regs. Sec. 1.199-4(a)). In determining the directly allocable COGS, they must consider: (1) Sec. 263A (uniform capitalization rules), Sec. 471 (general inventory rules) and Sec. 472 (LIFO inventory rules) when determining ending inventory; (2) inventory valuation...