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Final Section 199 regulations clarify application of domestic production incentive.

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.


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 or allocations. In order for specific identification of DPGR to be required, the relevant information must be readily available and the taxpayer must be able, without undue burden or expense, to specifically identify whether the receipts at issue are DPGR. (12) Furthermore, there is now a "reverse de minimis rule," so that if less than 5 percent of a taxpayer's gross receipts are DPGR, or if less than 5 percent of its gross receipts from specified items are DPGR, then it may treat all such receipts as non-DPGR. (13)


Proposed regulations had provided an exception for certain advertising and product placement revenues. Thus, for certain taxpayers, such revenue is deemed so inextricably linked to underlying DPGR (if any) that it is also treated as DPGR. (14) The final regulations expand on this exception for other qualifying activities. First, advertising revenue associated with newspapers, magazines, telephone directories, periodicals, and similar printed publications is deemed to constitute DPGR, if the receipts from the disposition of the publications are or would be DPGR. (15) Furthermore, advertising and product placement revenue associated with qualified films is likewise deemed to constitute DPGR if the receipts from the disposition of the qualified films are or would be DPGR. (16) The final regulations retain the rule that over-the-air broadcasting does not constitute a disposition for purposes of section 199, so any associated advertising revenue does not constitute DPGR. A license of qualified film to an unrelated cable company, however, does constitute a disposition for these purposes and therefore will trigger the advertising exception. (17)

COGS and Deduction Allocation

The standards for specific identification versus allocation of COGS are similar to those for gross receipts. Hence, in order for specific identification of COGS to be required, the relevant information must be readily available and the taxpayer must be able, without undue burden or expense, to specifically identify COGS allocable to DPGR. (18) Additionally, many taxpayers are required to apply the rules of the section 861 regulations to allocate and apportion deductions to gross income attributable to DPGR. (19)

Taxpayers had requested expansion of the proposed simplified allocation methods. (20) Although these have not been made universally available, the requirements have been modified. A taxpayer may use gross receipts under the simplified deduction method to apportion gross receipts between DPGR and non-DPGR if the taxpayer has either average annual gross receipts of $100,000,000 or less or total assets of $10,000,000 or less. (21) A taxpayer may use gross receipts under the small business simplified overall method to apportion COGS and deductions if any of the following conditions is satisfied: (a) the taxpayer has average annual gross receipts of $5,000,000 or less; (b) the taxpayer is engaged in the trade or business of farming and is not required to use the accrual method under section 447; (c) or the taxpayer is eligible to use the cash method under Rev. Proc. 2002-28. (22) The modifications, and particularly the increase of the gross receipts threshold for use of the simplified deduction method, (23) should simplify the computational process for a number of taxpayers.

Wage Limitation

For purposes of the W-2 wage limitation, the three methods previously contained in Notice 2005-14 and the proposed regulations have been moved to Rev. Proc. 2006-22. (24) The theory behind moving the guidance from the regulations to a revenue procedure is to simplify the revision process should there subsequently be changes to Form W-2. (25)

Recent statutory changes limit the W-2 wages that may be counted in the overall W-2 wage limitation to those properly allocable to DPGR and expand the wages that may be allocated to owners from passthrough entities. (26) The Treasury and IRS plan on issuing additional regulations and a revenue procedure reflecting these changes for taxable years beginning after May 17, 2006. (27)

Passthrough Entities

The general rule continues to be, with certain exceptions such as an EAG partnership, that there is no attribution of activities between a passthrough entity and its owners. (28) The government recognized at an early stage that this rule was problematic for certain industries (such as oil and gas) that had historically operated in partnership form and made in-kind distributions. If MPGE activities occurred within the partnership, and the products from such activities were simply distributed to partners who then sold the products, no taxpayer would have eligible receipts and thus no taxpayer would obtain the benefit of section 199. The final regulations permit the partners of a "qualifying in-kind partnership" to attribute activities of certain partnerships to their partners. (29) The activities that are specifically eligible under the final regulations are the extraction, refining, or processing of oil; natural gas; petrochemicals; or products derived from oil, natural gas, or petrochemical in whole or in significant part in the United States; and the production or generation of electricity in the United States. (30) The final regulations allow for the identification of additional eligible industries via publication in the Internal Revenue Bulletin, (31) and it seems likely that certain industries (such as mining) will press the case based on their similarities to the industries already deemed eligible.

As taxpayers have progressed through tax return compliance activities for calendar year 2005, there has been much concern and confusion over the appropriate level of reporting from passthrough entities that engage in eligible activities to their owners that potentially claim section 199 deductions. It remains clear that the deduction itself is computed at the owner level, (32) and the specific categories and amounts that ought to be reported to owners may likely be identified from the projected elements of the calculation of QPAI, but such reporting can introduce considerable complexity to the compliance process. Although a qualifying small taxpayer may use the small business simplified overall method to apportion COGS and deductions between DPGR and non-DPGR at the entity level, (33) the default rule appears to remain that other passthrough entities may not make such allocations at the entity level. The final regulations do provide, however, that the Secretary may, by publication in the Internal Revenue Bulletin, permit a partnership or S corporation to compute an owner's share of QPAI at the entity level. (34) Many taxpayers eagerly await such guidance.


The construction industry anticipated significant clarifications of the application of section 199 to its facts, and the final regulations do not disappoint. A case in point is an example in the initial regulations concerning an electrical contractor. The example indicated that, while the contractor's work generally qualified for section 199 benefit, materials the taxpayer installed did not give rise to DPGR and needed to be accounted for separately (35)--a result criticized as impractical and burdensome. In the final regulations, the Treasury and IRS reached a reasonable result that DPGR includes receipts derived from materials and supplies consumed in the construction project or that become part of the constructed real property, assuming all other requirements of section 199 are met. (36) The final regulations provide, however, that revenue from items that remain tangible personal property must be analyzed separately to determine whether it gives rise to DPGR.

A question exists about how much work is enough to constitute construction for purposes of section 199. Although a taxpayer who hires an unrelated party to perform construction on its behalf but does not otherwise participate in the construction effort will not qualify for section 199 benefits, it is now equally clear that one need not be a general contractor to be performing construction activities. The final regulations provide that activities constituting construction include activities typically performed by a general contractor, such as management and oversight of the construction process (including approvals, periodic inspection of the progress of the construction project, and required job modifications). (37)

Receipts from the disposition of land continue to be excluded from DPGR, but the final regulations clarify several matters. First, the Treasury and IRS have modified the previous rule excluding a variety of activities from the definition of construction under the rationale that they related to the land itself rather than the construction project. (38) Under the final regulations, services such as grading, demolition, clearing, excavating, and any other activities that physically transform the land are deemed to constitute construction if they are performed in connection with other activities (whether or not by the same taxpayer) that meet the requirements for construction under the regulations. (39) Certain other costs capitalized to the land, including zoning, planning, and entitlement costs, however, are deemed to concern activities related to the land itself rather than to the construction project. (40)

Second, although the land safe harbor was generally well received, many taxpayers thought it inappropriate to start the holding period at the time a taxpayer enters into an option to acquire the land. The government agreed and modified the safe harbor rule to provide that the holding period for purposes of the land safe harbor generally begins on the date the taxpayer acquires title to the land, unless the purchase price under the option agreement does not approximate the fair market value of the land. (41)

Finally, the final regulations permit a taxpayer to exclude gross receipts from the disposition of land for purposes of the de minimis construction rule. (42) Otherwise, it would be very difficult for taxpayers disposing of land in connection with construction projects to establish that less than 5 percent of receipts were attributable to non-construction activities.


Computer software has provided a challenging set of interpretative issues. The final regulations address some concerns in the area of software maintenance agreements. Software updates embedded in maintenance agreements may give rise to DPGR, assuming they meet the requirements of section 199, (43) a result consistent with prior administrative guidance. (44) Additionally, software maintenance agreements themselves may be deemed to give rise to DPGR in situations in which the maintenance fee is not separately stated from the underlying software license and in which the maintenance component is not separately offered or bargained for. (45)

In addition, the Treasury and IRS concluded that DPGR includes certain revenue derived from the online use of software that is not licensed or sold to customers. The temporary and proposed regulations make it clear that gross receipts derived from computer software exclude receipts from customer and technical support; telephone and other telecommunications services; online services, including Internet access services, online banking services, and access to online publications; and other similar services. (46) Certain industries such as publishing had argued that traditional means of production and analogous online distribution should be treated similarly, but this position is not generally reflected in the regulations.

Nevertheless, there are two key exceptions for software provided via multiple formats. If a taxpayer provides software online and the same taxpayer on a regular and ongoing basis in its business produces and provides via fixed medium or download software that has only minor or immaterial differences from the online software, then the provision of software online will give rise to DPGR. (47) Similarly, if a taxpayer provides software online and an unrelated taxpayer on a regular and ongoing basis in its business provides substantially identical software via fixed medium or download, then the provision of software online likewise gives rise to DPGR. (48) For this purpose, "substantially identical" is defined to include software that, from the customer's perspective, has the same functional result; and that has a significant overlap of features or purpose. (49) The first exception seemingly encompasses the now-classic example of a taxpayer who develops tax return preparation software for license on CD-ROM; download over the Internet; or use by customers on the taxpayer's Web site. The second exception is more expansive in that it looks to offerings by competitors. Significantly, for purposes of administrative ease, all computer software games are deemed to be substantially identical. (50)


The recent guidance from the Treasury and IRS on section 199 provides useful insight into the application of the deduction in a variety of settings. There will no doubt be further guidance as a result of comments, experience, and examinations. Tax executives at companies who may benefit from section 199 should carefully study the new guidance and provide commentary to the Treasury and IRS if necessary. Such input has clearly contributed to the development of the recent regulations.

(1) Section 199 was added to the Internal Revenue Code by section 102 of the American Jobs Creation Act of 2004, Public Law No. 108-357, and was amended by both section 403 of the Gulf Opportunity Zone Act of 2005, Public Law No. 109-135, and section 514 of the Tax Increase Prevention and Reconciliation Act of 2005, Public Law No. 109-222.

(2) T.D. 9263, 71 F.R. 31268 (final regulations under I.R.C. [section] 199); T.D. 9262, 71 F.R. 31074, and REG-111578-06, 71 F.R. 31128 (temporary and proposed regulations under I.R.C. [section] 199 concerning certain computer software transactions); and Rev. Proc. 200622, 2006-23 I.R.B. 1033 (concerning the W-2 wage limitation). The final regulations generally apply to years beginning on or after June 1, 2006, but may be applied to earlier taxable years if applied in their entirety. Treas. Reg. [section] 1.199-8(i)(1). Pursuant to Treas. Reg. [section] 1.199-9(k), Treas. Reg. [section] 1.199-9 does not apply to taxable years beginning after May 17, 2006. Prior guidance had been provided in REG-105847-105, 70 F.R. 67220, and Notice 2005-14, 2005-1 C.B. 498.

(3) I.R.C. [section] 199(a). The percentage is 3 percent for taxable years beginning in 2005 and 2006; 6 percent for taxable years beginning in 2007, 2008, and 2009; and 9 percent thereafter.

(4) I.R.C. [section] 199(b). This provision was amended for taxable years beginning after May 17, 2006, by section 514 of the Tax Increase Prevention and Reconciliation Act of 2005, Public Law No. 109-222.

(5) I.R.C. [section] 199(c)(1).

(6) I.R.C. [section] 199(c)(4).

(7) Treas. Reg. [section] 1.199-3(d)(1).

(8) Treas. Reg. [section] 1.199-3(d)(1)(i); Preamble, T.D. 9263.

(9) Treas. Reg. [section] 1.199-3(d)(1)(ii).

(10) For example, this term was used at a panel concerning section 199 at the May 5, 2006, meeting of the Tax Accounting Committee of the ABA Section of Taxation.

(11) This example is based on Treas. Reg. [section] 1.199-3(d)(4), Example 10.

(12) Treas. Reg. [section] 1.199-1(d)(2).

(13) See, e.g., Treas. Reg. [subsection] 1.199-1(d)(3)(ii), -3(i)(4)(ii), -3(1)(4)(iv)(B), -3(m)(1)(iii)(B), -3(n)(6)(ii).

(14) Prop. Reg. [section] 1.199-3(h)(5).

(15) Treas. Reg. [section] 1.199-3(i)(5)(i).

(16) Treas. Reg. [section] 1.199-3(i)(5)(ii).

(17) See Preamble, T.D. 9263; Treas. Reg. [section] 1.199-3(i)(5)(iii), Examples 3, 4, and 5.

(18) See Treas. Reg. [section] 1.199-4(b)(2)(i).

(19) See generally Treas. Reg. [section] 1.199-4(d).

(20) Earlier versions of the simplified deduction method and the small business simplified overall method appeared in Prop. Reg. [subsection] 1.199-4(e) and (f).

(21) Treas. Reg. [section] 1.199-4(e).

(22) Treas. Reg. [section] 1.199-4(f).

(23) Under Prop. Reg. [section] 1.199-4(e)(1), this average annual gross receipts threshold under the simplified deduction method had been $25,000,000, and under Prop. Reg. [section] 1.199-4(f)(2)(i), the first criterion under the small business simplified overall method had been that a taxpayer must have both average annual gross receipts of $5,000,000 or less and total costs for the current taxable year of $5,000,000 or less.

(24) See Rev. Proc. 2006-22, [section] 2; Notice 2005-14, [section] 4.02; Prop. Reg. [section] 1.199-2.

(25) See Preamble to T.D. 9263.

(26) Tax Increase Prevention and Reconciliation Act of 2005, Public Law No. 109-222, [section] 514.

(27) Rev. Proc. 2006-22, [section] 2.

(28) Treas. Reg. [section] 1.199-9(h). Under Treas. Reg. [section] 1.199-9(j)(1), an EAG partnership is defined as a partnership all of the interests in capital and profits of which are owned by members of a single expanded affiliated group at all times during the taxable year of the partnership.

(29) Treas. Reg. [section] 1.199-9(i).

(30) Treas. Reg. [subsection] 1.199-9(i)(2)(i), (ii).

(31) Treas. Reg. [section] 1.199-9(i)(2)(iii).

(32) See, e.g., Treas. Reg. [section] 1.199-9(b)(1)(i).

(33) Treas. Reg. [section] 1.199-9(k).

(34) Treas. Reg. [section] 1.199-9(b)(1)(ii),

(35) Prop. Reg. [section] 1.199-3(1)(5)(iii), Example 2.

(36) Treas. Reg. [section] 1.199-3(m)(6)(i); Treas. Reg. [section] 1.199-3(m)(6)(v), Example 2.

(37) Treas. Reg. [section] 1.199-3(m)(2)(i).

(38) See Prop. Reg. [section] 1.199-3(1)(5)(ii).

(39) Treas. Reg. [section] 1.199-3(m)(2)(iii).

(40) See Treas. Reg. [section] 1.199-3(m)(6)(iv)(A).

(41) Id.

(42) Treas. Reg. [section] 1.199-3(m)(1)(iii)(A).

(43) Treas. Reg. [section] 1.199-1(e)(3), Example 1.

(44) See, e.g., TAM 9231002.

(45) Treas. Reg. [section] 1.199-3(i)(4)(i)(B)(5).

(46) Temp. Reg. [section] 1.199-3T(i)(6)(ii).

(47) Temp. Reg. [section] 1.199-3T(i)(6)(iii)(A).

(48) Temp. Reg. [section] 1.199-3T(i)(6)(iii)(B).

(49) Temp. Reg. [section] 1.199-3T(i)(6)(iv)(A).

(50) Temp. Reg. [section] 1.199-3T(i)(6)(iv)(B).

SCOTT VANCE is a Principal in the Income Tax and Accounting Group of KPMG LLP's Washington National Tax Practice in Washington, D.C. He has 15 years experience dealing with a variety of federal tax issues, including section 199, income and expense recognition, inventory valuation, and capitalization and cost recovery. He may be contacted at
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Author:Vance, Scott
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Date:May 1, 2006
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