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

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 It repealed the extraterritorial income tax regime, but gave corporations various new tax incentives.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 and Treasury issued proposed regulations under Sec. 199. Final regulations are expected to be issued soon (but after this issue of The Tax Adviser goes to press).

Sec. 965

Subject to certain restrictions and limits, Sec. 965 generally permits a corporation that is a U.S. shareholder a deduction equal to 85% of cash dividends received during the tax year from CFCs and invested in the U.S. The nondeductible portion must be included in taxable income for the year of receipt. This provision is elective, and may be elected for either the taxpayer's last tax year beginning before the enactment date, or the taxpayer's first tax year that begins during the one-year period beginning on the enactment date. Thus, calendar-year taxpayers may make an election under Sec. 965 for 2004 or 2005. Since its enactment, the Sec. 965 deduction has been clarified several times in IRS notices.

Ordering Issues and Rules

Because Sec. 199 results in a deduction for qualifying taxpayers, questions began to arise shortly after the section's enactment that relate to the interplay of the deduction with other Code provisions. For example, the statute did not address how to calculate the deduction when the taxpayer has a net operating loss (NOL) carryover under Sec. 172. Specifically, was the allowable Sec. 199 deduction based on taxable income before or after applying the NOL carryover, and could the deduction increase an NOL carryover? These issues were clarified in proposed regulations, which noted that, for Sec. 199 deduction purposes, the definition of "taxable income" under Sec. 63 applies, meaning taxable income aider applying the NOL carryover. According to Prop. Regs. Sec. 1.199-1 (b) (1), the deduction cannot increase an NOL carryover or carryback (there is an exception for expanded affiliated group members in certain situations).Thus, if there is no taxable income after applying NOL carryovers, the taxpayer will not receive a Sec. 199 benefit.

A similar issue exists for Secs. 199 and 965--namely, whether the Sec. 199 deduction can reduce taxable income attributable to Sec. 965 dividend income. Apart from the treatment of taxpayers with NOL carryovers and carrybacks, the statute and proposed regulations under Sec. 199 do little to address ordering. Rather, the wording of the statute itself ostensibly resolves the interplay of the two sections. Specifically, Sec. 965(e)(2)(A) states that the taxable income of a U.S. shareholder will be no less than the amount of nondeductible CFC dividends received in such year. Under Sec. 63(a), taxable income equals gross income less deductions (other than the standard deduction) allowed by Title 26, Subtitle A, Chapter 1, which would include the Sec. 199 deduction and any NOL carryovers. Thus, Sec. 965(e) (2) (A) seemingly overrides the general rule under Sec. 63(a) by not allowing such deductions to the extent of includible CFC dividends. Sec. 965(e)(2)(B) goes on to state that nondeductible CFC dividends for a tax year will not be taken into account in determining the amount of any NOL for such tax year under Sec. 172, and in determining taxable income for such year for purposes of the second sentence of Sec. 172(b)(2) (which in turn governs the determination of remaining NOL carryforwards and carrybacks). As noted above, the Sec. 199 proposed regulations clarify that the Sec. 199 deduction may not create or increase an NOL carryforward or carryback. Given the various provisions, it thus appears the deduction can neither reduce the Sec. 965 inclusion nor increase the amount of any NOL carryforward or carryback from the Sec. 965 year. (This interpretation has been informally confirmed recently by one government official.)

Exercise Caution

The above discussion is relevant to taxpayers that, except for a Sec. 965 inclusion, would have a current-year loss, or an NOL carryforward that eliminates or reduces taxable income for the year or limits current taxable income. Further, although the amounts attributable to a CFC would presumably arise from DPGR, it is entirely possible that the domestic parent or its expanded affiliated group does have DPGR. As with any new provision, taxpayers should exercise care in applying Secs. 199 and 965 in the same year.

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Author:Vance, Scott
Publication:The Tax Adviser
Date:Jun 1, 2006
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