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State action on the domestic production activities deduction.

On Oct. 22, 2004, President Bush signed into law the American Jobs Creation Act of 2004 (AJCA), which provides taxpayers with the rare opportunity to lower their effective tax rates through a statutory mechanism. The legislation's centerpiece is the domestic production activities deduction (DPAD). It is estimated that this deduction, contained in Internal Revenue Code (IRC) Sec. 199, will represent a $76 billion Federal tax break for U.S. companies over the next 10 years.

The Federal tax benefits of this new legislation have been well examined over the past year. (1) However, as the deduction is available for tax years beginning after 2004, practitioners are just starting to pay attention to its state tax implications.

What actions have state legislators taken thus far (or not) in regard to the DPAD? How might the DPAD rules interact with some of the intricacies of multistate corporate taxation? This column addresses these questions but finds that, in many cases, there are no answers.

DPAD Basics

The DPAD deduction is intended to encourage domestic investment, by giving taxpayers that perform certain production activities in the U.S. (qualified production activities) an incentive to continue and increase such activities. Under Sec. 199(c)(5), the following activities are qualified production activities:

* The manufacture, production, growth or extraction in whole or significant part in the U.S. of tangible personal property (e.g., clothing, goods and food), software development or music recordings;

* Film production (with exclusions provided in the statute), provided at least 50% of the total compensation relating to the production of the film is compensation for specified production services performed in the U.S.;

* Production of electricity, natural gas or water in the U.S.;

* Construction or substantial renovation of real property in the U.S., including residential and commercial buildings and infrastructure, such as roads, power lines, water systems and communications facilities; or

* Engineering and architectural services performed in the U.S. and relating to the construction of real property.

The deduction is premised on domestic production gross receipts (DPGR), as defined in IRC Sec. 199(c)(4). Under IRC Sec. 199(c)(1), DPGR are reduced by the associated cost of goods sold, other allocable deductions and certain other deductions, to arrive at qualified production activites income (QPAI).

The DPAD is determined by multiplying the applicable percentage by the lesser of QPAI or taxable income; see IRC Sec. 199(a)(1). The deduction is limited to 50% of the taxpayer's W-2 wages. (2) Under IRC Sec. 199(a)(2), the deduction is 3% for tax years 2005 and 2006; 6% for tax years 2007, 2008 and 2009; and 9% for tax years 2010 or later.

IRC Sec. 199(d)(2) provides that the DPAD is calculated based on an expanded affiliated group basis (3); under IRC Sec. 199(d)(4), the deduction is allocated among group members based on each's proportionate QPAI.

State Conformity

As with the bonus depredation provisions in the Job Creation and Worker Assistance Act of 2002, (4) the states have to decide whether to conform to the DPAD provisions. However, one notable difference is that bonus depredation is a timing issue that is already reversing. In contrast, DPAD provides taxpayers with a permanent tax benefit. From a financial accounting perspective, DPAD joins the recent raft of related-member addback adjustments as a permanent state tax difference that will have to be tracked. Practitioners may become increasingly nostalgic for the days when computing current state taxes called for tittle more than applying a state effective rate to pretax income.

In the long run, bonus depreciation will not have an overall effect on state treasuries, (5) but the same cannot be said for DPAD. Each state has had to decide (or in some cases, is still deciding) whether it can afford this 10-year tax break.

The DPAD may also be evaluated in a business development context. If the Cuno (6) decision is ultimately upheld, conforming to the DPAD provisions may be one of the few permissible tax incentives offered by a state, even though the new deduction may be "rewarding" investments made outside of that state. Nonetheless, from the standpoint of economic development policy, conformity with IRC Sec. 199 may be touted as a pro-business incentive.

Conformity to DPAD depends on state conformity to the IRC. In general, states either automatically conform to the IRC or affirmatively adopt it as of a specific date, to include recent Federal changes. In either case, the DPAD's effect may not have been specifically considered.

The most clearly enunciated positions on DPAD conformity come from the states that have specifically rejected it; Georgia, Maine, Massachusetts, North Dakota and West Virginia have explicitly decoupled (7) from IRC Sec. 199 (also referred to as "Section 102 of Public Law 108-357").

A snapshot of state tax Conformity to the DPAD is provided by a Federation of Tax Administrators (FTA) survey. (8) As of June 1, 2005, representatives of 16 state tax agencies (9) indicated that their corporate tax regimes would conform to IRC Sec. 199; another 11 states (10) indicated that they were"likely" to conform. Fourteen states (11) responded that their taxing statutes did not conform to IRC Sec. 199, and the final six respondents (12) felt that their states were not likely to conform.

Update: As of July 15, 2005, several of these responses were superseded. On June 7, 2005, South Carolina Governor Mark Sanford signed HB 3768, which contains a provision (13) explicitly decoupling from IRC Sec. 199. Similarly, in Minnesota, a special legislative session produced H.E No. 138, which was signed by Governor Tim Pawlenty on July 13, 2005, and added new statutory language (14) requiring IRC Sec. 199 deductions to be added back to income.

New Jersey became the first (and only) state so far to partially decouple from the DPAD; on July 2, 2005, Acting Governor Richard J. Codey signed AB 4294. The legislation added language to the definition of entire net income, (15) which requires an addback of the Sec. 199 deduction, except for qualifying production property manufactured or produced by the taxpayer. As a consequence, if a DPAD results from growing and extracting; food processing; software development; filmmaking; sound recording; the production of electricity, natural gas or potable water; construction, engineering or architectural services; or agricultural and horticultural production, it will not be allowed for purposes of New Jersey's Corporation Business Tax.

At press time, the states are clearly not finished addressing the DPAD. Legislative action to decouple from IRC Sec. 199 is pending in Alaska (SB 151 is in committee) and California (AB 115 is under consideration by the Senate Revenue and Taxation Committee). In Oregon, two conference committees will be convened to resolve differences between the House conformity bill (HB 2542b), which would allow the DPAD, and the Senate version of this bill, which would deny the Sec. 199 deduction. The protracted budget battle in Wisconsin has delayed enactment of AB 100, which contains language that would conform to the AJCA's provisions.

These states may not be the only jurisdictions in which the DPAD becomes a tax issue for a year subsequent to 2005. In recent years, state actions concerning bonus depreciation took place in years following enactment of Federal legislation, and related-member addback provisions have been given retroactive effect. It would not be surprising to see states decoupling from the Federal DPAD provisions in 2006 or subsequent years, and even making such provisions retroactive for a year or two.

The DPAD at the State Level

It is likely that taxpayers will make every effort to maximize their DPAD deduction. However, the interaction of Federal and state rules may prove troublesome for taxpayers and practitioners alike. To date, aside from New Jersey's "partial" decoupiing as described above, the individual states have yet to address any state-specific issues arising in connection with the DPAD.

For example, the Federal DPAD is computed at the entity level. (16) As such, identifying the "taxpayer" for state reporting purposes will be an important first step in determining the DPAD for state purposes. One particularly troubling prospect is that states will limit the DPAD calculation to the separate-company filing in a state or to the combined or consolidated group filing in a state. If this differs from the DPAD computed for the Federal "expanded affiliated group," (17) which is allocated among the individual group members, computational problems will abound. In separate-return states, could taxpayers qualify for state DPADs even though the IRC limits preclude a Federal deduction?

Of the 27 states that told the FTA that they conform or were likely to conform to IRC Sec. 199,10 (18) require separate, single-company corporate returns. Even in states that permit or require combined filing, state combined groups are frequently different from Federal affiliated groups.

Additional controversy will arise if states limit the DPAD by taxable income after state modifications to Federal taxable income (the IRC Sec. 199 limit is by "taxable income" before DPAD, under IRC Sec. 199(a)(1)(B)). This kind of constraint seems likely, as it is difficult to believe that the states would permit a deduction limited by a number larger than their tax base.

As previously mentioned, a state's conformity to the DPAD may reward activity conducted outside of that state. Is it possible that states may try to limit the DPAD by redefining DPGR or QPAI based on activity conducted in the taxing state? If so, a new round of Cuno-style discrimination controversies is likely to ensue.

Because the Federal DPAD is limited to taxable income in excess of net operating losses (NOLs) (i.e., line 30) rather than income before NOLs and special deductions favored by most states (i.e., line 28), the integration of NOL planning with DPAD maximization may become another insidious twist in the state context. Once again, the differences between Federal and state filing groups may come into play, as well as state-specific rules governing the computation of NOLs and the differences between Federal and state carryback and carryforward periods.

Certainly, the states will gradually move to resolve these sorts of headaches. But will resolution by regulation or other technical guidance suffice or will deviations from the letter of the Federal DPAD provisions require further legislative amendment?


In the case of the DPAD, the conflict between Federal tax policy and state budgetary constraints has already caused more complexity for both taxpayers and practitioners. Once conformity issues are resolved, additional complexity will be manifest in attempting to integrate reporting mechanics with the specifics of DPAD calculations for state purposes.

Editor's note: Mr. Schaefer is a member of the AICPA Tax Division's State & Local Taxation Technical Resource Panel (TRP). For more information about this column, contact Mr. Schaefer at

(1) See News Notes," AJCA" 36 The Tax Adviser 4 (January 2005) and Morris, Tax Clinic, "The AJCA's FAS No. 109 Implications," 36 The Tax Adviser 255 (May 2005).

(2) See IRC Sec. 199(b)(1). Typically, expenses will be apportioned to DPGR using the IRC Sec. 861 sourcing rules.

(3) Generally, this is a Federal affiliated group with the ownership threshold reduced to 50%.

(4) Additional first-year depreciation was provided by the Jobs and Growth Tax Relief Reconciliation Act of 2003.

(5) More than 20 states decoupled from Federal bonus depreciation.

(6) Charlotte Cuno v. DaimlerChrysler, Inc., 6th Cir., 9/2/04.

(7) Georgia's HB 488 moved its IRC conformity date to Jan. 1, 2005, except for IRC Sec. 199's DPAD provision. A provision of FIB 343 moved Maine's conformity date to Dec. 31, 2004, but requires taxpayers to add back the Federal deduction taken for IRC Sec. 199 domestic production activity. Massachusetts' HB 5156 decoupled from the Federal production activity deduction as "necessary for the immediate preservation of the public convenience" North Dakota's HB 1108 requires adding back the deduction taken under IRC Sec. 199 to the extent taken in determining Federal taxable income. West Virginia's SB 614 disallows an IRC Sec. 199 deduction.

(8) See "Most States Will Conform to Sec. 199 Qualified Production Activity Income Deduction, Results of Survey of Tax Administrators," FTA Bulletin B-25/05 (6/7/05), available at, under "State Comparisons".

(9) See id. (AL,AZ, CO, CT, FL, ID, IA, KS, KY, MO, MT, NM, OH, OK, UT and VA).

(10) See id. (AK, DE, IL, LA, MI, NE, NY, OR, PA, VT and WI).

(11) See id. (AR, DC, GA, HI, IN, ME, MD, MA, MS, NC, ND, TN, TX and WV).

(12) See id. (CA, MN, NH, NJ, RI and SC).

(13) S.C.C.A. [section]12-6-50(7).

(14) M.S. [section]290A.03.3(b)(xiv).

(15) N.J.S.A. [section] 54:10A4(k)(2)(J).

(16) Except in the case of flowthrough entities.

(17) See IRC Sec. 199(d) (4)(B).

(18) AL, DE, IA, KY, LA, MO, OK, PA, VT and WI.

Frank Schaefer, CPA

Executive Director, State and Local Taxes

Grant Thornton LLP

New York, NY
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Author:Schaefer, Frank
Publication:The Tax Adviser
Date:Sep 1, 2005
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