Treasury Decision 9263 |
June 19, 2006 |
Income Attributable to Domestic Production Activities
Internal Revenue Service (IRS), Treasury.
This document contains final regulations concerning the deduction for
income attributable to domestic production activities under section 199 of
the Internal Revenue Code. Section 199 was enacted as part of the American
Jobs Creation Act of 2004 (Act). The regulations will affect taxpayers engaged
in certain domestic production activities.
Effective Date: These regulations are effective
June 1, 2006.
Date of Applicability: For date of applicability,
see §§1.199-8(i) and 1.199-9(k).
FOR FURTHER INFORMATION CONTACT:
Concerning §§1.199-1, 1.199-3, 1.199-6, and 1.199-8, Paul
Handleman or Lauren Ross Taylor, (202) 622-3040; concerning §1.199-2,
Alfred Kelley, (202) 622-6040; concerning §1.199-4(c) and (d), Richard
Chewning, (202) 622-3850; concerning all other provisions of §1.199-4,
Jeffery Mitchell, (202) 622-4970; concerning §1.199-7, Ken Cohen, (202)
622-7790; concerning §1.199-9, Martin Schaffer, (202) 622-3080 (not toll-free
numbers).
SUPPLEMENTARY INFORMATION:
The collection of information contained in these final regulations has
been reviewed and approved by the Office of Management and Budget in accordance
with the Paperwork Reduction Act (44 U.S.C. 3507) under control number 1545-1966.
Responses to this collection of information are mandatory so that patrons
of agricultural and horticultural cooperatives may claim the section 199 deduction.
An agency may not conduct or sponsor, and a person is not required to
respond to, a collection of information unless the collection of information
displays a valid control number assigned by the Office of Management and Budget.
The estimated annual burden per respondent varies from 15 minutes to
10 hours, depending on individual circumstances, with an estimated average
of 3 hours.
Comments concerning the accuracy of this burden estimate and suggestions
for reducing this burden should be sent to the Internal
Revenue Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP,
Washington, DC 20224, and to the Office of Management
and Budget, Attn: Desk Officer for the Department of the Treasury,
Office of Information and Regulatory Affairs, Washington, DC 20503.
Books or records relating to this collection of information must
be retained as long as their contents may become material in the administration
of any internal revenue law. Generally, tax returns and tax return information
are confidential, as required by 26 U.S.C. 6103.
This document amends 26 CFR part 1 to provide rules relating to the
deduction for income attributable to domestic production activities under
section 199 of the Internal Revenue Code (Code). Section 199 was added
to the Code by section 102 of the American Jobs Creation Act of 2004 (Public
Law 108-357, 118 Stat. 1418) (Act), and amended by section 403(a) of the Gulf
Opportunity Zone Act of 2005 (Public Law 109-135, 119 Stat. 25) (GOZA) and
section 514 of the Tax Increase Prevention and Reconciliation Act of 2005
(Public Law 109-222, 120 Stat. 345) (TIPRA). On January 19, 2005, the
IRS and Treasury Department issued Notice 2005-14, 2005-1 C.B. 498, providing
interim guidance on section 199. On November 4, 2005, the IRS and Treasury
Department published in the Federal Register proposed
regulations under section 199 (REG-105847-05, 2005-47 I.R.B. 987 [70 FR 67220])
(proposed regulations). On January 11, 2006, the IRS and Treasury Department
held a public hearing on the proposed regulations. Written and electronic
comments responding to the proposed regulations were received. This preamble
describes the most significant comments received by the IRS and Treasury Department.
Because of the large volume of comments received, however, the IRS and Treasury
Department are not able to address all of the comments in this preamble.
After consideration of all of the comments, the proposed regulations are adopted
as amended by this Treasury decision. Contemporaneous with the publication
of these final regulations, temporary (T.D. 9262, 2006-24 I.R.B. 1040) and
proposed (REG-111578-06, 2006-24 I.R.B. 1060) regulations have been published
involving the treatment under section 199 of computer software provided to
customers over the Internet.
Section 199(a)(1) allows a deduction equal to 9 percent (3 percent
in the case of taxable years beginning in 2005 or 2006, and 6 percent
in the case of taxable years beginning in 2007, 2008, or 2009) of the lesser
of (A) the qualified production activities income (QPAI) of the taxpayer for
the taxable year, or (B) taxable income (determined without regard to section 199)
for the taxable year (or, in the case of an individual, adjusted gross income
(AGI)).
Section 199(b)(1) limits the deduction for a taxable year to 50
percent of the W-2 wages paid by the taxpayer during the calendar year that
ends in such taxable year. For this purpose, section 199(b)(2) defines
the term W-2 wages to mean, with respect to any person
for any taxable year of such person, the sum of the amounts described in section 6051(a)(3)
and (8) paid by such person with respect to employment of employees by such
person during the calendar year ending during such taxable year. The term W-2
wages does not include any amount that is not properly included
in a return filed with the Social Security Administration on or before the
60th day after the due date (including extensions) for the return. Section 199(b)(3)
provides that the Secretary shall prescribe rules for the application of section 199(b)
in the case of an acquisition or disposition of a major portion of either
a trade or business or a separate unit of a trade or business during the taxable
year.
Section 514(a) of TIPRA amended section 199(b)(2) by excluding from
the term W-2 wages any amount that is not properly allocable
to domestic production gross receipts (DPGR) for purposes of section 199(c)(1).
The IRS and Treasury Department plan on issuing regulations on the amendments
made to section 199(b)(2) by section 514 of TIPRA.
Qualified Production Activities Income
Section 199(c)(1) defines QPAI for any taxable year as an amount
equal to the excess (if any) of (A) the taxpayer’s DPGR for such taxable
year, over (B) the sum of (i) the cost of goods sold (CGS) that are allocable
to such receipts; and (ii) other expenses, losses, or deductions (other than
the deduction under section 199) that are properly allocable to such receipts.
Section 199(c)(2) provides that the Secretary shall prescribe rules
for the proper allocation of items described in section 199(c)(1) for purposes
of determining QPAI. Such rules shall provide for the proper allocation of
items whether or not such items are directly allocable to DPGR.
Section 199(c)(3) provides special rules for determining costs
in computing QPAI. Under these special rules, any item or service brought
into the United States is treated as acquired by purchase, and its cost is
treated as not less than its value immediately after it enters the United
States. A similar rule applies in determining the adjusted basis of leased
or rented property when the lease or rental gives rise to DPGR. If the property
has been exported by the taxpayer for further manufacture, the increase in
cost or adjusted basis must not exceed the difference between the value of
the property when exported and its value when brought back into the United
States after further manufacture.
Section 199(c)(4)(A) defines DPGR to mean the taxpayer’s
gross receipts that are derived from: (i) any lease, rental, license, sale,
exchange, or other disposition of (I) qualifying production property (QPP)
that 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 (collectively, utilities) 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.
Section 199(c)(4)(B) excepts from DPGR gross receipts of the taxpayer
that are derived from: (i) the sale of food and beverages prepared by the
taxpayer at a retail establishment; (ii) the transmission or distribution
of utilities; or (iii) the lease, rental, license, sale, exchange, or other
disposition of land.
Section 199(c)(4)(C) provides that gross receipts derived from the manufacture
or production of any property described in section 199(c)(4)(A)(i)(I) shall
be treated as meeting the requirements of section 199(c)(4)(A)(i) if (i) such
property is manufactured or produced by the taxpayer pursuant to a contract
with the Federal Government, and (ii) the Federal Acquisition Regulation requires
that title or risk of loss with respect to such property be transferred to
the Federal Government before the manufacture or production of such property
is complete.
Section 199(c)(4)(D) provides that for purposes of section 199(c)(4),
if all of the interests in the capital and profits of a partnership are owned
by members of a single expanded affiliated group (EAG) at all times during
the taxable year of such partnership, the partnership and all members of such
group shall be treated as a single taxpayer during such period.
Section 199(c)(5) defines QPP to mean: (A) tangible personal property;
(B) any computer software; and (C) any property described in section 168(f)(4)
(certain sound recordings).
Section 199(c)(6) defines a qualified film to mean any property
described in section 168(f)(3) if not less than 50 percent of the total
compensation relating to production of the property is compensation for services
performed in the United States by actors, production personnel, directors,
and producers. The term does not include property with respect to which records
are required to be maintained under 18 U.S.C. 2257 (generally, films,
videotapes, or other matter that depict actual sexually explicit conduct and
are produced in whole or in part with materials that have been mailed or shipped
in interstate or foreign commerce, or are shipped or transported or are intended
for shipment or transportation in interstate or foreign commerce).
Section 199(c)(7) provides that DPGR does not include any gross
receipts of the taxpayer derived from property leased, licensed, or rented
by the taxpayer for use by any related person. However, DPGR may include
such property if the property is held for sublease, sublicense, or rent, or
is subleased, sublicensed, or rented, by the related person to an unrelated
person for the ultimate use of the unrelated person. See footnote 29 of H.R.
Conf. Rep. No. 755, 108th Cong. 2d Sess. 260 (2004) (Conference Report).
A person is treated as related to another person if both persons are treated
as a single employer under either section 52(a) or (b) (without regard
to section 1563(b)), or section 414(m) or (o).
Section 199(d)(1)(A) provides that, in the case of a partnership
or S corporation, (i) section 199 shall be applied at the partner or
shareholder level, (ii) each partner or shareholder shall take into account
such person’s allocable share of each item described in section 199(c)(1)(A)
or (B) (determined without regard to whether the items described in section
199(c)(1)(A) exceed the items described in section 199(c)(1)(B)), and (iii)
each partner or shareholder shall be treated for purposes of section 199(b)
as having W-2 wages for the taxable year in an amount equal to the lesser
of (I) such person’s allocable share of the W-2 wages of the partnership
or S corporation for the taxable year (as determined under regulations prescribed
by the Secretary), or (II) 2 times 9 percent (3 percent in the case of taxable
years beginning in 2005 or 2006, and 6 percent in the case of taxable years
beginning in 2007, 2008, or 2009) of so much of such person’s QPAI as
is attributable to items allocated under section 199(d)(1)(A)(ii) for the
taxable year.
Section 514(b) of TIPRA amended section 199(d)(1)(A)(iii) to provide
instead that each partner or shareholder shall be treated for purposes of
section 199(b) as having W-2 wages for the taxable year equal to such person’s
allocable share of the W-2 wages of the partnership or S corporation for the
taxable year (as determined under regulations prescribed by the Secretary).
The IRS and Treasury Department plan on issuing regulations on the amendments
made to section 199(d)(1)(A)(iii) by section 514 of TIPRA.
Section 199(d)(1)(B) provides that, in the case of a trust or estate,
(i) the items referred to in section 199(d)(1)(A)(ii) (as determined therein)
and the W-2 wages of the trust or estate for the taxable year, shall be apportioned
between the beneficiaries and the fiduciary (and among the beneficiaries)
under regulations prescribed by the Secretary, and (ii) for purposes of section
199(d)(2), AGI of the trust or estate shall be determined as provided in section
67(e) with the adjustments described in such paragraph.
Section 199(d)(1)(C) provides that the Secretary may prescribe rules
requiring or restricting the allocation of items and wages under section 199(d)(1)
and may prescribe such reporting requirements as the Secretary determines
appropriate.
In the case of an individual, section 199(d)(2) provides that the
deduction is equal to the applicable percent of the lesser of the taxpayer’s
(A) QPAI for the taxable year, or (B) AGI for the taxable year determined
after applying sections 86, 135, 137, 219, 221, 222, and 469, and without
regard to section 199.
Patrons of Certain Cooperatives
Section 199(d)(3)(A) provides that any person who receives a qualified
payment from a specified agricultural or horticultural cooperative shall be
allowed for the taxable year in which such payment is received a deduction
under section 199(a) equal to the portion of the deduction allowed under section
199(a) to such cooperative which is (i) allowed with respect to the portion
of the QPAI to which such payment is attributable, and (ii) identified by
such cooperative in a written notice mailed to such person during the payment
period described in section 1382(d).
Section 199(d)(3)(B) provides that the taxable income of a specified
agricultural or horticultural cooperative shall not be reduced under section
1382 by reason of that portion of any qualified payment as does not exceed
the deduction allowable under section 199(d)(3)(A) with respect to such payment.
Section 199(d)(3)(C) provides that, for purposes of section 199, the
taxable income of a specified agricultural or horticultural cooperative shall
be computed without regard to any deduction allowable under section 1382(b)
or (c) (relating to patronage dividends, per-unit retain allocations, and
nonpatronage distributions).
Section 199(d)(3)(D) provides that, for purposes of section 199,
a specified agricultural or horticultural cooperative described in section
199(d)(3)(F)(ii) shall be treated as having MPGE in whole or in significant
part any QPP marketed by the organization that its patrons have so MPGE.
Section 199(d)(3)(E) provides that, for purposes of section 199(d)(3),
the term qualified payment means, with respect to any
person, any amount that (i) is described in section 1385(a)(1) or (3), (ii)
is received by such person from a specified agricultural or horticultural
cooperative, and (iii) is attributable to QPAI with respect to which a deduction
is allowed to such cooperative under section 199(a).
Section 199(d)(3)(F) provides that, for purposes of section 199(d)(3),
the term specified agricultural or horticultural cooperative means
an organization to which part I of subchapter T applies that is engaged (i)
in the MPGE in whole or in significant part of any agricultural or horticultural
product, or (ii) in the marketing of agricultural or horticultural products.
Expanded Affiliated Group
Section 199(d)(4)(A) provides that all members of an EAG are treated
as a single corporation for purposes of section 199. Section 199(d)(4)(B)
provides that an EAG is an affiliated group as defined in section 1504(a),
determined by substituting “more than 50 percent” for “at
least 80 percent” each place it appears and without regard to section 1504(b)(2)
and (4).
Section 199(d)(4)(C) provides that, except as provided in regulations,
the section 199 deduction is allocated among the members of the EAG in
proportion to each member’s respective amount (if any) of QPAI.
Trade or Business Requirement
Section 199(d)(5) provides that section 199 is applied by
taking into account only items that are attributable to the actual conduct
of a trade or business.
Section 199(d)(6) provides that, for purposes of determining the
alternative minimum taxable income under section 55, (A) QPAI shall be determined
without regard to any adjustments under sections 56 through 59, and (B) in
the case of a corporation, section 199(a)(1)(B) shall be applied by substituting
“alternative minimum taxable income” for “taxable income.”
Unrelated Business Taxable Income
Section 199(d)(7) provides that, for purposes of determining the tax
imposed by section 511, section 199(a)(1)(B) shall be applied by substituting
“unrelated business taxable income” for “taxable income.”
Authority to Prescribe Regulations
Section 199(d)(8) authorizes the Secretary to prescribe such regulations
as are necessary to carry out the purposes of section 199, including
regulations that prevent more than one taxpayer from being allowed a deduction
under section 199 with respect to any activity described in section 199(c)(4)(A)(i).
The effective date of section 199 in section 102(e) of the Act was amended
by section 403(a)(19) of the GOZA. Section 102(e)(1) of the Act provides
that the amendments made by section 102 of the Act shall apply to taxable
years beginning after December 31, 2004. Section 102(e)(2) of the Act provides
that, in determining the deduction under section 199, items arising from a
taxable year of a partnership, S corporation, estate, or trust beginning before
January 1, 2005, shall not be taken into account for purposes of section 199(d)(1).
Section 514(c) of TIPRA provides that the amendments made by section 514
apply to taxable years beginning after May 17, 2006, the enactment date of
TIPRA.
Summary of Comments and Explanation of Provisions
The section 199 deduction is not taken into account in computing any
net operating loss (NOL) or the amount of any NOL carryback or carryover.
Thus, except as otherwise provided in §1.199-7(c)(2) of the final regulations
(concerning the portion of a section 199 deduction allocated to a member
of an EAG), the section 199 deduction cannot create, or increase, the amount
of an NOL deduction.
For purposes of section 199(a)(1)(B), taxable income is determined without
regard to section 199 and without regard to any amount excluded from gross
income pursuant to section 114 of the Code or pursuant to section 101(d) of
the Act. Thus, any extraterritorial income exclusion or amount excluded from
gross income pursuant to section 101(d) of the Act does not reduce taxable
income for purposes of section 199(a)(1)(B), even though such excluded
amounts are taken into account in determining QPAI.
The final regulations give the Secretary authority to provide for methods
of calculating W-2 wages. Contemporaneous with the publication of these final
regulations, Rev. Proc. 2006-22, 2006-23 I.R.B. 1033, has been published and
provides for taxable years beginning on or before May 17, 2006, the enactment
date of TIPRA, the same three methods of calculating W-2 wages as were contained
in Notice 2005-14 and the proposed regulations. It is expected that any new
revenue procedure applicable for taxable years beginning after May 17, 2006,
will contain methods for calculating W-2 wages similar to the three methods
in Rev. Proc. 2006-22. The methods are included in a revenue procedure rather
than the final regulations so that if changes are made to Form W-2, “Wage
and Tax Statement,” a new revenue procedure can be issued
reflecting those changes more promptly than an amendment to the final regulations.
Taxpayers have inquired whether remuneration paid to employees for domestic
services in a private home of the employer, which remuneration may be reported
on Schedule H (Form 1040), “Household Employment Taxes,”
or, under certain conditions, on Form 941, “Employer’s
QUARTERLY Federal Tax Return,” are included in W-2 wages.
Such remuneration is generally excepted from wages for income tax withholding
purposes by section 3401(a)(3) of the Code. Section 199(b)(5) provides that
section 199 shall be applied by only taking into account items that are attributable
to the actual conduct of a trade or business. Payments to employees of a
taxpayer for domestic services in a private home of the taxpayer are not attributable
to the actual conduct of a trade or business of the taxpayer. Accordingly,
such payments are not included in W-2 wages for purposes of section 199(b)(2).
The IRS and Treasury Department have also received numerous inquiries
concerning whether amounts paid to workers who receive Forms W-2 from professional
employer organizations (PEOs), or employee leasing firms, may be included
in the W-2 wages of the clients of the PEOs or employee leasing firms. In
order for wages reported on a Form W-2 to be included in the determination
of W-2 wages of a taxpayer, the Form W-2 must be for employment by the taxpayer.
Employees of the taxpayer are defined in §1.199-2(a)(1) of the final
regulations as including only common law employees of the taxpayer and officers
of a corporate taxpayer. Thus, the issue of whether the payments to the employees
are included in W-2 wages depends on an application of the common law rules
in determining whether the PEO, the employee leasing firm, or the client is
the employer of the worker. As noted in §1.199-2(a)(2) of the final
regulations, taxpayers may take into account wages reported on Forms W-2 issued
by other parties provided that the wages reported on the Forms W-2 were paid
to employees of the taxpayer for employment by the taxpayer. However, with
respect to individuals who taxpayers assert are their common law employees
for purposes of section 199, taxpayers are reminded of their duty to file
returns and apply the tax law on a consistent basis.
Commentators also raised the issue of whether an individual filing as
part of a joint return may include wages paid by his or her spouse to employees
of his or her spouse in determining the amount of the individual’s W-2
wages for purposes of the section 199 deduction. The example given was an
individual who had a trade or business reported on Schedule C (Form 1040)
with QPAI but no W-2 wages, and the individual’s spouse had W-2 wages
in a second trade or business reported on Schedule C (Form 1040) but no QPAI.
Section 1.199-2(a)(4) of the final regulations provides that married individuals
who file a joint return are treated as one taxpayer for purposes of determining
W-2 wages. Therefore, an individual filing as part of a joint return may
take into account wages paid to employees of his or her spouse in determining
the amount of W-2 wages provided the wages are paid in a trade or business
of the spouse and the other requirements of the final regulations are met.
In contrast, if the taxpayer and the taxpayer’s spouse file separate
returns, the taxpayer may not use the spouse’s wages in determining
the taxpayer’s W-2 wages for purposes of the taxpayer’s section
199 deduction because they are not considered one taxpayer.
Domestic Production Gross Receipts
Commentators suggested that rules similar to the de minimis rules
provided in §§1.199-1(d)(2) (gross receipts allocation), 1.199-3(h)(4)
(embedded services), 1.199-3(l)(1)(ii) (construction services), and 1.199-3(m)(4)
(engineering or architectural services) of the proposed regulations, under
which taxpayers may treat de minimis amounts of non-DPGR
as DPGR, should be available in the opposite situation. Thus, for example,
if a taxpayer’s gross receipts that are allocable to DPGR are less than
5 percent of its overall gross receipts for the taxable year, the commentators
suggested that the final regulations allow the taxpayer to treat those gross
receipts as non-DPGR. The IRS and Treasury Department agree with this suggestion,
and the final regulations provide such rules for the provisions discussed
above as well as under §1.199-3(l)(4)(iv)(B) for utilities.
Several comments were received regarding the burden imposed by the requirement
in the proposed regulations that QPAI be computed on an item-by-item basis
(rather than on a division-by-division, or product line-by-product line basis).
Several commentators urged the IRS and Treasury Department to limit the item-by-item
standard to the requirements of §1.199-3 in determining DPGR (that is,
the lease, rental, license, sale, exchange, or other disposition requirement,
the in-whole-or-in-significant-part requirement, etc.). Specifically, the
commentators argued that the item-by-item standard is inconsistent with the
cost allocation methods provided in §1.199-4. The IRS and Treasury Department
agree with this comment. Therefore, the final regulations clarify that the
item-by-item standard applies solely for purposes of the requirements of §1.199-3
noted above in determining whether the gross receipts derived from an item
are DPGR. The final regulations also provide that a taxpayer must determine,
using any reasonable method that is satisfactory to the Secretary based on
all of the facts and circumstances, whether gross receipts qualify as DPGR
on an item-by-item basis.
The proposed regulations provide that an item is defined as the property
offered for lease, rental, license, sale, exchange or other disposition to
customers that meets the requirements of section 199. The proposed regulations
also provide several examples to illustrate this rule. Some commentators
observed that the examples involving a manufacturer of toy cars that sold
the cars to toy stores appear to imply that, in the case of property offered
for lease, rental, license, sale, exchange or other disposition by a wholesaler,
the item is defined with reference to the property offered for sale to retail
consumers by the wholesaler’s customer. The rules for defining an item,
and the related examples, have been clarified in the final regulations to
provide that an item is defined with reference to the property offered by
the taxpayer for lease, rental, license, sale, exchange or other disposition
to the taxpayer’s customers in the normal course of the taxpayer’s
business, whether the taxpayer is a wholesaler or a retailer.
The proposed regulations provide that, if the property offered for lease,
rental, license, sale, exchange or other disposition by the taxpayer does
not meet the requirements of section 199, then the taxpayer must treat as
the item any portion of that property that does meet those requirements.
In a case where two or more portions of the property meet the requirements
of section 199, commentators inquired whether the two or more portions are
properly treated as a single item or as two or more items. The final regulations
generally are consistent with the rules of the proposed regulations, and provide
that if the gross receipts derived from the lease, rental, license, sale,
exchange or other disposition of the property offered in the normal course
of a taxpayer’s business do not qualify as DPGR, then any component
of such property is treated as the item, provided the gross receipts attributable
to the component qualify as DPGR. Allowing more than one component to be
treated as a single item would effectively permit taxpayers to define an item
as any combination of components that, in the aggregate, meets the requirements
of section 199, a result that the IRS and Treasury Department believe could
lead to significant distortions. Thus, the IRS and Treasury Department believe
that treating two or more components of the property offered for lease, rental,
license, sale, exchange or other disposition by the taxpayer as separate items
is the appropriate result. The final regulations clarify that, if the property
offered for lease, rental, license, sale, exchange or other disposition by
the taxpayer does not meet the requirements of section 199, then each component
that meets the requirements of §1.199-3 must be treated as a separate
item and such component may not be combined with a component that does not
meet the requirements to be treated as an item. The final regulations provide
examples illustrating this rule. It follows that the de minimis rule
for embedded services and nonqualifying property, as well as any other de
minimis exception that is applied at the item level, must be applied
separately to each component of the property that is treated as a separate
item.
The proposed regulations provide that gross receipts derived from a
lease, rental, license, sale, exchange or other disposition of qualifying
property constitute DPGR even if the taxpayer has already recognized gross
receipts from a previous lease, rental, license, sale, exchange or other disposition
of the property. The IRS and Treasury Department recognize that in some cases,
such as where the original item (for example, steel) that was MPGE or produced
by the taxpayer within the United States is disposed of by the taxpayer, and
incorporated by another person into other property (for example, an automobile)
that is subsequently acquired by the taxpayer, it would be extremely difficult
for the taxpayer to identify the item the gross receipts of which constitute
DPGR upon lease, rental, license, sale, exchange or other disposition of the
acquired property. Therefore, the final regulations provide that if a taxpayer
cannot reasonably determine without undue burden and expense whether the acquired
property contains any of the original qualifying property, or the amount,
grade, or kind of the original qualifying property, that the taxpayer MPGE
or produced within the United States, then the taxpayer is not required to
determine whether any portion of the acquired property qualifies as an item.
In such cases, the taxpayer may treat any gross receipts derived from the
disposition of the acquired property that are attributable to the original
qualifying property as non-DPGR.
The proposed regulations provide that, for purposes of the requirement
to allocate gross receipts between DPGR and non-DPGR, if a taxpayer can, without
undue burden or expense, specifically identify where an item was manufactured,
or if the taxpayer uses a specific identification method for other purposes,
then the taxpayer must use that specific identification method to determine
DPGR. One commentator observed that Notice 2005-14 applies a readily available
rather than an undue burden or expense standard for this purpose, and questioned
whether the proposed regulations were intended to impose a substantively different
standard. The standard was changed in the proposed regulations in response
to comments received on Notice 2005-14. The commentators were concerned that
taxpayers would be required under Notice 2005-14 to use specific identification
to allocate gross receipts under section 199 if their information systems
contained the information necessary to use specific identification, even if
capturing such information would require costly system reconfigurations.
The undue burden and expense standard, however, was not intended to expand
the scope of the requirement to use specific identification to include taxpayers
for whom the information necessary to use that method is not readily available
in their existing systems. Accordingly, the final regulations utilize both
terms.
Commentators were concerned that the disposition of qualifying property
would not give rise to DPGR if provided as part of a service related contract.
However, the proposed regulations in Example 4 in §1.199-3(d)(5)
already address this issue by illustrating a qualifying disposition resulting
in DPGR as part of a service related contract. In that example, Y is hired
to reconstruct and refurbish unrelated customers’ tangible personal
property. Y installs the replacement parts (QPP) that Y MPGE within the United
States. The example concludes that Y’s gross receipts from the MPGE
of the replacement parts are DPGR. The final regulations retain this example
and include other examples of service related contracts that also involve
the disposition of qualifying property giving rise to DPGR if all of the other
section 199 requirements are met.
The proposed regulations provide that, if a taxpayer recognizes and
reports on a Federal income tax return for a taxable year gross receipts that
the taxpayer identifies as DPGR, then the taxpayer must treat the CGS related
to such receipts as relating to DPGR, even if they are incurred in a subsequent
taxable year. The final regulations retain this rule in §1.199-4(b)(2).
One commentator questioned whether this rule applies to CGS incurred in a
taxable year to which section 199 applies, if the gross receipts were recognized
in a taxable year prior to the effective date of section 199 but would have
qualified as DPGR in that taxable year if section 199 had been in effect.
The IRS and Treasury Department believe that all gross receipts and costs
must be allocated between DPGR and non-DPGR on a year-by-year basis, and the
final regulations provide that for taxpayers using the section 861 method
or the simplified deduction method, CGS that relates to gross receipts recognized
in a taxable year prior to the effective date of section 199 must be allocated
to non-DPGR.
For items that are disposed of under contracts that span two or more
taxable years, the final regulations permit the use of historical data to
allocate gross receipts between DPGR and non-DPGR. If a taxpayer makes allocations
using historical data, and subsequently updates the data, then the taxpayer
must use the more recent or updated data, starting in the taxable year in
which the update is made.
Two commentators suggested that the final regulations permit taxpayers
to classify multi-year contracts for purposes of section 199 with reference
to their classification under section 460. For example, if a contract is
classified as a construction contract under section 460, the commentators
suggested that the contract also be classified as a construction contract
under section 199. The IRS and Treasury Department have determined, however,
that the statutory requirements under sections 199 and 460, and the regulations
thereunder, are sufficiently different that it would not be appropriate for
the final regulations to permit the classification of multi-year contracts
under section 460 to determine whether the requirements of section 199 are
met with respect to that contract. Accordingly, the final regulations do
not adopt this suggestion.
One commentator suggested a simplifying convention to determine which
party to a contract manufacturing arrangement has the benefits and burdens
of ownership under Federal income tax principles. The commentator requested
that the final regulations permit unrelated parties to a contract manufacturing
arrangement to designate, through a written and signed agreement between the
parties, which of them shall be treated for purposes of section 199 as engaging
in MPGE activities conducted pursuant to the arrangement. The final regulations
do not adopt the commentator’s suggestion. The IRS and Treasury Department
continue to believe that the benefits and burdens of ownership must be determined
based on all of the facts and circumstances and a designation of benefits
and burdens would not be appropriate.
Section 403(a)(7) of the GOZA added new section 199(c)(4)(C), which
contains a special rule for certain government contracts. The final regulations
clarify that the special rule for government contracts also applies to gross
receipts derived from certain subcontracts to manufacture or produce property
for the Federal government. See The Joint Committee on Taxation Staff, Technical
Explanation of the Revenue Provisions of H.R. 4440, The Gulf Opportunity Zone
Act of 2005, 109th Cong., 1st Sess. 77 (2005).
In Whole or in Significant Part
The proposed regulations, like Notice 2005-14, provide generally that
QPP is MPGE in whole or in significant part by the taxpayer within the United
States only if the taxpayer’s MPGE activity in the United States is
substantial in nature. Although some language in the section 199 substantial-in-nature
requirement bears similarities to language in the definition of manufacture
in §1.954-3(a)(4), the two standards are different both in purpose and
in substance. Whether operations are substantial in nature is relevant under
section 954 in determining whether manufacturing has occurred. By contrast,
the substantial-in-nature requirement under section 199 is relevant in determining
whether the MPGE activity, already determined to have occurred under the requirement
provided in §1.199-3(d) of the proposed regulations (§1.199-3(e)
of the final regulations), was performed in whole or in significant part by
the taxpayer within the United States. Accordingly, as stated in the preamble
to Notice 2005-14, case law and other precedent under section 954 are
not relevant for purposes of the substantial-in-nature requirement under section 199.
Nor are they relevant for purposes of determining whether an activity is
an MPGE activity under section 199. Similarly, the regulations under section
199 are not relevant for purposes of section 954.
Because the substantial-in-nature requirement is generally applied by
taking into account all of the facts and circumstances, both the proposed
regulations and Notice 2005-14 provide a safe harbor under which the in-whole-or-in-significant-part
requirement is satisfied if the taxpayer’s conversion costs (that is,
direct labor and related factory burden) are 20 percent or more of the taxpayer’s
CGS with respect to the property. Commentators expressed confusion concerning
the related factory burden component of this safe harbor, and suggested that
overhead be substituted for related factory burden in the final regulations.
Commentators further noted that not all transactions yielding DPGR under
section 199 involve CGS (for example, a lease, rental, or license of QPP).
In response to these comments, the IRS and Treasury Department have changed
the safe harbor in the final regulations. The final regulations provide that
the in-whole-or-in-significant-part requirement is satisfied if the taxpayer’s
direct labor and overhead to MPGE the QPP within the United States account
for 20 percent or more of the taxpayer’s CGS, or in a transaction without
CGS (for example, a lease, rental, or license) account for 20 percent or more
of the taxpayer’s unadjusted depreciable basis of the QPP. No inference
is intended regarding any similar safe harbor under the Code, including the
safe harbor in §1.954-3(a)(4)(iii). For taxpayers subject to section
263A, overhead is all costs required to be capitalized under section 263A
except direct materials and direct labor. For taxpayers not subject to section
263A, overhead may be computed using any reasonable method that is satisfactory
to the Secretary based on all of the facts and circumstances, but may not
include any cost, or amount of any cost, that would not be required to be
capitalized under section 263A if the taxpayer were subject to section 263A.
In no event are section 174 costs, and the cost of creating intangible assets,
attributable to tangible personal property ever treated as direct labor and
overhead, and taxpayers should exclude such costs from their CGS or unadjusted
depreciable basis, as applicable.
However, the final regulations also clarify that, in the case of computer
software and sound recordings, research and experimental expenditures under
section 174 relating to the computer software or sound recordings, the cost
of creating intangible assets for computer software or sound recordings, and
(in the case of computer software) costs of developing the computer software
that are described in Rev. Proc. 2000-50, 2000-2 C.B. 601 (software development
costs), are included in both direct labor and overhead and CGS or unadjusted
depreciable basis for purposes of the safe harbor, even if the costs are incurred
in a prior taxable year. In addition, the final regulations also clarify
that this is the case whether the computer software or sound recording is
itself the item for purposes of section 199, or is affixed or added to
tangible personal property and the taxpayer treats the combined property as
computer software or a sound recording under the rules of §1.199-3(i)(5)). In
the case where the taxpayer produces computer software and manufactures part
of the tangible personal property to which the computer software is affixed,
the taxpayer may combine the direct labor and overhead for the computer software
and tangible personal property produced or manufactured by the taxpayer in
determining whether it meets the safe harbor.
The final regulations provide that, in applying the safe harbor to an
item for the taxable year, all computer software development costs, any cost
of creating intangible assets for computer software or sound recordings, and
section 174 costs (for computer software or sound recordings), including those
paid or incurred in a prior taxable year, must be allocated over the estimated
number of units of the item of which the taxpayer expects to dispose. An
example of this rule is provided in the final regulations.
The proposed regulations provide that an EAG member must take into account
all of the previous MPGE or production activities of the other members of
the EAG in determining whether its MPGE or production activities are substantial
in nature. It has been suggested that this rule be modified to allow the
EAG member to take into account all MPGE or production activities of the other
EAG members rather than just the previous MPGE or production activities of
the members. The final regulations do not adopt this suggestion because the
IRS and Treasury Department believe that the EAG member must determine whether
its MPGE or production activities meet the substantial-in-nature requirement
at or before the time EAG member disposes of the property. Similar rules
apply for purposes of the safe harbor under §1.199-3(g)(3)(i).
Section 3.04(5)(d) of Notice 2005-14 generally provides that design
and development activities must be disregarded in applying the general substantial-in-nature
requirement and the safe harbor for tangible personal property. The proposed
regulations clarify that research and experimental activities under section
174 and the creation of intangibles do not qualify as substantial in nature.
A commentator questioned whether, with respect to tangible personal property,
activities that constitute both an MPGE activity as well as a section 174
activity must nonetheless be excluded from the determination of whether the
taxpayer’s MPGE of the QPP is substantial in nature because all section
174 activities are disregarded in making such a determination. The IRS and
Treasury Department continue to believe that, with the exception of computer
software and sound recordings, it is not appropriate to include any section
174 activities in the determination of whether the MPGE of QPP is substantial
in nature. However, the IRS and Treasury Department recognize that, although
section 174 costs are not required to be capitalized under section 263A to
the produced property, a taxpayer may capitalize such costs to the QPP under
section 263A. Accordingly, the final regulations permit, as a matter of administrative
convenience, a taxpayer to include such costs as CGS or unadjusted depreciable
basis for purposes of the 20 percent safe harbor.
A commentator asked that the final regulations clarify that gross receipts
relating to computer software updates that are provided as part of a computer
software maintenance contract qualify as DPGR if all of the requirements of
section 199(c)(4) are met. The final regulations include an example demonstrating
that gross receipts relating to computer software updates may qualify as DPGR
even if the computer software updates are provided pursuant to a computer
software maintenance agreement.
The preamble to the proposed regulations states that the creation and
licensing of copyrighted business information reports do not constitute the
MPGE of QPP because the database is not QPP. However, it has come to the
attention of the IRS and Treasury Department that some business information
reports published by the taxpayer may qualify as QPP, for example, business
information reports published by the taxpayer in books that qualify as QPP.
Therefore, no inference should be drawn from the preamble to the proposed
regulations as to whether business information reports qualify for the section
199 deduction.
The proposed regulations provide in §1.199-3(f)(2) that QPP will
be treated as MPGE in significant part by the taxpayer within the United States
if the MPGE of the QPP by the taxpayer within the United States is substantial
in nature taking into account all of the facts and circumstances, including
the relative value added by, and relative cost of, the taxpayer’s MPGE
activity within the United States, the nature of the property, and the nature
of the MPGE activity that the taxpayer performs within the United States.
One commentator suggested that, if a taxpayer manufactures a key component
of QPP and purchases the rest of the components, the fact that the taxpayer
manufactured the key component should satisfy the substantial-in-nature requirement
with respect to the QPP that incorporates the key component. For example,
X manufactures computer chips within the United States. X installs the computer
chips that it manufactures in computers that X purchases from unrelated persons
and sells the finished computers individually to customers. Although the
computer chips are key components of the computers and the computers will
not operate without them, the manufacture of the key components does not,
by itself, satisfy the substantial-in-nature requirement with respect to the
finished computers and the taxpayer’s activities with respect to the
finished computers must meet either the substantial-in-nature requirement
under §1.199-3(g)(2) or the safe harbor under §1.199-3(g)(3) of
the final regulations. The final regulations contain an example to illustrate
this rule.
In Example 4 in §1.199-3(f)(4) of the proposed
regulations, X licenses a qualified film to Y for duplication of the film
onto DVDs. Y purchases the DVDs from an unrelated person. The example concludes
that unless Y satisfies the safe harbor under §1.199-3(f)(3) of the proposed
regulations, Y’s income for duplicating X’s qualified film onto
DVDs is non-DPGR because the duplication is not substantial in nature relative
to the DVD with the film. One commentator disagreed with the conclusion in
this example because duplicating a DVD may involve considerable activities.
This example and other examples illustrating the substantial-in-nature requirement
have been removed from the final regulations because the determination of
what is substantial in nature is determined based on all the facts and circumstances.
No inference should be drawn as to whether an activity is, or is not, substantial
in nature by the removal of any example.
Derived From a Lease, Rental, License, Sale, Exchange, or
Other Disposition
Section 1.199-3(h)(1) of the proposed regulations provides that applicable
Federal income tax principles apply to determine whether a transaction is,
in substance, a lease, rental, license, sale, exchange, or other disposition
of QPP, whether it is a service, or whether it is some combination thereof.
In the preamble to the proposed regulations, the IRS and Treasury Department
acknowledge that the short-term nature of a transaction does not, by itself,
render the transaction a service for purposes of section 199 and that many
transactions include both service and property rental elements. The preamble
further states that not every transaction in which property is used in connection
with providing a service to customers, however, constitutes a mixture of services
and rental for which allocation of gross receipts is appropriate and provides
an example of a video arcade that features video game machines that the taxpayer
MPGE. The machines remain in the taxpayer’s possession during the customers’
use. The example concludes that gross receipts derived from customers’
use of the machines at the taxpayer’s arcade are not derived from the
lease, rental, license, sale, exchange, or other disposition of the machines.
Rather, the machines are used to provide a service and, thus, the gross receipts
are non-DPGR. While the general rule stated in §1.199-3(h)(1) of the
proposed regulations is retained in the final regulations under §1.199-(3)(I)(1),
the preamble example is not included in the final regulations because the
determination of whether a transaction is a service or a rental is based upon
all the facts and circumstances. No inference should be drawn as to whether
the transaction constitutes a service or rental (or some combination thereof)
by the removal of the example.
Section 1.199-3(h)(1) of the proposed regulations provides that the
value of property received by a taxpayer in a taxable exchange of QPP MPGE
in whole or in significant part within the United States, a qualified film
produced by the taxpayer, or utilities produced by the taxpayer in the United
States, for an unrelated person’s property is DPGR for the taxpayer.
However, unless the taxpayer meets all of the requirements under section
199 with respect to any further MPGE by the taxpayer of the QPP or any further
production by the taxpayer of the film or utilities received in the taxable
exchange, any gross receipts derived from the sale by the taxpayer of the
property received in the taxable exchange are non-DPGR, because the taxpayer
did not MPGE or produce such property, even if the property was QPP, a qualified
film, or utilities in the hands of the other party to the transaction.
A commentator requested that, with regard to certain taxable exchanges,
the final regulations provide a safe harbor that would accommodate long-standing
industry accounting practices for these exchanges. The final regulations
provide a safe harbor whereby the gross receipts derived by the taxpayer from
the sale of eligible property (as defined later) received in a taxable exchange,
net of any adjustments between the parties involved in the taxable exchange
to account for differences in the eligible property exchanged (for example,
location differentials and product differentials), may be treated as the value
of the eligible property received by the taxpayer in the taxable exchange. In
addition, if the taxpayer engages in any further MPGE or production activity
with respect to the eligible property received in the taxable exchange, then,
unless the taxpayer meets the in-whole-or-in significant-part requirement
under §1.199-3(g)(1) with respect to the property sold, the taxpayer
must also value the property sold without taking into account the gross receipts
attributable to the further MPGE or production activity. The final regulations
define eligible property as oil, natural gas, and petrochemicals, or products
derived from oil, natural gas, petrochemicals, or any other property or product
designated by publication in the Internal Revenue Bulletin. Under the safe
harbor, the taxable exchange is deemed to occur on the date of the sale of
the eligible property received in the exchange to the extent that the sale
occurs no later than the last day of the month following the month in which
the exchanged eligible property is received by the taxpayer.
The proposed regulations provide that, in the case of gross receipts
derived from a lease of QPP or a qualified film, the entire amount of the
lease income, including any interest that is not separately stated, is considered
derived from the lease of the QPP or qualified film. Commentators noted that
many leases of personal property separately state a finance or interest component.
The IRS and Treasury Department believe that Congress intended for all financing
or interest components of a lease of qualifying property to be considered
DPGR (assuming all the other requirements of section 199 are met). Accordingly,
the final regulations provide that all financing and interest components of
a lease of qualifying property are considered to be derived from the lease
of such qualifying property.
Section 1.199-3(h)(4) of the proposed regulations provides exceptions
to the general rule that DPGR does not include gross receipts derived from
services or nonqualifying property. The exceptions are for embedded qualified
warranties, delivery, operating manuals, and installation. The final regulations
retain these exceptions and provide a new exception for embedded computer
software maintenance contracts. None of these exceptions, which allow gross
receipts attributable to such embedded services and nonqualifying property
to be treated as DPGR, is available if, in the normal course of the taxpayer’s
trade or business, the price for the service or nonqualifying property is
separately stated or is separately offered to the customer.
One commentator asked for clarification concerning the meaning of the
term normal course of a taxpayer’s trade or business and when something
would be considered to be separately stated or separately offered to a customer.
The purpose of the exceptions is to reduce the burden on a taxpayer of having
to allocate a portion of its gross receipts to these commonly occurring types
of services and property if the taxpayer does not normally price or offer
such items separately. Whether a taxpayer separately offers or states the
price for such an item in the normal course of its trade or business depends
on the facts and circumstances. If, for example, a taxpayer separately states
the price for installation for a few of its customers on a case by case basis,
then the taxpayer may be considered to have not separately stated the price
of installation in the normal course of its trade or business. The requirements
have been changed in the final regulations to clarify that the normal-course-of-trade-or-business
requirement applies to both the separately stated price prong and the separately
offered prong of the embedded services and nonqualifying property rules.
Several comments were received concerning the rule in the proposed regulations
under which gross receipts attributable to advertising in newspapers, magazines,
telephone directories, or periodicals may qualify as DPGR to the extent that
the gross receipts, if any, derived from the disposition of those printed
materials qualifies as DPGR. The final regulations clarify that this list
is not limited to these four types of printed materials, and that the rule
applies to other similar printed materials.
Section 3 of Notice 2005-14 explains that the basis for the rule relating
to advertising income is that such income is inextricably linked to the gross
receipts (if any) derived from the disposition of the printed materials listed
in the proposed regulations. After considering the comments received, the
IRS and Treasury Department believe that the same reasoning applies in the
case of a qualified film (for example, a television program). Accordingly,
the rule for advertising has been extended in the final regulations to apply
to qualified films. The wording of the advertising rule has been changed
to clarify that the amount of gross receipts attributable to the disposition
of the printed materials or qualified film does not limit the amount of gross
receipts attributable to the advertising that may be treated as DPGR under
the rule. In addition, the final regulations clarify that there need be no
gross receipts attributable to the disposition of the printed materials or
qualified film for the gross receipts from the advertising to qualify as DPGR.
One commentator requested that the final regulations recognize that
gross receipts derived from the sale of advertising slots in live or delayed
television broadcasts (that are produced by the taxpayer and that otherwise
meet the requirements for a qualified film) are DPGR. While live
and delayed television programming may otherwise meet the requirements to
be treated as a qualified film, in order for the gross receipts derived from
advertising slots to be DPGR, there must also be a qualifying disposition
of the qualified film. The IRS and Treasury Department continue to believe
that a live or delayed television broadcast of a qualified film is not a lease,
rental, license, sale, exchange or other disposition of the qualified film.
Commentators noted, however, that if the live or delayed television programming
is licensed to an unrelated cable company, then the license of the programming
is a qualifying disposition that gives rise to DPGR and if the rule for advertising
were extended to qualified films, then the portion of the advertising receipts
relating to the license of the qualified film would also be DPGR. The IRS
and Treasury Department agree with these comments, and the final regulations
provide examples to clarify these points.
Qualifying Production Property
Under §1.199-3(i)(5)(i) of the proposed regulations, if a taxpayer
MPGE computer software or sound recordings that is affixed or added to tangible
personal property by the taxpayer (for example, a computer diskette or an
appliance), then the taxpayer may treat the tangible personal property as
computer software or sound recordings, as applicable. A commentator questioned
whether this rule should apply if, for example, a taxpayer hires an unrelated
person to affix computer software or sound recordings produced by the taxpayer
to a compact disc. In response to this comment, the final regulations have
dropped the by-the-taxpayer requirement in this context. A similar rule has
been provided for qualified films.
Section §1.199-3(j)(1) of the proposed regulations provides that,
a qualified film means any motion picture film or video tape under section
168(f)(3), or live or delayed television programming, if not less than 50 percent
of the total compensation paid to all actors, production personnel, directors,
and producers relating to the production of the motion picture film, video
tape, or television programming is compensation for services performed in
the United States by those individuals. One commentator was concerned that
the list of production personnel described under §1.199-3(j)(1) of the
proposed regulations diminishes the general rule under §1.199-3(j)(5)
that compensation for services includes all direct and indirect compensation
costs required to be capitalized under section 263A for film producers under
§1.263A-1(e)(2) and (3). The commentator also stated that it may be
difficult to determine which persons are production personnel. The final
regulations under §1.199-3(k)(1) clarify that the list of production
personnel is not exclusive, and that compensation for services includes all
direct and indirect compensation costs required to be capitalized under §1.263A-1(e)(2)
and (3).
In response to questions received by the IRS and Treasury Department,
the final regulations clarify that actors may include players, newscasters,
or any other persons performing in a qualified film. The final regulations
also clarify that the not-less-than-50-percent-of-the-total-compensation requirement
is determined by reference to all compensation paid in the production of the
film and is calculated using a fraction. The numerator of the fraction is
the compensation paid by the taxpayer to actors, production personnel, directors,
and producers for services relating to the production of the film (production
services) performed in the United States, and the denominator is the sum of
the total compensation paid by the taxpayer to all such individuals regardless
of where the production services are performed and the total compensation
paid by others to all such individuals regardless of where the production
services are performed. The final regulations provide an example of this
calculation.
Tangible Personal Property and Real Property
Commentators requested that the final regulations define tangible personal
property and real property for purposes of section 199. The final regulations
define tangible personal property as any tangible property other than land,
real property described in the construction rules in §1.199-3(m)(1),
computer software described in §1.199-3(j)(3), sound recordings described
in §1.199-3(j)(4), a qualified film described in §1.199-3(k)(1),
and utilities described in §1.199-3(l). In response to commentators’
suggestions, the final regulations further define tangible personal property
as also including any gas (other than natural gas described in §1.199-3(l)(2)),
chemicals, and similar property, for example, steam, oxygen, hydrogen, and
nitrogen.
The final regulations define the term real property to mean buildings
(including items that are structural components of such buildings), inherently
permanent structures (as defined in §1.263A-8(c)(3)) other than machinery
(as defined in §1.263A-8(c)(4)) (including items that are structural
components of such inherently permanent structures), inherently permanent
land improvements, oil and gas wells, and infrastructure (as defined in §1.199-3(m)(4)).
Property MPGE by a taxpayer that is not real property in the hands of such
taxpayer, but that may be incorporated into real property by another taxpayer,
is not treated as real property by the producing taxpayer (for example, bricks,
nails, paint, and windowpanes). Structural components of buildings and inherently
permanent structures include property such as walls, partitions, doors, wiring,
plumbing, central air conditioning and heating systems, pipes and ducts, elevators
and escalators, and other similar property. In addition, an entire utility
plant including both the shell and the interior will be treated as an inherently
permanent structure.
Construction of Real Property
One commentator recommended that DPGR derived from the construction
of real property as well as DPGR from engineering and architectural services
for a construction project include W-2 wages earned as an employee. At the
time the taxpayer performs construction activities, or engineering or architectural
services, the taxpayer must be engaged in a trade or business that is considered
construction, engineering or architectural services for purposes of the North
American Industry Classification System (NAICS). W-2 wages earned by an employee
are not earned in connection with a trade or business that is considered construction,
or engineering or architectural services, for purposes of the NAICS. Consequently,
this recommendation has not been adopted in the final regulations.
The proposed regulations include within the definition of construction
services activities relating to drilling an oil well and mining pursuant to
which the taxpayer could deduct intangible drilling and development costs
under section 263(c) and §1.612-4, and development expenditures for a
mine or natural deposit under section 616. The IRS and Treasury Department
are aware that in many situations taxpayers provide these services with respect
to property owned by another party, and therefore such taxpayers are ineligible
to claim the deductions for such costs under the provisions described above.
The language of the final regulations has been changed to clarify that taxpayers
providing such services are engaging in construction services that may qualify
under section 199.
The preamble to the proposed regulations states that commentators requested
that qualifying construction activities include construction activities related
to oil and gas wells. The preamble further states that the proposed regulations
provide as a matter of administrative grace that qualifying construction activities
include activities relating to drilling an oil well. Similarly, under §1.199-3(l)(2)
of the proposed regulations, construction activities include activities relating
to drilling an oil well. A commentator noted the inadvertent omission of
gas wells and the final regulations correct the omission.
The proposed regulations provide that DPGR does not include gross receipts
attributable to the sale or other disposition of land (including zoning, planning,
entitlement costs, and other costs capitalized into the land such as grading
and demolition of structures under section 280B). Commentators contended
that grading and demolition are construction-related activities, and that
gross receipts attributable to these activities should qualify as DPGR. After
considering the comments, the IRS and Treasury Department believe it is appropriate
to apply to grading and demolition activities the same rule that the proposed
regulations apply to other construction activities, such as landscaping and
painting. Accordingly, services such as grading, demolition, clearing, excavating,
and any other activities that physically transform the land are activities
constituting construction only if these services are performed in connection
with other activities (whether or not by the same taxpayer) that constitute
the erection or substantial renovation of real property. The IRS and Treasury
Department continue to believe that gross receipts attributable to the sale
or other disposition of land (including zoning, planning, and entitlement
costs) are properly considered gross receipts attributable to the land, not
to a qualifying construction activity, and, therefore, are non-DPGR.
In response to a suggestion by a commentator, the final regulations
provide that a taxpayer engaged in a construction activity must make a reasonable
inquiry or a reasonable determination whether the activity relates to the
erection or substantial renovation of real property in the United States.
The proposed regulations contain an example of an electrical contractor
who purchases wires, conduits, and other electrical materials that the contractor
installs in construction projects in the United States and that are considered
structural components. The example concludes that the gross receipts that
the contractor derives from installing these materials are derived from construction,
but that the gross receipts attributable to the purchased materials are not.
Commentators objected to this result, contending that it places an unreasonable
administrative burden on taxpayers performing construction activities. The
final regulations, including the example, provide that, in such circumstances,
the taxpayer performing the construction services is not required to allocate
gross receipts to the purchased materials and treat such gross receipts as
non-DPGR, provided the materials and supplies are consumed in the construction
project or become part of the constructed real property.
Section 199(c)(4)(A), as amended by the GOZA, requires that a taxpayer
be engaged in the active conduct of a construction trade or business for the
taxpayer’s construction activity to qualify under section 199. The
proposed regulations provide that a taxpayer may not treat as DPGR gross receipts
derived from construction unless the taxpayer is engaged in a construction
trade or business on a regular and ongoing basis. Commentators expressed
concern that this requirement would preclude construction project-specific
joint ventures or partnerships, a common business structure in the construction
industry, from qualifying under section 199. Typically, such entities are
formed for the purpose of a specific construction project, and are terminated
or dissolved when the project is completed. The final regulations continue
to require that a taxpayer be engaged in a regular and ongoing construction
trade or business, but provide a safe harbor rule under which entities formed
specifically for purposes of a particular construction project may qualify.
Under the safe harbor rule, if a taxpayer is engaged in a construction trade
or business, then the taxpayer will be considered to be engaged in such trade
or business on a regular and ongoing basis if the taxpayer derives gross receipts
from an unrelated person by selling or exchanging the constructed real property
within 60 months of the date on which construction is complete.
Commentators also expressed concern that taxpayers would not meet the
requirement of being engaged in a construction business on a regular and ongoing
basis if the taxpayer is newly-formed or otherwise is in the first taxable
year of a new construction trade or business. Although some taxpayers may
meet the regular-and-ongoing-business requirement under the safe harbor rule
discussed previously, the final regulations provide that, in the case of a
newly-formed trade or business or a taxpayer in its first taxable year, the
taxpayer will satisfy the regular-and-ongoing-basis requirement if it reasonably
expects to be engaged in a construction trade or business on a regular and
ongoing basis.
The IRS and Treasury Department received a comment requesting clarification
of the land safe harbor of §1.199-3(l)(5)(ii) of the proposed regulations.
Under the land safe harbor, the taxpayer is permitted to allocate gross receipts
between real property other than land, and land, according to a formula.
The taxpayer must reduce gross receipts by the costs of the land and any other
costs capitalized to the land, plus a percentage of those costs, and costs
related to DPGR must be reduced by the costs of the land and any other costs
capitalized to the land. The percentage ranges from 5 to 15 percent, depending
upon the length of time the taxpayer held the land. The commentator asked
whether the holding period of a previous owner of the land would be attributed
to the new owner, and what rules apply for purposes of computing the new owner’s
cost basis. Generally, if an existing provision of the Code or regulations
would apply to require attribution of the holding period of a previous owner
of property to a new owner, the same rules will apply in the case of a previous
owner’s holding period in land for purposes of the land safe harbor
rule of section 199. For example, the holding period of the previous owner
(P) would carry over to the new owner (N) under existing Federal income tax
principles if P were a partner in partnership N, and P contributed the land
to N. The same result would apply if, instead, the land was distributed by
partnership P to N, its partner. In the case of partnership or other pass-thru
entity, the land safe harbor is applied at the partnership or other pass-thru
entity level and is not applied at the partner or owner level.
With regard to the land safe harbor discussed in the preceding paragraph,
the proposed regulations state that the length of time a taxpayer is deemed
to hold the land begins on the date the taxpayer acquires the land, including
the date the taxpayer enters into the first option to acquire all or a portion
of the land, and ends on the date the taxpayer sells each item of real property
on the land. Commentators stated that development of the land generally does
not begin until the land is acquired and any option to acquire land is based
on the land’s fair market value. Because developers are paying fair
market value, the commentators suggested that the period for determining the
percentage should not include any option period. The IRS and Treasury Department
generally agree with the commentator’s suggestion, and the final regulations
do not include the option period except where the option does not include
provisions to adjust the purchase price to approximate fair market value.
Example 1 in §1.199-3(m)(5)(iii) of the proposed
regulations provides that X, who is in a construction trade or business under
NAICS Code 23 on a regular and ongoing basis, purchases a building and retains
Y, a general contractor, to perform construction services in connection with
a substantial renovation of the building. The example concludes that X’s
gross receipts derived from the disposition of the building are non-DPGR,
and that Y’s gross receipts from amounts paid to it by X are DPGR.
In addition, the example illustrates that gross receipts of subcontractors
hired by Y qualify as DPGR. Some commentators inferred from this example
that the taxpayer must, at a minimum, be a legally designated general contractor
before its gross receipts may qualify as DPGR. The example was not intended
to imply that a taxpayer must be a licensed general contractor. The final
regulations clarify that activities constituting construction include activities
typically performed by a general contractor, or that constitute general contractor-level
work, such as activities relating to management and oversight of the construction
process (for example, approvals, periodic inspection of the progress of the
construction project, and required job modifications). The example has been
modified in the final regulations to illustrate that the person hired by the
building owner, although not a licensed general contractor, qualifies as engaging
in construction activities by virtue of providing management and oversight
of the construction process.
Several commentators recommended that the final regulations provide
that, for purposes of the de minimis exception of §1.199-3(l)(5)(ii)
(regarding construction services), gross receipts attributable to land be
disregarded for purposes of calculating the de minimis exception.
In response to the comments, the final regulations clarify that, if a taxpayer
applies the land safe harbor, then the gross receipts excluded under the land
safe harbor are excluded in determining total gross receipts under the de
minimis exception. The final regulations also provide that, if
a taxpayer does not apply the land safe harbor and uses any reasonable method
(for example, an appraisal of the land) to allocate gross receipts attributable
to the land to non-DPGR, then a taxpayer applies the de minimis exception
by excluding such gross receipts derived from the sale, exchange, or other
disposition of the land from total gross receipts.
A commentator requested that the definition of construction activities
not be limited to direct activities and should include services incidental
to the performance of such activities. As an administrative convenience,
the final regulations provide that construction activities include certain
administrative support services such as billing and secretarial services performed
by the taxpayer. The final regulations provide a similar rule for engineering
and architectural services.
Engineering and Architectural Services
A commentator suggested that the definition of engineering and architectural
services include services related to the inspection or evaluation of real
property after construction has been completed. The final regulations do
not adopt this suggestion because engineering and architectural services relating
to post-construction activities are not activities constituting construction.
Allocation of Cost of Goods Sold and Deductions
A commentator requested clarification as to whether a taxpayer’s
CGS allocable to DPGR is determined using the methods of accounting used to
compute CGS for the taxpayer’s books or financial statements or the
methods of accounting used to compute CGS in determining Federal taxable income.
Section 1.199-4(b) of the proposed regulations provides that CGS is determined
under the methods of accounting that the taxpayer uses to compute Federal
taxable income. Accordingly, this section has not been modified and the final
regulations continue to provide that, in determining CGS allocable to DPGR,
CGS is determined using the methods of accounting that the taxpayer uses to
compute its Federal taxable income.
Consistent with both the proposed regulations and Notice 2005-14, the
final regulations continue to provide three methods for allocating and apportioning
deductions (that is, the section 861 method, the simplified deduction method,
and the small business simplified overall method). However, modifications
have been made in the final regulations to the qualification requirements
of the simplified deduction method.
Under the simplified deduction method, a taxpayer’s expenses,
losses, or deductions (deductions) (other than a net operating loss deduction)
are apportioned between DPGR and non-DPGR based on relative gross receipts.
The proposed regulations permit a taxpayer to use the simplified deduction
method if it has average annual gross receipts of $25,000,000 or less, or
total assets at the end of the taxable year of $10,000,000 or less. Several
commentators requested that the average annual gross receipts threshold for
the simplified deduction method be either increased or removed. In response
to these comments, the IRS and Treasury Department have modified the eligibility
requirements for the simplified deduction method. Under the final regulations,
a taxpayer may use the simplified deduction method if it has average annual
gross receipts of $100,000,000 or less, or total assets at the end of the
taxable year of $10,000,000 or less. The IRS and Treasury Department continue
to believe that for taxpayers above these thresholds the section 861 method
is the appropriate method for allocating and apportioning deductions for purposes
of determining QPAI.
Under the land safe harbor provided in §1.199-3(l)(5)(ii) of the
proposed regulations, a taxpayer may allocate gross receipts between the proceeds
from the sale, exchange, or other disposition of real property constructed
by the taxpayer and land by reducing its costs related to DPGR under §1.199-4
by the cost of land and other costs capitalized to the land (land costs) and
reducing its DPGR by those land costs plus a percentage. Under the small
business simplified overall method, a taxpayer’s CGS and deductions
are apportioned between DPGR and other receipts based on relative gross receipts.
Commentators have questioned whether a taxpayer that uses the small business
simplified overall method would have to reallocate land costs using the allocation
formula provided by that method even though such costs have already been allocated
in accordance with the land safe harbor. The final regulations clarify that
a taxpayer that uses the land safe harbor to allocate gross receipts between
real property constructed by the taxpayer and land does not take into account
under the small business simplified overall method provided in §1.199-4(f)
the costs that have already been taken into account for purposes of section
199 pursuant to the land safe harbor.
Expanded Affiliated Groups
The proposed regulations provide generally that if a member of an EAG
(the disposing member) derives gross receipts from the lease, rental, license,
sale, exchange, or other disposition of QPP, a qualified film, or utilities
MPGE or produced by another member or members of the same EAG, the disposing
member is treated as conducting the activities conducted by each other member
of the EAG with respect to the QPP, qualified film, or utilities in determining
whether its gross receipts are DPGR. A question arose as to when the determination
of whether corporations are members of the same EAG for purposes of the attribution
of activities is to be made. The final regulations clarify that attribution
of activities between members of the same EAG is tested at the time that the
disposing member disposes of the QPP, qualified film, or utilities. Examples
are provided to illustrate this provision.
Section 1.199-1(d) of the proposed regulations provides a de
minimis rule that allows a taxpayer to treat all of its gross receipts
as DPGR if less than 5 percent of the taxpayer’s total gross receipts
are non-DPGR. The proposed regulations provide that the 5 percent threshold
is determined at the corporation level, rather than at the EAG or consolidated
group level. Several commentators requested that the IRS and Treasury Department
reconsider this position and apply the threshold at the EAG or consolidated
group level.
The de minimis rule is intended to eliminate the
burden to a taxpayer of allocating gross receipts between DPGR and non-DPGR
when less than 5 percent of its total gross receipts are non-DPGR. Applying
this de minimis rule at the EAG level would create many
burdensome issues for the EAG and its members, including additional information
reporting and circularity problems that could require members to compute QPAI
twice and, thus, would not further the policy goals of providing de
minimis rules to ease a taxpayer’s administrative burdens.
As a result, the IRS and Treasury Department continue to believe that, with
respect to a corporation that is a member of an EAG but not a member of a
consolidated group, the application of this threshold at the EAG member level
is appropriate.
However, with respect to a consolidated group, §1.1502-13(c)(1)(i)
and (c)(4) requires that the separate entity attributes of a company’s
intercompany items or corresponding items must be redetermined to the extent
necessary to produce the effect as if the consolidated group members engaged
in an intercompany transaction were divisions of a single corporation. If
the de minimis rule were applied at the consolidated
group member level, then a different result could apply to the consolidated
group than would apply if the consolidated group members were divisions of
a single corporation. Accordingly, with respect to a consolidated group,
the final regulations provide that the de minimis rule
is applied at the consolidated group level, rather than at the consolidated
group member level.
Similarly, with respect to a corporation that is a member of an EAG
but not a member of a consolidated group, the new de minimis rule
that allows a taxpayer to treat all of its gross receipts as non-DPGR if less
than 5 percent of the taxpayer’s total gross receipts are DPGR is determined
at the EAG member level, rather than at the EAG group level. However, with
respect to a consolidated group, the final regulations provide that this de
minimis rule is applied at the consolidated group level, rather
than at the consolidated group member level.
A commentator was concerned that the license of an intangible asset
between members of a consolidated group could reduce the section 199 deduction
available to the members of a consolidated group, because the licensee member’s
royalty expense would reduce the group’s QPAI, but the licensor member’s
royalty income from the license would not increase the group’s QPAI.
The commentator requested that language be added to the final regulations
to provide that the intercompany transaction rules of §1.1502-13 shall
be taken into account for purposes of determining the QPAI and DPGR of a consolidated
group.
As specifically noted in the preamble to the proposed regulations, the
regulations under §1.1502-13(c) already ensure that the section 199 deduction
cannot be reduced on account of an intercompany transaction. As discussed
above concerning the application of the de minimis rules
that allow treatment of gross receipts as DPGR or non-DPGR, §1.1502-13(c)(1)(i)
and (c)(4) requires that the separate entity attributes of a company’s
intercompany items or corresponding items must be redetermined to the extent
necessary to produce the effect as if the consolidated group members engaged
in an intercompany transaction were divisions of a single corporation. There
is nothing in the proposed regulations that would prevent this rule from applying.
In fact, several examples specifically illustrate the application of these
rules. An additional example concerning the license of an intangible between
members of a consolidated group has been added to the final regulations.
Another commentator requested clarification of the application of §1.199-7(b)(2)
of the proposed regulations where the EAG is comprised of more than one consolidated
group. Section 1.199-7(b)(2) of the proposed regulations (§1.199-7(b)(3)
of the final regulations) provides that, in determining the taxable income
of an EAG, if a member of an EAG has an NOL carryback or carryover to the
taxable year, then the amount of the NOL used to offset taxable income cannot
exceed the taxable income of that member. The final regulations continue to
treat a consolidated group as a single member of the EAG. Accordingly, if
a consolidated group has a consolidated NOL (CNOL) carryback or carryover,
the amount of the CNOL used to offset taxable income cannot exceed the consolidated
group’s taxable income, and may not be used to offset taxable income
of other members of the EAG, whether separate corporations or consolidated
groups. An example has been provided to illustrate this provision.
Trade or Business Requirement
Pursuant to section 199(d)(5), §§1.199-1 through 1.199-9 are
applied by taking into account only items that are attributable to the actual
conduct of a trade or business. An individual engaged in the actual
conduct of a trade or business must apply §§1.199-1 through 1.199-9
by taking into account in computing QPAI only items that are attributable
to that trade or business (or trades or businesses) and any items allocated
from a pass-thru entity engaged in a trade or business. Compensation received
by an individual employee for services performed as an employee is not considered
gross receipts for purposes of computing QPAI under §§1.199-1 through
1.199-9. Similarly, any costs or expenses paid or incurred by an individual
employee with respect to those services performed as an employee are not considered
CGS or deductions of that employee for purposes of computing QPAI under §§1.199-1
through 1.199-9. For purposes of the trade-or-business requirement, a trust
or estate is treated as an individual.
As noted above, section 514(b) of TIPRA amended section 199(d)(1)(A)(iii)
with respect to a partner’s or shareholder’s share of W-2 wages
from a partnership or S corporation for taxable years beginning after May
17, 2006. Section 1.199-9 of the final regulations contains guidance for
pass-thru entities with taxable years beginning on or before May 17, 2006.
A taxpayer must apply §1.199-9 to a taxable year beginning on or before
May 17, 2006, if that taxpayer applies §§1.199-1 through 1.199-8
to the taxable year. The portions of §1.199-3 relating to qualifying
in-kind partnerships and EAG partnerships, and all of §1.199-5 relating
to pass-thru entities, in the final regulations are reserved for taxable years
beginning after May 17, 2006. The IRS and Treasury Department intend to issue
regulations that take into account the amendments made to section 199(d)(1)(A)(iii)
for pass-thru entities.
Section 199 applies at the owner level in a manner consistent with the
economic arrangement of the owners of the pass-thru entity. Under the
proposed regulations, each owner computes its section 199 deduction by
taking into account its distributive or proportionate share of the pass-thru
entity’s items (including items of income and gain, as well as items
of loss and deduction not otherwise disallowed by the Code), CGS allocated
to such items of income, and gross receipts included in such items of income.
Generally, section 199 is applied at the shareholder, partner, or similar
level. For a non-grantor trust or estate, this level may refer to one or
more beneficiaries, the trust or estate, or both.
Section 199(d)(1)(A)(iii), however, limits the amount of W-2 wages from
a partnership or S corporation that may be used by each partner or shareholder
to compute the partner’s or shareholder’s section 199 deduction.
Pursuant to the authority granted in section 199(d)(1)(C), the final regulations
provide that this wage limitation will apply to non-grantor trusts and estates
in the same way it applies to partnerships and S corporations. Thus, for
all purposes of this wage limitation, references in the final regulations
to pass-thru entities include not only partnerships and S corporations, but
also all non-grantor trusts and estates.
The final regulations clarify that the section 199 deduction has no
effect on a shareholder’s adjusted basis in the stock of an S corporation
or a partner’s adjusted basis in an interest in a partnership because
the section 199 deduction is not described in section 1367(a) or section 705(a).
However, the shareholder’s or partner’s proportionate or distributive
share of the S corporation or partnership items that are included in computing
the shareholder’s or partner’s section 199 deduction will affect
the shareholder’s or partner’s adjusted basis under the rules
of section 1367(a) or section 705(a).
The proposed regulations provide that deductions of a partnership that
otherwise would be taken into account in computing the partner’s section 199
deduction are taken into account only if and to the extent the partner’s
distributive share of those deductions from all of the partnership’s
activities is not disallowed by section 465, 469, or 704(d), or any other
provision of the Code. If only a portion of the partner’s distributive
share of the losses or deductions is allowed for a taxable year, a proportionate
share of those allowable losses or deductions that are allocated to the partner’s
share of the partnership’s qualified production activities, determined
in a manner consistent with sections 465, 469, and 704(d), and any other
applicable provision of the Code (disallowed losses), is taken into account
in computing the section 199 deduction for that taxable year. To the
extent that any of the disallowed losses are allowed in a later taxable year,
the partner takes into account a proportionate share of those losses in computing
its QPAI for that later taxable year.
In response to comments received, the IRS and Treasury Department intend
to issue separate guidance by publication in the Internal Revenue Bulletin
regarding the treatment of disallowed losses in determining a taxpayer’s
section 199 deduction. As a matter of administrative convenience and to reduce
complexity for taxpayers, the final regulations clarify that disallowed losses
of the taxpayer that are disallowed for taxable years beginning on or before
December 31, 2004, are not taken into account in a later taxable year for
purposes of computing the taxpayer’s QPAI for that later taxable year
regardless of whether the disallowed losses are allowed for other purposes.
The final regulations provide that similar rules concerning disallowed losses
apply to taxpayers that are not partners or S corporation shareholders. See
§1.199-8(h).
Generally, in the case of a pass-thru entity, the calculations required
to determine QPAI (that is, the allocation or apportionment of gross receipts,
CGS, or deductions) are performed at the owner level. Notice 2005-14 and
the proposed regulations provide that a partnership or S corporation that
is a qualifying small taxpayer may use the small business simplified overall
method to apportion CGS and deductions between DPGR and non-DPGR. This rule
is not included in the final regulations, except that §1.199-9(k) permits
a partnership or S corporation that is a qualifying small taxpayer to use
the small business simplified overall method to apportion CGS and deductions
between DPGR and non-DPGR at the entity level under §1.199-4(f) of the
proposed regulations. In addition, §1.199-9(b)(1)(ii) and (c)(1)(ii)
of the final regulations provides that the Secretary may, by publication in
the Internal Revenue Bulletin, permit a partnership or S corporation to calculate
a partner’s or shareholder’s share of QPAI at the entity level.
If a partnership or S corporation calculates a partner’s or shareholder’s
share of QPAI at the entity level, the owner’s share of QPAI and W-2
wages from the partnership or S corporation are combined with the owner’s
QPAI and W-2 wages from other sources. The final regulations also clarify
that, if a pass-thru entity calculates QPAI at the entity level, then generally
the owner of the pass-thru entity is not permitted to use another cost allocation
method to reallocate the costs of the pass-thru entity regardless of the method
used by the pass-thru entity’s owner to allocate or apportion costs.
A taxpayer that receives QPAI from a partnership or S corporation does not
take into account any gross receipts, income, assets, deductions, or other
items of the partnership or S corporation when the taxpayer allocates and
apportions deductions to determine the taxpayer’s QPAI from other sources.
Regarding the rule allowing partnerships that extract, refine, or process
oil or natural gas to attribute these activities to their partners, some commentators
requested that the rule be expanded to other industries that operate in a
substantially similar manner. The exception for the oil and gas industry
was provided in the proposed regulations to prevent a clearly qualifying activity
from being disqualified under section 199 because of several decades-long
industry practices. Among the historical industry practices taken into account
by the IRS and Treasury Department in establishing the oil and gas exception
was the fact that for decades the oil and gas industry generally has operated
in a business model in which a partnership produces qualifying property and
distributes such property in-kind to its partners (generally engaged themselves
in the production of oil and gas), generally the partnership does not derive
any gross receipts from the produced property, the property is marketed and
sold exclusively and separately by each partner as competitors, and generally
there is no marketing or sale by the partnership of the produced property,
and no joint marketing or sale of the distributed property by any of the partners.
In addition, the partnership typically qualifies to elect out of subchapter
K.
In response to the requests that this attribution rule be expanded to
industries that historically have operated in a manner substantially similar
to the oil and gas industry, the final regulations provide that, if a partnership
that MPGE or produces property is a qualifying in-kind partnership (as defined
later), then each partner may be treated as MPGE or producing the property
MPGE or produced by the partnership that is distributed to that partner.
If a partner of a qualifying in-kind partnership derives gross receipts from
the lease, rental, license, sale, exchange, or other disposition of the property
that was MPGE or produced by the qualifying in-kind partnership, then, provided
such partner is a partner of the qualifying in-kind partnership at the time
the partner disposes of the property, the partner is treated as conducting
the MPGE or production activities previously conducted by the qualifying in-kind
partnership with respect to that property. For this purpose, a qualifying
in-kind partnership is defined in §1.199-9(i)(2) of the final regulations
to include only certain partnerships operating solely in a designated industry:
oil and gas, petrochemical, or electricity generation. Partnerships in other
industries with substantially similar historical industry practices may be
designated by the IRS and Treasury Department as qualifying in-kind partnerships
by publication in the Internal Revenue Bulletin.
The proposed regulations provide that, if an EAG partnership (as defined
in §1.199-9(j)(2) of the final regulations) MPGE or produces property
and distributes, leases, rents, licenses, sells, exchanges, or otherwise disposes
of that property to a member of an EAG of which the partners of the EAG partnership
are members, then the MPGE or production activity conducted by the EAG partnership
will be treated as having been conducted by the disposing member of the EAG.
Similarly, if one or more members of an EAG of which the partners of an EAG
partnership are members MPGE or produces property and contributes, leases,
rents, licenses, sells, exchanges, or otherwise disposes of that property
to the EAG partnership, then the MPGE or production activity conducted by
the EAG member (or members) will be treated as having been conducted by the
EAG partnership. A question arose as to when a corporation needs to be a
member of an EAG of which the partners of the EAG partnership are members
for attribution of MPGE or production activities to take place. The final
regulations clarify that attribution of such activities between an EAG partnership
and members of the EAG of which the partners of the EAG partnership are members
is determined at the time that the EAG partnership disposes of the property
(in the case of property MPGE or produced by an EAG member or members) or
at the time that the member or members of the EAG of which the partners of
the EAG partnership are members dispose of the property (in the case of property
MPGE or produced by the EAG partnership). Attribution is effective only for
those taxable years that the disposing or producing member is a member of
the EAG of which the partners of the EAG partnership are members for the entire
taxable year of the EAG partnership. The final regulations also clarify that
EAG partnerships, the partners of which are members of the same EAG, may attribute
their production activities between themselves on a similar basis, provided
that the producing EAG partnership and the disposing EAG partnership are owned
by members of the same EAG for the entire taxable year of the respective EAG
partnership that includes the date on which the disposing EAG partnership
disposes of the property.
Because the sale of an interest in a pass-thru entity does not reflect
the realization of DPGR by that entity, DPGR generally does not include gain
or loss recognized on the sale, exchange or other disposition of an interest
in the entity. However, consistent with Notice 2005-14 and the proposed regulations,
if section 751(a) or (b) applies, then gain or loss attributable to partnership
assets giving rise to ordinary income under section 751(a) or (b), the sale,
exchange, or other disposition of which would give rise to an item of DPGR,
is taken into account in computing the partner’s section 199 deduction.
One commentator stated that many commercial real estate developers dispose
of commercial real property by selling interests in special purpose partnerships
that hold commercial real property. Because a sale, exchange or other disposition
of the commercial real property may result in section 1231 gain rather than
ordinary income, the commentator suggested that the definition of inventory
items be expanded for purposes of §1.199-9(e) by treating section 751(d)
as not containing the words “and other than property described in section
1231.” As a result, a sale or exchange of an interest in a partnership
that holds commercial real property would generate DPGR if a sale or exchange
of the commercial real property would generate DPGR regardless of whether
the sale or exchange would result in ordinary income. The final regulations
do not include the commentator’s suggestion because the rule in §1.199-9(e)
applies aggregate treatment to a sale or exchange of a partnership interest
only to the extent section 751 specifically allows such treatment. Modifying
the explicit terms of section 751(d) as suggested would be inconsistent with
the purposes of section 751 and section 199.
In the preamble to the proposed regulations, the IRS and Treasury Department
invited taxpayers to submit comments on issues relating to section 199 including
whether taxpayers can apply statistical sampling to section 199, what specific
areas of section 199 statistical sampling could be applied to, and whether
application of statistical sampling should be limited to specific areas of
section 199. Comments were received on statistical sampling and the IRS and
Treasury Department are considering those comments and intend to issue subsequent
guidance addressing the application of statistical sampling for purposes of
section 199.
Elections under the Section 861 Regulations
The preamble to the proposed regulations states that, because the provisions
of section 199 may cause taxpayers to reconsider previously made elections
under §§1.861-8 through 1.861-17 and §§1.861-8T through
1.861-14T (the section 861 regulations), the IRS and Treasury Department intend
to issue a revenue procedure granting taxpayers automatic consent to change
certain of those elections. In the proposed regulations, the IRS and Treasury
Department requested comments on which elections should be included in such
a revenue procedure and the appropriate time period during which the automatic
consent should apply. Several commentators urged promulgation of such a revenue
procedure, and several comments specifically requested that the revenue procedure
provide taxpayers automatic consent for more than one taxable year to change
previously made elections.
The IRS and Treasury Department intend to issue a revenue procedure
that provides taxpayers automatic consent to change certain elections relating
to the apportionment of interest expense and research and experimental expenditures
under the section 861 regulations. It is intended that the automatic consent
afforded under the revenue procedure will provide taxpayers the consent required
by §§1.861-8T(c)(2) and 1.861-9(i)(2), with respect to the apportionment
of interest expense, and by §1.861-17(e), with respect to the apportionment
of research and experimental expenditures, to change an election, effective
for a taxpayer’s first taxable year beginning after December 31, 2004
(the taxpayer’s 2005 taxable year). In addition, it is intended that
the revenue procedure will provide taxpayers the consent required by those
regulations for a taxpayer’s taxable year immediately following the
taxpayer’s 2005 taxable year, but, in such case, a taxpayer would not
be provided automatic consent to change any election that first took effect
with respect to the taxpayer’s 2005 taxable year.
Financial and Administrative Burden
Several commentators objected to the complexity of the proposed regulations,
and to the financial and administrative burden that the commentators believe
the regulations will impose on taxpayers (particularly on small businesses).
The complexity and burden of the regulations are a function of the statutory
language and framework of section 199, which are complex and contain many
requirements. For example, with the exception of a few specific services
(namely, construction, architecture, and engineering) only gross receipts
derived from certain dispositions of certain property qualify under the statute.
In addition, in the case of manufacturing activities, the property must be
manufactured by the taxpayer in whole or in significant part within the United
States. Also, under section 199, costs must be allocated between qualifying
and nonqualifying gross receipts. All of these statutory requirements (and
others) potentially necessitate that taxpayers obtain information, make determinations
and computations, and retain records that might not otherwise be required
for business purposes. In the case of partnerships and S corporations, the
statute requires that the deduction be computed at the owner level, necessitating
the sharing between entity and owner of information that might not be needed
for purposes other than section 199. Both the proposed and the final regulations
provide a number of safe harbors and de minimis rules
that are intended to balance the need for compliance with these statutory
requirements against the burden imposed on taxpayers.
In the preamble to the proposed regulations, the IRS and Treasury Department
certify that the collection of information required under the proposed regulations
(relating to information to be provided by cooperatives to their patrons)
will not have a significant economic impact on a substantial number of small
entities, and therefore that a Regulatory Flexibility Analysis is not required
by the Regulatory Flexibility Act (RFA). One commentator asserted that the
certification did not provide sufficient information for small entities to
determine the impact the regulations will have on their businesses. The commentator
also contended that the IRS and Treasury Department, in making the certification,
failed to consider burdens imposed by the proposed regulations on other small
entities, such as partnerships and S corporations, that are required under
the regulations to provide certain information to their owners.
The IRS and Treasury Department believe that the certification for the
proposed regulations, as well as for these final regulations, is appropriate
and complies with the requirements of the RFA. With respect to cooperatives,
the regulations provide cooperatives with specific rules about the information
they must provide to patrons under section 199. The IRS and Treasury Department
believe that cooperatives have the necessary information to comply with this
requirement. The IRS and Treasury Department continue to believe that this
requirement is the only collection of information in the regulations that
is within the scope of the RFA. Certain other recordkeeping and reporting
requirements of the regulations relating to information sharing between pass-thru
entities (partnerships and S corporations) and their owners are subsumed within
other existing income tax regulations that currently require that such entities
report to their owners all information that is necessary for the owners to
determine their tax liability.
Section 199 applies to taxable years beginning after December 31, 2004.
Sections 1.199-1 through 1.199-8 are applicable for taxable years beginning
on or after June 1, 2006. For a taxable year beginning on or before May 17,
2006, the enactment date of TIPRA, a taxpayer may apply §§1.199-1
through 1.199-9 provided that the taxpayer applies all provisions in §§1.199-1
through 1.199-9 to the taxable year. For a taxable year beginning after May
17, 2006, and before June 1, 2006, a taxpayer may apply §§1.199-1
through 1.199-8 provided that the taxpayer applies all provisions in §§1.199-1
through 1.199-8 to the taxable year. Section 1.199-9 may not be applied to
a taxable year that begins after May 17, 2006.
For a taxpayer who chooses not to rely on these final regulations for
a taxable year beginning before June 1, 2006, the guidance on section 199
that applies to such taxable year is contained in Notice 2005-14, 2005-1 C.B.
498. In addition, a taxpayer also may rely on the provisions of REG-105847-05,
2005-47 I.R.B. 987 (see §601.601(d)(2)) for a taxable year beginning
before June 1, 2006. If Notice 2005-14 and REG-105847-05 include different
rules for the same particular issue, then a taxpayer may rely on either the
rule set forth in Notice 2005-14 or the rule set forth in REG-105847-05.
However, if REG-105847-05 includes a rule that was not included in Notice
2005-14, then a taxpayer is not permitted to rely on the absence of a rule
to apply a rule contrary to REG-105847-05. For taxable years beginning after
May 17, 2006, and before June 1, 2006, a taxpayer may not apply Notice 2005-14,
REG-105847-05, or any other guidance under section 199 in a manner inconsistent
with amendments made to section 199 by section 514 of TIPRA. In determining
the deduction under section 199, items arising from a taxable year of a partnership,
S corporation, estate, or trust beginning before January 1, 2005, shall not
be taken into account for purposes of section 199(d)(1). Members of
an EAG that are not members of a consolidated group may each apply the effective
date rules without regard to how other members of the EAG apply the effective
date rules.
EFFECT ON OTHER DOCUMENTS
Notice 2005-14, 2005-1 C.B. 498, is obsolete for taxable years beginning
on or after June 1, 2006.
It has been determined that this Treasury decision is not a significant
regulatory action as defined in Executive Order 12866. Therefore, a
regulatory assessment is not required. It is hereby certified that the collection
of information in this regulation will not have a significant economic impact
on a substantial number of small entities. This certification is based upon
the fact that any burden on cooperatives is minimal. Accordingly, a Regulatory
Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter
6) is not required. Pursuant to section 7805(f) of the Code, the notice
of proposed rulemaking was submitted to the Chief Counsel for Advocacy of
the Small Business Administration for comment on its impact on small business.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 602 are amended as follows:
Paragraph 1. The authority citation for part 1 is amended by adding
entries to read, in part, as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.199-1 also issued under 26 U.S.C. 199(d).
Section 1.199-2 also issued under 26 U.S.C. 199(d).
Section 1.199-3 also issued under 26 U.S.C. 199(d).
Section 1.199-4 also issued under 26 U.S.C. 199(d).
Section 1.199-5 also issued under 26 U.S.C. 199(d).
Section 1.199-6 also issued under 26 U.S.C. 199(d).
Section 1.199-7 also issued under 26 U.S.C. 199(d).
Section 1.199-8 also issued under 26 U.S.C. 199(d).
Section 1.199-9 also issued under 26 U.S.C. 199(d). * * *
Par. 2. Sections 1.199-0 through 1.199-9 are added to read as
follows:
§1.199-0 Table of contents.
This section lists the section headings that appear in §§1.199-1
through 1.199-9.
§1.199-1 Income attributable to domestic production
activities.
(a) In general.
(b) Taxable income and adjusted gross income.
(1) In general.
(2) Examples.
(c) Qualified production activities income.
(d) Allocation of gross receipts.
(1) In general.
(2) Reasonable method of allocation.
(3) De minimis rules.
(i) DPGR.
(ii) Non-DPGR.
(4) Example.
(e) Certain multiple-year transactions.
(1) Use of historical data.
(2) Percentage of completion method.
(3) Examples.
§1.199-2 Wage limitation.
(a) Rules of application.
(1) In general.
(2) Wages paid by entity other than common law employer.
(3) Requirement that wages must be reported on return filed with the
Social Security Administration.
(i) In general.
(ii) Corrected return filed to correct a return that was filed within
60 days of the due date.
(iii) Corrected return filed to correct a return that was filed later
than 60 days after the due date.
(4) Joint return.
(b) Application in the case of a taxpayer with a short taxable year.
(c) Acquisition or disposition of a trade or business (or major portion).
(d) Non-duplication rule.
(e) Definition of W-2 wages.
(1) In general.
(2) Limitation on W-2 wages for taxable years beginning after May 17,
2006, the enactment date of the Tax Increase Prevention and Reconciliation
Act of 2005. [Reserved].
(3) Methods for calculating W-2 wages.
§1.199-3 Domestic production gross receipts.
(a) In general.
(b) Related persons.
(1) In general.
(2) Exceptions.
(c) Definition of gross receipts.
(d) Determining domestic production gross receipts.
(1) In general.
(2) Special rules.
(3) Exception.
(4) Examples.
(e) Definition of manufactured, produced, grown, or extracted.
(1) In general.
(2) Packaging, repackaging, labeling, or minor assembly.
(3) Installing.
(4) Consistency with section 263A.
(5) Examples.
(f) Definition of by the taxpayer.
(1) In general.
(2) Special rule for certain government contracts.
(3) Subcontractor.
(4) Examples.
(g) Definition of in whole or in significant part.
(1) In general.
(2) Substantial in nature.
(3) Safe harbor.
(i) In general.
(ii) Unadjusted depreciable basis.
(iii) Computer software and sound recordings.
(4) Special rules.
(i) Contract with unrelated persons.
(ii) Aggregation.
(5) Examples.
(h) Definition of United States.
(i) Derived from the lease, rental, license, sale, exchange, or other
disposition.
(1) In general.
(i) Definition.
(ii) Lease income.
(iii) Income substitutes.
(iv) Exchange of property.
(A) Taxable exchanges.
(B) Safe harbor.
(C) Eligible property.
(2) Examples.
(3) Hedging transactions.
(i) In general.
(ii) Currency fluctuations.
(iii) Effect of identification and nonidentification.
(iv) Other rules.
(4) Allocation of gross receipts.
(i) Embedded services and non-qualified property.
(A) In general.
(B) Exceptions.
(ii) Non-DPGR.
(iii) Examples.
(5) Advertising income.
(i) Tangible personal property.
(ii) Qualified film.
(iii) Examples.
(6) Computer software.
(i) In general.
(ii) through (v) [Reserved].
(7) Qualifying in-kind partnership for taxable years beginning after
May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation
Act of 2005. [Reserved].
(8) Partnerships owned by members of a single expanded affiliated group
for taxable years beginning after May 17, 2006, the enactment date of the
Tax Increase Prevention and Reconciliation Act of 2005. [Reserved].
(9) Non-operating mineral interests.
(j) Definition of qualifying production property.
(1) In general.
(2) Tangible personal property.
(i) In general.
(ii) Local law.
(iii) Intangible property.
(3) Computer software.
(i) In general.
(ii) Incidental and ancillary rights.
(iii) Exceptions.
(4) Sound recordings.
(i) In general.
(ii) Exception.
(5) Tangible personal property with computer software or sound recordings.
(i) Computer software and sound recordings.
(ii) Tangible personal property.
(k) Definition of qualified film.
(1) In general.
(2) Tangible personal property with a film.
(i) Film not produced by a taxpayer.
(ii) Film produced by a taxpayer.
(A) Qualified film.
(B) Nonqualified film.
(3) Derived from a qualified film.
(i) In general.
(ii) Exceptions.
(4) Compensation for services.
(5) Determination of 50 percent.
(6) Exception.
(7) Examples.
(l) Electricity, natural gas, or potable water.
(1) In general.
(2) Natural gas.
(3) Potable water.
(4) Exceptions.
(i) Electricity.
(ii) Natural gas.
(iii) Potable water.
(iv) De minimis exception.
(A) DPGR.
(B) Non-DPGR.
(5) Example.
(m) Definition of construction performed in the United States.
(1) Construction of real property.
(i) In general.
(ii) Regular and ongoing basis.
(A) In general.
(B) New trade or business.
(iii) De minimis exception.
(A) DPGR.
(B) Non-DPGR.
(2) Activities constituting construction.
(i) In general.
(ii) Tangential services.
(iii) Other construction activities.
(iv) Administrative support services.
(v) Exceptions.
(3) Definition of real property.
(4) Definition of infrastructure.
(5) Definition of substantial renovation.
(6) Derived from construction.
(i) In general.
(ii) Qualified construction warranty.
(iii) Exceptions.
(iv) Land safe harbor.
(A) In general.
(B) Determining gross receipts and costs.
(v) Examples.
(n) Definition of engineering and architectural services.
(1) In general.
(2) Engineering services.
(3) Architectural services.
(4) Administrative support services.
(5) Exceptions.
(6) De minimis exception for performance of services
in the United States.
(i) DPGR.
(ii) Non-DPGR.
(7) Example.
(o) Sales of certain food and beverages.
(1) In general.
(2) De minimis exception.
(3) Examples.
(p) Guaranteed payments.
§1.199-4 Costs allocable to domestic production gross
receipts.
(a) In general.
(b) Cost of goods sold allocable to domestic production gross receipts.
(1) In general.
(2) Allocating cost of goods sold.
(i) In general.
(ii) Gross receipts recognized in an earlier taxable year.
(3) Special rules for imported items or services.
(4) Rules for inventories valued at market or bona fide selling
prices.
(5) Rules applicable to inventories accounted for under the last-in,
first-out (LIFO) inventory method.
(i) In general.
(ii) LIFO/FIFO ratio method.
(iii) Change in relative base-year cost method.
(6) Taxpayers using the simplified production method or simplified
resale method for additional section 263A costs.
(7) Examples.
(c) Other deductions properly allocable to domestic production gross
receipts or gross income attributable to domestic production gross receipts.
(1) In general.
(2) Treatment of net operating losses.
(3) W-2 wages.
(d) Section 861 method.
(1) In general.
(2) Deductions for charitable contributions.
(3) Research and experimental expenditures.
(4) Deductions allocated or apportioned to gross receipts treated as
domestic production gross receipts.
(5) Treatment of items from a pass-thru entity reporting qualified
production activities income.
(6) Examples.
(e) Simplified deduction method.
(1) In general.
(2) Eligible taxpayer.
(3) Total assets.
(i) In general.
(ii) Members of an expanded affiliated group.
(4) Members of an expanded affiliated group.
(i) In general.
(ii) Exception.
(iii) Examples.
(f) Small business simplified overall method.
(1) In general.
(2) Qualifying small taxpayer.
(3) Total costs for the current taxable year.
(i) In general.
(ii) Land safe harbor.
(4) Members of an expanded affiliated group.
(i) In general.
(ii) Exception.
(iii) Examples.
(5) Trusts and estates.
(g) Average annual gross receipts.
(1) In general.
(2) Members of an expanded affiliated group.
§1.199-5 Application of section 199 to pass-thru entities
for taxable years beginning after May 17, 2006, the enactment date of the
Tax Increase Prevention and Reconciliation Act of 2005. [Reserved].
§1.199-6 Agricultural and horticultural cooperatives.
(a) In general.
(b) Cooperative denied section 1382 deduction for portion of qualified
payments.
(c) Determining cooperative’s taxable income.
(d) Special rule for marketing cooperatives.
(e) Qualified payment.
(f) Specified agricultural or horticultural cooperative.
(g) Written notice to patrons.
(h) Additional rules relating to passthrough of section 199 deduction.
(i) W-2 wages.
(j) Recapture of section 199 deduction.
(k) Section is exclusive.
(l) No double counting.
(m) Examples.
§1.199-7 Expanded affiliated groups.
(a) In general.
(1) Definition of expanded affiliated group.
(2) Identification of members of an expanded affiliated group.
(i) In general.
(ii) Becoming or ceasing to be a member of an expanded affiliated group.
(3) Attribution of activities.
(i) In general.
(ii) Special rule.
(4) Examples.
(5) Anti-avoidance rule.
(b) Computation of expanded affiliated group’s section 199 deduction.
(1) In general.
(2) Example.
(3) Net operating loss carrybacks and carryovers.
(c) Allocation of an expanded affiliated group’s section 199
deduction among members of the expanded affiliated group.
(1) In general.
(2) Use of section 199 deduction to create or increase a net operating
loss.
(d) Special rules for members of the same consolidated group.
(1) Intercompany transactions.
(2) Attribution of activities in the construction of real property
and the performance of engineering and architectural services.
(3) Application of the simplified deduction method and the small business
simplified overall method.
(4) Determining the section 199 deduction.
(i) Expanded affiliated group consists of consolidated group and non-consolidated
group members.
(ii) Expanded affiliated group consists only of members of a single
consolidated group.
(5) Allocation of the section 199 deduction of a consolidated group
among its members.
(e) Examples.
(f) Allocation of income and loss by a corporation that is a member
of the expanded affiliated group for only a portion of the year.
(1) In general.
(i) Pro rata allocation method.
(ii) Section 199 closing of the books method.
(iii) Making the section 199 closing of the books election.
(2) Coordination with rules relating to the allocation of income under
§1.1502-76(b).
(g) Total section 199 deduction for a corporation that is a member
of an expanded affiliated group for some or all of its taxable year.
(1) Member of the same expanded affiliated group for the entire taxable
year.
(2) Member of the expanded affiliated group for a portion of the taxable
year.
(3) Example.
(h) Computation of section 199 deduction for members of an expanded
affiliated group with different taxable years.
(1) In general.
(2) Example.
(a) In general.
(b) Individuals.
(c) Trade or business requirement.
(1) In general.
(2) Individuals.
(3) Trusts and estates.
(d) Coordination with alternative minimum tax.
(e) Nonrecognition transactions.
(1) In general.
(i) Sections 351, 721, and 731.
(ii) Exceptions.
(A) Section 708(b)(1)(B).
(B) Transfers by reason of death.
(2) Section 1031 exchanges.
(3) Section 381 transactions.
(f) Taxpayers with a 52-53 week taxable year.
(g) Section 481(a) adjustments.
(h) Disallowed losses or deductions.
(i) Effective dates.
(1) In general.
(2) Pass-thru entities.
(3) Non-consolidated EAG members.
(4) Computer software provided to customers over the Internet. [Reserved].
§1.199-9 Application of section 199 to pass-thru entities
for taxable years beginning on or before May 17, 2006, the enactment date
of the Tax Increase Prevention and Reconciliation Act of 2005.
(a) In general.
(b) Partnerships.
(1) In general.
(i) Determination at partner level.
(ii) Determination at entity level.
(2) Disallowed losses or deductions.
(3) Partner’s share of W-2 wages.
(4) Transition percentage rule for W-2 wages.
(5) Partnerships electing out of subchapter K.
(6) Examples.
(c) S corporations.
(1) In general.
(i) Determination at shareholder level.
(ii) Determination at entity level.
(2) Disallowed losses or deductions.
(3) Shareholder’s share of W-2 wages.
(4) Transition percentage rule for W-2 wages.
(d) Grantor trusts.
(e) Non-grantor trusts and estates.
(1) Allocation of costs.
(2) Allocation among trust or estate and beneficiaries.
(i) In general.
(ii) Treatment of items from a trust or estate reporting qualified
production activities income.
(3) Beneficiary’s share of W-2 wages.
(4) Transition percentage rule for W-2 wages.
(5) Example.
(f) Gain or loss from the disposition of an interest in a pass-thru
entity.
(g) Section 199(d)(1)(A)(iii) wage limitation and tiered structures.
(1) In general.
(2) Share of W-2 wages.
(3) Example.
(h) No attribution of qualified activities.
(i) Qualifying in-kind partnership.
(1) In general.
(2) Definition of qualifying in-kind partnership.
(3) Special rules for distributions.
(4) Other rules.
(5) Example.
(j) Partnerships owned by members of a single expanded affiliated group.
(1) In general.
(2) Attribution of activities.
(i) In general.
(ii) Attribution between EAG partnerships.
(iii) Exception to attribution.
(3) Special rules for distributions.
(4) Other rules.
(5) Examples.
(k) Effective dates.
§1.199-1 Income attributable to domestic production
activities.
(a) In general. A taxpayer may deduct an amount
equal to 9 percent (3 percent in the case of taxable years beginning in 2005
or 2006, and 6 percent in the case of taxable years beginning in 2007,
2008, or 2009) of the lesser of the taxpayer’s qualified production
activities income (QPAI) (as defined in paragraph (c) of this section) for
the taxable year, or the taxpayer’s taxable income for the taxable year
(or, in the case of an individual, adjusted gross income). The amount of
the deduction allowable under this paragraph (a) for any taxable year cannot
exceed 50 percent of the W-2 wages of the employer for the taxable year (as
determined under §1.199-2). The provisions of this section apply solely
for purposes of section 199 of the Internal Revenue Code.
(b) Taxable income and adjusted gross income—(1)
In general. For purposes of paragraph (a) of this section,
the definition of taxable income under section 63 applies, except that
taxable income is determined without regard to section 199 and without regard
to any amount excluded from gross income pursuant to section 114 or pursuant
to section 101(d) of the American Jobs Creation Act of 2004, Public Law 108-357,
118 Stat. 1418 (Act). In the case of individuals, adjusted gross income for
the taxable year is determined after applying sections 86, 135, 137,
219, 221, 222, and 469, and without regard to section 199 and without
regard to any amount excluded from gross income pursuant to section 114 or
pursuant to section 101(d) of the Act. For purposes of determining the tax
imposed by section 511, paragraph (a) of this section is applied using
unrelated business taxable income. Except as provided in §1.199-7(c)(2),
the deduction under section 199 is not taken into account in computing any
net operating loss or the amount of any net operating loss carryback or carryover.
(2) Examples. The following examples illustrate
the application of this paragraph (b):
Example 1. X, a corporation that is not part of
an expanded affiliated group (EAG) (as defined in §1.199-7), engages
in production activities that generate QPAI and taxable income (without taking
into account the deduction under this section and an NOL deduction) of $600
in 2010. During 2010, X incurs W-2 wages as defined in §1.199-2(e) of
$300. X has an NOL carryover to 2010 of $500. X’s deduction under
this section for 2010 is $9 (.09 x (lesser of QPAI of $600 and taxable income
of $100 ($600 taxable income - $500 NOL)). Because the wage limitation is
$150 (50% x $300), X’s deduction is not limited.
Example 2. (i) Facts. X,
a corporation that is not part of an EAG, engages in production activities
that generate QPAI and taxable income (without taking into account the deduction
under this section and an NOL deduction) of $100 in 2010. X has an NOL carryover
to 2010 of $500 that reduces its taxable income for 2010 to $0. X’s
deduction under this section for 2010 is $0 (.09 x (lesser of QPAI of $100
and taxable income of $0)).
(ii) Carryover to 2011. X’s taxable income
for purposes of determining its NOL carryover to 2011 is $100. Accordingly,
X’s NOL carryover to 2011 is $400 ($500 NOL carryover to 2010 - $100
NOL used in 2010).
(c) Qualified production activities income. QPAI
for any taxable year is an amount equal to the excess (if any) of the taxpayer’s
domestic production gross receipts (DPGR) (as defined in §1.199-3) over
the sum of—
(1) The cost of goods sold (CGS) that is allocable to such receipts;
and
(2) Other expenses, losses, or deductions (other than the deduction
allowed under this section) that are properly allocable to such receipts.
See §§1.199-3 and 1.199-4.
(d) Allocation of gross receipts—(1) In
general. A taxpayer must determine the portion of its gross receipts
for the taxable year that is DPGR and the portion of its gross receipts that
is non-DPGR. Applicable Federal income tax principles apply to determine
whether a transaction is, in substance, a lease, rental, license, sale, exchange,
or other disposition the gross receipts of which may constitute DPGR (assuming
all the other requirements of §1.199-3 are met), whether it is a service
the gross receipts of which may constitute non-DPGR, or some combination thereof.
For example, if a taxpayer leases qualifying production property (QPP) (as
defined in §1.199-3(j)(1)) and in connection with that lease, also provides
services, the taxpayer must allocate its gross receipts from the transaction
using any reasonable method that is satisfactory to the Secretary based on
all of the facts and circumstances and that accurately identifies the gross
receipts that constitute DPGR and non-DPGR.
(2) Reasonable method of allocation. Factors
taken into consideration in determining whether the taxpayer’s method
of allocating gross receipts between DPGR and non-DPGR is reasonable include
whether the taxpayer uses the most accurate information available; the relationship
between the gross receipts and the method used; the accuracy of the method
chosen as compared with other possible methods; whether the method is used
by the taxpayer for internal management or other business purposes; whether
the method is used for other Federal or state income tax purposes; the time,
burden, and cost of using alternative methods; and whether the taxpayer applies
the method consistently from year to year. Thus, if a taxpayer has the information
readily available and can, without undue burden or expense, specifically identify
whether the gross receipts derived from an item are DPGR, then the taxpayer
must use that specific identification to determine DPGR. If a taxpayer does
not have information readily available to specifically identify whether the
gross receipts derived from an item are DPGR or cannot, without undue burden
or expense, specifically identify whether the gross receipts derived from
an item are DPGR, then the taxpayer is not required to use a method that specifically
identifies whether the gross receipts derived from an item are DPGR.
(3) De minimis rules—(i)
DPGR. All of a taxpayer’s gross receipts may
be treated as DPGR if less than 5 percent of the taxpayer’s total gross
receipts are non-DPGR (after application of the exceptions provided in §1.199-3(i)(4)(i)(B),
(l)(4)(iv)(A), (m)(1)(iii)(A), (n)(6)(i), and (o)(2) that may result in gross
receipts being treated as DPGR). If the amount of the taxpayer’s gross
receipts that are non-DPGR equals or exceeds 5 percent of the taxpayer’s
total gross receipts, then, except as provided in paragraph (d)(3)(ii) of
this section, the taxpayer is required to allocate all gross receipts between
DPGR and non-DPGR in accordance with paragraph (d)(1) of this section. If
a corporation is a member of an EAG, but is not a member of a consolidated
group, then the determination of whether less than 5 percent of the taxpayer’s
total gross receipts are non-DPGR is made at the corporation level. If a
corporation is a member of a consolidated group, then the determination of
whether less than 5 percent of the taxpayer’s total gross receipts are
non-DPGR is made at the consolidated group level. In the case of an S corporation,
partnership, trust (to the extent not described in §1.199-9(d)) or estate,
or other pass-thru entity, the determination of whether less than 5 percent
of the pass-thru entity’s total gross receipts are non-DPGR is made
at the pass-thru entity level. In the case of an owner of a pass-thru entity,
the determination of whether less than 5 percent of the owner’s total
gross receipts are non-DPGR is made at the owner level, taking into account
all gross receipts of the owner from its other trade or business activities
and the owner’s share of the gross receipts of the pass-thru entity.
(ii) Non-DPGR. All of a taxpayer’s gross
receipts may be treated as non-DPGR if less than 5 percent of the taxpayer’s
total gross receipts are DPGR (after application of the exceptions provided
in §1.199-3(i)(4)(ii), (l)(4)(iv)(B), (m)(1)(iii)(B), and (n)(6)(ii)
that may result in gross receipts being treated as non-DPGR). If a corporation
is a member of an EAG, but is not a member of a consolidated group, then the
determination of whether less than 5 percent of the taxpayer’s total
gross receipts are DPGR is made at the corporation level. If a corporation
is a member of a consolidated group, then the determination of whether less
than 5 percent of the taxpayer’s total gross receipts are DPGR is made
at the consolidated group level. In the case of an S corporation, partnership,
trust (to the extent not described in §1.199-9(d)) or estate, or other
pass-thru entity, the determination of whether less than 5 percent of the
pass-thru entity’s total gross receipts are DPGR is made at the pass-thru
entity level. In the case of an owner of a pass-thru entity, the determination
of whether less than 5 percent of the owner’s total gross receipts are
DPGR is made at the owner level, taking into account all gross receipts of
the owner from its other trade or business activities and the owner’s
share of the gross receipts of the pass-thru entity.
(4) Example. The following example illustrates
the application of this paragraph (d):
Example. X derives its gross receipts from the
sale of gasoline refined by X within the United States and the sale of refined
gasoline that X acquired by purchase from an unrelated person. If at least
5% of X’s gross receipts are derived from gasoline refined by X within
the United States (that qualify as DPGR if all the other requirements of §1.199-3
are met) and at least 5% of X’s gross receipts are derived from the
resale of the acquired gasoline (that do not qualify as DPGR), then X does
not qualify for the de minimis rules under paragraphs
(d)(3)(i) and (ii) of this section, and X must allocate its gross receipts
between the gross receipts derived from the sale of gasoline refined by X
within the United States and the gross receipts derived from the resale of
the acquired gasoline. If less than 5% of X’s gross receipts are derived
from the resale of the acquired gasoline, then, X may either allocate its
gross receipts between the gross receipts derived from the gasoline refined
by X within the United States and the gross receipts derived from the resale
of the acquired gasoline, or, pursuant to paragraph (d)(3)(i) of this section,
X may treat all of its gross receipts derived from the sale of the refined
gasoline as DPGR. If X’s gross receipts attributable to the gasoline
refined by X within the United States constitute less than 5% of X’s
total gross receipts, then, X may either allocate its gross receipts between
the gross receipts derived from the gasoline refined by X within the United
States and the gross receipts derived from the resale of the acquired gasoline,
or, pursuant to paragraph (d)(3)(ii) of this section, X may treat all of its
gross receipts derived from the sale of the refined gasoline as non-DPGR.
(e) Certain multiple-year transactions—(1)
Use of historical data. If a taxpayer recognizes and
reports gross receipts from advance payments or other similar payments on
a Federal income tax return for a taxable year, then the taxpayer’s
use of historical data in making an allocation of gross receipts from the
transaction between DPGR and non-DPGR may constitute a reasonable method.
If a taxpayer makes allocations using historical data, and subsequently updates
the data, then the taxpayer must use the more recent or updated data, starting
in the taxable year in which the update is made.
(2) Percentage of completion method. A taxpayer
using a percentage of completion method under section 460 must determine the
ratio of DPGR and non-DPGR using a reasonable method that is satisfactory
to the Secretary based on all of the facts and circumstances that accurately
identifies the gross receipts that constitute DPGR. See paragraph (d)(2)
of this section for the factors taken into consideration in determining whether
the taxpayer’s method is reasonable.
(3) Examples. The following examples illustrate
the application of this paragraph (e):
Example 1. On December 1, 2007, X, a calendar
year accrual method taxpayer, sells for $100 a one-year computer software
maintenance agreement that provides for (i) computer software updates that
X expects to produce in the United States, and (ii) customer support services.
At the end of 2007, X uses a reasonable method that is satisfactory to the
Secretary based on all of the facts and circumstances to allocate 60% of the
gross receipts ($60) to the computer software updates and 40% ($40) to the
customer support services. X treats the $60 as DPGR in 2007. At the expiration
of the one-year agreement on November 30, 2008, no computer software updates
are provided by X. Pursuant to paragraph (e)(1) of this section, because
X used a reasonable method that is satisfactory to the Secretary based on
all of the facts and circumstances to identify gross receipts as DPGR, X is
not required to make any adjustments to its 2007 Federal income tax return
(for example, by amended return) or in 2008 for the $60 that was properly
treated as DPGR in 2007, even though no computer software updates were provided
under the contract.
Example 2. X manufactures automobiles within the
United States and sells 5-year extended warranties to customers. The sales
price of the warranty is based on historical data that determines what repairs
and services are performed on an automobile during the 5-year period. X sells
the 5-year warranty to Y for $1,000 in 2007. Under X’s method of accounting,
X recognizes warranty revenue when received. Using historical data, X concludes
that 60% of the gross receipts attributable to a 5-year warranty will be derived
from the sale of parts (QPP) that X manufactures within the United States,
and 40% will be derived from the sale of purchased parts X did not manufacture
and non-qualifying services. X’s method of allocating its gross receipts
with respect to the 5-year warranty between DPGR and non-DPGR is a reasonable
method that is satisfactory to the Secretary based on all of the facts and
circumstances. Therefore, X properly treats $600 as DPGR in 2007.
Example 3. The facts are the same as in Example
2 except that in 2009 X updates its historical data. The updated
historical data show that 50% of the gross receipts attributable to a 5-year
warranty will be derived from the sale of parts (QPP) that X manufactures
within the United States and 50% will be derived from the sale of purchased
parts X did not manufacture and non-qualifying services. In 2009, X sells
a 5-year warranty for $1,000 to Z. Under all of the facts and circumstances,
X’s method of allocation is still a reasonable method. Relying on its
updated historical data, X properly treats $500 as DPGR in 2009.
Example 4. The facts are the same as in Example
2 except that Y pays for the 5-year warranty over time ($200 a
year for 5 years). Under X’s method of accounting, X recognizes each
$200 payment as it is received. In 2009, X updates its historical data and
the updated historical data show that 50% of the gross receipts attributable
to a 5-year warranty will be derived from the sale of QPP that X manufactures
within the United States and 50% will be derived from the sale of purchased
parts X did not manufacture and non-qualifying services. Under all of the
facts and circumstances, X’s method of allocation is still a reasonable
method. When Y makes its $200 payment for 2009, X, relying on its updated
historical data, properly treats $100 as DPGR in 2009.
§1.199-2 Wage limitation.
(a) Rules of application—(1) In
general. The provisions of this section apply solely for purposes
of section 199 of the Internal Revenue Code. The amount of the deduction
allowable under §1.199-1(a) (section 199 deduction) to a taxpayer for
any taxable year shall not exceed 50 percent of the W-2 wages (as defined
in paragraph (e) of this section) of the taxpayer. For this purpose, except
as provided in paragraph (a)(3) of this section and paragraph (b) of this
section, the Forms W-2, “Wage and Tax Statement,”
used in determining the amount of W-2 wages are those issued for the calendar
year ending during the taxpayer’s taxable year for wages paid to employees
(or former employees) of the taxpayer for employment by the taxpayer. For
purposes of this section, employees of the taxpayer are limited to employees
of the taxpayer as defined in section 3121(d)(1) and (2) (that is, officers
of a corporate taxpayer and employees of the taxpayer under the common law
rules). See paragraph (a)(3) of this section for the requirement that W-2
wages must have been included in a return filed with the Social Security Administration
(SSA) within 60 days after the due date (including extensions) of the return.
(2) Wages paid by entity other than common law employer.
In determining W-2 wages, a taxpayer may take into account any wages paid
by another entity and reported by the other entity on Forms W-2 with the other
entity as the employer listed in Box c of the Forms W-2, provided that the
wages were paid to employees of the taxpayer for employment by the taxpayer.
If the taxpayer is treated as an employer described in section 3401(d)(1)
because of control of the payment of wages (that is, the taxpayer is not the
common law employer of the payee of the wages), the payment of wages may not
be included in determining W-2 wages of the taxpayer. If the taxpayer is
paying wages as an agent of another entity to individuals who are not employees
of the taxpayer, the wages may not be included in determining the W-2 wages
of the taxpayer.
(3) Requirement that wages must be reported on return filed
with the Social Security Administration—(i) In
general. The term W-2 wages shall not include
any amount that is not properly included in a return filed with SSA on or
before the 60th day after the due date (including extensions) for such return.
Under §31.6051-2 of this chapter, each Form W-2 and the transmittal
Form W-3, “Transmittal of Wage and Tax Statements,”
together constitute an information return to be filed with SSA. Similarly,
each Form W-2c, “Corrected Wage and Tax Statement,”
and the transmittal Form W-3 or W-3c, “Transmittal of Corrected
Wage and Tax Statements,” together constitute an information
return to be filed with SSA. In determining whether any amount has been properly
included in a return filed with SSA on or before the 60th day after the due
date (including extensions) for such return, each Form W-2 together with its
accompanying Form W-3 shall be considered a separate information return and
each Form W-2c together with its accompanying Form W-3 or Form W-3c shall
be considered a separate information return. Section 31.6071(a)-1(a)(3) of
this chapter provides that each information return in respect of wages as
defined in the Federal Insurance Contributions Act or of income tax withheld
from wages which is required to be made under §31.6051-2 of this chapter
shall be filed on or before the last day of February (March 31 if filed electronically)
of the year following the calendar year for which it is made, except that
if a tax return under §31.6011(a)-5(a) of this chapter is filed as a
final return for a period ending prior to December 31, the information statement
shall be filed on or before the last day of the second calendar month following
the period for which the tax return is filed. Corrected Forms W-2 are required
to be filed with SSA on or before the last day of February (March 31 if filed
electronically) of the year following the year in which the correction is
made, except that if a tax return under §31.6011(a)-5(a) is filed as
a final return for a period ending prior to December 31 for the period in
which the correction is made, the corrected Forms W-2 are required to be filed
by the last day of the second calendar month following the period for which
the final return is filed.
(ii) Corrected return filed to correct a return that was
filed within 60 days of the due date. If a corrected information
return (Return B) is filed with SSA on or before the 60th day after the due
date (including extensions) of Return B to correct an information return (Return
A) that was filed with SSA on or before the 60th day after the due date (including
extensions) of the information return (Return A) and paragraph (a)(3)(ii)
of this section does not apply, then the wage information on Return B must
be included in determining W-2 wages. If a corrected information return (Return
D) is filed with SSA later than the 60th day after the due date (including
extensions) of Return D to correct an information return (Return C) that was
filed with SSA on or before the 60th day after the due date (including extensions)
of the information return (Return C), then if Return D reports an increase
(or increases) in wages included in determining W-2 wages from the wage amounts
reported on Return C, then such increase (or increases) on Return D shall
be disregarded in determining W-2 wages (and only the wage amounts on Return
C may be included in determining W-2 wages). If Return D reports a decrease
(or decreases) in wages included in determining W-2 wages from the amounts
reported on Return C, then, in determining W-2 wages, the wages reported on
Return C must be reduced by the decrease (or decreases) reflected on Return
D.
(iii) Corrected return filed to correct a return that was
filed later than 60 days after the due date. If an information
return (Return F) is filed to correct an information return (Return E) that
was not filed with SSA on or before the 60th day after the due date (including
extensions) of Return E, then Return F (and any subsequent information returns
filed with respect to Return E) will not be considered filed on or before
the 60th day after the due date (including extensions) of Return F (or the
subsequent corrected information return). Thus, if a Form W-2c (or corrected
Form W-2) is filed to correct a Form W-2 that was not filed with SSA on or
before the 60th day after the due date (including extensions) of the information
return including the Form W-2 (or to correct a Form W-2c relating to a information
return including a Form W-2 that had not been filed with SSA on or before
the 60th day after the due date (including extensions) of the information
return including the Form W-2), then the information return including this
Form W-2c (or corrected Form W-2) shall not be considered to have been filed
with SSA on or before the 60th day after the due date (including extensions)
for this information return including the Form W-2c (or corrected Form W-2),
regardless of when the information return including the Form W-2c (or corrected
Form W-2) is filed.
(4) Joint return. An individual and his or her
spouse are considered one taxpayer for purposes of determining the amount
of W-2 wages for a taxable year, provided that they file a joint return for
the taxable year. Thus, an individual filing as part of a joint return may
include the wages of employees of his or her spouse in determining W-2 wages,
provided the employees are employed in a trade or business of the spouse and
the other requirements of this section are met. However, a married taxpayer
filing a separate return from his or her spouse for the taxable year may not
include the wages of employees of the taxpayer’s spouse in determining
the taxpayer’s W-2 wages for the taxable year.
(b) Application in the case of a taxpayer with a short taxable
year. In the case of a taxpayer with a short taxable year, subject
to the rules of paragraph (a) of this section, the W-2 wages of the taxpayer
for the short taxable year shall include only those wages paid during the
short taxable year to employees of the taxpayer, only those elective deferrals
(within the meaning of section 402(g)(3)) made during the short taxable year
by employees of the taxpayer and only compensation actually deferred under
section 457 during the short taxable year with respect to employees of the
taxpayer. The Secretary shall have the authority to issue published guidance
setting forth the method that is used to calculate W-2 wages in case of a
taxpayer with a short taxable year. See paragraph (e)(3) of this section.
(c) Acquisition or disposition of a trade or business (or
major portion). If a taxpayer (a successor) acquires a trade or
business, the major portion of a trade or business, or the major portion of
a separate unit of a trade or business from another taxpayer (a predecessor),
then, for purposes of computing the respective section 199 deduction of the
successor and of the predecessor, the W-2 wages paid for that calendar year
shall be allocated between the successor and the predecessor based on whether
the wages are for employment by the successor or for employment by the predecessor.
Thus, in this situation, the W-2 wages are allocated based on whether the
wages are for employment for a period during which the employee was employed
by the predecessor or for employment for a period during which the employee
was employed by the successor, regardless of which permissible method for
Form W-2 reporting is used.
(d) Non-duplication rule. Amounts that are treated
as W-2 wages for a taxable year under any method shall not be treated as W-2
wages of any other taxable year. Also, an amount shall not be treated as
W-2 wages by more than one taxpayer.
(e) Definition of W-2 wages—(1) In
general. Under section 199(b)(2), the term W-2 wages means,
with respect to any person for any taxable year of such person, the sum of
the amounts described in section 6051(a)(3) and (8) paid by such person with
respect to employment of employees by such person during the calendar year
ending during such taxable year. Thus, the term W-2 wages includes the total
amount of wages as defined in section 3401(a); the total amount of elective
deferrals (within the meaning of section 402(g)(3)); the compensation
deferred under section 457; and for taxable years beginning after December
31, 2005, the amount of designated Roth contributions (as defined in section 402A).
(2) Limitation on W-2 wages for taxable years beginning after
May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation
Act of 2005. [Reserved].
(3) Methods for calculating W-2 wages. The Secretary
may provide by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b)
of this chapter) for methods to be used in calculating W-2 wages, including
W-2 wages for short taxable years. For example, see Rev. Proc. 2006-22, 2006-23
I.R.B. 1033) (see §601.601(d)(2) of this chapter).
§1.199-3 Domestic production gross receipts.
(a) In general. The provisions of this section
apply solely for purposes of section 199 of the Internal Revenue Code (Code).
Domestic production gross receipts (DPGR) are the gross receipts (as defined
in paragraph (c) of this section) of the taxpayer that are—
(1) Derived from any lease, rental, license, sale, exchange, or other
disposition (as defined in paragraph (i) of this section) of—
(i) Qualifying production property (QPP) (as defined in paragraph (j)(1)
of this section) that is manufactured, produced, grown, or extracted (MPGE)
(as defined in paragraph (e) of this section) by the taxpayer (as defined
in paragraph (f) of this section) in whole or in significant part (as defined
in paragraph (g) of this section) within the United States (as defined in
paragraph (h) of this section);
(ii) Any qualified film (as defined in paragraph (k) of this section)
produced by the taxpayer; or
(iii) Electricity, natural gas, or potable water (as defined in paragraph
(l) of this section) (collectively, utilities) produced by the taxpayer in
the United States;
(2) Derived from, in the case of a taxpayer engaged in the active conduct
of a construction trade or business, construction of real property (as defined
in paragraph (m) of this section) performed in the United States by the taxpayer
in the ordinary course of such trade or business; or
(3) Derived from, in the case of a taxpayer engaged in the active conduct
of an engineering or architectural services trade or business, engineering
or architectural services (as defined in paragraph (n) of this section) 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.
(b) Related persons—(1) In general.
DPGR does not include any gross receipts of the taxpayer derived from property
leased, licensed, or rented by the taxpayer for use by any related person.
A person is treated as related to another person if both persons are treated
as a single employer under either section 52(a) or (b) (without regard
to section 1563(b)), or section 414(m) or (o). Any other person
is an unrelated person for purposes of §§1.199-1 through 1.199-9.
(2) Exceptions. Notwithstanding paragraph (b)(1)
of this section, gross receipts derived from any QPP or qualified film leased
or rented by the taxpayer to a related person may qualify as DPGR if the QPP
or qualified film is held for sublease or rent, or is subleased or rented,
by the related person to an unrelated person for the ultimate use of the unrelated
person. Similarly, notwithstanding paragraph (b)(1) of this section, gross
receipts derived from the license of QPP or a qualified film to a related
person for reproduction and sale, exchange, lease, rental, or sublicense to
an unrelated person for the ultimate use of the unrelated person may qualify
as DPGR.
(c) Definition of gross receipts. The term gross
receipts means the taxpayer’s receipts for the taxable year
that are recognized under the taxpayer’s methods of accounting used
for Federal income tax purposes for the taxable year. If the gross receipts
are recognized in an intercompany transaction within the meaning of §1.1502-13,
see also §1.199-7(d). For this purpose, gross receipts include total
sales (net of returns and allowances) and all amounts received for services.
In addition, gross receipts include any income from investments and from
incidental or outside sources. For example, gross receipts include interest
(including original issue discount and tax-exempt interest within the meaning
of section 103), dividends, rents, royalties, and annuities, regardless
of whether the amounts are derived in the ordinary course of the taxpayer’s
trade of business. Gross receipts are not reduced by cost of goods sold (CGS)
or by the cost of property sold if such property is described in section 1221(a)(1),
(2), (3), (4), or (5). Gross receipts do not include the amounts received
in repayment of a loan or similar instrument (for example, a repayment of
the principal amount of a loan held by a commercial lender) and, except to
the extent of gain recognized, do not include gross receipts derived from
a non-recognition transaction, such as a section 1031 exchange. Finally,
gross receipts do not include amounts received by the taxpayer with respect
to sales tax or other similar state and local taxes if, under the applicable
state or local law, the tax is legally imposed on the purchaser of the good
or service and the taxpayer merely collects and remits the tax to the taxing
authority. If, in contrast, the tax is imposed on the taxpayer under the
applicable law, then gross receipts include the amounts received that are
allocable to the payment of such tax.
(d) Determining domestic production gross receipts—(1) In
general. For purposes of §§1.199-1 through 1.199-9,
a taxpayer determines, using any reasonable method that is satisfactory to
the Secretary based on all of the facts and circumstances, whether gross receipts
qualify as DPGR on an item-by-item basis (and not, for example, on a division-by-division,
product line-by-product line, or transaction-by-transaction basis).
(i) The term item means the property offered by
the taxpayer in the normal course of the taxpayer’s business for lease,
rental, license, sale, exchange, or other disposition (for purposes of this
paragraph (d), collectively referred to as disposition) to customers, if the
gross receipts from the disposition of such property qualify as DPGR; or
(ii) If paragraph (d)(1)(i) of this section does not apply to the property,
then any component of the property described in paragraph (d)(1)(i) of this
section is treated as the item, provided that the gross receipts from the
disposition of the property described in paragraph (d)(1)(i) of this section
that are attributable to such component qualify as DPGR. Each component that
meets the requirements under this paragraph (d)(1)(ii) must be treated as
a separate item and a component that meets the requirements under this paragraph
(d)(1)(ii) may not be combined with a component that does not meet these requirements.
(2) Special rules. The following special rules
apply for purposes of paragraph (d)(1) of this section:
(i) For purposes of paragraph (d)(1)(i) of this section, in no event
may a single item consist of two or more properties unless those properties
are offered for disposition, in the normal course of the taxpayer’s
business, as a single item (regardless of how the properties are packaged).
(ii) In the case of property customarily sold by weight or by volume,
the item is determined using the custom of the industry (for example, barrels
of oil).
(iii) In the case of construction activities and services or engineering
and architectural services, a taxpayer may use any reasonable method that
is satisfactory to the Secretary based on all of the facts and circumstances
to determine what construction activities and services or engineering or architectural
services constitute an item.
(3) Exception. If a taxpayer MPGE QPP within
the United States or produces a qualified film or produces utilities in the
United States that it disposes of, and the taxpayer leases, rents, licenses,
purchases, or otherwise acquires property that contains or may contain the
QPP, qualified film, or the utilities (or a portion thereof), and the taxpayer
cannot reasonably determine, without undue burden and expense, whether the
acquired property contains any of the original QPP, qualified film, or utilities
MPGE or produced by the taxpayer, then the taxpayer is not required to determine
whether any portion of the acquired property qualifies as an item for purposes
of paragraph (d)(1) of this section. Therefore, the gross receipts derived
from the disposition of the acquired property may be treated as non-DPGR.
Similarly, the preceding sentences shall apply if the taxpayer can reasonably
determine that the acquired property contains QPP, a qualified film, or utilities
(or a portion thereof) MPGE or produced by the taxpayer, but cannot reasonably
determine, without undue burden or expense, how much, or what type, grade,
etc., of the QPP, qualified film, or utilities MPGE or produced by the taxpayer
the acquired property contains.
(4) Examples. The following examples illustrate
the application of paragraph (d) of this section:
Example 1. Q manufactures leather and rubber shoe
soles in the United States. Q imports shoe uppers, which are the
parts of the shoe above the sole. Q manufactures shoes for sale by sewing
or otherwise attaching the soles to the imported uppers. Q offers the shoes
for sale to customers in the normal course of Q’s business. If the gross
receipts derived from the sale of the shoes do not qualify as DPGR under this
section, then under paragraph (d)(1)(ii) of this section, Q must treat the
sole as the item if the gross receipts derived from the sale of the sole qualify
as DPGR under this section.
Example 2. The facts are the same as in Example
1 except that Q also buys some finished shoes from unrelated persons
and resells them to retail shoe stores. Q offers all shoes (manufactured
and purchased) for sale to customers, in the normal course of Q’s business,
in individual pairs, and requires no minimum quantity order. Q ships the
shoes in boxes, each box containing as many as 50 pairs of shoes. A full,
or partially full, box may contain some shoes that Q manufactured, and some
that Q purchased. Under paragraph (d)(2)(i) of this section, Q cannot treat
a box of 50 (or fewer) pairs of shoes as an item, because Q offers the shoes
for sale in the normal course of Q’s business in individual pairs.
Example 3. R manufactures toy cars in the United
States. R also purchases cars that were manufactured by unrelated persons.
R offers the cars for sale to customers, in the normal course of R’s
business, in sets of three, and requires no minimum quantity order. R sells
the three-car sets to toy stores. A three-car set may contain some cars manufactured
by R and some cars purchased by R. If the gross receipts derived from the
sale of the three-car sets do not qualify as DPGR under this section, then,
under paragraph (d)(1)(ii) of this section, R must treat a toy car in the
three-car set as the item, provided the gross receipts derived from the sale
of the toy car qualify as DPGR under this section.
Example 4. The facts are the same as Example
3 except that R offers the toy cars for sale individually to customers
in the normal course of R’s business, rather than in sets of three.
R’s customers resell the individual toy cars at three for $10. Frequently,
this results in retail customers purchasing three individual cars in one transaction.
In determining R’s DPGR, under paragraph (d)(2)(i) of this section,
each toy car is an item and R cannot treat three individual toy cars as one
item, because the individual toy cars are not offered for sale in sets of
three by R in the normal course of R’s business.
Example 5. The facts are the same as in Example
3 except that R offers the toy cars for sale to customers in the
normal course of R’s business both individually and in sets of three.
The results are the same as Example 3 with respect to
the three-car sets. The results are the same as in Example
4 with respect to the individual toy cars that are not included
in the three-car sets and offered for sale individually. Thus, R has two
items, an individual toy car and a set of three toy cars.
Example 6. S produces television sets in the United
States. S also produces the same model of television set outside the United
States. In both cases, S packages the sets one to a box. S sells the television
sets to large retail consumer electronics stores. S requires that
its customers purchase a minimum of 100 television sets per order. With respect
to a particular order by a customer of 100 television sets, some were manufactured
by S in the United States, and some were manufactured by S outside the United
States. Under paragraph (d)(2)(i) of this section, a minimum order of 100
television sets is the item provided that the gross receipts derived from
the sale of the 100 television sets qualify as DPGR.
Example 7. T produces in bulk form in the United
States the active ingredient for a pharmaceutical product. T sells the active
ingredient in bulk form to FX, a foreign corporation. This sale qualifies
as DPGR assuming all the other requirements of this section are met. FX uses
the active ingredient to produce the finished dosage form drug. FX sells
the drug in finished dosage to T, which sells the drug to customers. Assume
that T knows how much of the active ingredient is in the finished dosage.
Under paragraph (d)(1)(ii) of this section, if T’s gross receipts derived
from the sale of the finished dosage do not qualify as DPGR under this section,
then T must treat the active ingredient component as the item because the
gross receipts attributable to the active ingredient qualify as DPGR under
this section. The exception in paragraph (d)(3) of this section does not
apply because T can reasonably determine without undue burden or expense that
the finished dosage contains the active ingredient and the quantity of the
active ingredient in the finished dosage.
Example 8. U produces steel within the United
States and sells its steel to a variety of customers, including V, an unrelated
person, who uses the steel for the manufacture of equipment. V
also purchases steel from other steel producers. For its steel operations,
U purchases equipment from V that may contain steel produced by U. U
sells the equipment after 5 years. If U cannot reasonably determine without
undue burden and expense whether the equipment contains any steel produced
by U, then, under paragraph (d)(3) of this section, U may treat the gross
receipts derived from sale of the equipment as non-DPGR.
Example 9. The facts are the same as in Example
8 except that U knows that the equipment purchased from V does
contain some amount of steel produced by U. If U cannot reasonably determine
without undue burden and expense how much steel produced by U the equipment
contains, then, under paragraph (d)(3) of this section, U may treat the gross
receipts derived from sale of the equipment as non-DPGR.
Example 10. W manufactures sunroofs, stereos,
and tires within the United States. W purchases automobiles from unrelated
persons and installs the manufactured components in the automobiles. W, in
the normal course of W’s business, sells the automobiles with the components
to customers. If the gross receipts derived from the sale of the automobiles
with the components do not qualify as DPGR under this section, then under
paragraph (d)(1)(ii) of this section, W must treat each component (sunroofs,
stereos, and tires) that it manufactures as a separate item if the gross receipts
derived from the sale of each component qualify as DPGR under this section.
Example 11. X manufacturers leather soles within
the United States. X purchases shoe uppers, metal eyelets, and laces. X
manufactures shoes by sewing or otherwise attaching the soles to the uppers;
attaching the metal eyelets to the shoes; and threading the laces through
the eyelets. X, in the normal course of X’s business, sells the shoes
to customers. If the gross receipts derived from the sale of the shoes do
not qualify as DPGR under this section, then under paragraph (d)(1)(ii) of
this section, X must treat the sole as the item if the gross receipts derived
from the sale of the sole qualify as DPGR under this section. X may not treat
the shoe upper, metal eyelets or laces as part of the item because under paragraph
(d)(1)(ii) of this section the sole is the component that is treated as the
item.
Example 12. Y manufactures glass windshields
for automobiles within the United States. Y purchases automobiles from unrelated
persons and installs the windshields in the automobiles. Y, in the normal
course of Y’s business, sells the automobiles with the windshields to
customers. If the automobiles with the windshields do not meet the requirements
for being an item, then, under paragraph (d)(1)(ii) of this section, Y must
treat each windshield that it manufactures as an item if the gross receipts
derived from the sale of the windshield qualify as DPGR under this section.
Y may not treat any other portion of the automobile as part of the item because
under paragraph (d)(1)(ii) of this section the windshield is the component.
(e) Definition of manufactured, produced, grown, or extracted—(1)
In general. Except as provided in paragraphs (e)(2)
and (3) of this section, the term MPGE includes manufacturing,
producing, growing, extracting, installing, developing, improving, and creating
QPP; making QPP out of scrap, salvage, or junk material as well as from new
or raw material by processing, manipulating, refining, or changing the form
of an article, or by combining or assembling two or more articles; cultivating
soil, raising livestock, fishing, and mining minerals. The term MPGE also
includes storage, handling, or other processing activities (other than transportation
activities) within the United States related to the sale, exchange, or other
disposition of agricultural products, provided the products are consumed in
connection with or incorporated into the MPGE of QPP, whether or not by the
taxpayer. Pursuant to paragraph (f)(1) of this section, the taxpayer must
have the benefits and burdens of ownership of the QPP under Federal income
tax principles during the period the MPGE activity occurs in order for gross
receipts derived from the MPGE of QPP to qualify as DPGR.
(2) Packaging, repackaging, labeling, or minor assembly.
If a taxpayer packages, repackages, labels, or performs minor assembly of
QPP and the taxpayer engages in no other MPGE activity with respect to that
QPP, the taxpayer’s packaging, repackaging, labeling, or minor assembly
does not qualify as MPGE with respect to that QPP.
(3) Installing. If a taxpayer installs QPP and
engages in no other MPGE activity with respect to the QPP, the taxpayer’s
installing activity does not qualify as an MPGE activity. Notwithstanding
paragraph (i)(4)(i)(B)(4) of this section, if the taxpayer
installs QPP MPGE by the taxpayer and, except as provided in paragraph (f)(2)
of this section, the taxpayer has the benefits and burdens of ownership of
the QPP under Federal income tax principles during the period the installing
activity occurs, then the portion of the installing activity that relates
to the QPP is an MPGE activity.
(4) Consistency with section 263A. A taxpayer
that has MPGE QPP for the taxable year should treat itself as a producer under
section 263A with respect to the QPP unless the taxpayer is not subject
to section 263A. A taxpayer that currently is not properly accounting
for its production activities under section 263A, and wishes to change
its method of accounting to comply with the producer requirements of section 263A,
must follow the applicable administrative procedures issued under §1.446-1(e)(3)(ii)
for obtaining the Commissioner’s consent to a change in accounting method
(for further guidance, for example, see Rev. Proc. 97-27, 1997-1 C.B. 680,
or Rev. Proc. 2002-9, 2002-1 C.B. 327, whichever applies (see §601.601(d)(2)
of this chapter)).
(5) Examples. The following examples illustrate
the application of this paragraph (e):
Example 1. A, B, and C are unrelated persons and
are not cooperatives to which Part I of subchapter T of the Code applies.
B grows agricultural products in the United States and sells them to A, who
owns agricultural storage bins in the United States. A stores the agricultural
products and has the benefits and burdens of ownership under Federal income
tax principles of the agricultural products while they are being stored.
A sells the agricultural products to C, who processes them into refined agricultural
products in the United States. The gross receipts from A’s, B’s,
and C’s activities are DPGR from the MPGE of QPP.
Example 2. The facts are the same as in Example
1 except that B grows the agricultural products outside the United
States and C processes them into refined agricultural products outside the
United States. Pursuant to paragraph (e)(1) of this section, the gross receipts
derived by A from its sale of the agricultural products to C are DPGR from
the MPGE of QPP within the United States. B’s and C’s respective
MPGE activities occur outside the United States and, therefore, their respective
gross receipts are non-DPGR.
Example 3. Y is hired to reconstruct and refurbish
unrelated customers’ tangible personal property. As part of the reconstruction
and refurbishment, Y installs purchased replacement parts that constitute
QPP in the customers’ property. Y’s installation of purchased
replacement parts does not qualify as MPGE pursuant to paragraph (e)(3) of
this section because Y did not MPGE the replacement parts.
Example 4. The facts are the same as in Example
3 except that Y manufactures the replacement parts it uses for
the reconstruction and refurbishment of customers’ tangible personal
property. Y has the benefits and burdens of ownership under Federal income
tax principles of the replacement parts during the reconstruction and refurbishment
activity and while installing the parts. Y’s gross receipts derived
from the MPGE of the replacement parts and Y’s gross receipts derived
from the installation of the replacement parts, which is an MPGE activity
pursuant to paragraph (e)(3) of this section, are DPGR (assuming all the other
requirements of this section are met).
Example 5. Z MPGE QPP within the United States.
The following activities are performed by Z as part of the MPGE of the QPP
while Z has the benefits and burdens of ownership under Federal income tax
principles: materials analysis and selection, subcontractor inspections and
qualifications, testing of component parts, assisting customers in their review
and approval of the QPP, routine production inspections, product documentation,
diagnosis and correction of system failure, and packaging for shipment to
customers. Because Z MPGE the QPP, these activities performed by Z are part
of the MPGE of the QPP.
Example 6. X purchases automobiles from unrelated
persons and customizes them by adding ground effects, spoilers, custom wheels,
specialized paint and decals, sunroofs, roof racks, and similar accessories.
X does not manufacture any of the accessories. X’s activity is minor
assembly under paragraph (e)(2) of this section which is not an MPGE activity.
Example 7. Y manufactures furniture in the United
States that it sells to unrelated persons. Y also engraves customers’
names on pens and pencils purchased from unrelated persons and sells the pens
and pencils to such customers. Although Y’s sales of furniture qualify
as DPGR if all the other requirements of this section are met, Y must determine
whether its gross receipts derived from the sale of the pens and pencils qualify
as DPGR. Y’s status as a manufacturer of furniture in the United States
does not carry over to its other activities.
Example 8. X produces computer software within
the United States. In 2007, X enters into an agreement with Y, an unrelated
person, under which X will manage Y’s networks using computer software
that X produced. Pursuant to the terms of the agreement, X also provides
to Y for Y’s use on Y’s own hardware computer software that X
produced (additional computer software). Assume that, based on all of the
facts and circumstances, the transaction between X and Y relating to the additional
computer software is a lease or sale of the additional computer software.
Y pays X monthly fees of $100 under the agreement during 2007. No separate
charge for the additional computer software is stated in the agreement or
in the monthly invoices that X provides to Y. The portion of X’s gross
receipts that is derived from the lease or sale of the additional computer
software is DPGR (assuming all the other requirements of this section are
met).
(f) Definition of by the taxpayer—(1) In
general. With the exception of the rules applicable to an expanded
affiliated group (EAG) under §1.199-7, qualifying in-kind partnerships
under §1.199-9(i), EAG partnerships under §1.199-9(j), and government
contracts under paragraph (f)(2) of this section, only one taxpayer may claim
the deduction under §1.199-1(a) with respect to any qualifying activity
under paragraphs (e)(1), (k)(1), and (l)(1) of this section performed in connection
with the same QPP, or the production of a qualified film or utilities. If
one taxpayer performs a qualifying activity under paragraph (e)(1), (k)(1),
or (l)(1) of this section pursuant to a contract with another party,
then only the taxpayer that has the benefits and burdens of ownership of the
QPP, qualified film, or utilities under Federal income tax principles during
the period in which the qualifying activity occurs is treated as engaging
in the qualifying activity.
(2) Special rule for certain government contracts.
Gross receipts derived from the MPGE of QPP in whole or in significant part
within the United States will be treated as gross receipts derived from the
lease, rental, license, sale, exchange, or other disposition of QPP MPGE by
the taxpayer in whole or in significant part within the United States notwithstanding
the requirements of paragraph (f)(1) of this section if—
(i) The QPP is MPGE by the taxpayer within the United States pursuant
to a contract with the Federal government; and
(ii) The Federal Acquisition Regulation (Title 48, Code of Federal
Regulations) requires that title or risk of loss with respect to the QPP be
transferred to the Federal government before the MPGE of the QPP is completed.
(3) Subcontractor. If a taxpayer (subcontractor)
enters into a contract or agreement to MPGE QPP on behalf of a taxpayer to
which paragraph (f)(2) of this section applies, and the QPP under the contract
or agreement is subject to paragraph (f)(2)(ii) of this section, then, notwithstanding
the requirements of paragraph (f)(1) of this section, the subcontractor’s
gross receipts derived from the MPGE of the QPP in whole or in significant
part within the United States will be treated as gross receipts derived from
the lease, rental, license, sale, exchange, or other disposition of QPP MPGE
by the subcontractor in whole or in significant part within the United States.
(4) Examples. The following examples illustrate
the application of this paragraph (f):
Example 1. X designs machines that it uses in
its trade or business. X contracts with Y, an unrelated person, for the manufacture
of the machines. The contract between X and Y is a fixed-price contract.
The contract specifies that the machines will be manufactured in the United
States using X’s design. X owns the intellectual property attributable
to the design and provides it to Y with a restriction that Y may only use
it during the manufacturing process and has no right to exploit the intellectual
property. The contract specifies that Y controls the details of the manufacturing
process while the machines are being produced; Y bears the risk of loss or
damage during manufacturing of the machines; and Y has the economic loss or
gain upon the sale of the machines based on the difference between Y’s
costs and the fixed price. Y has legal title during the manufacturing process
and legal title to the machines is not transferred to X until final manufacturing
of the machines has been completed. Based on all of the facts and circumstances,
pursuant to paragraph (f)(1) of this section Y has the benefits and burdens
of ownership of the machines under Federal income tax principles during the
period the manufacturing occurs and, as a result, Y is treated as the manufacturer
of the machines.
Example 2. X designs and engineers machines that
it sells to customers. X contracts with Y, an unrelated person, for the manufacture
of the machines. The contract between X and Y is a cost-reimbursable type
contract. Assume that X has the benefits and burdens of ownership of the
machines under Federal income tax principles during the period the manufacturing
occurs except that legal title to the machines is not transferred to X until
final manufacturing of the machines is completed. Based on all of the facts
and circumstances, X is treated as the manufacturer of the machines under
paragraph (f)(1) of this section.
Example 3. X manufactures machines within the
United States pursuant to a contract with the Federal government and the Federal
Acquisition Regulation requires that the title or risk of loss with respect
to the machines be transferred to the Federal government before X completes
manufacture of the machines. X subcontracts with Y, an unrelated person,
for the manufacture of components for the machines that Y manufactures within
the United States. Assume that the machines manufactured by X, and the components
for the machines manufactured by Y, are QPP. Both the machines and components
are subject to the Federal Acquisition Regulation that requires title or risk
of loss with respect to the machines and components be transferred to the
Federal government before manufacturing of the machines and components are
complete. Under paragraph (f)(2) of this section, the gross receipts derived
by X from the manufacture within the United States of the machines for the
Federal government are treated as having been derived from the lease, rental,
license, sale, exchange, or other disposition of the machines manufactured
by X in whole or in significant part within the United States. Under paragraph
(f)(3) of this section, the gross receipts derived by Y from the manufacture
within the United States of the components for X are also treated as having
been derived from the lease, rental, license, sale, exchange, or other disposition
of the components manufactured by Y in whole or in significant part within
the United States.
(g) Definition of in whole or in significant part—(1)
In general. QPP must be MPGE in whole or in significant
part by the taxpayer and in whole or in significant part within the United
States to qualify under section 199(c)(4)(A)(i)(I). If a taxpayer enters
into a contract with an unrelated person for the unrelated person to MPGE
QPP for the taxpayer and the taxpayer has the benefits and burdens of ownership
of the QPP under applicable Federal income tax principles during the period
the MPGE activity occurs, then, pursuant to paragraph (f)(1) of this section,
the taxpayer is considered to MPGE the QPP under this section. The unrelated
person must perform the MPGE activity on behalf of the taxpayer in whole or
in significant part within the United States in order for the taxpayer to
satisfy the requirements of this paragraph (g)(1).
(2) Substantial in nature. QPP will be treated
as MPGE in significant part by the taxpayer within the United States for purposes
of paragraph (g)(1) of this section if the MPGE of the QPP by the taxpayer
within the United States is substantial in nature taking into account all
of the facts and circumstances, including the relative value added by, and
relative cost of, the taxpayer’s MPGE activity within the United States,
the nature of the QPP, and the nature of the MPGE activity that the taxpayer
performs within the United States. The MPGE of a key component of QPP does
not, in itself, meet the substantial-in-nature requirement with respect to
the QPP under this paragraph (g)(2). In the case of tangible personal property
(as defined in paragraph (j)(2) of this section), research and experimental
activities under section 174 and the creation of intangible assets are not
taken into account in determining whether the MPGE of QPP is substantial in
nature for any QPP other than computer software (as defined in paragraph (j)(3)
of this section) and sound recordings (as defined in paragraph (j)(4) of this
section). Thus, for example, a taxpayer may take into account its design
and development activities when determining whether its MPGE of computer software
is substantial in nature.
(3) Safe harbor—(i) In general.
A taxpayer will be treated as having MPGE QPP in whole or in significant
part within the United States for purposes of paragraph (g)(1) of this section
if, in connection with the QPP, the direct labor and overhead of such taxpayer
to MPGE the QPP within the United States account for 20 percent or more of
the taxpayer’s CGS of the QPP, or in a transaction without CGS (for
example, a lease, rental, or license) account for 20 percent or more of the
taxpayer’s unadjusted depreciable basis (as defined
in paragraph (g)(3)(ii) of this section) in the QPP. For taxpayers subject
to section 263A, overhead is all costs required to be capitalized under section
263A except direct materials and direct labor. For taxpayers not subject
to section 263A, overhead may be computed using any reasonable method that
is satisfactory to the Secretary based on all of the facts and circumstances,
but may not include any cost, or amount of any cost, that would not be required
to be capitalized under section 263A if the taxpayer were subject to section
263A. Research and experimental expenditures under section 174 and the costs
of creating intangible assets are not taken into account in determining direct
labor or overhead for any tangible personal property. However, for a special
rule regarding computer software and sound recordings, see paragraph (g)(3)(iii)
of this section. In the case of tangible personal property (as defined in
paragraph (j)(2) of this section), research and experimental expenditures
under section 174 and any other costs incurred in the creation of intangible
assets may be excluded from CGS or unadjusted depreciable basis for purposes
of determining whether the taxpayer meets the safe harbor under this paragraph
(g)(3).
(ii) Unadjusted depreciable basis. The term unadjusted
depreciable basis means the basis of property for purposes of section
1011 without regard to any adjustments described in section 1016(a)(2) and
(3). This basis does not reflect the reduction in basis for—
(A) Any portion of the basis the taxpayer properly elects to treat
as an expense under section 179 or 179C; or
(B) Any adjustments to basis provided by other provisions of the Code
and the regulations under the Code (for example, a reduction in basis by the
amount of the disabled access credit pursuant to section 44(d)(7)).
(iii) Computer software and sound recordings.
In determining direct labor and overhead under paragraph (g)(3)(i) of this
section, the costs of direct labor and overhead for developing computer software
as described in Rev. Proc. 2000-50, 2000-2 C.B. 601 (see §601.601(d)(2)
of this chapter), research and experimental expenditures under section 174,
and any other costs of creating intangible assets for computer software and
sound recordings are treated as direct labor and overhead. These costs must
be included in the taxpayer’s CGS or unadjusted depreciable basis of
computer software and sound recordings for purposes of determining whether
the taxpayer meets the safe harbor under paragraph (g)(3)(i) of this section.
If the taxpayer expects to lease, rent, license, sell, exchange, or otherwise
dispose of computer software or sound recordings over more than one taxable
year, the costs of developing computer software as described in Rev. Proc.
2000-50, 2000-2 C.B. 601, research and experimental expenditures under section
174, and any other costs of creating intangible assets for computer software
and sound recordings must be allocated over the estimated number of units
that the taxpayer expects to lease, rent, license, sell, exchange, or otherwise
dispose of.
(4) Special rules—(i) Contract
with an unrelated person. If a taxpayer enters into a contract
with an unrelated person for the unrelated person to MPGE QPP within the United
States for the taxpayer, and the taxpayer is considered to MPGE the QPP pursuant
to paragraph (f)(1) of this section, then, for purposes of the substantial-in-nature
requirement under paragraph (g)(2) of this section and the safe harbor under
paragraph (g)(3)(i) of this section, the taxpayer’s MPGE or production
activities or direct labor and overhead shall include both the taxpayer’s
MPGE or production activities or direct labor and overhead to MPGE the QPP
within the United States as well as the MPGE or production activities or direct
labor and overhead of the unrelated person to MPGE the QPP within the United
States under the contract.
(ii) Aggregation. In determining whether the
substantial-in-nature requirement under paragraph (g)(2) of this section or
the safe harbor under paragraph (g)(3)(i) of this section is met at the time
the taxpayer disposes of an item of QPP—
(A) An EAG member must take into account all of the previous MPGE or
production activities or direct labor and overhead of the other members of
the EAG;
(B) An EAG partnership (as defined in §1.199-9(j)) must take into
account all of the previous MPGE or production activities or direct labor
and overhead of all members of the EAG in which the partners of the EAG partnership
are members (as well as the previous MPGE or production activities of any
other EAG partnerships owned by members of the same EAG);
(C) A member of an EAG in which the partners of an EAG partnership
are members must take into account all of the previous MPGE or production
activities or direct labor and overhead of the EAG partnership (as well as
those of any other members of the EAG and any previous MPGE or production
activities of any other EAG partnerships owned by members of the same EAG);
and
(D) A partner of a qualifying in-kind partnership (as defined in §1.199-9(i))
must take into account all of the previous MPGE or production activities or
direct labor and overhead of the qualifying in-kind partnership.
(5) Examples. The following examples illustrate
the application of this paragraph (g):
Example 1. X purchases from Y, an unrelated person,
unrefined oil extracted outside the United States. X refines the oil in the
United States. The refining of the oil by X is an MPGE activity that is substantial
in nature.
Example 2. X purchases gemstones and precious
metal from outside the United States and then uses these materials to produce
jewelry within the United States by cutting and polishing the gemstones, melting
and shaping the metal, and combining the finished materials. X’s MPGE
activities are substantial in nature under paragraph (g)(2) of this section.
Therefore, X has MPGE the jewelry in significant part within the United States.
Example 3. (i) Facts. X
operates an automobile assembly plant in the United States. In connection
with such activity, X purchases assembled engines, transmissions, and certain
other components from Y, an unrelated person, and X assembles all of the component
parts into an automobile. X also conducts stamping, machining, and subassembly
operations, and X uses tools, jigs, welding equipment, and other machinery
and equipment in the assembly of automobiles. On a per-unit basis, X ’s
selling price and costs of such automobiles are as follows:
(ii) Analysis. Although X’s direct labor
and overhead are less than 20% of total CGS ($325/$1,800, or 18%) and X is
not within the safe harbor under paragraph (g)(3)(i) of this section, the
activities conducted by X in connection with the assembly of an automobile
are substantial in nature under paragraph (g)(2) of this section taking into
account the nature of X’s activity and the relative value of X’s
activity. Therefore, X’s automobiles will be treated as MPGE in significant
part by X within the United States for purposes of paragraph (g)(1) of this
section.
Example 4. X imports into the United States QPP
that is partially manufactured. Assume that X completes the manufacture of
the QPP within the United States and X’s completion of the manufacturing
of the QPP within the United States satisfies the in-whole-or-in-significant-part
requirement under paragraph (g)(1) of this section. Therefore, X’s
gross receipts from the lease, rental, license, sale, exchange, or other disposition
of the QPP qualify as DPGR if all other applicable requirements under this
section are met.
Example 5. X manufactures QPP in significant part
within the United States and exports the QPP for further manufacture outside
the United States. X retains title to the QPP while the QPP is being further
manufactured outside the United States. Assuming X meets all the requirements
under this section for the QPP after the further manufacturing, X’s
gross receipts derived from the lease, rental, license, sale, exchange, or
other disposition of the QPP will be considered DPGR, regardless of whether
the QPP is imported back into the United States prior to the lease, rental,
license, sale, exchange, or other disposition of the QPP.
Example 6. X is a retailer within the United States
that sells cigars and pipe tobacco that X purchases from an unrelated person.
While being displayed and offered for sale by X, the cigars and pipe tobacco
age on X’s shelves in a room with controlled temperature and humidity.
Although X’s cigars and pipe tobacco may become more valuable as they
age, the gross receipts derived by X from the sale of the cigars and pipe
tobacco are non-DPGR because the aging of the cigars and pipe tobacco while
being displayed and offered for sale by X does not qualify as an MPGE activity
that is substantial in nature.
Example 7. X incurs $1,000,000 in computer software
development costs in direct labor and overhead to develop computer software.
X begins producing the computer software and expects to license one million
copies of the computer software. In determining its direct labor and overhead
for the computer software under paragraph (g)(3)(i) of this section, X must
allocate under paragraph (g)(3)(iii) of this section the $1,000,000 to the
computer software X expects to produce. Thus, for each copy of the computer
software produced by X, $1 ($1,000,000 in computer software development costs/one
million estimated number of units to be licensed) in computer software development
costs are treated as direct labor and overhead.
Example 8. X creates computer software for microwave
ovens. X also manufactures the electric motors used in the ovens. X purchases
the other components of the microwave ovens from unrelated persons. X sells
each microwave oven individually to customers. Assume that X’s assembly
of the finished microwave ovens is not minor assembly. To determine whether
the manufacture of the microwave ovens satisfies the safe harbor under paragraph
(g)(3)(i) of this section, X’s direct labor and overhead include X’s
direct labor and overhead for creating the computer software, manufacturing
the electric motors, and assembling the finished microwave ovens that are
offered for sale.
Example 9. X designs shirts within the United
States, but X cuts and sews the shirts outside of the United States. Because
X’s design activity is the creation of an intangible, its design activity
is not taken into account in determining whether the manufacture of the shirts
is substantial in nature under paragraph (g)(2) of this section, and the costs
X incurs in creating the design of the shirts are not direct labor or overhead
under paragraph (g)(3)(i) of this section. Therefore, X has not MPGE the
shirts in significant part within the United States.
Example 10. X manufactures computer chips within
the United States. X installs the computer chips that it manufactures in
computers that X purchases from unrelated persons and sells the finished computers
individually to customers. The computer chips are key components of the computers
and the computers will not operate without them. The manufacture of the computer
chips is not, in itself, substantial in nature with respect to the finished
computers. Therefore, the taxpayer’s MPGE activities must meet either
the substantial-in-nature requirement under paragraph (g)(2) of this section,
or the safe harbor under paragraph (g)(3) of this section, in order to qualify
with respect to the finished computers.
(h) Definition of United States. For purposes
of this section, the term United States includes the
50 states, the District of Columbia, the territorial waters of the United
States, and the seabed and subsoil of those submarine areas that are adjacent
to the territorial waters of the United States and over which the United States
has exclusive rights, in accordance with international law, with respect to
the exploration and exploitation of natural resources. The term United
States does not include possessions and territories of the United
States or the airspace or space over the United States and these areas.
(i) Derived from the lease, rental, license, sale, exchange,
or other disposition—(1) In general—(i)
Definition. The term derived from the lease,
rental, license, sale, exchange, or other disposition is defined
as, and limited to, the gross receipts directly derived from the lease, rental,
license, sale, exchange, or other disposition of QPP, a qualified film, or
utilities, even if the taxpayer has already recognized gross receipts from
a previous lease, rental, license, sale, exchange, or other disposition of
the same QPP, qualified film, or utilities. Applicable Federal income tax
principles apply to determine whether a transaction is, in substance, a lease,
rental, license, sale, exchange, or other disposition, whether it is a service,
or whether it is some combination thereof.
(ii) Lease income. The financing and interest
components of a lease of QPP or a qualified film are considered to be derived
from the lease of such QPP or qualified film. However, any portion of the
lease income that is attributable to services or non-qualified property as
defined in paragraph (i)(4) of this section is not derived from the lease
of QPP or a qualified film.
(iii) Income substitutes. The proceeds from business
interruption insurance, governmental subsidies, and governmental payments
not to produce are treated as gross receipts derived from the lease, rental,
license, sale, exchange, or other disposition to the extent that they are
substitutes for gross receipts that would qualify as DPGR.
(iv) Exchange of property—(A) Taxable
exchanges. Except as provided in paragraph (i)(1)(iv)(B) of this
section, the value of property received by a taxpayer in a taxable exchange
of QPP MPGE in whole or in significant part by the taxpayer within the United
States, a qualified film produced by the taxpayer, or utilities produced by
the taxpayer within the United States is DPGR for the taxpayer (assuming all
the other requirements of this section are met). However, unless the taxpayer
meets all of the requirements under this section with respect to any further
MPGE by the taxpayer of the QPP or any further production by the taxpayer
of the film or utilities received in the taxable exchange, any gross receipts
derived from the sale by the taxpayer of the property received in the taxable
exchange are non-DPGR, because the taxpayer did not MPGE or produce such property,
even if the property was QPP, a qualified film, or utilities in the hands
of the other party to the transaction.
(B) Safe harbor. For purposes of paragraph (i)(1)(iv)(A)
of this section, the gross receipts derived by the taxpayer from the sale
of eligible property (as defined in paragraph (i)(1)(iv)(C) of this section)
received in a taxable exchange, net of any adjustments between the parties
involved in the taxable exchange to account for differences in the eligible
property exchanged (for example, location differentials and product differentials),
may be treated as the value of the eligible property received by the taxpayer
in the taxable exchange. For purposes of the preceding sentence, the taxable
exchange is deemed to occur on the date of the sale of the eligible property
received in the taxable exchange by the taxpayer, to the extent the sale occurs
no later than the last day of the month following the month in which the exchanged
eligible property is received by the taxpayer. In addition, if the taxpayer
engages in any further MPGE or production activity with respect to the eligible
property received in the taxable exchange, then, unless the taxpayer meets
the in-whole-or-in-significant-part requirement under paragraph (g)(1) of
this section with respect to the property sold, for purposes of this paragraph
(i)(1)(iv)(B), the taxpayer must also value the property sold without taking
into account the gross receipts attributable to the further MPGE or production
activity.
(C) Eligible property. For purposes of paragraph
(i)(1)(iv)(B) of this section, eligible property is—
(1) Oil, natural gas (as described in paragraph
(l)(2) of this section), or petrochemicals, or products derived from oil,
natural gas, or petrochemicals; or
(2) Any other property or product designated by
publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b)
of this chapter).
(2) Examples. The following examples illustrate
the application of paragraph (i)(1) of this section:
Example 1. X MPGE QPP in whole or in significant
part within the United States and uses the QPP in its business. After several
years X sells the QPP that it MPGE to Y. The gross receipts derived from
the sale of the QPP to Y are DPGR (assuming all the other requirements of
this section are met).
Example 2. X MPGE QPP within the United States
and sells the QPP to Y, an unrelated person. Y leases the QPP for 3 years
to Z, a taxpayer unrelated to both X and Y, and shortly after Y enters into
the lease with Z, X repurchases the QPP from Y subject to the lease. At the
end of the lease term, Z purchases the QPP from X. X’s proceeds derived
from the sale of the QPP to Y, from the lease to Z (including any financing
and interest components of the lease), and from the sale of the QPP to Z all
qualify as DPGR (assuming all the other requirements of this section are met).
Example 3. X MPGE QPP within the United States
and sells the QPP to Y, an unrelated person, for $25,000. X finances Y’s
purchase of the QPP and receives total payments of $35,000, of which $10,000
relates to interest and finance charges. The $25,000 qualifies as DPGR, but
the $10,000 in interest and finance charges do not qualify as DPGR because
the $10,000 is not derived from the MPGE of QPP within the United States,
but rather from X’s lending activity.
Example 4. Cable company X charges subscribers
$15 a month for its basic cable television. Y, an unrelated person, produces
a qualified film within the meaning of paragraph (k)(1) of this section that
it licenses to X for $.10 per subscriber per month. The gross receipts derived
by Y are derived from the license of a qualified film produced by Y and are
DPGR (assuming all the other requirements of this section are met).
Example 5. X manufactures cars within the United
States. X also manufactures replacement parts within the United States.
The replacement parts are QPP under paragraph (j)(1) of this section. X offers
extended warranties to its customers. X sells a car to Y. Y purchases an
extended warranty and brings the car to X’s service department for maintenance.
X repairs the car and replaces damaged parts with replacement parts that
X manufactured within the United States. The portion of X’s gross receipts
derived from the sale of the extended warranty relating to the manufactured
parts are DPGR.
(3) Hedging transactions—(i) In
general. For purposes of this section, provided that the risk
being hedged relates to QPP described in section 1221(a)(1) or relates to
property described in section 1221(a)(8) consumed in an activity giving rise
to DPGR, and provided that the transaction is a hedging transaction within
the meaning of section 1221(b)(2)(A) and §1.1221-2(b) and is properly
identified as a hedging transaction in accordance with §1.1221-2(f),
then—
(A) In the case of a hedge of purchases of property described in section
1221(a)(1), gain or loss on the hedging transaction must be taken into account
in determining CGS;
(B) In the case of a hedge of sales of property described in section
1221(a)(1), gain or loss on the hedging transaction must be taken into account
in determining DPGR; and
(C) In the case of a hedge of purchases of property described in section
1221(a)(8), gain or loss on the hedging transaction must be taken into account
in determining DPGR.
(ii) Currency fluctuations. For purposes of this
section, in the case of a transaction that manages the risk of currency fluctuations,
the determination of whether the transaction is a hedging transaction within
the meaning of §1.1221-2(b) is made without regard to whether the transaction
is a section 988 transaction. See §1.1221-2(a)(4). The preceding
sentence applies only to the extent that §1.988-5(b) does not apply.
(iii) Effect of identification and nonidentification.
If a taxpayer does not make an identification that satisfies all of the requirements
of §1.1221-2(f) but the taxpayer has no reasonable grounds for treating
the transaction as other than a hedging transaction, then a loss from the
transaction is taken into account under this paragraph (i)(3). If the inadvertent
identification rule of §1.1221-2(g)(1)(ii) or the inadvertent error rule
of §1.1221-2(g)(2)(ii) applies, then the taxpayer is treated as not having
identified the transaction as a hedging transaction or as having identified
the transaction as a hedging transaction, as the case may be. If a taxpayer
identifies a transaction as a hedging transaction in accordance with §1.1221-2(f)(1),
then—
(A) That identification is binding with respect to loss for purposes
of this paragraph (i)(3), whether or not all of the requirements of §1.1221-2(f)
are satisfied and whether or not the transaction is in fact a hedging transaction
within the meaning of section 1221(b)(2)(A) and §1.1221-2(b), and
(B) This paragraph (i)(3) does not apply to require gain to be taken
into account in determining CGS or DPGR, if the transaction is not in fact
a hedging transaction within the meaning of section 1221(b)(2)(A) and §1.1221-2(b).
(iv) Other rules. See §1.1221-2(e) for rules
applicable to hedging by members of a consolidated group and §1.446-4
for rules regarding the timing of income, deductions, gains, or losses with
respect to hedging transactions.
(4) Allocation of gross receipts—(i) Embedded
services and non-qualified property—(A) In general.
Except as otherwise provided in paragraph (i)(4)(i)(B), paragraph (m) (relating
to construction), and paragraph (n) (relating to engineering and architectural
services) of this section, gross receipts derived from the performance of
services do not qualify as DPGR. In the case of an embedded service, that
is, a service the price of which, in the normal course of the taxpayer’s
business, is not separately stated from the amount charged for the lease,
rental, license, sale, exchange, or other disposition of QPP, a qualified
film, or utilities, DPGR include only the gross receipts derived from the
lease, rental, license, sale, exchange, or other disposition of QPP, a qualified
film, or utilities (assuming all the other requirements of this section are
met) and not any receipts attributable to the embedded service. In addition,
DPGR does not include the gross receipts derived from the lease, rental, license,
sale, exchange, or other disposition of property that does not meet all of
the requirements under this section (non-qualified property). The allocation
of the gross receipts attributable to the embedded services or non-qualified
property will be deemed to be reasonable if the allocation reflects the fair
market value of the embedded services or non-qualified property. For example,
gross receipts derived from the lease, rental, license, sale, exchange, or
other disposition of a replacement part that is non-qualified property does
not qualify as DPGR. In addition, see §1.199-1(e) for other instances
when an allocation of gross receipts attributable to embedded services or
non-qualified property will be deemed reasonable.
(B) Exceptions. There are six exceptions to the
rules under paragraph (i)(4)(i)(A) of this section regarding embedded services
and non-qualified property. A taxpayer may include in DPGR, if all the other
requirements of this section are met with respect to the underlying item of
QPP, qualified films, or utilities to which the embedded services or non-qualified
property relate, the gross receipts derived from—
(1) A qualified warranty, that is, a warranty
(other than a computer software maintenance agreement described in paragraph
(i)(4)(i)(B)(5) of this section) that is provided in
connection with the lease, rental, license, sale, exchange, or other disposition
of QPP, a qualified film, or utilities if, in the normal course of the taxpayer’s
business—
(i) The price for the warranty is not separately
stated from the amount charged for the lease, rental, license, sale, exchange,
or other disposition of the QPP, qualified film, or utilities; and
(ii) The warranty is neither separately offered
by the taxpayer nor separately bargained for with customers (that is, a customer
cannot purchase the QPP, qualified film, or utilities without the warranty);
(2) A qualified delivery, that is, a delivery
or distribution service that is provided in connection with the lease, rental,
license, sale, exchange, or other disposition of QPP if, in the normal course
of the taxpayer’s business—
(i) The price for the delivery or distribution
service is not separately stated from the amount charged for the lease, rental,
license, sale, exchange, or other disposition of the QPP; and
(ii) The delivery or distribution service is neither
separately offered by the taxpayer nor separately bargained for with customers
(that is, a customer cannot purchase the QPP without the delivery or distribution
service);
(3) A qualified operating manual, that is, a manual
of instructions (including electronic instructions) that is provided in connection
with the lease, rental, license, sale, exchange, or other disposition of QPP,
a qualified film or utilities if, in the normal course of the taxpayer’s
business—
(i) The price for the manual is not separately
stated from the amount charged for the lease, rental, license, sale, exchange,
or other disposition of the QPP, qualified film, or utilities;
(ii) The manual is neither separately offered
by the taxpayer nor separately bargained for with customers (that is, a customer
cannot purchase the QPP, qualified film, or utilities without the manual);
and
(iii) The manual is not provided in connection
with a training course for customers;
(4) A qualified installation, that is, an installation
service (including minor assembly) for tangible personal property that is
provided in connection with the lease, rental, license, sale, exchange, or
other disposition of the tangible personal property if, in the normal course
of the taxpayer’s business—
(i) The price for the installation service is
not separately stated from the amount charged for the lease, rental, license,
sale, exchange, or other disposition of the tangible personal property; and
(ii) The installation is neither separately offered
by the taxpayer nor separately bargained for with customers (that is, a customer
cannot purchase the tangible personal property without the installation service);
(5) Services performed pursuant to a qualified
computer software maintenance agreement. A qualified computer software maintenance
agreement is an agreement provided in connection with the lease, rental, license,
sale, exchange, or other disposition of the computer software that entitles
the customer to receive future updates, cyclical releases, rewrites of the
underlying software, or customer support services for the computer software
if, in the normal course of the taxpayer’s business—
(i) The price for the agreement is not separately
stated from the amount charged for the lease, rental, license, sale, exchange,
or other disposition of the computer software; and
(ii) The agreement is neither separately offered
by the taxpayer nor separately bargained for with customers (that is, a customer
cannot purchase the computer software without the agreement); and
(6) A de minimis amount of
gross receipts from embedded services and non-qualified property for each
item of QPP, qualified films, or utilities. For purposes of the preceding
sentence, a de minimis amount of gross receipts from
embedded services and non-qualified property is less than 5 percent of
the total gross receipts derived from the lease, rental, license, sale, exchange,
or other disposition of each item of QPP, qualified films, or utilities.
In the case of gross receipts derived from the lease, rental, license, sale,
exchange, or other disposition of QPP, a qualified film, or utilities that
are received over a period of time (for example, a multi-year lease or installment
sale), this de minimis exception is applied by taking
into account the total gross receipts for the entire period derived (and to
be derived) from the lease, rental, license, sale, exchange, or other disposition
of the item of QPP, qualified films, or utilities. For purposes of the preceding
sentence, if a taxpayer treats gross receipts as DPGR under this de
minimis exception, then the taxpayer must treat the gross receipts
recognized in each taxable year consistently as DPGR. The gross receipts
that the taxpayer treats as DPGR under paragraphs (i)(4)(i)(B)(1),
(2), (3), (4),
and (5) and (l)(4)(iv)(A) of this section are treated
as DPGR for purposes of applying this de minimis exception.
This de minimis exception does not apply if the price
of a service or non-qualified property is separately stated by the taxpayer,
or if the service or non-qualified property is separately offered or separately
bargained for with the customer (that is, the customer can purchase the QPP,
qualified film, or utilities without the service or non-qualified property).
(ii) Non-DPGR. All of a taxpayer’s gross
receipts derived from the lease, rental, license, sale, exchange or other
disposition of an item of QPP, qualified films, or utilities may be treated
as non-DPGR if less than 5 percent of the taxpayer’s total gross receipts
derived from the lease, rental, license, sale, exchange or other disposition
of that item are DPGR. In the case of gross receipts derived from the lease,
rental, license, sale, exchange, or other disposition of QPP, a qualified
film, and utilities that are received over a period of time (for example,
a multi-year lease or installment sale), this paragraph (i)(4)(ii) is applied
by taking into account the total gross receipts for the entire period derived
(and to be derived) from the lease, rental, license, sale, exchange, or other
disposition of the item of QPP, qualified films, or utilities. For purposes
of the preceding sentence, if a taxpayer treats gross receipts as non-DPGR
under this de minimis exception, then the taxpayer must
treat the gross receipts recognized in each taxable year consistently as non-DPGR.
(iii) Examples. The following examples illustrate
the application of this paragraph (i)(4):
Example 1. X MPGE QPP within the United States.
As part of the sale of the QPP to Z, X trains Z’s employees on how
to use and operate the QPP. No other services or property are provided to
Z in connection with the sale of the QPP to Z. In the normal course of X’s
business, the QPP and training services are separately stated in the sales
contract. Because, in the normal course of the X’s business, the training
services are separately stated, the training services are not treated as embedded
services under the de minimis exception in paragraph
(i)(4)(i)(B)(6) of this section.
Example 2. The facts are the same as in Example
1 except that, in the normal course of X’s business, the
training services are not separately stated in the sales contract and the
customer cannot purchase the QPP without the training services. If the gross
receipts for the embedded training services are less than 5% of the gross
receipts derived from the sale of X’s QPP to Z, after applying the exceptions
under paragraphs (i)(4)(i)(B)(1) through (5)
of this section, then the gross receipts may be included in DPGR under the de
minimis exception in paragraph (i)(4)(i)(B)(6)
of this section.
Example 3. X MPGE QPP within the United States.
As part of the sale of the QPP to retailers, X charges a fee for delivering
the QPP. In the normal course of X’s business, the price of the QPP
and the delivery fee are separately stated in X’s sales contracts.
Because, in the normal course of X’s business, the delivery fee is separately
stated, the delivery fee does not qualify as DPGR under the qualified delivery
exception in paragraph (i)(4)(i)(B)(2) of this section
or the de minimis exception under paragraph (i)(4)(i)(B)(6)
of this section. The result would be the same even if the retailer’s
customers cannot purchase the QPP without paying the delivery fee.
Example 4. (i) Facts. X
manufactures industrial sewing machines within the United States that X offers
for sale individually to customers. X enters into a single, lump-sum priced
contract with Y, an unrelated person, and the contract has the following terms:
X will manufacture industrial sewing machines within the United States for
Y; X will deliver the industrial sewing machines to Y; X will provide a one-year
warranty on the industrial sewing machines; X will provide operating manuals
with the industrial sewing machines; X will provide 100 hours of training
and training manuals to Y’s employees on the use and maintenance of
the industrial sewing machines; X will provide purchased spare parts for the
industrial sewing machines; and X will provide a 3-year service agreement
for the industrial sewing machines. In the normal course of X’s business,
none of the services or property described above are separately stated, separately
offered or separately bargained for.
(ii) Analysis. The receipts for the manufacture
of the industrial sewing machines are DPGR under paragraphs (e)(1) and (g)
of this section (assuming all the other requirements of this section are met).
X may include in DPGR the gross receipts derived from delivering the industrial
sewing machines, which is a qualified delivery under paragraph (i)(4)(i)(B)(2)
of this section; the gross receipts derived from the one-year warranty, which
is a qualified warranty under paragraph (i)(4)(i)(B)(1)
of this section; and the gross receipts derived from the operating manuals,
which is a qualified operating manual under paragraph (i)(4)(i)(B)(3)
of this section. If the gross receipts allocable to each industrial sewing
machine for the embedded services consisting of the employee training and
3-year service agreement, and for the non-qualified property consisting of
the purchased spare parts and the employee training manuals, which are not
qualified operating manuals, are in total less than 5% of the gross receipts
derived from the sale of each industrial sewing machine to Y (after applying
the exceptions under paragraphs (i)(4)(i)(B)(1) through
(5) of this section), then those gross receipts may be
included in DPGR under the de minimis exception in paragraph
(i)(4)(i)(B)(6) of this section. If, however, the gross
receipts allocable to each industrial sewing machine for the embedded services
and non-qualified property consisting of employee training, the 3-year service
agreement, purchased spare parts, and employee training manuals equal or exceed,
in total, 5% of the gross receipts derived from the sale of each industrial
sewing machine to Y (after applying the exceptions under paragraphs (i)(4)(i)(B)(1)
through (5) of this section), then those gross receipts
do not qualify as DPGR under the de minimis exception
in paragraph (i)(4)(i)(B)(6) of this section (and X must
allocate gross receipts between DPGR and non-DPGR under §1.199-1(d)(1)).
(5) Advertising income—(i) Tangible
personal property. A taxpayer’s gross receipts that are
derived from the lease, rental, license, sale, exchange, or other disposition
of newspapers, magazines, telephone directories, periodicals, and other similar
printed publications that are MPGE in whole or in significant part within
the United States include advertising income from advertisements placed in
those media, but only if the gross receipts, if any, derived from the lease,
rental, license, sale, exchange, or other disposition of the newspapers, magazines,
telephone directories, or periodicals are (or would be) DPGR.
(ii) Qualified film. A taxpayer’s gross
receipts that are derived from the lease, rental, license, sale, exchange,
or other disposition of a qualified film include advertising income and product-placement
income with respect to that qualified film, that is, compensation for placing
or integrating advertising or a product into the qualified film, but only
if the gross receipts, if any, derived from the qualified film are (or would
be) DPGR.
(iii) Examples. The following examples illustrate
the application of this paragraph (i)(5):
Example 1. X MPGE, and sells, newspapers within
the United States. X’s gross receipts from the newspapers include gross
receipts derived from the sale of newspapers to customers and payments from
advertisers to publish display advertising or classified advertisements in
X’s newspapers. X’s gross receipts described above are DPGR derived
from the sale of X’s newspapers.
Example 2. The facts are the same as in Example
1 except that X disposes of the newspapers free of charge to customers,
rather than selling them. X’s gross receipts from the display advertising
or classified advertisements are DPGR.
Example 3. X produces two live television programs
that are qualified films. X licenses the first television program to Y’s
television station and X licenses the second television program to Z’s
television station. Z broadcasts the second television program
on its station. Both television programs contain product placements and advertising
for which X received compensation. X and Y are unrelated persons. X and
Z are non-consolidated members of an EAG. The gross receipts derived by X
from licensing the first television program to Y are DPGR. As a result, pursuant
to paragraph (i)(5)(ii) of this section, all of X’s product placement
and advertising income for the first television program is treated as gross
receipts that are derived from the license of the qualified film. The gross
receipts derived by X from licensing the second television program to Z are
non-DPGR under paragraph (b)(1) of this section. Paragraph (b)(2) of this
section does not apply because Z’s broadcast of the second television
program on Z’s television station is not a lease, rental, license, sale,
exchange, or other disposition of the second television program. As a result,
pursuant to paragraph (i)(5)(ii) of this section, none of X’s product
placement and advertising income for the second television program is treated
as gross receipts derived from the qualified film.
Example 4. The facts are the same as in Example
3 except that Z sublicenses to an unrelated person the television
program instead of broadcasting the television program on its station. The
gross receipts derived by X from licensing the television program to Z are
DPGR under paragraph (b)(2) of this section. As a result, pursuant to paragraph
(i)(5)(ii) of this section, X’s product placement and advertising income
for the television program licensed to Z is treated as gross receipts derived
from the qualified film. In addition, Z’s receipts from the sublicense
of the qualified film are DPGR under §1.199-7(a)(3)(i).
Example 5. X produces television programs that
are qualified films. X licenses the qualified films to Y, an unrelated person,
and the license agreement provides that X will receive advertising time slots
as part of its payments from Y under the license agreement. X’s gross
receipts derived from the license of the qualified films to Y include income
attributable to the advertising time slots and are DPGR under paragraph (b)(2)
of this section.
(6) Computer software—(i) In
general. DPGR include the gross receipts of the taxpayer that
are derived from the lease, rental, license, sale, exchange, or other disposition
of computer software MPGE by the taxpayer in whole or in significant part
within the United States. Such gross receipts qualify as DPGR even if the
customer provides the computer software to its employees or others over the
Internet.
(ii) through (v). [Reserved]. For further guidance, see §1.199-3T(i)(6)(ii)
through (v).
(7) Qualifying in-kind partnership for taxable years beginning
after May 17, 2006, the enactment date of the Tax Increase Prevention and
Reconciliation Act of 2005. [Reserved].
(8) Partnerships owned by members of a single expanded affiliated
group for taxable years beginning after May 17, 2006, the enactment date of
the Tax Increase Prevention and Reconciliation Act of 2005. [Reserved].
(9) Non-operating mineral interests. DPGR does
not include gross receipts derived from non-operating mineral interests (for
example, interests other than operating mineral interests within the meaning
of §1.614-2(b)).
(j) Definition of qualifying production property—(1)
In general. QPP means—
(i) Tangible personal property (as defined in paragraph (j)(2) of this
section);
(ii) Computer software (as defined in paragraph (j)(3) of this section);
and
(iii) Sound recordings (as defined in paragraph (j)(4) of this section).
(2) Tangible personal property—(i) In
general. The term tangible personal property is
any tangible property other than land, real property described in paragraph
(m)(3) of this section, and any property described in paragraph (j)(3), (j)(4),
(k)(1), or (l) of this section. For purposes of the preceding sentence, tangible
personal property also includes any gas (other than natural gas described
in paragraph (l)(2) of this section), chemical, and similar property, for
example, steam, oxygen, hydrogen, and nitrogen. Property such as machinery,
printing presses, transportation and office equipment, refrigerators, grocery
counters, testing equipment, display racks and shelves, and neon and other
signs that are contained in or attached to a building constitutes tangible
personal property for purposes of this paragraph (j)(2)(i). Except as provided
in paragraphs (j)(5)(ii) and (k)(2)(i) of this section, computer software,
sound recordings, and qualified films are not treated as tangible personal
property regardless of whether they are affixed to a tangible medium. However,
the tangible medium to which such property may be affixed (for example, a
videocassette, a computer diskette, or other similar tangible item) is tangible
personal property.
(ii) Local law. In determining whether property
is tangible personal property, local law is not controlling.
(iii) Intangible property. The term tangible
personal property does not include property in a form other than
in a tangible medium. For example, mass-produced books are tangible personal
property, but neither the rights to the underlying manuscript nor an online
version of the book is tangible personal property.
(3) Computer software—(i) In
general. The term computer software means
any program or routine or any sequence of machine-readable code that is designed
to cause a computer to perform a desired function or set of functions, and
the documentation required to describe and maintain that program or routine.
Thus, for example, an electronic book available online or for download is
not computer software. For purposes of this paragraph (j)(3), computer software
also includes the machine-readable code for video games and similar programs,
for equipment that is an integral part of other property, and for typewriters,
calculators, adding and accounting machines, copiers, duplicating equipment,
and similar equipment, regardless of whether the code is designed to operate
on a computer (as defined in section 168(i)(2)(B)). Computer programs of
all classes, for example, operating systems, executive systems, monitors,
compilers and translators, assembly routines, and utility programs, as well
as application programs, are included. Except as provided in paragraph (j)(5)
of this section, if the medium in which the software is contained, whether
written, magnetic, or otherwise, is tangible, then such medium is considered
tangible personal property for purposes of this section.
(ii) Incidental and ancillary rights. Computer
software also includes any incidental and ancillary rights that are necessary
to effect the acquisition of the title to, the ownership of, or the right
to use the computer software, and that are used only in connection with that
specific computer software. Such incidental and ancillary rights are not
included in the definition of trademark or trade name under §1.197-2(b)(10)(i).
For example, a trademark or trade name that is ancillary to the ownership
or use of a specific computer software program in the taxpayer’s trade
or business and is not acquired for the purpose of marketing the computer
software is included in the definition of computer software and is not included
in the definition of trademark or trade name.
(iii) Exceptions. Computer software does not
include any data or information base unless the data or information base is
in the public domain and is incidental to a computer program. For this purpose,
a copyrighted or proprietary data or information base is treated as in the
public domain if its availability through the computer program does not contribute
significantly to the cost of the program. For example, if a word-processing
program includes a dictionary feature that may be used to spell-check a document
or any portion thereof, then the entire program (including the dictionary
feature) is computer software regardless of the form in which the dictionary
feature is maintained or stored.
(4) Sound recordings—(i) In general.
The term sound recordings means any works that result
from the fixation of a series of musical, spoken, or other sounds under section 168(f)(4).
The definition of sound recordings is limited to the master copy of the recordings
(or other copy from which the holder is licensed to make and produce copies),
and, except as provided in paragraph (j)(5) of this section, if the medium
(such as compact discs, tapes, or other phonorecordings) in which the sounds
may be embodied is tangible, then the medium is considered tangible personal
property for purposes of paragraph (j)(2) of this section.
(ii) Exception. The term sound recordings does
not include the creation of copyrighted material in a form other than a sound
recording, such as lyrics or music composition.
(5) Tangible personal property with computer software or
sound recordings—(i) Computer software and sound
recordings. If a taxpayer MPGE in whole or in significant part
computer software or sound recordings within the United States that is affixed
or added to tangible personal property (for example, a computer diskette,
or an appliance), whether or not the taxpayer MPGE such tangible personal
property in whole or in significant part within the United States, then for
purposes of this section—
(A) The computer software and the tangible personal property may be
treated by the taxpayer as computer software. If the taxpayer treats the
computer software and the tangible personal property as computer software,
activities the cost of which are described in Rev. Proc. 2000-50, 2000-2 C.B.
601, activities giving rise to research and experimental expenditures under
section 174, and the creation of intangible assets for computer software are
considered in determining whether the taxpayer’s MPGE activity is substantial
in nature under paragraph (g)(2) of this section. In determining direct labor
and overhead under paragraph (g)(3)(i) of this section, the costs of direct
labor and overhead for developing the computer software as described in Rev.
Proc. 2000-50, 2000-2 C.B. 601, research and experimental expenditures under
section 174, and any other costs of creating intangible assets for the computer
software are treated as direct labor and overhead. These costs must be included
in the taxpayer’s CGS of the computer software for purposes of determining
whether the taxpayer meets the safe harbor under paragraph (g)(3)(i) of this
section. However, any costs under section 174, and the costs to create intangible
assets, attributable to the tangible personal property are not considered
in determining whether the taxpayer’s activity is substantial in nature
under paragraph (g)(2) of this section and are not direct labor and overhead
under paragraph (g)(3)(i) of this section; and
(B) The sound recordings and the tangible personal property with the
sound recordings may be treated by the taxpayer as sound recordings. If the
taxpayer treats the sound recordings and the tangible personal property as
sound recordings, activities giving rise to research and experimental expenditures
under section 174 and the creation of intangible assets for sound recordings
are considered in determining whether the taxpayer’s MPGE activity is
substantial in nature under paragraph (g)(2) of this section. In determining
direct labor and overhead under paragraph (g)(3)(i) of this section, research
and experimental expenditures under section 174 and any other costs of creating
intangible assets for sound recordings are treated as direct labor and overhead.
These costs must be included in the taxpayer’s CGS of sound recordings
for purposes of determining whether the taxpayer meets the safe harbor under
paragraph (g)(3)(i) of this section. However, any costs under section 174,
and the costs to create intangible assets, attributable to the tangible personal
property are not considered in determining whether the taxpayer’s activity
is substantial in nature under paragraph (g)(2) of this section and are not
direct labor and overhead under paragraph (g)(3)(i) of this section.
(ii) Tangible personal property. If a taxpayer
MPGE tangible personal property (for example, a computer diskette or an appliance)
in whole or in significant part within the United States but not the computer
software or sound recordings that is affixed or added to such tangible personal
property, then for purposes of this section the tangible personal property
with the computer software or sound recordings may be treated by the taxpayer
as tangible personal property under paragraph (j)(2) of this section. Any
costs under section 174, and the costs to create intangible assets, attributable
to the tangible personal property are not considered in determining whether
the taxpayer’s activity is substantial in nature under paragraph (g)(2)
of this section and are not direct labor or overhead under paragraph (g)(3)(i)
of this section. For purposes of paragraph (g)(3) of this section, the taxpayer’s
CGS (or unadjusted depreciable basis, if applicable) for each item of tangible
personal property includes the taxpayer’s cost of leasing, renting,
licensing, buying, or otherwise acquiring the computer software or sound recordings.
(k) Definition of qualified film—(1) In
general. The term qualified film means any
motion picture film or video tape under section 168(f)(3), or live or delayed
television programming, if not less than 50 percent of the total compensation
paid to actors, production personnel, directors, and producers relating to
the production of the motion picture film, video tape, or television programming
is compensation paid by the taxpayer for services relating to the production
of the film performed in the United States by those individuals. For purposes
of this paragraph (k), actors include players, newscasters, or any other persons
performing in a qualified film. The term production personnel includes,
for example, writers, choreographers and composers providing services during
the production of a film, casting agents, camera operators, set designers,
lighting technicians, make-up artists, and others whose activities are directly
related to the production of the film. Except as provided in paragraph (k)(2)
of this section, the definition of qualified film does
not include tangible personal property embodying the qualified film, such
as DVDs or videocassettes.
(2) Tangible personal property with a film—(i)
Film not produced by a taxpayer. If a taxpayer MPGE
tangible personal property (for example, a DVD) in whole or in significant
part in the United States and a film not produced by a taxpayer is affixed
to the tangible personal property, then the taxpayer may treat the tangible
personal property with the affixed film as tangible personal property, regardless
of whether the film is a qualified film. The determination of whether the
gross receipts of such a taxpayer derived from the lease, rental, license,
sale, exchange, or other disposition of the tangible personal property with
the affixed film are DPGR is made under the rules of this section. For purposes
of paragraph (g)(2) of this section, in determining whether the taxpayer’s
MPGE activity is substantial in nature, the taxpayer must consider the value
of the licensed film. For purposes of paragraph (g)(3) of this section, the
taxpayer’s CGS (or unadjusted depreciable basis, as applicable) for
each item of tangible personal property includes the taxpayer’s cost
of leasing, renting, licensing, buying, or otherwise acquiring the film.
(ii) Film produced by a taxpayer. If a taxpayer
produces a film and the film is affixed to tangible personal property (for
example, a DVD), then for purposes of this section—
(A) Qualified film. If the film is a qualified
film, the taxpayer may treat the tangible personal property, whether or not
the taxpayer MPGE such tangible personal property, to which the qualified
film is affixed as part of the qualified film; and
(B) Nonqualified film. If the film is not a qualified
film (nonqualified film), a taxpayer cannot treat the tangible personal property
to which the nonqualified film is affixed as part of the nonqualified film.
(3) Derived from a qualified film—(i) In
general. DPGR include the gross receipts of a taxpayer that are
derived from any lease, rental, license, sale, exchange, or other disposition
of any qualified film produced by such taxpayer.
(ii) Exceptions. The showing of a qualified film
(for example, in a movie theater or by broadcast on a television station)
by a taxpayer is not a lease, rental, license, sale, exchange, or other disposition
of the qualified film by such taxpayer. Ticket sales for viewing a qualified
film do not constitute DPGR because the gross receipts are not derived from
the lease, rental, license, sale, exchange, or other disposition of a qualified
film. Because a taxpayer that merely writes a screenplay or other similar
material is not considered to have produced a qualified film under paragraph
(k)(1) of this section, the amounts that the taxpayer receives from the sale
of the script or screenplay, even if the script is developed into a qualified
film, are not gross receipts derived from a qualified film. In addition,
revenue from the sale of film-themed merchandise is revenue from the sale
of tangible personal property and not gross receipts derived from a qualified
film. Gross receipts derived from a license of the right to use or exploit
the film characters are not gross receipts derived from a qualified film.
(4) Compensation for services. The term compensation
for services means all payments for services performed by actors
(as described in paragraph (k)(1) of this section), production personnel,
directors, and producers, including participations and residuals. In the
case of a taxpayer that uses the income forecast method of section 167(g)
and capitalizes participations and residuals into the adjusted basis of the
qualified film, the taxpayer must use the same estimate of participations
and residuals for services performed by actors, production personnel, directors,
and producers for purposes of this section. In the case of a taxpayer that
excludes participations and residuals from the adjusted basis of the qualified
film under section 167(g)(7)(D)(i), the taxpayer must determine the compensation
expected to be paid for services performed by actors, production personnel,
directors, and producers as participations and residuals based on the total
forecasted income used in determining income forecast depreciation. Compensation
for services includes all direct and indirect compensation costs required
to be capitalized under section 263A for film producers under §1.263A-1(e)(2)
and (3). Compensation for services is not limited to W-2 wages and includes
compensation paid to independent contractors.
(5) Determination of 50 percent. The not-less-than-50-percent-of-the-total-compensation
requirement under paragraph (k)(1) of this section is determined by reference
to all compensation paid in the production of the film and is calculated using
a fraction. The numerator of the fraction is the compensation paid by the
taxpayer to actors, production personnel, directors, and producers for services
relating to the production of the film (production services) performed in
the United States, and the denominator is the sum of the total compensation
paid by the taxpayer to all such individuals regardless of where the production
services are performed and the total compensation paid by others to all such
individuals regardless of where the production services are performed. A
taxpayer may use any reasonable method that is satisfactory to the Secretary
based on all of the facts and circumstances, including all historic information
available, to determine the compensation for services performed in the United
States by actors (as described in paragraph (k)(1) of this section), production
personnel, directors, and producers, and the total compensation paid to those
individuals for services relating to the production of the film. Among the
factors to be considered in determining whether a taxpayer’s method
of allocating compensation is reasonable is whether the taxpayer uses that
method consistently from one taxable year to another.
(6) Exception. A qualified film does
not include property with respect to which records are required to be maintained
under 18 U.S.C. 2257. Section 2257 of Title 18 requires maintenance
of certain records with respect to any book, magazine, periodical, film, videotape,
or other matter that—
(i) Contains one or more visual depictions made after November 1, 1990,
of actual sexually explicit conduct; and
(ii) Is produced in whole or in part with materials that have been
mailed or shipped in interstate or foreign commerce, or is shipped or transported
or is intended for shipment or transportation in interstate or foreign commerce.
(7) Examples. The following examples illustrate
the application of this paragraph (k):
Example 1. X produces a qualified film and duplicates
the film onto purchased DVDs. X sells the DVDs with the qualified film to
customers. Under paragraph (k)(2)(ii)(A) of this section, X treats the DVD
with the qualified film as a qualified film. Accordingly, X’s
gross receipts derived from the sale of the qualified film to customers are
DPGR (assuming all the other requirements of this section are met).
Example 2. The facts are the same as in Example
1 except that the film is a nonqualified film because the film
does not satisfy the not-less-than-50-percent-of-the-total-compensation requirement
under (k)(1) of this section and X manufactures the DVDs in the United States.
Under paragraph (k)(2)(ii)(B) of this section, X cannot treat the DVD as
part of the nonqualified film. X’s gross receipts (not including the
gross receipts attributable to the nonqualified film) derived from the sale
of the tangible personal property are DPGR (assuming all the other requirements
of this section are met).
Example 3. X produces live television programs
that are qualified films. X shows the programs on its own television station.
X sells advertising time slots to advertisers for the television programs.
Because showing a qualified film on a television station is not a lease,
rental, license, sale, exchange, or other disposition pursuant to paragraph
(k)(3)(ii) of this section, the advertising income X receives from advertisers
is not derived from the lease, rental, license, sale, exchange, or other disposition
of the qualified films and is non-DPGR.
Example 4. The facts are the same as in Example
3 except that X also licenses the qualified films to Y, an unrelated
cable company that broadcasts X’s qualified films. As part
of the license agreement, X can sell advertising time slots. Because X’s
gross receipts from Y are derived from the licensing of qualified films pursuant
to paragraph (k)(3)(i) of this section, X’s gross receipts derived from
licensing the qualified film are DPGR. In addition, the gross receipts derived
from the advertising income X receives that is related to the qualified films
licensed to Y is DPGR pursuant to paragraph (i)(5)(ii) of this section. Because
showing a qualified film on a television station is not a lease, rental, license,
sale, exchange, or other disposition pursuant to paragraph (k)(3)(ii) of this
section, the portion of the advertising income X derives from advertisers
for the qualified films it broadcasts on its own television station is not
derived from the lease, rental, license, sale, exchange, or other disposition
of the qualified films and is non-DPGR.
Example 5. X produces a qualified film and contracts
with Y, an unrelated person, to duplicate the film onto DVDs. Y manufactures
blank DVDs within the United States, duplicates X’s film onto the DVDs
in the United States, and sells the DVDs with the qualified film to X who
then sells them to customers. Y has all of the benefits and burdens of ownership
under Federal income tax principles of the DVDs during the MPGE and duplication
process. Assume Y’s activities relating to manufacture of the blank
DVDs and duplicating the film onto the DVDs collectively satisfy the safe
harbor under paragraph (g)(3) of this section. Y’s gross receipts from
manufacturing the DVDs and duplicating the film onto the DVDs are DPGR (assuming
all the other requirements of this section are met). X’s gross receipts
from the sale of the DVDs to customers are DPGR (assuming all the other requirements
of this section are met).
Example 6. X creates a television program in the
United States that includes scenes from films licensed by X from unrelated
persons Y and Z. Assume that Y and Z produced the films licensed by X. The
not-less-than-50-percent-of-the-total-compensation requirement under paragraph
(k)(1) of this section is determined by reference to all compensation paid
in the production of the television program, including the films licensed
by X from Y and Z, and is calculated using a fraction as described in paragraph
(k)(5) of this section. The numerator of the fraction is the compensation
paid by X to actors, production personnel, directors, and producers for production
services performed in the United States, and the denominator is the sum of
the total compensation paid by X to such individuals regardless of where the
production services are performed and the total compensation paid by Y and
Z to actors, production personnel, directors, and producers relating to the
production of the films licensed by X (regardless of where the services are
performed). However, for purposes of calculating the denominator, in determining
the total compensation paid by Y and Z, X need only include the total compensation
paid by Y and Z to actors, production personnel, directors, and producers
for the production of the scenes used by X in creating its television program.
(l) Electricity, natural gas, or potable water—(1)
In general. DPGR include gross receipts derived from
any lease, rental, license, sale, exchange, or other disposition of utilities
produced by the taxpayer in the United States if all other requirements of
this section are met. In the case of an integrated producer that both produces
and delivers utilities, see paragraph (l)(4) of this section that describes
certain gross receipts that do not qualify as DPGR.
(2) Natural gas. The term natural gas includes
only natural gas extracted from a natural deposit and does not include, for
example, methane gas extracted from a landfill. In the case of natural gas,
production activities include all activities involved in extracting natural
gas from the ground and processing the gas into pipeline quality gas.
(3) Potable water. The term potable
water means unbottled drinking water. In the case of potable water,
production activities include the acquisition, collection, and storage of
raw water (untreated water), transportation of raw water to a water treatment
facility, and treatment of raw water at such a facility. Gross receipts attributable
to any of these activities are included in DPGR if all other requirements
of this section are met.
(4) Exceptions—(i) Electricity.
Gross receipts attributable to the transmission of electricity from the generating
facility to a point of local distribution and gross receipts attributable
to the distribution of electricity to customers are non-DPGR.
(ii) Natural gas. Gross receipts attributable
to the transmission of pipeline quality gas from a natural gas field (or,
if treatment at a natural gas processing plant is necessary to produce pipeline
quality gas, from a natural gas processing plant) to a local distribution
company’s citygate (or to another customer) are non-DPGR. Likewise,
gross receipts of a local gas distribution company attributable to distribution
from the citygate to the local customers are non-DPGR.
(iii) Potable water. Gross receipts attributable
to the storage of potable water after completion of treatment of the potable
water, as well as gross receipts attributable to the transmission and distribution
of potable water, are non-DPGR.
(iv) De minimis exception—(A)
DPGR. Notwithstanding paragraphs (l)(4)(i), (ii), and
(iii) of this section, if less than 5 percent of a taxpayer’s gross
receipts derived from a sale, exchange, or other disposition of utilities
are attributable to the transmission or distribution of the utilities and
the storage of potable water after completion of treatment of the potable
water, then the gross receipts derived from the lease, rental, license, sale,
exchange, or other disposition of the utilities that are attributable to the
transmission and distribution of the utilities and the storage of potable
water after completion of treatment of the potable water may be treated as
being DPGR (assuming all other requirements of this section are met). In
the case of gross receipts derived from the lease, rental, license, sale,
exchange, or other disposition of utilities that are received over a period
of time (for example, a multi-year lease or installment sale), this de
minimis exception is applied by taking into account the total gross
receipts for the entire period derived (and to be derived) from the lease,
rental, license, sale, exchange, or other disposition of the utilities. For
purposes of the preceding sentence, if a taxpayer treats gross receipts as
DPGR under this de minimis exception, then the taxpayer
must treat the gross receipts recognized in each taxable year consistently
as DPGR.
(B) Non-DPGR. If less than 5 percent of
a taxpayer’s gross receipts derived from a sale, exchange, or other
disposition of utilities are DPGR, then the gross receipts derived from the
sale, exchange, or other disposition of the utilities may be treated as non-DPGR.
In the case of gross receipts derived from the lease, rental, license, sale,
exchange, or other disposition of utilities that are received over a period
of time (for example, a multi-year lease or installment sale), this de
minimis exception is applied by taking into account the total gross
receipts for the entire period derived (and to be derived) from the lease,
rental, license, sale, exchange, or other disposition of the utilities. For
purposes of the preceding sentence, if a taxpayer treats gross receipts as
non-DPGR under this de minimis exception, then the taxpayer
must treat the gross receipts recognized in each taxable year consistently
as non-DPGR.
(5) Example. The following example illustrates
the application of this paragraph (l):
Example. X owns a wind turbine in the United States
that generates electricity and Y owns a high voltage transmission line that
passes near X’s wind turbine and ends near the system of local distribution
lines of Z. X sells the electricity produced at the wind turbine to Z and
contracts with Y to transmit the electricity produced at the wind turbine
to Z who sells the electricity to customers using Z’s distribution network.
The gross receipts received by X from the sale of electricity produced at
the wind turbine are DPGR. The gross receipts of Y derived from transporting
X’s electricity to Z are non-DPGR under paragraph (l)(4)(i) of this
section. Likewise, the gross receipts of Z derived from distributing the
electricity are non-DPGR under paragraph (l)(4)(i) of this section. If X
made direct sales of electricity to customers in Z’s service area and
Z receives remuneration for the distribution of electricity, the gross receipts
of Z are non-DPGR under paragraph (l)(4)(i) of this section. If X, Y, and
Z are related persons (as defined in paragraph (b) of this section), then
X, Y, and Z must allocate gross receipts among the production activities (that
are DPGR), and the transmission and distribution activities (that are non-DPGR).
(m) Definition of construction performed in the United States—(1) Construction
of real property—(i) In general. The
term construction means activities and services relating
to the construction or erection of real property (as defined in paragraph
(m)(3) of this section) in the United States by a taxpayer that, at the time
the taxpayer constructs the real property, is engaged in a trade or business
(but not necessarily its primary, or only, trade or business) that is considered
construction for purposes of the North American Industry Classification System
(NAICS) on a regular and ongoing basis. A trade or business that is considered
construction under the NAICS means a construction activity under the two-digit
NAICS code of 23 and any other construction activity in any other NAICS code
provided the construction activity relates to the construction of real property
such as NAICS code 213111 (drilling oil and gas wells) and 213112 (support
activities for oil and gas operations). For purposes of this paragraph (m),
the term construction project means the construction
activities and services treated as the item under paragraph (d)(2)(iii) of
this section. Tangible personal property (for example, appliances, furniture,
and fixtures) that is sold as part of a construction project is not considered
real property for purposes of this paragraph (m)(1)(i). In determining whether
property is real property, the fact that property is real property under local
law is not controlling. Conversely, property may be real property for purposes
of this paragraph (m)(1)(i) even though under local law the property is considered
tangible personal property.
(ii) Regular and ongoing basis—(A) In
general. For purposes of paragraph (m)(1)(i) of this section,
a taxpayer engaged in a construction trade or business will be considered
to be engaged in such trade or business on a regular and ongoing basis if
the taxpayer derives gross receipts from an unrelated person by selling or
exchanging the constructed real property described in paragraph (m)(3) of
this section within 60 months of the date on which construction is complete
(for example, on the date a certificate of occupancy is issued for the property).
(B) New trade or business. In the case of a newly-formed
trade or business or a taxpayer in its first taxable year, the taxpayer is
considered to be engaged in a trade or business on a regular and ongoing basis
if the taxpayer reasonably expects that it will engage in a trade or business
on a regular and ongoing basis.
(iii) De minimis exception—(A)
DPGR. For purposes of paragraph (m)(1)(i) of this section,
if less than 5 percent of the total gross receipts derived by a taxpayer
from a construction project (as described in paragraph (m)(1)(i) of this section)
are derived from activities other than the construction of real property in
the United States (for example, from non-construction activities or the sale
of tangible personal property or land), then the total gross receipts derived
by the taxpayer from the project may be treated as DPGR from construction.
If a taxpayer applies the land safe harbor under paragraph (m)(6)(iv) of
this section, for a construction project (as described in paragraph (m)(1)(i)
of this section), then the gross receipts excluded under the land safe harbor
are excluded in determining total gross receipts under this paragraph (m)(1)(iii)(A).
If a taxpayer does not apply the land safe harbor and uses any reasonable
method (for example, an appraisal of the land) to allocate gross receipts
attributable to the land to non-DPGR, then a taxpayer applies this paragraph
(m)(1)(iii)(A) by excluding such gross receipts derived from the sale, exchange,
or other disposition of the land from total gross receipts. In the case of
gross receipts derived from construction that are received over a period of
time (for example, an installment sale), this de minimis exception
is applied by taking into account the total gross receipts for the entire
period derived (and to be derived) from construction. For purposes of the
preceding sentence, if a taxpayer treats gross receipts as DPGR under this de
minimis exception, then the taxpayer must treat the gross receipts
recognized in each taxable year consistently as DPGR.
(B) Non-DPGR. For purposes of paragraph (m)(1)(i)
of this section, if less than 5 percent of the total gross receipts derived
by a taxpayer from a construction project qualify as DPGR, then the total
gross receipts derived by the taxpayer from the construction project may be
treated as non-DPGR. In the case of gross receipts derived from construction
that are received over a period of time (for example, an installment sale),
this de minimis exception is applied by taking into account
the total gross receipts for the entire period derived (and to be derived)
from construction. For purposes of the preceding sentence, if a taxpayer
treats gross receipts as non-DPGR under this de minimis exception,
then the taxpayer must treat the gross receipts recognized in each taxable
year consistently as non-DPGR.
(2) Activities constituting construction—(i)
In general. Activities constituting construction are
activities performed in connection with a project to erect or substantially
renovate real property, including activities performed by a general contractor
or that constitute activities typically performed by a general contractor,
for example, activities relating to management and oversight of the construction
process such as approvals, periodic inspection of the progress of the construction
project, and required job modifications.
(ii) Tangential services. Activities constituting
construction do not include tangential services such as hauling trash and
debris, and delivering materials, even if the tangential services are essential
for construction. However, if the taxpayer performing construction also,
in connection with the construction project, provides tangential services
such as delivering materials to the construction site and removing its construction
debris, then the gross receipts derived from the tangential services are DPGR.
(iii) Other construction activities. Improvements
to land that are not capitalizable to the land (for example, landscaping)
and painting are activities constituting construction only if these activities
are performed in connection with other activities (whether or not by the same
taxpayer) that constitute the erection or substantial renovation of real property
and provided the taxpayer meets the requirements under paragraph (m)(1) of
this section. Services such as grading, demolition (including demolition
of structures under section 280B), clearing, excavating, and any other activities
that physically transform the land are activities constituting construction
only if these services are performed in connection with other activities (whether
or not by the same taxpayer) that constitute the erection or substantial renovation
of real property and provided the taxpayer meets the requirements under paragraph
(m)(1) of this section. A taxpayer engaged in these activities must make
a reasonable inquiry or a reasonable determination as to whether the activity
relates to the erection or substantial renovation of real property in the
United States. Construction activities also include activities relating to
drilling an oil or gas well and mining and include any activities the cost
of which are intangible drilling and development costs within the meaning
of §1.612-4 or development expenditures for a mine or natural deposit
under section 616.
(iv) Administrative support services. If the
taxpayer performing construction activities also provides, in connection with
the construction project, administrative support services (for example, billing
and secretarial services) incidental and necessary to such construction project,
then these administrative support services are considered construction activities.
(v) Exceptions. The lease, license, or rental
of equipment, for example, bulldozers, generators, or computers, for use in
the construction of real property is not a construction activity under this
paragraph (m)(2). The term construction does not include
any activity that is within the definition of engineering and architectural
services under paragraph (n) of this section.
(3) Definition of real property. The term real
property means buildings (including items that are structural components
of such buildings), inherently permanent structures (as defined in §1.263A-8(c)(3))
other than machinery (as defined in §1.263A-8(c)(4)) (including items
that are structural components of such inherently permanent structures), inherently
permanent land improvements, oil and gas wells, and infrastructure (as defined
in paragraph (m)(4) of this section). For purposes of the preceding sentence,
an entire utility plant including both the shell and the interior will be
treated as an inherently permanent structure. Property produced by a taxpayer
that is not real property in the hands of that taxpayer, but that may be incorporated
into real property by another taxpayer, is not treated as real property by
the producing taxpayer (for example, bricks, nails, paint, and windowpanes).
For purposes of this paragraph (m)(3), structural components of buildings
and inherently permanent structures include property such as walls, partitions,
doors, wiring, plumbing, central air conditioning and heating systems, pipes
and ducts, elevators and escalators, and other similar property.
(4) Definition of infrastructure. The term infrastructure includes
roads, power lines, water systems, railroad spurs, communications facilities,
sewers, sidewalks, cable, and wiring. The term also includes inherently permanent
oil and gas platforms.
(5) Definition of substantial renovation. The
term substantial renovation means the renovation of a
major component or substantial structural part of real property that materially
increases the value of the property, substantially prolongs the useful life
of the property, or adapts the property to a new or different use.
(6) Derived from construction—(i) In
general. Assuming all the requirements of this section are
met, DPGR derived from the construction of real property performed in the
United States includes the proceeds from the sale, exchange, or other disposition
of real property constructed by the taxpayer in the United States (whether
or not the property is sold immediately after construction is completed and
whether or not the construction project is completed). DPGR derived from
the construction of real property includes compensation for the performance
of construction services by the taxpayer in the United States. DPGR derived
from the construction of real property includes gross receipts derived from
materials and supplies consumed in the construction project or that become
part of the constructed real property, assuming all the requirements of this
section are met.
(ii) Qualified construction warranty. DPGR derived
from the construction of real property includes gross receipts from any qualified
construction warranty, that is, a warranty that is provided in connection
with the constructed real property if, in the normal course of the taxpayer’s
business—
(A) The price for the construction warranty is not separately stated
from the amount charged for the constructed real property; and
(B) The construction warranty is neither separately offered by the
taxpayer nor separately bargained for with customers (that is, the customer
cannot purchase the constructed real property without the construction warranty).
(iii) Exceptions. DPGR derived from the construction
of real property performed in the United States does not include gross receipts
derived from the sale, exchange, or other disposition of real property acquired
by the taxpayer even if the taxpayer originally constructed the property.
In addition, DPGR derived from the construction of real property does not
include gross receipts from the lease or rental of real property constructed
by the taxpayer or, except as provided in paragraph (m)(2)(iii) of this section,
gross receipts derived from the sale or other disposition of land (including
zoning, planning, entitlement costs, and other costs capitalized to the land).
(iv) Land safe harbor—(A) In
general. For purposes of paragraph (m)(6)(i) of this section,
a taxpayer may allocate gross receipts between the gross receipts derived
from the sale, exchange, or other disposition of real property constructed
by the taxpayer and the gross receipts derived from the sale, exchange, or
other disposition of land by reducing its costs related to DPGR under §1.199-4
by the costs of the land and any other costs capitalized to the land (collectively,
land costs) (including zoning, planning, entitlement costs, and other costs
capitalized to the land (except costs for activities listed in paragraph (m)(2)(iii)
of this section) and land costs in any common improvements as defined in section
2.01 of Rev. Proc. 92-29, 1992-1 C.B. 748, (see §601.601(d)(2) of this
chapter)) and by reducing its DPGR by those land costs plus a percentage.
Generally, the percentage is based on the number of months that elapse between
the date the taxpayer acquires the land (not including any options to acquire
the land) and ends on the date the taxpayer sells each item of real property
on the land. However, a taxpayer will be deemed, for purposes of
this paragraph (m)(6)(iv)(A), to acquire the land on the date the taxpayer
entered into an option agreement to acquire the land if the taxpayer acquired
the land pursuant to such option agreement and the purchase price of the land
under the option agreement does not approximate the fair market value of the
land. In the case of a sale or disposition of land between related persons
(as defined in paragraph (b)(1) of this section) for less than fair market
value, for purposes of determining the percentage, the purchaser or transferee
of the land must include the months during which the land was held by the
seller or transferor. The percentage is 5 percent for land
held not more than 60 months, 10 percent for land held more than 60 months
but not more than 120 months, and 15 percent for land held more than 120 months
but not more than 180 months. Land held by a taxpayer for more than 180 months
is not eligible for the safe harbor under this paragraph (m)(6)(iv)(A).
(B) Determining gross receipts and costs. In
the case of a taxpayer that uses the small business simplified overall method
of cost allocation under §1.199-4(f), gross receipts derived from the
sale, exchange, or other disposition of land, and costs attributable to the
land, pursuant to the land safe harbor under paragraph (m)(6)(iv)(A) of this
section, are not taken into account for purposes of computing QPAI under §§1.199-1
through 1.199-9 except that the gross receipts are taken into account for
determining eligibility for that method of cost allocation. All other taxpayers
must treat the gross receipts derived from the sale, exchange, or other disposition
of land, pursuant to the land safe harbor under paragraph (m)(6)(iv)(A) of
this section, as non-DPGR. In the case of a pass-thru entity, if the pass-thru
entity would be eligible to use the small business simplified overall method
of cost allocation if the method were applied at the pass-thru entity level,
then the gross receipts derived from the sale, exchange, or other disposition
of land, and costs allocated to the land, pursuant to the land safe harbor
under paragraph (m)(6)(iv)(A) of this section, are not taken into account
by the pass-thru entity or its owner or owners for purposes of computing QPAI
under §§1.199-1 through 1.199-9. For purposes of the preceding
sentence, in determining whether the pass-thru entity would be eligible for
the small business simplified overall method of cost allocation, the gross
receipts excluded pursuant to the land safe harbor under paragraph (m)(6)(iv)(A)
of this section are taken into account for determining eligibility for that
method of cost allocation. All other pass-thru entities (including all trusts
and estates described in §1.199-9(e)) must treat the gross receipts attributable
to the sale, exchange, or other disposition of land, pursuant to the land
safe harbor under paragraph (m)(6)(iv)(A) of this section, as non-DPGR.
(v) Examples. The following examples illustrate
the application of this paragraph (m)(6):
Example 1. A, who is in the trade or business
of construction under NAICS code 23 on a regular and ongoing basis, purchases
a building in the United States and retains B, an unrelated person, to oversee
a substantial renovation of the building (within the meaning of paragraph
(m)(5) of this section). Although not licensed as a general contractor, B
performs general contractor level work and activities relating to management
and oversight of the construction process such as approvals, periodic inspection
of the progress of the construction project, and required job modifications.
B retains C (a general contractor) to oversee day-to-day operations and hire
subcontractors. C hires D (a subcontractor) to install a new electrical system
in the building as part of that substantial renovation. The amounts that
B receives from A for construction services, the amounts that C receives from
B for construction services, and the amounts that D receives from C for construction
services qualify as DPGR under paragraph (m)(6)(i) of this section provided
B, C, and D meet all of the requirements of paragraph (m)(1) of this section.
The gross receipts that A receives from the subsequent sale of the building
do not qualify as DPGR because A did not engage in any activity constituting
construction under paragraph (m)(2) of this section even though A is in the
trade or business of construction. The results would be the same if A, B,
C, and D were members of the same EAG under §1.199-7(a). However, if
A, B, C, and D were members of the same consolidated group, see §1.199-7(d)(2).
Example 2. X is engaged as an electrical contractor
under NAICS code 238210 on a regular and ongoing basis. X purchases the wires,
conduits, and other electrical materials that it installs in construction
projects in the United States. In a particular construction project, all
of the wires, conduits, and other electrical materials installed by X for
the operation of that building are considered structural components of the
building. X’s gross receipts derived from installing that property are
derived from the construction of real property under paragraph (m)(1) of this
section. In addition, pursuant to paragraph (m)(6)(i) of this section, X’s
gross receipts derived from the purchased materials qualify as DPGR because
the wires, conduits, and other electrical materials are consumed during the
construction of the building or become structural components of the building.
Example 3. X is engaged in a trade or business
on a regular and ongoing basis that is considered construction under the two-digit
NAICS code of 23. X buys unimproved land in the United States. X gets the
land zoned for residential housing through an entitlement process. X grades
the land and sells the land to home builders who construct houses on the land.
The gross receipts that X derives from the sale of the land that are attributable
to the grading qualify as DPGR under paragraphs (m)(2)(iii) and (6)(i) of
this section because those services are undertaken in connection with a construction
project in the United States. X’s gross receipts derived from the land
including capitalized costs of entitlements (including zoning) do not qualify
as DPGR under paragraph (m)(6)(i) of this section because the gross receipts
are not derived from the construction of real property.
Example 4. The facts are the same as in Example
3 except that X constructs roads, sewers, and sidewalks, and installs
power and water lines on the land. X conveys the roads, sewers, sidewalks,
and power and water lines to the local government and utilities. The gross
receipts that X derives from the sale of lots that are attributable to grading,
and the construction of the roads, sewers, sidewalks, and power and water
lines (that qualify as infrastructure under paragraph (m)(4) of this section)
are DPGR. X’s gross receipts derived from the land including
capitalized costs of entitlements (including zoning) do not qualify as DPGR
under paragraph (m)(6)(i) of this section because the gross receipts are not
derived from the construction of real property.
Example 5. (i) Facts. X,
who is engaged in the trade or business of construction under NAICS code 23
on a regular and ongoing basis, constructs housing that is real property under
paragraph (m)(3) of this section. On June 1, 2007, X pays $50,000,000 and
acquires 1,000 acres of land that X will develop as a new housing development.
In November 2007, after the expenditure of $10,000,000 for entitlement costs,
X receives permits to begin construction. After this expenditure, X’s
land costs total $60,000,000. The development consists of 1,000 houses to
be built on half-acre lots over 5 years. On January 31, 2012, the first house
is sold for $300,000. Construction costs for each house are $170,000. Common
improvements consisting of streets, sidewalks, sewer lines, playgrounds, clubhouses,
tennis courts, and swimming pools that X is contractually obligated or required
by law to provide cost $55,000 per lot. The common improvements
of $55,000 per lot include $30,000 in land costs underlying the common improvements.
(ii) Land safe harbor. Pursuant to the land safe
harbor under paragraph (m)(6)(iv) of this section, X calculates the basis
for each house sold as $195,000 (total costs of $255,000 ($170,000 in construction
costs plus $55,000 in common improvements (including $30,000 in land costs)
plus $30,000 in land costs for the lot), which are reduced by land costs of
$60,000). X calculates the DPGR for each house sold by taking the gross receipts
of $300,000 and reducing that amount by land costs of $60,000 plus a percentage
of $60,000. As X acquired the land on June 1, 2007, for each house sold on
the land between January 31, 2012, and June 1, 2012, the percentage reduction
for X is 5% because X has held the land for not more than 60 months from the
date of acquisition. Thus, X’s DPGR for each house is $237,000 ($300,000
- $60,000 - $3,000) with costs for each house of $195,000 ($255,000 - $60,000).
For each house sold on the land between June 2, 2012 and June 1, 2017, the
percentage reduction for X is 10% because X has held the land for more than
60 months but not more than 120 months from the date of acquisition. Thus,
of the $300,000 of gross receipts, X’s DPGR for each house is $234,000
($300,000 - $60,000 - $6,000) with costs for each house of $195,000 ($255,000
- $60,000).
Example 6. The facts are the same as in Example
5 except that on December 31, 2007, after X received the permits
to begin construction, X sold the entitled land to Y, an unrelated corporation,
for $75,000,000. Y is engaged in a trade or business on a regular and ongoing
basis that is considered construction under NAICS code 23. Y subsequently
incurred the construction costs and the costs of the common improvements,
and Y sold the houses. Because X did not perform any construction activities,
none of X’s $75,000,000 in gross receipts derived from Y are DPGR and
none of X’s costs are allocable to DPGR. Pursuant to the land safe
harbor under paragraph (m)(6)(iv) of this section, Y calculates the basis
for each house sold as $195,000 (total costs of $270,000 ($170,000 in construction
costs plus $62,500 in common improvements (including $37,500 in land costs)
plus $37,500 in land costs for the lot), which are reduced by land costs of
$75,000). Y calculates the DPGR for each house sold by taking the gross receipts
of $300,000 and reducing that amount by land costs of $75,000 plus a percentage
of $75,000. As Y acquired the land on December 31, 2007, for the houses sold
on the land between January 31, 2012, and December 31, 2012, the percentage
reduction for Y is 5% because Y held the land for not more than 60 months
from the date of acquisition. Thus, of the $300,000 of gross receipts, the
DPGR for each house is $221,250 ($300,000 - $75,000 - $3,750) with costs for
each house of $195,000. For the houses sold on the land between January 1,
2013, and December 31, 2017, the percentage reduction for Y is 10% because
Y held the land for more than 60 months but not more than 120 months from
the date of acquisition. Thus, of the $300,000 of gross receipts, the DPGR
for each house is $217,500 ($300,000 - $75,000 - $7,500) with costs for each
house of $195,000. The results would be the same if X and Y were members
of the same EAG, provided X and Y were not members of the same consolidated
group.
Example 7. The facts are the same as in Example
6 except that Y is a member of the same consolidated group as X.
Pursuant to §1.1502-13(c)(1)(ii), Y’s holding period in the land
includes the period of time X held the land. In order to produce the same
effect as if X and Y were divisions of a single corporation (see §1.1502-13(c)(1)(i)),
for each house sold between January 31, 2012, and June 1, 2012, Y’s
DPGR are redetermined to be $237,000, the same as X’s DPGR for houses
sold between January 31, 2012, and June 1, 2012, in Example 5.
Y’s costs for each house do not have to be redetermined because Y’s
costs are $195,000, the same as the costs would be if X and Y were divisions
of a single corporation. For each house sold between June 2, 2012, and June
1, 2017, Y’s DPGR are redetermined to be $234,000, the same as X’s
DPGR for each house sold between June 2, 2012, and June 1, 2017, in Example
5. Y’s costs for each house do not have to be redetermined
because Y’s costs are $195,000, the same as the costs would be if X
and Y were divisions of a single corporation.
Example 8. X, who is engaged in the trade or business
of construction under NAICS code 23 on a regular and ongoing basis, purchases
land for development and builds an office building on the land. Y enters
into a contract with X to purchase the office building. As part of the contract,
X is required to furnish the office space with desks, chairs, and lamps.
Upon completion of the sale of the building, X uses the land safe harbor under
paragraph (m)(6)(iv) of this section to account for the land. After application
of the land safe harbor, X uses the de minimis exception
under paragraph (m)(1)(iii)(A) of this section in determining whether the
gross receipts derived from the sale of the desks, chairs, and lamps qualify
as DPGR. If the gross receipts derived from the sale of the desks, chairs,
and lamps are less than 5% of the total gross receipts derived by X from the
sale of the furnished office building (excluding any gross receipts taken
into account under the land safe harbor pursuant to paragraph (m)(6)(iv)(B)
of this section), then all of the gross receipts derived from the sale of
the furnished office building, after the reduction under the land safe harbor,
may be treated as DPGR.
(n) Definition of engineering and architectural services—(1)
In general. DPGR include gross receipts derived from
engineering or architectural services performed in the United States for a
construction project described in paragraph (m)(1)(i) of this section. At
the time the taxpayer performs the engineering or architectural services,
the taxpayer must be engaged in a trade or business (but not necessarily its
primary, or only, trade or business) that is considered engineering or architectural
services for purposes of the NAICS, for example NAICS codes 541330 (engineering
services) or 541310 (architectural services), on a regular and ongoing basis.
In the case of a newly-formed trade or business or a taxpayer in its first
taxable year, a taxpayer is considered to be engaged in a trade or business
on a regular and ongoing basis if the taxpayer reasonably expects that it
will engage in a trade or business on a regular and ongoing basis. DPGR include
gross receipts derived from engineering or architectural services, including
feasibility studies for a construction project in the United States, even
if the planned construction project is not undertaken or is not completed.
(2) Engineering services. Engineering services
in connection with any construction project include any professional services
requiring engineering education, training, and experience and the application
of special knowledge of the mathematical, physical, or engineering sciences
to those professional services such as consultation, investigation, evaluation,
planning, design, or responsible supervision of construction (for the purpose
of assuring compliance with plans, specifications, and design) or erection,
in connection with any construction project.
(3) Architectural services. Architectural services
in connection with any construction project include the offering or furnishing
of any professional services such as consultation, planning, aesthetic and
structural design, drawings and specifications, or responsible supervision
of construction (for the purpose of assuring compliance with plans, specifications,
and design) or erection, in connection with any construction project.
(4) Administrative support services. If the taxpayer
performing engineering or architectural services also provides administrative
support services (for example, billing and secretarial services) incidental
and necessary to such engineering or architectural services, then these administrative
support services are considered engineering or architectural services.
(5) Exceptions. Engineering or architectural
services do not include post-construction services such as annual audits and
inspections.
(6) De minimis exception for performance
of services in the United States—(i) DPGR.
If less than 5 percent of the total gross receipts derived by a taxpayer
from engineering or architectural services performed in the United States
for a construction project (described in paragraph (m)(1)(i) of this section)
are derived from services not relating to a construction project (for example,
the services are performed outside the United States or in connection with
property other than real property), then the total gross receipts derived
by the taxpayer may be treated as DPGR from engineering or architectural services
performed in the United States for the construction project. In the case
of gross receipts derived from engineering or architectural services that
are received over a period of time (for example, an installment sale), this de
minimis exception is applied by taking into account the total gross
receipts for the entire period derived (and to be derived) from engineering
or architectural services. For purposes of the preceding sentence, if a taxpayer
treats gross receipts as DPGR under this de minimis exception,
then the taxpayer must treat the gross receipts recognized in each taxable
year consistently as DPGR.
(ii) Non-DPGR. If less than 5 percent of
the total gross receipts derived by a taxpayer from engineering or architectural
services performed in the United States for a construction project qualify
as DPGR, then the total gross receipts derived by the taxpayer from engineering
or architectural services performed in the United States for the construction
project may be treated as non-DPGR. In the case of gross receipts derived
from engineering or architectural services that are received over a period
of time (for example, an installment sale), this de minimis exception
is applied by taking into account the total gross receipts for the entire
period derived (and to be derived) from engineering or architectural services.
For purposes of the preceding sentence, if a taxpayer treats gross receipts
as non-DPGR under this de minimis exception, then the
taxpayer must treat the gross receipts recognized in each taxable year consistently
as non-DPGR.
(7) Example. The following example illustrates
the application of this paragraph (n):
Example. X is engaged in the trade or business
of providing engineering services under NAICS code 541330 on a regular and
ongoing basis. Y buys unimproved land. Y hires X to provide engineering
services for roads, sewers, sidewalks, and power and water lines that qualify
as infrastructure under paragraph (m)(4) of this section and that will be
constructed on Y’s land. X’s gross receipts from engineering
services for the infrastructure are DPGR. X’s gross receipts from engineering
services relating to land (except as provided in paragraph (m)(2)(iii) of
this section) do not qualify as DPGR under paragraph (n)(1) of this section
because the gross receipts are not derived from engineering services for a
construction project described in paragraph (m)(1)(i) of this section.
(o) Sales of certain food and beverages—(1)
In general. DPGR does not include gross receipts of
the taxpayer that are derived from the sale of food or beverages prepared
by the taxpayer at a retail establishment. A retail establishment is defined
as tangible property (both real and personal) owned, leased, occupied, or
otherwise used by the taxpayer in its trade or business of selling food or
beverages to the public at which retail sales are made. In addition, a facility
that prepares food and beverages for take out service or delivery is a retail
establishment (for example, a caterer). If a taxpayer’s facility is
a retail establishment, then, for purposes of this section, the taxpayer may
allocate its gross receipts between the gross receipts derived from the retail
sale of the food and beverages prepared and sold at the retail establishment
(that are non-DPGR) and gross receipts derived from the wholesale sale of
the food and beverages prepared and sold at the retail establishment (that
are DPGR assuming all the other requirements of section 199 are met). Wholesale
sales are defined as food and beverages held for resale by the purchaser.
The exception for sales of certain food and beverages also applies to food
and beverages for non-human consumption. A retail establishment does not
include the bonded premises of a distilled spirits plant or wine cellar, or
the premises of a brewery (other than a tavern on the brewery premises).
See Chapter 51 of Title 26 of the United States Code and the implementing
regulations thereunder.
(2) De minimis exception.
A taxpayer may treat a facility at which food or beverages are prepared as
not being a retail establishment if less than 5 percent of the gross
receipts derived from the sale of food or beverages at that facility during
the taxable year are attributable to retail sales.
(3) Examples. The following examples illustrate
the application of this paragraph (o):
Example 1. X buys coffee beans and roasts those
beans at a facility in the United States, the only activity of which is the
roasting and packaging of coffee beans. X sells the roasted coffee beans
through a variety of unrelated third-party vendors and also sells roasted
coffee beans at X’s retail establishments. At X’s retail establishments,
X prepares brewed coffee and other foods. To the extent that the gross receipts
of X’s retail establishments are derived from the sale of coffee beans
roasted at the facility, the receipts are DPGR (assuming all the other requirements
of this section are met). To the extent the gross receipts of X’s retail
establishments are derived from the retail sale of brewed coffee or food prepared
at the retail establishments, the receipts are non-DPGR. However, pursuant
to §1.199-1(d)(1)(ii), X must allocate part of the receipts from the
retail sale of the brewed coffee as DPGR to the extent of the value of the
coffee beans that were roasted at the facility and that were used to brew
coffee.
Example 2. Y operates a bonded winery within the
United States. Bottles of wine produced by Y at the bonded winery are sold
to consumers at the taxpaid premises. Pursuant to paragraph (o)(1) of this
section, the bonded premises is not considered a retail establishment and
is treated as separate and apart from the taxpaid premises, which is considered
a retail establishment for purposes of paragraph (o)(1) of this section.
Accordingly, the wine produced by Y in the bonded premises and sold by Y from
the taxpaid premises is not considered to have been produced at a retail establishment,
and the gross receipts derived from the sales of the wine are DPGR (assuming
all the other requirements of this section are met).
(p) Guaranteed payments. DPGR does not include
guaranteed payments under section 707(c). Thus, partners, including partners
in partnerships described in §1.199-9(i) and (j), may not treat guaranteed
payments as DPGR. See §1.199-9(b)(6) Example 5.
§1.199-4 Costs allocable to domestic production gross
receipts.
(a) In general. The provisions of this section
apply solely for purposes of section 199 of the Internal Revenue Code (Code).
To determine its qualified production activities income (QPAI) (as defined
in §1.199-1(c)) for a taxable year, a taxpayer must subtract from its
domestic production gross receipts (DPGR) (as defined in §1.199-3(a))
the cost of goods sold (CGS) allocable to DPGR and other expenses, losses,
or deductions (deductions), other than the deduction allowed under section
199, that are properly allocable to such receipts. Paragraph (b) of this
section provides rules for determining CGS allocable to DPGR. Paragraph (c)
of this section provides rules for determining the deductions that are properly
allocable to DPGR. Paragraph (d) of this section provides that a taxpayer
generally must determine deductions allocable to DPGR or to gross income attributable
to DPGR using §§1.861-8 through 1.861-17 and §§1.861-8T
through 1.861-14T (the section 861 regulations), subject to the rules in paragraph
(d) of this section (the section 861 method). Paragraph (e) of this section
provides that certain taxpayers may apportion deductions to DPGR using the
simplified deduction method. Paragraph (f) of this section provides a small
business simplified overall method that a qualifying small taxpayer may use
to apportion CGS and deductions to DPGR.
(b) Cost of goods sold allocable to domestic production gross
receipts—(1) In general. When determining
its QPAI, a taxpayer must subtract from DPGR the CGS allocable to DPGR. A
taxpayer determines its CGS allocable to DPGR in accordance with this paragraph
(b) or, if applicable, paragraph (f) of this section. In the case of a sale,
exchange, or other disposition of inventory, CGS is equal to beginning inventory
plus purchases and production costs incurred during the taxable year and included
in inventory costs, less ending inventory. CGS is determined under the methods
of accounting that the taxpayer uses to compute taxable income. See sections
263A, 471, and 472. If section 263A requires a taxpayer to include additional
section 263A costs (as defined in §1.263A-1(d)(3)) in inventory, additional
section 263A costs must be included in determining CGS. CGS allocable to
DPGR also includes inventory valuation adjustments such as writedowns under
the lower of cost or market method. In the case of a sale, exchange, or other
disposition (including, for example, theft, casualty, or abandonment) of non-inventory
property, CGS for purposes of this section includes the adjusted basis of
the property. CGS allocable to DPGR for a taxable year may include the inventory
cost and adjusted basis of qualifying production property (QPP) (as defined
in §1.199-3(j)(1)), a qualified film (as defined in §1.199-3(k)(1)),
or electricity, natural gas, and potable water (as defined in §1.199-3(l))
(collectively, utilities) that will generate (or have generated) DPGR notwithstanding
that the gross receipts attributable to the sale, lease, rental, license,
exchange, or other disposition of the QPP, qualified film, or utilities will
be, or have been, included in the computation of gross income for a different
taxable year. For example, advance payments that are DPGR may be included
in gross income under §1.451-5(b)(1)(i) in a different taxable year than
the related CGS allocable to that DPGR. If gross receipts are treated as
DPGR pursuant to §1.199-1(d)(3)(i) or §1.199-3(i)(4)(i)(B)(6),
(l)(4)(iv)(A), (m)(1)(iii)(A), (n)(6)(i), or (o)(2), then CGS must be allocated
to such DPGR. Similarly, if gross receipts are treated as non-DPGR pursuant
to §1.199-1(d)(3)(ii) or §1.199-3(i)(4)(ii), (l)(4)(iv)(B), (m)(1)(iii)(B),
or (n)(6)(ii), then CGS must be allocated to such non-DPGR. See §1.199-3(m)(6)(iv)
for rules relating to treatment of certain costs in the case of a taxpayer
that uses the land safe harbor under that paragraph.
(2) Allocating cost of goods sold—(i) In
general. A taxpayer must use a reasonable method that is satisfactory
to the Secretary based on all of the facts and circumstances to allocate CGS
between DPGR and non-DPGR. Whether an allocation method is reasonable is
based on all of the facts and circumstances including whether the taxpayer
uses the most accurate information available; the relationship between CGS
and the method used; the accuracy of the method chosen as compared with other
possible methods; whether the method is used by the taxpayer for internal
management or other business purposes; whether the method is used for other
Federal or state income tax purposes; the availability of costing information;
the time, burden, and cost of using alternative methods; and whether the taxpayer
applies the method consistently from year to year. Depending on the facts
and circumstances, reasonable methods may include methods based on gross receipts,
number of units sold, number of units produced, or total production costs.
Ordinarily, if a taxpayer uses a method to allocate gross receipts between
DPGR and non-DPGR, then the use of a different method to allocate CGS that
is not demonstrably more accurate than the method used to allocate gross receipts
will not be considered reasonable. However, if a taxpayer has information
readily available to specifically identify CGS allocable to DPGR and can specifically
identify that amount without undue burden or expense, CGS allocable to DPGR
is that amount irrespective of whether the taxpayer uses another allocation
method to allocate gross receipts between DPGR and non-DPGR. A taxpayer that
does not have information readily available to specifically identify CGS allocable
to DPGR and that cannot, without undue burden or expense, specifically identify
that amount is not required to use a method that specifically identifies CGS
allocable to DPGR.
(ii) Gross receipts recognized in an earlier taxable year.
If a taxpayer (other than a taxpayer that uses the small business simplified
overall method of paragraph (f) of this section) recognizes and reports gross
receipts on a Federal income tax return for a taxable year, and incurs CGS
related to such gross receipts in a subsequent taxable year, then regardless
of whether the gross receipts ultimately qualify as DPGR, the taxpayer must
allocate the CGS to—
(A) DPGR if the taxpayer identified the related gross receipts as DPGR
in the prior taxable year; or
(B) Non-DPGR if the taxpayer identified the related gross receipts
as non-DPGR in the prior taxable year or if the taxpayer recognized under
the taxpayer’s methods of accounting those gross receipts in a taxable
year to which section 199 does not apply.
(3) Special rules for imported items or services.
The cost of any item or service brought into the United States (as defined
in §1.199-3(h)) without an arm’s length transfer price may not
be treated as less than its value immediately after it entered the United
States for purposes of determining the CGS to be used in the computation of
QPAI. Similarly, the adjusted basis of leased or rented property that gives
rise to DPGR that has been brought into the United States (as defined in §1.199-3(h))
without an arm’s length transfer price may not be treated as less than
its value immediately after it entered the United States. When an item or
service is imported into the United States that had been exported by the taxpayer
for further manufacture, the increase in cost may not exceed the difference
between the value of the property when exported and the value of the property
when imported back into the United States after further manufacture. For
this purpose, the value of property is its customs value as defined in section 1059A(b)(1).
(4) Rules for inventories valued at market or bona fide selling
prices. If part of CGS is attributable to inventory valuation
adjustments, then CGS allocable to DPGR includes inventory adjustments to
QPP that is MPGE in whole or in significant part within the United States,
a qualified film produced by the taxpayer, or utilities produced by the taxpayer
in the United States. Accordingly, taxpayers that value inventory under §1.471-4
(inventories at cost or market, whichever is lower) or §1.471-2(c) (subnormal
goods at bona fide selling prices) must allocate a proper
share of such adjustments (for example, writedowns) to DPGR based on a reasonable
method that is satisfactory to the Secretary based on all of the facts and
circumstances. Factors taken into account in determining whether the method
is reasonable include whether the taxpayer uses the most accurate information
available; the relationship between the adjustment and the allocation base
chosen; the accuracy of the method chosen as compared with other possible
methods; whether the method is used by the taxpayer for internal management
or other business purposes; whether the method is used for other Federal or
state income tax purposes; the time, burden, and cost of using alternative
methods; and whether the taxpayer applies the method consistently from year
to year. If a taxpayer has information readily available to specifically
identify the proper amount of inventory valuation adjustments allocable to
DPGR, then the taxpayer must allocate that amount to DPGR. A taxpayer that
does not have information readily available to specifically identify the proper
amount of inventory valuation adjustments allocable to DPGR and that cannot,
without undue burden or expense, specifically identify the proper amount of
inventory valuation adjustments allocable to DPGR, is not required to use
a method that specifically identifies inventory valuations adjustments to
DPGR.
(5) Rules applicable to inventories accounted for under the
last-in, first-out (LIFO) inventory method—(i) In
general. This paragraph applies to inventories accounted for using
the specific goods last-in, first-out (LIFO) method or the dollar-value LIFO
method. Whenever a specific goods grouping or a dollar-value pool contains
QPP, qualified films, or utilities that produces DPGR and goods that do not,
the taxpayer must allocate CGS attributable to that grouping or pool between
DPGR and non-DPGR using a reasonable method that is satisfactory to the Secretary
based on all of the facts and circumstances. Whether a method of allocating
CGS between DPGR and non-DPGR is reasonable must be determined in accordance
with paragraph (b)(2) of this section. In addition, this paragraph (b)(5)
provides methods that a taxpayer may use to allocate CGS for inventories accounted
for using the LIFO method. If a taxpayer uses the LIFO/FIFO ratio method
provided in paragraph (b)(5)(ii) of this section or the change in relative
base-year cost method provided in paragraph (b)(5)(iii) of this section, then
the taxpayer must use that method for all inventory accounted for under the
LIFO method.
(ii) LIFO/FIFO ratio method. A taxpayer using
the specific goods LIFO method or the dollar-value LIFO method may use the
LIFO/FIFO ratio method. The LIFO/FIFO ratio method is applied with respect
to all LIFO inventory of a taxpayer on a grouping-by-grouping or pool-by-pool
basis. Under the LIFO/FIFO ratio method, a taxpayer computes the CGS of a
grouping or pool allocable to DPGR by multiplying the CGS of QPP, qualified
films, or utilities in the grouping or pool that produced DPGR computed using
the first-in, first-out (FIFO) method by the LIFO/FIFO ratio of the grouping
or pool. The LIFO/FIFO ratio of a grouping or pool is equal to the total CGS
of the grouping or pool computed using the LIFO method over the total CGS
of the grouping or pool computed using the FIFO method.
(iii) Change in relative base-year cost method.
A taxpayer using the dollar-value LIFO method may use the change in relative
base-year cost method. The change in relative base-year cost method is applied
with respect to all LIFO inventory of a taxpayer on a pool-by-pool basis.
The change in relative base-year cost method determines the CGS allocable
to DPGR by increasing or decreasing the total production costs (section 471
costs and additional section 263A costs) of QPP, a qualified film, or utilities
that generate DPGR by a portion of any increment or liquidation of the dollar-value
pool. The portion of an increment or liquidation allocable to DPGR is determined
by multiplying the LIFO value of the increment or liquidation (expressed as
a positive number) by the ratio of the change in total base-year cost (expressed
as a positive number) of the QPP, qualified film, or utilities that will generate
DPGR in ending inventory to the change in total base-year cost (expressed
as a positive number) of all goods in the ending inventory. The portion of
an increment or liquidation allocable to DPGR may be zero but cannot exceed
the amount of the increment or liquidation. Thus, a ratio in excess of 1.0
must be treated as 1.0.
(6) Taxpayers using the simplified production method or simplified
resale method for additional section 263A costs. A taxpayer that
uses the simplified production method or simplified resale method to allocate
additional section 263A costs, as defined in §1.263A-1(d)(3), to ending
inventory must follow the rules in paragraph (b)(2) of this section to determine
the amount of additional section 263A costs allocable to DPGR. Allocable
additional section 263A costs include additional section 263A costs included
in beginning inventory as well as additional section 263A costs incurred during
the taxable year. Ordinarily, if a taxpayer uses the simplified production
method or the simplified resale method, the additional section 263A costs
should be allocated in the same proportion as section 471 costs are allocated.
(7) Examples. The following examples illustrate
the application of this paragraph (b) and assume that the taxpayer does not
use the small business simplified overall method provided in paragraph (f)
of this section:
Example 1. Advance payments.
T, a calendar year taxpayer, is a manufacturer of furniture in the United
States. Under its method of accounting, T includes advance payments and other
gross receipts derived from the sale of furniture in gross income when the
payments are received. In December 2007, T receives an advance payment of
$5,000 from X with respect to an order of furniture to be manufactured for
a total price of $20,000. In 2008, T produces and sells the furniture to
X. In 2008, T incurs $14,000 of section 471 and additional section 263A costs
to produce the furniture ordered by X. T receives the remaining
$15,000 of the contract price from X in 2008. Assuming that in 2007, T can
reasonably determine that all the requirements of §§1.199-1 and
1.199-3 will be met with respect to the furniture, the advance payment qualifies
as DPGR in 2007. Assuming further that all the requirements of §§1.199-1
and 1.199-3 are met with respect to the furniture in 2008, the remaining $15,000
of the contract price must be included in income and DPGR when received by
T in 2008. T must include the $14,000 it incurred to produce the furniture
in CGS and CGS allocable to DPGR in 2008. See §1.199-4(b)(2)(ii) for
rules regarding gross receipts and costs recognized in different taxable years.
Example 2. Use of standard cost method.
X, a calendar year taxpayer, manufactures item A in a factory located in
the United States and item B in a factory located in Country Y. Item A is
produced by X within the United States and the sale of A generates DPGR.
X uses the FIFO inventory method to account for its inventory and determines
the cost of item A using a standard cost method. At the beginning of its
2007 taxable year, X’s inventory contains 2,000 units of item A at a
standard cost of $5 per unit. X did not incur significant cost variances
in previous taxable years. During the 2007 taxable year, X produces 8,000
units of item A at a standard cost of $6 per unit. X determines that with
regard to its production of item A it has incurred a significant cost variance.
When X reallocates the cost variance to the units of item A that it has produced,
the production cost of item A is $7 per unit. X sells 7,000 units of item
A during the taxable year. X can identify from its books and records that
CGS related to the sales of item A during the taxable year are $45,000 ((2,000
x $5) + (5,000 x $7)). Accordingly, X has CGS allocable to DPGR of $45,000.
Example 3. Change in relative base-year
cost method. (i) Y elects, beginning with the calendar year 2007,
to compute its inventories using the dollar-value, LIFO method under section
472. Y establishes a pool for items A and B. Y produces item A within the
United States and the sales of item A generate DPGR. Y does not produce item
B within the United States and the sale of item B does not generate DPGR.
The composition of the inventory for the pool at the base date, January 1,
2007, is as follows:
(ii) Y uses a standard cost method to allocate all direct and indirect
costs (section 471 and additional section 263A costs) to the units
of item A and item B that it produces. During 2007, Y incurs $52,500 of section
471 costs and additional section 263A costs to produce 10,000 units of item
A and $114,000 of section 471 costs and additional section 263A costs to produce
20,000 units of item B.
(iii) The closing inventory of the pool at December 31, 2007, contains
3,000 units of item A and 2,500 units of item B. The closing inventory of
the pool at December 31, 2007, shown at base-year and current-year cost is
as follows:
(iv) The base-year cost of the closing LIFO inventory at December 31,
2007, amounts to $25,000, and exceeds the $15,000 base-year cost of the opening
inventory for the taxable year by $10,000 (the increment stated at base-year
cost). The increment valued at current-year cost is computed by multiplying
the increment stated at base-year cost by the ratio of the current-year cost
of the pool to total base-year cost of the pool (that is, $30,000/$25,000,
or 120%). The increment stated at current-year cost is $12,000 ($10,000 x
120%).
(v) The change in relative base-year cost of item A is $5,000 ($15,000
- $10,000). The change in relative base-year cost (the increment stated at
base-year cost) of the total inventory is $10,000 ($25,000 - $15,000). The
ratio of the change in base-year cost of item A to the change in base-year
cost of the total inventory is 50% ($5,000/$10,000).
(vi) CGS allocable to DPGR is $46,500, computed as follows:
Example 4. Change in relative base-year
cost method. (i) The facts are the same as in Example
3 except that, during the calendar year 2008, Y experiences an
inventory decrement. During 2008, Y incurs $66,000 of section 471 costs and
additional section 263A costs to produce 12,000 units of item A and $150,000
of section 471 costs and additional section 263A costs to produce 25,000 units
of item B.
(ii) The closing inventory of the pool at December 31, 2008, contains
2,000 units of item A and 2,500 units of item B. The closing inventory of
the pool at December 31, 2008, shown at base-year and current-year cost is
as follows:
(iii) The base-year cost of the closing LIFO inventory at December
31, 2008, amounts to $20,000, and is less than the $25,000 base-year cost
of the opening inventory for that taxable year by $5,000 (the decrement stated
at base-year cost). This liquidation is reflected by reducing the most recent
layer of increment. The LIFO value of the inventory at December 31, 2008
is:
(iv) The change in relative base-year cost of item A is $5,000 ($15,000
- $10,000). The change in relative base-year cost of the total inventory is
$5,000 ($25,000 - $20,000). The ratio of the change in base-year cost of
item A to the change in base-year cost of the total inventory is 100% ($5,000/$5,000).
(v) CGS allocable to DPGR is $72,000, computed as follows:
Example 5. LIFO/FIFO ratio method.
(i) The facts are the same as in Example 3 except that
Y uses the LIFO/FIFO ratio method to determine its CGS allocable to DPGR.
(ii) Y’s CGS related to item A on a FIFO basis is $46,750 ((2,000
units at $5) + (7,000 units at $5.25)).
(iii) Y’s total CGS computed on a LIFO basis is $154,500 (beginning
inventory of $15,000 plus total production costs of $166,500 less ending inventory
of $27,000).
(iv) Y’s total CGS computed on a FIFO basis is $151,500 (beginning
inventory of $15,000 plus total production costs of $166,500 less ending inventory
of $30,000).
(v) The ratio of Y’s CGS computed using the LIFO method to its
CGS computed using the FIFO method is 102% ($154,500/$151,500). Y’s
CGS related to DPGR computed using the LIFO/FIFO ratio method is $47,685 ($46,750
x 102%).
Example 6. LIFO/FIFO ratio method.
(i) The facts are the same as in Example 4 except that
Y uses the LIFO/FIFO ratio method to compute CGS allocable to DPGR.
(ii) Y’s CGS related to item A on a FIFO basis is $70,750 ((3,000
units at $5.25) + (10,000 units at $5.50)).
(iii) Y’s total CGS computed on a LIFO basis is $222,000 (beginning
inventory of $27,000 plus total production costs of $216,000 less ending inventory
of $21,000).
(iv) Y’s total CGS computed on a FIFO basis is $220,000 (beginning
inventory of $30,000 plus total production costs of $216,000 less ending inventory
of $26,000).
(v) The ratio of Y’s CGS computed using the LIFO method to its
CGS computed using the FIFO method is 101% ($222,000/$220,000). Y’s
CGS related to DPGR computed using the LIFO/FIFO ratio method is $71,457 ($70,750
x 101%).
(c) Other deductions properly allocable to domestic production
gross receipts or gross income attributable to domestic production gross receipts—(1)
In general. In determining its QPAI, a taxpayer must
subtract from its DPGR, in addition to its CGS allocable to DPGR, the deductions
that are properly allocable to DPGR. A taxpayer generally must allocate and
apportion these deductions using the rules of the section 861 method.
In lieu of the section 861 method, certain taxpayers may apportion these
deductions using the simplified deduction method provided in paragraph (e)
of this section. Paragraph (f) of this section provides a small business
simplified overall method that may be used by a qualifying small taxpayer,
as defined in that paragraph. A taxpayer using the simplified deduction method
or the small business simplified overall method must use that method for all
deductions. A taxpayer eligible to use the small business simplified overall
method may choose at any time for any taxable year to use the small business
simplified overall method, the simplified deduction method, or the section
861 method for a taxable year. A taxpayer eligible to use the simplified
deduction method may choose at any time for any taxable year to use the simplified
deduction method or the section 861 method for a taxable year.
(2) Treatment of net operating losses. A deduction
under section 172 for a net operating loss is not allocated or apportioned
to DPGR or gross income attributable to DPGR.
(3) W-2 wages. Although only W-2 wages as described
in §1.199-2 are taken into account in computing the W-2 wage limitation,
all wages paid (or incurred in the case of an accrual method taxpayer) in
a taxpayer’s trade or business during the taxable year are taken into
account in computing QPAI for that taxable year.
(d) Section 861 method—(1) In
general. Under the section 861 method, a taxpayer must allocate
and apportion its deductions using the allocation and apportionment rules
provided under the section 861 regulations under which section 199 is treated
as an operative section described in §1.861-8(f). Accordingly, the taxpayer
applies the rules of the section 861 regulations to allocate and apportion
deductions (including, if applicable, its distributive share of deductions
from pass-thru entities) to gross income attributable to DPGR. Gross receipts
that are allocable to land under the safe harbor provided in §1.199-3(m)(6)(iv)
are treated as non-DPGR. See §1.199-3(m)(6)(iv)(B). If the taxpayer
applies the allocation and apportionment rules of the section 861 regulations
for section 199 and another operative section, then the taxpayer must use
the same method of allocation and the same principles of apportionment for
purposes of all operative sections (subject to the rules provided in paragraphs
(c)(2) and (d)(2) and (3) of this section). See §1.861-8(f)(2)(i).
(2) Deductions for charitable contributions.
Deductions for charitable contributions (as allowed under section 170 and
section 873(b)(2) or 882(c)(1)(B)) must be ratably apportioned between gross
income attributable to DPGR and gross income attributable to non-DPGR based
on the relative amounts of gross income.
(3) Research and experimental expenditures. Research
and experimental expenditures must be allocated and apportioned in accordance
with §1.861-17 without taking into account the exclusive apportionment
rule of §1.861-17(b).
(4) Deductions allocated or apportioned to gross receipts
treated as domestic production gross receipts. If gross receipts
are treated as DPGR pursuant to §1.199-1(d)(3)(i) or §1.199-3(i)(4)(i)(B)(6),
(l)(4)(iv)(A), (m)(1)(iii)(A), (n)(6)(i), or (o)(2), then deductions must
be allocated or apportioned to the gross income attributable to such DPGR.
Similarly, if gross receipts are treated as non-DPGR pursuant to §1.199-1(d)(3)(ii)
or §1.199-3(i)(4)(ii), (l)(4)(iv)(B), (m)(1)(iii)(B), or (n)(6)(ii),
then deductions must be allocated or apportioned to the gross income attributable
to such non-DPGR.
(5) Treatment of items from a pass-thru entity reporting
qualified production activities income. If, pursuant to §1.199-9(e)(2)
or to the authority granted in §1.199-9(b)(1)(ii) or (c)(1)(ii), a taxpayer
must combine QPAI and W-2 wages from a partnership, S corporation, trust (to
the extent not described in §1.199-9(d)) or estate with the taxpayer’s
total QPAI and W-2 wages from other sources, then for purposes of apportioning
the taxpayer’s interest expense under this paragraph §1.199-4(d),
the taxpayer’s interest in such partnership (and, where relevant in
apportioning the taxpayer’s interest expense, the partnership’s
assets), the taxpayer’s shares in such S corporation, or the taxpayer’s
interest in such trust shall be disregarded.
(6) Examples. The following examples illustrate
the operation of the section 861 method. Assume in the following examples
that all corporations are calendar year taxpayers, that all taxpayers have
sufficient W-2 wages as defined in §1.199-2(e) so that the section 199
deduction is not limited under section 199(b)(1), and that, with respect to
the allocation and apportionment of interest expense, §1.861-10T does
not apply.
Example 1. Section 861 method and no
EAG. (i) Facts. X, a United States corporation
that is not a member of an expanded affiliated group (EAG) (as defined in
§1.199-7), engages in activities that generate both DPGR and non-DPGR.
All of X’s production activities that generate DPGR are within Standard
Industrial Classification (SIC) Industry Group AAA (SIC AAA). All of X’s
production activities that generate non-DPGR are within SIC Industry Group
BBB (SIC BBB). X is able to specifically identify CGS allocable to DPGR and
to non-DPGR. X incurs $900 of research and experimentation expenses (R&E)
that are deductible under section 174, $300 of which are performed with respect
to SIC AAA and $600 of which are performed with respect to SIC BBB. None
of the R&E is legally mandated R&E as described in §1.861-17(a)(4)
and none of the R&E is included in CGS. X incurs section 162 selling
expenses that are not includible in CGS and are definitely related to all
of X’s gross income. For 2010, the adjusted basis of X’s assets
is $5,000, $4,000 of which generates gross income attributable to DPGR and
$1,000 of which generates gross income attributable to non-DPGR. For 2010,
X’s taxable income is $1,380 based on the following Federal income tax
items:
(ii) X’s QPAI. X allocates and apportions
its deductions to gross income attributable to DPGR under the section 861
method of this paragraph (d). In this case, the section 162 selling expenses
are definitely related to all of X’s gross income. Based on the facts
and circumstances of this specific case, apportionment of those expenses between
DPGR and non-DPGR on the basis of X’s gross receipts is appropriate.
For purposes of apportioning R&E, X elects to use the sales method as
described in §1.861-17(c). X elects to apportion interest expense under
the tax book value method of §1.861-9T(g). X has $2,400 of gross income
attributable to DPGR (DPGR of $3,000 - CGS of $600 allocated based on X’s
books and records). X’s QPAI for 2010 is $1,320, as shown below:
(iii) Section 199 deduction determination. X’s
tentative deduction under §1.199-1(a) is $119 (.09 x (lesser of QPAI
of $1,320 and taxable income of $1,380)). Because the facts of this example
assume that X’s W-2 wages as defined in §1.199-2(e) are sufficient
to avoid a limitation on the section 199 deduction, X’s section 199
deduction for 2010 is $119.
Example 2. Section 861 method and EAG.
(i) Facts. The facts are the same as in Example
1 except that X owns stock in Y, a United States corporation, equal
to 75% of the total voting power of stock of Y and 80% of the total value
of stock of Y. X and Y are not members of an affiliated group as defined
in section 1504(a). Accordingly, the rules of §1.861-14T do not apply
to X’s and Y’s selling expenses, R&E, and charitable contributions.
X and Y are, however, members of an affiliated group for purposes of allocating
and apportioning interest expense (see §1.861-11T(d)(6)) and are also
members of an EAG. For 2010, the adjusted basis of Y’s assets is $45,000,
$21,000 of which generates gross income attributable to DPGR and $24,000 of
which generates gross income attributable to non-DPGR. All of Y’s activities
that generate DPGR are within SIC Industry Group AAA (SIC AAA). All of Y’s
activities that generate non-DPGR are within SIC Industry Group BBB (SIC BBB).
None of X’s and Y’s sales are to each other. Y is not able to
specifically identify CGS allocable to DPGR and non-DPGR. In this case, because
CGS is definitely related under the facts and circumstances to all of Y’s
gross receipts, apportionment of CGS between DPGR and non-DPGR based on gross
receipts is appropriate. For 2010, Y’s taxable income is $1,910 based
on the following Federal income tax items:
(ii) QPAI. (A) X’s QPAI.
Determination of X’s QPAI is the same as in Example 1 except
that interest is apportioned to gross income attributable to DPGR based on
the combined adjusted bases of X’s and Y’s assets. See §1.861-11T(c).
Accordingly, X’s QPAI for 2010 is $1,410, as shown below:
(B) Y’s QPAI. Y makes the same elections
under the section 861 method as does X. Y has $1,800 of gross income attributable
to DPGR (DPGR of $3,000 - CGS of $1,200 allocated based on Y’s gross
receipts). Y’s QPAI for 2010 is $1,005, as shown below:
(iii) Section 199 deduction determination. The
section 199 deduction of the X and Y EAG is determined by aggregating the
separately determined QPAI, taxable income, and W-2 wages of X and Y. See
§1.199-7(b). Accordingly, the X and Y EAG’s tentative section
199 deduction is $217 (.09 x (lesser of combined taxable incomes of X and
Y of $3,290 (X’s taxable income of $1,380 plus Y’s taxable income
of $1,910) and combined QPAI of $2,415 (X’s QPAI of $1,410 plus Y’s
QPAI of $1,005)). Because the facts of this example assume that the W-2 wages
of X and Y are sufficient to avoid a limitation on the section 199 deduction,
X and Y EAG’s section 199 deduction for 2010 is $217. The $217 is allocated
to X and Y in proportion to their QPAI. See §1.199-7(c).
(e) Simplified deduction method—(1) In
general. An eligible taxpayer may use the simplified deduction
method to apportion deductions between DPGR and non-DPGR. The simplified
deduction method does not apply to CGS. Under the simplified deduction method,
a taxpayer’s deductions (except the net operating loss deduction as
provided in paragraph (c)(2) of this section) are ratably apportioned between
DPGR and non-DPGR based on relative gross receipts. Accordingly, the amount
of deductions for the current taxable year apportioned to DPGR is equal to
the same proportion of the total deductions for the current taxable year that
the amount of DPGR bears to total gross receipts. Gross receipts that are
allocable to land under the safe harbor provided in §1.199-3(m)(6)(iv)
are treated as non-DPGR. See §1.199-3(m)(6)(iv)(B). Whether a trust
(to the extent not described in §1.199-9(d)) or an estate may use the
simplified deduction method is determined at the trust or estate level. If
a trust or estate qualifies to use the simplified deduction method, the simplified
deduction method must be applied at the trust or estate level, taking into
account the trust’s or estate’s DPGR, non-DPGR, and other items
from all sources, including its distributive or allocable share of those items
of any lower-tier entity, prior to any charitable or distribution deduction.
Whether the owner of a pass-thru entity may use the simplified deduction
method is determined at the level of the entity’s owner. If the owner
of a pass-thru entity qualifies and uses the simplified deduction method,
then the simplified deduction method is applied at the level of the owner
of the pass-thru entity taking into account the owner’s DPGR, non-DPGR,
and other items from all sources including its distributive or allocable share
of those items of the pass-thru entity.
(2) Eligible taxpayer. For purposes of this paragraph
(e), an eligible taxpayer is—
(i) A taxpayer that has average annual gross receipts (as defined in
paragraph (g) of this section) of $100,000,000 or less; or
(ii) A taxpayer that has total assets (as defined in paragraph (e)(3)
of this section) of $10,000,000 or less.
(3) Total assets—(i) In general.
For purposes of the simplified deduction method, total assets means the total
assets the taxpayer has at the end of the taxable year. In the case of a
C corporation, the corporation’s total assets at the end of the taxable
year is the amount required to be reported on Schedule L of Form 1120, “United
States Corporation Income Tax Return,” in accordance with
the Form 1120 instructions.
(ii) Members of an expanded affiliated group.
To compute the total assets of an EAG, the total assets at the end of the
taxable year of each corporation that is a member of the EAG at the end of
the taxable year that ends with or within the taxable year of the computing
member (as described in §1.199-7(h)) are aggregated. For purposes of
this paragraph, a consolidated group is treated as one member of the EAG.
(4) Members of an expanded affiliated group—(i)
In general. Whether the members of an EAG may use the
simplified deduction method is determined by reference to all the members
of the EAG. If the average annual gross receipts of the EAG are less than
or equal to $100,000,000 or the total assets of the EAG are less than or equal
to $10,000,000, then each member of the EAG may individually determine whether
to use the simplified deduction method, regardless of the cost allocation
method used by the other members.
(ii) Exception. Notwithstanding paragraph (e)(4)(i)
of this section, all members of the same consolidated group must use the same
cost allocation method.
(iii) Examples. The following examples illustrate
the application of paragraph (e) of this section:
Example 1. Corporations X, Y, and Z are the only
three members of an EAG. Neither X, Y, nor Z is a member of a consolidated
group. X, Y, and Z have average annual gross receipts of $20,000,000, $70,000,000,
and $5,000,000, respectively. X, Y, and Z each have total assets at the end
of the taxable year of $5,000,000. Because the average annual gross receipts
of the EAG are less than or equal to $100,000,000, each of X, Y, and Z may
use either the simplified deduction method or the section 861 method.
Example 2. The facts are the same as in Example
1 except that X and Y are members of the same consolidated group.
X, Y, and Z may use either the simplified deduction method or the section
861 method. However, X and Y must use the same cost allocation method.
Example 3. The facts are the same as in Example
1 except that Z’s average annual gross receipts are $15,000,000.
Because the average annual gross receipts of the EAG are greater than $100,000,000
and the total assets of the EAG at the end of the taxable year are greater
than $10,000,000, X, Y, and Z must each use the section 861 method.
(f) Small business simplified overall method—(1)
In general. A qualifying small taxpayer may use the
small business simplified overall method to apportion CGS and deductions between
DPGR and non-DPGR. Under the small business simplified overall method, a
taxpayer’s total costs for the current taxable year (as defined in paragraph
(f)(3) of this section) are apportioned between DPGR and non-DPGR based on
relative gross receipts. Accordingly, the amount of total costs for the current
taxable year apportioned to DPGR is equal to the same proportion of total
costs for the current taxable year that the amount of DPGR bears to total
gross receipts. Total gross receipts for this purpose do not include gross
receipts that are allocated to land under the land safe harbor provided in
§1.199-3(m)(6)(iv). See §1.199-3(m)(6)(iv)(B).
(2) Qualifying small taxpayer. Except as provided
in paragraph (f)(5), for purposes of this paragraph (f), a qualifying
small taxpayer is—
(i) A taxpayer that has average annual gross receipts (as defined in
paragraph (g) of this section) of $5,000,000 or less;
(ii) A taxpayer that is engaged in the trade or business of farming
that is not required to use the accrual method of accounting under section
447; or
(iii) A taxpayer that is eligible to use the cash method as provided
in Rev. Proc. 2002-28, 2002-1 C.B. 815 (that is, certain taxpayers with average
annual gross receipts of $10,000,000 or less that are not prohibited from
using the cash method under section 448, including partnerships, S corporations,
C corporations, or individuals). See §601.601(d)(2) of this chapter.
(3) Total costs for the current taxable year—(i)
In general. For purposes of the small business simplified
overall method, total costs for the current taxable year means the total CGS
and deductions (excluding the net operating loss deduction as provided in
paragraph (c)(2) of this section) for the current taxable year. Total costs
for the current taxable year are determined under the methods of accounting
that the taxpayer uses to compute taxable income.
(ii) Land safe harbor. A taxpayer that uses the
land safe harbor provided in §1.199-3(m)(6)(iv) must reduce total costs
for the current taxable year by the costs of land and any other costs capitalized
to the land (except costs for activities listed in §1.199-3(m)(2)(iii))
prior to applying the small business simplified overall method. See §1.199-3(m)(6)(iv)(B).
For example, if a taxpayer has $1,000 of total costs for the current taxable
year and $600 of such costs is attributable to land under the land safe harbor,
then only $400 of such costs is apportioned between DPGR and non-DPGR under
the small business simplified overall method.
(4) Members of an expanded affiliated group—(i)
In general. Whether the members of an EAG may use the
small business simplified overall method is determined by reference to all
the members of the EAG. If the average annual gross receipts of the EAG are
less than or equal to $5,000,000, the EAG (viewed as a single corporation)
is engaged in the trade or business of farming that is not required to use
the accrual method of accounting under section 447, or the EAG (viewed as
a single corporation) is eligible to use the cash method as provided in Rev.
Proc. 2002-28, then each member of the EAG may individually determine whether
to use the small business simplified overall method, regardless of the cost
allocation method used by the other members.
(ii) Exception. Notwithstanding paragraph (f)(4)(i)
of this section, all members of the same consolidated group must use the same
cost allocation method.
(iii) Examples. The following examples illustrate
the application of paragraph (f) of this section:
Example 1. Corporations L, M, and N are the only
three members of an EAG. Neither L, M, nor N is a member of a consolidated
group. L, M, and N have average annual gross receipts for the current taxable
year of $1,000,000, $1,500,000, and $2,000,000, respectively. Because the
average annual gross receipts of the EAG are less than or equal to $5,000,000,
each of L, M, and N may use the small business simplified overall method,
the simplified deduction method, or the section 861 method.
Example 2. The facts are the same as in Example
1 except that M and N are members of the same consolidated group.
L, M, and N may use the small business simplified overall method, the simplified
deduction method, or the section 861 method. However, M and N must use the
same cost allocation method.
Example 3. The facts are the same as in Example
1 except that N has average annual gross receipts of $4,000,000.
Unless the EAG, viewed as a single corporation, is engaged in the trade or
business of farming that is not required to use the accrual method of accounting
under section 447, or the EAG, viewed as a single corporation, is eligible
to use the cash method as provided in Rev. Proc. 2002-28, because the average
annual gross receipts of the EAG are greater than $5,000,000, L, M, and N
are all ineligible to use the small business simplified overall method.
(5) Trusts and estates. Trusts and estates under
§1.199-9(e) may not use the small business simplified overall method.
(g) Average annual gross receipts—(1) In
general. For purposes of the simplified deduction method and the
small business simplified overall method, average annual gross receipts means
the average annual gross receipts of the taxpayer (including gross receipts
attributable to the sale, exchange, or other disposition of land under the
land safe harbor provided in §1.199-3(m)(6)(iv)) for the 3 taxable years
(or, if fewer, the taxable years during which the taxpayer was in existence)
preceding the current taxable year, even if one or more of such taxable years
began before the effective date of section 199. In the case of any taxable
year of less than 12 months (a short taxable year), the gross receipts shall
be annualized by multiplying the gross receipts for the short period by 12
and dividing the result by the number of months in the short period.
(2) Members of an expanded affiliated group.
To compute the average annual gross receipts of an EAG, the gross receipts,
for the entire taxable year, of each corporation that is a member of the EAG
at the end of its taxable year that ends with or within the taxable year of
the computing member are aggregated. For purposes of this paragraph, a consolidated
group is treated as one member of the EAG.
§1.199-5 Application of section 199 to pass-thru entities
for taxable years beginning after May 17, 2006, the enactment date of the
Tax Increase Prevention and Reconciliation Act of 2005. [Reserved].
§1.199-6 Agricultural and horticultural cooperatives.
(a) In general. A patron who receives a qualified
payment (as defined in paragraph (e) of this section) from a specified agricultural
or horticultural cooperative (cooperative) (as defined in paragraph (f) of
this section) is allowed a deduction under §1.199-1(a) (section 199 deduction)
for the taxable year the qualified payment is received for the portion of
the cooperative’s section 199 deduction passed through to the patron
and identified by the cooperative in a written notice mailed to the person
during the payment period described in section 1382(d). The provisions of
this section apply solely for purposes of section 199 of the Internal Revenue
Code (Code).
(b) Cooperative denied section 1382 deduction for portion
of qualified payments. A cooperative must reduce its
section 1382 deduction by an amount equal to the portion of any qualified
payment that is attributable to the cooperative’s section 199 deduction
passed through to the patron.
(c) Determining cooperative’s taxable income.
For purposes of determining its section 199 deduction, the cooperative’s
taxable income is computed without taking into account any deduction allowable
under section 1382(b) or (c) (relating to patronage dividends, per-unit retain
allocations, and nonpatronage distributions).
(d) Special rule for marketing cooperatives.
In the case of a cooperative engaged in the marketing of agricultural and/or
horticultural products described in paragraph (f) of this section, the cooperative
is treated as having manufactured, produced, grown, or extracted (MPGE) (as
defined in §1.199-3(e)) in whole or in significant part (as defined in
§1.199-3(g)) within the United States (as defined in §1.199-3(h))
any agricultural or horticultural products marketed by the cooperative that
its patrons have MPGE.
(e) Qualified payment. The term qualified
payment means any amount of a patronage dividend or per-unit retain
allocation, as described in section 1385(a)(1) or (3) received by a patron
from a cooperative, that is attributable to the portion of the cooperative’s
qualified production activities income (QPAI) (as defined in §1.199-1(c)),
for which the cooperative is allowed a section 199 deduction. For this purpose,
patronage dividends and per-unit retain allocations include any advances on
patronage and per-unit retains paid in money during the taxable year.
(f) Specified agricultural or horticultural cooperative.
A specified agricultural or horticultural cooperative means
a cooperative to which Part I of subchapter T of the Code applies and the
cooperative has MPGE in whole or significant part within the United States
any agricultural or horticultural product, or has marketed agricultural or
horticultural products. For this purpose, agricultural or horticultural products
also include fertilizer, diesel fuel, and other supplies used in agricultural
or horticultural production.
(g) Written notice to patrons. In order for a
patron to qualify for the section 199 deduction, paragraph (a) of this section
requires that the cooperative identify in a written notice the patron’s
portion of the section 199 deduction that is attributable to the portion
of the cooperative’s QPAI for which the cooperative is allowed a section
199 deduction. This written notice must be mailed by the cooperative
to its patrons no later than the 15th day of the ninth month following the
close of the taxable year. The cooperative may use the same written notice,
if any, that it uses to notify patrons of their respective allocations of
patronage dividends, or may use a separate timely written notice(s) to comply
with this section. The cooperative must report the amount of the patron’s
section 199 deduction on Form 1099-PATR, “Taxable Distributions
Received From Cooperatives,” issued to the patron.
(h) Additional rules relating to passthrough of section 199
deduction. The cooperative may, at its discretion, pass through
all, some, or none of the section 199 deduction to its patrons. However,
the cooperative may not apply section 199(d)(3) and this section to any portion
of the section 199 deduction that is not passed through to its patrons. A
cooperative member of a federated cooperative may pass through the section
199 deduction it receives from the federated cooperative to its member patrons. Patrons
may claim the section 199 deduction for the taxable year in which they
receive the written notice from the cooperative informing them of the section
199 amount without regard to the taxable income limitation under §1.199-1(a)
and (b).
(i) W-2 wages. The W-2 wage limitation described
in §1.199-2 shall be applied at the cooperative level whether or not
the cooperative chooses to pass through some or all of the section 199 deduction.
Any section 199 deduction that has been passed through by a cooperative to
its patrons is not subject to the W-2 wage limitation a second time at the
patron level.
(j) Recapture of section 199 deduction. If the
amount of the section 199 deduction that was passed through to patrons
exceeds the amount allowable as a section 199 deduction as determined on audit
or reported on an amended return, then recapture of the excess will occur
at the cooperative level in the taxable year the cooperative took the excess
section 199 deduction amount into account.
(k) Section is exclusive. This section is the
exclusive method for cooperatives and their patrons to compute the amount
of the section 199 deduction. Thus, a patron may not deduct any amount with
respect to a patronage dividend or a per-unit retain allocation unless the
requirements of this section are satisfied.
(l) No double counting. To the extent a cooperative
passes through the section 199 deduction to a patron, a qualified payment
received by the patron of the cooperative is not taken in account for purposes
of section 199.
(m) Examples. The following examples illustrate
the application of this section:
Example 1. (i) Cooperative X markets corn grown
by its members within the United States for sale to retail grocers. For its
calendar year ended December 31, 2007, Cooperative X has gross receipts of
$1,500,000, all derived from the sale of corn grown by its members within
the United States. Cooperative X pays $370,000 for its members’ corn
and its W-2 wages (as defined in §1.199-2(e)) for 2007 total $130,000.
Cooperative X has no other costs. Patron A is a member of Cooperative X.
Patron A is a cash basis taxpayer and files Federal income tax returns on
a calendar year basis. All corn grown by Patron A in 2007 is sold through
Cooperative X and Patron A is eligible to share in patronage dividends paid
by Cooperative X for that year.
(ii) Cooperative X is a cooperative described in paragraph (f) of this
section. Accordingly, this section applies to Cooperative X and its patrons
and all of Cooperative X’s gross receipts from the sale of its patrons’
corn qualify as domestic production gross receipts (as defined §1.199-3(a)).
Cooperative X’s QPAI is $1,000,000. Cooperative X’s section
199 deduction for its taxable year 2007 is $60,000 (.06 x $1,000,000). Because
this amount is less than 50% of Cooperative X’s W-2 wages, the entire
amount is allowed as a section 199 deduction subject to the rules of section
199(d)(3) and this section.
Example 2. (i) The facts are the same as in Example
1 except that Cooperative X decides to pass its entire section
199 deduction through to its members. Cooperative X declares a patronage
dividend for its 2007 taxable year of $1,000,000, which it pays on March 15,
2008. Pursuant to paragraph (g) of this section, Cooperative X notifies members
in written notices that accompany the patronage dividend notification that
it is allocating to them the section 199 deduction it is entitled to claim
in the taxable year 2007. On March 15, 2008, Patron A receives a $10,000
patronage dividend that is a qualified payment under paragraph (e) of this
section from Cooperative X. In the notice that accompanies the patronage
dividend, Patron A is designated a $600 section 199 deduction. Under paragraph
(a) of this section, Patron A must claim a $600 section 199 deduction for
the taxable year ending December 31, 2008, without regard to the taxable income
limitation under §1.199-1(a) and (b). Cooperative X must report the
amount of Patron A’s section 199 deduction on Form 1099-PATR, “Taxable
Distributions Received From Cooperatives,” issued to Patron
A for the calendar year 2008.
(ii) Under paragraph (b) of this section, Cooperative X is required
to reduce its patronage dividend deduction of $1,000,000 by the $60,000 section
199 deduction passed through to members (whether or not Cooperative X pays
patronage on book or Federal income tax net earnings). As a consequence,
Cooperative X is entitled to a patronage dividend deduction for the taxable
year ending December 31, 2007, in the amount of $940,000 ($1,000,000
- $60,000) and to a section 199 deduction in the amount of $60,000 ($1,000,000
x .06). Its taxable income for 2007 is $0.
Example 3. (i) The facts are the same as in Example
1 except that Cooperative X paid out $500,000 to its patrons as
advances on expected patronage net earnings. In 2007, Cooperative X pays
its patrons a $500,000 ($1,000,000 - $500,000 already paid) patronage dividend
in cash or a combination of cash and qualified written notices of allocation.
Under paragraph (b) of this section and section 1382, Cooperative X is allowed
a patronage dividend deduction of $440,000 ($500,000 - $60,000 section 199
deduction), whether patronage net earnings are distributed on book or Federal
income tax net earnings.
(ii) The patrons will have received a gross amount of $1,000,000 in
qualified payments under paragraph (e) of this section from Cooperative X
($500,000 paid during the taxable year as advances and the additional $500,000
paid as patronage dividends). If Cooperative X passes through its entire
section 199 deduction to its members by providing the notice required by paragraph
(g) of this section, then the patrons will be allowed a $60,000 section 199
deduction, resulting in a net $940,000 taxable distribution from Cooperative
X. Pursuant to paragraph (l) of this section, the $1,000,000 received by
the patrons from Cooperative X is not taken into account for purposes of section
199 in the hands of the patrons.
§1.199-7 Expanded affiliated groups.
(a) In general. The provisions of this section
apply solely for purposes of section 199 of the Internal Revenue Code (Code).
All members of an expanded affiliated group (EAG) are treated as a single
corporation for purposes of section 199. Notwithstanding the preceding sentence,
except as otherwise provided in the Code and regulations (see, for example,
sections 199(c)(7) and 267, §1.199-3(b), paragraph (a)(3) of this section,
and the consolidated return regulations), each member of an EAG is a separate
taxpayer that computes its own taxable income or loss, qualified production
activities income (QPAI) (as defined in §1.199-1(c)), and W-2 wages (as
defined in §1.199-2(e)). If members of an EAG are also members of a
consolidated group, see paragraph (d) of this section.
(1) Definition of expanded affiliated group.
An EAG is an affiliated group as defined in section 1504(a), determined by
substituting more than 50 percent for at least
80 percent each place it appears and without regard to section
1504(b)(2) and (4).
(2) Identification of members of an expanded affiliated group—(i)
In general. A corporation must determine if it is a
member of an EAG on a daily basis.
(ii) Becoming or ceasing to be a member of an expanded affiliated
group. If a corporation becomes or ceases to be a member of an
EAG, the corporation is treated as becoming or ceasing to be a member of the
EAG at the end of the day on which its status as a member changes.
(3) Attribution of activities—(i) In
general. If a member of an EAG (the disposing member) derives
gross receipts (as defined in §1.199-3(c)) from the lease, rental, license,
sale, exchange, or other disposition (as defined in §1.199-3(i)) of qualifying
production property (QPP) (as defined in §1.199-3(j)) that was manufactured,
produced, grown or extracted (MPGE) (as defined in §1.199-3(e)), in whole
or in significant part (as defined in §1.199-3(g)) in the United States
(as defined in §1.199-3(h)), a qualified film (as defined in §1.199-3(k)),
or electricity, natural gas, or potable water (as defined in §1.199-3(l))
(collectively, utilities) that was produced in the United States, such property
was MPGE or produced by another corporation (or corporations), and the disposing
member is a member of the same EAG as the other corporation (or corporations)
at the time that the disposing member disposes of the QPP, qualified film,
or utilities, then the disposing member is treated as conducting the previous
activities conducted by such other corporation (or corporations) with respect
to the QPP, qualified film, or utilities in determining whether its gross
receipts are domestic production gross receipts (DPGR) (as defined in §1.199-3(a)).
With respect to a lease, rental, or license, the disposing member is treated
as having disposed of the QPP, qualified film, or utilities on the date or
dates on which it takes into account the gross receipts derived from the lease,
rental, or license under its methods of accounting. With respect to a sale,
exchange, or other disposition, the disposing member is treated as having
disposed of the QPP, qualified film, or utilities on the date on which it
ceases to own the QPP, qualified film, or utilities for Federal income tax
purposes, even if no gain or loss is taken into account.
(ii) Special rule. Attribution of activities
does not apply for purposes of the construction of real property under §1.199-3(m)
or the performance of engineering and architectural services under §1.199-3(n).
A member of an EAG must engage in a construction activity under §1.199-3(m)(2),
provide engineering services under §1.199-3(n)(2), or provide architectural
services under §1.199-3(n)(3) in order for the member’s gross receipts
to be derived from construction, engineering, or architectural services.
(4) Examples. The following examples illustrate
the application of paragraph (a)(3) of this section. Assume that all taxpayers
are calendar year taxpayers. The examples are as follows:
Example 1. Corporations M and N are members of
the same EAG. M is engaged solely in the trade or business of manufacturing
furniture in the United States that it sells to unrelated persons. N is engaged
solely in the trade or business of engraving companies’ names on pens
and pencils purchased from unrelated persons and then selling the pens and
pencils to such companies. For purposes of this example, assume that if N
was not a member of an EAG, its activities would not qualify as MPGE. Accordingly,
although M’s sales of the furniture qualify as DPGR (assuming all the
other requirements of §1.199-3 are met), N’s sales of the engraved
pens and pencils do not qualify as DPGR because neither N nor another member
of the EAG MPGE the pens and pencils.
Example 2. For the entire 2007 year, Corporations
A and B are members of the same EAG. A is engaged solely in the trade or
business of MPGE machinery in the United States. A and B each own 45% of
partnership C and unrelated persons own the remaining 10%. C is engaged solely
in the trade or business of MPGE the same type of machinery in the United
States as A. In 2007, B purchases and then resells the machinery MPGE in
2007 by A and C. B also resells machinery it purchases from unrelated persons.
If only B’s activities were considered, B would not qualify for the
deduction under §1.199-1(a) (section 199 deduction). However, because
at the time B disposes of the machinery B is a member of the EAG that includes
A, B is treated as conducting A’s previous MPGE activities in determining
whether B’s gross receipts from the sale of the machinery MPGE by A
are DPGR. C is not a member of the EAG and thus C’s MPGE activities
are not attributed to B in determining whether B’s gross receipts from
the sale of the machinery MPGE by C are DPGR. Accordingly, B’s gross
receipts attributable to its sale of the machinery it purchases from A are
DPGR (assuming all the other requirements of §1.199-3 are met). B’s
gross receipts attributable to its sale of the machinery it purchases from
C and from the unrelated persons are non-DPGR because no member of the EAG
MPGE the machinery and because C does not qualify as an EAG partnership.
Example 3. The facts are the same as in Example
2 except that rather than reselling the machinery, B rents the
machinery to unrelated persons and B takes the gross receipts attributable
to the rental of the machinery into account under its methods of accounting
in 2007, 2008, and 2009. In addition, as of the close of business on December
31, 2008, A and B cease to be members of the same EAG. With respect to the
machinery acquired from C and the unrelated persons, B’s gross receipts
attributable to the rental of the machinery in 2007, 2008, and 2009 are non-DPGR
because no member of the EAG MPGE the machinery and because C does not qualify
as an EAG partnership. With respect to machinery acquired from A, B’s
gross receipts in 2007 and 2008 attributable to the rental of the machinery
are DPGR because at the time B takes into account the gross receipts derived
from the rental of the machinery under its methods of accounting, B is a member
of the same EAG as A and B is treated as conducting A’s previous MPGE
activities. However, with respect to the rental receipts in 2009, because
A and B are not members of the same EAG in 2009, B’s rental receipts
are non-DPGR.
Example 4. For the entire 2007 year, Corporation
P owns over 50% of the stock of Corporation S. In 2007, P MPGE QPP in the
United States and transfers the QPP to S. On February 28, 2008, P disposes
of stock of S, reducing P’s ownership of S below 50% and P and S cease
to be members of the same EAG. On June 30, 2008, S sells the QPP
to an unrelated person. Unless P’s transfer of the QPP to S took place
in a transaction to which section 381(a) applies (see §1.199-8(e)(3)),
because S is not a member of the same EAG as P on June 30, 2008, S is not
treated as conducting the activities conducted by P in determining if S’s
receipts are DPGR, notwithstanding that P and S were members of the same EAG
when P MPGE the QPP and when P transferred the QPP to S.
Example 5. For the entire 2007 year, Corporations
X and Y are unrelated corporations. In 2007, X MPGE QPP in the United States
and sells the QPP to Y. On August 31, 2008, X acquires over 50% of the stock
of Y, thus making X and Y members of the same EAG. On November 30, 2008,
Y sells the QPP to an unrelated person. Because X and Y are members of the
same EAG on November 30, 2008, Y is treated as conducting the activities conducted
by X in 2007 in determining if Y’s receipts are DPGR, notwithstanding
that X and Y were not members of the same EAG when X MPGE the QPP nor when
X sold the QPP to Y.
(5) Anti-avoidance rule. If a transaction between
members of an EAG is engaged in or structured with a principal purpose of
qualifying for, or increasing the amount of, the section 199 deduction of
the EAG or the portion of the section 199 deduction allocated to one or more
members of the EAG, adjustments must be made to eliminate the effect of the
transaction on the computation of the section 199 deduction.
(b) Computation of expanded affiliated group’s section
199 deduction—(1) In general. The
section 199 deduction for an EAG is determined by the EAG by aggregating each
member’s taxable income or loss, QPAI, and W-2 wages, if any. For purposes
of this determination, a member’s QPAI may be positive or negative.
A member’s taxable income or loss and QPAI shall be determined by reference
to the member’s methods of accounting.
(2) Example. The following example illustrates
the application of paragraph (b)(1) of this section:
Example. Corporations X, Y, and Z, calendar year
taxpayers, are the only members of an EAG and are not members of a consolidated
group. X has taxable income of $50,000, QPAI of $15,000, and W-2 wages of
$1,000. Y has taxable income of ($20,000), QPAI of ($1,000), and W-2 wages
of $750. Z has $0 taxable income and $0 QPAI, but has W-2 wages of $2,000.
In determining the EAG’s section 199 deduction, the EAG aggregates
each member’s taxable income or loss, QPAI, and W-2 wages. Accordingly,
the EAG has taxable income of $30,000 ($50,000 + ($20,000) + $0), QPAI of
$14,000 ($15,000 + ($1,000) + $0), and W-2 wages of $3,750 ($1,000 + $750
+ $2,000).
(3) Net operating loss carrybacks and carryovers.
In determining the taxable income of an EAG, if a member of an EAG has a
net operating loss (NOL) carryback or carryover to the taxable year, then
the amount of the NOL used to offset taxable income cannot exceed the taxable
income of that member.
(c) Allocation of an expanded affiliated group’s section
199 deduction among members of the expanded affiliated group—(1)
In general. An EAG’s section 199 deduction as
determined in paragraph (b)(1) of this section is allocated among the members
of the EAG in proportion to each member’s QPAI, regardless of whether
the EAG member has taxable income or loss or W-2 wages for the taxable year.
For this purpose, if a member has negative QPAI, the QPAI of the member shall
be treated as zero.
(2) Use of section 199 deduction to create or increase a
net operating loss. Notwithstanding §1.199-1(b), if a member
of an EAG has some or all of the EAG’s section 199 deduction allocated
to it under paragraph (c)(1) of this section and the amount allocated exceeds
the member’s taxable income (determined prior to allocation of the section
199 deduction), the section 199 deduction will create an NOL for the member.
Similarly, if a member of an EAG, prior to the allocation of some or all
of the EAG’s section 199 deduction to the member, has an NOL for the
taxable year, the portion of the EAG’s section 199 deduction allocated
to the member will increase the member’s NOL.
(d) Special rules for members of the same consolidated group—(1)
Intercompany transactions. In the case of an intercompany
transaction between consolidated group members S and B (as the terms intercompany
transaction, S, and B are defined in §1.1502-13(b)(1)), S takes the intercompany
transaction into account in computing the section 199 deduction at the same
time and in the same proportion as S takes into account the income, gain,
deduction, or loss from the intercompany transaction under §1.1502-13.
(2) Attribution of activities in the construction of real
property and the performance of engineering and architectural services.
Notwithstanding paragraph (a)(3)(ii) of this section, a disposing member
(as described in paragraph (a)(3)(i) of this section) is treated as conducting
the previous activities conducted by each other member of its consolidated
group with respect to the construction of real property under §1.199-3(m)
and the performance of engineering and architectural services under §1.199-3(n),
but only with respect to activities performed during the period of consolidation.
(3) Application of the simplified deduction method and the
small business simplified overall method. For purposes of applying
the simplified deduction method under §1.199-4(e) and the small business
simplified overall method under §1.199-4(f), a consolidated group determines
its QPAI using its members’ DPGR, non-DPGR, cost of goods sold (CGS),
and all other deductions, expenses, or losses (deductions), determined after
application of §1.1502-13.
(4) Determining the section 199 deduction—(i)
Expanded affiliated group consists of consolidated group and non-consolidated
group members. In determining the section 199 deduction, if an
EAG includes corporations that are members of the same consolidated group
and corporations that are not members of the same consolidated group, the
consolidated taxable income or loss, QPAI, and W-2 wages, if any, of the consolidated
group (and not the separate taxable income or loss, QPAI, and W-2 wages of
the members of the consolidated group), are aggregated with the taxable income
or loss, QPAI, and W-2 wages, if any, of the non-consolidated group members. For
example, if A, B, C, S1, and S2 are members of the same EAG, and A, S1, and
S2 are members of the same consolidated group (the A consolidated group),
then the A consolidated group is treated as one member of the EAG. Accordingly,
the EAG is considered to have three members, the A consolidated group, B,
and C. The consolidated taxable income or loss, QPAI, and W-2 wages, if any,
of the A consolidated group are aggregated with the taxable income or loss,
QPAI, and W-2 wages, if any, of B and C in determining the EAG’s section
199 deduction.
(ii) Expanded affiliated group consists only of members of
a single consolidated group. If all the members of an EAG are
members of the same consolidated group, the consolidated group’s section
199 deduction is determined using the consolidated group’s consolidated
taxable income or loss, QPAI, and W-2 wages, rather than the separate taxable
income or loss, QPAI, and W-2 wages of its members.
(5) Allocation of the section 199 deduction of a consolidated
group among its members. The section 199 deduction of a consolidated
group (or the section 199 deduction allocated to a consolidated group that
is a member of an EAG) is allocated to the members of the consolidated group
in proportion to each consolidated group member’s QPAI, regardless of
whether the consolidated group member has separate taxable income or loss
or W-2 wages for the taxable year. In allocating the section 199 deduction
of a consolidated group among its members, any redetermination of a corporation’s
receipts, CGS, or other deductions from an intercompany transaction under
§1.1502-13(c)(1)(i) or (c)(4) for purposes of section 199 is not taken
into account. Also, for purposes of this allocation, if a consolidated group
member has negative QPAI, the QPAI of the member shall be treated as zero.
(e) Examples. The following examples illustrate
the application of paragraphs (a) through (d) of this section:
Example 1. Corporations X and Y are members of
the same EAG but are not members of a consolidated group. All the activities
described in this example take place during the same taxable year. X and
Y each use the section 861 method described in §1.199-4(d) for allocating
and apportioning their deductions. X incurs $5,000 in costs in manufacturing
a machine, all of which are capitalized. X is entitled to a $1,000 depreciation
deduction for the machine in the current taxable year. X rents the machine
to Y for $1,500. Y uses the machine in manufacturing QPP within the United
States. Y incurs $1,400 of CGS in manufacturing the QPP. Y sells the QPP
to unrelated persons for $7,500. Pursuant to section 199(c)(7) and §1.199-3(b),
X’s rental income is non-DPGR (and its related costs are not attributable
to DPGR). Accordingly, Y has $4,600 of QPAI (Y’s $7,500 DPGR received
from unrelated persons - Y’s $1,400 CGS allocable to such receipts -
Y’s $1,500 of rental expense), X has $0 of QPAI, and the EAG has $4,600
of QPAI.
Example 2. The facts are the same as in Example
1 except that X and Y are members of the same consolidated group.
Pursuant to section 199(c)(7) and §1.199-3(b), X’s rental income
ordinarily would not be DPGR (and its related costs would not be allocable
to DPGR). However, because X and Y are members of the same consolidated group,
§1.1502-13(c)(1)(i) provides that the separate entity attributes of X’s
intercompany items or Y’s corresponding items, or both, may be redetermined
in order to produce the same effect as if X and Y were divisions of a single
corporation. If X and Y were divisions of a single corporation, X and Y would
have QPAI of $5,100 ($7,500 DPGR received from unrelated persons - $1,400
CGS allocable to such receipts - $1,000 depreciation deduction). To obtain
this same result for the consolidated group, X’s rental income is redetermined
as DPGR, which results in the consolidated group having $9,000 of DPGR (the
sum of Y’s DPGR of $7,500 + X’s DPGR of $1,500) and $3,900 of
costs allocable to DPGR (the sum of Y’s $1,400 CGS + Y’s $1,500
rental expense + X’s $1,000 depreciation expense). For purposes of
determining how much of the consolidated group’s section 199 deduction
is allocated to X and Y, pursuant to paragraph (d)(5) of this section, the
redetermination of X’s rental income as DPGR under §1.1502-13(c)(1)(i)
is not taken into account (X’s costs are considered to be allocable
to DPGR because they are allocable to the consolidated group deriving DPGR).
Accordingly, for this purpose, X is deemed to have ($1,000) of QPAI (X’s
$0 DPGR - X’s $1,000 depreciation deduction). Because X is deemed to
have negative QPAI, also pursuant to paragraph (d)(5) of this section, X’s
QPAI is treated as zero. Y has $4,600 of QPAI (Y’s $7,500 DPGR - Y’s
$1,400 CGS allocable to such receipts - Y’s $1,500 of rental expense).
Accordingly, X is allocated $0/($0 + $4,600) of the consolidated group’s
section 199 deduction and Y is allocated $4,600/($0 + $4,600) of the consolidated
group’s section 199 deduction.
Example 3. Corporations P and S are members of
the same EAG but are not members of a consolidated group. P and S each use
the section 861 method for allocating and apportioning their deductions and
are both calendar year taxpayers. In 2007, P incurs $1,000 in research and
development expenses in creating an intangible asset and deducts these expenses
in 2007. P anticipates that it will license the intangible asset to S. On
January 1, 2008, P licenses the intangible asset to S for $2,500. S uses
the intangible asset in manufacturing QPP within the United States. S incurs
$2,000 of additional costs in manufacturing the QPP. On December 31,
2008, S sells the QPP to unrelated persons for $10,000. Because on December
31, 2007, P anticipates that it will license the intangible asset to S, a
related person, and also because the intangible asset is not QPP, P’s
license receipts from S will be non-DPGR. Accordingly, P’s research
and development expenses in 2007 are not attributable to DPGR. In 2008, S
has $5,500 of QPAI (S’s $10,000 DPGR received from unrelated persons
- S’s $2,000 additional costs in manufacturing the QPP - S’s $2,500
of license expense), P has $0 of QPAI, and the EAG has $5,500 of QPAI.
Example 4. (i) Determination of consolidated
group’s QPAI. The facts are the same as in Example
3 except that P and S are members of the same consolidated group.
Pursuant to section 199(c)(7) and §1.199-3(b), and also because the
intangible asset is not QPP, P’s license income ordinarily would not
be DPGR (and its related costs would not be allocable to DPGR). However,
because P and S are members of the same consolidated group, §1.1502-13(c)(1)(i)
provides that the separate entity attributes of P’s intercompany items
or S’s corresponding items, or both, may be redetermined in order to
produce the same effect as if P and S were divisions of a single corporation.
If P and S were divisions of a single corporation, in 2007 the single corporation
would have $1,000 of expenses allocable to the anticipated DPGR from the sale
of the QPP to unrelated persons, resulting in a negative QPAI (from this individual
item) of $1,000. In 2008, the single corporation would have QPAI of $8,000
($10,000 DPGR received from unrelated persons - $2,000 additional costs in
manufacturing the QPP). To obtain this same result for the consolidated group,
P’s license income from S is redetermined as DPGR. P’s research
and development expenses are allocable to DPGR. This results in the consolidated
group having negative QPAI in 2007 (from the research and development expense)
of $1,000. In 2008, the consolidated group has $12,500 of DPGR (the sum of
S’s DPGR of $10,000 + P’s DPGR of $2,500) and $4,500 of costs
allocable to DPGR (the sum of S’s $2,000 additional costs + S’s
$2,500 license expense), resulting in $8,000 of QPAI in 2008.
(ii) Allocation of deduction. Since the consolidated
group has no QPAI in 2007, there is no section 199 deduction to be allocated
between P and S in 2007. In 2008, the consolidated group has $8,000 of QPAI
and, assuming that the group has positive taxable income and W-2 wages, the
consolidated group will have a section 199 deduction. For purposes of determining
how much of the consolidated group’s section 199 deduction is allocated
to P and S, pursuant to paragraph (d)(5) of this section, the redetermination
of P’s license income as DPGR under §1.1502-13(c)(1)(i) is not
taken into account. Accordingly, for purposes of allocating the consolidated
group’s section 199 deduction between P and S, P is deemed to have $0
DPGR and $0 QPAI in 2008. S has $5,500 of QPAI (S’s $10,000 DPGR -
S’s $2,000 in additional costs allocable to such receipts - S’s
$2,500 of license expense). Accordingly, P is allocated $0/($0 + $5,500)
of the consolidated group’s section 199 deduction in 2008 and S is allocated
$5,500/($0 + $5,500) of the consolidated group’s section 199 deduction.
Example 5. (i) Facts. Corporations
A and B are the only two members of an EAG but are not members of a consolidated
group. A and B each file Federal income tax returns on a calendar year basis.
The average annual gross receipts of the EAG are less than or equal to $100,000,000
and A and B each use the simplified deduction method under §1.199-4(e).
In 2007, A MPGE televisions within the United States. A has $10,000,000
of DPGR from sales of televisions to unrelated persons and $2,000,000 of DPGR
from sales of televisions to B. In addition, A has gross receipts from computer
consulting services with unrelated persons of $3,000,000. A has CGS of $6,000,000.
A is able to determine from its books and records that $4,500,000 of its
CGS are attributable to televisions sold to unrelated persons and $1,500,000
are attributable to televisions sold to B (see §1.199-4(b)(2)). A has
other deductions of $4,000,000. A has no other items of income, gain, or
deductions. In 2007, B sells the televisions it purchased from A to unrelated
persons for $4,100,000. B also pays $100,000 for administrative services
performed in 2007. B has no other items of income, gain, or deductions.
(ii) QPAI. (A) A’s QPAI.
In order to determine A’s QPAI, A subtracts its $6,000,000 CGS from
its $12,000,000 DPGR. Under the simplified deduction method, A then apportions
its remaining $4,000,000 of deductions to DPGR in proportion to the ratio
of its DPGR to total gross receipts. Thus, of A’s $4,000,000 of deductions,
$3,200,000 is apportioned to DPGR ($4,000,000 x $12,000,000/$15,000,000).
Accordingly, A’s QPAI is $2,800,000 ($12,000,000 DPGR - $6,000,000
CGS - $3,200,000 deductions apportioned to its DPGR).
(B) B’s QPAI. Although B did not MPGE the
televisions it sold, pursuant to paragraph (a)(3) of this section, B is treated
as conducting A’s MPGE of the televisions in determining whether B’s
gross receipts are DPGR. Thus, B has $4,100,000 of DPGR. In order to determine
B’s QPAI, B subtracts its $2,000,000 CGS from its $4,100,000 DPGR.
Under the simplified deduction method, B then apportions its remaining $100,000
of deductions to DPGR in proportion to the ratio of its DPGR to total gross
receipts. Thus, because B has no other gross receipts, all of B’s $100,000
of deductions is apportioned to DPGR ($100,000 x $4,100,000/$4,100,000).
Accordingly, B’s QPAI is $2,000,000 ($4,100,000 DPGR - $2,000,000 CGS
- $100,000 deductions apportioned to its DPGR).
Example 6. (i) Facts. The
facts are the same as in Example 5 except that A and
B are members of the same consolidated group, B does not sell the televisions
purchased from A until 2008, and B’s $100,000 paid for administrative
services are paid in 2008 for services performed in 2008. In addition, in
2008, A has $3,000,000 in gross receipts from computer consulting services
with unrelated persons and $1,000,000 in related deductions.
(ii) Consolidated group’s 2007 QPAI. The
consolidated group’s DPGR and total gross receipts in 2007 are $10,000,000
and $13,000,000, respectively, because, pursuant to paragraph (d)(1) of this
section and §1.1502-13, the sale of the televisions from A to B is not
taken into account in 2007. In order to determine the consolidated group’s
QPAI, the consolidated group subtracts its $4,500,000 CGS from the televisions
sold to unrelated persons from its $10,000,000 DPGR. Under the simplified
deduction method, the consolidated group apportions its remaining $4,000,000
of deductions to DPGR in proportion to the ratio of its DPGR to total gross
receipts. Thus, $3,076,923 ($4,000,000 x $10,000,000/$13,000,000) is allocated
to DPGR. Accordingly, the consolidated group’s QPAI for 2007 is $2,423,077
($10,000,000 DPGR - $4,500,000 CGS - $3,076,923 deductions apportioned to
its DPGR).
(iii) Allocation of consolidated group’s 2007 section
199 deduction to its members. Because B’s only activity
during 2007 is the purchase of televisions from A, B has no DPGR or deductions
and thus, no QPAI, in 2007. Accordingly, the entire section 199 deduction
in 2007 for the consolidated group will be allocated to A.
(iv) Consolidated group’s 2008 QPAI. Pursuant
to paragraph (d)(1) of this section and §1.1502-13(c), A’s sale
of televisions to B in 2007 is taken into account in 2008 when B sells the
televisions to unrelated persons. However, because A and B are members of
a consolidated group, §1.1502-13(c)(1)(i) provides that the separate
entity attributes of A’s intercompany items or B’s corresponding
items, or both, may be redetermined in order to produce the same effect as
if A and B were divisions of a single corporation. Accordingly, A’s
$2,000,000 of gross receipts are redetermined to be non-DPGR and as not being
gross receipts for purposes of allocating costs between DPGR and non-DPGR,
and B’s $2,000,000 CGS are redetermined to be not allocable to DPGR.
Notwithstanding that A’s receipts are redetermined to be non-DPGR and
as not being gross receipts for purposes of allocating costs between DPGR
and non-DPGR, A’s CGS are still considered to be allocable to DPGR because
they are allocable to the consolidated group deriving DPGR. Accordingly,
the consolidated group’s DPGR in 2008 is $4,100,000 from B’s sales
of televisions, and its total receipts are $7,100,000 ($4,100,000 DPGR plus
$3,000,000 non-DPGR from A’s computer consulting services). To determine
the consolidated group’s QPAI, the consolidated group subtracts A’s
$1,500,000 CGS from the televisions sold to B from its $4,100,000 DPGR. Under
the simplified deduction method, the consolidated group apportions its remaining
$1,100,000 of deductions ($1,000,000 from A and $100,000 from B) to DPGR in
proportion to the consolidated group’s ratio of its DPGR to total gross
receipts. Thus, $635,211 ($1,100,000 x $4,100,000/$7,100,000) is allocated
to DPGR. Accordingly, the consolidated group’s QPAI for 2008 is
$1,964,789 ($4,100,000 DPGR - $1,500,000 CGS - $635,211 deductions apportioned
to its DPGR), the same QPAI that would result if A and B were divisions of
a single corporation.
(v) Allocation of consolidated group’s 2008 section
199 deduction to its members. (A) A’s QPAI.
For purposes of allocating the consolidated group’s section 199 deduction
to its members, pursuant to paragraph (d)(5) of this section, the redetermination
of A’s $2,000,000 in receipts is disregarded. Accordingly, for this
purpose, A’s DPGR are $2,000,000 (receipts from the sale of televisions
to B taken into account in 2008) and its total receipts are $5,000,000 ($2,000,000
DPGR + $3,000,000 non-DPGR from its computer consulting services). In determining
A’s QPAI, A subtracts its $1,500,000 CGS from the televisions sold to
B from its $2,000,000 DPGR. Under the simplified deduction method,
A apportions its remaining $1,000,000 of deductions in proportion to the ratio
of its DPGR to total receipts. Thus, $400,000 ($1,000,000 x $2,000,000/$5,000,000)
is allocated to DPGR. Thus, A’s QPAI is $100,000 ($2,000,000 DPGR -
$1,500,000 CGS - $400,000 deductions allocated to its DPGR).
(B) B’s QPAI. B’s DPGR and its total
gross receipts are each $4,100,000. For purposes of allocating the consolidated
group’s section 199 deduction to its members, pursuant to paragraph
(d)(5) of this section, the redetermination of B’s $2,000,000 CGS as
not allocable to DPGR is disregarded. In determining B’s QPAI, B subtracts
its $2,000,000 CGS from the televisions purchased from A from its $4,100,000
DPGR. Under the simplified deduction method, B apportions its remaining $100,000
deductions in proportion to the ratio of its DPGR to total receipts. Thus,
all $100,000 ($100,000 x $4,100,000/$4,100,000) is allocated to DPGR. Thus,
B’s QPAI is $2,000,000 ($4,100,000 DPGR - $2,000,000 CGS - $100,000
deductions allocated to its DPGR).
(C) Allocation to A and B. Pursuant to paragraph
(d)(5) of this section, the consolidated group’s section 199 deduction
for 2008 is allocated $100,000/($100,000 + $2,000,000) to A and $2,000,000/($100,000
+ $2,000,000) to B.
Example 7. Corporations S and B are members of
the same consolidated group that files its Federal income tax returns on a
calendar year basis. In 2007, S manufactures office furniture for B to use
in B’s corporate headquarters and S sells the office furniture to B.
S and B have no other activities in the taxable year. If S and B were not
members of a consolidated group, S’s gross receipts from the sale of
the office furniture to B would be DPGR (assuming all the other requirements
of §1.199-3 are met) and S’s CGS or other deductions, expenses,
or losses from the sale to B would be allocable to S’s DPGR. However,
because S and B are members of a consolidated group, the separate entity attributes
of S’s intercompany items or B’s corresponding items, or both,
may be redetermined under §1.1502-13(c)(1)(i) or (c)(4) in order to produce
the same effect as if S and B were divisions of a single corporation. If
S and B were divisions of a single corporation, there would be no DPGR with
respect to the office furniture because there would be no lease, rental, license,
sale, exchange, or other disposition of the furniture by the single corporation
(and no CGS or other deductions allocable to DPGR). Thus, in order to produce
the same effect as if S and B were divisions of a single corporation, S’s
gross receipts are redetermined as non-DPGR. Accordingly, the consolidated
group has no DPGR (and no CGS or other deductions allocated or apportioned
to DPGR) and receives no section 199 deduction in 2007.
Example 8. (i) Facts. A
and B are members of the same consolidated group that files its Federal income
tax returns on a calendar year basis. On January 1, 2007, A MPGE QPP which
is 10-year recovery property for $100 and depreciates it under the straight-line
method. On January 1, 2009, A sells the property to B for $130. Under section
168(i)(7), B is treated as A for purposes of section 168 to the extent B’s
$130 basis does not exceed A’s adjusted basis at the time of the sale.
B’s additional basis is treated as new 10-year recovery property for
which B elects the straight-line method of recovery. (To simplify the example,
the half-year convention is disregarded.)
(ii) Depreciation; intercompany gain. A claims
$10 of depreciation for each taxable year 2007 and 2008 and has an $80 basis
at the time of the sale to B. Thus, A has a $50 intercompany gain from its
sale to B. For each taxable year 2009 through 2016, B has $10 of depreciation
with respect to $80 of its basis (the portion of its $130 basis not exceeding
A’s adjusted basis) and $5 of depreciation with respect to the $50 of
its additional basis that exceeds A’s adjusted basis. For each taxable
year 2017 and 2018, B has $5 of depreciation with respect to the $50 of its
additional basis that exceeds A’s adjusted basis.
(iii) Timing. A’s $50 gain is taken into
account to reflect the difference for each consolidated return year between
B’s depreciation taken into account with respect to the property and
the depreciation that would have been taken into account if A and B were divisions
of a single corporation. For each taxable year 2009 through 2016, B takes
into account $15 of depreciation rather than the $10 of depreciation that
would have been taken into account if A and B were divisions of a single corporation.
For each taxable year 2017 and 2018, B takes into account $5 of depreciation
rather than the $0 of depreciation that would have been taken into account
if A and B were divisions of a single corporation (the QPP would have been
fully depreciated after the 2016 taxable year if A and B were divisions of
a single corporation). Thus, A takes $5 of gain into account in each of the
2009 through 2018 taxable years (10% of its $50 gain). Pursuant to §1.199-7(d)(1),
A takes its sale to B into account in computing the section 199 deduction
at the same time and in the same proportion as A takes into account the income,
gain, deduction, or loss from the intercompany transaction under §1.1502-13.
Thus, in each taxable year 2009 through 2018, A takes into account $13 of
gross receipts (10% of its $130 gross receipts) from the sale to B. The group’s
income in each taxable year 2009 through 2016 is a $10 loss ($5 gain - $15
depreciation), the same net amount it would have been if A and B were divisions
of a single corporation. The group’s income in each taxable year 2017
and 2018 is $0 ($5 gain - $5 depreciation), the same net amount it would have
been if A and B were divisions of a single corporation.
(iv) Attributes. If A and B were not members of
a consolidated group, A’s gross receipts on the sale of the QPP to B
would be DPGR (assuming all the other requirements of §1.199-3 are met).
However, because A and B are members of a consolidated group, the separate
entity attributes of A’s DPGR may be redetermined under §1.1502-13(c)(1)(i)
or (c)(4) in order to produce the same effect as if A and B were divisions
of a single corporation. If A and B were divisions of a single corporation,
there would be no DPGR with respect to the QPP because there would be no lease,
rental, license, sale, exchange, or other disposition of the QPP by the single
corporation (and no CGS or other deductions allocable to DPGR). Thus, in
order to produce the same effect as if A and B were divisions of a single
corporation, A’s $13 of gross receipts taken into account in each year
is redetermined as non-DPGR. Accordingly, the consolidated group has no DPGR
(and no CGS or other deductions allocable or apportioned to DPGR) and receives
no section 199 deduction.
Example 9. Corporations X, Y, and Z are members
of the same EAG but are not members of a consolidated group. X, Y, and Z
each files Federal income tax returns on a calendar year basis. Assume that
the EAG has W-2 wages in excess of the section 199(b) wage limitation. Prior
to 2007, X had no taxable income or loss. In 2007, X has $0 of taxable income
and $2,000 of QPAI, Y has $4,000 of taxable income and $3,000 of QPAI, and
Z has $4,000 of taxable income and $5,000 of QPAI. Accordingly, the EAG has
taxable income of $8,000, the sum of X’s taxable income of $0, Y’s
taxable income of $4,000, and Z’s taxable income of $4,000. The EAG
has QPAI of $10,000, the sum of X’s QPAI of $2,000, Y’s QPAI of
$3,000, and Z’s QPAI of $5,000. Because X’s, Y’s, and Z’s
taxable years all began in 2007, the transition percentage under section 199(a)(2)
is 6%. Thus, the EAG’s section 199 deduction for 2007 is $480 (6% of
the lesser of the EAG’s taxable income of $8,000 or the EAG’s
QPAI of $10,000). Pursuant to paragraph (c)(1) of this section, the $480
section 199 deduction is allocated to X, Y, and Z in proportion to their respective
amounts of QPAI, that is $96 to X ($480 x $2,000/$10,000), $144 to Y ($480
x $3,000/$10,000), and $240 to Z ($480 x $5,000/$10,000). Although X’s
taxable income for 2007 determined prior to allocation of a portion of the
EAG’s section 199 deduction to it was $0, pursuant to paragraph (c)(2)
of this section X will have an NOL for 2007 equal to $96. Because X’s
NOL for 2007 cannot be carried back to a previous taxable year, X’s
NOL carryover to 2008 will be $96.
Example 10. (i) Facts.
Corporation P owns all of the stock of Corporations S and T, and P, S, and
T file a consolidated Federal income tax return on a calendar year basis.
In 2007, P MPGE QPP in the United States at a cost of $1,000. On November
30, 2007, P sells the QPP to S for $2,500. On February 28, 2008, P disposes
of 60% of the stock of S. On June 30, 2008, S sells the QPP to an unrelated
person for $3,000.
(ii) Analysis. Because P and S are members of
a consolidated group in 2007, pursuant to §1.199-7(d)(1) and §1.1502-13,
neither P’s $1,500 of gain on the sale of QPP to S nor P’s $2,500
gross receipts from the sale are taken into account in 2007. Under §1.1502-13(d),
P takes the intercompany transaction into account immediately before S becomes
a non-member of the consolidated group. In order to produce the same effect
as if P and S were divisions of a single corporation, P’s gross receipts
from the sale of the QPP to S are redetermined under §1.1502-13(c)(1)(i)
as non-DPGR. Further, because P and S are not members of the same EAG when
S sells the QPP to the unrelated person, and because P’s transfer of
the QPP to S did not take place in a transaction to which section 381(a) applies,
S is not treated as conducting the activities conducted by P in determining
if S’s receipts are DPGR, notwithstanding that P and S were members
of the same EAG when P MPGE the QPP and when P sold the QPP to S. Accordingly,
neither the P consolidated group nor S will have DPGR with respect to the
QPP.
Example 11. Corporation X is the common parent
of a consolidated group, consisting of X and Y, which has filed a consolidated
Federal income tax return for many years. Corporation P is the common parent
of a consolidated group, consisting of P and S, which has filed a consolidated
Federal income tax return for many years. The X and P consolidated groups
each file their consolidated Federal income tax returns on a calendar year
basis. X, Y, P and S are members of the same EAG in 2008. In 2007, the X
consolidated group incurred a consolidated net operating loss (CNOL) of $25,000,
none of which was carried back and used to offset taxable income of prior
taxable years. Neither P nor S (nor the P consolidated group) has ever incurred
an NOL. In 2008, the X consolidated group has (prior to the deduction under
section 172) taxable income of $8,000 and the P consolidated group has taxable
income of $20,000. The X consolidated group uses $8,000 of its CNOL from
2007 to offset the X consolidated group’s taxable income in 2008. None
of the X consolidated group’s remaining CNOL may be used to offset taxable
income of the P consolidated group under paragraph (b)(3) of this section.
Accordingly, for purposes of determining the EAG’s section 199 deduction,
the EAG has taxable income of $20,000 (the X consolidated group’s taxable
income (after the deduction under section 172) of $0 plus the P consolidated
group’s taxable income of $20,000).
(f) Allocation of income and loss by a corporation that is
a member of the expanded affiliated group for only a portion of the year—(1)
In general. A corporation that becomes or ceases to
be a member of an EAG during its taxable year must allocate its taxable income
or loss, QPAI, and W-2 wages between the portion of the taxable year that
it is a member of the EAG and the portion of the taxable year that it is not
a member of the EAG. In general, this allocation of items is made by using
the pro rata allocation method described in paragraph
(f)(1)(i) of this section. However, a corporation may elect to use the section
199 closing of the books method described in paragraph (f)(1)(ii) of this
section. Neither the pro rata allocation method nor
the section 199 closing of the books method is a method of accounting.
(i) Pro rata allocation method. Under the pro
rata allocation method, an equal portion of a corporation’s
taxable income or loss, QPAI, and W-2 wages for the taxable year is assigned
to each day of the corporation’s taxable year. Those items assigned
to those days that the corporation was a member of the EAG are then aggregated.
(ii) Section 199 closing of the books method.
Under the section 199 closing of the books method, a corporation’s
taxable income or loss, QPAI, and W-2 wages for the period during which the
corporation was a member of an EAG are computed by treating the corporation’s
taxable year as two separate taxable years, the first of which ends at the
close of the day on which the corporation’s status as a member of the
EAG changes and the second of which begins at the beginning of the day after
the corporation’s status as a member of the EAG changes.
(iii) Making the section 199 closing of the books election.
A corporation makes the section 199 closing of the books election by making
the following statement: “The section 199 closing of the books election
is hereby made with respect to [insert name of corporation and its employer
identification number] with respect to the following periods [insert dates
of the two periods between which items are allocated pursuant to the closing
of the books method].” The statement must be filed with the corporation’s
timely filed (including extensions) Federal income tax return for the taxable
year that includes the periods that are subject to the election. Once made,
a section 199 closing of the books election is irrevocable.
(2) Coordination with rules relating to the allocation of
income under §1.1502-76(b). If §1.1502-76(b) (relating
to items included in a consolidated return) applies to a corporation that
is a member of an EAG, then any allocation of items required under this paragraph
(f) is made only after the allocation of the corporation’s items pursuant
to §1.1502-76(b).
(g) Total section 199 deduction for a corporation that is
a member of an expanded affiliated group for some or all of its taxable year—(1)
Member of the same expanded affiliated group for the entire taxable
year. If a corporation is a member of the same EAG for its entire
taxable year, the corporation’s section 199 deduction for the taxable
year is the amount of the section 199 deduction allocated to the corporation
by the EAG under paragraph (c)(1) of this section.
(2) Member of the expanded affiliated group for a portion
of the taxable year. If a corporation is a member of an EAG only
for a portion of its taxable year and is either not a member of any EAG or
is a member of another EAG, or both, for another portion of the taxable year,
the corporation’s section 199 deduction for the taxable year is the
sum of its section 199 deductions for each portion of the taxable year.
(3) Example. The following example illustrates
the application of paragraphs (f) and (g) of this section:
Example. Corporations X and Y, calendar year corporations,
are members of the same EAG for the entire 2007 taxable year. Corporation
Z, also a calendar year corporation, is a member of the EAG of which X and
Y are members for the first half of 2007 and not a member of any EAG for the
second half of 2007. During the 2007 taxable year, Z does not join in the
filing of a consolidated return. Z makes a section 199 closing of the books
election. As a result, Z has $80 of taxable income and $100 of QPAI that
is allocated to the first half of 2007 and a $150 taxable loss and ($200)
of QPAI that is allocated to the second half of 2007. Taking into account
Z’s taxable income, QPAI, and W-2 wages allocated to the first half
of 2007 pursuant to the section 199 closing of the books election, the EAG
has positive taxable income and QPAI for 2007 and W-2 wages in excess of the
section 199(b) wage limitation. Because the EAG has both positive taxable
income and QPAI and sufficient W-2 wages, and because Z has positive QPAI
for the first half of 2007, a portion of the EAG’s section 199 deduction
is allocated to Z. Because Z has negative QPAI for the second half of 2007,
Z is allowed no section 199 deduction for the second half of 2007. Thus,
despite the fact that Z has a $70 taxable loss and ($100) of QPAI for the
entire 2007 taxable year, Z is entitled to a section 199 deduction for 2007
equal to the section 199 deduction allocated to Z as a member of the EAG.
(h) Computation of section 199 deduction for members of an
expanded affiliated group with different taxable years—(1)
In general. If members of an EAG have different taxable
years, in determining the section 199 deduction of a member (the computing
member), the computing member is required to take into account the taxable
income or loss, determined without regard to the section 199 deduction, QPAI,
and W-2 wages of each other group member that are both—
(i) Attributable to the period that each other member of the EAG and
the computing member are members of the EAG; and
(ii) Taken into account in a taxable year that begins after the effective
date of section 199 and such taxable year ends with or within the taxable
year of the computing member with respect to which the section 199 deduction
is computed.
(2) Example. The following example illustrates
the application of this paragraph (h):
Example. (i) Corporations X, Y, and Z are members
of the same EAG. Neither X, Y, nor Z is a member of a consolidated group.
X and Y are calendar year taxpayers and Z is a June 30 fiscal year taxpayer.
Z came into existence on July 1, 2007. Each corporation has taxable income
that exceeds its QPAI and has sufficient W-2 wages to avoid the limitation
under section 199(b). For the taxable year ending December 31, 2007, X’s
QPAI is $8,000 and Y’s QPAI is ($6,000). For its taxable year ending
June 30, 2008, Z’s QPAI is $2,000.
(ii) In computing X’s and Y’s respective section 199
deductions for their taxable years ending December 31, 2007, X’s and
Y’s taxable income, QPAI, and W-2 wages from their respective taxable
years ending December 31, 2007, are aggregated. The EAG’s QPAI for
this purpose is $2,000 (X’s QPAI of $8,000 + Y’s QPAI of ($6,000)).
Because the taxable years of the computing members, X and Y, began in 2007,
the transition percentage under section 199(a)(2) is 6%. Accordingly, the
EAG’s section 199 deduction is $120 ($2,000 x .06). The $120 deduction
is allocated to each of X and Y in proportion to their respective QPAI as
a percentage of the QPAI of each member of the EAG that was taken into account
in computing the EAG’s section 199 deduction. Pursuant to paragraph
(c)(1) of this section, in allocating the section 199 deduction between X
and Y, because Y’s QPAI is negative, Y’s QPAI is treated as being
$0. Accordingly, X’s section 199 deduction for its taxable year ending
December 31, 2007, is $120 ($120 x $8,000/($8,000 + $0)). Y’s section
199 deduction for its taxable year ending December 31, 2007, is $0 ($120 x
$0/($8,000 + $0)).
(iii) In computing Z’s section 199 deduction for its taxable
year ending June 30, 2008, X’s and Y’s items from their respective
taxable years ending December 31, 2007, are taken into account. Therefore,
X’s and Y’s taxable income or loss, determined without regard
to the section 199 deduction, QPAI, and W-2 wages from their taxable years
ending December 31, 2007, are aggregated with Z’s taxable income or
loss, QPAI, and W-2 wages from its taxable year ending June 30, 2008. The
EAG’s QPAI is $4,000 (X’s QPAI of $8,000 + Y’s QPAI of ($6,000)
+ Z’s QPAI of $2,000). Because the taxable year of the computing member,
Z, began in 2007, the transition percentage under section 199(a)(2) is 6%.
Accordingly, the EAG’s section 199 deduction is $240 ($4,000 x .06).
A portion of the $240 deduction is allocated to Z in proportion to its QPAI
as a percentage of the QPAI of each member of the EAG that was taken into
account in computing the EAG’s section 199 deduction. Pursuant to paragraph
(c)(1) of this section, in allocating a portion of the $240 deduction to Z,
because Y’s QPAI is negative, Y’s QPAI is treated as being $0.
Z’s section 199 deduction for its taxable year ending June 30, 2008,
is $48 ($240 x $2,000/($8,000 + $0 + $2,000)).
(a) In general. The provisions of this section
apply solely for purposes of section 199 of the Internal Revenue Code
(Code). When calculating the deduction under §1.199-1(a) (section 199
deduction), taxpayers are required to make numerous allocations under §§1.199-1
through 1.199-9. In making these allocations, taxpayers may use any reasonable
method that is satisfactory to the Secretary based on all of the facts and
circumstances, unless the regulations under §§1.199-1 through 1.199-9
specify a method. A change in a taxpayer’s method of allocating or
apportioning gross receipts, cost of goods sold (CGS), expenses, losses, or
deductions (deductions) does not constitute a change in method of accounting
to which the provisions of sections 446 and 481 and the regulations thereunder
apply.
(b) Individuals. In the case of an individual,
the section 199 deduction is equal to the applicable percentage of the lesser
of the taxpayer’s qualified production activities income (QPAI) (as
defined in §1.199-1(c)) for the taxable year, or adjusted gross income
(AGI) for the taxable year determined after applying sections 86, 135,
137, 219, 221, 222, and 469, and without regard to section 199.
(c) Trade or business requirement—(1) In
general. Sections 1.199-1 through 1.199-9 are applied by
taking into account only items that are attributable to the actual conduct
of a trade or business.
(2) Individuals. An individual engaged in the
actual conduct of a trade or business must apply §§1.199-1 through
1.199-9 by taking into account in computing QPAI only items that are attributable
to that trade or business (or trades or businesses) and any items allocated
from a pass-thru entity engaged in a trade or business. Compensation received
by an individual employee for services performed as an employee is not considered
gross receipts for purposes of computing QPAI under §§1.199-1 through
1.199-9. Similarly, any costs or expenses paid or incurred by an individual
employee with respect to those services performed as an employee are not considered
CGS or deductions of that employee for purposes of computing QPAI under §§1.199-1
through 1.199-9.
(3) Trusts and estates. For purposes of this
paragraph (c), a trust or estate is treated as an individual.
(d) Coordination with alternative minimum tax.
For purposes of determining alternative minimum taxable income (AMTI) under
section 55, a taxpayer that is not a corporation must deduct an amount equal
to 9 percent (3 percent in the case of taxable years beginning in 2005 or
2006, and 6 percent in the case of taxable years beginning in 2007, 2008,
or 2009) of the lesser of the taxpayer’s QPAI for the taxable year,
or the taxpayer’s taxable income for the taxable year, determined without
regard to the section 199 deduction (or in the case of an individual, AGI).
For purposes of determining AMTI in the case of a corporation (including
a corporation subject to tax under section 511(a)), a taxpayer must deduct
an amount equal to 9 percent (3 percent in the case of taxable years beginning
in 2005 or 2006, and 6 percent in the case of taxable years beginning in 2007,
2008, or 2009) of the lesser of the taxpayer’s QPAI for the taxable
year, or the taxpayer’s AMTI for the taxable year, determined without
regard to the section 199 deduction. For purposes of computing AMTI, QPAI
is determined without regard to any adjustments under sections 56 through
59. In the case of an individual or a non-grantor trust or estate, AGI and
taxable income are also determined without regard to any adjustments under
sections 56 through 59. The amount of the deduction allowable under this
paragraph (d) for any taxable year cannot exceed 50 percent of the W-2 wages
of the employer for the taxable year (as determined under §1.199-2).
The section 199 deduction is not taken into account in determining the amount
of the alternative tax net operating loss deduction (ATNOL) allowed under
section 56(a)(4). For example, assume that for the calendar year 2007, a
corporation has both AMTI (before the NOL deduction and before the section
199 deduction) and QPAI of $1,000,000, and has an ATNOL carryover to 2007
of $5,000,000. Assume that the taxpayer has W-2 wages in excess of the section
199(b) wage limitation. Under section 56(d), the ATNOL deduction for 2007
is $900,000 (90 percent of $1,000,000), reducing AMTI to $100,000. The taxpayer
must then further reduce the AMTI by the section 199 deduction of $6,000 (six
percent of the lesser of $1,000,000 or $100,000) to $94,000. The ATNOL carryover
to 2008 is $4,100,000.
(e) Nonrecognition transactions—(1) In
general—(i) Sections 351, 721, and 731.
Except as provided for an EAG partnership (as defined in §1.199-9(j))
and an expanded affiliated group (EAG) (as defined in §1.199-7), if property
is transferred by the taxpayer to an entity in a transaction to which section
351 or 721 applies, then whether the gross receipts derived by the entity
are domestic production gross receipts (DPGR) (as defined in §1.199-3)
shall be determined based solely on the activities performed by the entity
without regard to the activities performed by the taxpayer prior to the contribution
of the property to the entity. Except as provided for a qualifying in-kind
partnership (as defined in §1.199-9(i)) and an EAG partnership, if property
is transferred by a partnership to a partner in a transaction to which section
731 applies, then whether gross receipts derived by the partner are DPGR shall
be determined based on the activities performed by the partner without regard
to the activities performed by the partnership before the distribution of
the property to the partner.
(ii) Exceptions—(A) Section 708(b)(1)(B).
If property is deemed to be contributed by a partnership (transferor partnership)
to another partnership (transferee partnership) as a result of a termination
under section 708(b)(1)(B), then the transferee partnership shall be treated
as performing those activities performed by the transferor partnership with
respect to the transferred property of the transferor partnership.
(B) Transfers by reason of death. If property
is transferred upon or by reason of the death of an individual (decedent),
then the decedent’s successor(s) in interest shall be treated as having
performed those activities performed by or deemed to have been performed (pursuant
to §1.199-9(i)) by the decedent with respect to the transferred property.
For this purpose, a transfer shall include without limitation the passing
of the property by bequest, contractual provision, beneficiary designation,
or operation of law, and successor in interest shall include without limitation
the decedent’s heirs or legatees, the decedent’s estate or trust,
or the beneficiary or beneficiaries of the decedent’s estate or trust.
(2) Section 1031 exchanges. If a taxpayer exchanges
property for replacement property in a transaction to which section 1031 applies,
then whether the gross receipts derived from the lease, rental, license, sale,
exchange, or other disposition of the replacement property are DPGR shall
be determined based solely on the activities performed by the taxpayer with
respect to the replacement property.
(3) Section 381 transactions. If a corporation
(the acquiring corporation) acquires the assets of another corporation (the
target corporation) in a transaction to which section 381(a) applies, then
the acquiring corporation shall be treated as performing those activities
of the target corporation with respect to the acquired assets of the target
corporation. Therefore, to the extent that the acquired assets of the target
corporation would have given rise to DPGR if leased, rented, licensed, sold,
exchanged, or otherwise disposed of by the target corporation, such assets
will give rise to DPGR if leased, rented, licensed, sold, exchanged, or otherwise
disposed of by the acquiring corporation (assuming all the other requirements
of §1.199-3 are met).
(f) Taxpayers with a 52-53 week taxable year.
For purposes of applying §1.441-2(c)(1) in the case of a taxpayer using
a 52-53 week taxable year, any reference in section 199(a)(2) (the phase-in
rule), §§1.199-1 through 1.199-9 to a taxable year beginning after
a particular calendar year means a taxable year beginning after December 31st
of that year. Similarly, any reference to a taxable year beginning in a particular
calendar year means a taxable year beginning after December 31st of the preceding
calendar year. For example, a 52-53 week taxable year that begins on December
26, 2006, is deemed to begin on January 1, 2007, and the transition percentage
for that taxable year is 6 percent.
(g) Section 481(a) adjustments. For purposes
of determining QPAI, a section 481(a) adjustment, whether positive or negative,
taken into account by a taxpayer during the taxable year that is solely attributable
to either the taxpayer’s gross receipts, CGS, or deductions must be
allocated or apportioned between DPGR and non-DPGR using the methods used
by a taxpayer to allocate or apportion gross receipts, CGS, and deductions
between DPGR and non-DPGR for the current taxable year. See §§1.199-1
and 1.199-4 for rules related to the allocation and apportionment of gross
receipts, CGS, and deductions, respectively. For example, if a taxpayer changes
its method of accounting for inventories from the last-in, first-out (LIFO)
method to the first-in, first-out (FIFO) method and the taxpayer uses the
small business simplified overall method to apportion CGS between DPGR and
non-DPGR, the taxpayer is required to apportion the resulting section 481(a)
adjustment, whether positive or negative, between DPGR and non-DPGR using
the small business simplified overall method. If a section 481(a) adjustment
is not solely attributable to either gross receipts, CGS, or deductions (for
example, the taxpayer changes its overall method of accounting from an accrual
method to the cash method) and the section 481(a) adjustment cannot be specifically
identified with either gross receipts, CGS, or deductions, then the section
481(a) adjustment, whether positive or negative, must be attributed to, or
among, gross receipts, CGS, or deductions using any reasonable method that
is satisfactory to the Secretary based on all of the facts and circumstances,
and then allocated or apportioned between DPGR and non-DPGR using the same
methods the taxpayer uses to allocate or apportion gross receipts, CGS, or
deductions between DPGR and non-DPGR for the taxable year or taxable years
that the section 481(a) adjustment is taken into account. Factors taken into
consideration in determining whether the method is reasonable include whether
the taxpayer uses the most accurate information available; the relationship
between the section 481(a) adjustment and the apportionment base chosen; the
accuracy of the method chosen as compared with other possible methods; and
the time, burden, and cost of using alternative methods. If a section 481(a)
adjustment is spread over more than one taxable year, then a taxpayer must
attribute the section 481(a) adjustment among gross receipts, CGS, or deductions,
as applicable, in the same amount for each taxable year within the spread
period. For example, if a taxpayer, using a reasonable method that is satisfactory
to the Secretary based on all of the facts and circumstances, determines that
a section 481(a) adjustment that is required to be spread over four taxable
years should be attributed half to gross receipts and half to deductions,
then the taxpayer must attribute the section 481(a) adjustment half to gross
receipts and half to deductions in each of the four taxable years of the spread
period. Further, if such taxpayer uses the simplified deduction method to
apportion deductions between DPGR and non-DPGR in the first taxable year of
the spread period, then the taxpayer must use the simplified deduction method
to apportion half the section 481(a) adjustment for that taxable year between
DPGR and non-DPGR for that taxable year. Similarly, if in the second taxable
year of the spread period the taxpayer uses the section 861 method to apportion
and allocate costs between DPGR and non-DPGR, then the taxpayer must use the
section 861 method to allocate and apportion half the section 481(a) adjustment
for that taxable year between DPGR and non-DPGR for that taxable year.
(h) Disallowed losses or deductions. Except as
provided by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b)
of this chapter), losses or deductions of a taxpayer that otherwise would
be taken into account in computing the taxpayer’s section 199 deduction
are taken into account only if and to the extent the deductions are not disallowed
by section 465 or 469, or any other provision of the Code. If only a portion
of the taxpayer’s share of the losses or deductions is allowed for a
taxable year, the proportionate share of those allowable losses or deductions
that are allocated to the taxpayer’s qualified production activities,
determined in a manner consistent with sections 465 and 469, and any other
applicable provision of the Code, is taken into account in computing QPAI
for purposes of the section 199 deduction for that taxable year. To
the extent that any of the disallowed losses or deductions are allowed in
a later taxable year, the taxpayer takes into account a proportionate share
of those losses or deductions in computing its QPAI for that later taxable
year. Losses or deductions of the taxpayer that are disallowed for taxable
years beginning on or before December 31, 2004, are not taken into account
in a later taxable year for purposes of computing the taxpayer’s QPAI
and the wage limitation of section 199(d)(1)(A)(iii) under §1.199-9
for that taxable year, regardless of whether the losses or deductions are
allowed for other purposes. For taxpayers that are partners in partnerships,
see §1.199-9(b)(2). For taxpayers that are shareholders in S corporations,
see §1.199-9(c)(2).
(i) Effective dates—(1) In general.
Section 199 applies to taxable years beginning after December 31, 2004.
Sections 1.199-1 through 1.199-8 are applicable for taxable years beginning
on or after June 1, 2006. For a taxable year beginning on or before May 17,
2006, the enactment date of the Tax Increase Prevention and Reconciliation
Act of 2005 (Public Law 109-222, 120 Stat. 345), a taxpayer may apply
§§1.199-1 through 1.199-9 provided that the taxpayer applies all
provisions in §§1.199-1 through 1.199-9 to the taxable year. For
a taxable year beginning after May 17, 2006, and before June 1, 2006,
a taxpayer may apply §§1.199-1 through 1.199-8 provided that the
taxpayer applies all provisions in §§1.199-1 through 1.199-8 to
the taxable year. For a taxpayer who chooses not to rely on these final regulations
for a taxable year beginning before June 1, 2006, the guidance under section
199 that applies to such taxable year is contained in Notice 2005-14, 2005-1
C.B. 498 (see §601.601(d)(2) of this chapter). In addition, a taxpayer
also may rely on the provisions of REG-105847-05, 2005-47 I.R.B. 987 (see
§601.601(d)(2) of this chapter), for a taxable year beginning before
June 1, 2006. If Notice 2005-14 and REG-105847-05 include different rules
for the same particular issue, then a taxpayer may rely on either the rule
set forth in Notice 2005-14 or the rule set forth in REG-105847-05. However,
if REG-105847-05 includes a rule that was not included in Notice 2005-14,
then a taxpayer is not permitted to rely on the absence of a rule in Notice
2005-14 to apply a rule contrary to REG-105847-05. For taxable years beginning
after May 17, 2006, and before June 1, 2006, a taxpayer may not apply Notice
2005-14, REG-105847-05, or any other guidance under section 199 in a manner
inconsistent with amendments made to section 199 by section 514 of the Tax
Increase Prevention and Reconciliation Act of 2005.
(2) Pass-thru entities. In determining the deduction
under section 199, items arising from a taxable year of a partnership, S corporation,
estate, or trust beginning before January 1, 2005, shall not be taken into
account for purposes of section 199(d)(1).
(3) Non-consolidated EAG members. A member of
an EAG that is not a member of a consolidated group may apply paragraph (i)(1)
of this section without regard to how other members of the EAG apply paragraph
(i)(1) of this section.
(4) Computer software provided to customers over the Internet.
[Reserved]. For further guidance, see §1.199-8T(i)(4).
§1.199-9 Application of section 199 to pass-thru entities
for taxable years beginning on or before May 17, 2006, the enactment date
of the Tax Increase Prevention and Reconciliation Act of 2005.
(a) In general. The provisions of this section
apply solely for purposes of section 199 of the Internal Revenue Code (Code).
(b) Partnerships—(1) In general—(i) Determination
at partner level. The deduction with respect to the qualified
production activities of the partnership allowable under §1.199-1(a)
(section 199 deduction) is determined at the partner level. As a result,
each partner must compute its deduction separately. The section 199 deduction
has no effect on the adjusted basis of the partner’s interest in the
partnership. Except as provided by publication pursuant to paragraph (b)(1)(ii)
of this section, for purposes of this section, each partner is allocated,
in accordance with sections 702 and 704, its share of partnership items
(including items of income, gain, loss, and deduction), cost of goods sold
(CGS) allocated to such items of income, and gross receipts that are included
in such items of income, even if the partner’s share of CGS and other
deductions and losses exceeds domestic production gross receipts (DPGR) (as
defined in §1.199-3(a)) and regardless of the amount of the partner’s
share of W-2 wages (as defined in §1.199-2(e)) of the partnership for
the taxable year. A partnership may specially allocate items of income, gain,
loss, or deduction to its partners, subject to the rules of section 704(b)
and the supporting regulations. Guaranteed payments under section 707(c)
are not considered allocations of partnership income for purposes of this
section. Guaranteed payments under section 707(c) are deductions by the partnership
that must be taken into account under the rules of §1.199-4. See §1.199-3(p)
and paragraph (b)(6) Example 5 of this section. Except
as provided in paragraph (b)(1)(ii) of this section, to determine its section 199
deduction for the taxable year, a partner aggregates its distributive share
of such items, to the extent they are not otherwise disallowed by the Code,
with those items it incurs outside the partnership (whether directly or indirectly)
for purposes of allocating and apportioning deductions to DPGR and computing
its qualified production activities income (QPAI) (as defined in §1.199-1(c)).
(ii) Determination at entity level. The Secretary
may, by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b)
of this chapter), permit a partnership to calculate a partner’s share
of QPAI at the entity level, instead of allocating, in accordance with sections
702 and 704, the partner’s share of partnership items (including items
of income, gain, loss, and deduction). If a partnership does calculate QPAI
at the entity level—
(A) The partner is allocated its share of QPAI and W-2 wages (as defined
in §1.199-2(e)), which (subject to the limitations of paragraph (b)(2)
of this section and section 199(d)(1)(A)(iii), respectively) are combined
with the partner’s QPAI and W-2 wages from other sources;
(B) For purposes of computing QPAI under §§1.199-1 through
1.199-9, a partner does not take into account the items from such a partnership
(for example, a partner does not take into account items from such a partnership
in determining whether a threshold or de minimis rule
applies or when the partner allocates and apportions deductions in calculating
its QPAI from other sources);
(C) A partner generally does not recompute its share of QPAI from the
partnership using another method; however, the partner might have to adjust
its share of QPAI from the partnership to take into account certain disallowed
losses or deductions, or the allowance of suspended losses or deductions;
and
(D) A partner’s distributive share of QPAI from a partnership
may be less than zero.
(2) Disallowed losses or deductions. Except as
provided by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b)
of this chapter), losses or deductions of a partnership that otherwise would
be taken into account in computing the partner’s section 199 deduction
for a taxable year are taken into account in that year only if and to the
extent the partner’s distributive share of those losses or deductions
from all of the partnership’s activities is not disallowed by section
465, 469, or 704(d), or any other provision of the Code. If only a portion
of the partner’s distributive share of the losses or deductions is allowed
for a taxable year, a proportionate share of those allowable losses or deductions
that are allocated to the partnership’s qualified production activities,
determined in a manner consistent with sections 465, 469, and 704(d),
and any other applicable provision of the Code, is taken into account in computing
QPAI and the wage limitation of section 199(d)(1)(A)(iii) for that taxable
year. To the extent that any of the disallowed losses or deductions are allowed
in a later taxable year, the partner takes into account a proportionate share
of those losses or deductions in computing its QPAI for that later taxable
year. Losses or deductions of the partnership that are disallowed for taxable
years beginning on or before December 31, 2004, are not taken into account
in a later taxable year for purposes of computing the partner’s QPAI
or the wage limitation of section 199(d)(1)(A)(iii) for that taxable
year, regardless of whether the losses or deductions are allowed for other
purposes.
(3) Partner’s share of W-2 wages. Under
section 199(d)(1)(A)(iii), a partner’s share of W-2 wages of a
partnership for purposes of determining the partner’s section 199(b)
wage limitation is the lesser of the partner’s allocable share of those
wages (without regard to section 199(d)(1)(A)(iii)), or 2 times 3 percent
of the QPAI computed by taking into account only the items of the partnership
allocated to the partner for the taxable year of the partnership. Except
as provided by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b)
of this chapter), this QPAI calculation is performed by the partner using
the same cost allocation method that the partner uses in calculating the partner’s
section 199 deduction. The partnership must allocate W-2 wages (prior to
the application of the wage limitation) among the partners in the same manner
as wage expense. The partner must add the partner’s share of the W-2
wages from the partnership, as limited by section 199(d)(1)(A)(iii), to the
partner’s W-2 wages from other sources, if any. If QPAI, computed by
taking into account only the items of the partnership allocated to the partner
for the taxable year (as required by the wage limitation of section 199(d)(1)(A)(iii))
is not greater than zero, then the partner may not take into account any W-2
wages of the partnership in applying the wage limitation of §1.199-2
(but the partner will, nevertheless, aggregate its distributive share of partnership
items including wage expense with those items not from the partnership in
computing its QPAI when determining its section 199 deduction). See §1.199-2
for the computation of W-2 wages, and paragraph (g) of this section for rules
regarding pass-thru entities in a tiered structure.
(4) Transition percentage rule for W-2 wages.
With regard to partnerships, for purposes of section 199(d)(1)(A)(iii)(II)
the transition percentages determined under section 199(a)(2) shall be determined
by reference to the partnership’s taxable year. Thus, if a partner
uses a calendar year taxable year, and owns an interest in a partnership that
has a taxable year ending on April 30, the partner’s section 199(d)(1)(A)(iii)
wage limitation for the partnership’s taxable year beginning on May
1, 2006, would be calculated using 3 percent, even though the partner includes
the partner’s distributive share of partnership items from that taxable
year on the partner’s 2007 Federal income tax return.
(5) Partnerships electing out of subchapter K.
For purposes of §§1.199-1 through 1.199-9, the rules of paragraph
(b) of this section shall apply to all partnerships, including those partnerships
electing under section 761(a) to be excluded, in whole or in part, from the
application of subchapter K of chapter 1 of the Code.
(6) Examples. The following examples illustrate
the application of this paragraph (b). Assume that each partner has sufficient
adjusted gross income or taxable income so that the section 199 deduction
is not limited under section 199(a)(1)(B); that the partnership and each of
its partners (whether individual or corporate) are calendar year taxpayers;
and that the amount of the partnership’s W-2 wages equals wage expense
for each taxable year. The examples are as follows:
Example 1. Section 861 method with interest
expense. (i) Partnership Federal income tax items.
X and Y, unrelated United States corporations, are each 50% partners in PRS,
a partnership that engages in production activities that generate both DPGR
and non-DPGR. X and Y share all items of income, gain, loss, deduction, and
credit 50% each. Both X and Y are engaged in a trade or business. PRS is
not able to specifically identify CGS allocable to DPGR and non-DPGR. In
this case, because CGS is definitely related under the facts and circumstances
to all of PRS’s gross income, apportionment of CGS between DPGR and
non-DPGR based on gross receipts is appropriate. For 2006, the adjusted basis
of PRS’s business assets is $5,000, $4,000 of which generate gross income
attributable to DPGR and $1,000 of which generate gross income attributable
to non-DPGR. For 2006, PRS has the following Federal income tax items:
(ii) Allocation of PRS’s items of income, gain, loss,
deduction, or credit. X and Y each receive the following distributive
share of PRS’s items of income, gain, loss, deduction or credit, as
determined under the principles of §1.704-1(b)(1)(vii):
(iii) Determination of QPAI. (A) X’s
QPAI. Because the section 199 deduction is determined at the partner
level, X determines its QPAI by aggregating, to the extent necessary, its
distributive share of PRS’s Federal income tax items with all other
such items from all other, non-PRS-related activities. For 2006, X does not
have any other such items. For 2006, the adjusted basis of X’s non-PRS
assets, all of which are investment assets, is $10,000. X’s only gross
receipts for 2006 are those attributable to the allocation of gross income
from PRS. X allocates and apportions its deductible items to gross income
attributable to DPGR under the section 861 method of §1.199-4(d). In
this case, the section 162 selling expenses (including W-2 wages) are definitely
related to all of PRS’s gross receipts. Based on the facts and circumstances
of this specific case, apportionment of those expenses between DPGR and non-DPGR
on the basis of PRS’s gross receipts is appropriate. X elects to apportion
its distributive share of interest expense under the tax book value method
of §1.861-9T(g). X’s QPAI for 2006 is $366, as shown below:
(B) Y’s QPAI. (1)
For 2006, in addition to the activities of PRS, Y engages in production activities
that generate both DPGR and non-DPGR. Y is able to specifically identify
CGS allocable to DPGR and to non-DPGR. For 2006, the adjusted basis of Y’s
non-PRS assets attributable to its production activities that generate DPGR
is $8,000 and to other production activities that generate non-DPGR is $2,000.
Y has no other assets. Y has the following Federal income tax items relating
to its non-PRS activities:
(2) Y determines its QPAI in the same general
manner as X. However, because Y has other trade or business activities outside
of PRS, Y must aggregate its distributive share of PRS’s Federal income
tax items with its own such items. Y allocates and apportions its deductible
items to gross income attributable to DPGR under the section 861 method of
§1.199-4(d). In this case, Y’s distributive share of PRS’s
section 162 selling expenses (including W-2 wages), as well as those selling
expenses from Y’s non-PRS activities, are definitely related to all
of its gross income. Based on the facts and circumstances of this specific
case, apportionment of those expenses between DPGR and non-DPGR on the basis
of Y’s gross receipts is appropriate. Y elects to apportion its distributive
share of interest expense under the tax book value method of §1.861-9T(g).
Y has $1,290 of gross income attributable to DPGR ($3,000 DPGR ($1,500 from
PRS and $1,500 from non-PRS activities) - $1,710 CGS ($810 from PRS and $900
from non-PRS activities)). Y’s QPAI for 2006 is $642, as shown below:
(iv) PRS W-2 wages allocated to X and Y under section 199(d)(1)(A)(iii).
Solely for purposes of calculating the PRS W-2 wages that are allocated to
them under section 199(d)(1)(A)(iii) for purposes of the wage limitation of
section 199(b), X and Y must separately determine QPAI taking into account
only the items of PRS allocated to them. X and Y must use the same methods
of allocation and apportionment that they use to determine their QPAI in paragraphs
(iii)(A) and (B) of this Example 1, respectively. Accordingly,
X and Y must apportion deductible section 162 selling expenses that include
W-2 wage expense on the basis of gross receipts, and must apportion interest
expense according to the tax book value method of §1.861-9T(g).
(A) QPAI of X and Y, solely for this purpose, is determined by allocating
and apportioning each partner’s share of PRS expenses to each partner’s
share of PRS gross income of $690 attributable to DPGR ($1,500 DPGR - $810
CGS, apportioned based on gross receipts). Thus, QPAI of X and Y solely for
this purpose is $270, as shown below:
(B) X’s and Y’s shares of PRS’s W-2 wages determined
under section 199(d)(1)(A)(iii) for purposes of the wage limitation of section
199(b) are $16, the lesser of $250 (partner’s allocable share of PRS’s
W-2 wages ($100 included in total CGS, and $150 included in selling expenses)
and $16 (2 x ($270 x .03)).
(v) Section 199 deduction determination. (A)
X’s tentative section 199 deduction is $11 (.03 x $366 (that is, QPAI
determined at partner level)) subject to the wage limitation of $8 (50% x
$16). Accordingly, X’s section 199 deduction for 2006 is $8.
(B) Y’s tentative section 199 deduction is $19 (.03 x $642 (that
is, QPAI determined at the partner level) subject to the wage limitation of
$133 (50% x ($16 from PRS and $250 from non-PRS activities)). Accordingly,
Y’s section 199 deduction for 2006 is $19.
Example 2. Section 861 method with R&E
expense. (i) Partnership items of income, gain, loss,
deduction or credit. X and Y, unrelated United States corporations
each of which is engaged in a trade or business, are partners in PRS, a partnership
that engages in production activities that generate both DPGR and non-DPGR.
Neither X nor Y is a member of an affiliated group. X and Y share all items
of income, gain, loss, deduction, and credit 50% each. All of PRS’s
domestic production activities that generate DPGR are within Standard Industrial
Classification (SIC) Industry Group AAA (SIC AAA). All of PRS’s production
activities that generate non-DPGR are within SIC Industry Group BBB (SIC BBB).
PRS is not able to specifically identify CGS allocable to DPGR and to non-DPGR
and, therefore, apportions CGS to DPGR and non-DPGR based on its gross receipts.
PRS incurs $900 of research and experimentation expenses (R&E) that are
deductible under section 174, $300 of which are performed with respect to
SIC AAA and $600 of which are performed with respect to SIC BBB. None of
the R&E is legally mandated R&E as described in §1.861-17(a)(4)
and none is included in CGS. PRS incurs section 162 selling expenses (that
include W-2 wage expense) that are not includible in CGS and are definitely
related to all of PRS’s gross income. For 2006, PRS has the following
Federal income tax items:
(ii) Allocation of PRS’s items of income, gain, loss,
deduction, or credit. X and Y each receive the following distributive
share of PRS’s items of income, gain, loss, deduction, or credit, as
determined under the principles of §1.704-1(b)(1)(vii):
(iii) Determination of QPAI. (A) X’s
QPAI. Because the section 199 deduction is determined at the partner
level, X determines its QPAI by aggregating, to the extent necessary, its
distributive shares of PRS’s Federal income tax items with all other
such items from all other, non-PRS-related activities. For 2006, X does not
have any other such tax items. X’s only gross receipts for 2006 are
those attributable to the allocation of gross income from PRS. As stated,
all of PRS’s domestic production activities that generate DPGR are within
SIC AAA. X allocates and apportions its deductible items to gross income
attributable to DPGR under the section 861 method of §1.199-4(d). In
this case, the section 162 selling expenses (including W-2 wages) are definitely
related to all of PRS’s gross income. Based on the facts and circumstances
of this specific case, apportionment of those expenses between DPGR and non-DPGR
on the basis of PRS’s gross receipts is appropriate. For purposes of
apportioning R&E, X elects to use the sales method as described in §1.861-17(c).
Because X has no direct sales of products, and because all of PRS’s
SIC AAA sales attributable to X’s share of PRS’s gross income
generate DPGR, all of X’s share of PRS’s section 174 R&E attributable
to SIC AAA is taken into account for purposes of determining X’s QPAI.
Thus, X’s total QPAI for 2006 is $540, as shown below:
(B) Y’s QPAI. (1)
For 2006, in addition to the activities of PRS, Y engages in domestic production
activities that generate both DPGR and non-DPGR. With respect to those non-PRS
activities, Y is not able to specifically identify CGS allocable to DPGR and
to non-DPGR. In this case, because CGS is definitely related under the facts
and circumstances to all of Y’s non-PRS gross receipts, apportionment
of CGS between DPGR and non-DPGR based on Y’s non-PRS gross receipts
is appropriate. For 2006, Y has the following non-PRS Federal income tax
items:
(2) Because Y has DPGR as a result of activities
outside PRS, Y must aggregate its distributive share of PRS’s Federal
income tax items with such items from all its other, non-PRS-related activities.
Y allocates and apportions its deductible items to gross income attributable
to DPGR under the section 861 method of §1.199-4(d). In this case, the
section 162 selling expenses (including W-2 wages) are definitely related
to all of Y’s gross income. Based on the facts and circumstances of
the specific case, apportionment of such expenses between DPGR and non-DPGR
on the basis of Y’s gross receipts is appropriate. For purposes of
apportioning R&E, Y elects to use the sales method as described in §1.861-17(c).
(3) With respect to sales that generate DPGR,
Y has gross income of $2,400 ($4,500 DPGR ($1,500 from PRS and $3,000 from
non-PRS activities) - $2,100 CGS ($600 from sales of products by PRS and $1,500
from non-PRS activities)). Because all of the sales in SIC AAA generate DPGR,
all of Y’s share of PRS’s section 174 R&E attributable to
SIC AAA and the section 174 R&E attributable to SIC AAA that Y incurs
in its non-PRS activities are taken into account for purposes of determining
Y’s QPAI. Because only a portion of the sales within SIC BBB generate
DPGR, only a portion of the section 174 R&E attributable to SIC BBB is
taken into account in determining Y’s QPAI. Thus, Y’s QPAI for
2006 is $1,282, as shown below:
(iv) PRS W-2 wages allocated to X and Y under section 199(d)(1)(A)(iii).
Solely for purposes of calculating the PRS W-2 wages that are allocated to
X and Y under section 199(d)(1)(A)(iii) for purposes of the wage limitation
of section 199(b), X and Y must separately determine QPAI taking into account
only the items of PRS allocated to them. X and Y must use the same
methods of allocation and apportionment that they use to determine their QPAI
in paragraphs (iii)(A) and (B) of this Example 2, respectively.
Accordingly, X and Y must apportion section 162 selling expenses that include
W-2 wage expense on the basis of gross receipts, and apportion section 174
R&E expense under the sales method as described in §1.861-17(c).
(A) QPAI of X and Y, solely for this purpose, is determined by allocating
and apportioning each partner’s share of PRS expenses to each partner’s
share of PRS gross income of $900 attributable to DPGR ($1,500 DPGR - $600
CGS, allocated based on PRS’s gross receipts). Because all of PRS’s
SIC AAA sales generate DPGR, all of X’s and Y’s shares of PRS’s
section 174 R&E attributable to SIC AAA is taken into account for purposes
of determining X’s and Y’s QPAI. None of PRS’s section
174 R&E attributable to SIC BBB is taken into account because PRS has
no DPGR within SIC BBB. Thus, X and Y each has QPAI, solely for this purpose,
of $540, as shown below:
(B) X’s and Y’s shares of PRS’s W-2 wages determined
under section 199(d)(1)(A)(iii) for purposes of the wage limitation of section
199(b) are $32, the lesser of $150 (partner’s allocable share of PRS’s
W-2 wages ($100 included in CGS, and $50 included in selling expenses)) and
$32 (2 x ($540 x .03)).
(v) Section 199 deduction determination. (A)
X’s tentative section 199 deduction is $16 (.03 x $540 (QPAI determined
at partner level)) subject to the wage limitation of $16 (50% x $32). Accordingly,
X’s section 199 deduction for 2006 is $16.
(B) Y’s tentative section 199 deduction is $38 (.03 x $1,282
(QPAI determined at partner level) subject to the wage limitation of $144
(50% x $287 ($32 from PRS + $255 from non-PRS activities)). Accordingly,
Y’s section 199 deduction for 2006 is $38.
Example 3. Partnership with special
allocations. (i) In general. X and Y are
unrelated corporate partners in PRS and each is engaged in a trade or business.
PRS is a partnership that engages in a domestic production activity and other
activities. In general, X and Y share all partnership items of income, gain,
loss, deduction, and credit equally, except that 80% of the wage expense of
PRS and 20% of PRS’s other expenses are specially allocated to X (substantial
economic effect under section 704(b) is presumed). In the 2006 taxable year,
PRS’s only wage expense is $2,000 for marketing, which is not included
in CGS. PRS has $8,000 of gross receipts ($6,000 of which is DPGR), $4,000
of CGS ($3,500 of which is allocable to DPGR), and $3,000 of deductions (comprised
of $2,000 of wages for marketing and $1,000 of other expenses). X qualifies
for and uses the simplified deduction method under §1.199-4(e). Y
does not qualify to use that method and, therefore, must use the section 861
method under §1.199-4(d). In the 2006 taxable year, X has gross receipts
attributable to non-partnership trade or business activities of $1,000 and
wages of $200. None of X’s non-PRS gross receipts is DPGR.
(ii) Allocation and apportionment of costs. Under
the partnership agreement, X’s distributive share of the items of PRS
is $1,250 of gross income attributable to DPGR ($3,000 DPGR - $1,750 allocable
CGS), $750 of gross income attributable to non-DPGR ($1,000 non-DPGR - $250
allocable CGS), and $1,800 of deductions (comprised of X’s special allocations
of $1,600 of wage expense ($2,000 x 80%) for marketing and $200 of other expenses
($1,000 x 20%)). Under the simplified deduction method, X apportions $1,200
of other deductions to DPGR ($2,000 ($1,800 from the partnership and $200
from non-partnership activities) x ($3,000 DPGR/$5,000 total gross receipts)).
Accordingly, X’s QPAI is $50 ($3,000 DPGR - $1,750 CGS - $1,200 of
deductions). However, in determining the section 199(d)(1)(A)(iii) wage limitation,
QPAI is computed taking into account only the items of PRS allocated to X
for the taxable year of PRS. Thus, X apportions $1,350 of deductions to DPGR
($1,800 x ($3,000 DPGR/$4,000 total gross receipts from PRS)). Accordingly,
X’s QPAI for purposes of the section 199(d)(1)(A)(iii) wage limitation
is $0 ($3,000 DPGR - $1,750 CGS - $1,350 of deductions). X’s share
of PRS’s W-2 wages is $0, the lesser of $1,600 (X’s 80% allocable
share of $2,000 of wage expense for marketing) and $0 (2 x ($0 QPAI x .03)). X’s
tentative deduction is $2 ($50 QPAI x .03), subject to the section 199(b)(1)
wage limitation of $100 (50% x $200 ($0 of PRS-related W-2 wages + $200 of
non-PRS W-2 wages)). Accordingly, X’s section 199 deduction for the
2006 taxable year is $2.
Example 4. Partnership with no W-2 wages.
(i) Facts. A, an individual, and B, an individual,
are partners in PRS. PRS is a partnership that engages in manufacturing activities
that generate both DPGR and non-DPGR. A and B share all items of income,
gain, loss, deduction, and credit equally. In the 2006 taxable year, PRS
has total gross receipts of $2,000 ($1,000 of which is DPGR), CGS of $400
and deductions of $800. PRS has no W-2 wages. A and B each use the small
business simplified overall method under §1.199-4(f). A has trade or
business activities outside of PRS. With respect to those activities, A has
total gross receipts of $1,000 ($500 of which is DPGR), CGS of $400 (including
$50 of W-2 wages) and deductions of $200 for the 2006 taxable year. B has
no trade or business activities outside of PRS and pays $0 of W-2 wages directly
for the 2006 taxable year. A’s distributive share of the items of the
partnership is $500 DPGR, $500 non-DPGR, $200 CGS, and $400 of deductions.
(ii) Section 199(d)(1)(A)(iii) wage limitation.
A’s CGS and deductions apportioned to DPGR from PRS equal $300 (($200
CGS + $400 of other deductions) x ($500 DPGR/$1,000 total gross receipts)).
Accordingly, for purposes of the wage limitation of section 199(d)(1)(A)(iii),
A’s QPAI is $200 ($500 DPGR - $300 CGS and other deductions). A’s
share of partnership W-2 wages after application of the section 199(d)(1)(A)(iii)
limitation is $0, the lesser of $0 (A’s 50% allocable share of PRS’s
$0 of W-2 wages) or $12 (2 x ($200 QPAI x .03)). B’s share of PRS’s
W-2 wages also is $0.
(iii) Section 199 deduction computation. A’s
total CGS and deductions apportioned to DPGR equal $600 (($200 PRS CGS + $400
outside trade or business CGS + $400 PRS deductions + $200 outside trade or
business deductions) x ($1,000 total DPGR ($500 from PRS + $500 from outside
trade or business)/$2,000 total gross receipts ($1,000 from PRS + $1,000 from
outside trade or business)). Accordingly, A’s QPAI is $400 ($1,000
DPGR - $600 CGS and deductions). A’s tentative deduction is $12 ($400
QPAI x .03), subject to the section 199(b)(1) wage limitation of $25 (50%
x $50 total W-2 wages). A’s section 199 deduction for the 2006 taxable
year is $12. B’s total section 199 deduction for the 2006 taxable year
is $0 because B has no W-2 wages for the 2006 taxable year.
Example 5. Guaranteed payment.
(i) Facts. The facts are the same as Example
4 except that in 2006 PRS also makes a guaranteed payment of $200
to A for services, and PRS pays $200 of W-2 wages to PRS employees, which
is included within the $400 of CGS. See section 707(c). This guaranteed
payment is taxable to A as ordinary income and is properly deducted by PRS
under section 162. Pursuant to §1.199-3(p), A may not treat any part
of this payment as DPGR. Accordingly, PRS has total gross receipts of $2,000
($1,000 of which is DPGR), CGS of $400 (including $200 of W-2 wages) and deductions
of $1,000 (including the $200 guaranteed payment) for the 2006 taxable year.
A’s distributive share of the items of the partnership is $500 DPGR,
$500 non-DPGR, $200 CGS, and $500 of deductions.
(ii) Section 199(d)(1)(A)(iii) wage limitation.
A’s CGS and deductions apportioned to DPGR from PRS equal $350 (($200
CGS + $500 of other deductions) x ($500 DPGR/$1,000 total gross receipts)).
Accordingly, for purposes of the wage limitation of section 199(d)(1)(A)(iii),
A’s QPAI is $150 ($500 DPGR - $350 CGS and other deductions). A’s
share of partnership W-2 wages after application of the section 199(d)(1)(A)(iii)
limitation is $9, the lesser of $100 (A’s 50% allocable share of PRS’s
$200 of W-2 wages) or $9 (2 x ($150 QPAI x .03)). B’s share of PRS’s
W-2 wages after application of section 199(d)(1)(A)(iii) also is $9.
(iii) A’s section 199 deduction computation.
A’s total CGS and deductions apportioned to DPGR equal $591 (($200
PRS CGS + $400 outside trade or business CGS + $500 PRS deductions + $200
outside trade or business deductions) x ($1,000 total DPGR ($500 from PRS
+ $500 from outside trade or business)/$2,200 total gross receipts ($1,000
from PRS + $200 guaranteed payment + $1,000 from outside trade or business)).
Accordingly, A’s QPAI is $409 ($1,000 DPGR - $591 CGS and other deductions).
A’s tentative deduction is $12 ($409 QPAI x .03), subject to the section
199(b)(1) wage limitation of $30 (50% x $59 ($9 PRS W-2 wages + $50 W-2 wages
from A’s trade or business activities outside of PRS)). A’s section
199 deduction for the 2006 taxable year is $12.
(iv) B’s section 199 deduction computation.
B’s QPAI is $150 ($500 DPGR - $350 CGS and other deductions). B’s
tentative deduction is $5 ($150 QPAI x .03), subject to the section 199(b)(1)
wage limitation of $5 (50% x $9). Assuming that B engages in no other activities
generating DPGR, B’s section 199 deduction for the 2006 taxable year
is $5.
(c) S corporations—(1) In general—(i) Determination
at shareholder level. The section 199 deduction with respect to
the qualified production activities of an S corporation is determined at the
shareholder level. As a result, each shareholder must compute its deduction
separately. The section 199 deduction will have no effect on the basis of
a shareholder’s stock in an S corporation. Except as provided by publication
pursuant to paragraph (c)(1)(ii) of this section, for purposes of this section,
each shareholder is allocated, in accordance with section 1366, its pro
rata share of S corporation items (including items of income, gain,
loss, and deduction), CGS allocated to such items of income, and gross receipts
included in such items of income, even if the shareholder’s share of
CGS and other deductions and losses exceeds DPGR, and regardless of the amount
of the shareholder’s share of the W-2 wages of the S corporation for
the taxable year. Except as provided by publication under paragraph (c)(1)(ii)
of this section, to determine its section 199 deduction for the taxable
year, the shareholder aggregates its pro rata share of
such items, to the extent they are not otherwise disallowed by the Code, with
those items it incurs outside the S corporation (whether directly or indirectly)
for purposes of allocating and apportioning deductions to DPGR and computing
its QPAI.
(ii) Determination at entity level. The Secretary
may, by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b)
of this chapter), permit an S corporation to calculate a shareholder’s
share of QPAI at the entity level, instead of allocating, in accordance with
section 1366, the shareholder’s pro rata share
of S corporation items (including items of income, gain, loss, and deduction).
If an S corporation does calculate QPAI at the entity level—
(A) Each shareholder is allocated its share of QPAI and W-2 wages,
which (subject to the limitations under paragraph (c)(2) of this section and
section 199(d)(1)(A)(iii), respectively) are combined with the shareholder’s
QPAI and W-2 wages from other sources;
(B) For purposes of computing QPAI under §§1.199-1 through
1.199-9, a shareholder does not take into account the items from such an S
corporation (for example, a shareholder does not take into account items from
such an S corporation in determining whether a threshold or de minimis rule
applies or when the shareholder allocates and apportions deductions in calculating
its QPAI from other sources);
(C) A shareholder generally does not recompute its share of QPAI from
the S corporation using another method; however, the shareholder might have
to adjust its share of QPAI from the S corporation to take into account certain
disallowed losses or deductions, or the allowance of suspended losses or deductions;
and
(D) A shareholder’s share of QPAI from an S corporation may be
less than zero.
(2) Disallowed losses or deductions. Except as
provided by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b)
of this chapter), losses or deductions of the S corporation that otherwise
would be taken into account in computing the shareholder’s section 199
deduction for a taxable year are taken into account in that year only if and
to the extent the shareholder’s pro rata share
of the losses or deductions from all of the S corporation’s activities
is not disallowed by section 465, 469, or 1366(d), or any other provision
of the Code. If only a portion of the shareholder’s share of the losses
or deductions is allowed for a taxable year, a proportionate share of those
allowable losses or deductions that are allocated to the S corporation’s
qualified production activities, determined in a manner consistent with sections 465,
469, and 1366(d), and any other applicable provision of the Code, is taken
into account in computing the QPAI and the wage limitation of section 199(d)(1)(A)(iii)
for that taxable year. To the extent that any of the disallowed losses or
deductions are allowed in a later taxable year, the shareholder takes into
account a proportionate share of those losses or deductions in computing its
QPAI for that later taxable year. Losses or deductions of the S corporation
that are disallowed for taxable years beginning on or before December 31,
2004, are not taken into account in a later taxable year for purposes of computing
the shareholder’s QPAI or the wage limitation of section 199(d)(1)(A)(iii)
for that taxable year, regardless of whether the losses or deductions are
allowed for other purposes.
(3) Shareholder’s share of W-2 wages. Under
section 199(d)(1)(A)(iii), an S corporation shareholder’s share
of the W-2 wages of the S corporation for purposes of determining the shareholder’s
section 199(b) limitation is the lesser of the shareholder’s allocable
share of those wages (without regard to section 199(d)(1)(A)(iii)), or
2 times 3 percent of the QPAI computed by taking into account only the
items of the S corporation allocated to the shareholder for the taxable year
of the S corporation. Except as provided by publication in the Internal Revenue
Bulletin (see §601.601(d)(2)(ii)(b) of this chapter),
this QPAI calculation is performed by the shareholder using the same cost
allocation method that the shareholder uses in calculating the shareholder’s
section 199 deduction. The S corporation must allocate W-2 wages (prior to
the application of the wage limitation) among the shareholders in the same
manner as wage expense. The shareholder must add the shareholder’s
share of W-2 wages from the S corporation, as limited by section 199(d)(1)(A)(iii),
to the shareholder’s W-2 wages from other sources, if any. If QPAI,
computed by taking into account only the items of the S corporation allocated
to the shareholder for the taxable year (as required by the wage limitation
of section 199(d)(1)(A)(iii)), is not greater than zero, then the shareholder
may not take into account any W-2 wages of the S corporation in applying the
wage limitation of §1.199-2 (but the shareholder will, nevertheless,
aggregate its distributive share of S corporation items including wage expense
with those items not from the S corporation in computing its QPAI when determining
its section 199 deduction). See §1.199-2 for the computation of W-2
wages, and paragraph (g) of this section for rules regarding pass-thru entities
in a tiered structure.
(4) Transition percentage rule for W-2 wages.
With regard to S corporations, for purposes of section 199(d)(1)(A)(iii)(II)
the transition percentages determined under section 199(a)(2) shall be determined
by reference to the S corporation’s taxable year. Thus, if an S corporation
shareholder uses a calendar year taxable year, and owns stock in an S corporation
that has a taxable year ending on April 30, the shareholder’s section
199(d)(1)(A)(iii) wage limitation for the S corporation’s taxable year
beginning on May 1, 2006, would be calculated using 3 percent, even though
the shareholder includes the shareholder’s pro rata share
of S corporation items from that taxable year on the shareholder’s 2007
Federal income tax return.
(d) Grantor trusts. To the extent that the grantor
or another person is treated as owning all or part (the owned portion) of
a trust under sections 671 through 679, such person (owner) computes its QPAI
with respect to the owned portion of the trust as if that QPAI had been generated
by activities performed directly by the owner. Similarly, for purposes of
the section 199(b) wage limitation, the owner of the trust takes into account
the owner’s share of the W-2 wages of the trust that are attributable
to the owned portion of the trust. The section 199(d)(1)(A)(iii) wage limitation
is not applicable to the owned portion of the trust. The provisions of paragraph
(e) of this section do not apply to the owned portion of a trust.
(e) Non-grantor trusts and estates—(1) Allocation
of costs. The trust or estate calculates each beneficiary’s
share (as well as the trust’s or estate’s own share, if any) of
QPAI and W-2 wages from the trust or estate at the trust or estate level.
The beneficiary of a trust or estate is not permitted to use another cost
allocation method to recompute its share of QPAI from the trust or estate
or to reallocate the costs of the trust or estate. Except as provided in
paragraph (d) of this section, the QPAI of a trust or estate must be computed
by allocating expenses described in section 199(d)(5) in one of two ways,
depending on the classification of those expenses under §1.652(b)-3. Specifically,
directly attributable expenses within the meaning of §1.652(b)-3 are
allocated pursuant to §1.652(b)-3, and expenses not directly attributable
within the meaning of §1.652(b)-3 (other expenses) are allocated under
the simplified deduction method of §1.199-4(e) (unless the trust or estate
does not qualify to use the simplified deduction method, in which case it
must use the section 861 method of §1.199-4(d) with respect to such other
expenses). For this purpose, depletion and depreciation deductions described
in section 642(e) and amortization deductions described in section 642(f)
are treated as other expenses described in section 199(d)(5). Also for this
purpose, the trust’s or estate’s share of other expenses from
a lower-tier pass-thru entity is not directly attributable to any class of
income (whether or not those other expenses are directly attributable to the
aggregate pass-thru gross income as a class for purposes other than section
199). A trust or estate may not use the small business simplified overall
method for computing its QPAI. See §1.199-4(f)(5).
(2) Allocation among trust or estate and beneficiaries—(i)
In general. The QPAI of a trust or estate (which will
be less than zero if the CGS and deductions allocated and apportioned to DPGR
exceed the trust’s or estate’s DPGR) and W-2 wages of the trust
or estate are allocated to each beneficiary and to the trust or estate based
on the relative proportion of the trust’s or estate’s distributable
net income (DNI), as defined by section 643(a), for the taxable year that
is distributed or required to be distributed to the beneficiary or is retained
by the trust or estate. To the extent that the trust or estate has no DNI
for the taxable year, any QPAI and W-2 wages are allocated entirely to the
trust or estate. A trust or estate is allowed the section 199 deduction in
computing its taxable income to the extent that QPAI and W-2 wages are allocated
to the trust or estate. A beneficiary of a trust or estate is allowed the
section 199 deduction in computing its taxable income based on its share of
QPAI and W-2 wages from the trust or estate, which (subject to the wage limitation
as described in paragraph (e)(3) of this section) are aggregated with the
beneficiary’s QPAI and W-2 wages from other sources.
(ii) Treatment of items from a trust or estate reporting
qualified production activities income. When, pursuant to this
paragraph (e), a taxpayer must combine QPAI and W-2 wages from a trust or
estate with the taxpayer’s total QPAI and W-2 wages from other sources,
the taxpayer, when applying §§1.199-1 through 1.199-9 to determine
the taxpayer’s total QPAI and W-2 wages from such other sources, does
not take into account the items from such trust or estate. Thus, for example,
a beneficiary of an estate that receives QPAI from the estate does not take
into account the beneficiary’s distributive share of the estate’s
gross receipts, gross income, or deductions when the beneficiary determines
whether a threshold or de minimis rule applies or when
the beneficiary allocates and apportions deductions in calculating its QPAI
from other sources.
(3) Beneficiary’s share of W-2 wages. The
trust or estate must compute each beneficiary’s share of W-2 wages from
the trust or estate in accordance with section 199(d)(1)(A)(iii), as if the
beneficiary were a partner in a partnership. The application of section 199(d)(1)(A)(iii)
to each trust and estate therefore means that if QPAI, computed by taking
into account only the items of the trust or estate allocated to the beneficiary
for the taxable year, is not greater than zero, then the beneficiary may not
take into account any W-2 wages of the trust or estate in applying the wage
limitation of §1.199-2 (but the beneficiary will, nevertheless, aggregate
its QPAI from the trust or estate with its QPAI from other sources when determining
the beneficiary’s section 199 deduction). See paragraph (g) of this
section for rules applicable to pass-thru entities in a tiered structure.
(4) Transition percentage rule for W-2 wages.
With regard to trusts and estates, for purposes of section 199(d)(1)(A)(iii)(II),
the transition percentages determined under section 199(a)(2) shall be determined
by reference to the taxable year of the trust or estate.
(5) Example. The following example illustrates
the application of this paragraph (e) and paragraph (g) of this section.
Assume that the partnership, trust, and trust beneficiary all are calendar
year taxpayers.
Example. (i) Computation of DNI and
inclusion and deduction amounts. (A) Trust’s distributive
share of partnership items. Trust, a complex trust, is a partner
in PRS, a partnership that engages in activities that generate DPGR and non-DPGR.
In 2006, PRS distributes $10,000 cash to Trust. Trust’s distributive
share of PRS items, which are properly included in Trust’s DNI, is as
follows:
(B) Trust’s direct activities. In addition
to its cash distribution in 2006 from PRS, Trust also directly has the following
items which are properly included in Trust’s DNI:
(C) Allocation of deductions under §1.652(b)-3.
(1) Directly attributable expenses.
In computing Trust’s DNI for the taxable year, the distributive share
of expenses of PRS are directly attributable under §1.652(b)-3(a) to
the distributive share of income of PRS. Accordingly, the $5,000 of CGS,
$3,000 of selling expenses, and $2,000 of other expenses are subtracted from
the gross receipts from PRS ($20,000), resulting in net income from PRS of
$10,000. With respect to the Trust’s direct expenses, $1,000 of the
trustee commissions, the $1,000 of real estate taxes, and the $2,000 of W-2
wages are directly attributable under §1.652(b)-3(a) to the rental income.
(2) Non-directly attributable expenses.
Under §1.652(b)-3(b), the trustee must allocate a portion of the sum
of the balance of the trustee commissions ($2,000), state income and personal
property taxes ($5,000), and the other business expenses ($1,000) to the $10,000
of tax-exempt interest. The portion to be attributed to tax-exempt interest
is $2,222 ($8,000 x ($10,000 tax-exempt interest/$36,000 gross receipts net
of direct expenses)), resulting in $7,778 ($10,000 - $2,222) of net tax-exempt
interest. Pursuant to its authority recognized under §1.652(b)-3(b),
the trustee allocates the entire amount of the remaining $5,778 of trustee
commissions, state income and personal property taxes, and other business
expenses to the $6,000 of net rental income, resulting in $222 ($6,000 - $5,778)
of net rental income.
(D) Amounts included in taxable income. For 2006,
Trust has DNI of $28,000 (net dividend income of $10,000 + net PRS income
of $10,000 + net rental income of $222 + net tax-exempt income of $7,778).
Pursuant to Trust’s governing instrument, Trustee distributes 50%,
or $14,000, of that DNI to B, an individual who is a discretionary beneficiary
of Trust. Assume that there are no separate shares under Trust, and no distributions
are made to any other beneficiary that year. Consequently, with respect to
the $14,000 distribution B receives from Trust, B properly includes in B’s
gross income $5,000 of income from PRS, $111 of rents, and $5,000 of dividends,
and properly excludes from B’s gross income $3,889 of tax-exempt interest.
Trust includes $20,222 in its adjusted total income and deducts $10,111 under
section 661(a) in computing its taxable income.
(ii) Section 199 deduction. (A) Simplified
deduction method. For purposes of computing the section 199 deduction
for the taxable year, assume Trust qualifies for the simplified deduction
method under §1.199-4(e). The determination of Trust’s QPAI under
the simplified deduction method requires multiple steps to allocate costs.
First, the Trust’s expenses directly attributable to DPGR under §1.652(b)-3(a)
are subtracted from the Trust’s DPGR. In this step, the directly attributable
$5,000 of CGS and selling expenses of $3,000 are subtracted from the $15,000
of DPGR from PRS. Next, Trust must identify its other trade or business expenses
directly related to non-DPGR trade or business income. In this example, the
portion of the trustee commissions not directly attributable to the rental
operation ($2,000), as well as the portion of the state income and personal
property taxes not directly attributable to either the PRS interests or the
rental operation, are not trade or business expenses and, thus, are ignored
in computing QPAI. The portion of the state income and personal property
taxes that is treated as other trade or business expenses is $3,000 ($5,000
x $30,000 total trade or business gross receipts/$50,000 total gross receipts).
Trust then allocates its other trade or business expenses on the basis of
its total gross receipts from the conduct of a trade or business ($20,000
from PRS + $10,000 rental income). Trust then combines its non-directly attributable
(other) business expenses ($2,000 from PRS + $4,000 ($1,000 of other expenses
+ $3,000 of income and property taxes) from its own activities) and then apportions
this total between DPGR and other receipts on the basis of Trust’s total
trade or business gross receipts ($6,000 x $15,000 DPGR/$30,000 total trade
or business gross receipts = $3,000). Thus, for purposes of computing Trust’s
and B’s section 199 deduction, Trust’s QPAI is $4,000 ($7,000
- $3,000). Because the distribution of Trust’s DNI to B equals one-half
of Trust’s DNI, Trust and B each has QPAI from PRS for purposes of the
section 199 deduction of $2,000.
(B) Section 199(d)(1)(A)(iii) wage limitation.
The wage limitation under section 199(d)(1)(A)(iii) must be applied both
at the Trust level and at B’s level. After applying this limitation
to the Trust’s share of PRS’s W-2 wages, Trust is allocated $330
of W-2 wages from PRS (the lesser of Trust’s allocable share of PRS’s
W-2 wages ($4,000) or 2 x 3% of Trust’s QPAI from PRS ($5,500)). Trust’s
QPAI from PRS for purposes of the section 199(d)(1)(A)(iii) limitation is
determined by taking into account only the items of PRS allocated to Trust
($15,000 DPGR - ($5,000 of CGS + $3,000 selling expenses + $1,500 of other
expenses)). For this purpose, the $1,500 of other expenses is determined
by multiplying $2,000 of other expenses from PRS by $15,000 of DPGR from PRS,
divided by $20,000 of total gross receipts from PRS. Trust adds this $330
of W-2 wages to Trust’s own $2,000 of W-2 wages (thus, $2,330). Because
the $14,000 Trust distribution to B equals one-half of Trust’s DNI,
Trust and B each has W-2 wages of $1,165. After applying the section 199(d)(1)(A)(iii)
wage limitation to B’s share of the W-2 wages allocated from Trust,
B has W-2 wages of $120 from Trust (lesser of $1,165 (allocable share of W-2
wages) or 2 x .03 x $2,000 (B’s share of Trust’s QPAI)). B has
W-2 wages of $100 from non-Trust activities for a total of $220 of W-2 wages.
(C) Section 199 deduction computation. (1)
B’s computation. B is eligible to use the small
business simplified overall method. Assume that B has sufficient adjusted
gross income so that the section 199 deduction is not limited under section
199(a)(1)(B). B has $1,000 of QPAI from non-Trust activities that is added
to the $2,000 QPAI from Trust for a total of $3,000 of QPAI. B’s tentative
deduction is $90 (.03 x $3,000), but it is limited under section 199(b) to
$110 (50% x $220 W-2 wages). Accordingly, B’s section 199 deduction
for 2006 is $90.
(2) Trust’s computation.
Trust has sufficient adjusted gross income so that the section 199 deduction
is not limited under section 199(a)(1)(B). Trust’s tentative deduction
is $60 (.03 x $2,000 QPAI), but it is limited under section 199(b) to $583
(50% x $1,165 W-2 wages). Accordingly, Trust’s section 199 deduction
for 2006 is $60.
(f) Gain or loss from the disposition of an interest in a
pass-thru entity. DPGR generally does not include gain or loss
recognized on the sale, exchange, or other disposition of an interest in a
pass-thru entity. However, with respect to a partnership, if section 751(a)
or (b) applies, then gain or loss attributable to assets of the partnership
giving rise to ordinary income under section 751(a) or (b), the sale, exchange,
or other disposition of which would give rise to DPGR, is taken into account
in computing the partner’s section 199 deduction. Accordingly,
to the extent that cash or property received by a partner in a sale or exchange
for all or part of its partnership interest is attributable to unrealized
receivables or inventory items within the meaning of section 751(c) or (d),
respectively, and the sale or exchange of the unrealized receivable or inventory
items would give rise to DPGR if sold, exchanged, or otherwise disposed of
by the partnership, the cash or property received by the partner is taken
into account by the partner in determining its DPGR for the taxable year.
Likewise, to the extent that a distribution of property to a partner is treated
under section 751(b) as a sale or exchange of property between the partnership
and the distributee partner, and any property deemed sold or exchanged would
give rise to DPGR if sold, exchanged, or otherwise disposed of by the partnership,
the deemed sale or exchange of the property must be taken into account in
determining the partnership’s and distributee partner’s DPGR to
the extent not taken into account under the qualifying in-kind partnership
rules. See §1.751-1(b) and paragraph (i) of this section.
(g) Section 199(d)(1)(A)(iii) wage limitation and tiered
structures—(1) In general. If a pass-thru
entity owns an interest, directly or indirectly, in one or more pass-thru
entities, then the wage limitation of section 199(d)(1)(A)(iii) must be applied
at each tier (that is, separately for each entity). For purposes of this
wage limitation, references to pass-thru entities includes partnerships, S
corporations, trusts (to the extent not described in paragraph (d) of this
section) and estates. Thus, at each tier, the owner of a pass-thru entity
(or the entity on behalf of the owner) calculates the amounts described in
sections 199(d)(1)(A)(iii)(I) (owner’s allocable share) and 199(d)(1)(A)(iii)(II)
(twice the applicable percentage of the owner’s QPAI from that entity)
separately with regard to its interest in that pass-thru entity.
(2) Share of W-2 wages. For purposes of section
199(d)(1)(A)(iii) and section 199(b), the W-2 wages of the owner of an interest
in a pass-thru entity (upper-tier entity) that owns an interest in one or
more pass-thru entities (lower-tier entities) are equal to the sum of the
owner’s allocable share of W-2 wages of the upper-tier entity, as limited
in accordance with section 199(d)(1)(A)(iii), and the owner’s own W-2
wages. The upper-tier entity’s W-2 wages are equal to the sum of the
upper-tier entity’s allocable share of W-2 wages of the next lower-tier
entity, as limited in accordance with section 199(d)(1)(A)(iii), and the upper-tier
entity’s own W-2 wages. The W-2 wages of each lower-tier entity in
a tiered structure, in turn, is computed as described in the preceding sentence.
Except as provided by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b)
of this chapter)—
(i) An upper-tier entity may compute its share of QPAI attributable
to items from a lower-tier entity solely for purposes of section 199(d)(1)(A)(iii)(II)
by applying either the section 861 method described in §1.199-4(d) or
the simplified deduction method described in §1.199-4(e), provided the
upper tier entity would otherwise qualify to use such method.
(ii) Alternatively, the upper-tier entity (other than a trust or estate
described in paragraph (e) of this section) may compute its share of QPAI
attributable to items from a lower-tier entity solely for purposes of section
199(d)(1)(A)(iii)(II) by applying the small business simplified overall method
described in §1.199-4(f), regardless of whether such upper-tier entity
would otherwise qualify to use the small business simplified overall method.
(3) Example. The following example illustrates
the application of this paragraph (g). Assume that each partnership
and each partner (whether or not an individual) is a calendar year taxpayer.
Example. (i) In 2006, A, an individual, owns
a 50% interest in a partnership, UTP, which in turn owns a 50% interest in
another partnership, LTP. All partnership items are allocated in proportion
to these ownership percentages. LTP has $900 DPGR, $450 CGS (which includes
W-2 wages of $100), and $50 other deductions. Before taking into account
its share of items from LTP, UTP has $500 DPGR, $500 CGS (which includes W-2
wages of $200), and $500 other deductions. UTP chooses to compute its share
of QPAI attributable to items from LTP for purposes of section 199(d)(1)(A)(iii)(II)
by applying the small business simplified overall method described in §1.199-4(f).
For purposes of the wage limitation of section 199(d)(1)(A)(iii), UTP’s
distributive share of LTP’s QPAI is $200 ($450 DPGR - $250 CGS and other
deductions).
(ii) UTP’s share of LTP’s W-2 wages for purposes of the
section 199(d)(1)(A)(iii) limitation is $12, the lesser of $50 (UTP’s
50% allocable share of LTP’s $100 of W-2 wages) or $12 (2 x ($200 QPAI
x .03)). After taking into account its share of items from LTP, UTP has $950
DPGR, $725 CGS, and $525 other deductions. A is eligible for and uses the
simplified deduction method described in §1.199-4(e). For purposes of
the wage limitation of section 199(d)(1)(A)(iii), A’s distributive share
of UTP’s QPAI is ($151) ($475 DPGR - $363 CGS - $263 other deductions).
A’s wage limitation under section 199(d)(1)(A)(iii) with respect to
A’s interest in UTP is $0, the lesser of $106 (A’s 50% allocable
share of UTP’s $212 of W-2 wages) or $0 (because A’s share of
UTP’s QPAI ($151), is less than zero).
(h) No attribution of qualified activities. Except
as provided in paragraph (i) of this section regarding qualifying in-kind
partnerships and paragraph (j) of this section regarding EAG partnerships,
an owner of a pass-thru entity is not treated as conducting the qualified
production activities of the pass-thru entity, and vice versa. For example,
if a partnership MPGE QPP within the United States, or produces a qualified
film or produces utilities in the United States, and distributes or leases,
rents, licenses, sells, exchanges, or otherwise disposes of such property
to a partner who then, without performing its own qualifying MPGE or other
production, leases, rents, licenses, sells, exchanges, or otherwise disposes
of such property, then the partner’s gross receipts from this latter
lease, rental, license, sale, exchange, or other disposition are treated as
non-DPGR. In addition, if a partner MPGE QPP within the United States, or
produces a qualified film or produces utilities in the United States, and
contributes or leases, rents, licenses, sells, exchanges, or otherwise disposes
of such property to a partnership which then, without performing its own qualifying
MPGE or other production, leases, rents, licenses, sells, exchanges, or otherwise
disposes of such property, then the partnership’s gross receipts from
this latter disposition are treated as non-DPGR.
(i) Qualifying in-kind partnership—(1) In
general. If a partnership is a qualifying in-kind partnership
described in paragraph (i)(2) of this section, then each partner is treated
as MPGE or producing the property MPGE or produced by the partnership that
is distributed to that partner. If a partner of a qualifying in-kind partnership
derives gross receipts from the lease, rental, license, sale, exchange, or
other disposition of the property that was MPGE or produced by the qualifying
in-kind partnership, then, provided such partner is a partner of the qualifying
in-kind partnership at the time the partner disposes of the property, the
partner is treated as conducting the MPGE or production activities previously
conducted by the qualifying in-kind partnership with respect to that property.
With respect to a lease, rental, or license, the partner is treated as having
disposed of the property on the date or dates on which it takes into account
its gross receipts derived from the lease, rental, or license under its methods
of accounting. With respect to a sale, exchange, or other disposition, the
partner is treated as having disposed of the property on the date on which
it ceases to own the property for Federal income tax purposes, even if no
gain or loss is taken into account.
(2) Definition of qualifying in-kind partnership.
For purposes of this paragraph (i), a qualifying in-kind partnership is a
partnership engaged solely in—
(i) The extraction, refining, or processing of oil, natural gas (as
described in §1.199-3(l)(2)), petrochemicals, or products derived from
oil, natural gas, or petrochemicals in whole or in significant part within
the United States;
(ii) The production or generation of electricity in the United States;
or
(iii) An activity or industry designated by the Secretary by publication
in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b)
of this chapter).
(3) Special rules for distributions. If a qualifying
in-kind partnership distributes property to a partner, then, solely for purposes
of section 199(d)(1)(A)(iii)(II), the partnership is treated as having gross
receipts in the taxable year of the distribution equal to the fair market
value of the distributed property at the time of distribution to the partner
and the deemed gross receipts are allocated to that partner, provided that
the partner derives gross receipts from the distributed property (and takes
into account such receipts under its method of accounting) during the taxable
year of the partner with or within which the partnership’s taxable year
(in which the distribution occurs) ends. For rules for taking costs into
account (such as costs included in the adjusted basis of the distributed property),
see §1.199-4.
(4) Other rules. Except as provided in this paragraph
(i), a qualifying in-kind partnership is treated the same as other partnerships
for purposes of section 199. Accordingly, a qualifying in-kind partnership
is subject to the rules of this section regarding the application of section
199 to pass-thru entities, including application of the section 199(d)(1)(A)(iii)
wage limitation under paragraph (b)(3) of this section. In determining whether
a qualifying in-kind partnership or its partners MPGE QPP in whole or in significant
part within the United States, see §1.199-3(g)(2) and (3).
(5) Example. The following example illustrates
the application of this paragraph (i). Assume that PRS and X are calendar
year taxpayers.
Example. X, Y and Z are partners in PRS, a qualifying
in-kind partnership described in paragraph (i)(2) of this section. X, Y,
and Z are corporations. In 2006, PRS distributes oil to X that PRS derived
from its oil extraction. PRS incurred $600 of CGS, including $500 of W-2
wages (as defined in §1.199-2(e)), extracting the oil distributed to
X, and X’s adjusted basis in the distributed oil is $600. The fair
market value of the oil at the time of the distribution to X is $1,000. X
incurs $200 of CGS, including $100 of W-2 wages, in refining the oil within
the United States. In 2006, X, while it is a partner in PRS, sells the oil
to a customer for $1,500, taking the gross receipts into account under its
method of accounting in the same taxable year. Under paragraph (i)(1) of
this section, X is treated as having extracted the oil. The extraction and
refining of the oil qualify as an MPGE activity under §1.199-3(e)(1).
Therefore, X’s $1,500 of gross receipts qualify as DPGR. X subtracts
from the $1,500 of DPGR the $600 of CGS incurred by PRS and the $200 of refining
costs incurred by X. Thus, X’s QPAI is $700 for 2006. In addition,
PRS is treated as having $1,000 of DPGR solely for purposes of applying the
wage limitation in section 199(d)(1)(A)(iii) based on the applicable percentage
of QPAI. Accordingly, X’s share of PRS’s W-2 wages determined
under section 199(d)(1)(A)(iii) is $24, the lesser of $500 (X’s allocable
share of PRS’s W-2 wages included in CGS) and $24 (2 x ($400 ($1,000
deemed DPGR less $600 of CGS) x .03)). X adds the $24 of PRS W-2 wages to
its $100 of W-2 wages incurred in refining the oil for purposes of section
199(b).
(j) Partnerships owned by members of a single expanded affiliated
group—(1) In general. For purposes
of this section, if all of the interests in the capital and profits of a partnership
are owned by members of a single EAG at all times during the taxable year
of the partnership (EAG partnership), then the EAG partnership and all members
of that EAG are treated as a single taxpayer for purposes of section 199(c)(4)
during that taxable year.
(2) Attribution of activities—(i) In
general. If a member of an EAG (disposing member) derives gross
receipts from the lease, rental, license, sale, exchange, or other disposition
of property that was MPGE or produced by an EAG partnership, all the partners
of which are members of the same EAG to which the disposing member belongs
at the time that the disposing member disposes of such property, then the
disposing member is treated as conducting the MPGE or production activities
previously conducted by the EAG partnership with respect to that property.
The previous sentence applies only for those taxable years in which the disposing
member is a member of the EAG of which all the partners of the EAG partnership
are members for the entire taxable year of the EAG partnership. With respect
to a lease, rental, or license, the disposing member is treated as having
disposed of the property on the date or dates on which it takes into account
its gross receipts from the lease, rental, or license under its methods of
accounting. With respect to a sale, exchange, or other disposition, the disposing
member is treated as having disposed of the property on the date on which
it ceases to own the property for Federal income tax purposes, even if no
gain or loss is taken into account. Likewise, if an EAG partnership derives
gross receipts from the lease, rental, license, sale, exchange, or other disposition
of property that was MPGE or produced by a member (or members) of the same
EAG (the producing member) to which all the partners of the EAG partnership
belong at the time that the EAG partnership disposes of such property, then
the EAG partnership is treated as conducting the MPGE or production activities
previously conducted by the producing member with respect to that property.
The previous sentence applies only for those taxable years in which the producing
member is a member of the EAG of which all the partners of the EAG partnership
are members for the entire taxable year of the EAG partnership. With respect
to a lease, rental, or license, the EAG partnership is treated as having disposed
of the property on the date or dates on which it takes into account its gross
receipts derived from the lease, rental, or license under its methods of accounting.
With respect to a sale, exchange, or other disposition, the EAG partnership
is treated as having disposed of the property on the date on which it ceases
to own the property for Federal income tax purposes, even if no gain or loss
is taken into account. See paragraph (j)(5) Example 3 of
this section.
(ii) Attribution between EAG partnerships. If
an EAG partnership (disposing partnership) derives gross receipts from the
lease, rental, license, sale, exchange, or other disposition of property that
was MPGE or produced by another EAG partnership (producing partnership), then
the disposing partnership is treated as conducting the MPGE or production
activities previously conducted by the producing partnership with respect
to that property, provided that the producing partnership and the disposing
partnership are owned by members of the same EAG for the entire taxable year
of the respective partnership in which the disposing partnership disposes
of such property. With respect to a lease, rental, or license, the disposing
partnership is treated as having disposed of the property on the date or dates
on which it takes into account its gross receipts from the lease, rental,
or license under its methods of accounting. With respect to a sale, exchange,
or other disposition, the disposing partnership is treated as having disposed
of the property on the date on which it ceases to own the property for Federal
income tax purposes, even if no gain or loss is taken into account.
(iii) Exceptions to attribution. Attribution
of activities does not apply for purposes of the construction of real property
under §1.199-3(m)(1) and the performance of engineering and architectural
services under §1.199-3(n)(2) and (3), respectively.
(3) Special rules for distributions. If an EAG
partnership distributes property to a partner, then, solely for purposes of
section 199(d)(1)(A)(iii)(II), the EAG partnership is treated as having gross
receipts in the taxable year of the distribution equal to the fair market
value of the property at the time of distribution to the partner and the deemed
gross receipts are allocated to that partner, provided that the partner derives
gross receipts from the distributed property (and takes such receipts into
account under its methods of accounting) during the taxable year of the partner
with or within which the partnership’s taxable year (in which the distribution
occurs) ends. For rules for taking costs into account (such as costs included
in the adjusted basis of the distributed property), see §1.199-4.
(4) Other rules. Except as provided in this paragraph
(j), an EAG partnership is treated the same as other partnerships for purposes
of section 199. Accordingly, an EAG partnership is subject to the rules of
this section regarding the application of section 199 to pass-thru entities,
including application of the section 199(d)(1)(A)(iii) wage limitation under
paragraph (b)(3) of this section. In determining whether a member of an EAG
or an EAG partnership MPGE QPP in whole or in significant part within the
United States or produced a qualified film or produced utilities within the
United States, see §1.199-3(g)(2) and (3) and Example 5 of
paragraph (j)(5) of this section.
(5) Examples. The following examples illustrate
the rules of this paragraph (j). Assume that PRS, X, Y, and Z all are calendar
year taxpayers.
Example 1. Contribution.
X and Y are the only partners in PRS, a partnership, for PRS’s entire
2006 taxable year. X and Y are both members of a single EAG for the entire
2006 year. In 2006, X MPGE QPP within the United States and contributes the
property to PRS. In 2006, PRS sells the QPP for $1,000. Under this paragraph
(j), PRS is treated as having MPGE the QPP within the United States, and PRS’s
$1,000 gross receipts constitute DPGR. PRS, X, and Y must apply the rules
of this section regarding the application of section 199 to pass-thru entities
with respect to the activity of PRS, including application of the section
199(d)(1)(A)(iii) wage limitation under paragraph (b)(3) of this section.
Example 2. Sale. X, Y, and
Z are the only members of a single EAG for the entire 2006 year. X and Y
each own 50% of the capital and profits interests in PRS, a partnership, for
PRS’s entire 2006 taxable year. In 2006, PRS MPGE QPP within the United
States and then sells the property to X for $6,000, its fair market value
at the time of the sale. PRS’s gross receipts of $6,000 qualify as
DPGR. In 2006, X sells the QPP to customers for $10,000, incurring selling
expenses of $2,000. Under this paragraph (j), X is treated as having MPGE
the QPP within the United States, and X’s $10,000 of gross receipts
qualify as DPGR. PRS, X and Y must apply the rules of this section regarding
the application of section 199 to pass-thru entities with respect to the activity
of PRS, including application of the section 199(d)(1)(A)(iii) wage limitation
under paragraph (b)(3) of this section. The results would be the same if
PRS sold the property to Z rather than to X.
Example 3. Lease. X, Y,
and Z are the only members of a single EAG for the entire 2005 year. X and
Y each own 50% of the capital and profits interests in PRS, a partnership,
for PRS’s entire 2005 taxable year. In 2005, PRS MPGE QPP within the
United States and then sells the property to X for $6,000, its fair market
value at the time of the sale. PRS’s gross receipts of $6,000 qualify
as DPGR. In 2005, X rents the QPP it acquired from PRS to customers unrelated
to X. X takes the gross receipts attributable to the rental of the QPP into
account under its methods of accounting in 2005 and 2006. On July 1, 2006,
X ceases to be a member of the same EAG to which Y, the other partner in PRS,
belongs. For 2005, X is treated as having MPGE the QPP in the United States,
and its gross receipts derived from the rental of the QPP qualify as DPGR.
For 2006, however, because X and Y, partners in PRS, are no longer members
of the same EAG for the entire year, the gross rental receipts X takes into
account in 2006 do not qualify as DPGR.
Example 4. Distribution.
X and Y are the only partners in PRS, a partnership, for PRS’s entire
2006 taxable year. X and Y are both members of a single EAG for the entire
2006 year. In 2006, PRS MPGE QPP within the United States, incurring $600
of CGS, including $500 of W-2 wages (as defined in §1.199-2(e)), and
then distributes the QPP to X. X’s adjusted basis in the QPP is $600.
At the time of the distribution, the fair market value of the QPP is $1,000.
X incurs $200 of directly allocable costs, including $100 of W-2 wages, to
further MPGE the QPP within the United States. In 2006, X sells the QPP for
$1,500 to an unrelated customer and takes the gross receipts into account
under its method of accounting in the same taxable year. Under paragraph
(j)(1) of this section, X is treated as having MPGE the QPP within the United
States, and X’s $1,500 of gross receipts qualify as DPGR. In addition,
PRS is treated as having DPGR of $1,000 solely for purposes of applying the
wage limitation in section 199(d)(1)(A)(iii) based on the applicable percentage
of QPAI.
Example 5. Multiple sales.
(i) Facts. X and Y are the only partners in PRS, a
partnership, for PRS’s entire 2006 taxable year. X and Y are both non-consolidated
members of a single EAG for the entire 2006 year. PRS produces in bulk form
in the United States the active ingredient for a pharmaceutical product.
Assume that PRS’s own MPGE activity with respect to the active ingredient
is not substantial in nature, taking into account all of the facts and circumstances,
and PRS’s direct labor and overhead to MPGE the active ingredient within
the United States are $15 and account for 15% of PRS’s $100 CGS of the
active ingredient. In 2006, PRS sells the active ingredient in bulk form
to X. X uses the active ingredient to produce the finished dosage form drug.
Assume that X’s own MPGE activity with respect to the drug is not substantial
in nature, taking into account all of the facts and circumstances, and X’s
direct labor and overhead to MPGE the drug within the United States are $12
and account for 10% of X’s $120 CGS of the drug. In 2006, X sells the
drug in finished dosage to Y and Y sells the drug to customers. Assume that
Y’s own MPGE activity with respect to the drug is not substantial in
nature, taking into account all of the facts and circumstances, and Y incurs
$2 of direct labor and overhead and Y’s CGS in selling the drug to customers
is $130.
(ii) Analysis. PRS’s gross receipts from
the sale of the active ingredient to X are non-DPGR because PRS’s MPGE
activity is not substantial in nature and PRS does not satisfy the safe harbor
described in §1.199-3(g)(3) because PRS’s direct labor and overhead
account for less than 20% of PRS’s CGS of the active ingredient. X’s
gross receipts from the sale of the drug to Y are DPGR because X is considered
to have MPGE the drug in significant part in the United States pursuant to
the safe harbor described in §1.199-3(g)(3) because the $27 ($15 + $12)
of direct labor and overhead incurred by PRS and X equals or exceeds 20% of
X’s total CGS ($120) of the drug at the time X disposes of the drug
to Y. Similarly, Y’s gross receipts from the sale of the drug to customers
are DPGR because Y is considered to have MPGE the drug in significant part
in the United States pursuant to the safe harbor described in §1.199-3(g)(3)
because the $29 ($15 + $12 + $2) of direct labor and overhead incurred by
PRS, X, and Y equals or exceeds 20% of Y’s total CGS ($130) of the drug
at the time Y disposes of the drug to Y’s customers.
(k) Effective dates. Section 199 applies to taxable
years beginning after December 31, 2004. In determining the deduction under
section 199, items arising from a taxable year of a partnership, S corporation,
estate, or trust beginning before January 1, 2005, shall not be taken
into account for purposes of section 199(d)(1). Section 1.199-9 does
not apply to taxable years beginning after May 17, 2006, the enactment date
of the Tax Increase Prevention and Reconciliation Act of 2005 (Public Law
109-222, 120 Stat. 345). For taxable years beginning on or before May
17, 2006, a taxpayer must apply §1.199-9 if the taxpayer applies §§1.199-1
through 1.199-8 to that taxable year. Notwithstanding the preceding sentence,
a partnership or S corporation that is a qualifying small taxpayer under §1.199-4(f)
of REG-105847-05, 2005-47 I.R.B. 987 (see §601.601(d)(2) of this chapter)
may use the small business simplified overall method to apportion CGS and
deductions between DPGR and non-DPGR at the entity level under §1.199-4(f)
of REG-105847-05 for taxable years beginning on or before May 17, 2006. If
a taxpayer chooses not to rely on §§1.199-1 through 1.199-9 (as
provided in §1.199-8(i)) for a taxable year beginning before June 1,
2006, the guidance under section 199 that applies to taxable years beginning
before June 1, 2006, is contained in Notice 2005-14, 2005-1 C.B. 498 (see
§601.601(d)(2) of this chapter). In addition, a taxpayer also may rely
on the provisions of REG-105847-05 for taxable years beginning before June
1, 2006. If Notice 2005-14 and REG-105847-05 include different rules for
the same particular issue, then a taxpayer may rely on either the rule set
forth in Notice 2005-14 or the rule set forth in REG-105847-05. However,
if REG-105847-05 includes a rule that was not included in Notice 2005-14,
then a taxpayer is not permitted to rely on the absence of a rule in Notice
2005-14 to apply a rule contrary to REG-105847-05. For taxable years beginning
after May 17, 2006, and before June 1, 2006, a taxpayer may not apply Notice
2005-14, REG-105847-05, or any other guidance under section 199 in a manner
inconsistent with amendments made to section 199 by section 514 of the Tax
Increase Prevention and Reconciliation Act of 2005.
PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT
Par. 3. The authority citation for part 602 continues to read as follows:
Authority: 26 U.S.C. 7805.
Par. 4. In §602.101, paragraph (b) is amended by adding an entry
to the table in numerical order to read, in part, as follows:
§602.101 OMB Control numbers.
* * * * *
(b) * * *
Mark E. Matthews, Deputy
Commissioner for Services and Enforcement.
Approved May 2, 2006.
Eric Solomon, Acting
Deputy Assistant Secretary of the Treasury.
Note
(Filed by the Office of the Federal Register on May 24, 2006, 11:47
a.m., and published in the issue of the Federal Register for June 1, 2006,
71 F.R. 31267)
The principal authors of these regulations are Paul Handleman and Lauren
Ross Taylor, Office of the Associate Chief Counsel (Passthroughs and Special
Industries), IRS. However, other personnel from the IRS and Treasury Department
participated in their development.
* * * * *
Internal Revenue Bulletin 2006-25
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