[Federal Register: June 1, 2006 (Volume 71, Number 105)]
[Rules and Regulations]
[Page 31267-31333]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr01jn06-18]
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Part II
Department of the Treasury
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Internal Revenue Service
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26 CFR Parts 1 and 602
Income Attributable to Domestic Production Activities; Final Rule
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
[TD 9263]
RIN 1545-BE33
Income Attributable to Domestic Production Activities
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: 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.
DATES: Effective Date: These regulations are effective June 1, 2006.
Date of Applicability: For date of applicability see Sec. Sec.
1.199-8(i) and 1.199-9(k).
FOR FURTHER INFORMATION CONTACT: Concerning Sec. Sec. 1.199-1, 1.199-
3, 1.199-6, and 1.199-8, Paul Handleman or Lauren Ross Taylor, (202)
622-3040; concerning Sec. 1.199-2, Alfred Kelley, (202) 622-6040;
concerning Sec. 1.199-4(c) and (d), Richard Chewning, (202) 622-3850;
concerning all other provisions of Sec. 1.199-4, Jeffery Mitchell,
(202) 622-4970; concerning Sec. 1.199-7, Ken Cohen, (202) 622-7790;
concerning Sec. 1.199-9, Martin Schaffer, (202) 622-3080 (not toll-
free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
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.
Background
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 (Pub. L. 108-357, 118 Stat. 1418) (Act), and amended by section
403(a) of the Gulf Opportunity Zone Act of 2005 (Pub. L. 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 (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 and proposed
regulations have been published involving the treatment under section
199 of computer software provided to customers over the Internet.
General Overview
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
[[Page 31269]]
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).
Pass-Thru Entities
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.
Individuals
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.
[[Page 31270]]
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.
Alternative Minimum Tax
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).
Effective Date
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
Taxable Income
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 Sec. 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.
Wage Limitation
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 (2006-22 I.R.B.) 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
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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 Sec. 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 Sec.
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 Sec. Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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
[[Page 31272]]
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 Sec. 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
Sec. 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 Sec. 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.
By the Taxpayer
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
[[Page 31273]]
benefits and burdens would not be appropriate.
Government Contracts
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 Sec. 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 Sec. 1.199-3(d) of the proposed regulations
(Sec. 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 Sec. 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 (2000-1 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 Sec. 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 Sec. 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
[[Page 31274]]
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 Sec. 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 Sec. 1.199-3(g)(2) or the safe harbor under
Sec. 1.199-3(g)(3) of the final regulations. The final regulations
contain an example to illustrate this rule.
In Example 4 in Sec. 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 Sec. 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 Sec. 1.199-3(h)(1) of
the proposed regulations is retained in the final regulations under
Sec. 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
[[Page 31275]]
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 Sec. 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 Sec. 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.
[[Page 31276]]
Qualified Films
Section Sec. 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 Sec. 1.199-3(j)(1) of the
proposed regulations diminishes the general rule under Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 1.199-3(m)(1), computer software described in Sec.
1.199-3(j)(3), sound recordings described in Sec. 1.199-3(j)(4), a
qualified film described in Sec. 1.199-3(k)(1), and utilities
described in Sec. 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
Sec. 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 Sec.
1.263A-8(c)(3)) other than machinery (as defined in Sec. 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
Sec. 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 Sec. 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 Sec. 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
[[Page 31277]]
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 Sec. 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 Sec. 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
[[Page 31278]]
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 Sec. 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 Sec. 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 Sec. 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 Sec. 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
[[Page 31279]]
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, Sec. 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.
Consolidated Groups
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 Sec. 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 Sec. 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, Sec. 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
Sec. 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 (Sec. 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), Sec. Sec. 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 Sec. Sec. 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 Sec. Sec. 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 Sec. Sec. 1.199-1 through 1.199-9. For purposes
of the trade-or-business requirement, a trust or estate is treated as
an individual.
Pass-Thru Entities
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 Sec. 1.199-9 to a
taxable year beginning on or before May 17, 2006, if that taxpayer
applies Sec. Sec. 1.199-1 through 1.199-8 to the taxable year. The
portions of Sec. 1.199-3 relating to qualifying in-kind partnerships
and EAG partnerships, and all of Sec. 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
[[Page 31280]]
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 Sec. 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 Sec. 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 Sec. 1.199-4(f) of
the proposed regulations. In addition, Sec. 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 Sec. 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
[[Page 31281]]
in Sec. 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 (and vice versa) 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 Sec. 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 Sec. 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.
Statistical Sampling
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 Sec. Sec. 1.861-8 through 1.861-17 and Sec. Sec.
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 Sec. Sec.
1.861-8T(c)(2) and 1.861-9(i)(2), with respect to the apportionment of
interest expense, and by Sec. 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
[[Page 31282]]
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.
Effective Date
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
Sec. Sec. 1.199-1 through 1.199-9 provided that the taxpayer applies
all provisions in Sec. Sec. 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 Sec. Sec. 1.199-1 through 1.199-8
provided that the taxpayer applies all provisions in Sec. Sec. 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 Sec.
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 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.
Special Analyses
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.
Drafting Information
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.
List of Subjects
26 CFR Part I
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
0
Accordingly, 26 CFR parts 1 and 602 are amended as follows:
PART 1--INCOME TAXES
0
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).
[[Page 31283]]
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). * * *
0
Par. 2. Sections 1.199-0 through 1.199-9 are added to read as follows:
Sec. 1.199-0 Table of contents.
This section lists the section headings that appear in Sec. Sec.
1.199-1 through 1.199-9.
Sec. 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.
Sec. 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.
Sec. 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.
[[Page 31284]]
(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.
Sec. 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.
Sec. 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].
Sec. 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.
Sec. 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 Sec. 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.
Sec. 1.199-8 Other rules.
(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].
Sec. 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.
[[Page 31285]]
(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.
Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. Sec. 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 Sec. 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 Sec. 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 Sec. 1.199-
[[Page 31286]]
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 Sec.
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 Sec. 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 Sec.
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 Sec. 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.
[[Page 31287]]
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.
Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 an 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
[[Page 31288]]
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 Sec.
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 (2006-22 I.R.B.) (see Sec.
601.601(d)(2) of this chapter).
Sec. 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 Sec. Sec. 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 Sec. 1.1502-13, see
also Sec. 1.199-7(d). For this purpose, gross receipts include total
sales (net of returns and allowances) and all amounts
[[Page 31289]]
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 Sec. Sec. 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,