Income Attributable to Domestic Production Activities

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-105847-05]

RIN 1545-BE33

Income Attributable to Domestic Production Activities

AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Notice of proposed rulemaking and notice of public hearing.

SUMMARY:

This document contains proposed regulations concerning the deduction for income attributable to domestic production activities under section 199. Section 199 was enacted as part of the American Jobs Creation Act of 2004, (the Act). The regulations will affect taxpayers engaged in certain domestic production activities. This document also provides a notice of a public hearing on these proposed regulations.

DATES:

Written or electronic comments must be received by January 3, 2006. Outlines of topics to be discussed at the public hearing scheduled for Wednesday, January 11, 2006, must be received by December 21, 2005.

ADDRESSES:

Send submissions to: CC:PA:LPD:PR (REG-105847-05), room 5203, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-105847-05), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, DC, or sent electronically, via the IRS Internet site at

http://www.irs.gov/regs

or via the Federal eRulemaking Portal at

http://www.regulations.gov

(IRS-REG-105847-05). The public hearing will be held in the IRS Auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT:

Concerning §§ 1.199-1, 1.199-3, 1.199-6, and 1.199-8, Paul Handleman or Lauren Ross Taylor, (202) 622-3040; concerning § 1.199-2, Alfred Kelley, (202) 622-6040; concerning § 1.199-4(c) and (d), Richard Chewning, (202) 622-3850; concerning all other provisions of § 1.199-4, Scott Rabinowitz, (202) 622-4970; concerning § 1.199-5, Martin Schaffer, (202) 622-3080; concerning § 1.199-7, Ken Cohen, (202) 622-7790; concerning submission of comments, the hearing, and/or to be placed on the building access list to attend the hearing, LaNita Van Dyke, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in this notice of proposed rulemaking have been submitted to the Office of Management and Budget for review in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). Comments on the collections of information should be sent 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, with copies to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. Comments on the collection of information should be received by January 3, 2006.

Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the proper performance of the functions of the IRS, including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed collection of information;

How the quality, utility, and clarity of the information to be collected may be enhanced;

How the burden of complying with the proposed collections of information may be minimized, including through the application of automated collection techniques or other forms of information technology; and

Estimates of capital or start-up costs and costs of operation, maintenance, and purchase of service to provide information.

The collection of information in these proposed regulations is in § 1.199-6(b) involving patrons of agricultural and horticultural cooperatives. This information is required so that patrons of agricultural and horticultural cooperatives may claim the section 199 deduction. The collections of information is mandatory. The likely respondents are business or other for-profit institutions.

Estimated total annual reporting burden:

9,000 hours.

Estimated average annual burden hours per respondent:

3 hours.

Estimated number of respondents:

3,000.

Estimated annual frequency of responses:

annually.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget.

Books or records relating to a 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 contains proposed regulations 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 Act (Public Law 108-357, 118 Stat. 1418). On January 19, 2005, the IRS and Treasury Department issued Notice 2005-14 (2005-7 I.R.B. 498) providing interim guidance on section 199 and inviting comments on issues arising under section 199. Written and electronic comments responding to Notice 2005-14 were received. The IRS and Treasury Department have reviewed and considered all the comments in the process of preparing these proposed regulations. This preamble to the proposed regulations describes many of the more 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.

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 the sum of the aggregate amounts the taxpayer is required under section 6051(a)(3) and (8) to include on the Forms W-2, “Wage and Tax Statement,” of the taxpayer's employees during the calendar year ending during the

taxpayer's taxable year. 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.

Qualified Production Activities Income

Under section 199(c)(1), QPAI is the excess of domestic production gross receipts (DPGR) over the sum of: (a) The cost of goods sold (CGS) allocable to such receipts; (b) other deductions, expenses, or losses directly allocable to such receipts; and (c) a ratable portion of deductions, expenses, and losses not directly allocable to such receipts or another class of income.

Section 199(c)(2) provides that the Secretary shall prescribe rules for the proper allocation of items of income, deduction, expense, and loss for purposes of determining QPAI.

Section 199(c)(3) provides special rules for determining costs in computing QPAI. Under these special rules, any item or service imported into the United States without an arm's length transfer price shall be treated as acquired by purchase, and its cost shall be 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 imported 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) construction performed in the United States; or (iii) engineering or architectural services performed in the United States for construction projects 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; and (ii) the transmission or distribution of electricity, natural gas, or potable water.

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. 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) provides that, in the case of an S corporation, partnership, estate or trust, or other pass-thru entity, section 199 generally is applied at the shareholder, partner, or similar level, except as otherwise provided in rules applicable to patrons of cooperatives. Section 199(d)(1) further provides that the Secretary shall prescribe rules for the application of section 199, including rules relating to: (a) Restrictions on the allocation of the deduction to taxpayers at the partner or similar level; and (b) additional reporting requirements.

The general rule is that section 199 is applied at the shareholder, partner, or similar level. However, section 199(d)(1)(B) limits the amount of W-2 wages from a pass-thru entity that may be used by each shareholder, partner, or similar person to compute the section 199 deduction. Specifically, section 199(d)(1)(B) provides that such person is treated as having been allocated W-2 wages from such entity in an amount equal to the lesser of: (i) Such person's allocable share of such wages (without regard to this rule) from such entity 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 the QPAI of that entity allocated to such person for the taxable year.

Individuals

In the case of an individual, section 199(d)(2) provides that the deduction is equal to the applicable percentage of the lesser of the taxpayer's: (a) QPAI for the taxable year; or (b) AGI for the taxable year determined after applying sections 86, 135, 137, 219, 221, 222, and 469, and without regard to section 199.

Patrons of Certain Cooperatives

Section 199(d)(3) provides special rules under which a taxpayer receiving certain patronage dividends or certain qualified per-unit retain allocations from a cooperative (to which subchapter T applies) engaged in the MPGE, in whole or in significant part, or in the marketing of any agricultural or horticultural product is allowed a section 199 deduction with respect to the amount of the patronage dividends or qualified per-unit retain allocations that are: (a) Allocable to the portion of the cooperative's QPAI that would be deductible by the cooperative; and (b) designated as such by the cooperative in a written notice mailed to its patrons during the payment period described in section 1382. Such an amount, however, does not reduce the taxable income of the cooperative under section 1382.

In determining the portion of the cooperative's QPAI that would be deductible by the cooperative, the cooperative's taxable income is computed without taking into account any deduction allowable under section 1382(b) or (c) (relating to patronage dividends, per-unit retain allocations, and nonpatronage distributions) and, in the case of a cooperative engaged in marketing agricultural and horticultural products, the cooperative is treated as having MPGE, in whole or in significant part, any agricultural and horticultural products marketed by the cooperative that its patrons have MPGE.

Expanded Affiliated Groups

Section 199(d)(4)(A) provides that all members of an expanded affiliated group (EAG) are treated as a single corporation for purposes of section 199. Taking into account the provisions of the Congressional Letter, as described elsewhere, 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 rules to coordinate the deduction allowed under section 199 with the alternative minimum tax (AMT) imposed by section 55. Taking into account the provisions of the Congressional Letter, as described elsewhere, section 199(d)(6) provides that for purposes of determining alternative minimum taxable income (AMTI) under section 55, the section 199 deduction shall be determined without regard to any adjustments under sections 56 through 59, except that in the case of a corporation (including a corporation subject to tax under section 511), the taxable income limitation is the corporation's AMTI.

Authority To Prescribe Regulations

Section 199(d)(7) authorizes the Secretary to prescribe such regulations as are necessary to carry out the purposes of section 199.

Congressional Letter

On July 21, 2005, the Chairman and Ranking Member of the Senate Finance Committee and the Chairman of the House Ways and Means Committee introduced the Tax Technical Corrections Act of 2005, H.R. 3376 and S. 1447, 109th Cong. (2005). In a letter on the same date to the Treasury Department (the Congressional Letter), they provided clarification for several issues so that appropriate regulatory guidance may be issued reflecting their intention. These proposed regulations reflect the intent expressed in the Congressional Letter with respect to section 199.

Summary of Comments

Qualified Production Activities Income

One commentator requested that the proposed regulations clarify the treatment of advance payments, and the costs related to those payments, for purposes of computing QPAI. Section 4.03(3) of Notice 2005-14 provides that, in the case of advance payments (for goods, services, and use of property) that are recognized under the taxpayer's method of accounting in a taxable year earlier than that in which the property or services are delivered, performed, and provided, the taxpayer must accurately identify, based on a reasonable method, whether the receipts (and the corresponding expenses) qualify as DPGR. If a taxpayer recognizes an advance payment in Year 1, and the CGS in Year 2, the commentator asks whether CGS must be applied to reduce DPGR in Year 2, even though the DPGR and CGS are recognized in different taxable years.

The proposed regulations clarify that, in the example the commentator cites involving advance payments, as well as other circumstances (such as taxpayers that use the cash receipts and disbursements method) where gross receipts and corresponding expenses are recognized in different taxable years, taxpayers must take the receipts and expenses into account for purposes of section 199 in the taxable year such items are recognized under their methods of accounting for Federal income tax purposes. The IRS and Treasury Department believe it would be unduly burdensome and complicated to create a separate set of timing rules for purposes of section 199. Thus, gross receipts and costs are taken into account for purposes of computing QPAI in the taxable year they are recognized for Federal income tax purposes under the taxpayer's methods of accounting, even if the related gross receipts or costs, as applicable, are taken into account in different taxable years. If the gross receipts are recognized in an intercompany transaction within the meaning of § 1.1502-13, see also § 1.199-7(d).

A commentator requested clarification of how the advance payment rules would apply in the following scenario. In Year 1, a taxpayer sells for $100 a one-year software maintenance agreement that provides for software updates (that the taxpayer would MPGE in whole or in significant part within the United States) and customer support services. At the end of Year 1, the taxpayer uses a reasonable method to allocate 60 percent of the gross receipts ($60) to the software updates and 40 percent ($40) to the customer support services. The taxpayer treats the $60 as DPGR in Year 1. In Year 2, no software updates are provided. The commentator asks whether the taxpayer in this scenario would be required to amend its Year 1 return and reduce its DPGR by $60, reduce DPGR by $60 in Year 2, or make no adjustment for Year 1 or Year 2.

Consistent with the application of the rules relating to advance payments, which require that the taxpayer follow its methods of accounting for Federal income tax purposes, the taxpayer should make no adjustment in Year 1 (by amended return) or in Year 2 for the $60 that was appropriately treated as DPGR in Year 1, even though no software updates were provided in Year 2.

A commentator suggested that the proposed regulations clarify how a taxpayer that uses a long-term contract method determines the portion of the percentage of completion revenue reported for each contract for the taxable year that is allocated to DPGR. The proposed regulations provide that taxpayers using a long-term contract method (for example, under section 460) may use any reasonable method of allocating gross receipts under such a contract between DPGR and non-DPGR.

A number of comments were received regarding the rule in section 4.03(1) of Notice 2005-14 that requires that section 199 be applied on an item-by-item basis. Some commentators stated that applying section 199 on an item-by-item basis is unduly burdensome, and that the proposed regulations should permit taxpayers to determine QPAI on a division or product-line basis instead. The IRS and Treasury Department, however, continue to believe that applying section 199 on a basis other than item-by-item would allow taxpayers to receive the benefits of section 199 with respect to gross receipts that should not qualify as DPGR. Accordingly, the proposed regulations retain the requirement that section 199 be applied on an item-by-item basis.

Many commentators requested clarification of what constitutes an item. Commentators asked whether an item is a final product or whether one or more component parts of the final product may qualify as an item. For example, if a final product does not meet the in whole or in significant part requirement (so that gross receipts from the sale of the final product are non-DPGR), commentators inquired whether they could allocate gross receipts to a component of the product that did meet all of the requirements of section 199(c), and thereby treat that portion of the gross receipts as DPGR.

H.R. Conf. Rep. No. 755, 108th Cong., 2d Sess. 272 n. 27 (2004) (the Conference Report) indicates that a component may be treated as qualifying property in the case of food and beverages. Footnote 27 of the Conference Report explains that, in the context of food and beverages prepared

at a retail establishment, although a cup of coffee prepared at a retail establishment does not qualify under section 199(c), a portion of the cup of coffee, that is, the coffee beans (roasted at a facility separate from the retail establishment) that meet the requirements under section 199(c), does qualify under section 199. The Joint Committee on Taxation Staff,

General Explanation of Tax Legislation Enacted in the 108th Congress,

109th Cong., 1st Sess. 172 (2005) (the Blue Book), indicates Congressional intent that this treatment is not limited to food and beverages, but rather, is permitted with respect to section 199 in general. Accordingly, in the case of QPP, qualified films, and utilities, the proposed regulations define an

item

as the property offered for sale to customers that meets all of the requirements under section 199(c). If the property offered for sale does not meet all of the requirements under section 199(c), a taxpayer must treat as the item any portion of the property offered for sale that meets all of these requirements. However, in no case shall the portion of the property offered for sale that is treated as the item exclude any other portion that meets all of the requirements under section 199(c). For example, assume that the taxpayer MPGE software entirely within the United States, attaches the software to a router that it MPGE entirely outside the United States, and then sells the combined property. Assume further that if the combined property is treated as the item, the gross receipts from the sale will not qualify as DPGR because the combined property does not satisfy the in whole or in significant part requirement. The proposed regulations require the taxpayer to treat the software as an item; separate from the router, because the software meets all of the requirements of section 199(c) (that is, it is computer software that is MPGE by the taxpayer in whole or in significant part within the United States). This is the case even if the software is not offered for sale to customers separately from the router. Accordingly, the gross receipts from the software qualify as DPGR, but the gross receipts from the router do not qualify as DPGR.

Alternatively, assume that the taxpayer MPGE only software but that some of the content is MPGE within the United States and some content is MPGE outside the United States. Assuming that the software does not meet the requirements of section 199(c), that portion of the software that is MPGE within the United States must be treated as the item. Accordingly, gross receipts from the sale of the software must be allocated (using any reasonable method) between that portion that is MPGE within the United States (which is DPGR if all other requirements of section 199(c) are met) and that portion that is MPGE outside the United States (which is non-DPGR).

In the case of construction and architectural and engineering services, commentators asked that the proposed regulations clarify whether the item is the construction project itself, or whether the item can constitute a task or sub-task that is performed as part of the construction project. The IRS and Treasury Department believe that the determination of what constitutes the item for purposes of construction and architectural or engineering services should be made on a case-by-case basis taking into account all of the facts and circumstances. Taxpayers may use any reasonable method of determining the item for this purpose.

A commentator requested that the proposed regulations clarify how the rules for determining DPGR apply in the case of a taxpayer that repairs or rebuilds property for a customer. The commentator suggested the IRS and Treasury Department distinguish between “repair” activities and “rebuild” activities. In the case of a repair contract where the customer retains the benefits and burdens of the property while it is being repaired, the commentator suggests that the contractor should be permitted to treat as DPGR the gross receipts attributable to parts that the contractor MPGE in whole or in significant part within the United States, as well as the gross receipts attributable to the installation of those parts. Gross receipts attributable to the parts MPGE by the taxpayer in whole or in significant part within the United States are DPGR (assuming all the other requirements of section 199(c) are met). Consistent with the general rule for installation (discussed below), the installation activity will be considered an MPGE activity only if the contractor retains the benefits and burdens of ownership with respect to the parts while the parts are being installed. In addition, the gross receipts attributable to the installation of parts that the contractor MPGE may qualify as DPGR if the exception for embedded installation described in § 1.199-3(h)(4)(ii)(D) of the proposed regulations applies. The contractor is not permitted to treat as DPGR gross receipts attributable to purchased parts, or the installation of purchased parts.

The commentator suggested that the proposed regulations provide a special rule for “rebuild” contracts, which the commentator suggested be defined as any contract where the value of the rebuild work performed exceeds 25 percent of the value of the preexisting property immediately before the rebuild. The commentator further suggested that if more than 50 percent of the contractor's costs of performing the rebuild is attributable to the cost of parts that the contractor MPGE, the contractor should not be required to allocate its gross receipts between parts that it MPGE and any parts that it purchased. The commentator's suggested rule would effectively create for rebuild contracts a separate

de minimis

exception to the general allocation requirement. The IRS and Treasury Department believe that the

de minimis

exceptions provided in the proposed regulations (for example, the 5 percent

de minimis

exception discussed later generally applicable to embedded services and embedded nonqualifying property) are appropriate. Accordingly, the proposed regulations do not adopt this suggestion.

Section 4.03(2) of Notice 2005-14 provides that, if the amount of the taxpayer's gross receipts that do not qualify as DPGR equals or exceeds 5 percent of the total gross receipts, the taxpayer is required to allocate all gross receipts between DPGR and non-DPGR. For purposes of this 5 percent

de minimis

rule, the proposed regulations in § 1.199-1(d)(2) provide that, in the case of an S corporation, partnership, estate, trust, 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 the owner's share of any of the pass-thru entity's gross receipts as well as all other gross receipts of the owner. In addition, the 5 percent

de minimis

exception in § 1.199-3(h)(4)(ii)(E) applies at the entity level to each item that qualifies.

Commentators also observed that, in determining whether the taxpayer's method of allocating gross receipts and CGS between DPGR and non-DPGR is reasonable, the list of factors cited in section 4.03(2) of Notice 2005-14 with respect to gross receipts is inconsistent with the list of factors cited in section 4.05(2)(b) of the notice with respect to CGS. The list of factors was intended to be as consistent as possible for both gross receipts and CGS, and appropriate changes to the lists have been

incorporated into the proposed regulations as necessary.

Taxable Income

In the Congressional Letter, the Treasury Department was advised that unrelated business taxable income, rather than taxable income, applies for purposes of section 199(a)(1) in computing the unrelated business income tax under section 511. Accordingly, the proposed regulations in § 1.199-1(b) provide that, for purposes of determining the tax imposed by section 511, section 199(a)(1)(B) is applied using unrelated business taxable income.

The Congressional Letter also indicates that the section 199 deduction is not taken into account for purposes of computing taxable income under the rules relating to the carryover of a net operating loss (NOL). Accordingly, the proposed regulations provide that for purposes of computing the section 199 deduction, the definition of taxable income under section 63 applies, but without regard to section 199. The proposed regulations also provide that the section 199 deduction is not taken into account in computing taxable income when determining the amount of the NOL carryback and carryover under section 172(b)(2). Thus, except as otherwise provided in § 1.199-7(c)(2) of the proposed regulations (concerning the portion of a section 199 deduction allocated to a member of an EAG), the section 199 deduction can neither create an NOL carryback or carryover nor increase the amount of an NOL carryback or carryover.

Wage Limitation

A commentator requested that the IRS and Treasury Department clarify whether self-employment income of self-employed individuals as reported on the individuals' Schedule SE, “Self-Employment Income,” of Form 1040 and/or payments for nonemployee compensation reported by the taxpayer on Form 1099-MISC, “Miscellaneous Income,” are included in determining the amount of the W-2 wages of the taxpayer. A commentator also requested that the IRS clarify whether guaranteed payments to partners are included in W-2 wages for purposes of section 199.

The statutory language in section 199(b) refers to the amounts a taxpayer is required to report as wages on Form W-2 pursuant to section 6051 with respect to the employment of employees of the taxpayer. Neither self-employment income nor guaranteed payments to partners are required to be reported under section 6051. In addition, section 4.02(1)(a) of Notice 2005-14 and § 1.199-2(a)(1) of the proposed regulations define employees as including only common law employees of the taxpayer and officers of a corporate taxpayer. Consistent with the statutory intent, this definition does not include independent contractors or partners. Thus, payments to independent contractors and self-employment income, including guaranteed payments made to partners, are not included in determining W-2 wages.

The proposed regulations provide for the same three methods of calculating W-2 wages as contained in Notice 2005-14. It is anticipated that when final regulations are issued, these three methods will be published in a notice rather than as part of the final regulations. It is anticipated that this notice will be published at the same time as the final regulations. The methods will be included in a notice rather than the final regulations so that if changes are made to the box numbers on Form W-2, “Wage and Tax Statement,” a new notice can be issued reflecting those changes more promptly than an amendment to final regulations.

The non-duplication rule in § 1.199-2(e) continues to provide that amounts that are treated as W-2 wages for any taxable year under any method may not be treated as W-2 wages for any other taxable year. Additional language has been added to the non-duplication rule to clarify that the same W-2 wages cannot be claimed by more than one taxpayer for purposes of section 199.

Domestic Production Gross Receipts

DPGR includes the gross receipts of the taxpayer that are derived from any lease, rental, license, sale, exchange, or other disposition of property described in section 199(c)(4)(A)(i). Commentators specifically asked whether fees such as cotton or real estate broker's fees are DPGR. These fees are non-DPGR because they are not derived from any lease, rental, license, sale, exchange, or other disposition of property under section 199(c)(4)(A)(i).

Commentators asked for clarification of whether DPGR includes gross receipts derived by a taxpayer from the subsequent sale or lease of QPP MPGE within the United States by the taxpayer, sold, and then reacquired by the taxpayer. The proposed regulations in § 1.199-3(h)(2) provide an example to illustrate the rule that gross receipts from the subsequent sale or lease of QPP are DPGR to the taxpayer that originally MPGE the QPP within the United States. Any interest component of the lease payment also qualifies as DPGR because section 199(c)(4)(A)(i) provides that DPGR means gross receipts derived by the taxpayer from any lease.

Commentators pointed out that the rule for allocating gross receipts for purposes of identifying DPGR under section 3.04(1) of Notice 2005-14 appears to adopt a specific identification standard, whereas section 4.03(2) appears to provide a reasonable basis standard. The proposed regulations provide in § 1.199-1(d)(1) that the taxpayer must allocate its gross receipts from all transactions based on a 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. 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. If a taxpayer does not use a specific identification method for other purposes and cannot, without undue burden or expense, use a specific identification method, the taxpayer is not required to use a specific identification method to determine DPGR.

Related Persons

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. 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). However, footnote 29 in the Conference Report indicates that this provision is not intended to apply to property leased by the taxpayer to a related person if the property is held for sublease or is subleased to an unrelated person for the ultimate use of such unrelated person, or to a license to a related person for reproduction and sale, exchange, lease, rental or sublicense to an unrelated person for the ultimate use of such unrelated person. Accordingly, the proposed regulations include these exceptions from the general rule of exclusion under section 199(c)(7).

One commentator stated that if a television network licenses programming to an affiliate station, applying section 199(c)(7) to treat the royalty payment received from the affiliate as non-DPGR places these vertically integrated companies at a competitive disadvantage. The commentator therefore suggested that the proposed regulations provide an

exception for networks and affiliate stations. The proposed regulations do not adopt this suggestion, which is not consistent with section 199(c)(7).

Derived From a Lease, Rental, License, Sale, Exchange, or Other Disposition

Commentators asked whether gains and losses associated with hedging transactions are included in DPGR. For example, utilities may hedge to manage the risk of changes in prices of ordinary inputs into the production process. For purposes of section 199 only, the proposed regulations include a rule in § 1.199-3(h)(3) concerning hedges (within the meaning of section 1221(b)(2) and § 1.1221-2(b)) of inventory that is QPP and supplies consumed in activities giving rise to DPGR. The proposed regulations require gain or loss on the hedging transaction to be taken into account in determining DPGR. The proposed rule applies to hedges that manage the risk of currency fluctuations but only to the extent that the hedges are not integrated with an underlying transaction under § 1.988-5(b).

Commentators suggested that the proposed regulations treat gross receipts attributable to the distribution or delivery of QPP as derived from the lease, rental, license, sale, exchange, or other disposition of that property. The commentators stated that section 199(c)(4)(B)(ii), which specifically provides that DPGR does not include gross receipts derived from the transmission and distribution of utilities, indicates (by negative implication) that gross receipts attributable to the distribution or delivery of QPP is intended to be considered DPGR. Moreover, some commentators interpreted language in section 3.04(10)(c) of Notice 2005-14, stating that bottled water is treated as QPP and that DPGR may include gross receipts attributable to distribution of bottled water, as suggesting that gross receipts attributable to distribution and delivery of QPP are considered DPGR.

In general, the IRS and Treasury Department believe that gross receipts attributable to distribution and delivery of QPP are not DPGR because distribution and delivery are properly regarded as services, regardless of whether the taxpayer retains the benefits and burdens of ownership of the property at the time it is delivered. No inference to the contrary in Notice 2005-14 was intended. Thus, the proposed regulations clarify that taxpayers generally must allocate gross receipts between the lease, rental, license, sale, exchange, or other disposition of the property itself and the delivery component. The IRS and Treasury Department, however, believe that, because distribution and delivery are service components common to QPP, it is appropriate, as a matter of administrative convenience, to treat embedded distribution and delivery services similar to the qualified warranty exception in section 4.04(7)(b) of Notice 2005-14. Thus, the taxpayer must include in DPGR gross receipts attributable to the distribution and delivery of QPP if (1) in the normal course of business, the charge for the delivery or distribution service is included in the price charged for the sale of the QPP, and (2) the charge for the delivery or distribution service is neither separately offered nor separately bargained for with the customer.

For similar reasons, the proposed regulations also treat embedded qualified operating manuals provided in connection with the sale or disposition of QPP, qualified films, and utilities similar to embedded qualified warranties.

The proposed regulations also provide special rules for installation activities. The IRS and Treasury Department believe that, in some circumstances, installation is appropriately viewed as an MPGE activity, and in others it is appropriately viewed as a service. For example, installation is properly viewed as an MPGE activity if the taxpayer MPGE QPP within the United States and installs the QPP while the taxpayer retains the benefits and burdens of ownership of the QPP. In that case, gross receipts attributable to the installation, whether or not embedded, are derived from the lease, rental, license, sale, exchange, or other disposition of the QPP. If, however, the benefits and burdens of ownership pass to the customer prior to the installation of the QPP, the taxpayer is performing a service by installing the customer's property. In that case, gross receipts attributable to installation are not derived from the lease, rental, license, sale, exchange, or other disposition of the property, and the taxpayer generally is required under the proposed regulations to allocate gross receipts between the proceeds of sale or disposition of the property (DPGR) and the installation service (non-DPGR). However, the IRS and Treasury Department believe that, because installation is a service component common to sales or dispositions of QPP, if the benefits and burdens of ownership pass to the customer prior to the installation, it is appropriate to treat embedded installation similar to an embedded qualified warranty, qualified delivery, and a qualified operating manual.

A number of commentators suggested that the IRS and Treasury Department expand the exception to the allocation requirement for a qualified warranty to include all services (including training, technical and customer support, and regular maintenance of the property), as well as all nonqualifying property (including purchased spare parts), the charge for which is embedded in the contract price of the lease, rental, license, sale, exchange, or other disposition of QPP, qualified films, and utilities. Other commentators stated that the proposed regulations should adopt principles similar to § 1.482-2(b), so that services that are ancillary and incidental to the sale of QPP, qualified films, and utilities would not be treated as embedded services and no allocation of gross receipts to those services would be required. These commentators believe that footnote 27 in the Conference Report supports such a position in stating that the conferees intend that the Secretary provide guidance regarding the allocation of gross receipts that draws on the principles of section 482. Other commentators stated that, elsewhere in the Code and regulations, transactions are given a single characterization based on their predominant nature and that section 199 should be applied in the same manner. For example, if the predominant nature of a transaction is the sale of property, all gross receipts from the transaction should be treated as proceeds from the sale. Finally, some commentators stated that a taxpayer's treatment of a transaction for financial reporting purposes should govern its characterization for section 199 purposes.

The IRS and Treasury Department infer that the commentators are referring to § 1.482-2(b)(8), which provides that, in general, no separate allocation will be made in connection with ancillary and subsidiary services provided with a transfer of property. Services ancillary and subsidiary to another transaction may be referred to, outside the section 199 context, as embedded services. The IRS and Treasury Department do not intend that services defined as embedded services under section 199 will be treated in the same manner provided in § 1.482-2(b)(8) because such treatment would be generally inconsistent with the intent and purpose of section 199.

The IRS and Treasury Department further believe that the reference to section 482 principles in footnote 27 of the Conference Report reflects an intent to apply section 482 principles

consistently with the general intent and purpose of section 199. The IRS and Treasury Department continue to believe that the statutory language and legislative history require that transactions be bifurcated into qualifying and nonqualifying elements and that gross receipts be allocated accordingly for purposes of section 199. The IRS and Treasury Department further believe that the exceptions to this general rule should be limited. Expanding the special exceptions to include all, or ancillary or incidental, embedded services and embedded nonqualifying property would result in the inclusion in DPGR of gross receipts that the IRS and Treasury Department do not believe were intended to be within the scope of section 199. The legislative history also does not support adopting principles applicable to other Code sections under which a single predominant nature character is assigned to a transaction, or characterizing transactions for purposes of section 199 according to their treatment for financial reporting purposes. Accordingly, the proposed regulations do not adopt these suggestions.

One commentator requested that the proposed regulations clarify whether the embedded services rule is intended to require taxpayers to treat certain service-type activities that take place as part of the MPGE process as embedded services. The proposed regulations clarify that embedded services do not include service-type activities that take place as part of the MPGE process (that is, while the taxpayer is engaged in an MPGE activity with respect to the property and retains the benefits and burdens of ownership of the property). For example, with respect to QPP, activities such as non-construction engineering, materials analysis and selection, subcontractor inspections and approval, routine production inspections, product testing and documentation, and assistance with certain regulatory approvals, if undertaken in connection with a qualifying MPGE activity, are considered part of the MPGE of the QPP and are not considered embedded services. No separate allocation of gross receipts to such activities is required.

Services and nonqualifying property are not considered embedded if they are either separately offered or separately bargained for, or a charge for the service or nonqualifying property is separately stated. Thus, for example, if a charge for freight or delivery is separately stated on an invoice for the sale of an item of QPP, the delivery service is not embedded and gross receipts attributable to that service are non-DPGR, even if the purchaser does not have the option of refusing the service. Further, separately stated or bargained for amounts will not be respected unless they reflect the fair market value of the service or nonqualifying property. For example, if a taxpayer offers contracts to customers that include a cellular phone priced on the invoice at $595 and three years of cellular telephone service priced on the invoice at $5, the $5 stated amount for the service will only be respected if it represents an allocation of gross receipts consistent with the principles of section 482.

Gross receipts attributable to embedded services, embedded nonqualifying property, or any other embedded element (other than a qualified warranty, qualified delivery, qualified installation, and a qualified operating manual) may be considered DPGR under the 5 percent de minimis exception. The proposed regulations clarify that, with respect to the de minimis exception, taxpayers should apply the 5 percent against the total amount of the gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of the item of QPP, qualified films, or utilities. The total amount of DPGR includes gross receipts attributable to a qualified warranty, qualified delivery, qualified installation, and/or a qualified operating manual that are treated as DPGR with respect to that item. In the case of a lease or an installment sale, the de minimis exception is applied by taking into account the total amount of gross receipts under the lease or installment sale that are attributable to the item of QPP, qualified films, or utilities.

Under the proposed regulations, as under Notice 2005-14, applicable Federal income tax principles apply in determining whether a transaction (or any part of a transaction) is, in substance, a lease, rental, license, sale, exchange, or other disposition, or whether it is a service. For this purpose, section 3.04(7)(a) of Notice 2005-14 cites Rev. Rul. 88-65 (1988-2 C.B. 32), and describes that revenue ruling as treating a short-term rental as a service. Many commentators asked that the proposed regulations clarify that not all short-term rentals will be regarded as services for purposes of section 199. They observed that Rev. Rul. 88-65 involves the lease of automobiles and trucks on a daily basis (normally for not more than one week), and that the taxpayer performs significant services in connection with the vehicle, including maintenance and repairs, and pays all taxes and insurance on the vehicle. 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. Therefore, the proposed regulations clarify that, in such cases, taxpayers must allocate gross receipts between the qualifying rental of QPP or qualified films (DPGR) and the non-qualifying services (non-DPGR). The allocation must be based on the facts and circumstances of each transaction. Generally, in the case of short-term transactions, such as those described in Rev. Rul. 88-65, in which significant services are provided in connection with the property, the transaction will consist mostly of services.

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. For example, assume that a taxpayer operates a video game arcade that features video game machines that the taxpayer MPGE. The machines remain in the taxpayer's possession during the customers' use. 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.

A number of commentators objected to the position taken in section 4.04(7)(d) of Notice 2005-14 that gross receipts from Internet access services, online services, customer support, telephone services, games played through a website, provider-controlled software online access services, and other services are not derived from a lease, rental, license, sale, exchange, or other disposition of the software. Consistent with the notice, the proposed regulations reflect the position that the use of online computer software does not rise to the level of a lease, rental, license, sale, exchange, or other disposition as required under section 199 but is instead a service. This is the case even if the customer must agree to terms and conditions (which may be termed a

license

by the software provider) before using the software online, or receive enabling software to facilitate the customer's use of the primary software on the customer's hardware.

If gross receipts attributable to the use of online software were permitted to qualify as DPGR because the same or similar software also is available to

customers on disk or by download, different items of software available online would be subject to disparate treatment under section 199. In addition, if online software were permitted to qualify as DPGR, it would be difficult to distinguish this online software from software that is used to facilitate a service. The IRS and Treasury Department are requesting comments in the Request for Comments section on this issue.

One commentator suggested that the term lease, rental, license, sale, exchange, or other disposition, especially the term other disposition, was intended to be interpreted broadly to include gross receipts from any means of commercialization of property, whether or not an actual transfer of the property occurs. Another commentator noted that section 3.04(7)(d) of Notice 2005-14 states that gross receipts derived by a taxpayer from software that is merely offered for use to customers online for a fee are non-DPGR, and suggested that if the software is also offered to customers on disk or by download, then gross receipts for online use of otherwise qualifying software would be DPGR. The commentator also noted that the same section provides that a “service provided using computer software that does not involve a transfer of the computer software does not result in [DPGR],” and suggested that this language implies that if the software is not used in providing a service, no transfer is required for purposes of section 199. The IRS and Treasury Department did not intend the results suggested by the commentators and the proposed regulations have been clarified as necessary.

A number of commentators requested clarification and expansion of the rule in Notice 2005-14 that treats advertising receipts attributable to the sale or other disposition of newspapers and magazines as DPGR. Notice 2005-14 explains that advertising receipts in this context are inextricably linked to the gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of the newspapers and magazines. In response to comments, the proposed regulations clarify that this rule also applies, under the same rationale, to advertising receipts relating to telephone directories and periodicals, whereby a taxpayer's gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of the telephone directories or periodicals that are MPGE in whole or in significant part within the United States includes advertising income from advertisements placed in those media, but only to the extent the gross receipts, if any, derived from the lease, rental, license, sale, exchange, or other disposition of the telephone directories or periodicals are DPGR. The proposed regulations clarify that advertising revenue for advertising in online newspapers and periodicals is non-DPGR, because any underlying receipts from the property itself are non-DPGR, as there is no lease, rental, license, sale, exchange, or other disposition of such property. The proposed regulations provide similar treatment for gross receipts attributable to product placements in a qualified film. The gross receipts attributable to product placements will be treated as DPGR, but (as with newspapers) only if the gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of the qualified film are DPGR. Thus, for product placement revenue to be derived from a qualified film, there must be a lease, rental, license, sale, exchange, or other disposition of the qualified film.

Section 3.04(9)(a) of Notice 2005-14 provides that revenue from the licensing of film characters is not derived from the lease, rental, license, sale, exchange, or other disposition of a qualified film. One commentator stated that this treatment is inconsistent with the income forecast method, and that revenue from licensing of film-related intangibles is inextricably linked to (and therefore should be treated as derived from) the qualified film. The proposed regulations do not adopt this comment. Section 199(c)(4)(A)(i)(II) clearly requires that receipts must be derived from a lease, rental, license, sale, exchange, or other disposition of a qualified film to be DPGR. Receipts derived from the licensing of related intangibles, including film characters, trademarks, and trade names, do not meet this requirement. Further, the IRS and Treasury Department do not agree that receipts derived from licensing of film-related intangibles are inextricably linked to the gross receipts derived from a qualified film.

Some commentators objected to the rule in section 4.04(7)(a) of Notice 2005-14 that provides that if a taxpayer exchanges QPP MPGE by the taxpayer in whole or in significant part within the United States for other property in a taxable exchange, the value of the property received by the taxpayer is DPGR; whereas any gross receipts derived from a subsequent sale by the taxpayer of the acquired property are non-DPGR because the taxpayer did not MPGE the acquired property. The commentators noted that in their industry, fungible commodities held for sale to customers are exchanged routinely between producers as a practical means of avoiding logistical problems in meeting customers' needs and reducing transportation and storage costs. The commentators noted that these exchanges typically are not treated as taxable exchanges on the parties' financial records. The commentators requested that the proposed regulations instead provide that if the property relinquished in the exchange is QPP, qualified films, or utilities, then the property received in the exchange should be treated as QPP, qualified films, or utilities and gross receipts derived from the subsequent sale of that property should be treated as DPGR. Another commentator suggested that this treatment be applied only to nontaxable exchanges.

The proposed regulations do not adopt these suggestions. The IRS and Treasury Department believe that the character of property as having been MPGE in whole or in significant part by the taxpayer within the United States is not an attribute of the property, like basis and holding periods, that may be substituted with the transfer of the property. The IRS and Department Treasury believe that the commentators' interpretations are inconsistent with section 199(c)(4)(A)(i)(I).

Commentators requested that the IRS and Treasury Department clarify whether gross receipts from mineral royalties and net profits interests are properly treated as DPGR. Mineral royalties, including net profits interests, are returns on passive interests in mineral properties, the owner of which makes no expenditure for operation or development. The courts and the IRS have long considered these types of income to be in the nature of rent (see, for example,

Kirby Petroleum Co.

v.

Comm'r

, 326 U.S. 599 (1946)). Accordingly, the proposed regulations in § 1.199-3(h)(9) provide that gross receipts from mineral interests and net profits interests other than operating or working interests are not treated as DPGR.

Definition of Manufactured, Produced, Grown, or Extracted

Section 4.04(3)(b) of Notice 2005-14 provides that a taxpayer that MPGE QPP for the taxable year should treat itself as a producer under section 263A with respect to the QPP for the taxable year unless the taxpayer is not subject to section 263A. In response, commentators questioned whether all taxpayers that are subject to section 263A are considered to have MPGE QPP for purposes of section 199. Taxpayers who do not MPGE QPP may nevertheless be subject to section 263A. For example, a taxpayer that has

property produced for it under a contract is considered a producer of property under section 263A, but may not be considered as having MPGE property for purposes of section 199 if it does not have the benefits and burdens of ownership of the property while it is being produced. Additionally, in some circumstances a taxpayer that manufactures property for a customer pursuant to a contract may be considered the producer of the property for purposes of section 263A and not to have MPGE the property for purposes of section 199. Accordingly, not all taxpayers that are subject to section 263A are considered to have MPGE QPP for purposes of section 199.

Commentators also have questioned whether a taxpayer that engages in certain production activities that are exempt from section 263A (for example, developing computer software under Rev. Proc. 2000-50 (2000-1 C.B. 601), producing property pursuant to a long-term contract under section 460, or farming exempt under section 263A(d)) must treat itself as a producer under section 263A if the taxpayer wants to be treated as MPGE QPP for purposes of section 199. The proposed regulations in § 1.199-3(d)(4) provide that a taxpayer that has MPGE QPP for the taxable year should treat itself as a producer under section 263A with respect to the QPP for the taxable year unless the taxpayer is not subject to section 263A. A taxpayer whose MPGE activity is exempt from section 263A is not required to change its method of accounting under section 263A to treat itself as engaged in the MPGE of QPP for purposes of section 199.

Commentators requested clarification as to whether a reseller that engages in de minimis production activities or that has property produced for it under contract, which constitutes the MPGE of QPP under section 199, is precluded from using the simplified resale method provided by § 1.263A-3(d). Section 1.263A-3(a)(4)(ii) provides that a reseller with de minimis production activities is permitted to use the simplified resale method. Likewise, § 1.263A-3(a)(4)(iii) provides that a reseller otherwise permitted to use the simplified resale method is permitted to use the method if it has personal property produced for it under a contract if the contract is entered into incident to its resale activities and the property is sold to its customers. The section 263A consistency rule provided in § 1.199-3(d)(4) of the proposed regulations does not affect the rules provided in § 1.263A-3. Accordingly, a reseller with de minimis production or that has property produced for it under a contract that is considered the MPGE of QPP for purposes of section 199 is not precluded from using the simplified resale method if the taxpayer meets the requirements of § 1.263A-3(a)(4)(ii) or (iii).

Definition of By the Taxpayer

Section 1.199-3(e)(1) of the proposed regulations provides that, with the exception of rules that are applicable to an EAG, certain oil and gas partnerships described in § 1.199-3(h)(7), EAG partnerships described in § 1.199-3(h)(8), and certain government contracts described in § 1.199-3(e)(2), only one taxpayer may claim the section 199 deduction with respect to the MPGE of QPP. If one taxpayer MPGE QPP pursuant to a contract with another person, then only the taxpayer that has the benefits and burdens of ownership of the property under Federal income tax principles during the time the property is MPGE will be considered to have MPGE the QPP. In contrast, § 1.263A-2(a)(1)(ii)(B) provides that property produced for the taxpayer under a contract is considered as produced by the taxpayer to the extent the taxpayer makes payments or otherwise incurs costs with respect to the property, even if the taxpayer is not the owner of the property while the property is being produced. Commentators questioned why a similar rule does not apply in the context of section 199. The rule provided by § 1.263A-2(a)(1)(ii)(B) is derived from section 263A(g)(2). That section specifically provides that a taxpayer is treated as producing property produced for it under a contract to the extent that it has made payments or incurred costs with respect to the contract. In contrast, section 199(c)(4)(A)(i) provides that DPGR only includes gross receipts of the taxpayer that are derived from any lease, rental, license, sale, exchange, or other disposition of QPP MPGE by the taxpayer in whole in significant part within the United States. Accordingly, the proposed regulations do not contain a provision that is analogous to § 1.263A-2(a)(1)(ii)(B).

While sections 199, 263A, and 936 all have benefits and burdens standards, the standard under section 199 is not the same as those under sections 263A and 936. Commentators suggested that the proposed regulations adopt the broader standard under § 1.263A-2(a)(1)(ii)(A) that provides that a taxpayer is not considered to be producing property unless the taxpayer is considered the owner of the property produced under Federal income tax principles. The determination of whether a taxpayer is considered an owner is based on all of the facts and circumstances, including the various benefits and burdens of ownership vested with the taxpayer. Because the standard under the section 263A regulations is broad, it has been interpreted to allow two taxpayers to be considered the producer of the same property. Compare, for example,

Suzy's Zoo

v.

Comm'r

, 114 T.C. 1 (2000),

aff'd

273 F.3d 875 (9th Cir. 2001) and

Golden Gate Litho

v.

Comm'r

, T.C. Memo (1998-184).

The IRS and Treasury Department continue to believe that the requirement of section 199(c)(4)(A)(i) that property be MPGE by the taxpayer means that only one taxpayer may claim the section 199 deduction with respect to the same function performed with respect to the same property. Therefore, it would be inappropriate to adopt the standard under the section 263A regulations. In addition, this interpretation is supported by the Congressional Letter that states the Treasury Department has the authority to prescribe rules to prevent the section 199 deduction from being claimed by more than one taxpayer with respect to the same economic activity described in section 199(c)(4)(A)(i). Thus, consistent with Notice 2005-14, the proposed regulations in § 1.199-3(e)(1) provide that only one taxpayer may claim the section 199 deduction with respect to any MPGE activity.

Commentators also proposed other alternatives to the benefits and burdens standard, such as looking to the person that has the economic risks and benefits, adopting the qualified research rules under § 1.41-2(e)(2), providing safe harbors based on contract terms, treating the person that arranges for the acquisition of the property as the owner, and looking to the person that controls the process by which the property is MPGE. The proposed regulations do not adopt any of these suggestions because the IRS and Treasury Department believe that there is considerable variation in the types of contract manufacturing situations. Therefore, the proposed regulations contain the same benefits and burdens standard used in Notice 2005-14 because it is a standard that the IRS and Treasury Department believe covers all of the varied factual situations.

Commentators requested that the proposed regulations provide examples of how to apply the benefits and burdens standard. The proposed regulations contain examples illustrating contract manufacturing situations in which the taxpayer with the benefits and burdens of ownership

under Federal income tax principles is treated as manufacturing the QPP.

In the Congressional Letter, the Treasury Department was advised that gross receipts derived from certain contracts to manufacture or produce property for the Federal government are derived from the sale of such property and, therefore, are DPGR. The proposed regulations in § 1.199-3(e)(2) provide that a taxpayer will be treated as meeting the by the taxpayer requirement if the QPP, qualified films, or utilities are MPGE or otherwise produced in the United States by the taxpayer pursuant to a contract with the Federal government and the Federal Acquisition Regulation requires that title or risk of loss with respect to the QPP, qualified films, or utilities be transferred to the Federal government before the MPGE or production of the QPP, qualified films, or utilities is complete.

In Whole or In Significant Part

Under section 199(c)(4)(A)(i)(I), QPP must be MPGE in whole or in significant part by the taxpayer within the United States. The proposed regulations in § 1.199-3(f)(1) clarify that the in whole or in significant part requirement applies to both the by the taxpayer requirement and the within the United States requirement.

Section 4.04(5)(b) of Notice 2005-14 provides that QPP will be treated as having been MPGE in significant part by the taxpayer within the United States if the MPGE of the QPP performed within the United States is substantial in nature. Design and development costs do not qualify as substantial in nature for any QPP other than computer software and sound recordings. The proposed regulations in § 1.199-3(f)(2) substitute research and experimental expenditures under section 174 for design and development costs.

Section 4.04(5)(c) of Notice 2005-14 provides that a taxpayer will be treated as having MPGE property in whole or in significant part within the United States if, in connection with the property, conversion costs (direct labor and related factory burden) to MPGE the property are incurred by the taxpayer within the United States and the costs account for 20 percent or more of the total CGS of the property. The proposed regulations in § 1.199-3(f)(3) provide that, in the case of tangible personal property, research and experimental expenditures under section 174 and any other costs of creating intangibles may be excluded from total CGS for purposes of the safe harbor.

A commentator suggested that a taxpayer's activity within the United States that is critical to the functionality or nature of property should be considered to meet the in significant part requirement under section 199(c)(4)(A)(i)(I) even if the activity is not substantial in nature. The proposed regulations do not adopt this suggestion because the IRS and Treasury Department do not believe that this is an accurate measurement of the degree of activity required to satisfy the in whole or in significant part requirement.

Qualifying Production Property

Commentators requested that the IRS and Treasury Department reconsider the rule under section 4.04(8)(c) and (d) of Notice 2005-14 which provides that, if the medium in which computer software or sound recordings are contained is tangible, then such medium is considered tangible personal property for purposes of section 199. This rule has been removed and the proposed regulations in § 1.199-3(i)(5) provide that if a taxpayer MPGE computer software or sound recordings that the taxpayer fixed on, or added to, tangible personal property (for example, a computer diskette or an appliance), then the tangible medium with the computer software or sound recordings may be treated by the taxpayer as computer software or sound recordings, as applicable. However, the proposed regulations provide that, if a taxpayer treats the tangible medium as computer software or sound recordings, any costs under section 174 attributable to the tangible medium are not considered in determining whether the taxpayer's activity is substantial in nature under § 1.199-3(f)(2) or conversion costs under § 1.199-3(f)(3). In addition, because a taxpayer may MPGE tangible personal property, but not computer software or sound recordings that the taxpayers fixes on, or adds to, the tangible personal property MPGE by the taxpayer, the proposed regulations provide that the computer software or sound recordings may be treated by the taxpayer as tangible personal property.

Commentators requested that the proposed regulations clarify whether the exceptions from computer software under section 168(i)(2)(B)(iv) apply to computer software under section 199. In response to this comment, the proposed regulations provide in § 1.199-3(i)(3)(i) that these exceptions do not apply for purposes of section 199 and computer software also includes the machine-readable code for video games and similar programs, for equipment that is an integral part of other property, and for typewriters, calculators, adding and accounting machines, copiers, duplicating equipment, and similar equipment, regardless of whether the code is designed to operate on a computer (as defined in section 168(i)(2)(B)). Computer programs of all classes, for example, operating systems, executive systems, monitors, compilers and translators, assembly routines, and utility programs as well as application programs, are included.

A commentator requested that the proposed regulations provide that the creation and licensing of copyrighted business information reports constitutes the MPGE of QPP. Formerly distributed in hard copy, this information is now generally distributed electronically. Customers are required to use the information only for their own use, and no copyright is transferred to them. The commentator contends that, while the activity of creating the business information reports provided to customers is not a production activity in the traditional sense, the definition of MPGE is broad enough to encompass this activity. The IRS and Treasury Department do not agree with this comment because creating a database of business information is not MPGE, the database is not QPP, and the business information reports are not QPP MPGE by the taxpayer.

Qualified Films

Similar to the rules for computer software, section 4.04(9)(a) of Notice 2005-14 provides that if a medium on which a qualified film is fixed is tangible (such as a DVD), the property consists of both a qualified film and tangible personal property. The notice contains examples in which taxpayers that either produce a qualified film and purchase the tangible medium, or MPGE the tangible medium and license the qualified film, must allocate gross receipts between the tangible medium and the qualified film. For the reasons stated under the discussion of computer software, the proposed regulations allow certain taxpayers to treat such combined property as either tangible personal property or a qualified film, as applicable.

One commentator requested that the proposed regulations clarify the requirement that 50 percent of the total compensation relating to the production of the film be compensation for services performed in the United States by actors, production personnel, directors, and producers. Specifically, the commentator requested that the phrase “total compensation relating to the production of the film” be interpreted to mean compensation for services performed only by actors, production personnel, directors, and producers. The commentator further requested that the term “compensation” be interpreted to

include all compensation (not just W-2 wages) that is paid to these individuals and that is required to be capitalized by film producers under section 263A and § 1.263A-1(e)(2) and (3). These suggestions have been adopted in the proposed regulations.

Definition of Construction Performed in the United States

Section 4.04(11)(a) of Notice 2005-14 defines the term “construction” to mean the construction or erection of real property by a taxpayer that is in a trade or business that is considered construction for purposes of the North American Industry Classification System (NAICS). Commentators asked how a taxpayer in multiple trades or businesses determines if it is in a construction NAICS code. The proposed regulations clarify that in order for a taxpayer to be considered in a construction NAICS code, it must be engaged in a construction trade or business (but not necessarily its primary trade or business) on a regular and ongoing basis. The determination of whether an entity is in a NAICS code is generally tested on an entity-by-entity basis. Under this rule, a member of an EAG must perform the construction activity in order for its gross receipts to qualify as DPGR from construction. See § 1.199-7(a)(3). In addition, the taxpayer must actually perform the construction activity. For example, if a taxpayer in a construction NAICS code hired an unrelated general contractor to construct a building, the gross receipts derived by the taxpayer from the sale of the building would not be DPGR because the taxpayer did not construct the building. The proposed regulations provide an example to illustrate this rule.

Commentators also asked that the proposed regulations clarify whether eligible construction activities are limited to a specific NAICS code. Section 1.199-3(l)(1)(i) provides that a trade or business that is considered construction for purposes of the NAICS codes means a construction activity under the two-digit NAICS code of 23 and any other construction activity in any other NAICS code relating to the construction of real property. For example, a construction activity relating to the construction of real property that is not under the two-digit NAICS code of 23 but which qualifies as an eligible construction activity would include the construction of oil and gas wells for NAICS code 213111 (drilling oil and gas wells) and 213112 (support activities for oil and gas operations). Commentators also asked that the proposed regulations include a listing of construction activities relating to oil and gas wells. In response to this request, the proposed regulations provide, as a matter of administrative grace, that qualifying construction activities also include activities relating to drilling an oil well and mining, and include any activities treated by the taxpayer as intangible drilling and development costs under section 263(c) and § 1.612-4 and development expenditures for a mine or natural deposit under section 616.

Commentators contend that gross receipts attributable to the leasing or rental of constructed real property qualify as DPGR because the right to use constructed property represents one right in the bundle of rights derived from the construction of real property. The proposed regulations do not adopt this interpretation because gross receipts derived from the rental of real property that a taxpayer constructs are not derived from construction, but are instead compensation for the use or forbearance of the property. Similarly, gross receipts derived from renting or leasing equipment such as bulldozers and generators to contractors for use in the construction of real property are non-DPGR (assuming the rental companies do not manufacture the equipment).

Section 4.04(11)(a) of Notice 2005-14 contains a safe harbor rule for determining when tangible personal property that is sold as part of a construction project may be considered real property. If more than 95 percent of the total gross receipts derived by a taxpayer from a construction project are derived from real property (as defined in § 1.263A-8(c)), then the total gross receipts derived by the taxpayer from the project are DPGR from construction. Commentators stated that it was unclear what items of tangible personal property are included in this rule (for example, small or major appliances, home theaters, and fixtures installed by a builder) and whether it was intended that land be included for purposes of this safe harbor. Consequently, this rule has been replaced in the proposed regulations with a

de minimis

exception in § 1.199-3(l)(1)(ii). Accordingly, if less than 5 percent of the total gross receipts derived by a taxpayer from a construction project are derived from activities other than the construction of real property in the United States (for example, from non-construction activities, the sale of tangible personal property, or land) then the total gross receipts derived by the taxpayer from the project are DPGR from construction.

Many commentators suggested that the proposed regulations treat gross receipts attributable to the sale or other disposition of land as DPGR derived from construction of real property. Commentators also suggested that construction begins as soon as production activities begin, that is, when land is acquired and the entitlement process, such as obtaining proper zoning and permits, commences in connection with construction of real property. The proposed regulations do not adopt these suggestions. The IRS and Treasury Department continue to believe that Congress intended the benefit under section 199 only for construction services performed in the United States. Taxpayers do not construct land and thus any gain attributable to the disposition of land (including zoning, planning, entitlement costs and other costs capitalized to the land such as the demolition of structures under section 280B) is not eligible for the section 199 deduction. Commentators also argue that the land exclusion creates an administrative and financial burden because a valuation will be necessary for any sale of real property that includes land. To address the administrative burden in identifying and valuing the gross receipts attributable to land in connection with qualifying construction activities, the proposed regulations provide a safe harbor in § 1.199-3(l)(5)(ii). Under this safe harbor, a taxpayer may allocate gross receipts between the proceeds from the sale, exchange, or other disposition of real property constructed by the taxpayer and the gross receipts attributable to the sale, exchange, or other disposition of land by reducing its costs related to DPGR in § 1.199-4 by costs of the land and any other costs capitalized to the land (collectively, land costs) (including land costs in any common improvements as defined in section 2.01 of Rev. Proc. 92-29 (1992-1 C.B. 748)), and by reducing its DPGR from qualifying construction activities by those land costs plus a specified percentage. The percentage is based on the number of years that elapse between 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. The percentage is 5 percent for years zero through 5; 10 percent for years 6 through 10; and 15 percent for years 11 through 15. Land held by a taxpayer for 16 or more years is not eligible for the safe harbor and the taxpayer must allocate gross receipts between the land and the qualifying real property. For example, if a taxpayer acquires land in 2001 and constructs houses that it sells in 2005, 2008, and

2012, the houses sold in 2005 are subject to the 5 percent reduction; the houses sold in 2008 are subject to the 10 percent reduction; and the houses sold in 2012 are subject to the 15 percent reduction.

Commentators suggested that developers of raw land should be entitled to a section 199 deduction for improvements to land such as building roads, sidewalks, and installing utilities. In addition, they suggested that entitlements such as zoning, permits, and surveys that add value to the land should be included in DPGR similar to the treatment of design and development costs for software and sound recordings. The proposed regulations provide that a taxpayer in a construction NAICS code that sells developed land will have DPGR to the extent the receipts are attributable to real property such as infrastructure but not to the land and any entitlements attributable to the land. The proposed regulations provide examples in § 1.199-3(l)(5)(iii) to illustrate this rule.

Commentators suggested that the proposed regulations extend the embedded services exception for qualified warranties in connection with the sale of property to construction warranties. The IRS and Treasury Department agree with this suggestion. Accordingly, § 1.199-3(l)(5)(i) provides DPGR derived from the construction of real property includes gross receipts from any warranty that is provided in connection with the construction of the real property if, in the normal course of the taxpayer's business, the charge for the construction warranty is included in the price for the construction project and the construction warranty is neither separately offered by the taxpayer nor separately bargained for with the customer (that is, the customer cannot purchase the constructed real property without the construction warranty).

Engineering and Architectural Services

Section 4.04(12)(a) of Notice 2005-14 provides that DPGR includes gross receipts derived from engineering or architectural services performed in the United States for real property construction projects in the United States. Commentators stated that the definition of engineering and architectural services should not be limited to real property because this limitation is inconsistent with the rules for engineering and architectural services under the domestic international sales corporation, foreign sales corporation, and extraterritorial income exclusion provisions. The IRS and Treasury Department continue to believe that the statutory language in section 199(c)(4)(A)(iii) requires that only engineering and architectural services relating to real property qualify for the section 199 deduction and that the same rules relating to construction of real property apply for engineering or architectural services. In addition, the Blue Book at page 172 n. 292, states that DPGR includes gross receipts derived from the engineering or architectural services performed with respect to real property only. Thus, DPGR only includes gross receipts derived from engineering or architectural services performed in the United States for the construction of real property in the United States. In addition, the IRS and Treasury Department believe that, consistent with the rules for construction activities, a taxpayer performing engineering and architectural services must be in a trade or business described in an engineering or architectural NAICS code. Accordingly, the proposed regulations require that, at the time the taxpayer performs the engineering or architectural services, the taxpayer must be in a trade or business on a regular and ongoing basis (but not necessarily its primary trade or business) that is considered engineering or architectural services for purposes of the NAICS codes, for example NAICS codes 541330 (engineering services) or 541310 (architectural services).

A commentator also requested clarification of whether a structure enclosing an electric generation station as described in Rev. Rul. 69-412 (1969-2 C.B. 2) would be considered real property for purposes of section 199(c)(4)(A)(iii). In that revenue ruling, the structure qualified as section 38 property for investment credit purposes. The revenue ruling does not determine whether the property was real or personal property. Under section 4.04(11)(a) of Notice 2005-14, real property includes residential and commercial buildings including items that are structural components of such buildings and inherently permanent structures other than tangible personal property in the nature of machinery. The proposed regulations in § 1.199-3(l)(1)(i) retain this language. Thus, a structure enclosing an electric generation station as described in Rev. Rul. 69-412 is treated as real property for purposes of section 199(c)(4)(A)(iii).

In addition, similar to the rules for construction, the determination of whether an entity is in an engineering or architectural NAICS code is made on an entity-by-entity basis. Under this rule, a member of an EAG must perform the engineering or architectural services in order for its gross receipts to qualify as DPGR from engineering or architectural services. See § 1.199-7(a)(3). In addition, the taxpayer must actually perform the engineering or architectural services.

One commentator pointed out that the requirement in section 4.04(12)(a) of Notice 2005-14 that a taxpayer must substantiate that the engineering or architectural services relate to a construction project in the United States is unnecessary because taxpayers are already required to identify and allocate gross receipts attributable to DPGR based upon a reasonable method satisfactory to the Secretary for purposes of determining QPAI. Because there was no intention on the part of the IRS and Treasury Department to create an additional substantiation requirement for engineering and architectural services, this additional substantiation requirement is not required under the proposed regulations.

Commentators requested clarification of whether gross receipts attributable to feasibility studies, for example, planning possible road or building configurations for a potential real property development project, is a qualifying activity. The commentators state that engineering and architectural firms are often hired for these studies to determine a project's practicability. Accordingly, the proposed regulations provide in § 1.199-3(m)(1) that DPGR includes gross receipts derived from engineering or architectural services, including feasibility studies for a construction project in the United States, even if the planned construction project is not undertaken or is not completed.

Food and Beverages

Section 199(c)(4)(B)(i) provides that DPGR does not include gross receipts of the taxpayer that are derived from the sale of food and beverages prepared by the taxpayer at a retail establishment. Section 4.04(13) of Notice 2005-14 defines a “retail establishment” as real property leased, occupied, or otherwise used by the taxpayer in its trade or business of selling food or beverages to the public at which retail sales are made. One commentator stated that food carts and portable food stands should not be considered retail establishments because they do not constitute real property. The IRS and Treasury Department believe that the term “retail establishment” is intended to be interpreted broadly to include any facility at which the taxpayer prepares food or beverages and makes retail sales of the food or beverages to the public. See Conference Report at page 272 (footnote 27) (retail establishment not

limited to establishments at which customers dine on premises or to those engaged primarily in the dining trade). Accordingly, the proposed regulations do not adopt this suggestion, and the term “retail establishment” is clarified to include both real and personal property. In addition, a facility at which food and beverages are prepared solely for take out service or delivery is a retail establishment (for example, a caterer).

Consistent with Notice 2005-14, the proposed regulations provide that if a taxpayer's facility is a retail establishment, then, as a matter of administrative grace, a taxpayer is permitted to allocate its gross receipts between gross receipts derived from the wholesale sale of the food and beverages prepared at the retail establishment (which are DPGR, assuming all the other requirements of section 199(c) are met) and the gross receipts derived from the retail sale of the food and beverages prepared and sold at the retail establishment (which are non-DPGR). For this purpose, wholesale sales are defined as sales of food and beverages to be resold by the purchaser.

One commentator requested clarification how the retail establishment exception applies in the case of wineries. While producers of distilled spirits, wines, and beer may conduct retail sales of their products on their premises, such sales do not transform the entire premises of the distilled spirits plant, bonded wine cellar (or bonded winery), or brewery into a retail establishment. Chapter 51 of Title 26 of the United States Code, and the implementing regulations found in 27 CFR parts 19, 24, and 25, create clear distinctions between that portion of a distilled spirits plant, winery, or brewery devoted to production activities and the portion devoted to other activities, such as retail sales. Consistent with the treatment of such facilities for purposes of Chapter 51 of Title 26 of the United States Code and the regulations thereunder, the proposed regulations provide that the portion of a distilled spirits plant, bonded winery, or brewery that is restricted to production activities, including the processing and blending of distilled spirits, wine, and beer products, will not be treated as a retail establishment for purposes of section 199(c)(4)(B)(i). Thus, for example, for purposes of section 199, taxpaid wine sold from the taxpaid premises of a bonded winery is not considered to have been produced at a retail establishment because it is considered to have been produced on the bonded premises of the winery. Accordingly, the sales of such wine will be treated as DPGR for purposes of section 199 (assuming all the other requirements of section 199(c) are met). A similar result applies to the sale of taxpaid distilled spirits from the general (taxpaid) premises of a distilled spirits plant, and to the sale of taxpaid beer from the tavern portion of a brewery.

A commentator suggested that the proposed regulations interpret the term

food and beverages

to mean only items prepared by the taxpayer in a single serving size for immediate consumption by the purchaser. The commentator believes that the Conference Report in footnote 27 supports this interpretation because these characteristics are common to the examples that the footnote provides (that is, brewed coffee and venison sausage prepared at a restaurant). The commentator further contends that this interpretation eliminates the distinction between food and beverages prepared off-site (gross receipts from the retail sale of which may be DPGR) and those prepared on-site (gross receipts from the retail sale of which are non-DPGR), a distinction that the commentator believes Congress did not intend.

The IRS and Treasury Department do not believe that the statute or Conference Report supports the commentator's interpretation. If the commentator's interpretation was correct, then gross receipts from the retail sale of the roasted coffee beans in footnote 27 would have qualified as DPGR even if the taxpayer had roasted the beans at its retail establishment because the beans are not sold in single servings for immediate consumption. However, footnote 27 makes clear that the gross receipts attributable to the beans only qualify because the beans were roasted at a facility separate from the retail establishment. Thus, the statute and legislative history clearly provide different treatment for gross receipts attributable to the retail sale of food and beverages prepared at a retail establishment and food and beverages prepared elsewhere.

The same commentator requested clarification of how the food and beverages exception applies to in-store bakeries. Footnote 27 of the Conference Report provides an example of a taxpayer that operates a supermarket that includes an in-store bakery, and provides that the taxpayer may allocate its gross receipts between DPGR and non-DPGR. The commentator believes that the example could be interpreted to mean that all gross receipts allocable to sales (both retail and wholesale) of items prepared in the bakery are non-DPGR. Section 4.04(13) of Notice 2005-14 however, as a matter of administrative grace, permits gross receipts from wholesale sales of food and beverages produced at a retail establishment to qualify as DPGR (if all other requirements of section 199(c) are met), and the proposed regulations retain this rule. Thus, gross receipts from wholesale sales of items produced at the in-store bakery (for example, items sold to restaurants) may qualify as DPGR (if all other requirements of section 199(c) are met). The commentator further stated, consistent with the first comment, that gross receipts from retail sales of bakery products that require further processing by the consumer to be suitable for individual consumption (such as unsliced cakes and unsliced loaves of bread) should not be excluded from DPGR under section 199(c)(4)(B)(i). For the reasons stated above, the IRS and Treasury Department believe that retail sales of these items are subject to that exclusion. Receipts allocable to wholesale sales of these items, however, may qualify as DPGR under the administrative exception, assuming all the other requirements of section 199(c) are met.

Determining Costs

To determine its QPAI for the taxable year, a taxpayer must subtract from its DPGR the amount of CGS allocable to DPGR, the other deductions, expenses, and losses (deductions) directly allocable to DPGR, and a ratable portion of other deductions that are not directly allocable to DPGR or another class of income. A taxpayer's costs must be determined using the taxpayer's methods of accounting for Federal income tax purposes.

Allocation of Cost of Goods Sold

Notice 2005-14 provides that if a taxpayer can identify from its books and records CGS allocable to DPGR, CGS allocable to DPGR is that amount. The Notice also provides that if a taxpayer's books and records do not allow it to identify CGS allocable to DPGR, the taxpayer may use a reasonable allocation method to allocate CGS between DPGR and non-DPGR. The Notice further provides that, if a taxpayer uses a method to allocate gross receipts between DPGR and non-DPGR, then the taxpayer may not use a different method for purposes of allocating CGS.

Commentators suggested that a taxpayer should be permitted to allocate CGS using a reasonable method separate from the method used to allocate gross receipts because using the same allocation method for gross receipts and CGS may not be possible or may distort income. For example, a taxpayer that

can identify from its books and records gross receipts allocable to DPGR may not be able to specifically identify CGS allocable to DPGR. Commentators also questioned whether a taxpayer that can identify from its books and records CGS allocable to DPGR must allocate CGS on such basis when it allocates gross receipts using a different method. The proposed regulations clarify that if a taxpayer does, or can without undue burden or expense, specifically identify from its books and records CGS allocable to DPGR, CGS allocable to DPGR is that amount irrespective of whether the taxpayer uses another allocation method to allocate gross receipts between DPGR and other gross receipts. The proposed regulations also clarify that if a taxpayer cannot, without undue burden or expense, use a specific identification method to determine CGS allocable to DPGR, the taxpayer is not required to use a specific identification method to determine CGS allocable to DPGR, but may use some other reasonable method. A taxpayer's use of a method for purposes of allocating CGS between DPGR and non-DPGR that is different from its method for allocating gross receipts between DPGR and non-DPGR will ordinarily not be considered reasonable unless the method for allocating CGS is demonstrably more accurate than the method used to allocate gross receipts.

Commentators also suggested that CGS allocable to DPGR may not be readily ascertainable when a taxpayer uses the last-in, first-out (LIFO) method to account for its inventory. Therefore, commentators requested that a simplified method be provided to allocate CGS between DPGR and non-DPGR when a taxpayer uses the LIFO method to account for its inventory. The proposed regulations provide that a taxpayer that uses the LIFO method to account for its inventory may use any reasonable method to allocate CGS between DPGR and non-DPGR. In addition, the regulations provide simplified methods that a taxpayer may use to allocate CGS when a taxpayer uses the LIFO method to account for its inventories.

The IRS and Treasury Department also received comments requesting clarification of the types of costs that are required to be allocated as CGS allocable to DPGR. In particular, commentators stated that section 263A only requires taxpayers to capitalize costs with respect to inventory on hand at the end of the taxable year and that as a result taxpayers generally do not include indirect costs in CGS, but instead deduct the amount not allocated to ending inventory. Section 263A requires a taxpayer that produces inventory to include in inventory costs the direct costs of producing the property and the property's properly allocable share of indirect costs for purposes of determining both ending inventory and CGS. Consistent with Notice 2005-14, the proposed regulations provide that, for purposes of determining CGS allocable to DPGR, CGS includes the costs that would have been included in ending inventory under the principles of sections 263A, 471, and 472 if the goods sold during the taxable year were on hand at the end of the taxable year. However, a taxpayer is permitted to use any reasonable method to allocate indirect costs properly included in CGS between DPGR and non-DPGR if the taxpayer's books and records do not, or cannot without undue burden or expense, specifically identify CGS allocable to DPGR.

Comments also were received concerning whether a taxpayer is permitted to use a reasonable allocation method to allocate CGS if it uses the simplified production method or simplified resale method for additional section 263A costs. The proposed regulations clarify that a taxpayer that uses either the simplified production method or the simplified resale method for additional section 263A costs may use a reasonable allocation method to allocate both section 471 costs and additional section 263A costs included in CGS. The proposed regulations further provide that if a taxpayer uses the simplified production method or the simplified resale method to allocate additional section 263A costs to ending inventory, additional section 263A costs ordinarily should be allocated in the same proportion as section 471 costs are allocated.

Allocation and Apportionment of Deductions

Consistent with Notice 2005-14, the proposed regulations provide three methods for allocating and apportioning deductions. However, as described below, modifications have been made in these proposed regulations to the qualification requirements of the simplified deduction method and the small business simplified overall method.

The first method, the “section 861 method,” is required to be used by a taxpayer, unless the taxpayer is eligible and chooses to use either the simplified deduction method or the small business simplified overall method. Under the section 861 method, section 199 is treated as an operative section described in § 1.861-8(f). Accordingly, a taxpayer determines the deductions allocated and apportioned to DPGR by applying the allocation and apportionment rules provided by §§ 1.861-8 through 1.861-17 and §§ 1.861-8T through 1.861-14T (the section 861 regulations), subject to certain special rules. The IRS and Treasury Department recognize that the allocation and apportionment rules of the section 861 method may be burdensome to certain taxpayers, particularly smaller taxpayers, that otherwise would not be required to use these rules. Accordingly, the proposed regulations provide two alternative methods, the simplified deduction method and the small business simplified overall method, with a goal of minimizing the need for smaller taxpayers to devote additional resources to compliance.

Under the “simplified deduction method,” a taxpayer's deductions are apportioned between DPGR and other receipts based on relative gross receipts. The simplified deduction method does not apply to the allocation of CGS. Notice 2005-14 permits only taxpayers with average annual gross receipts of $25,000,000 or less to use the simplified deduction method. Several commentators requested that the simplified deduction method also be made available to taxpayers with gross receipts in excess of $25,000,000. Many of these comments were from taxpayers that have not in the past been required to allocate and apportion deductions under the section 861 regulations. Some commentators suggested that the simplified deduction method be used for all costs, except for limited identified costs such as interest, for which the section 861 method would continue to apply. Still other commentators suggested that taxpayers be allowed to use other existing cost allocation methods, such as those under section 263A or under other government regulatory procedures.

In response to these comments, the IRS and Treasury Department have modified the eligibility requirements for the simplified deduction method. Under the proposed regulations, a taxpayer may 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. However, the IRS and Treasury Department still believe that for taxpayers above this threshold the section 861 method is the appropriate method of allocating and apportioning deductions for purposes of determining QPAI. Furthermore, the alternative allocation methods suggested by commentators would each require additional rules and guidance to address

the interaction of the suggested methods with other Federal income tax rules and would result in administrative complexity and inefficiency. The IRS and Treasury Department believe that use of the section 861 method will result in an appropriate cost allocation and apportionment for purposes of section 199 and will be easier administratively for both taxpayers and the IRS than any new, equally comprehensive cost allocation and apportionment rules that might be created.

Section 1.199-4(f) of the proposed regulations provides that a qualifying small taxpayer may use the “small business simplified overall method” to apportion CGS and deductions to DPGR. Under Notice 2005-14, a qualifying small taxpayer is a taxpayer that has average annual gross receipts of $5,000,000 or less or a taxpayer that is eligible to use the cash method as provided in Rev. Proc. 2002-28 (2002-1 C.B. 815). The IRS and Treasury Department are concerned that the $5,000,000 average annual gross receipts threshold without further modification could be used by large taxpayers to circumvent the requirements to allocate and apportion deductions using the section 861 method. As a result, a deduction limitation has been added to this method. In addition, commentators requested that the definition of qualifying small taxpayer for purposes of the small business simplified overall method be expanded to include farmers that are not required to use the accrual method under section 447. The proposed regulations incorporate this suggestion. Accordingly, the proposed regulations provide that a qualifying small taxpayer is a taxpayer that; (1) has both average annual gross receipts of $5,000,000 or less, and CGS and deductions (excluding NOL deductions and deductions not attributable to the conduct of a trade or business) for the current taxable year of $5,000,000 or less; (2) is engaged in the trade or business of farming that is not required to use the accrual method under section 447; or (3) is eligible to use the cash method as provided in Rev. Proc. 2002-28.

Notice 2005-14 specifically requested comments on whether taxpayers should be able to change between the three cost allocation methods of section 199 on amended returns and whether there should be restrictions on a taxpayer's ability to change from one method to another. Several commentators suggested that a taxpayer should be allowed to change its cost allocation method on an amended return and that a taxpayer should be able to annually choose to use any of the three methods. The IRS and Treasury Department agree that a taxpayer that qualifies to use a particular allocation and apportionment method should be able to change to that method at any time. Accordingly, the proposed regulations generally provide that a taxpayer eligible to use the simplified deduction method may choose at any time to use the simplified deduction method or the section 861 method for a taxable year. A taxpayer eligible to use the small business simplified overall method may choose at any time to use the small business simplified overall method, the simplified deduction method, or the section 861 method for a taxable year. This rule does not affect, however, any restrictions or limitations that apply within the section 861 method.

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. In response to a commentator's inquiry, the proposed regulations make it clear that the owner of a pass-thru entity need not be engaged directly in the entity's trade or business in order to claim a section 199 deduction on the basis of that owner's share of the pass-thru entity's items.

Some commentators recommended that section 199 be applied to partnerships by using an aggregate approach in situations where the qualified production activities are conducted by the partnership, which distributes or sells the QPP, qualified films, or utilities to a partner who then leases, rents, licenses, sells, exchanges, or otherwise disposes of the property, or where the qualified production activities are conducted by a partner which contributes or sells the QPP, qualified films, or utilities to the partnership, which then leases, rents, licenses, sells, exchanges, or otherwise disposes of the property. The commentators maintained that the income derived by the partners and the partnerships from the lease, rental, license, sale, exchange, or other disposition of the property in these situations should be treated as QPAI and qualify for the section 199 deduction. The proposed regulations do not follow the commentators' recommendation because section 199(c)(4)(A) requires that the gross receipts must be derived from the taxpayer's own qualified production activities to qualify as DPGR. Accordingly, except for; (i) certain qualifying oil and gas partnerships; and (ii) EAG partnerships, discussed below, the proposed regulations provide that the owner of a pass-thru entity is not treated as directly conducting the qualified production activities of the pass-thru entity, and vice versa, with respect to the property transferred between the pass-thru entity and the owner. This rule applies to all partnerships, including partnerships that have elected out of subchapter K under section 761(a). In addition, attribution of activities does not apply for purposes of the construction of real property and the performance of engineering and architectural services.

The proposed regulations, pursuant to the Congressional Letter, provide a limited exception for certain partnerships in which all of the capital and profits interests are owned by members of a single EAG at all times during the taxable year of the partnership (EAG partnership). For purposes of determining the DPGR of a partnership and its partners, an EAG partnership and all members of the EAG in which the partners of the EAG partnership are members are treated as a single taxpayer during the taxable year for purposes of section 199(c)(4). Thus, if an EAG partnership MPGE or produces property and distributes, leases, rents, licenses, sells, exchanges, or otherwise disposes of that property to a member of an EAG in 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 members of the EAG. Similarly, if one or more members of an EAG in 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.

Except as otherwise provided, an EAG partnership is generally treated the same as other partnerships for purposes of section 199. Accordingly, the proposed regulations provide that an EAG partnership is subject to the rules of § 1.199-5 regarding the application of section 199 to pass-thru entities, and the application of the section 199(d)(1)(B)

wage limitation under § 1.199-5(a)(3). Under the proposed regulations, if an EAG partnership distributes property to a partner, then, solely for purposes of section 199(d)(1)(B)(ii), the EAG partnership is treated as having gross receipts in the taxable year of the distribution equal to the fair market value of the property at the time of distribution to the partner and the deemed gross receipts are allocated to that partner, provided the partner derives gross receipts from the distributed property during the taxable year of the partner with or within which the partnership's taxable year (in which the distribution occurs) ends. Costs included in the adjusted basis of the distributed property and any other relevant deductions are taken into account in computing the partner's QPAI. The proposed regulations provide that the small business simplified overall method is not available to EAG partnerships.

Another commentator asked whether the owner of a pass-thru entity might have to perform multiple QPAI calculations, distinguishing between pass-thru and non-pass-thru production activities. The proposed regulations make it clear that, when determining its section 199 deduction, an owner of a pass-thru entity aggregates items of income and expense from the entity (including W-2 wages) with its own items of income and expense (including W-2 wages) for purposes of allocating and apportioning deductions to DPGR. As noted above, the amount of W-2 wages of a pass-thru entity taken into account by an owner in applying the wage limitation of section 199(b) is determined under section 199(d)(1)(B). The proposed regulations provide that in determining an owner's allocable share of wages under section 199(d)(1)(B)(i), W-2 wages are deemed to be allocated in the same way as wage expense is allocated. In the case of a non-grantor trust or estate, the W-2 wages are deemed to be allocated among the trust or estate and the various beneficiaries in the same manner as QPAI, as described below. Although a pass-thru entity's QPAI is computed by deducting wages paid by the entity during its entire taxable year, generally it is the pass-thru entity's W-2 wages (as shown on the Forms W-2 for the calendar year ending within that taxable year) that are used to compute the wage limitation under section 199(b) and an owner's allocable share of wages under section 199(d)(1)(B)(i). If QPAI, computed by taking into account only the items of the pass-thru entity allocated to the owner, is not greater than zero, the owner may not take into account the W-2 wages of the entity in computing the section 199(b) wage limitation.

A commentator requested that the proposed regulations clarify and illustrate by example how the section 199(d)(1)(B) wage limitation applies in a tiered partnership structure. In particular, the commentator suggested that the W-2 wages of a lower-tier partnership with positive QPAI are properly allocable to the partner of the upper-tier partnership even if the QPAI allocated to the partner from the upper-tier partnership is less than zero. The proposed regulations do not adopt this suggestion. The proposed regulations provide that the section 199(d)(1)(B) wage limitation must be applied at each level in a tiered structure. Thus, in a tiered structure, the owner of a pass-thru entity (including an owner that itself is a pass-thru entity) calculates the amounts described in section 199(d)(1)(B)(i) (allocable share) and (d)(1)(B)(ii) (twice the applicable percentage of the QPAI from the entity) separately with regard to its interest in that pass-thru entity. The proposed regulations provide rules regarding the treatment of W-2 wages when a pass-thru entity (upper-tier entity) owns an interest in one or more other pass-thru entities (lower-tier entities). An example in the proposed regulations illustrates the application of these rules.

The proposed regulations contain special rules for trusts and estates. To the extent that a grantor or another person is treated as owning all or part of a trust under sections 671 through 679 (grantor trust), the owner will compute its QPAI with respect to the owned portion of the trust as if that QPAI had been generated by activities performed directly by the owner. In the case of a non-grantor trust or estate, the DPGR and expenses needed to compute the QPAI, as well as the W-2 wages relevant to the computation of the wage limitation, must be allocated among the trust or estate and its various beneficiaries. Each beneficiary's share of the trust's or estate's QPAI (which will be less than zero if the CGS and the deductions allocated and apportioned to DPGR exceed the trust's or estate's DPGR) and W-2 wages will be determined based on the proportion of the trust's or estate's distributable net income (DNI), as defined by section 643(a), that is deemed to be distributed to that beneficiary for that taxable year. Similarly, the proportion of the entity's DNI that is not deemed distributed by the trust or estate will determine the entity's share of the QPAI and W-2 wages. In addition, if the trust or estate has no DNI in a particular taxable year, any QPAI and W-2 wages are allocated to the trust or estate, and not to any beneficiary.

Section 199(d)(1)(A)(i) provides that, in the case of an estate or trust (or other pass-thru entity), section 199 shall apply at the beneficiary (or similar) level. Pursuant to this provision, as clarified by the Congressional Letter, the proposed regulations provide that a trust or estate may claim the section 199 deduction to the extent that QPAI is allocated to it.

Solely for purposes of determining the section 199 deduction for the taxable year, the QPAI of a trust or estate must be computed by allocating the expenses described in section 199(d)(5) under § 1.652(b)-3 with respect to directly attributable expenses. With respect to other expenses described in section 199(d)(5), a trust or estate that qualifies for the simplified deduction method described in § 1.199-4(e) must use that method, and any other trust or estate must use the section 861 method described in § 1.199-4(d). The small business simplified overall method is not available to a trust or estate.

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, 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.

Section 199 applies to taxable years beginning after December 31, 2004. Accordingly, these proposed regulations apply to taxable years of pass-thru entities that begin on or after January 1, 2005. The IRS and Treasury Department recognize that a pass-thru entity will need to provide certain information to its owners to allow those persons to compute the section 199 deduction. No special provision with regard to information reporting is made for electing large partnerships (ELPs) as defined by section 775, which are subject to the same methods for allocating and apportioning deductions as are other partnerships. Thus, ELPs are required to provide the same information to their partners as other partnerships for purposes of computing the section 199 deduction. The IRS and the Treasury Department intend to provide information reporting rules for

pass-thru entities in the relevant forms and instructions.

Agricultural and Horticultural Cooperatives

A commentator suggested that the proposed regulations provide that patrons cannot include patronage dividends and per-unit retain certificates in the computation of the QPAI from the patron's other farming operations to the extent that those amounts were taken into account by a cooperative in determining the cooperative's section 199 deduction. The commentator stated that in many cases, both the cooperative and its patrons will be engaged in qualifying activities. For example, gross receipts from crops raised by a farmer in the United States may be eligible for the section 199 deduction as well as the receipts the cooperative derives from the marketing of the crop. To avoid duplication of section 199 benefits, the proposed regulations clarify that under § 1.199-6(h) patronage dividends and per-unit allocations a patron receives from a cooperative that are taken into account as part of the cooperative's computation of QPAI may not be taken into account in computing the patron's QPAI from its own qualifying activities. In addition, patronage dividends and per-unit retain allocations include any advances on patronage or per-unit retains paid in money made during the taxable year. Examples are provided to illustrate this rule.

A commentator suggested that the proposed regulations clarify the amount of the section 199 deduction a cooperative is required to pass through to its patrons. Accordingly, the proposed regulations clarify in § 1.199-6(d) that the cooperative may, at its discretion, pass through all, some, or none of the allowable section 199 deduction to its patrons.

A commentator suggested that it would be useful if the proposed regulations address whether a cooperative member of a federated cooperative may pass through to its patrons the section 199 deduction it receives as a patron cooperative. Accordingly, the proposed regulations in § 1.199-6(d) provide that a cooperative patron of a federated cooperative may pass through the section 199 deduction it receives to its member patrons.

A commentator requested that the proposed regulations address the form, content, and timing of the patron notification requirements. The commentator stated that the notice should not have to accompany the patronage distribution. For instance, a cooperative should be permitted to send out a notice passing through an estimated amount of the section 199 deduction at the time patronage dividends are paid and a second notice (when the Federal income tax return is completed and the section 199 deduction is actually determined) covering anything that was not passed through by the first notice, provided the notice is sent during the payment period in section 1382(d). The proposed regulations provide in § 1.199-6(b) that, in order for a patron to qualify for the section 199 deduction, the cooperative must designate the patron's portion of the section 199 deduction in a written notice mailed by the cooperative to its patrons no later than the 15th day of the ninth month following the close of the cooperative's taxable year. The cooperative may use the same written notice, if any, that it uses to notify patrons of their respective allocations of patronage dividends, or may use a separate timely written notice(s) to comply with this section. The cooperative must report the amount of the patron's section 199 deduction on Form 1099-PATR, “Taxable Distributions Received From Cooperative,” issued to the patron.

A commentator suggested that the proposed regulations clarify that patrons (whether they use the cash or accrual method of accounting) are entitled to claim the section 199 deduction passed through from the cooperative on the return for the taxable year in which they receive written notification from the cooperative. The proposed regulations provide in § 1.199-6(d) that patrons may claim the section 199 deduction for the taxable year they receive the written notice informing them of the section 199 deduction amount.

A commentator suggested that the proposed regulations clarify that the section 199 deduction of a cooperative is subject to the W-2 wage limitation under section 199(b) at the cooperative level and that it is not subject to a second W-2 wage limitation at the patron level to the extent the section 199 deduction is passed through to its patrons. The proposed regulations provide in § 1.199-6(e) that the W-2 wage limitation shall be applied only at the cooperative level whether or not the cooperative chooses to pass through some or all of the section 199 deduction. In addition, the proposed regulations in § 1.199-6(d) provide that patrons may claim the section 199 deduction without regard to the taxable income limitation.

A commentator suggested that the proposed regulations address what happens when an audit determination results in a decrease in the amount of a cooperative's section 199 deduction passed through to its patrons. The proposed regulations provide in § 1.199-6(f) that, if an audit determines or an amended return reports that the amount of the section 199 deduction that was passed through to patrons exceeded the amount determined to be allowable by the audit or on the amended return, recapture of the audit adjustment amount or excess amended return amount will occur at the cooperative level.

Expanded Affiliated Groups

Section 199(d)(4)(A) provides that all members of an EAG are treated as a single corporation for purposes of section 199.

The single corporation language in section 199(d)(4)(A) has created confusion among commentators and the proposed regulations clarify the meaning of this language. The proposed regulations provide that except as otherwise provided in the Code and regulations (see, for example, sections 199(c)(7) and 267, §§ 1.199-3(b) and 1.199-7(a)(3), and the consolidated return regulations), each member of an EAG is a separate taxpayer that computes its own taxable income or loss, QPAI, and W-2 wages, which are then aggregated at the EAG level. For example, if corporations X and Y are members of the same EAG, but are not members of the same consolidated group, and X sells QPP it MPGE within the United States to Y, the transaction is taken into account in determining the EAG's section 199 deduction. If X and Y are members of the same consolidated group, see the section entitled Consolidated Groups, below.

The IRS and Treasury Department believe that Congress intended that an EAG should be eligible for the section 199 deduction if the activities to produce QPP, qualified films, and utilities are done by one or more members of the EAG other than the member who leases, rents, licenses, sells, exchanges, or otherwise disposes of the QPP, qualified films, and utilities. Accordingly, 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, qualified films, and utilities MPGE or otherwise 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 films, and utilities in determining whether its gross receipts are DPGR. However, in general, attribution of

activities does not apply for purposes of the construction of real property under § 1.199-3(l)(1) or the performance of engineering and architectural services under § 1.199-3(m)(1). A member of an EAG must engage in a construction activity under § 1.199-3(l)(2), provide engineering services under § 1.199-3(m)(2), or provide architectural services under § 1.199-3(m)(3) in order for the member's gross receipts to be derived from construction, engineering, or architectural services. Notwithstanding the above, attribution of activities in the construction of real property and the performance of engineering and architectural services does apply for members of the same consolidated group. For example, if X and Y are members of the same EAG, but are not members of the same consolidated group, and X constructs a commercial building and sells the building to Y, and Y, who performs no construction activities with respect to the building, sells the building to an unrelated person, Y is not attributed the construction activities of X and Y's receipts from the sale of the building will not be DPGR. However, if X and Y are members of the same consolidated group, Y is attributed the construction activities of X and, assuming all the requirements of section 199(c) are met, Y's receipts will be DPGR.

Some commentators suggested that the proposed regulations provide a special rule excluding finance companies from an EAG. Section 199(d)(4)(A) specifically states that all members of an EAG shall be treated as a single corporation. Neither the statute nor the legislative history provide any exceptions that would allow taxpayers to exclude certain types of companies, including finance companies, from the EAG. Accordingly, the commentators' suggestion has not been adopted.

Notwithstanding that a transaction between members of the same EAG (an intragroup transaction) generally is taken into account in determining the section 199 deduction, the IRS and Treasury Department recognize that taxpayers may engage in an intragroup transaction in an attempt to obtain a section 199 deduction when none should be available. Accordingly, the proposed regulations retain the anti-avoidance rule contained in Notice 2005-14. Thus, if a transaction between members of the same EAG is engaged in or structured with a principal purpose of qualifying for, or increasing the amount of, the section 199 deduction of the EAG or the portion of the section 199 deduction allocated to one or more members of the EAG, adjustments must be made to eliminate the effect of the transaction on the computation of the section 199 deduction.

Some commentators asked whether the $25,000,000 and $5,000,000 average annual gross receipts thresholds for using the simplified deduction method and the small business simplified overall method, respectively, are applied at the EAG level, the consolidated group level, or at the member level. If the EAG was a single corporation, the $25,000,000 and $5,000,000 average annual gross receipts thresholds would take into account the activities of all the members of the EAG. Accordingly, the $25,000,000 and $5,000,000 average annual gross receipts thresholds are applied at the EAG level. Similarly, the new $10,000,000 total assets threshold for using the simplified deduction method and the new $5,000,000 current year CGS and deductions threshold for using the small business simplified overall method also are applied at the EAG level. The determination of whether a taxpayer is engaged in the trade or business of farming that is not required to use the accrual method of accounting under section 447 is determined by taking into account the activities of all the members of the EAG. Similarly, the determination of whether a taxpayer is eligible to use the cash method as provided in Rev. Proc. 2002-28, and is thus eligible to use the small business simplified overall method, is determined by taking into account the activities of all the members of the EAG.

Commentators requested that the rule in Notice 2005-14 that requires all members of the same EAG to use the same cost allocation method be changed to allow members to use different cost allocation methods. In response to the comments received, the IRS and Treasury Department agree that if an EAG is eligible to use the simplified deduction method, each member of the EAG may individually determine whether it wants to use the section 861 method or the simplified deduction method, notwithstanding that another member of the EAG uses a different method. Similarly, if the EAG is eligible to use the small business simplified overall method, each member of the EAG may individually determine whether it wants to use the section 861 method, the simplified deduction method, or the small business simplified overall method, notwithstanding that another member of the EAG uses a different method. However, if the EAG is not eligible to use either the simplified deduction method or the small business simplified overall method, then all members of the EAG must use the section 861 method. Notwithstanding that the members of an EAG generally are not required to use the same cost allocation method, each member of a consolidated group must use the same cost allocation method. Examples are provided to illustrate these provisions.

A commentator also asked at what level the

de minimis

rule described in § 1.199-1(d)(2) is tested. Section 1.199-1(d)(2) treats all of a taxpayer's gross receipts as DPGR if less than 5 percent of the taxpayer's total gross receipts are non-DPGR. 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. When considering the purpose of the

de minimis

rule, the IRS and Treasury Department believe that it is appropriate that the 5 percent threshold be determined at the corporation level, rather than at the EAG or consolidated group level.

Consolidated Groups

The section 199 deduction of a consolidated group (or the section 199 deduction allocated to a consolidated group that is a member of an EAG) is allocated to the members of the consolidated group in proportion to each consolidated group member's QPAI, regardless of whether the consolidated group member has separate taxable income or loss or W-2 wages for the taxable year. Further, if two or more members of a consolidated group engage in an intercompany transaction, as defined in § 1.1502-13(b)(1), the proposed regulations clarify that if an item of income, gain, deduction, or loss is not yet taken into account under § 1.1502-13, the intercompany transaction that gave rise to the item is not taken into account in computing the section 199 deduction until the time and in the same proportion that the item is taken into account under § 1.1502-13. For example, if corporations X and Y file a consolidated Federal income tax return and X sells QPP it MPGE within the United States to Y, the transaction is not taken into account until the time (and in the same proportion) provided in the matching rule of § 1.1502-13(c) or the acceleration rule of § 1.1502-13(d). The proposed regulations provide examples to illustrate these principles.

Some commentators suggested that if X's receipts from an intercompany transaction with consolidated group member Y are non-DPGR (for example, X licenses non-QPP to Y) and Y's CGS and other deductions from the intercompany transaction are taken into

account in determining the consolidated group's QPAI, the consolidated group's QPAI could be different than if X and Y were divisions of a single corporation, contrary to the general intent of § 1.1502-13. The consolidated return regulations already prevent this result. Under § 1.1502-13(c)(1)(i) and (c)(4), X's, Y's, or both X's and Y's separate entity attributes must be redetermined to the extent necessary to treat X and Y as if they were divisions of a single corporation. Thus, X's income may be redetermined to be DPGR (notwithstanding section 199(c)(7) or that the item licensed by X in the intercompany transaction does not otherwise meet the requirements of section 199(c)) or Y's CGS and other deductions from the intercompany transaction may be redetermined to be not allocable to DPGR, whichever produces the effect as though X and Y were divisions of a single corporation. Similarly, if X MPGE QPP within the United States and sells the QPP to Y, but Y does not use the QPP in creating DPGR, in order to produce the effect as though X and Y were divisions of a single corporation, X's gross receipts from the sale of the QPP may be redetermined to be non-DPGR or Y's CGS and other deductions may be redetermined to be allocable to DPGR. In addition, if X MPGE QPP within the United States and sells the QPP to Y, and Y sells the QPP to an unrelated person, X's gross receipts may be redetermined to be non-DPGR (and non-receipts) and Y's CGS and other deductions may be redetermined to be not allocable to DPGR, to the extent necessary to produce the effect as though X and Y were divisions of a single corporation. The proposed regulations provide examples to illustrate the situations described above.

Some commentators asked whether the section 199 deduction results in a downward basis adjustment under § 1.1502-32 if the deduction is allocated to a subsidiary member (S) of a consolidated group. Section 1.1502-32(b)(3)(ii)(B) already addresses this situation. Although the section 199 deduction is taken into account under the general operating rules of § 1.1502-32(b)(3)(i), paragraph (b)(3)(ii)(B) of that section provides that not only is S's income taken into account under the general operating rules of § 1.1502-32(b)(3)(i), but an amount of S's income equivalent to the section 199 deduction is also treated as being tax-exempt income under § 1.1502-32(b)(3)(ii)(A). The net result is that the basis that P (S's parent) has in its S stock is not reduced on account of the section 199 deduction. For example, if S earns $100 and is entitled to a $9 section 199 deduction, P's basis in S increases by $100 because the $100 income and the $9 deduction are taken into account under § 1.1502-32(b)(3)(i) (resulting in $91 of the increase) and $9 of the income also is taken into account under § 1.1502-32(b)(3)(ii)(A) as tax-exempt income (resulting in $9 of the increase).

The proposed regulations treat a consolidated group as a single member of the EAG. For example, if A, B, C, S1, and S2 are members of the same EAG, and A, S1, and S2 are members of the same consolidated group (the A consolidated group), then the A consolidated group is treated as one member of the EAG. Thus, the EAG is considered to have three members, the A consolidated group, B, and C.

Alternative Minimum Tax

Section 199(d)(6), as clarified by the Congressional Letter, provides that for purposes of determining AMTI under section 55, the section 199 deduction must be computed in the same manner as for regular tax, except that in the case of a corporation, the taxable income limitation is the corporation's AMTI. Accordingly, the proposed regulations provide that for purposes of determining AMTI under section 55, a taxpayer that is not a corporation 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 QPAI for the taxable year, or the taxpayer's taxable income for the taxable year, determined without regard to the section 199 deduction (or in the case of an individual, AGI). In the case of a corporation (including a corporation subject to tax under section 511(a)), 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 QPAI for the taxable year, or the taxpayer's AMTI (as defined in section 55(b)(2)) for the taxable year, determined without regard to the section 199 deduction. For purposes of computing AMTI, QPAI is determined without regard to any adjustments under sections 56 through 59. In the case of an individual or a trust, AGI and taxable income are also determined without regard to any adjustments under sections 56 through 59. The amount of the deduction allowable for purposes of computing AMTI for any taxable year cannot exceed 50 percent of the W-2 wages of the employer for the taxable year (as determined under § 1.199-2).

Revocation of Election Under Section 631(a)

Section 102(c) of the Act allows a taxpayer to revoke an election under section 631(a) to treat the cutting of timber as a sale or exchange. Any section 631(a) election for a taxable year ending on or before October 22, 2004, may be revoked under section 102(c) of the Act for any taxable year ending after that date. In addition, any election under section 631(a) for a taxable year ending on or before October 22, 2004 (and any revocation of the election under section 102(c) of the Act), is disregarded for purposes of determining whether the taxpayer is eligible to make a subsequent election under section 631(a). A revocation under section 102(c) of the Act will remain in effect until the first taxable year for which the taxpayer makes a new election under section 631(a).

Commentators suggested that, if a taxpayer makes an election under section 631(a), section 199 should apply to any resulting section 1231 gain. A taxpayer that makes an election under section 631(a) reports the difference between the fair market value of the timber cut and its actual cost as section 1231 gain. The proposed regulations do not adopt the suggestion because timber is real property, not tangible personal property, and the cutting of timber does not qualify under section 199(c)(4)(A)(i)(I). In the case of a taxpayer who does not make an election under section 631(a), or a taxpayer who revokes an election under section 631(a) pursuant to section 102(c) of the Act, the cutting and sawing of timber produces lumber which qualifies as tangible personal property. The gross receipts derived by a taxpayer from the sale of lumber it produces qualify as DPGR (assuming all the other requirements of section 199(c) are met).

Proposed Effective Date

The regulations are proposed to be applicable to taxable years beginning after December 31, 2004. Section 199 applies to taxable years of pass-thru entities beginning after December 31, 2004. Accordingly, section 199 does not apply to taxable years of pass-thru entities beginning before January 1, 2005. For example, assume a pass-thru entity has a taxable year beginning July 1, 2004, and ending June 30, 2005, and the owners of the pass-thru entity have calendar taxable years. Because section 199 first applies to the pass-thru entity for its taxable year beginning July 1, 2005, the first taxable year in which an

owner of the pass-thru entity will be eligible to claim a section 199 deduction for the owner's allocable or pro rata share of items allocated or apportioned to the qualified production activities of the pass-thru entity will be the calendar year 2006. Conversely, assume that a pass-thru entity has a calendar taxable year beginning January 1, 2005, and has a short taxable year ending on June 30, 2005, due to the termination of the entity. Assume the owners of that pass-thru entity have taxable years beginning July 1, 2004, and ending June 30, 2005. Because section 199 first applies to the owners for their taxable years beginning July 1, 2005, under § 1.199-8(g), the owners of the pass-thru entity will be ineligible to claim a section 199 deduction for the owners' allocable or pro rata share of items allocated or apportioned to the qualified production activities of the pass-thru entity for their taxable years ending June 30, 2005.

Until the date final regulations are published in the

Federal Register

, the proposed regulations provide that taxpayers may rely on the rules set forth in the interim guidance on section 199 as set forth in Notice 2005-14 (Notice) as well as the proposed regulations under §§ 1.199-1 through 1.199-8 (proposed regulations). For this purpose, if the proposed regulations and the Notice include different rules for the same particular issue, then the taxpayer may rely on either the rule set forth in the proposed regulations or the rule set forth in the Notice. For example, the Notice and the proposed regulations both include the small business simplified overall method, however the eligibility requirements for the method under the Notice have been modified in the proposed regulations. Accordingly, a taxpayer may rely on the eligibility requirements for the method set forth in either the Notice or the proposed regulations. However, if the proposed regulations include a rule that was not included in the Notice, taxpayers are not permitted to rely on the absence of a rule to apply a rule contrary to the proposed regulations. For example, Notice 2005-14 does not include any rules regarding the treatment of hedging transactions whereas the proposed regulations include such rules. Accordingly, taxpayers are not permitted to treat hedging transactions contrary to the treatment provided in the proposed regulations.

Request for Comments

The IRS and Treasury Department invite taxpayers to submit comments on issues relating to section 199. The IRS and Treasury Department intend to finalize the proposed regulations as soon as possible so taxpayers will have the final regulations as they begin to prepare their 2005 Federal income tax returns. Accordingly, the IRS and Treasury Department encourage taxpayers to submit their comments by January 3, 2006 so they can be given proper consideration. In particular, the IRS and Treasury Department encourage taxpayers to submit comments on the following issues:

1. Questions have arisen as to the applicability under section 199 of a Large and Mid-Size Business (LMSB) directive dated March 14, 2002, “Field Directive on the Use of Estimates from Probability Samples,” that authorizes in appropriate circumstances the use of statistical sampling by taxpayers. LMSB taxpayers are not precluded from applying the concepts of the LMSB directive for purposes of section 199. The proposed regulations do not provide specific rules on the use of statistical sampling for 199 purposes, however comments are requested on how 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.

2. Taxpayers are eligible to make certain elections under the section 861 regulations. For example, § 1.861-9T(g)(1)(ii) permits a taxpayer to elect to determine the value of its assets on the basis of either their tax book value or fair market value. Some of the elections under the section 861 regulations require the consent of the Commissioner to revoke or to change to another method. See §§ 1.861-8T(c)(2), 1.861-9T(i)(2), and 1.861-17(e). Because the section 861 method requires certain taxpayers to use the rules of the section 861 regulations in a new context, these taxpayers may want to reconsider previously made elections under those regulations. The IRS and Treasury Department intend to issue a revenue procedure granting taxpayers automatic consent to change certain elections under the section 861 regulations. Comments are requested concerning such an automatic consent procedure, including which elections should be included and the appropriate time period during which the automatic consent should apply.

3. The IRS and Treasury Department note that there are special rules regarding the application of the section 861 method in the case of affiliated groups. See section 864(e)(5) and (6); see also §§ 1.861-11(d)(7), 1.861-11T(d)(6), 1.861-14(d) and 1.861-14T. Comments are requested regarding whether additional guidance is needed to clarify how the rules under §§ 1.861-11T(c) and (g) and 1.861-14T(c) apply under the section 861 method to allocate and apportion interest and other expenses such as research and experimentation expenses in computing QPAI of the members of such affiliated groups in which otherwise includible corporations are owned indirectly through foreign corporations and partnerships.

4. Comments are requested concerning whether gross receipts derived from the provision of certain types of online software should qualify under section 199 as being derived from a lease, rental, license, sale, exchange, or other disposition of the software and, if so, how to distinguish between such types of online software.

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply. 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, as previously discussed, 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, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. Comments are requested on all aspects of the proposed regulations. In addition, the IRS and Treasury Department specifically request comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying.

A public hearing has been scheduled for Wednesday, January 11, 2006, at 10 a.m. in the IRS Auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW., Washington DC. Due to building security procedures, visitors

must enter at the Constitution Avenue entrance. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 30 minutes before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see the

FOR FURTHER INFORMATION CONTACT

section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons who wish to present oral comments at the hearing must submit electronic or written comments and an outline of the topics to be discussed and the time to be devoted to each topic (a signed original and eight (8) copies) by December 21, 2005. A period of 10 minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Drafting Information

The principal authors of these regulations are Paul Handleman and Lauren Ross Taylor, Office of Associate Chief Counsel (Passthroughs and Special Industries), IRS. However, other personnel from the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1—INCOME TAXES

Paragraph 1.

The authority citation for part 1 is amended by adding entries in numerical order to read, in part, as follows:

Authority:

26 U.S.C. 7805 * * *

Section 1.199-1 also issued under 26 U.S.C. 199(d).

Section 1.199-2 also issued under 26 U.S.C. 199(d).

Section 1.199-3 also issued under 26 U.S.C. 199(d).

Section 1.199-4 also issued under 26 U.S.C. 199(d).

Section 1.199-5 also issued under 26 U.S.C. 199(d).

Section 1.199-6 also issued under 26 U.S.C. 199(d).

Section 1.199-7 also issued under 26 U.S.C. 199(d).

Section 1.199-8 also issued under 26 U.S.C. 199(d). * * *

Par. 2.

Sections 1.199-0 through 1.199-8 are added to read as follows:

§ 1.199-0

Table of contents.

This section lists the headings that appear in §§ 1.199-1 through 1.199-8.

§ 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.

(1) In general.

(2) Definition of item.

(i) In general.

(ii) Examples.

(d) Allocation of gross receipts.

(1) In general.

(2) De minimis rule.

(3) Examples.

(e) Timing rules for determining QPAI.

(1) Gross receipts and costs recognized in different taxable years.

(2) Percentage of completion method.

(3) Example.

§ 1.199-2

Wage limitation.

(a) Rules of application.

(1) In general.

(2) Wages paid by entity other than common law employer.

(b) No application in determining whether amounts are wages for employment tax purposes.

(c) Application in case of taxpayer with short taxable year.

(d) Acquisition or disposition of a trade or business (or major portion).

(e) Non-duplication rule.

(f) Definition of W-2 wages.

(1) In general.

(2) Methods for calculating W-2 wages.

(i) Unmodified box method.

(ii) Modified Box 1 method.

(iii) Tracking wages method.

§ 1.199-3

Domestic production gross receipts.

(a) In general.

(b) Related persons.

(1) In general.

(2) Exceptions.

(c) Definition of gross receipts.

(d) 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.

(e) Definition of by the taxpayer.

(1) In general.

(2) Special rule for certain government contracts.

(3) Examples.

(f) Definition of in whole or in significant part.

(1) In general.

(2) Substantial in nature.

(3) Safe harbor.

(4) Examples.

(g) Definition of United States.

(h) Definition of derived from the lease, rental, license, sale, exchange, or other disposition.

(1) In general.

(2) Examples.

(3) Hedging transactions.

(i) In general.

(ii) Currency fluctuations.

(iii) Other rules.

(4) Allocation of gross receipts—embedded services and non-qualified property.

(i) In general.

(ii) Exceptions.

(iii) Examples.

(5) Advertising income.

(i) Tangible personal property.

(ii) Qualified films.

(iii) Examples.

(6) Computer software.

(i) In general.

(ii) Examples.

(7) Exception for certain oil and gas partnerships.

(i) In general.

(ii) Example.

(8) Partnerships owned by members of a single expanded affiliated group.

(i) In general.

(ii) Special rules for distributions from EAG partnerships.

(iii) Examples.

(9) Non-operating mineral interests.

(i) Definition of qualifying production property.

(1) In general.

(2) Tangible personal property.

(i) In general.

(ii) Local law.

(iii) Machinery.

(iv) 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.

(j) Definition of qualified film.

(1) In general.

(2) Tangible personal property with a film.

(i) Film licensed by a taxpayer.

(ii) Film produced by a taxpayer.

(A) Qualified films.

(B) Nonqualified films.

(3) Derived from a qualified film.

(4) Examples.

(5) Compensation for services.

(6) Determination of 50 percent.

(7) Exception.

(k) 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.

(5) Example.

(l) Definition of construction performed in the United States.

(1) Construction of real property.

(i) In general.

(ii) De minimis exception.

(2) Activities constituting construction.

(3) Definition of infrastructure.

(4) Definition of substantial renovation.

(5) Derived from construction.

(i) In general.

(ii) Land safe harbor.

(iii) Examples.

(m) Definition of engineering and architectural services.

(1) In general.

(2) Engineering services.

(3) Architectural services.

(4) De minimis exception for performance of services in the United States.

(n) Exception for sales of certain food and beverages.

(1) In general.

(2) Examples.

§ 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.

(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 allocable or apportioned to domestic production gross receipts or gross income attributable to domestic production gross receipts.

(1) In general.

(2) Treatment of certain deductions.

(i) In general.

(ii) Net operating losses.

(iii) Deductions not attributable to the conduct of a trade or business.

(d) Section 861 method.

(1) In general.

(2) Deductions for charitable contributions.

(3) Research and experimental expenditures.

(4) Deductions related to gross receipts deemed to be domestic production gross receipts.

(5) Examples.

(e) Simplified deduction method.

(1) In general.

(2) 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) Members of an expanded affiliated group.

(i) In general.

(ii) Exception.

(iii) Examples.

(4) Ineligible pass-thru entities.

(g) Average annual gross receipts.

(1) In general.

(2) Members of an EAG.

(h) Total assets.

(1) In general.

(2) Members of an EAG.

(i) Total costs for the current taxable year.

(1) In general.

(2) Members of an EAG.

§ 1.199-5

Application of section 199 to pass-thru entities.

(a) Partnerships.

(1) Determination at partner level.

(2) Disallowed deductions.

(3) Partner's share of W-2 wages.

(4) Examples.

(b) S corporations.

(1) Determination at shareholder level.

(2) Disallowed deductions.

(3) Shareholder's share of W-2 wages.

(c) Grantor trusts.

(d) Non-grantor trusts and estates.

(1) Computation of section 199 deduction.

(2) Example.

(e) Gain or loss from the disposition of an interest in a pass-thru entity.

(f) Section 199(d)(1)(B) wage limitation and tiered structures.

(1) In general.

(2) Share of W-2 wages.

(3) Example.

(g) No attribution of qualified activities.

§ 1.199-6

Agricultural and horticultural cooperatives.

(a) In general.

(b) Written notice to patrons.

(c) Determining cooperative's qualified production activities income.

(d) Additional rules relating to pass-through of section 199 deduction.

(e) W-2 wages.

(f) Recapture of section 199 deduction.

(g) Section is exclusive.

(h) No double counting.

(i) Examples.

§ 1.199-7

Expanded affiliated groups.

(a) In general.

(1) Definition of expanded affiliated group.

(2) Identification of members of an expanded affiliated group.

(i) In general.

(ii) Becoming or ceasing to be a member of an expanded affiliated group.

(3) Attribution of activities.

(4) Examples.

(5) Anti-avoidance rule.

(b) Computation of expanded affiliated group's section 199 deduction.

(1) In gen

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